Principles of Macro-Economics

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PRINCIPLES OF

ECONOMICS Eighth Edition

N. GREGORY MANKIW H A RVA R D U N I V E R S I T Y

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

To Catherine, Nicholas, and Peter,

my other contributions to the next generation

About the Author

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

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

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

Jo rd

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Brief Contents

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

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

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

of Markets 133

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

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

PART V Firm Behavior and the Organization of Industry 245

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

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

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

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

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

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

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

Basic Concepts 653

32 A Macroeconomic Theory of the Open Economy 677

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

on Aggregate Demand 737

35 The Short-Run Trade-off between Inflation and Unemployment 763

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

Brief Contents

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

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

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

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

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

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

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

N. Gregory Mankiw December 2016

Preface: To the Student

Video A pplication

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

introduced to the subject matter. Developed by Professor Mike Brandl of The

Ohio State University, these concept-based animations provide students with

memorable context to the key

terminology required for your

introductory economics course.

C onceptClip Videos

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

in every chapter by delivering a highly relevant

deposition on the real-world context to the

economic principles that will be appearing in

the upcoming chapter. These videos are intended

to motivate students to better understand how

economics relates to their day-to-day lives and

in the world around them.

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G raph Builder

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Adaptive Test Prep Prepares Your

Students for High-Stakes Testing

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

questions in the exam do not have the same look and feel

as their homework assignments?

Adaptive Test Prep is a powerful tool that uses 4,000 new

test bank-like questions to give students almost unlimited

practice for each chapter and section. They can take as

many tests as they like that are immediately graded for

them. Students see how they did and the program

gives them immediate remediation in the form of

very robust feedback, a link right back into the text

where the question topic resides, and for about

2,000 questions, they get a brief Quick Coach video

with an instructor walking them through the exact

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Students can generate reports that show them

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

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

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

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

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

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

Mark Abajian, San Diego Mesa College

Rahi Abouk, University of Wisconsin Milwaukee

Mathew Abraham, Indiana University – Purdue University Indianapolis

Nathanael Adams, Cardinal Stritch University

Seemi Ahmad, Dutchess Community College

May Akabogu-Collins, Mira Costa College–Oceanside

Ercument Aksoy, Los Angeles Valley College

Basil Al-Hashimi, Mesa Community College

Rashid Al-Hmoud, Texas Tech University

William Aldridge, University of Alabama–Tuscaloosa

Donald L. Alexander, Western Michigan University

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

Pacific Shahina Amin, University of Northern

Iowa Catalina Amuedo-Dorantes,

San Diego State University Vivette Ancona, Hunter

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

Massachusetts Boston Becca Arnold, San Diego Community

College

Ali Ataiifar, Delaware County Community College

Shannon Aucoin, University of Louisiana Lafayette

Lisa Augustyniak, Lake Michigan College

Wesley Austin, University of Louisiana Lafayette

Dennis Avola, Framingham State University

Regena M. Aye, Allen Community College

Sang Hoo Bae, Clark University Karen Baehler, Hutchinson

Community College Sahar Bahmani, University of

Wisconsin-Parkside Mohsen Bahmani-Oskooee,

University of Wisconsin Milwaukee

Acknowledgments

xiACKNOWLEDGMENTS

Richard Baker, Copiah-Lincoln Community College

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

University Christoph Bauner, University of

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

California Nihal Bayraktar, Pennsylvania State

University Mike Belleman, St. Clair County

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

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

Community College Stacey Bertke, Owensboro Community &

Technical College Tibor Besedes, Georgia Institute of

Technology Abhijeet Bhattacharya, Illinois Valley

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

Islands Nicole Bissessar, Kent State

University-Ashtabula Janet Blackburn, San Jacinto South

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

Pan American Mike Bowyer, Montgomery Community

College William Brennan, Minnesota State

University–Mankato Genevieve Briand, Washington State

University Scott Broadbent, Western Kentucky

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

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

Minnesota-Crookston Christopher Brunt, Lake Superior State

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

Tennessee–Knoxville Don Bumpass, Sam Houston State

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

Oklahoma Rob Burrus, University of North

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

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

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

Wisconsin–Milwaukee Kalyan Chakraborty, Emporia State

University Suparna Chakraborty, Baruch

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

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

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

Seattle Kirill Chernomaz, San Francisco State

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

Oklahoma Mainul Chowdhury, Northern Illinois

University

Dmitriy Chulkov, Indiana University Kokomo

Lawrence Cima, John Carroll University Cindy Clement, University of

Maryland Matthew Clements, St. Edward’s

University Sondra Collins, University of Southern

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

University Kathleen Conway, Carnegie Mellon

University Stephen Cotten, University of Houston

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

Tennessee–Knoxville Matt Critcher, University of Arkansas

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

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

College Maria DaCosta, University of

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

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

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

State University Ahrash Dianat, George Mason

University Stephanie Dieringer, University of South

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

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

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

xii ACKNOWLEDGMENTS

Caf Dowlah, Queensborough Community College–CUNY

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

college Nazif Durmaz, University of

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

Alabama–Tuscaloosa Lynne Elkes, Loyola University

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

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

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

Maryland MohammadMahdi Farsiabi, Wayne

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

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

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

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

Birmingham Robert Gentenaar, Pima Downtown

Community College Soma Ghosh, Albright College

Edgar Ghossoub, University of Texas at San Antonio

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

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

University Joel Goldhar, IIT/Stuart School of

Business Michael Goode, Central Piedmont

Community College Michael J Gootzeit, University of

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

University Ilhami Gunduz, Brooklyn

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

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

LaCrosse David Hedrick, Central Washington

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

University Alexander Hill, University of

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

Oklahoma Kuang-Chung Hsu, University of

Central Oklahoma Jim Hubert, Seattle Central Community

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

Memphis Christopher Hyer, University of New

Mexico Kent Hymel, California State

University–Northridge Miren Ivankovic, Anderson University

Eric Jacobson, University of Delaware Bolormaa Jamiyansuren, Augsburg

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

University Ricot Jean, Valencia College Michal Jerzmanowski, Clemson

University Bonnie Johnson, California Lutheran

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

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

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

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

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

York-Fredonia David Karemera, St. Cloud State

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University-Pomona Wahhab Khandker, University of

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

Wisconsin–EauClaire Oleg Korenok, Virginia Commonwealth

University Janet Koscianski, Shippensburg

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

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

xiiiACKNOWLEDGMENTS

Yuexing Lan, Auburn Montgomery Daniel Lawson, Oakland Community

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

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

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and Northwestern University Brinda Mahalingam, University of

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Maryland

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Wisconsin–Eau Claire Meghan Mihal, St. Thomas Aquinas

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Rose James Murray, University of

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Technology Jason Patalinghug, University of New

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College

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Community College

xiv ACKNOWLEDGMENTS

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

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

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University

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Alabama Vera Tabakova, East Carolina U

niversity Ariuna Taivan, University of

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Orleans

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Mexico Chad Wassell, Central Washington

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Minnesota, Crookston Christopher Wimer, Bowling Green

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

Oklahoma Kent Zirlott, University of

Alabama–Tuscaloosa Joseph Zwiller,

Lake Michigan College

xvACKNOWLEDGMENTS

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

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

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

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

N. Gregory Mankiw December 2016

xvi

Contents

Preface: To the Student vi

Acknowledgments x

PART I Introduction 1 CHAPTER 1 Ten Principles of Economics 3

1-1 How People Make Decisions 4

1-1a Principle 1: People Face Trade-offs 4

1-1b Principle 2: The Cost of Something

Is What You Give Up to Get It 5

1-1c Principle 3: Rational People Think at the Margin 6

1-1d Principle 4: People Respond to Incentives 7

1-2 How People Interact 8

1-2a Principle 5: Trade Can Make Everyone Better Off 8

1-2b Principle 6: Markets Are Usually a Good Way to

Organize Economic Activity 9

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

Improve Market Outcomes 11

1-3 How the Economy as a Whole Works 13

1-3a Principle 8: A Country’s Standard of Living Depends

on Its Ability to Produce Goods and Services 13

1-3b Principle 9: Prices Rise When the Government

Prints Too Much Money 13

1-3c Principle 10: Society Faces a Short-Run Trade-off

between Inflation and Unemployment 14

1-4 Conclusion 15

Summary 16

Key Concepts 16

Questions for Review 16

Problems and Applications 17

CHAPTER 2 Thinking Like an Economist 19

2-1 The Economist as Scientist 20

2-1a The Scientific Method: Observation,

Theory, and More Observation 20

2-1b The Role of Assumptions 21

2-1c Economic Models 22

2-1d Our First Model: The Circular-Flow Diagram 22

2-1e Our Second Model: The Production Possibilities Frontier 24

2-1f Microeconomics and Macroeconomics 26

2-2 The Economist as Policy Adviser 27

2-2a Positive versus Normative Analysis 27

2-2b Economists in Washington 28

2-2c Why Economists’ Advice Is Not Always Followed 29

2-3 Why Economists Disagree 30

2-3a Differences in Scientific Judgments 30

2-3b Differences in Values 30

2-3c Perception versus Reality 31

ASK THE EXPERTS: Ticket Resale 32

2-4 Let’s Get Going 32

IN THE NEWS: Why You Should Study Economics 33 Summary 34

Key Concepts 34

Questions for Review 35

Problems and Applications 35

Appendix Graphing: A Brief Review 37

CHAPTER 3 Interdependence and the Gains from Trade 47

3-1 A Parable for the Modern Economy 48

3-1a Production Possibilities 49

3-1b Specialization and Trade 50

xviiCONTENTS

3-2 Comparative Advantage: The Driving Force

of Specialization 52

3-2a Absolute Advantage 52

3-2b Opportunity Cost and Comparative Advantage 52

3-2c Comparative Advantage and Trade 53

3-2d The Price of the Trade 54

FYI: The Legacy of Adam Smith and David Ricardo 55

3-3 Applications of Comparative Advantage 55

3-3a Should Serena Williams Mow Her Own Lawn? 55

IN THE NEWS: Economics within a Marriage 56 3-3b Should the United States Trade with Other Countries? 56

ASK THE EXPERTS: Trade between China and the United States 58

3-4 Conclusion 58

Summary 59

Key Concepts 59

Questions for Review 60

Problems and Applications 60

PART II How Markets Work 63

CHAPTER 4 The Market Forces of Supply and Demand 65

4-1 Markets and Competition 66

4-1a What Is a Market? 66

4-1b What Is Competition? 66

4-2 Demand 67

4-2a The Demand Curve: The Relationship between

Price and Quantity Demanded 67

4-2b Market Demand versus Individual Demand 68

4-2c Shifts in the Demand Curve 69

CASE STUDY: Two Ways to Reduce the Quantity of Smoking Demanded 71

4-3 Supply 73

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

and Quantity Supplied 73

4-3b Market Supply versus Individual Supply 74

4-3c Shifts in the Supply Curve 75

4-4 Supply and Demand Together 76

4-4a Equilibrium 76

4-4b Three Steps to Analyzing Changes in Equilibrium 78

4-5 Conclusion: How Prices Allocate Resources 83

ASK THE EXPERTS: Price Gouging 83 IN THE NEWS: Price Increases after Disasters 84

Summary 86

Key Concepts 86

Questions for Review 87

Problems and Applications 87

CHAPTER 5 Elasticity and Its Application 89

5-1 The Elasticity of Demand 90

5-1a The Price Elasticity of Demand and Its Determinants 90

5-1b Computing the Price Elasticity of Demand 91

5-1c The Midpoint Method: A Better Way to Calculate

Percentage Changes and Elasticities 92

5-1d The Variety of Demand Curves 93

FYI: A Few Elasticities from the Real World 93 5-1e Total Revenue and the Price Elasticity of Demand 95

5-1f Elasticity and Total Revenue along a Linear

Demand Curve 96

5-1g Other Demand Elasticities 98

5-2 The Elasticity of Supply 99

5-2a The Price Elasticity of Supply and Its Determinants 99

5-2b Computing the Price Elasticity of Supply 99

5-2c The Variety of Supply Curves 100

5-3 Three Applications of Supply, Demand, and Elasticity 102

5-3a Can Good News for Farming Be Bad News for

Farmers? 102

5-3b Why Did OPEC Fail to Keep the Price of Oil High? 104

5-3c Does Drug Interdiction Increase or Decrease

Drug-Related Crime? 105

5-4 Conclusion 107

Summary 108

Key Concepts 108

Questions for Review 109

Problems and Applications 109

CHAPTER 6 Supply, Demand, and Government Policies 111

6-1 Controls on Prices 112

6-1a How Price Ceilings Affect Market Outcomes 112

CASE STUDY: Lines at the Gas Pump 114

xviii CONTENTS

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

6-1b How Price Floors Affect Market Outcomes 116

ASK THE EXPERTS: Rent Control 116 CASE STUDY: The Minimum Wage 118 ASK THE EXPERTS: The Minimum Wage 119 6-1c Evaluating Price Controls 120

6-2 Taxes 120

6-2a How Taxes on Sellers Affect Market Outcomes 121

6-2b How Taxes on Buyers Affect Market Outcomes 122

CASE STUDY: Can Congress Distribute the Burden of a Payroll Tax? 124

6-2c Elasticity and Tax Incidence 124

CASE STUDY: Who Pays the Luxury Tax? 126

6-3 Conclusion 127

Summary 128

Key Concepts 128

Questions for Review 128

Problems and Applications 129

PART III Markets and Welfare 131

CHAPTER 7 Consumers, Producers, and the Efficiency of Markets 133

7-1 Consumer Surplus 134

7-1a Willingness to Pay 134

7-1b Using the Demand Curve to Measure Consumer

Surplus 135

7-1c How a Lower Price Raises Consumer Surplus 136

7-1d What Does Consumer Surplus Measure? 137

7-2 Producer Surplus 139

7-2a Cost and the Willingness to Sell 139

7-2b Using the Supply Curve to Measure Producer Surplus 140

7-2c How a Higher Price Raises Producer Surplus 141

7-3 Market Efficiency 142

7-3a The Benevolent Social Planner 143

7-3b Evaluating the Market Equilibrium 144

IN THE NEWS: The Invisible Hand Can Park Your Car 146 CASE STUDY: Should There Be a Market for Organs? 147 ASK THE EXPERTS: Supplying Kidneys 148

7-4 Conclusion: Market Efficiency and Market Failure 148

Summary 150

Key Concepts 150

Questions for Review 150

Problems and Applications 150

CHAPTER 8 Application: The Costs of Taxation 153

8-1 The Deadweight Loss of Taxation 154

8-1a How a Tax Affects Market Participants 155

8-1b Deadweight Losses and the Gains from Trade 157

8-2 The Determinants of the Deadweight Loss 158

CASE STUDY: The Deadweight Loss Debate 160

8-3 Deadweight Loss and Tax Revenue as Taxes Vary 161

CASE STUDY: The Laffer Curve and Supply-Side Economics 162

ASK THE EXPERTS: The Laffer Curve 163

8-4 Conclusion 164

Summary 165

Key Concept 165

Questions for Review 165

Problems and Applications 165

CHAPTER 9 Application: International Trade 167

9-1 The Determinants of Trade 168

9-1a The Equilibrium without Trade 168

9-1b The World Price and Comparative Advantage 169

9-2 The Winners and Losers from Trade 170

9-2a The Gains and Losses of an Exporting Country 170

9-2b The Gains and Losses of an Importing Country 171

9-2c Effects of a Tariff 173

FYI: Import Quotas: Another Way to Restrict Trade 175 9-2d The Lessons for Trade Policy 175

9-2e Other Benefits of International Trade 176

IN THE NEWS: Trade as a Tool for Economic Development 177

9-3 The Arguments for Restricting Trade 178

9-3a The Jobs Argument 178

IN THE NEWS: Should the Winners from Free Trade Compensate the Losers? 179

9-3b The National-Security Argument 180

9-3c The Infant-Industry Argument 180

9-3d The Unfair-Competition Argument 181

9-3e The Protection-as-a-Bargaining-Chip Argument 181

xixCONTENTS

CASE STUDY: Trade Agreements and the World Trade Organization 181

ASK THE EXPERTS: Trade Deals 182

9-4 Conclusion 182

Summary 184

Key Concepts 184

Questions for Review 184

Problems and Applications 185

PART IV The Economics of the Public Sector 187

CHAPTER 10 Externalities 189

10-1 Externalities and Market Inefficiency 191

10-1a Welfare Economics: A Recap 191

10-1b Negative Externalities 192

10-1c Positive Externalities 193

CASE STUDY: Technology Spillovers, Industrial Policy, and Patent Protection 194

10-2 Public Policies toward Externalities 195

10-2a Command-and-Control Policies: Regulation 195

10-2b Market-Based Policy 1: Corrective Taxes and

Subsidies 196

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

Change? 199

10-2c Market-Based Policy 2: Tradable Pollution

Permits 200

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

10-3 Private Solutions to Externalities 202

10-3a The Types of Private Solutions 202

10-3b The Coase Theorem 203

10-3c Why Private Solutions Do Not Always Work 204

IN THE NEWS: The Coase Theorem in Action 205

10-4 Conclusion 206

Summary 207

Key Concepts 207

Questions for Review 207

Problems and Applications 208

CHAPTER 11 Public Goods and Common Resources 211

11-1 The Different Kinds of Goods 212

11-2 Public Goods 214

11-2a The Free-Rider Problem 214

11-2b Some Important Public Goods 214

CASE STUDY: Are Lighthouses Public Goods? 216 11-2c The Difficult Job of Cost–Benefit Analysis 216

CASE STUDY: How Much Is a Life Worth? 217

11-3 Common Resources 218

11-3a The Tragedy of the Commons 218

11-3b Some Important Common Resources 219

ASK THE EXPERTS: Congesting Pricing 219 IN THE NEWS: The Case for Toll Roads 220 CASE STUDY: Why the Cow Is Not Extinct 222

11-4 Conclusion: The Importance of Property Rights 223

Summary 224

Key Concepts 224

Questions for Review 224

Problems and Applications 224

CHAPTER 12 The Design of the Tax System 227

12-1 An Overview of U.S. Taxation 228

12-1a Taxes Collected by the Federal Government 228

12-1b Taxes Collected by State and Local Governments 231

12-2 Taxes and Efficiency 232

12-2a Deadweight Losses 232

CASE STUDY: Should Income or Consumption Be Taxed? 233

12-2b Administrative Burden 234

12-2c Marginal Tax Rates versus Average Tax Rates 235

12-2d Lump-Sum Taxes 235

12-3 Taxes and Equity 236

12-3a The Benefits Principle 236

12-3b The Ability-to-Pay Principle 237

CASE STUDY: How the Tax Burden Is Distributed 238 12-3c Tax Incidence and Tax Equity 239

IN THE NEWS: Tax Expenditures 240 CASE STUDY: Who Pays the Corporate Income Tax? 240

12-4 Conclusion: The Trade-off between Equity and

Efficiency 242

Summary 243

Key Concepts 243

Questions for Review 244

Problems and Applications 244

xx CONTENTS

PART V Firm Behavior and the Organization of Industry 245

CHAPTER 13 The Costs of Production 247

13-1 What Are Costs? 248

13-1a Total Revenue, Total Cost, and Profit 248

13-1b Costs as Opportunity Costs 249

13-1c The Cost of Capital as an Opportunity Cost 249

13-1d Economic Profit versus Accounting Profit 250

13-2 Production and Costs 251

13-2a The Production Function 251

13-2b From the Production Function to the Total-Cost

Curve 253

13-3 The Various Measures of Cost 254

13-3a Fixed and Variable Costs 255

13-3b Average and Marginal Cost 255

13-3c Cost Curves and Their Shapes 256

13-3d Typical Cost Curves 258

13-4 Costs in the Short Run and in the Long Run 259

13-4a The Relationship between Short-Run and Long-Run

Average Total Cost 260

13-4b Economies and Diseconomies of Scale 261

FYI: Lessons from a Pin Factory 261

13-5 Conclusion 262

Summary 263

Key Concepts 264

Questions for Review 264

Problems and Applications 264

CHAPTER 14 Firms in Competitive Markets 267

14-1 What Is a Competitive Market? 268

14-1a The Meaning of Competition 268

14-1b The Revenue of a Competitive Firm 269

14-2 Profit Maximization and the Competitive Firm’s

Supply Curve 270

14-2a A Simple Example of Profit Maximization 270

14-2b The Marginal-Cost Curve and the Firm’s Supply

Decision 271

14-2c The Firm’s Short-Run Decision to Shut Down 273

14-2d Spilt Milk and Other Sunk Costs 275

CASE STUDY: Near-Empty Restaurants and Off-Season Miniature Golf 275

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

Market 276

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

Firm 277

14-3 The Supply Curve in a Competitive Market 279

14-3a The Short Run: Market Supply with a Fixed Number

of Firms 279

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

and Exit 279

14-3c Why Do Competitive Firms Stay in Business

If They Make Zero Profit? 280

14-3d A Shift in Demand in the Short Run and

Long Run 281

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

Upward 282

14-4 Conclusion: Behind the Supply Curve 284

Summary 285

Key Concepts 285

Questions for Review 285

Problems and Applications 286

CHAPTER 15 Monopoly 289

15-1 Why Monopolies Arise 290

15-1a Monopoly Resources 291

15-1b Government-Created Monopolies 291

15-1c Natural Monopolies 292

15-2 How Monopolies Make Production and Pricing

Decisions 293

15-2a Monopoly versus Competition 293

15-2b A Monopoly’s Revenue 294

15-2c Profit Maximization 296

15-2d A Monopoly’s Profit 298

FYI: Why a Monopoly Does Not Have a Supply Curve 298 CASE STUDY: Monopoly Drugs versus Generic Drugs 299

xxiCONTENTS

15-3 The Welfare Cost of Monopolies 300

15-3a The Deadweight Loss 301

15-3b The Monopoly’s Profit: A Social Cost? 303

15-4 Price Discrimination 303

15-4a A Parable about Pricing 304

15-4b The Moral of the Story 305

15-4c The Analytics of Price Discrimination 305

15-4d Examples of Price Discrimination 306

IN THE NEWS: Price Discrimination in Higher Education 308

15-5 Public Policy toward Monopolies 308

15-5a Increasing Competition with Antitrust Laws 308

15-5b Regulation 309

ASK THE EXPERTS: Airline Mergers 309 15-5c Public Ownership 310

15-5d Doing Nothing 311

15-6 Conclusion: The Prevalence of Monopolies 311

Summary 313

Key Concepts 313

Questions for Review 314

Problems and Applications 314

CHAPTER 16 Monopolistic Competition 319

16-1 Between Monopoly and Perfect Competition 320

16-2 Competition with Differentiated Products 322

16-2a The Monopolistically Competitive Firm in the

Short Run 322

16-2b The Long-Run Equilibrium 323

16-2c Monopolistic versus Perfect Competition 324

16-2d Monopolistic Competition and the Welfare of

Society 327

16-3 Advertising 328

16-3a The Debate over Advertising 328

CASE STUDY: Advertising and the Price of Eyeglasses 329 16-3b Advertising as a Signal of Quality 330

16-3c Brand Names 331

16-4 Conclusion 332

Summary 333

Key Concepts 334

Questions for Review 334

Problems and Applications 334

CHAPTER 17 Oligopoly 337

17-1 Markets with Only a Few Sellers 338

17-1a A Duopoly Example 338

17-1b Competition, Monopolies, and Cartels 339

17-1c The Equilibrium for an Oligopoly 340

17-1d How the Size of an Oligopoly Affects the Market

Outcome 341

ASK THE EXPERTS: Nash Equilibrium 341

17-2 The Economics of Cooperation 342

17-2a The Prisoners’ Dilemma 343

17-2b Oligopolies as a Prisoners’ Dilemma 344

CASE STUDY: OPEC and the World Oil Market 345 17-2c Other Examples of the Prisoners’ Dilemma 346

17-2d The Prisoners’ Dilemma and the Welfare of Society 347

17-2e Why People Sometimes Cooperate 348

CASE STUDY: The Prisoners’ Dilemma Tournament 348

17-3 Public Policy toward Oligopolies 349

17-3a Restraint of Trade and the Antitrust Laws 349

CASE STUDY: An Illegal Phone Call 350 17-3b Controversies over Antitrust Policy 350

CASE STUDY: The Microsoft Case 352 IN THE NEWS: Europe versus Google 354

17-4 Conclusion 354

Summary 355

Key Concepts 356

Questions for Review 356

Problems and Applications 356

PART VI The Economics of Labor Markets 359

CHAPTER 18 The Markets for the Factors of Production 361

18-1 The Demand for Labor 362

18-1a The Competitive Profit-Maximizing Firm 363

18-1b The Production Function and the Marginal Product of

Labor 363

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

Labor 365

18-1d What Causes the Labor-Demand Curve to Shift? 366

FYI: Input Demand and Output Supply: Two Sides of the Same Coin 367

18-2 The Supply of Labor 368

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

xxii CONTENTS

18-2b What Causes the Labor-Supply Curve to Shift? 368

ASK THE EXPERTS: Immigration 369

18-3 Equilibrium in the Labor Market 369

18-3a Shifts in Labor Supply 370

18-3b Shifts in Labor Demand 371

IN THE NEWS: The Economics of Immigration 372 CASE STUDY: Productivity and Wages 373 FYI: Monopsony 374

18-4 The Other Factors of Production: Land and Capital 375

18-4a Equilibrium in the Markets for Land and Capital 375

FYI: What Is Capital Income? 376 18-4b Linkages among the Factors of Production 377

CASE STUDY: The Economics of the Black Death 377

18-5 Conclusion 378

Summary 379

Key Concepts 379

Questions for Review 379

Problems and Applications 380

CHAPTER 19 Earnings and Discrimination 383

19-1 Some Determinants of Equilibrium Wages 384

19-1a Compensating Differentials 384

19-1b Human Capital 385

CASE STUDY: The Increasing Value of Skills 385 ASK THE EXPERTS: Inequality and Skills 386 IN THE NEWS: Schooling as a Public Investment 387 19-1c Ability, Effort, and Chance 388

CASE STUDY: The Benefits of Beauty 388 19-1d An Alternative View of Education: Signaling 389

19-1e The Superstar Phenomenon 390

19-1f Above-Equilibrium Wages: Minimum-Wage Laws,

Unions, and Efficiency Wages 390

19-2 The Economics of Discrimination 391

19-2a Measuring Labor-Market Discrimination 391

CASE STUDY: Is Emily More Employable than Lakisha? 393

19-2b Discrimination by Employers 393

CASE STUDY: Segregated Streetcars and the Profit Motive 394

19-2c Discrimination by Customers and

Governments 395

CASE STUDY: Discrimination in Sports 395

19-3 Conclusion 396

Summary 397

Key Concepts 398

Questions for Review 398

Problems and Applications 398

CHAPTER 20 Income Inequality and Poverty 401

20-1 The Measurement of Inequality 402

20-1a U.S. Income Inequality 402

20-1b Inequality around the World 403

IN THE NEWS: A Worldwide View of the Income Distribution 405

20-1c The Poverty Rate 406

20-1d Problems in Measuring Inequality 407

CASE STUDY: Alternative Measures of Inequality 408 20-1e Economic Mobility 409

20-2 The Political Philosophy of Redistributing Income 409

20-2a Utilitarianism 410

20-2b Liberalism 411

20-2c Libertarianism 412

20-3 Policies to Reduce Poverty 413

20-3a Minimum-Wage Laws 413

20-3b Welfare 414

20-3c Negative Income Tax 414

20-3d In-Kind Transfers 415

20-3e Antipoverty Programs and Work Incentives 415

IN THE NEWS: International Differences in Income Redistribution 416

20-4 Conclusion 418

Summary 419

Key Concepts 420

Questions for Review 420

Problems and Applications 420

PART VII Topics for Further Study 423

CHAPTER 21 The Theory of Consumer Choice 425

21-1 The Budget Constraint: What the Consumer

Can Afford 426

21-2 Preferences: What the Consumer Wants 428

21-2a Representing Preferences with Indifference

Curves 428

21-2b Four Properties of Indifference Curves 429

xxiiiCONTENTS

21-2c Two Extreme Examples of Indifference Curves 430

21-3 Optimization: What the Consumer Chooses 432

21-3a The Consumer’s Optimal Choices 432

FYI: Utility: An Alternative Way to Describe Preferences and Optimization 433

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

Choices 434

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

Choices 435

21-3d Income and Substitution Effects 436

21-3e Deriving the Demand Curve 438

21-4 Three Applications 439

21-4a Do All Demand Curves Slope Downward? 439

CASE STUDY: The Search for Giffen Goods 440 21-4b How Do Wages Affect Labor Supply? 440

CASE STUDY: Income Effects on Labor Supply: Historical Trends, Lottery Winners, and the Carnegie Conjecture 443

21-4c How Do Interest Rates Affect Household Saving? 444

21-5 Conclusion: Do People Really Think This Way? 446

Summary 447

Key Concepts 448

Questions for Review 448

Problems and Applications 448

CHAPTER 22 Frontiers of Microeconomics 451

22-1 Asymmetric Information 452

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

Hazard 452

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

the Lemons Problem 454

22-1c Signaling to Convey Private Information 455

CASE STUDY: Gifts as Signals 455 22-1d Screening to Uncover Private Information 456

22-1e Asymmetric Information and Public Policy 456

22-2 Political Economy 457

22-2a The Condorcet Voting Paradox 457

22-2b Arrow’s Impossibility Theorem 458

22-2c The Median Voter Is King 459

22-2d Politicians Are People Too 461

22-3 Behavioral Economics 461

22-3a People Aren’t Always Rational 462

22-3b People Care about Fairness 463

IN THE NEWS: Using Deviations from Rationality 464 22-3c People Are Inconsistent over Time 466

22-4 Conclusion 467

Summary 468

Key Concepts 468

Questions for Review 468

Problems and Applications 468

PART VIII The Data of Macroeconomics 471

CHAPTER 23 Measuring a Nation’s Income 473

23-1 The Economy’s Income and Expenditure 474

23-2 The Measurement of GDP 476

23-2a “GDP Is the Market Value . . .” 476

23-2b “. . . of All . . .” 476

23-2c “. . . Final . . .” 476

23-2d “. . . Goods and Services . . .” 477

23-2e “. . . Produced . . .” 477

23-2f “. . . Within a Country . . .” 477

23-2g “. . . In a Given Period of Time.” 477

FYI: Other Measures of Income 478

23-3 The Components of GDP 479

23-3a Consumption 479

23-3b Investment 479

IN THE NEWS: Sex, Drugs, and GDP 480 23-3c Government Purchases 480

23-3d Net Exports 480

CASE STUDY: The Components of U.S. GDP 481

23-4 Real versus Nominal GDP 482

23-4a A Numerical Example 482

23-4b The GDP Deflator 484

CASE STUDY: A Half Century of Real GDP 485 IN THE NEWS: Gauging the High-Tech Economy 486

23-5 Is GDP a Good Measure of Economic Well-Being? 486

IN THE NEWS: Measuring Macroeconomic Well-Being 488 CASE STUDY: International Differences in GDP and the

Quality of Life 490

23-6 Conclusion 491

Summary 492

Key Concepts 492

Questions for Review 492

Problems and Applications 493

xxiv CONTENTS

CHAPTER 24 Measuring the Cost of Living 495

24-1 The Consumer Price Index 496

24-1a How the CPI Is Calculated 496

FYI: What’s in the CPI’s Basket? 498 24-1b Problems in Measuring the Cost of Living 499

IN THE NEWS: Monitoring Inflation in the Internet Age 500 24-1c The GDP Deflator versus the Consumer Price Index 502

24-2 Correcting Economic Variables for the Effects of

Inflation 503

24-2a Dollar Figures from Different Times 503

FYI: Mr. Index Goes to Hollywood 504 CASE STUDY: Regional Differences in the Cost of Living 505 24-2b Indexation 506

24-2c Real and Nominal Interest Rates 506

CASE STUDY: Interest Rates in the U.S. Economy 508

24-3 Conclusion 508

Summary 510

Key Concepts 510

Questions for Review 510

Problems and Applications 511

PART IX The Real Economy in the Long Run 513

CHAPTER 25 Production and Growth 515

25-1 Economic Growth around the World 516

25-2 Productivity: Its Role and Determinants 518

25-2a Why Productivity Is So Important 518

FYI: Are You Richer Than the Richest American? 518 25-2b How Productivity Is Determined 519

FYI: A Picture Is Worth a Thousand Statistics 520 FYI: The Production Function 523 CASE STUDY: Are Natural Resources a Limit to Growth? 524

25-3 Economic Growth and Public Policy 525

25-3a Saving and Investment 525

25-3b Diminishing Returns and the Catch-Up Effect 525

25-3c Investment from Abroad 527

25-3d Education 528

25-3e Health and Nutrition 528

25-3f Property Rights and Political Stability 529

25-3g Free Trade 530

25-3h Research and Development 531

ASK THE EXPERTS: Innovation and Growth 531 IN THE NEWS: Curmudgeon versus Optimist 532 25-3i Population Growth 534

IN THE NEWS: Using Experiments to Evaluate Aid 536

25-4 Conclusion: The Importance of Long-Run Growth 538

Summary 539

Key Concepts 539

Questions for Review 539

Problems and Applications 540

CHAPTER 26 Saving, Investment, and the Financial System 541

26-1 Financial Institutions in the U.S. Economy 542

26-1a Financial Markets 542

26-1b Financial Intermediaries 544

FYI: Key Numbers for Stock Watchers 545 26-1c Summing Up 546

26-2 Saving and Investment in the National Income

Accounts 547

26-2a Some Important Identities 547

26-2b The Meaning of Saving and Investment 549

26-3 The Market for Loanable Funds 549

26-3a Supply and Demand for Loanable Funds 550

26-3b Policy 1: Saving Incentives 551

26-3c Policy 2: Investment Incentives 553

26-3d Policy 3: Government Budget Deficits and Surpluses 554

ASK THE EXPERTS: Fiscal Policy and Saving 555 CASE STUDY: The History of U.S. Government Debt 556 FYI: Financial Crises 558

26-4 Conclusion 558

Summary 559

Key Concepts 560

Questions for Review 560

Problems and Applications 560

CHAPTER 27 The Basic Tools of Finance 563

27-1 Present Value: Measuring the Time Value of Money 564

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

27-2 Managing Risk 566

27-2a Risk Aversion 566

xxvCONTENTS

27-2b The Markets for Insurance 567

27-2c Diversification of Firm-Specific Risk 568

27-2d The Trade-off between Risk and Return 569

27-3 Asset Valuation 571

27-3a Fundamental Analysis 571

27-3b The Efficient Markets Hypothesis 571

CASE STUDY: Random Walks and Index Funds 572 ASK THE EXPERTS: Diversification 573 27-3c Market Irrationality 573

27-4 Conclusion 574

Summary 575

Key Concepts 575

Questions for Review 575

Problems and Applications 576

CHAPTER 28 Unemployment 577

28-1 Identifying Unemployment 578

28-1a How Is Unemployment Measured? 578

CASE STUDY: Labor-Force Participation of Men and Women in the U.S. Economy 581

28-1b Does the Unemployment Rate Measure What We Want It

To? 582

28-1c How Long Are the Unemployed without Work? 584

28-1d Why Are There Always Some People Unemployed? 584

FYI: The Jobs Number 585

28-2 Job Search 586

28-2a Why Some Frictional Unemployment Is Inevitable 586

28-2b Public Policy and Job Search 586

28-2c Unemployment Insurance 587

28-3 Minimum-Wage Laws 588

CASE STUDY: Who Earns the Minimum Wage? 589 IN THE NEWS: Should the Minimum Wage Be Raised

to $15 an Hour? 590

28-4 Unions and Collective Bargaining 592

28-4a The Economics of Unions 592

28-4b Are Unions Good or Bad for the Economy? 593

28-5 The Theory of Efficiency Wages 594

28-5a Worker Health 594

28-5b Worker Turnover 594

28-5c Worker Quality 595

28-5d Worker Effort 595

CASE STUDY: Henry Ford and the Very Generous $5-a-Day Wage 595

28-6 Conclusion 596

Summary 597

Key Concepts 598

Questions for Review 598

Problems and Applications 598

PART X Money and Prices in the Long Run 601

CHAPTER 29 The Monetary System 603

29-1 The Meaning of Money 604

29-1a The Functions of Money 605

29-1b The Kinds of Money 605

IN THE NEWS: Why Gold? 606 29-1c Money in the U.S. Economy 607

CASE STUDY: Where Is All the Currency? 608 FYI: Why Credit Cards Aren’t Money 609

29-2 The Federal Reserve System 609

29-2a The Fed’s Organization 609

29-2b The Federal Open Market Committee 610

29-3 Banks and the Money Supply 611

29-3a The Simple Case of 100-Percent-Reserve Banking 611

29-3b Money Creation with Fractional-Reserve Banking 612

29-3c The Money Multiplier 613

29-3d Bank Capital, Leverage, and the Financial Crisis

of 2008–2009 615

29-4 The Fed’s Tools of Monetary Control 616

29-4a How the Fed Influences the Quantity of Reserves 617

29-4b How the Fed Influences the Reserve Ratio 618

29-4c Problems in Controlling the Money Supply 619

CASE STUDY: Bank Runs and the Money Supply 619 IN THE NEWS: A Trip to Jekyll Island 620 29-4d The Federal Funds Rate 621

29-5 Conclusion 622

Summary 623

Key Concepts 624

Questions for Review 624

Problems and Applications 624

xxvi CONTENTS

CHAPTER 30 Money Growth and Inflation 627

30-1 The Classical Theory of Inflation 629

30-1a The Level of Prices and the Value of Money 629

30-1b Money Supply, Money Demand, and Monetary

Equilibrium 630

30-1c The Effects of a Monetary Injection 631

30-1d A Brief Look at the Adjustment Process 632

30-1e The Classical Dichotomy and Monetary Neutrality 633

30-1f Velocity and the Quantity Equation 634

CASE STUDY: Money and Prices during Four Hyperinflations 636

30-1g The Inflation Tax 637

FYI: Hyperinflation in Zimbabwe 638 30-1h The Fisher Effect 639

30-2 The Costs of Inflation 640

30-2a A Fall in Purchasing Power? The Inflation Fallacy 641

30-2b Shoeleather Costs 641

30-2c Menu Costs 642

30-2d Relative-Price Variability and the Misallocation of

Resources 642

30-2e Inflation-Induced Tax Distortions 643

30-2f Confusion and Inconvenience 644

30-2g A Special Cost of Unexpected Inflation: Arbitrary

Redistributions of Wealth 645

30-2h Inflation Is Bad, but Deflation May Be Worse 646

CASE STUDY: The Wizard of Oz and the Free-Silver Debate 646

30-3 Conclusion 647

Summary 649

Key Concepts 649

Questions for Review 649

Problems and Applications 649

PART XI The Macroeconomics of Open Economies 651

CHAPTER 31 Open-Economy Macroeconomics: Basic Concepts 653

31-1 The International Flows of Goods and Capital 654

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

Net Exports 654

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

IN THE NEWS: The Complicated Politics of Trade Agreements 656

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

Outflow 658

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

Outflow 659

31-1d Saving, Investment, and Their Relationship

to the International Flows 660

31-1e Summing Up 661

CASE STUDY: Is the U.S. Trade Deficit a National Problem? 662

ASK THE EXPERTS: Trade Balances and Trade Negotiations 664

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

Exchange Rates 664

31-2a Nominal Exchange Rates 665

31-2b Real Exchange Rates 665

FYI: The Euro 666

31-3 A First Theory of Exchange-Rate Determination:

Purchasing-Power Parity 667

31-3a The Basic Logic of Purchasing-Power Parity 668

31-3b Implications of Purchasing-Power Parity 668

CASE STUDY: The Nominal Exchange Rate during a Hyperinflation 670

31-3c Limitations of Purchasing-Power Parity 671

CASE STUDY: The Hamburger Standard 671

31-4 Conclusion 672

Summary 673

Key Concepts 673

Questions for Review 674

Problems and Applications 674

CHAPTER 32 A Macroeconomic Theory of the Open Economy 677

32-1 Supply and Demand for Loanable Funds and for Foreign-

Currency Exchange 678

32-1a The Market for Loanable Funds 678

32-1b The Market for Foreign-Currency Exchange 680

xxviiCONTENTS

FYI: Purchasing-Power Parity as a Special Case 682

32-2 Equilibrium in the Open Economy 683

32-2a Net Capital Outflow: The Link between the

Two Markets 683

32-2b Simultaneous Equilibrium in Two Markets 684

FYI: Disentangling Supply and Demand 685

32-3 How Policies and Events Affect an Open Economy 686

32-3a Government Budget Deficits 686

32-3b Trade Policy 688

32-3c Political Instability and Capital Flight 690

IN THE NEWS: Is a Strong Currency Always in a Nation’s Interest? 692

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

32-4 Conclusion 695

Summary 696

Key Concepts 696

Questions for Review 696

Problems and Applications 697

PART XII Short-Run Economic Fluctuations 699

CHAPTER 33 Aggregate Demand and Aggregate Supply 701

33-1 Three Key Facts about Economic Fluctuations 702

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

Unpredictable 702

33-1b Fact 2: Most Macroeconomic Quantities

Fluctuate Together 704

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

33-2 Explaining Short-Run Economic Fluctuations 705

33-2a The Assumptions of Classical Economics 705

33-2b The Reality of Short-Run Fluctuations 705

33-2c The Model of Aggregate Demand and

Aggregate Supply 706

33-3 The Aggregate-Demand Curve 707

33-3a Why the Aggregate-Demand Curve Slopes Downward 707

33-3b Why the Aggregate-Demand Curve Might Shift 710

33-4 The Aggregate-Supply Curve 712

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

Long Run 712

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

Might Shift 713

33-4c Using Aggregate Demand and Aggregate Supply to

Depict Long-Run Growth and Inflation 715

33-4d Why the Aggregate-Supply Curve Slopes Upward

in the Short Run 716

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

Might Shift 720

33-5 Two Causes of Economic Fluctuations 721

33-5a The Effects of a Shift in Aggregate Demand 722

FYI: Monetary Neutrality Revisited 724 CASE STUDY: Two Big Shifts in Aggregate Demand:

The Great Depression and World War II 725

CASE STUDY: The Great Recession of 2008–2009 726 IN THE NEWS: What Have We Learned? 728 33-5b The Effects of a Shift in Aggregate Supply 728

CASE STUDY: Oil and the Economy 731 FYI: The Origins of the Model of Aggregate Demand

and Aggregate Supply 732

33-6 Conclusion 733

Summary 734

Key Concepts 734

Questions for Review 735

Problems and Applications 735

CHAPTER 34 The Influence of Monetary and Fiscal Policy on Aggregate Demand 737

34-1 How Monetary Policy Influences Aggregate Demand 738

34-1a The Theory of Liquidity Preference 739

34-1b The Downward Slope of the Aggregate-Demand

Curve 741

FYI: Interest Rates in the Long Run and the Short Run 742 34-1c Changes in the Money Supply 743

34-1d The Role of Interest-Rate Targets in Fed Policy 745

CASE STUDY: Why the Fed Watches the Stock Market (and Vice Versa) 745

34-1e The Zero Lower Bound 746

34-2 How Fiscal Policy Influences Aggregate Demand 747

34-2a Changes in Government Purchases 747

34-2b The Multiplier Effect 748

34-2c A Formula for the Spending Multiplier 748

34-2d Other Applications of the Multiplier Effect 750

34-2e The Crowding-Out Effect 750

34-2f Changes in Taxes 752

FYI: How Fiscal Policy Might Affect Aggregate Supply 752

34-3 Using Policy to Stabilize the Economy 753

34-3a The Case for Active Stabilization Policy 753

IN THE NEWS: How Large Is the Fiscal Policy Multiplier? 754

xxviii CONTENTS

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

34-3c Automatic Stabilizers 758

34-4 Conclusion 758

Summary 759

Key Concepts 760

Questions for Review 760

Problems and Applications 760

CHAPTER 35 The Short-Run Trade-off between Inflation and Unemployment 763

35-1 The Phillips Curve 764

35-1a Origins of the Phillips Curve 764

35-1b Aggregate Demand, Aggregate Supply, and the

Phillips Curve 765

35-2 Shifts in the Phillips Curve: The Role of Expectations 767

35-2a The Long-Run Phillips Curve 767

35-2b The Meaning of “Natural” 769

35-2c Reconciling Theory and Evidence 770

35-2d The Short-Run Phillips Curve 771

35-2e The Natural Experiment for the Natural-Rate

Hypothesis 772

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

Shocks 773

35-4 The Cost of Reducing Inflation 776

35-4a The Sacrifice Ratio 777

35-4b Rational Expectations and the Possibility of Costless

Disinflation 778

35-4c The Volcker Disinflation 779

35-4d The Greenspan Era 780

35-4e A Financial Crisis Takes Us for a Ride along the Phillips

Curve 781

35-5 Conclusion 782

Summary 784

Key Concepts 784

Questions for Review 784

Problems and Applications 784

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

36-1 Should Monetary and Fiscal Policymakers Try

to Stabilize the Economy? 790

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

Economy 790

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

Economy 790

36-2 Should the Government Fight Recessions with

Spending Hikes Rather Than Tax Cuts? 792

36-2a Pro: The Government Should Fight Recessions

with Spending Hikes 792

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

Cuts 793

36-3 Should Monetary Policy Be Made by Rule Rather

Than by Discretion? 794

36-3a Pro: Monetary Policy Should Be Made by Rule 795

36-3b Con: Monetary Policy Should Not Be Made by Rule 796

FYI: Inflation Targeting 797

36-4 Should the Central Bank Aim for Zero Inflation? 797

36-4a Pro: The Central Bank Should Aim for Zero Inflation 798

36-4b Con: The Central Bank Should Not Aim for Zero

Inflation 799

IN THE NEWS: On Kiwis and Currencies 800

36-5 Should the Government Balance Its Budget? 802

36-5a Pro: The Government Should Balance Its Budget 802

36-5b Con: The Government Should Not Balance

Its Budget 803

36-6 Should the Tax Laws Be Reformed to Encourage

Saving? 805

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

Saving 805

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

to Encourage Saving 806

36-7 Conclusion 807

Summary 808

Questions for Review 809

Problems and Applications 809

Glossary 811

Index 819

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1 T

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4 PART I INTRODUCTION

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

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

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

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

scarcity

the limited nature of

society’s resources

economics

the study of how soci-

ety manages its scarce

resources

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

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

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

1-1 How People Make Decisions

5CHAPTER 1 TEN PRINCIPLES OF ECONOMICS

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

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

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

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

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

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

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

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

efficiency

the property of society

getting the most it can

from its scarce resources

equality

the property of distribut-

ing economic prosperity

uniformly among the

members of society

6 PART I INTRODUCTION

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

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

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

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

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

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

opportunity cost

whatever must be given

up to obtain some item

rational people

people who systematically

and purposefully do the

best they can to achieve

their objectives

marginal change

a small incremental

adjustment to a plan of

action

7CHAPTER 1 TEN PRINCIPLES OF ECONOMICS

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

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

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

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

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

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

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

incentive

something that induces a

person to act

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

BL EN

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ES /

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8 PART I INTRODUCTION

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

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

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

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

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

QuickQuiz Describe an important trade-off you recently faced. Give an example of

some action that has both a monetary and nonmonetary opportunity cost.

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

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

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

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

9CHAPTER 1 TEN PRINCIPLES OF ECONOMICS

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

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

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

Like families, countries also benefit from the ability to trade with one another. Trade allows countries to specialize in what they do best and to enjoy a greater variety of goods and services. The Chinese, as well as the French, Egyptians, and Brazilians, are as much our partners in the world economy as they are our competitors.

1-2b Principle 6: Markets Are Usually a Good Way to Organize Economic Activity

The collapse of communism in the Soviet Union and Eastern Europe in the late 1980s and early 1990s was one of the last century’s most transformative events. Communist countries operated on the premise that government officials were in the best position to allocate the economy’s scarce resources. These central plan- ners 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.

Most countries that once had centrally planned economies have abandoned the system and are instead developing 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. In a market econ- omy, 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 decentral- ized decision making and self-interested decision makers, market economies have proven remarkably successful in organizing economic activity to promote 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 “in- visible hand” that leads them to desirable market outcomes. One of our goals in 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. In any market, buyers look at

market economy

an economy that allocates

resources through the

decentralized decisions

of many firms and house-

holds as they interact in

markets for goods and

services

“For $5 a week you can watch baseball without being nagged to cut the grass!”

FR O

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10 PART I INTRODUCTION

the price when determining how much to demand, and sellers look at the price when deciding how much to supply. As a result of the decisions that buyers and sellers make, market prices reflect both the value of a good to society and the cost to society of making the good. Smith’s great insight was that prices adjust to guide these individual buyers and sellers to reach outcomes that, in many cases, maximize the well-being of society as a whole.

Smith’s insight has an important corollary: When a government prevents prices from adjusting naturally to supply and demand, it impedes the invisible hand’s ability to coordinate the decisions of the households and firms that make up an economy. This corollary explains why taxes adversely affect the allocation of resources: They distort prices and thus the decisions of households and firms. It also explains the great 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 plan- ners. These planners lacked the necessary information about consumers’ tastes and producers’ costs, which in a market economy is reflected in prices. Central planners failed because they tried to run the economy with one hand tied behind their backs—the invisible hand of the marketplace.

Adam Smith and the Invisible Hand

BE TT

M A

N N

/C O

RB IS

Adam Smith

I t may be only a coincidence that Adam Smith’s great book The Wealth of

Nations was published in 1776, the exact year in which American revolu-

tionaries signed the Declaration of Independence. But the two documents

share a point of view that was prevalent at the time: Individuals are usu-

ally 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 do 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

in 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 favour, and show

them that it is for their own advan-

tage to do for him what he requires

of them. . . . Give me that which I

want, and you shall have this which

you want, is the meaning of every

such offer; and it is in this manner

that we obtain from one another the

far greater part of those good offices

which we stand in need of.

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 inter-

est. We address ourselves, not

to their humanity but to their self-love, and never talk to them of our own

necessities but of their advantages. Nobody but a beggar chooses to de-

pend chiefly upon the benevolence of his fellow-citizens. . . .

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 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 econom-

ics. Our analysis in the coming chapters will allow us to express Smith’s

conclusions more precisely and to analyze more fully the strengths and

weaknesses of the market’s invisible hand. ■

F Y I

11CHAPTER 1 TEN PRINCIPLES OF ECONOMICS

CASE STUDY

ADAM SMITH WOULD HAVE LOVED UBER You have probably never lived in a centrally planned economy, but if you have ever tried to hail a cab in a major city, you have likely experienced a highly regulated market. In many cities, the local gov-

ernment imposes strict controls in the market for taxis. The rules usually go well beyond regulation of insurance and safety. For example, the government may limit entry into the market by approving only a certain number of taxi medallions or permits. It may determine the prices that taxis are allowed to charge. The gov- ernment uses its police powers—that is, the threat of fines or jail time—to keep unauthorized drivers off the streets and to prevent all drivers from charging un- authorized prices.

Recently, however, this highly controlled market has been invaded by a disrup- tive force: Uber. Launched in 2009, this company provides an app for smartphones that connects passengers and drivers. Because Uber cars do not roam the streets looking for taxi-hailing pedestrians, they are technically not taxis and so are not subject to the same regulations. But they offer much the same service. Indeed, rides from Uber cars are often more convenient. On a cold and rainy day, who wants to stand on the side of the road waiting for an empty cab to drive by? It is more pleas- ant to remain inside, use your smartphone to arrange for a ride, and stay warm and dry until the car arrives.

Uber cars often charge less than taxis, but not always. Uber allows drivers to raise their prices significantly when there is a surge in demand, such as during a sudden rainstorm or late on New Year ’s Eve, when numerous tipsy partiers are looking for a safe way to get home. By contrast, regulated taxis are typically pre- vented from surge pricing.

Not everyone is fond of Uber. Drivers of traditional taxis complain that this new competition eats into their source of income. This is hardly a surprise: Suppliers of goods and services usually dislike new competitors. But vigorous competition among producers makes a market work well for consumers.

That is why economists love Uber. A 2014 survey of several dozen prominent economists asked whether car services such as Uber increased consumer well- being. Yes, said every single economist. The economists were also asked whether surge pricing increased consumer well-being. Yes, said 85 percent of them. Surge pricing makes consumers pay more at times, but because Uber drivers respond to incentives, it also increases the quantity of car services supplied when they are most needed. Surge pricing also helps allocate the services to those consum- ers who value them most highly and reduces the costs of searching and waiting for a car.

If Adam Smith were alive today, he would surely have the Uber app on his phone. ●

1-2c Principle 7: Governments Can Sometimes Improve Market Outcomes

If the invisible hand of the market is so great, why do we need government? One purpose of studying economics is to refine your view about the proper role and scope of government policy.

One reason we need government is that the invisible hand can work its magic only if the government enforces the rules and maintains the institutions that are key to a market economy. Most important, market economies need institutions to enforce property rights so individuals can own and control scarce resources.

property rights

the ability of an individ-

ual to own and exercise

control over scarce

resources

Technology can improve this market.

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12 PART I INTRODUCTION

A farmer won’t grow food if she expects her crop to be stolen; a restaurant won’t serve meals unless it is assured that customers will pay before they leave; and a film company won’t produce movies if too many potential customers avoid paying by making illegal copies. We all rely on government-provided police and courts to enforce our rights over the things we produce—and the invisible hand counts on our ability to enforce those rights.

Another reason we need government is that, although the invisible hand is powerful, it is not omnipotent. There are two broad rationales for a government to intervene in the economy and change the allocation of resources that people would choose on their own: to promote efficiency or to promote equality. That is, most policies aim either to enlarge the economic pie or to change how the pie is divided.

Consider first the goal of efficiency. Although the invisible hand usually leads markets to allocate resources to maximize the size of the economic pie, this is not always the case. Economists use the term market failure to refer to a situation in which the market on its own fails to produce an efficient allocation of resources. As we will see, one possible cause of market failure is an exter- nality, which is the impact of one person’s actions on the well-being of a by- stander. The classic example of an externality is pollution. When the production of a good pollutes the air and creates health problems for those who live near the factories, the market left to its own devices may fail to take this cost into ac- count. Another possible cause of market failure is market power, which refers to the ability of a single person or firm (or a small group) to unduly influence mar- ket prices. For example, if everyone in town needs water but there is only one well, the owner of the well is not subject to the rigorous competition with which the invisible hand normally keeps self-interest in check; she may take advantage of this opportunity by restricting the output of water so she can charge a higher price. In the presence of externalities or market power, well-designed public policy can enhance economic efficiency.

Now consider the goal of equality. Even when the invisible hand yields efficient outcomes, it can nonetheless leave sizable disparities in economic well-being. A market economy rewards people according to their ability to pro- duce 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. This inequality may, depending on one’s political philosophy, call for gov- ernment intervention. In practice, many public policies, such as the income tax and the welfare system, aim to achieve a more equal distribution of economic well-being.

To say that the government can improve on market outcomes 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. As you study economics, you will become a better judge of when a government policy is justifiable because it promotes efficiency or equality and when it is not.

QuickQuiz Why is a country better off not isolating itself from all other countries?

Why do we have markets, and according to economists, what roles

should government play in them?

market failure

a situation in which a

market left on its own

fails to allocate resources

efficiently

externality

the impact of one per-

son’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

13CHAPTER 1 TEN PRINCIPLES OF ECONOMICS

1-3 How the Economy as a Whole Works We started by discussing how individuals make decisions and then looked at how people interact with one another. All these decisions and interactions together make up “the economy.” The last three principles concern the workings of the economy as a whole.

1-3a Principle 8: A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services

The differences in living standards around the world are staggering. In 2014, the average American had an income of about $55,000. In the same year, the average Mexican earned about $17,000, the average Chinese about $13,000, and the aver- age Nigerian only $6,000. Not surprisingly, this large variation in average income is reflected in various measures of quality of life. Citizens of high-income coun- tries have more TV sets, more cars, better nutrition, better healthcare, and a longer life expectancy than citizens of low-income countries.

Changes in living standards over time are also large. In the United States, incomes have historically grown about 2 percent per year (after adjusting for changes in the cost of living). At this rate, average income doubles every 35 years. Over the past century, average U.S. income has risen about eightfold.

What explains these large differences in living standards among countries and over time? The answer is surprisingly simple. Almost all variation in living stan- dards is attributable to differences in countries’ productivity—that is, the amount of goods and services produced by each unit of labor input. In nations where workers can produce a large quantity of goods and services per hour, most peo- ple enjoy a high standard of living; in nations where workers are less produc- tive, most people endure a more meager existence. Similarly, the growth rate of a nation’s productivity determines the growth rate of its average income.

The fundamental relationship between productivity and living standards is sim- ple, but its implications are far-reaching. If productivity is the primary determinant of living standards, other explanations must be of secondary importance. For example, it might be tempting to credit labor unions or minimum-wage laws for the rise in living standards of American workers over the past century. Yet the real hero of American workers is their rising productivity. As another example, some commentators have claimed that increased competition from Japan and other countries explained the slow growth in U.S. incomes during the 1970s and 1980s. Yet the real villain was not competition from abroad but flagging productivity growth in the United States.

The relationship between productivity and living standards also has profound implications for public policy. When thinking about how any policy will affect liv- ing standards, the key question is how it will affect our ability to produce goods and services. To boost living standards, policymakers need to raise productivity by ensuring that workers are well educated, have the tools they need to produce goods and services, and have access to the best available technology.

1-3b Principle 9: Prices Rise When the Government Prints Too Much Money

In January 1921, a daily newspaper in Germany cost 0.30 marks. Less than two years later, in November 1922, the same newspaper cost 70,000,000 marks. All other prices in the economy rose by similar amounts. This episode is one of his- tory’s most spectacular examples of inflation, an increase in the overall level of prices in the economy.

productivity

the quantity of goods and

services produced from

each unit of labor input

inflation

an increase in the over-

all level of prices in the

economy

14 PART I INTRODUCTION

Although the United States has never experienced inflation even close to that of Germany in the 1920s, inflation has at times been an economic problem. During the 1970s, for instance, when the overall level of prices more than doubled, Presi- dent Gerald Ford called inflation “public enemy number one.” By contrast, infla- tion in the first decade of the 21st century ran about 2½ percent per year; at this rate, it would take almost 30 years for prices to double. Because high inflation imposes various costs on society, keeping inflation at a low level is a goal of eco- nomic policymakers around the world.

What causes inflation? In almost all cases of large or persistent inflation, the culprit is growth in the quantity of money. When a government creates large quan- tities of the nation’s money, the value of the money falls. In Germany in the early 1920s, when prices were on average tripling every month, the quantity of money was also tripling every month. Although less dramatic, the economic history of the United States points to a similar conclusion: The high inflation of the 1970s was associated with rapid growth in the quantity of money, and the return of low inflation in the 1980s was associated with slower growth in the quantity of money.

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

Although a higher level of prices is, in the long run, the primary effect of increas- ing the quantity of money, the short-run story is more complex and controversial. Most economists describe the short-run effects of monetary injections as follows:

Increasing the amount of money in the economy stimulates the overall level of spending and thus the demand for goods and services. Higher demand may over time cause firms to raise their prices, but in the meantime, it also encourages them to hire more workers and produce a larger quantity of goods and services. More hiring means lower unemployment.

This line of reasoning leads to one final economy-wide trade-off: a short-run trade-off between inflation and unemployment.

Although some economists still question these ideas, most accept that society faces a short-run trade-off between inflation and unemployment. This simply means that, over a period of a year or two, many economic policies push inflation and un- employment in opposite directions. Policymakers face this trade-off regardless of whether inflation and unemployment both start out at high levels (as they did in the early 1980s), at low levels (as they did in the late 1990s), or someplace in between. This short-run trade-off plays a key role in the analysis of the business cycle—the irregular and largely unpredictable fluctuations in economic activity, as measured by the production of goods and services or the number of people employed.

Policymakers can exploit the short-run trade-off between inflation and un- employment using various policy instruments. By changing the amount that the government spends, the amount it taxes, and the amount of money it prints, pol- icymakers can influence the overall demand for goods and services. Changes in demand in turn influence the combination of inflation and unemployment that the economy experiences in the short run. Because these instruments of economic policy are potentially so powerful, how policymakers should use them to control the economy, if at all, is a subject of continuing debate.

This debate heated up in the early years of Barack Obama’s presidency. In 2008 and 2009, the U.S. economy, as well as many other economies around the world, experi- enced a deep economic downturn. Problems in the financial system, caused by bad

business cycle

fluctuations in economic

activity, such as employ-

ment and production

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“Well it may have been 68 cents when you got in line, but it’s 74 cents now!”

15CHAPTER 1 TEN PRINCIPLES OF ECONOMICS

bets on the housing market, spilled over into the rest of the economy, causing incomes to fall and unemployment to soar. Policymakers responded in various ways to increase the overall demand for goods and services. President Obama’s first major initiative was a stimulus package of reduced taxes and increased government spending. At the same time, the nation’s central bank, the Federal Reserve, increased the supply of money. The goal of these policies was to reduce unemployment. Some feared, how- ever, that these policies might over time lead to an excessive level of inflation.

QuickQuiz List and briefly explain the three principles that describe how the econ-

omy as a whole works.

1-4 Conclusion You now have a taste of what economics is all about. In the coming chapters, we develop many specific insights about people, markets, and economies. Mastering these insights will take some effort, but it is not an overwhelming task. The field of economics is based on a few big ideas that can be applied in many different situations.

Throughout this book, we will refer back to the Ten Principles of Economics high- lighted in this chapter and summarized in Table 1. Keep these building blocks in mind: Even the most sophisticated economic analysis is founded on the ten prin- ciples introduced here.

TABLE 1

Ten Principles of

Economics

How People Make Decisions

1: People Face Trade-offs

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

3: Rational People Think at the Margin

4: People Respond to Incentives

How People Interact

5: Trade Can Make Everyone Better Off

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

7: Governments Can Sometimes Improve Market Outcomes

How the Economy as a Whole Works

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

9: Prices Rise When the Government Prints Too Much Money

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

1. Economics is best defined as the study of

a. how society manages its scarce resources.

b. how to run a business most profitably.

c. how to predict inflation, unemployment, and stock

prices.

d. how the government can stop the harm from

unchecked self-interest.

2. Your opportunity cost of going to a movie is

a. the price of the ticket.

b. the price of the ticket plus the cost of any soda

and popcorn you buy at the theater.

c. the total cash expenditure needed to go to the

movie plus the value of your time.

d. zero, as long as you enjoy the movie and consider

it a worthwhile use of time and money.

CHAPTER QuickQuiz

16 PART I INTRODUCTION

1. Give three examples of important trade-offs that you

face in your life.

2. What items would you include to figure out the

opportunity cost of a vacation to Disney World?

3. Water is necessary for life. Is the marginal benefit of a

glass of water large or small?

4. Why should policymakers think about incentives?

5. Why isn’t trade among countries like a game with

some winners and some losers?

6. What does the “invisible hand” of the marketplace

do?

The fundamental lessons about individual decision

making are that people face trade-offs among alter-

native goals, that the cost of any action is measured

in terms of forgone opportunities, that rational people

make decisions by comparing marginal costs and mar-

ginal benefits, and that people change their behavior in

response to the incentives they face.

The fundamental lessons about interactions among

people are that trade and interdependence can be

mutually beneficial, that markets are usually a good

way of coordinating economic activity among people,

and that the government can potentially improve mar-

ket outcomes by remedying a market failure or by pro-

moting greater economic equality.

The fundamental lessons about the economy as a

whole are that productivity is the ultimate source

of living standards, that growth in the quantity of

money is the ultimate source of inflation, and that

society faces a short-run trade-off between inflation

and unemployment.

scarcity, p. 4

economics, p. 4

efficiency, p. 5

equality, p. 5

opportunity cost, p. 6

rational people, p. 6

marginal change, p. 6

incentive, p. 7

market economy, p. 9

property rights, p. 11

market failure, p. 12

externality, p. 12

market power, p. 12

productivity, p. 13

inflation, p. 13

business cycle, p. 14

3. A marginal change is one that

a. is not important for public policy.

b. incrementally alters an existing plan.

c. makes an outcome inefficient.

d. does not influence incentives.

4. Adam Smith’s “invisible hand” refers to

a. the subtle and often hidden methods that busi-

nesses use to profit at consumers’ expense.

b. the ability of free markets to reach desirable

outcomes, despite the self-interest of market

participants.

c. the ability of government regulation to benefit con-

sumers, even if the consumers are unaware of the

regulations.

d. the way in which producers or consumers in

unregulated markets impose costs on innocent

bystanders.

5. Governments may intervene in a market economy in

order to

a. protect property rights.

b. correct a market failure due to externalities.

c. achieve a more equal distribution of income.

d. All of the above.

6. If a nation has high and persistent inflation, the most

likely explanation is

a. the central bank creating excessive amounts of

money.

b. unions bargaining for excessively high wages.

c. the government imposing excessive levels of taxation.

d. firms using their monopoly power to enforce exces-

sive price hikes.

KEY CONCEPTS

QUESTIONS FOR REVIEW

SUMMARY

17CHAPTER 1 TEN PRINCIPLES OF ECONOMICS

7. What are the two main causes of market failure? Give

an example of each.

8. Why is productivity important?

9. What is inflation and what causes it?

10. How are inflation and unemployment related in the

short run?

1. Describe some of the trade-offs faced by each of the

following:

a. a family deciding whether to buy a new car

b. a member of Congress deciding how much to

spend on national parks

c. a company president deciding whether to open a

new factory

d. a professor deciding how much to prepare for

class

e. a recent college graduate deciding whether to go

to graduate school

2. You are trying to decide whether to take a vacation.

Most of the costs of the vacation (airfare, hotel, and

forgone wages) are measured in dollars, but the ben-

efits of the vacation are psychological. How can you

compare the benefits to the costs?

3. You were planning to spend Saturday working at your

part-time job, but a friend asks you to go skiing. What

is the true cost of going skiing? Now suppose you had

been planning to spend the day studying at the library.

What is the cost of going skiing in this case? Explain.

4. You win $100 in a basketball pool. You have a choice

between spending the money now and putting it

away for a year in a bank account that pays 5 percent

interest. What is the opportunity cost of spending the

$100 now?

5. The company that you manage has invested $5 million

in developing a new product, but the development is

not quite finished. At a recent meeting, your salespeo-

ple report that the introduction of competing products

has reduced the expected sales of your new product to

$3 million. If it would cost $1 million to finish devel-

opment and make the product, should you go ahead

and do so? What is the most that you should pay to

complete development?

6. A 1996 bill reforming the federal government’s anti-

poverty programs limited many welfare recipients to

only two years of benefits.

a. How does this change affect the incentives for

working?

b. How might this change represent a trade-off

between equality and efficiency?

7. Explain whether each of the following government

activities is motivated by a concern about equality or a

concern about efficiency. In the case of efficiency, dis-

cuss the type of market failure involved.

a. regulating cable TV prices

b. providing some poor people with vouchers that

can be used to buy food

c. prohibiting smoking in public places

d. breaking up Standard Oil (which once owned

90 percent of all oil refineries) into several smaller

companies

e. imposing higher personal income tax rates on

people with higher incomes

f. instituting laws against driving while intoxicated

8. Discuss each of the following statements from the

standpoints of equality and efficiency.

a. “Everyone in society should be guaranteed the

best healthcare possible.”

b. “When workers are laid off, they should be able

to collect unemployment benefits until they find a

new job.”

9. In what ways is your standard of living different from

that of your parents or grandparents when they were

your age? Why have these changes occurred?

10. Suppose Americans decide to save more of their in-

comes. If banks lend this extra saving to businesses,

which use the funds to build new factories, how might

this lead to faster growth in productivity? Who do you

suppose benefits from the higher productivity? Is soci-

ety getting a free lunch?

11. During the Revolutionary War, the American colonies

could not raise enough tax revenue to fully fund the

war effort. To make up the difference, the colonies

decided to print more money. Printing money to cover

expenditures is sometimes referred to as an “inflation

tax.” Who do you think is being “taxed” when more

money is printed? Why?

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

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E very field of study has its own language and its own way of thinking. Mathematicians talk about axioms, integrals, and vector spaces. Psychologists talk about ego, id, and cognitive dissonance. Lawyers talk about venue, torts,

and promissory estoppel. Economics is no different. Supply, demand, elasticity, comparative advantage,

consumer surplus, deadweight loss—these terms are part of the economist’s lan- guage. In the coming chapters, you will encounter many new terms and some familiar words that economists use in specialized ways. At first, this new language may seem needlessly arcane. But as you will see, its value lies in its ability to provide you with a new and useful way of thinking about the world in which you live.

Thinking Like an Economist CHAPTER

20 PART I INTRODUCTION

The purpose of this book is to help you learn the economist’s way of thinking. Just as you cannot become a mathematician, psychologist, or lawyer overnight, learning to think like an economist will take some time. Yet with a combination of theory, case studies, and examples of economics in the news, this book will give you ample opportunity to develop and practice this skill.

Before delving into the substance and details of economics, it is helpful to have an overview of how economists approach the world. This chapter discusses the field’s methodology. What is distinctive about how economists confront a question? What does it mean to think like an economist?

2-1 The Economist as Scientist Economists try to address their subject with a scientist’s objectivity. They approach the study of the economy in much the same way a physicist approaches the study of matter and a biologist approaches the study of life: They devise theories, collect data, and then analyze these data in an attempt to verify or refute their theories.

To beginners, the claim that economics is a science can seem odd. After all, economists do not work with test tubes or telescopes. The essence of science, however, is the scientific method—the dispassionate development and testing of theories about how the world works. This method of inquiry is as applicable to studying a nation’s economy as it is to studying the earth’s gravity or a species’ evolution. As Albert Einstein once put it, “The whole of science is nothing more than the refinement of everyday thinking.”

Although Einstein’s comment is as true for social sciences such as economics as it is for natural sciences such as physics, most people are not accustomed to look- ing at society through a scientific lens. Let’s discuss some of the ways economists apply the logic of science to examine how an economy works.

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

Isaac Newton, the famous 17th-century scientist and mathematician, allegedly became intrigued one day when he saw an apple fall from a tree. This observation motivated Newton to develop a theory of gravity that applies not only to an apple falling to the earth but to any two objects in the universe. Subsequent testing of Newton’s theory has shown that it works well in many circumstances (albeit not in all circumstances, as Einstein would later show). Because Newton’s theory has been so successful at explaining observation, it is still taught in undergraduate physics courses around the world.

This interplay between theory and observation also occurs in economics. An economist might live in a country experiencing rapidly increasing prices and be moved by this observation to develop a theory of inflation. The theory might assert that high inflation arises when the government prints too much money. To test this theory, the economist could collect and analyze data on prices and money from many different countries. If growth in the quantity of money were completely unrelated to the rate of price increase, the economist would start to doubt the validity of this theory of inflation. If money growth and inflation were strongly correlated in international data, as in fact they are, the economist would become more confident in the theory.

Although economists use theory and observation like other scientists, they face an obstacle that makes their task especially challenging: In economics,

“I’m a social scientist, Michael. That means I can’t explain electricity or anything like that, but if you ever want to know about people, I’m your man.”

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21CHAPTER 2 THINKING LIKE AN ECONOMIST

conducting experiments is often impractical. Physicists studying gravity can drop many objects in their laboratories to generate data to test their theories. By contrast, economists studying inflation are not allowed to manipulate a nation’s monetary policy simply to generate useful data. Economists, like astronomers and evolutionary biologists, usually have to make do with whatever data the world happens to give them.

To find a substitute for laboratory experiments, economists pay close attention to the natural experiments offered by history. When a war in the Middle East inter- rupts the supply of crude oil, for instance, oil prices skyrocket around the world. For consumers of oil and oil products, such an event depresses living standards. For economic policymakers, it poses a difficult choice about how best to respond. But for economic scientists, the event provides an opportunity to study the effects of a key natural resource on the world’s economies. Throughout this book, there- fore, we consider many historical episodes. These episodes are valuable to study because they give us insight into the economy of the past and, more important, because they allow us to illustrate and evaluate economic theories of the present.

2-1b The Role of Assumptions If you ask a physicist how long it would take a marble to fall from the top of a ten-story building, he will likely answer the question by assuming that the mar- ble falls in a vacuum. Of course, this assumption is false. In fact, the building is surrounded by air, which exerts friction on the falling marble and slows it down. Yet the physicist will point out that the friction on the marble is so small that its effect is negligible. Assuming the marble falls in a vacuum simplifies the problem without substantially affecting the answer.

Economists make assumptions for the same reason: Assumptions can sim- plify the complex world and make it easier to understand. To study the effects of international trade, for example, we might assume that the world consists of only two countries and that each country produces only two goods. In reality, there are numerous countries, each of which produces thousands of different types of goods. But by considering a world with only two countries and two goods, we can focus our thinking on the essence of the problem. Once we understand inter- national trade in this simplified imaginary world, we are in a better position to understand international trade in the more complex world in which we live.

The art in scientific thinking—whether in physics, biology, or economics— is deciding which assumptions to make. Suppose, for instance, that instead of dropping a marble from the top of the building, we were dropping a beach ball of the same weight. Our physicist would realize that the assumption of no fric- tion is less accurate in this case: Friction exerts a greater force on the beach ball because it is much larger than a marble. The assumption that gravity works in a vacuum is reasonable when studying a falling marble but not when studying a falling beach ball.

Similarly, economists use different assumptions to answer different questions. Suppose that we want to study what happens to the economy when the govern- ment changes the number of dollars in circulation. An important piece of this analysis, it turns out, is how prices respond. Many prices in the economy change infrequently: The newsstand prices of magazines, for instance, change only once every few years. Knowing this fact may lead us to make different assumptions when studying the effects of the policy change over different time horizons. For studying the short-run effects of the policy, we may assume that prices do not change much. We may even make the extreme and artificial assumption that

22 PART I INTRODUCTION

all prices are completely fixed. For studying the long-run effects of the policy, however, we may assume that all prices are completely flexible. Just as a physicist uses different assumptions when studying falling marbles and falling beach balls, economists use different assumptions when studying the short-run and long-run effects of a change in the quantity of money.

2-1c Economic Models High school biology teachers teach basic anatomy with plastic replicas of the human body. These models have all the major organs—the heart, the liver, the kidneys, and so on—which allow teachers to show their students very simply how the important parts of the body fit together. Because these plastic models are stylized and omit many details, no one would mistake one of them for a real person. Despite this lack of realism—indeed, because of this lack of realism— studying these models is useful for learning how the human body works.

Economists also use models to learn about the world, but unlike plastic manikins, their models mostly consist of diagrams and equations. Like a biology teacher ’s plastic model, economic models omit many details to allow us to see what is truly important. Just as the biology teacher ’s model does not include all the body’s muscles and capillaries, an economist’s model does not include every feature of the economy.

As we use models to examine various economic issues throughout this book, you will see that all the models are built with assumptions. Just as a physicist begins the analysis of a falling marble by assuming away the existence of friction, economists assume away many details of the economy that are irrelevant to the question at hand. All models—in physics, biology, and economics—simplify real- ity to improve our understanding of it.

2-1d Our First Model: The Circular-Flow Diagram The economy consists of millions of people engaged in many activities—buying, sell- ing, working, hiring, manufacturing, and so on. To understand how the economy works, we must find some way to simplify our thinking about all these activities. In other words, we need a model that explains, in general terms, how the economy is organized and how participants in the economy interact with one another.

Figure 1 presents a visual model of the economy called a circular-flow diagram. In this model, the economy is simplified to include only two types of decision makers—firms and households. Firms produce goods and services using inputs, such as labor, land, and capital (buildings and machines). These inputs are called the factors of production. Households own the factors of production and consume all the goods and services that the firms produce.

Households and firms interact in two types of markets. In the markets for goods and services, households are buyers, and firms are sellers. In particular, households buy the output of goods and services that firms produce. In the markets for the fac- tors of production, households are sellers, and firms are buyers. In these markets, households provide the inputs that firms use to produce goods and services. The circular-flow diagram offers a simple way of organizing the economic transac- tions that occur between households and firms in the economy.

The two loops of the circular-flow diagram are distinct but related. The inner loop represents the flows of inputs and outputs. The households sell the use of their labor, land, and capital to the firms in the markets for the factors of pro- duction. The firms then use these factors to produce goods and services, which in turn are sold to households in the markets for goods and services. The outer

circular-flow diagram

a visual model of the

economy that shows

how dollars flow through

markets among

households and firms

23CHAPTER 2 THINKING LIKE AN ECONOMIST

loop of the diagram represents the corresponding flow of dollars. The households spend money to buy goods and services from the firms. The firms use some of the revenue from these sales to pay for the factors of production, such as the wages of their workers. What’s left is the profit of the firm owners, who are themselves members of households.

Let’s take a tour of the circular flow by following a dollar bill as it makes its way from person to person through the economy. Imagine that the dollar begins at a household—say, in your wallet. If you want to buy a cup of coffee, you take the dollar (along with a few of its brothers and sisters) to one of the economy’s markets for goods and services, such as your local Starbucks coffee shop. There, you spend it on your favorite drink. When the dollar moves into the Starbucks cash register, it becomes revenue for the firm. The dollar doesn’t stay at Starbucks for long, however, because the firm uses it to buy inputs in the markets for the factors of production. Starbucks might use the dollar to pay rent to its landlord for the space it occupies or to pay the wages of its workers. In either case, the dollar enters the income of some household and, once again, is back in someone’s wallet. At that point, the story of the economy’s circular flow starts once again.

The circular-flow diagram in Figure 1 is a very simple model of the economy. A more complex and realistic circular-flow model would include, for instance, the roles of government and international trade. (A portion of that dollar you gave to Starbucks might be used to pay taxes or to buy coffee beans from a farmer in Brazil.) Yet these details are not crucial for a basic understanding of how the economy is organized. Because of its simplicity, this circular-flow

FIGURE 1

The Circular Flow

This diagram is a schematic representa-

tion of the organization of the economy.

Decisions are made by households and

firms. Households and firms interact in

the markets for goods and services (where

households are buyers and firms are sellers)

and in the markets for the factors of

production (where firms are buyers and

households are sellers). The outer set of

arrows shows the flow of dollars, and the

inner set of arrows shows the correspond-

ing flow of inputs and outputs.

Spending

Goods and services bought

Revenue

Goods and services sold

Labor, land, and capital

Income

5 Flow of inputs and outputs

5 Flow of dollars

Factors of production

Wages, rent, and profit

FIRMS • Produce and sell goods and services • Hire and use factors of production

• Buy and consume goods and services • Own and sell factors of production

HOUSEHOLDS

• Households sell • Firms buy

MARKETS FOR

FACTORS OF PRODUCTION

• Firms sell • Households buy

MARKETS FOR

GOODS AND SERVICES

24 PART I INTRODUCTION

diagram is useful to keep in mind when thinking about how the pieces of the economy fit together.

2-1e Our Second Model: The Production Possibilities Frontier Most economic models, unlike the circular-flow diagram, are built using the tools of mathematics. Here we use one of the simplest such models, called the produc- tion possibilities frontier, to illustrate some basic economic ideas.

Although real economies produce thousands of goods and services, let’s consider an economy that produces only two goods—cars and computers. Together, the car industry and the computer industry use all of the economy’s factors of production. The production possibilities frontier is a graph that shows the various combinations of output—in this case, cars and computers— that the economy can possibly produce given the available factors of pro- duction and the available production technology that firms use to turn these factors into output.

Figure 2 shows this economy’s production possibilities frontier. If the economy uses all its resources in the car industry, it produces 1,000 cars and no computers. If it uses all its resources in the computer industry, it produces 3,000 computers and no cars. The two endpoints of the production possibilities frontier represent these extreme possibilities.

More likely, the economy divides its resources between the two industries, pro- ducing some cars and some computers. For example, it can produce 600 cars and 2,200 computers, shown in the figure by point A. Or, by moving some of the fac- tors of production to the car industry from the computer industry, the economy can produce 700 cars and 2,000 computers, represented by point B.

Because resources are scarce, not every conceivable outcome is feasible. For example, no matter how resources are allocated between the two industries, the economy cannot produce the amount of cars and computers represented by point C. Given the technology available for manufacturing cars and computers, the econ- omy does not have enough of the factors of production to support that level of output. With the resources it has, the economy can produce at any point on or

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

FIGURE 2

The Production Possibilities Frontier

The production possibilities frontier shows

the combinations of output—in this case,

cars and computers—that the economy can

possibly produce. The economy can produce

any combination on or inside the frontier.

Points outside the frontier are not feasible

given the economy’s resources. The slope of

the production possibilities frontier measures

the opportunity cost of a car in terms of com-

puters. This opportunity cost varies, depending

on how much of the two goods the economy is

producing.

1,000

2,200

Production possibilities frontier

Quantity of Cars Produced

7006003000

2,000

3,000

1,000

Quantity of Computers

Produced

25CHAPTER 2 THINKING LIKE AN ECONOMIST

inside the production possibilities frontier, but it cannot produce at points outside the frontier.

An outcome is said to be efficient if the economy is getting all it can from the scarce resources it has available. Points on (rather than inside) the production possibilities frontier represent efficient levels of production. When the economy is producing at such a point, say point A, there is no way to produce more of one good without producing less of the other. Point D represents an inefficient outcome. For some reason, perhaps widespread unemployment, the economy is producing less than it could from the resources it has available: It is producing only 300 cars and 1,000 computers. If the source of the inefficiency is eliminated, the economy can increase its production of both goods. For example, if the econ- omy moves from point D to point A, its production of cars increases from 300 to 600, and its production of computers increases from 1,000 to 2,200.

One of the Ten Principles of Economics discussed in Chapter 1 is that people face trade-offs. The production possibilities frontier shows one trade-off that society faces. Once we have reached an efficient point on the frontier, the only way of producing more of one good is to produce less of the other. When the economy moves from point A to point B, for instance, society produces 100 more cars at the expense of producing 200 fewer computers.

This trade-off helps us understand another of the Ten Principles of Economics: The cost of something is what you give up to get it. This is called the opportu- nity cost. The production possibilities frontier shows the opportunity cost of one good as measured in terms of the other good. When society moves from point A to point B, it gives up 200 computers to get 100 additional cars. That is, at point A, the opportunity cost of 100 cars is 200 computers. Put another way, the opportunity cost of each car is two computers. Notice that the opportunity cost of a car equals the slope of the production possibilities frontier. (If you don’t recall what slope is, you can refresh your memory with the graphing appendix to this chapter.)

The opportunity cost of a car in terms of the number of computers is not con- stant in this economy but depends on how many cars and computers the economy is producing. This is reflected in the shape of the production possibilities frontier. Because the production possibilities frontier in Figure 2 is bowed outward, the opportunity cost of a car is highest when the economy is producing many cars and few computers, such as at point E, where the frontier is steep. When the econ- omy is producing few cars and many computers, such as at point F, the frontier is flatter, and the opportunity cost of a car is lower.

Economists believe that production possibilities frontiers often have this bowed shape. When the economy is using most of its resources to make com- puters, the resources best suited to car production, such as skilled autoworkers, are being used in the computer industry. Because these workers probably aren’t very good at making computers, increasing car production by one unit will cause only a slight reduction in the number of computers produced. Thus, at point F, the opportunity cost of a car in terms of computers is small, and the frontier is relatively flat. By contrast, when the economy is using most of its resources to make cars, such as at point E, the resources best suited to making cars are already at work in the car industry. Producing an additional car means moving some of the best computer technicians out of the computer industry and turning them into autoworkers. As a result, producing an additional car requires a substantial loss of computer output. The opportunity cost of a car is high, and the frontier is steep.

The production possibilities frontier shows the trade-off between the outputs of different goods at a given time, but the trade-off can change over time. For

26 PART I INTRODUCTION

example, suppose a technological advance in the computer industry raises the number of computers that a worker can produce per week. This advance expands society’s set of opportunities. For any given number of cars, the economy can now make more computers. If the economy does not produce any computers, it can still produce 1,000 cars, so one endpoint of the frontier stays the same. But if the economy devotes some of its resources to the computer industry, it will produce more computers from those resources. As a result, the production possibilities frontier shifts outward, as in Figure 3.

This figure illustrates what happens when an economy grows. Society can move production from a point on the old frontier to a point on the new fron- tier. Which point it chooses depends on its preferences for the two goods. In this example, society moves from point A to point G, enjoying more computers (2,300 instead of 2,200) and more cars (650 instead of 600).

The production possibilities frontier simplifies a complex economy to high- light some basic but powerful ideas: scarcity, efficiency, trade-offs, opportunity cost, and economic growth. As you study economics, these ideas will recur in var- ious forms. The production possibilities frontier offers one simple way of thinking about them.

2-1f Microeconomics and Macroeconomics Many subjects are studied on various levels. Consider biology, for example. Molecular biologists study the chemical compounds that make up living things. Cellular biologists study cells, which are made up of many chemical compounds and, at the same time, are themselves the building blocks of living organisms. Evolutionary biologists study the many varieties of animals and plants and how species change gradually over the centuries.

Economics is also studied on various levels. We can study the decisions of indi- vidual households and firms. Or we can study the interaction of households and

FIGURE 3

A Shift in the Production Possibilities Frontier

A technological advance in the computer

industry enables the economy to produce

more computers for any given number of

cars. As a result, the production possibilities

frontier shifts outward. If the economy moves

from point A to point G, then the production

of both cars and computers increases.

2,300 2,200

Quantity of Cars Produced

600 6500

4,000

3,000

1,000

Quantity of Computers

Produced

27CHAPTER 2 THINKING LIKE AN ECONOMIST

firms in markets for specific goods and services. Or we can study the operation of the economy as a whole, which is the sum of the activities of all these decision makers in all these markets.

The field of economics is traditionally divided into two broad subfields. Microeconomics is the study of how households and firms make decisions and how they interact in specific markets. Macroeconomics is the study of economy-wide phenomena. A microeconomist might study the effects of rent control on housing in New York City, the impact of foreign competition on the U.S. auto industry, or the effects of compulsory school attendance on workers’ earnings. A macroeconomist might study the effects of borrowing by the federal government, the changes over time in the economy’s rate of unemployment, or alternative policies to promote growth in national living standards.

Microeconomics and macroeconomics are closely intertwined. Because changes in the overall economy arise from the decisions of millions of individuals, it is impossible to understand macroeconomic developments without considering the associated microeconomic decisions. For example, a macroeconomist might study the effect of a federal income tax cut on the overall production of goods and ser- vices. But to analyze this issue, he must consider how the tax cut affects house- holds’ decisions about how much to spend on goods and services.

Despite the inherent link between microeconomics and macroeconomics, the two fields are distinct. Because they address different questions, each field has its own set of models, which are often taught in separate courses.

In what sense is economics like a science? Draw a production possi-

bilities frontier for a society that produces food and clothing. Show an

efficient point, an inefficient point, and an infeasible point. Show the effects of a drought.

Define microeconomics and macroeconomics.

2-2 The Economist as Policy Adviser Often, economists are asked to explain the causes of economic events. Why, for example, is unemployment higher for teenagers than for older workers? Sometimes, economists are asked to recommend policies to improve economic outcomes. What, for instance, should the government do to improve the eco- nomic well-being of teenagers? When economists are trying to explain the world, they are scientists. When they are trying to help improve it, they are policy advisers.

2-2a Positive versus Normative Analysis To help clarify the two roles that economists play, let’s examine the use of lan- guage. Because scientists and policy advisers have different goals, they use lan- guage in different ways.

For example, suppose that two people are discussing minimum-wage laws. Here are two statements you might hear:

portia: Minimum-wage laws cause unemployment. noah: The government should raise the minimum wage.

Ignoring for now whether you agree with these statements, notice that Portia and Noah differ in what they are trying to do. Portia is speaking like a scientist: She

microeconomics

the study of how house-

holds and firms make

decisions and how they

interact in markets

macroeconomics

the study of economy-

wide phenomena,

including inflation,

unemployment, and

economic growth

QuickQuiz

28 PART I INTRODUCTION

is making a claim about how the world works. Noah is speaking like a policy adviser: He is making a claim about how he would like to change the world.

In general, statements about the world come in two types. One type, such as Portia’s, is positive. Positive statements are descriptive. They make a claim about how the world is. A second type of statement, such as Noah’s, is normative. Norma- tive statements are prescriptive. They make a claim about how the world ought to be.

A key difference between positive and normative statements is how we judge their validity. We can, in principle, confirm or refute positive statements by ex- amining evidence. An economist might evaluate Portia’s statement by analyzing data on changes in minimum wages and changes in unemployment over time. By contrast, evaluating normative statements involves values as well as facts. Noah’s statement cannot be judged using data alone. Deciding what is good or bad policy is not just a matter of science. It also involves our views on ethics, religion, and political philosophy.

Positive and normative statements are fundamentally different, but within a person’s set of beliefs, they are often intertwined. In particular, positive views about how the world works affect normative views about what policies are desir- able. Portia’s claim that the minimum wage causes unemployment, if true, might lead her to reject Noah’s conclusion that the government should raise the mini- mum wage. Yet normative conclusions cannot come from positive analysis alone; they involve value judgments as well.

As you study economics, keep in mind the distinction between positive and normative statements because it will help you stay focused on the task at hand. Much of economics is positive: It just tries to explain how the economy works. Yet those who use economics often have normative goals: They want to learn how to improve the economy. When you hear economists making normative statements, you know they are speaking not as scientists but as policy advisers.

2-2b Economists in Washington President Harry Truman once said that he wanted to find a one-armed economist. When he asked his economists for advice, they always answered, “On the one hand, . . . . On the other hand, . . . .“

Truman was right in realizing that economists’ advice is not always straight- forward. This tendency is rooted in one of the Ten Principles of Economics: People face trade-offs. Economists are aware that trade-offs are involved in most policy decisions. A policy might increase efficiency at the cost of equality. It might help future generations but hurt current generations. An economist who says that all policy decisions are easy or clear-cut is an economist not to be trusted.

Truman was not the only president who relied on the advice of economists. Since 1946, the president of the United States has received guidance from the Council of Economic Advisers, which consists of three members and a staff of a few dozen economists. The council, whose offices are just a few steps from the White House, has no duty other than to advise the president and to write the an- nual Economic Report of the President, which discusses recent developments in the economy and presents the council’s analysis of current policy issues.

The president also receives input from economists in many administrative departments. Economists at the Office of Management and Budget help formu- late spending plans and regulatory policies. Economists at the Department of the Treasury help design tax policy. Economists at the Department of Labor analyze data on workers and those looking for work to help formulate labor-market policies. Economists at the Department of Justice help enforce the nation’s antitrust laws.

positive statements

claims that attempt to

describe the world as it is

normative statements

claims that attempt to

prescribe how the world

should be

“Let’s switch. I’ll make the policy, you implement it, and he’ll explain it. “

A M

ES S

TE VE

N SO

N /

TH E

N EW

Y O

RK ER

LL EC

TI O

N /

W W

W .C

A RT

O O

N BA

N K.

CO M

29CHAPTER 2 THINKING LIKE AN ECONOMIST

Economists are also found outside the administrative branch of government. To obtain independent evaluations of policy proposals, Congress relies on the advice of the Congressional Budget Office, which is staffed by economists. The Federal Reserve, the institution that sets the nation’s monetary policy, employs hundreds of economists to analyze economic developments in the United States and throughout the world.

The influence of economists on policy goes beyond their role as advisers: Their research and writings often affect policy indirectly. Economist John Maynard Keynes offered this observation:

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distill- ing their frenzy from some academic scribbler of a few years back.

These words were written in 1935, but they remain true today. Indeed, the “aca- demic scribbler” now influencing public policy is often Keynes himself.

2-2c Why Economists’ Advice Is Not Always Followed Any economist who advises presidents or other elected leaders knows that his recommendations are not always heeded. Frustrating as this can be, it is easy to understand. The process by which economic policy is actually made differs in many ways from the idealized policy process assumed in economics textbooks.

Throughout this text, whenever we discuss economic policy, we often focus on one question: What is the best policy for the government to pursue? We act as if policy were set by a benevolent king. Once the king figures out the right policy, he has no trouble putting his ideas into action.

In the real world, figuring out the right policy is only part of a leader ’s job, sometimes the easiest part. After a president hears from his economic advisers about what policy is best from their perspective, he turns to other advisers for related input. His communications advisers will tell him how best to explain the proposed policy to the public, and they will try to anticipate any misunderstand- ings that might make the challenge more difficult. His press advisers will tell him how the news media will report on his proposal and what opinions will likely be expressed on the nation’s editorial pages. His legislative affairs advisers will tell him how Congress will view the proposal, what amendments members of Congress will suggest, and the likelihood that Congress will pass some version of the president’s proposal into law. His political advisers will tell him which groups will organize to support or oppose the proposed policy, how this proposal will affect his standing among different groups in the electorate, and whether it will change support for any of the president’s other policy initiatives. After hearing and weighing all this advice, the president then decides how to proceed.

Making economic policy in a representative democracy is a messy affair— and there are often good reasons why presidents (and other politicians) do not advance the policies that economists advocate. Economists offer crucial input to the policy process, but their advice is only one ingredient of a complex recipe.

Give an example of a positive statement and an example of a normative

statement that somehow relates to your daily life. Name three parts of

government that regularly rely on advice from economists.

QuickQuiz

30 PART I INTRODUCTION

“If all economists were laid end to end, they would not reach a conclusion.” This quip from George Bernard Shaw is revealing. Economists as a group are often criticized for giving conflicting advice to policymakers. President Ronald Reagan once joked that if the game Trivial Pursuit were designed for economists, it would have 100 questions and 3,000 answers.

Why do economists so often appear to give conflicting advice to policymakers? There are two basic reasons:

Economists may disagree about the validity of alternative positive theories of how the world works. Economists may have different values and therefore different normative views about what government policy should aim to accomplish.

Let’s discuss each of these reasons.

2-3a Differences in Scientific Judgments Several centuries ago, astronomers debated whether the earth or the sun was at the center of the solar system. More recently, climatologists have debated whether the earth is experiencing global warming and, if so, why. Science is an ongoing search to understand the world around us. It is not surprising that as the search continues, scientists sometimes disagree about the direction in which truth lies.

Economists often disagree for the same reason. Economics is a young science, and there is still much to be learned. Economists sometimes disagree because they have different hunches about the validity of alternative theories or about the size of important parameters that measure how economic variables are related.

For example, economists disagree about whether the government should tax a household’s income or its consumption (spending). Advocates of a switch from the current income tax to a consumption tax believe that the change would en- courage households to save more because income that is saved would not be taxed. Higher saving, in turn, would free resources for capital accumulation, leading to more rapid growth in productivity and living standards. Advocates of the current income tax system believe that household saving would not respond much to a change in the tax laws. These two groups of economists hold different normative views about the tax system because they have different positive views about saving’s responsiveness to tax incentives.

2-3b Differences in Values Suppose that Peter and Paula both take the same amount of water from the town well. To pay for maintaining the well, the town taxes its residents. Peter has income of $150,000 and is taxed $15,000, or 10 percent of his income. Paula has income of $30,000 and is taxed $6,000, or 20 percent of her income.

Is this policy fair? If not, who pays too much and who pays too little? Does it matter whether Paula’s low income is due to a medical disability or to her deci- sion to pursue an acting career? Does it matter whether Peter’s high income is due to a large inheritance or to his willingness to work long hours at a dreary job?

These are difficult questions about which people are likely to disagree. If the town hired two experts to study how it should tax its residents to pay for the well, we would not be surprised if they offered conflicting advice.

2-3 Why Economists Disagree

31CHAPTER 2 THINKING LIKE AN ECONOMIST

This simple example shows why economists sometimes disagree about public policy. As we know from our discussion of normative and positive analysis, pol- icies cannot be judged on scientific grounds alone. Sometimes, economists give conflicting advice because they have different values. Perfecting the science of economics will not tell us whether Peter or Paula pays too much.

2-3c Perception versus Reality Because of differences in scientific judgments and differences in values, some disagreement among economists is inevitable. Yet one should not overstate the amount of disagreement. Economists agree with one another to a much greater extent than is sometimes understood.

Table 1 contains twenty propositions about economic policy. In surveys of professional economists, these propositions were endorsed by an overwhelming

Proposition (and percentage of economists who agree)

1. A ceiling on rents reduces the quantity and quality of housing available. (93%)

2. Tariffs and import quotas usually reduce general economic welfare. (93%)

3. Flexible and floating exchange rates offer an effective international monetary arrangement.

(90%)

4. Fiscal policy (for example, tax cut and/or government expenditure increase) has a

significant stimulative impact on a less than fully employed economy. (90%)

5. The United States should not restrict employers from outsourcing work to foreign countries.

(90%)

6. Economic growth in developed countries like the United States leads to greater levels of

well-being. (88%)

7. The United States should eliminate agricultural subsidies. (85%)

8. An appropriately designed fiscal policy can increase the long-run rate of capital formation.

(85%)

9. Local and state governments should eliminate subsidies to professional sports franchises.

(85%)

10. If the federal budget is to be balanced, it should be done over the business cycle rather

than yearly. (85%)

11. The gap between Social Security funds and expenditures will become unsustainably large

within the next 50 years if current policies remain unchanged. (85%)

12. Cash payments increase the welfare of recipients to a greater degree than do transfers-in-

kind of equal cash value. (84%)

13. A large federal budget deficit has an adverse effect on the economy. (83%)

14. The redistribution of income in the United States is a legitimate role for the government.

(83%)

15. Inflation is caused primarily by too much growth in the money supply. (83%)

16. The United States should not ban genetically modified crops. (82%)

17. A minimum wage increases unemployment among young and unskilled workers. (79%)

18. The government should restructure the welfare system along the lines of a “negative

income tax.” (79%)

19. Effluent taxes and marketable pollution permits represent a better approach to pollution

control than the imposition of pollution ceilings. (78%)

20. Government subsidies on ethanol in the United States should be reduced or eliminated. (78%)

Source: Richard M. Alston, J. R. Kearl, and Michael B. Vaughn, “Is There Consensus among Economists in the 1990s?” American Economic Review (May 1992): 203–209; Dan

Fuller and Doris Geide-Stevenson, “Consensus among Economists Revisited,” Journal of Economics Education (Fall 2003): 369–387; Robert Whaples, “Do Economists Agree on

Anything? Yes!” Economists’ Voice (November 2006): 1–6; Robert Whaples, “The Policy Views of American Economic Association Members: The Results of a New Survey,” Econ

Journal Watch (September 2009): 337–348.

TABLE 1

Propositions about

Which Most

Economists Agree

32 PART I INTRODUCTION

majority of respondents. Most of these propositions would fail to command a similar consensus among the public.

The first proposition in the table is about rent control, a policy that sets a legal maximum on the amount landlords can charge for their apartments. Almost all economists believe that rent control adversely affects the availability and quality of housing and is a costly way of helping the neediest members of society. Nonetheless, many city governments ignore the advice of econ- omists and place ceilings on the rents that landlords may charge their tenants.

The second proposition in the table concerns tariffs and import quotas, two policies that restrict trade among nations. For reasons we discuss more fully later in this text, almost all economists oppose such barriers to free trade. Nonetheless, over the years, presidents and Congress have chosen to restrict the import of certain goods.

Why do policies such as rent control and trade barriers per- sist if the experts are united in their opposition? It may be that the realities of the political process stand as immovable obsta- cles. But it also may be that economists have not yet convinced enough of the public that these policies are undesirable. One purpose of this book is to help you understand the economist’s view on these and other subjects and, perhaps, to persuade you that it is the right one.

As you read the book, you will occasionally see small boxes called “Ask the Experts.” These are based on the IGM Economics Experts Panel, an ongoing sur- vey of several dozen of the world’s most prominent economists. Every few weeks, these experts are offered a proposition and then asked whether they agree with it, disagree with it, or are uncertain. The results in these boxes will give you a sense of when economists are united, when they are divided, and when they just don’t know what to think.

You can see an example here regarding the resale of tickets to entertainment and sporting events. Lawmakers sometimes try to prohibit reselling tickets, or “scalping” as it is sometimes called. The survey results show that many econo- mists side with the scalpers rather than the lawmakers.

Why might economic advisers to the president disagree about a question

of policy?

2-4 Let’s Get Going The first two chapters of this book have introduced you to the ideas and methods of economics. We are now ready to get to work. In the next chapter, we start learn- ing in more detail the principles of economic behavior and economic policy.

As you proceed through this book, you will be asked to draw on many of your intellectual skills. You might find it helpful to keep in mind some advice from the great economist John Maynard Keynes:

The study of economics does not seem to require any specialized gifts of an unusually high order. Is it not . . . a very easy subject compared with the higher branches of philosophy or pure science? An easy subject, at which very few

QuickQuiz

“Laws that limit the resale of tickets for entertainment and

sports events make potential audience members for those

events worse off on average.”

Source: IGM Economic Experts Panel, April 16, 2012.

Ticket Resale

ASK THE EXPERTS

12% uncertain

80% agree

8% disagree

What do economists say?

33CHAPTER 2 THINKING LIKE AN ECONOMIST

excel! The paradox finds its explanation, perhaps, in that the master-economist must possess a rare combination of gifts. He must be mathematician, historian, statesman, philosopher—in some degree. He must understand symbols and speak in words. He must contemplate the particular in terms of the general, and touch abstract and concrete in the same flight of thought. He must study the present in the light of the past for the purposes of the future. No part of man’s nature or his institutions must lie entirely outside his regard. He must be purposeful and disinterested in a simultaneous mood; as aloof and incorrupt- ible as an artist, yet sometimes as near the earth as a politician.

This is a tall order. But with practice, you will become more and more accustomed to thinking like an economist.

Source: The Wall Street Journal, June 4, 2003.

In this excerpt from a commencement

address, the former president of the Fed-

eral Reserve Bank of Dallas makes the

case for studying economics.

The Dismal Science? Hardly!

By Robert D. McTeer, Jr.

M y take on training in economics is that

it becomes increasingly valuable as you

move up the career ladder. I can’t imagine a

better major for corporate CEOs, congressmen,

or American presidents. You’ve learned a sys-

tematic, disciplined way of thinking that will

serve you well. By contrast, the economically

challenged must be perplexed about how it is

that economies work better the fewer people

they have in charge. Who does the planning?

Who makes decisions? Who decides what to

produce?

For my money, Adam Smith’s invisible hand

is the most important thing you’ve learned by

studying economics. You understand how we

can each work for our own self-interest and

still produce a desirable social outcome. You

know how uncoordinated activity gets coordi-

nated by the market to enhance the wealth of

nations. You understand the magic of markets

and the dangers of tampering with them too

much. You know better what you first learned in

kindergarten: that you shouldn’t kill or cripple

the goose that lays the golden eggs. . . .

Economics training will help you under-

stand fallacies and unintended consequences.

In fact, I am inclined to define economics as

the study of how to anticipate unintended con-

sequences. . . .

Little in the literature seems more relevant to

contemporary economic debates than what usu-

ally is called the broken window fallacy. Whenever

a government program is justified not on its mer-

its but by the jobs it will create, remember the

broken window: Some teenagers, being the little

beasts that they are, toss a brick through a bak-

ery window. A crowd gathers and laments, “What

a shame.” But before you know it, someone sug-

gests a silver lining to the situation: Now the

baker will have to spend money to have the win-

dow repaired. This will add to the income of the

repairman, who will spend his additional income,

which will add to another seller’s income, and so

on. You know the drill. The chain of spending will

multiply and generate higher income and em-

ployment. If the broken window is large enough, it

might produce an economic boom! . . .

Most voters fall for the broken window fallacy,

but not economics majors. They will say, “Hey,

wait a minute!” If the baker hadn’t spent his

money on window repair, he would have spent it

on the new suit he was saving to buy. Then the

tailor would have the new income to spend, and

so on. The broken window didn’t create net new

spending; it just diverted spending from some-

where else. The broken window does not create

new activity, just different activity. People see the

activity that takes place. They don’t see the activ-

ity that would have taken place.

The broken window fallacy is perpetuated in

many forms. Whenever job creation or retention

is the primary objective I call it the job-count-

ing fallacy. Economics majors understand the

non-intuitive reality that real progress comes

from job destruction. It once took 90 percent of

our population to grow our food. Now it takes 3

percent. Pardon me, Willie, but are we worse off

because of the job losses in agriculture? The

would-have-been farmers are now college pro-

fessors and computer gurus. . . .

So instead of counting jobs, we should make

every job count. We will occasionally hit a soft

spot when we have a mismatch of supply and

demand in the labor market. But that is tem-

porary. Don’t become a Luddite and destroy the

machinery, or become a protectionist and try to

grow bananas in New York City. ■

Why You Should Study Economics

IN THE NEWS

34 PART I INTRODUCTION

Chapter QuickQuiz

1. An economic model is

a. a mechanical machine that replicates the

functioning of the economy.

b. a fully detailed, realistic description of the

economy.

c. a simplified representation of some aspect of the

economy.

d. a computer program that predicts the future of the

economy.

2. The circular-flow diagram illustrates that, in markets

for the factors of production,

a. households are sellers, and firms are buyers.

b. households are buyers, and firms are sellers.

c. households and firms are both buyers.

d. households and firms are both sellers.

3. A point inside the production possibilities frontier is

a. efficient but not feasible.

b. feasible but not efficient.

c. both efficient and feasible.

d. neither efficient nor feasible.

4. An economy produces hot dogs and hamburgers. If

a discovery of the remarkable health benefits of hot

dogs were to change consumers’ preferences, it would

a. expand the production possibilities frontier.

b. contract the production possibilities frontier.

c. move the economy along the production

possibilities frontier.

d. move the economy inside the production

possibilities frontier.

5. All of the following topics fall within the study of

microeconomics EXCEPT

a. the impact of cigarette taxes on the smoking

behavior of teenagers.

b. the role of Microsoft’s market power in the pricing

of software.

c. the effectiveness of antipoverty programs in

reducing homelessness.

d. the influence of the government budget deficit on

economic growth.

6. Which of the following is a positive, rather than a

normative, statement?

a. Law X will reduce national income.

b. Law X is a good piece of legislation.

c. Congress ought to pass law X.

d. The president should veto law X.

SUMMARY

Economists try to address their subject with a scien-

tist’s objectivity. Like all scientists, they make appro-

priate assumptions and build simplified models to

understand the world around them. Two simple eco-

nomic models are the circular-flow diagram and the

production possibilities frontier.

The field of economics is divided into two subfields:

microeconomics and macroeconomics. Microecono-

mists study decision making by households and firms

and the interactions among households and firms in

the marketplace. Macroeconomists study the forces

and trends that affect the economy as a whole.

A positive statement is an assertion about how the

world is. A normative statement is an assertion about how the world ought to be. When economists make normative statements, they are acting more as policy

advisers than as scientists.

Economists who advise policymakers sometimes offer

conflicting advice either because of differences in sci-

entific judgments or because of differences in values.

At other times, economists are united in the advice

they offer, but policymakers may choose to ignore

the advice because of the many forces and constraints

imposed by the political process.

KEY CONCEPTS

circular-flow diagram, p. 22

production possibilities frontier, p. 24

microeconomics, p. 27

macroeconomics, p. 27

positive statements, p. 28

normative statements, p. 28

35CHAPTER 2 THINKING LIKE AN ECONOMIST

QUESTIONS FOR REVIEW

1. In what ways is economics a science?

2. Why do economists make assumptions?

3. Should an economic model describe reality exactly?

4. Name a way that your family interacts in the factor

market and a way that it interacts in the product

market.

5. Name one economic interaction that isn’t covered by

the simplified circular-flow diagram.

6. Draw and explain a production possibilities frontier

for an economy that produces milk and cookies. What

happens to this frontier if a disease kills half of the

economy’s cows?

7. Use a production possibilities frontier to describe the

idea of “efficiency.”

8. What are the two subfields into which economics is

divided? Explain what each subfield studies.

9. What is the difference between a positive and a

normative statement? Give an example of each.

10. Why do economists sometimes offer conflicting advice

to policymakers?

PROBLEMS AND APPLICATIONS

1. Draw a circular-flow diagram. Identify the parts of the

model that correspond to the flow of goods and ser-

vices and the flow of dollars for each of the following

activities.

a. Selena pays a storekeeper $1 for a quart of milk.

b. Stuart earns $8 per hour working at a fast-food

restaurant.

c. Shanna spends $40 to get a haircut.

d. Salma earns $20,000 from her 10 percent owner-

ship of Acme Industrial.

2. Imagine a society that produces military goods and

consumer goods, which we’ll call “guns” and “butter.”

a. Draw a production possibilities frontier for guns

and butter. Using the concept of opportunity

cost, explain why it most likely has a bowed-out

shape.

b. Show a point that is impossible for the economy

to achieve. Show a point that is feasible but

inefficient.

c. Imagine that the society has two political parties,

called the Hawks (who want a strong military)

and the Doves (who want a smaller military).

Show a point on your production possibilities

frontier that the Hawks might choose and a point

that the Doves might choose.

d. Imagine that an aggressive neighboring country

reduces the size of its military. As a result, both

the Hawks and the Doves reduce their desired

production of guns by the same amount. Which

party would get the bigger “peace dividend,”

measured by the increase in butter production?

Explain.

3. The first principle of economics discussed in

Chapter 1 is that people face trade-offs. Use a

production possibilities frontier to illustrate society’s

trade-off between two “goods”—a clean environment

and the quantity of industrial output. What do you

suppose determines the shape and position of the

frontier? Show what happens to the frontier if

engineers develop a new way of producing electricity

that emits fewer pollutants.

4. An economy consists of three workers: Larry, Moe,

and Curly. Each works 10 hours a day and can pro-

duce two services: mowing lawns and washing cars.

In an hour, Larry can either mow one lawn or wash

one car; Moe can either mow one lawn or wash two

cars; and Curly can either mow two lawns or wash

one car.

a. Calculate how much of each service is produced

under the following circumstances, which we

label A, B, C, and D:

All three spend all their time mowing lawns. (A)

All three spend all their time washing cars. (B)

A l l t h re e s p e n d h a l f t h e i r t i m e o n e a c h

activity. (C)

Larry spends half his time on each activity, while

Moe only washes cars and Curly only mows

lawns. (D)

b. Graph the production possibilities frontier for this

economy. Using your answers to part a, identify points A, B, C, and D on your graph.

c. Explain why the production possibilities frontier

has the shape it does.

d. Are any of the allocations calculated in

part a inefficient? Explain.

36 PART I INTRODUCTION

5. Classify the following topics as relating to

microeconomics or macroeconomics.

a. a family’s decision about how much

income to save

b. the effect of government regulations on auto

emissions

c. the impact of higher national saving on economic

growth

d. a firm’s decision about how many workers to hire

e. the relationship between the inflation rate and

changes in the quantity of money

6. Classify each of the following statements as positive or

normative. Explain.

a. Society faces a short-run trade-off between

inflation and unemployment.

b. A reduction in the rate of money growth will

reduce the rate of inflation.

c. The Federal Reserve should reduce the rate of

money growth.

d. Society ought to require welfare recipients to look

for jobs.

e. Lower tax rates encourage more work and more

saving.

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

Graphing: A Brief Review Many of the concepts that economists study can be expressed with numbers—the price of bananas, the quantity of bananas sold, the cost of growing bananas, and so on. Often, these economic variables are related to one another: When the price of bananas rises, people buy fewer bananas. One way of expressing the relation- ships among variables is with graphs.

Graphs serve two purposes. First, when developing economic theories, graphs offer a visual way to express ideas that might be less clear if described with equa- tions or words. Second, when analyzing economic data, graphs provide a power- ful way of finding and interpreting patterns. Whether we are working with theory or with data, graphs provide a lens through which a recognizable forest emerges from a multitude of trees.

Numerical information can be expressed graphically in many ways, just as there are many ways to express a thought in words. A good writer chooses words that will make an argument clear, a description pleasing, or a scene dramatic. An effective economist chooses the type of graph that best suits the purpose at hand.

In this appendix, we discuss how economists use graphs to study the mathe- matical relationships among variables. We also discuss some of the pitfalls that can arise in the use of graphical methods.

Graphs of a Single Variable Three common graphs are shown in Figure A-1. The pie chart in panel (a) shows how total income in the United States is divided among the sources of income, including compensation of employees, corporate profits, and so on. A slice of the pie represents each source’s share of the total. The bar graph in panel (b) compares income in four countries. The height of each bar represents the average income in each country. The time-series graph in panel (c) traces the ris- ing productivity in the U.S. business sector over time. The height of the line shows output per hour in each year. You have probably seen similar graphs in newspapers and magazines.

Graphs of Two Variables: The Coordinate System The three graphs in Figure A-1 are useful in showing how a variable changes over time or across individuals, but they are limited in how much they can tell us. These graphs display information only about a single variable. Economists are often concerned with the relationships between variables. Thus, they need to display two variables on a single graph. The coordinate system makes this possible.

Suppose you want to examine the relationship between study time and grade point average. For each student in your class, you could record a pair of numbers: hours per week spent studying and grade point average. These numbers could then be placed in parentheses as an ordered pair and appear as a single point on the graph. Albert E., for instance, is represented by the ordered pair (25 hours/week, 3.5 GPA),

Appendix

38 PART I INTRODUCTION

while his “what-me-worry?” classmate Alfred E. is represented by the ordered pair (5 hours/week, 2.0 GPA).

We can graph these ordered pairs on a two-dimensional grid. The first number in each ordered pair, called the x-coordinate, tells us the horizontal location of the point. The second number, called the y-coordinate, tells us the vertical location of the point. The point with both an x-coordinate and a y-coordinate of zero is known as the origin. The two coordinates in the ordered pair tell us where the point is located in relation to the origin: x units to the right of the origin and y units above it.

Figure A-2 graphs grade point average against study time for Albert E., Alfred E., and their classmates. This type of graph is called a scatter plot because it plots

The pie chart in panel (a) shows how U.S. national income is derived from various sources. The

bar graph in panel (b) compares the average income in four countries. The time-series graph in

panel (c) shows the productivity of labor in U.S. businesses over time.Types of Graphs

FIGURE A-1

(a) Pie Chart (c) Time-Series Graph

United States

($54,630) United

Kingdom ($39,137)

(b) Bar Graph

Mexico ($17,167)

India ($5,833)

Productivity Index

Income per Person in 2014

120 100 80 60 40 20

1950 1960 1970 1980 1990 2000 2010

40,000

50,000

$60,000

30,000

20,000

10,000

0 Compensation of employees

(61%)

Rental income (4%)

Interest income (3%)

Taxes on production (8%)

Proprietors’ income (9%)

Corporate profits (15%)

Grade point average is measured on

the vertical axis and study time on the

horizontal axis. Albert E., Alfred E.,

and their classmates are represented

by various points. We can see from the

graph that students who study more

tend to get higher grades.

Using the Coordinate System

FIGURE A-2 Grade Point

Average

2.5

2.0

1.5

1.0

0.5

40 Study Time

(hours per week)

3.0

3.5

4.0

0 5 10 15 20 25 30 35

Alfred E. (5, 2.0)

Albert E. (25, 3.5)

39CHAPTER 2 THINKING LIKE AN ECONOMIST

scattered points. Looking at this graph, we immediately notice that points farther to the right (indicating more study time) also tend to be higher (indicating a better grade point average). Because study time and grade point average typically move in the same direction, we say that these two variables have a positive correlation. By contrast, if we were to graph party time and grades, we would likely find that higher party time is associated with lower grades. Because these variables typi- cally move in opposite directions, we say that they have a negative correlation. In either case, the coordinate system makes the correlation between two variables easy to see.

Curves in the Coordinate System Students who study more do tend to get higher grades, but other factors also influence a student’s grades. Previous preparation is an important factor, for instance, as are talent, attention from teachers, even eating a good breakfast. A scatter plot like Figure A-2 does not attempt to isolate the effect that study- ing has on grades from the effects of other variables. Often, however, econo- mists prefer looking at how one variable affects another, holding everything else constant.

To see how this is done, let’s consider one of the most important graphs in eco- nomics: the demand curve. The demand curve traces out the effect of a good’s price on the quantity of the good consumers want to buy. Before showing a demand curve, however, consider Table A-1, which shows how the number of novels that Emma buys depends on her income and on the price of novels. When novels are cheap, Emma buys them in large quantities. As they become more expensive, she instead borrows books from the library or chooses to go to the movies rather than read. Similarly, at any given price, Emma buys more novels when she has a higher income. That is, when her income increases, she spends part of the additional income on novels and part on other goods.

We now have three variables—the price of novels, income, and the number of novels purchased—which is more than we can represent in two dimensions. To put the information from Table A-1 in graphical form, we need to hold one of the three variables constant and trace out the relationship between the other two. Because the demand curve represents the relationship between price and quantity demanded, we hold Emma’s income constant and show how the number of nov- els she buys varies with the price of novels.

TABLE A-1

Novels Purchased by Emma

This table shows the number of novels

Emma buys at various incomes and prices.

For any given level of income, the data

on price and quantity demanded can be

graphed to produce Emma’s demand curve

for novels, as shown in Figures A-3 and A-4.

Price For $30,000

Income:

For $40,000

Income:

For $50,000

Income:

$10

2 novels

Demand curve, D 3

5 novels

Demand curve, D 1

8 novels

Demand curve, D 2

40 PART I INTRODUCTION

Suppose that Emma’s income is $40,000 per year. If we place the number of novels Emma purchases on the x-axis and the price of novels on the y-axis, we can graphically represent the middle column of Table A-1. When the points that rep- resent these entries from the table—(5 novels, $10), (9 novels, $9), and so on—are connected, they form a line. This line, pictured in Figure A-3, is known as Emma’s demand curve for novels; it tells us how many novels Emma purchases at any given price, holding income constant. The demand curve is downward-sloping, indicating that a higher price reduces the quantity of novels demanded. Because the quantity of novels demanded and the price move in opposite directions, we say that the two variables are negatively related. (Conversely, when two variables move in the same direction, the curve relating them is upward-sloping, and we say that the variables are positively related.)

Now suppose that Emma’s income rises to $50,000 per year. At any given price, Emma will purchase more novels than she did at her previous level of income. Just as earlier we drew Emma’s demand curve for novels using the entries from the middle column of Table A-1, we now draw a new demand curve using the entries from the right column of the table. This new demand curve (curve D

2 ) is

pictured alongside the old one (curve D 1 ) in Figure A-4; the new curve is a similar

line drawn farther to the right. We therefore say that Emma’s demand curve for novels shifts to the right when her income increases. Likewise, if Emma’s income were to fall to $30,000 per year, she would buy fewer novels at any given price and her demand curve would shift to the left (to curve D

3 ).

In economics, it is important to distinguish between movements along a curve and shifts of a curve. As we can see from Figure A-3, if Emma earns $40,000 per year and novels cost $8 apiece, she will purchase 13 novels per year. If the price of

The line D 1 shows how Emma’s

purchases of novels depend on the

price of novels when her income is

held constant. Because the price and

the quantity demanded are negatively

related, the demand curve slopes

downward.

Demand Curve

FIGURE A-3 Price of Novels

30 Quantity of Novels

Purchased

$11

0 5 10 15 20 25

Demand, D1

(5, $10)

(9, $9)

(13, $8)

(17, $7)

(21, $6)

(25, $5)

41CHAPTER 2 THINKING LIKE AN ECONOMIST

novels falls to $7, Emma will increase her purchases of novels to 17 per year. The demand curve, however, stays fixed in the same place. Emma still buys the same number of novels at each price, but as the price falls, she moves along her demand curve from left to right. By contrast, if the price of novels remains fixed at $8 but her income rises to $50,000, Emma increases her purchases of novels from 13 to 16 per year. Because Emma buys more novels at each price, her demand curve shifts out, as shown in Figure A-4.

There is a simple way to tell when it is necessary to shift a curve: When a rel- evant variable that is not named on either axis changes, the curve shifts. Income is on neither the x-axis nor the y-axis of the graph, so when Emma’s income changes, her demand curve must shift. The same is true for any change that affects Emma’s purchasing habits, with the sole exception of a change in the price of novels. If, for instance, the public library closes and Emma must buy all the books she wants to read, she will demand more novels at each price, and her demand curve will shift to the right. Or if the price of movies falls and Emma spends more time at the movies and less time reading, she will demand fewer novels at each price, and her demand curve will shift to the left. By contrast, when a variable on an axis of the graph changes, the curve does not shift. We read the change as a movement along the curve.

Slope One question we might want to ask about Emma is how much her purchasing habits respond to price. Look at the demand curve pictured in Figure A-5. If this curve is very steep, Emma purchases nearly the same number of novels regardless

The location of Emma’s demand

curve for novels depends on how

much income she earns. The more

she earns, the more novels she will

purchase at any given price, and the

farther to the right her demand curve

will lie. Curve D 1 represents Emma’s

original demand curve when her

income is $40,000 per year. If her

income rises to $50,000 per year,

her demand curve shifts to D 2 . If her

income falls to $30,000 per year, her

demand curve shifts to D 3 .

Shifting Demand Curves

FIGURE A-4Price of Novels

30 Quantity of Novels

Purchased

$11

0 5 13 1610 15 20 25

(13, $8)

(16, $8)

D3 (income = $30,000)

D1 (income = $40,000)

D2 (income = $50,000)

(10, $8) When income increases, the demand curve shifts to the right.

When income decreases, the demand curve shifts to the left.

42 PART I INTRODUCTION

of whether they are cheap or expensive. If this curve is much flatter, the number of novels Emma purchases is more sensitive to changes in the price. To answer questions about how much one variable responds to changes in another variable, we can use the concept of slope.

The slope of a line is the ratio of the vertical distance covered to the horizontal distance covered as we move along the line. This definition is usually written out in mathematical symbols as follows:

slope 5 Δy

, Δx

where the Greek letter Δ (delta) stands for the change in a variable. In other words, the slope of a line is equal to the “rise” (change in y) divided by the “run” (change in x). The slope will be a small positive number for a fairly flat upward-sloping line, a large positive number for a steep upward-sloping line, and a negative number for a downward-sloping line. A horizontal line has a slope of zero because in this case the y-variable never changes; a vertical line is said to have an infinite slope because the y-variable can take any value without the x-variable changing at all.

What is the slope of Emma’s demand curve for novels? First of all, because the curve slopes down, we know the slope will be negative. To calculate a numerical value for the slope, we must choose two points on the line. With Emma’s income at $40,000, she will purchase 21 novels at a price of $6 or 13 novels at a price of $8. When we apply the slope formula, we are concerned with the change between these two points. In other words, we are concerned with the difference between

To calculate the slope of the demand

curve, we can look at the changes in

the x- and y-coordinates as we move

from the point (21 novels, $6) to the

point (13 novels, $8). The slope of

the line is the ratio of the change in

the y-coordinate (−2) to the change

in the x-coordinate (+8), which

equals −¼.

Calculating the Slope of a Line

FIGURE A-5 Price of Novels

30 Quantity of Novels

Purchased

$11

0 5 211310 15 20 25

Demand, D1

(13, $8)

(21, $6) 6 2 8 5 22

21 2 13 5 8

43CHAPTER 2 THINKING LIKE AN ECONOMIST

them, which lets us know that we will have to subtract one set of values from the other, as follows:

slope 5 Δy

5 first y-coordinate − second y-coordinate

5 6 − 8

5 − 2

5 − 1

Δx first x-coordinate − second x-coordinate 21 − 13 8 4

Figure A-5 shows graphically how this calculation works. Try computing the slope of Emma’s demand curve using two different points. You should get exactly the same result, −¼. One of the properties of a straight line is that it has the same slope everywhere. This is not true of other types of curves, which are steeper in some places than in others.

The slope of Emma’s demand curve tells us something about how responsive her purchases are to changes in the price. A small slope (a number close to zero) means that Emma’s demand curve is relatively flat; in this case, she adjusts the number of novels she buys substantially in response to a price change. A larger slope (a number farther from zero) means that Emma’s demand curve is relatively steep; in this case, she adjusts the number of novels she buys only slightly in response to a price change.

Cause and Effect Economists often use graphs to advance an argument about how the economy works. In other words, they use graphs to argue about how one set of events causes another set of events. With a graph like the demand curve, there is no doubt about cause and effect. Because we are varying price and holding all other vari- ables constant, we know that changes in the price of novels cause changes in the quantity Emma demands. Remember, however, that our demand curve came from a hypothetical example. When graphing data from the real world, it is often more difficult to establish how one variable affects another.

The first problem is that it is difficult to hold everything else constant when studying the relationship between two variables. If we are not able to hold other variables constant, we might decide that one variable on our graph is causing changes in the other variable when those changes are actually being caused by a third omitted variable not pictured on the graph. Even if we have identified the cor- rect two variables to look at, we might run into a second problem—reverse causality. In other words, we might decide that A causes B when in fact B causes A. The omitted-variable and reverse-causality traps require us to proceed with caution when using graphs to draw conclusions about causes and effects.

Omitted Variables To see how omitting a variable can lead to a deceptive graph, let’s consider an example. Imagine that the government, spurred by public

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44 PART I INTRODUCTION

concern about the large number of deaths from cancer, commissions an exhaus- tive study from Big Brother Statistical Services, Inc. Big Brother examines many of the items found in people’s homes to see which of them are associated with the risk of cancer. Big Brother reports a strong relationship between two variables: the number of cigarette lighters that a household owns and the probability that some- one in the household will develop cancer. Figure A-6 shows this relationship.

What should we make of this result? Big Brother advises a quick policy response. It recommends that the government discourage the ownership of ciga- rette lighters by taxing their sale. It also recommends that the government require warning labels: “Big Brother has determined that this lighter is dangerous to your health.”

In judging the validity of Big Brother ’s analysis, one question is key: Has Big Brother held constant every relevant variable except the one under consideration? If the answer is no, the results are suspect. An easy explanation for Figure A-6 is that people who own more cigarette lighters are more likely to smoke cigarettes and that cigarettes, not lighters, cause cancer. If Figure A-6 does not hold constant the amount of smoking, it does not tell us the true effect of owning a cigarette lighter.

This story illustrates an important principle: When you see a graph used to support an argument about cause and effect, it is important to ask whether the movements of an omitted variable could explain the results you see.

Reverse Causality Economists can also make mistakes about causality by misreading its direction. To see how this is possible, suppose the Association of American Anarchists commissions a study of crime in America and arrives at Figure A-7, which plots the number of violent crimes per thousand people in major cities against the number of police officers per thousand people. The anarchists note the curve’s upward slope and argue that because police increase rather than decrease the amount of urban violence, law enforcement should be abolished.

If we could run a controlled experiment, we would avoid the danger of reverse causality. To run an experiment, we would randomly assign different numbers of police to different cities and then examine the correlation between police and crime. Figure A-7, however, is not based on such an experiment. We simply

The upward-sloping curve shows

that members of households with

more cigarette lighters are more

likely to develop cancer. Yet we

should not conclude that ownership

of lighters causes cancer because the

graph does not take into account the

number of cigarettes smoked.

Graph with an Omitted Variable

FIGURE A-6 Risk of Cancer

Number of Lighters in House 0

45CHAPTER 2 THINKING LIKE AN ECONOMIST

observe that more dangerous cities have more police officers. The explanation for this may be that more dangerous cities hire more police. In other words, rather than police causing crime, crime may cause police. Nothing in the graph itself allows us to establish the direction of causality.

It might seem that an easy way to determine the direction of causality is to examine which variable moves first. If we see crime increase and then the police force expand, we reach one conclusion. If we see the police force expand and then crime increase, we reach the other. This approach, however, is also flawed: Often, people change their behavior not in response to a change in their present con- ditions but in response to a change in their expectations of future conditions. A city that expects a major crime wave in the future, for instance, might hire more police now. This problem is even easier to see in the case of babies and minivans. Couples often buy a minivan in anticipation of the birth of a child. The minivan comes before the baby, but we wouldn’t want to conclude that the sale of mini- vans causes the population to grow!

There is no complete set of rules that says when it is appropriate to draw causal conclusions from graphs. Yet just keeping in mind that cigarette lighters don’t cause cancer (omitted variable) and that minivans don’t cause larger families (reverse causality) will keep you from falling for many faulty economic arguments.

The upward-sloping curve shows that

cities with a higher concentration of

police are more dangerous. Yet the

graph does not tell us whether police

cause crime or crime-plagued cities

hire more police.

Graph Suggesting Reverse Causality

FIGURE A-7Violent Crimes

(per 1,000 people)

Police Officers (per 1,000 people)

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CHAPTER

3 Interdependence and the Gains from Trade

C onsider your typical day. You wake up in the morning and pour yourself juice from oranges grown in Florida and coffee from beans grown in Brazil. Over breakfast, you read a newspaper written in New York on a tablet made in

China. You get dressed in clothes made of cotton grown in Georgia and sewn in fac- tories in Thailand. You drive to class in a car made of parts manufactured in more than a dozen countries around the world. Then you open up your economics text- book written by an author living in Massachusetts, published by a company located in Ohio, and printed on paper made from trees grown in Oregon.

48 PART I INTRODUCTION

Every day, you rely on many people, most of whom you have never met, to provide you with the goods and services that you enjoy. Such interdependence is possible because people trade with one another. Those people providing you with goods and services are not acting out of generosity. Nor is some govern- ment agency directing them to satisfy your desires. Instead, people provide you and other consumers with the goods and services they produce because they get something in return.

In subsequent chapters, we examine how an economy coordinates the activi- ties of millions of people with varying tastes and abilities. As a starting point for this analysis, in this chapter we consider the reasons for economic interdepen- dence. One of the Ten Principles of Economics highlighted in Chapter 1 is that trade can make everyone better off. We now examine this principle more closely. What exactly do people gain when they trade with one another? Why do people choose to become interdependent?

The answers to these questions are key to understanding the modern global economy. Most countries today import from abroad many of the goods and ser- vices they consume, and they export to foreign customers many of the goods and services they produce. The analysis in this chapter explains interdependence not only among individuals but also among nations. As we will see, the gains from trade are much the same whether you are buying a haircut from your local barber or a T-shirt made by a worker on the other side of the globe.

3-1 A Parable for the Modern Economy To understand why people choose to depend on others for goods and services and how this choice improves their lives, let’s examine a simple economy. Imagine that there are only two goods in the world: meat and potatoes. And there are only two people in the world: a cattle rancher named Ruby and a potato farmer named Frank. Both Ruby and Frank would like to eat a diet of both meat and potatoes.

The gains from trade are most obvious if Ruby can produce only meat and Frank can produce only potatoes. In one scenario, Frank and Ruby could choose to have nothing to do with each other. But after several months of eating beef roasted, boiled, broiled, and grilled, Ruby might decide that self-sufficiency is not all it’s cracked up to be. Frank, who has been eating potatoes mashed, fried, baked, and scalloped, would likely agree. It is easy to see that trade would allow both of them to enjoy greater variety: Each could then have a steak with a baked potato or a burger with fries.

Although this scene illustrates most simply how everyone can benefit from trade, the gains would be similar if Frank and Ruby were each capable of produc- ing the other good, but only at great cost. Suppose, for example, that Ruby is able to grow potatoes but her land is not very well suited for it. Similarly, suppose that Frank is able to raise cattle and produce meat but is not very good at it. In this case, Frank and Ruby can each benefit by specializing in what he or she does best and then trading with the other person.

The gains from trade are less obvious, however, when one person is better at producing every good. For example, suppose that Ruby is better at raising cattle and better at growing potatoes than Frank. In this case, should Ruby choose to remain self- sufficient? Or is there still reason for her to trade with Frank? To answer this question, we need to look more closely at the factors that affect such a decision.

49CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

3-1a Production Possibilities Suppose that Frank and Ruby each work 8 hours per day and can devote this time to growing potatoes, raising cattle, or a combination of the two. The table in Figure 1 shows the amount of time each person requires to produce 1 ounce of each good. Frank can produce an ounce of potatoes in 15 minutes and an ounce of meat in 60 minutes. Ruby, who is more productive in both activities, can produce an ounce of potatoes in 10 minutes and an ounce of meat in 20 minutes. The last two columns in the table show the amounts of meat or potatoes Frank and Ruby can produce if they devote all 8 hours to producing only that good.

Panel (b) of Figure 1 illustrates the amounts of meat and potatoes that Frank can produce. If Frank devotes all 8 hours of his time to potatoes, he produces 32 ounces of potatoes (measured on the horizontal axis) and no meat. If he devotes all of his time to meat, he produces 8 ounces of meat (measured on the vertical axis) and no potatoes. If Frank divides his time equally between the two activities, spending 4 hours on each, he produces 16 ounces of potatoes and 4 ounces of meat. The figure shows these three possible outcomes and all others in between.

This graph is Frank’s production possibilities frontier. As we discussed in Chapter 2, a production possibilities frontier shows the various mixes of output

FIGURE 1

The Production Possibilities

Frontier

Panel (a) shows the production opportunities available to Frank the farmer and Ruby the

rancher. Panel (b) shows the combinations of meat and potatoes that Frank can produce.

Panel (c) shows the combinations of meat and potatoes that Ruby can produce. Both

production possibilities frontiers are derived assuming that Frank and Ruby each work

8 hours per day. If there is no trade, each person’s production possibilities frontier is

also his or her consumption possibilities frontier.

(a) Production Opportunities

Minutes Needed to Amount

Make 1 Ounce of: Produced in 8 Hours

Meat Potatoes Meat Potatoes

Frank the farmer 60 min/oz 15 min/oz 8 oz 32 oz

Ruby the rancher 20 min/oz 10 min/oz 24 oz 48 oz

Potatoes (ounces) 16 32

Meat (ounces)

(b) Frank’s Production Possibilities Frontier

If there is no trade, Frank chooses this production and consumption.

Potatoes (ounces) 24

Meat (ounces)

24 If there is no trade, Ruby chooses this production and consumption.

50 PART I INTRODUCTION

that an economy can produce. It illustrates one of the Ten Principles of Economics in Chapter 1: People face trade-offs. Here Frank faces a trade-off between producing meat and producing potatoes.

You may recall that the production possibilities frontier in Chapter 2 was drawn bowed out. In that case, the rate at which society could trade one good for the other depended on the amounts that were being produced. Here, how- ever, Frank’s technology for producing meat and potatoes (as summarized in Figure 1) allows him to switch between the two goods at a constant rate. When- ever Frank spends 1 hour less producing meat and 1 hour more producing pota- toes, he reduces his output of meat by 1 ounce and raises his output of potatoes by 4 ounces—and this is true regardless of how much he is already producing. As a result, the production possibilities frontier is a straight line.

Panel (c) of Figure 1 shows the production possibilities frontier for Ruby. If Ruby devotes all 8 hours of her time to potatoes, she produces 48 ounces of pota- toes and no meat. If she devotes all of her time to meat, she produces 24 ounces of meat and no potatoes. If Ruby divides her time equally, spending 4 hours on each activity, she produces 24 ounces of potatoes and 12 ounces of meat. Once again, the production possibilities frontier shows all the possible outcomes.

If Frank and Ruby choose to be self-sufficient rather than trade with each other, then each consumes exactly what he or she produces. In this case, the production possibilities frontier is also the consumption possibilities frontier. That is, without trade, Figure 1 shows the possible combinations of meat and potatoes that Frank and Ruby can each produce and then consume.

These production possibilities frontiers are useful in showing the trade-offs that Frank and Ruby face, but they do not tell us what Frank and Ruby will actu- ally choose to do. To determine their choices, we need to know the tastes of Frank and Ruby. Let’s suppose they choose the combinations identified by points A and B in Figure 1. Based on his production opportunities and food preferences, Frank decides to produce and consume 16 ounces of potatoes and 4 ounces of meat, while Ruby decides to produce and consume 24 ounces of potatoes and 12 ounces of meat.

3-1b Specialization and Trade After several years of eating combination B, Ruby gets an idea and goes to talk to Frank:

ruby: Frank, my friend, have I got a deal for you! I know how to improve life for both of us. I think you should stop producing meat alto- gether and devote all your time to growing potatoes. According to my calculations, if you work 8 hours a day growing potatoes, you’ll produce 32 ounces of potatoes. If you give me 15 of those 32 ounces, I’ll give you 5 ounces of meat in return. In the end, you’ll get to eat 17 ounces of potatoes and 5 ounces of meat every day, instead of the 16 ounces of potatoes and 4 ounces of meat you now get. If you go along with my plan, you’ll have more of both foods. [To illustrate her point, Ruby shows Frank panel (a) of Figure 2.]

frank: (sounding skeptical) That seems like a good deal for me. But I don’t understand why you are offering it. If the deal is so good for me, it can’t be good for you too.

ruby: Oh, but it is! Suppose I spend 6 hours a day raising cattle and 2 hours growing potatoes. Then I can produce 18 ounces of meat and 12 ounces of potatoes. After I give you 5 ounces of my meat in exchange for 15 ounces of your potatoes, I’ll end up with 13 ounces

51CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

of meat and 27 ounces of potatoes, instead of the 12 ounces of meat and 24 ounces of potatoes that I now get. So I will also consume more of both foods than I do now. [She points out panel (b) of Figure 2.]

frank: I don’t know. . . . This sounds too good to be true. ruby: It’s really not as complicated as it first seems. Here—I’ve summa-

rized my proposal for you in a simple table. [Ruby shows Frank a copy of the table at the bottom of Figure 2.]

frank: (after pausing to study the table) These calculations seem correct, but I am puzzled. How can this deal make us both better off?

ruby: We can both benefit because trade allows each of us to specialize in doing what we do best. You will spend more time growing potatoes and less time raising cattle. I will spend more time raising cattle

FIGURE 2

How Trade Expands the Set

of Consumption Opportunities

The proposed trade between Frank the farmer and Ruby the rancher offers each of them

a combination of meat and potatoes that would be impossible in the absence of trade. In

panel (a), Frank gets to consume at point A* rather than point A. In panel (b), Ruby gets to

consume at point B* rather than point B. Trade allows each to consume more meat and more

potatoes.

Frank Ruby

Meat Potatoes Meat Potatoes

Without Trade:

Production and Consumption 4 oz 16 oz 12 oz 24 oz

With Trade:

Production 0 oz 32 oz 18 oz 12 oz

Trade Gets 5 oz Gives 15 oz Gives 5 oz Gets 15 oz

Consumption 5 oz 17 oz 13 oz 27 oz

GAINS FROM TRADE:

Increase in Consumption 11 oz 11 oz 11 oz 13 oz

4 5

Potatoes (ounces) 16 17

Meat (ounces)

(a) Frank’s Production and Consumption

Frank's production and consumption without trade

Frank's consumption with trade

Frank's production with trade

Potatoes (ounces) 2412 27

Meat (ounces)

(b) Ruby’s Production and Consumption

Ruby's consumption with trade

Ruby's production with trade

Ruby's production and consumption without trade

52 PART I INTRODUCTION

and less time growing potatoes. As a result of specialization and trade, each of us can consume more meat and more potatoes with- out working any more hours.

Draw an example of a production possibilities frontier for Robinson

Crusoe, a shipwrecked sailor who spends his time gathering coconuts and

catching fish. Does this frontier limit Crusoe’s consumption of coconuts and fish if he lives

by himself? Would he face the same limits if he could trade with natives on the island?

QuickQuiz

3-2 Comparative Advantage: The Driving Force of Specialization Ruby’s explanation of the gains from trade, though correct, poses a puzzle: If Ruby is better at both raising cattle and growing potatoes, how can Frank ever specialize in doing what he does best? Frank doesn’t seem to do anything best. To solve this puzzle, we need to look at the principle of comparative advantage.

As a first step in developing this principle, consider the following question: In our example, who can produce potatoes at a lower cost—Frank or Ruby? There are two possible answers, and in these two answers lie the solution to our puzzle and the key to understanding the gains from trade.

3-2a Absolute Advantage One way to answer the question about the cost of producing potatoes is to com- pare the inputs required by the two producers. Economists use the term absolute advantage when comparing the productivity of one person, firm, or nation to that of another. The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good.

In our example, time is the only input, so we can determine absolute advantage by looking at how much time each type of production takes. Ruby has an absolute advantage in producing both meat and potatoes because she requires less time than Frank to produce a unit of either good. Ruby needs to input only 20 minutes to produce an ounce of meat, whereas Frank needs 60 minutes. Similarly, Ruby needs only 10 minutes to produce an ounce of potatoes, whereas Frank needs 15 minutes. Thus, if we measure cost in terms of the quantity of inputs, Ruby has the lower cost of producing potatoes.

3-2b Opportunity Cost and Comparative Advantage There is another way to look at the cost of producing potatoes. Rather than comparing inputs required, we can compare opportunity costs. Recall from Chapter 1 that the opportunity cost of some item is what we give up to get that item. In our example, we assumed that Frank and Ruby each spend 8 hours a day working. Time spent producing potatoes, therefore, takes away from time available for producing meat. When reallocating time between the two goods, Ruby and Frank give up units of one good to produce units of the other, thereby moving along the production possibilities frontier. The opportunity cost measures the trade-off between the two goods that each producer faces.

Let’s first consider Ruby’s opportunity cost. According to the table in panel (a) of Figure 1, producing 1 ounce of potatoes takes 10 minutes of work. When Ruby spends those 10 minutes producing potatoes, she spends 10 fewer minutes producing meat. Because Ruby needs 20 minutes to produce 1 ounce of meat, 10 minutes of work would yield ½ ounce of meat. Hence, Ruby’s opportunity cost of producing 1 ounce of potatoes is ½ ounce of meat.

absolute advantage

the ability to produce a

good using fewer inputs

than another producer

opportunity cost

whatever must be given

up to obtain some item

53CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Now consider Frank’s opportunity cost. Producing 1 ounce of potatoes takes him 15 minutes. Because he needs 60 minutes to produce 1 ounce of meat, 15 minutes of work would yield ¼ ounce of meat. Hence, Frank’s opportunity cost of 1 ounce of potatoes is ¼ ounce of meat.

Table 1 shows the opportunity costs of meat and potatoes for the two produc- ers. Notice that the opportunity cost of meat is the inverse of the opportunity cost of potatoes. Because 1 ounce of potatoes costs Ruby ½ ounce of meat, 1 ounce of meat costs Ruby 2 ounces of potatoes. Similarly, because 1 ounce of potatoes costs Frank ¼ ounce of meat, 1 ounce of meat costs Frank 4 ounces of potatoes.

Economists use the term comparative advantage when describing the opportu- nity costs faced by two producers. The producer who gives up less of other goods to produce Good X has the smaller opportunity cost of producing Good X and is said to have a comparative advantage in producing it. In our example, Frank has a lower opportunity cost of producing potatoes than Ruby: An ounce of potatoes costs Frank only ¼ ounce of meat, but it costs Ruby ½ ounce of meat. Conversely, Ruby has a lower opportunity cost of producing meat than Frank: An ounce of meat costs Ruby 2 ounces of potatoes, but it costs Frank 4 ounces of potatoes. Thus, Frank has a comparative advantage in growing potatoes, and Ruby has a comparative advantage in producing meat.

Although it is possible for one person to have an absolute advantage in both goods (as Ruby does in our example), it is impossible for one person to have a comparative advantage in both goods. Because the opportunity cost of one good is the inverse of the opportunity cost of the other, if a person’s opportunity cost of one good is relatively high, the opportunity cost of the other good must be rel- atively low. Comparative advantage reflects the relative opportunity cost. Unless two people have the same opportunity cost, one person will have a comparative advantage in one good, and the other person will have a comparative advantage in the other good.

3-2c Comparative Advantage and Trade The gains from specialization and trade are based not on absolute advantage but on comparative advantage. When each person specializes in producing the good for which he or she has a comparative advantage, total production in the econ- omy rises. This increase in the size of the economic pie can be used to make every- one better off.

In our example, Frank spends more time growing potatoes, and Ruby spends more time producing meat. As a result, the total production of potatoes rises from 40 to 44 ounces, and the total production of meat rises from 16 to 18 ounces. Frank and Ruby share the benefits of this increased production.

We can also view the gains from trade in terms of the price that each party pays the other. Because Frank and Ruby have different opportunity costs, they can both

comparative advantage

the ability to produce a

good at a lower oppor-

tunity cost than another

producer

TABLE 1

The Opportunity Cost of Meat and

Potatoes

Opportunity Cost of:

1 oz of Meat 1 oz of Potatoes

Frank the farmer 4 oz potatoes ¼ oz meat

Ruby the rancher 2 oz potatoes ½ oz meat

54 PART I INTRODUCTION

get a bargain. That is, each of them benefits from trade by obtaining a good at a price that is lower than his or her opportunity cost of that good.

Consider the proposed deal from Frank’s viewpoint. Frank receives 5 ounces of meat in exchange for 15 ounces of potatoes. In other words, Frank buys each ounce of meat for a price of 3 ounces of potatoes. This price of meat is lower than his opportunity cost for an ounce of meat, which is 4 ounces of potatoes. Thus, Frank benefits from the deal because he gets to buy meat at a good price.

Now consider the deal from Ruby’s viewpoint. Ruby buys 15 ounces of potatoes at a cost of 5 ounces of meat. That is, the price for an ounce of potatoes is 1/3 ounce of meat. This price of potatoes is lower than her opportunity cost of an ounce of potatoes, which is ½ ounce of meat. Ruby benefits because she gets to buy potatoes at a good price.

The story of Ruby the rancher and Frank the farmer has a simple moral, which should now be clear: Trade can benefit everyone in society because it allows people to specialize in activities in which they have a comparative advantage.

3-2d The Price of the Trade The principle of comparative advantage establishes that there are gains from specialization and trade, but it raises a couple of related questions: What determines the price at which trade takes place? How are the gains from trade shared between the trading parties? The precise answers to these questions are beyond the scope of this chapter, but we can state one general rule: For both parties to gain from trade, the price at which they trade must lie between the two opportunity costs.

In our example, Frank and Ruby agreed to trade at a rate of 3 ounces of potatoes for each ounce of meat. This price is between Ruby’s opportunity cost (2 ounces of potatoes per ounce of meat) and Frank’s opportunity cost (4 ounces of potatoes per ounce of meat). The price need not be exactly in the middle for both parties to gain, but it must be somewhere between 2 and 4.

To see why the price has to be in this range, consider what would happen if it were not. If the price of meat were below 2 ounces of potatoes, both Frank and Ruby would want to buy meat, because the price would be below each of their opportunity costs. Similarly, if the price of meat were above 4 ounces of potatoes, both would want to sell meat, because the price would be above their opportunity costs. But there are only two members of this economy. They can- not both be buyers of meat, nor can they both be sellers. Someone has to take the other side of the deal.

A mutually advantageous trade can be struck at a price between 2 and 4. In this price range, Ruby wants to sell meat to buy potatoes, and Frank wants to sell potatoes to buy meat. Each party can buy a good at a price that is lower than his or her opportunity cost. In the end, each person specializes in the good for which he or she has a comparative advantage and, as a result, is better off.

Robinson Crusoe can gather 10 coconuts or catch 1 fish per hour. His

friend Friday can gather 30 coconuts or catch 2 fish per hour. What is

Crusoe’s opportunity cost of catching 1 fish? What is Friday’s? Who has an absolute advan-

tage in catching fish? Who has a comparative advantage in catching fish?

QuickQuiz

55CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

The Legacy of Adam Smith and David Ricardo

E conomists have long understood the gains from trade. Here is how the

great economist Adam Smith put the argument:

It is a maxim of every prudent master of a family, never to attempt

to make at home what it will cost him more to make than to buy. The

tailor does not attempt to make his own shoes, but buys them of the

shoemaker. The shoemaker does not attempt to make his own clothes

but employs a tailor. The farmer attempts to make neither the one

nor the other, but employs those different artificers. All of them find

it for their interest to employ their whole industry in a way in which

they have some advantage over their neighbors, and to purchase

with a part of its produce, or what is the

same thing, with the price of part of it,

whatever else they have occasion for.

This quotation is from Smith’s 1776

book An Inquiry into the Nature and

Causes of the Wealth of Nations, which

was a landmark in the analysis of trade

and economic interdependence.

S m i t h ’s b o o k i n s p i r e d D a v i d

Ricardo, a millionaire stockbroker, to

become an economist. In his 1817 book

P r i n c i p l e s o f P o l i t i c a l

Economy and Taxation,

R i c a r d o d e v e l o p e d t h e

principle of comparative

advantage as we know it

today. He considered an ex-

ample with two goods (wine and

cloth) and two countries (England and Portugal). He showed that both

countries can gain by opening up trade and specializing based on com-

parative advantage.

Ricardo’s theory is the starting point of modern international eco-

nomics, but his defense of free trade was not a mere academic exercise.

Ricardo put his beliefs to work as a member of the British Parliament,

where he opposed the Corn Laws, which restricted the import of grain.

The conclusions of Adam Smith and David Ricardo on the gains

from trade have held up well over time. Although economists often

disagree on questions of policy, they are united in their support of free

trade. Moreover, the central argument for free trade has not changed

much in the past two centuries. Even though the field of economics has

broadened its scope and refined its theories since the time of Smith

and Ricardo, economists’ opposition to trade restrictions is still based

largely on the principle of comparative advantage. ■

F Y I

3-3 Applications of Comparative Advantage The principle of comparative advantage explains interdependence and the gains from trade. Because interdependence is so prevalent in the modern world, the principle of comparative advantage has many applications. Here are two exam- ples, one fanciful and one of great practical importance.

3-3a Should Serena Williams Mow Her Own Lawn? When Serena Williams plays at the Wimbledon tennis tournament, she spends a lot of time running around on grass. One of the most talented tennis players of all time, she can hit a ball with a speed and accuracy that most casual athletes can only dream of. Most likely, she is talented at other physical activities as well. For example, let’s imagine that Serena can mow her lawn faster than anyone else. But just because she can mow her lawn fast, does this mean she should?

To answer this question, we can use the concepts of opportunity cost and com- parative advantage. Let’s say that Serena can mow her lawn in 2 hours. In that same 2 hours, she could film a television commercial and earn $30,000. By con- trast, Forrest Gump, the boy next door, can mow Serena’s lawn in 4 hours. In that same 4 hours, Forrest could work at McDonald’s and earn $50.

“They did a nice job with this grass.”

A LL

ST A

R PI

CT U

RE L

IB RA

RY /

A LA

M Y

BE TT

M A

N N

/C O

RB IS

David Ricardo

56 PART I INTRODUCTION

An economist argues that you shouldn’t

always unload the dishwasher just

because you’re better at it than your

partner.

You’re Dividing the Chores

Wrong

By Emily Oster

N o one likes doing chores. In happiness

surveys, housework is ranked down there

with commuting as activities that people

enjoy the least. Maybe that’s why figuring out

who does which chores usually prompts, at

best, tense discussion in a household and, at

worst, outright fighting.

If everyone is good at something differ-

ent, assigning chores is easy. If your part-

ner is great at grocery shopping and you are

great at the laundry, you’re set. But this isn’t

always—or even usually—the case. Often

one person is better at everything. (And let’s

be honest, often that person is the woman.)

Better at the laundry, the grocery shopping,

the cleaning, the cooking. But does that mean

she should have to do everything?

Before my daughter was born, I both

cooked and did the dishes. It wasn’t a big

deal, it didn’t take too much time, and

honestly I was a lot better at both than my

husband. His cooking repertoire extended

only to eggs and chili, and when I left him

in charge of the dishwasher, I’d often find he

had run it “full” with one pot and eight forks.

After we had a kid, we had more to do

and less time to do it in. It seemed like it was

time for some reassignments. But, of course, I

was still better at doing both things. Did that

mean I should do them both?

I could have appealed to the principle of

fairness: We should each do half. I could have

appealed to feminism—surveys show that

women more often than not get the short end

of the chore stick. In time-use data, women do

about 44 minutes more housework than men

(2 hours and 11 minutes versus 1 hour and

27 minutes). Men outwork women only in the

areas of “lawn” and “exterior maintenance.” I

could have suggested he do more chores to rec-

tify this imbalance, to show our daughter, in the

Free To Be You and Me style, that Mom and Dad

are equal and that housework is fun if we do it to-

gether! I could have simply smashed around the

pans in the dishwasher while sighing loudly in the

hopes he would notice and offer to do it himself.

But luckily for me and my husband, I’m an

economist, so I have more effective tools than

passive aggression. And some basic economic

principles provided the answer. We needed

to divide the chores because it is simply not

efficient for the best cook and dishwasher to

do all the cooking and dishwashing. The eco-

nomic principle at play here is increasing mar-

ginal cost. Basically, people get worse when

they are tired. When I teach my students at the

University of Chicago this principle, I explain

it in the context of managing their employ-

ees. Imagine you have a good employee and

a not-so-good one. Should you make the good

employee do literally everything?

Usually, the answer is no. Why not? It’s

likely that the not-so-good employee is better

at 9 a.m. after a full night of sleep than the

good employee is at 2 a.m. after a 17-hour

workday. So you want to give at least a few

tasks to your worse guy. The same principle

applies in your household. Yes, you (or your

spouse) might be better at everything. But

anyone doing the laundry at 4 a.m. is likely to

put the red towels in with the white T-shirts.

Some task splitting is a good idea. How much

depends on how fast people’s skills decay.

Economics within a Marriage

IN THE NEWS

In this example, Serena has an absolute advantage in mowing lawns because she can do the work with a lower input of time. Yet because Serena’s opportunity cost of mowing the lawn is $30,000 and Forrest’s opportunity cost is only $50, For- rest has a comparative advantage in mowing lawns.

The gains from trade in this example are tremendous. Rather than mowing her own lawn, Serena should make the commercial and hire Forrest to mow the lawn. As long as Serena pays Forrest more than $50 and less than $30,000, both of them are better off.

3-3b Should the United States Trade with Other Countries? Just as individuals can benefit from specialization and trade with one another, so can populations of people in different countries. Many of the goods that

57CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

To “optimize” your family efficiency (every

economist’s ultimate goal—and yours, too),

you want to equalize effectiveness on the fi-

nal task each person is doing. Your partner

does the dishes, mows the lawn, and makes

the grocery list. You do the cooking, laundry,

shopping, cleaning, and paying the bills. This

may seem imbalanced, but when you look at

it, you see that by the time your partner gets

to the grocery-list task, he is wearing thin

and starting to nod off. It’s all he can do to

figure out how much milk you need. In fact,

he is just about as good at that as you are

when you get around to paying the bills, even

though that’s your fifth task.

If you then made your partner also do

the cleaning—so it was an even four and

four—the house would be a disaster, since

he is already exhausted by his third chore

while you are still doing fine. This system

may well end up meaning one person does

more, but it is unlikely to result in one per-

son doing everything.

Once you’ve decided you need to divide up

the chores in this way, how should you decide

who does what? One option would be ran-

domly assigning tasks; another would be hav-

ing each person do some of everything. One

spousal-advice website I read suggested you

should divide tasks based on which ones you

like the best. None of these are quite right.

(In the last case, how would anyone ever end

up with the job of cleaning the bathroom?)

To decide who does what, we need more

economics. Specifically, the principle of com-

parative advantage. Economists usually talk

about this in the context of trade. Imagine

Finland is better than Sweden at making both

reindeer hats and snowshoes. But they are

much, much better at the hats and only a lit-

tle better at the snowshoes. The overall world

production is maximized when Finland makes

hats and Sweden makes snowshoes.

We say that Finland has an absolute

advantage in both things but a comparative

advantage only in hats. This principle is part

of the reason economists value free trade,

but that’s for another column (and probably

another author). But it’s also a guideline for

how to trade tasks in your house. You want to

assign each person the tasks on which he or

she has a comparative advantage. It doesn’t

matter that you have an absolute advantage

in everything. If you are much, much better at

the laundry and only a little better at cleaning

the toilet, you should do the laundry and have

your spouse get out the scrub brush. Just ex-

plain that it’s efficient!

In our case, it was easy. Other than using

the grill—which I freely admit is the husband

domain—I’m much, much better at cooking.

And I was only moderately better at the dishes.

So he got the job of cleaning up after meals,

even though his dishwasher loading habits

had already come under scrutiny. The good

news is another economic principle I hadn’t

even counted on was soon in play: learning by

doing. As people do a task, they improve at it.

Eighteen months into this new arrangement the

dishwasher is almost a work of art: neat rows

of dishes and everything carefully screened

for “top-rack only” status. I, meanwhile, am

forbidden from getting near the dishwasher.

Apparently, there is a risk that I’ll “ruin it.” ■

Ms Oster is a professor of economics at Brown

University.

Americans enjoy are produced abroad, and many of the goods produced in the United States are sold abroad. Goods produced abroad and sold domestically are called imports. Goods produced domestically and sold abroad are called exports.

To see how countries can benefit from trade, suppose there are two countries, the United States and Japan, and two goods, food and cars. Imagine that the two countries produce cars equally well: An American worker and a Japanese worker can each produce one car per month. By contrast, because the United States has more and better land, it is better at producing food: A U.S. worker can produce 2 tons of food per month, whereas a Japanese worker can produce only 1 ton of food per month.

imports

goods produced abroad

and sold domestically

exports

goods produced domesti-

cally and sold abroad

RO BE

RT N

EU BE

CK ER

Source: Slate, November 21, 2012.

58 PART I INTRODUCTION

QuickQuiz

The principle of comparative advantage states that each good should be produced by the country that has the smaller opportunity cost of producing that good. Because the op- portunity cost of a car is 2 tons of food in the United States but only 1 ton of food in Japan, Japan has a comparative ad- vantage in producing cars. Japan should produce more cars than it wants for its own use and export some of them to the United States. Similarly, because the opportunity cost of a ton of food is 1 car in Japan but only 1/2 car in the United States, the United States has a comparative advantage in producing food. The United States should produce more food than it wants to consume and export some to Japan. Through spe- cialization and trade, both countries can have more food and more cars.

In reality, of course, the issues involved in trade among nations are more complex than this example suggests. Most important among these issues is that each country has many cit- izens with different interests. International trade can make some individuals worse off, even as it makes the country as a whole better off. When the United States exports food and imports cars, the impact on an American farmer is not the same as the impact on an American autoworker. Yet, contrary to the opin- ions sometimes voiced by politicians and pundits, international trade is not like war, in which some countries win and others lose. Trade allows all countries to achieve greater prosperity.

Suppose that a skilled brain surgeon also happens

to be the world’s fastest typist. Should she do her

own typing or hire a secretary? Explain.

3-4 Conclusion You should now understand more fully the benefits of living

in an interdependent economy. When Americans buy tube socks from China, when residents of Maine drink orange juice from Florida, and when a home- owner hires the kid next door to mow her lawn, the same economic forces are at work. The principle of comparative advantage shows that trade can make everyone better off.

Having seen why interdependence is desirable, you might naturally ask how it is possible. How do free societies coordinate the diverse activities of all the people involved in their economies? What ensures that goods and services will get from those who should be producing them to those who should be con- suming them? In a world with only two people, such as Ruby the rancher and Frank the farmer, the answer is simple: These two people can bargain and allo- cate resources between themselves. In the real world with billions of people, the answer is less obvious. We take up this issue in the next chapter, where we see that free societies allocate resources through the market forces of supply and demand.

ASK THE EXPERTS

Trade between China and the United States

“Trade with China makes most Americans better off because,

among other advantages, they can buy goods that are made or

assembled more cheaply in China.”

“Some Americans who work in the production of competing

goods, such as clothing and furniture, are made worse off by

trade with China.”

Source: IGM Economic Experts Panel, June 19, 2012.

0% uncertain

100% agree

0% disagree

What do economists say?

4% uncertain

96% agree

0% disagree

What do economists say?

59CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

SUMMARY

Each person consumes goods and services produced

by many other people both in the United States and

around the world. Interdependence and trade are de-

sirable because they allow everyone to enjoy a greater

quantity and variety of goods and services.

There are two ways to compare the ability of two peo-

ple to produce a good. The person who can produce

the good with the smaller quantity of inputs is said

to have an absolute advantage in producing the good. The person who has the smaller opportunity cost of

producing the good is said to have a comparative advan- tage. The gains from trade are based on comparative advantage, not absolute advantage.

Trade makes everyone better off because it allows peo-

ple to specialize in those activities in which they have a

comparative advantage.

The principle of comparative advantage applies to

countries as well as to people. Economists use the prin-

ciple of comparative advantage to advocate free trade

among countries.

KEY CONCEPTS

absolute advantage, p. 52

opportunity cost, p. 52

comparative advantage, p. 53

imports, p. 57

exports, p. 57

CHAPTER QuickQuiz

1. In an hour, Mateo can wash 2 cars or mow 1 lawn,

and Tyler can wash 3 cars or mow 1 lawn. Who has

the absolute advantage in car washing, and who has

the absolute advantage in lawn mowing?

a. Mateo in washing, Tyler in mowing.

b. Tyler in washing, Mateo in mowing.

c. Mateo in washing, neither in mowing.

d. Tyler in washing, neither in mowing.

2. Once again, in an hour, Mateo can wash 2 cars or mow

1 lawn, and Tyler can wash 3 cars or mow 1 lawn. Who

has the comparative advantage in car washing, and

who has the comparative advantage in lawn mowing?

a. Mateo in washing, Tyler in mowing.

b. Tyler in washing, Mateo in mowing.

c. Mateo in washing, neither in mowing.

d. Tyler in washing, neither in mowing.

3. When two individuals produce efficiently and then

make a mutually beneficial trade based on compara-

tive advantage,

a. they both obtain consumption outside their pro-

duction possibilities frontier.

b. they both obtain consumption inside their produc-

tion possibilities frontier.

c. one individual consumes inside her production

possibilities frontier, while the other consumes

outside hers.

d. each individual consumes a point on her own

production possibilities frontier.

4. Which goods will a nation typically import?

a. those goods in which the nation has an absolute

advantage

b. those goods in which the nation has a comparative

advantage

c. those goods in which other nations have an abso-

lute advantage

d. those goods in which other nations have a compar-

ative advantage

5. Suppose that in the United States, producing an air-

craft takes 10,000 hours of labor and producing a shirt

takes 2 hours of labor. In China, producing an aircraft

takes 40,000 hours of labor and producing a shirt

takes 4 hours of labor. What will these nations trade?

a. China will export aircraft, and the United States

will export shirts.

b. China will export shirts, and the United States will

export aircraft.

c. Both nations will export shirts.

d. There are no gains from trade in this situation.

6. Kayla can cook dinner in 30 minutes and wash the

laundry in 20 minutes. Her roommate takes half as

long to do each task. How should the roommates allo-

cate the work?

a. Kayla should do more of the cooking based on her

comparative advantage.

b. Kayla should do more of the washing based on her

comparative advantage.

c. Kayla should do more of the washing based on her

absolute advantage.

d. There are no gains from trade in this situation.

60 PART I INTRODUCTION

PROBLEMS AND APPLICATIONS

1. Maria can read 20 pages of economics in an hour.

She can also read 50 pages of sociology in an hour.

She spends 5 hours per day studying.

a. Draw Maria’s production possibilities frontier

for reading economics and sociology.

b. What is Maria’s opportunity cost of reading

100 pages of sociology?

2. American and Japanese workers can each produce

4 cars a year. An American worker can produce

10 tons of grain a year, whereas a Japanese worker can

produce 5 tons of grain a year. To keep things simple,

assume that each country has 100 million workers.

a. For this situation, construct a table analogous to

the table in Figure 1.

b. Graph the production possibilities frontiers for

the American and Japanese economies.

c. For the United States, what is the opportunity

cost of a car? Of grain? For Japan, what is the

opportunity cost of a car? Of grain? Put this

information in a table analogous to Table 1.

d. Which country has an absolute advantage in

producing cars? In producing grain?

e. Which country has a comparative advantage in

producing cars? In producing grain?

f. Without trade, half of each country’s workers pro-

duce cars and half produce grain. What quantities

of cars and grain does each country produce?

g. Starting from a position without trade, give an

example in which trade makes each country better off.

3. Pat and Kris are roommates. They spend most of their

time studying (of course), but they leave some time

for their favorite activities: making pizza and brewing

root beer. Pat takes 4 hours to brew a gallon of root

beer and 2 hours to make a pizza. Kris takes 6 hours

to brew a gallon of root beer and 4 hours to make a

pizza.

a. What is each roommate’s opportunity cost of

making a pizza? Who has the absolute advantage

in making pizza? Who has the comparative

advantage in making pizza?

b. If Pat and Kris trade foods with each other, who

will trade away pizza in exchange for root beer?

c. The price of pizza can be expressed in terms of gal-

lons of root beer. What is the highest price at which

pizza can be traded that would make both room-

mates better off? What is the lowest price? Explain.

4. Suppose that there are 10 million workers in Canada

and that each of these workers can produce either

2 cars or 30 bushels of wheat in a year.

a. What is the opportunity cost of producing a car

in Canada? What is the opportunity cost of pro-

ducing a bushel of wheat in Canada? Explain the

relationship between the opportunity costs of the

two goods.

b. Draw Canada’s production possibilities frontier.

If Canada chooses to consume 10 million cars,

how much wheat can it consume without trade?

Label this point on the production possibilities

frontier.

c. Now suppose that the United States offers to buy

10 million cars from Canada in exchange for

20 bushels of wheat per car. If Canada continues to

consume 10 million cars, how much wheat does this

deal allow Canada to consume? Label this point on

your diagram. Should Canada accept the deal?

5. England and Scotland both produce scones and

sweaters. Suppose that an English worker can

produce 50 scones per hour or 1 sweater per hour.

QUESTIONS FOR REVIEW

1. Under what conditions is the production possibilities

frontier linear rather than bowed out?

2. Explain how absolute advantage and comparative

advantage differ.

3. Give an example in which one person has an absolute

advantage in doing something but another person has

a comparative advantage.

4. Is absolute advantage or comparative advantage more

important for trade? Explain your reasoning using the

example in your answer to question 3.

5. If two parties trade based on comparative advantage

and both gain, in what range must the price of the

trade lie?

6. Why do economists oppose policies that restrict trade

among nations?

61CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE

Suppose that a Scottish worker can produce 40 scones

per hour or 2 sweaters per hour.

a. Which country has the absolute advantage in the

production of each good? Which country has the

comparative advantage?

b. If England and Scotland decide to trade, which com-

modity will Scotland export to England? Explain.

c. If a Scottish worker could produce only 1 sweater

per hour, would Scotland still gain from trade?

Would England still gain from trade? Explain.

6. The following table describes the production possibili-

ties of two cities in the country of Baseballia:

Pairs of Red Socks Pairs of White Socks

per Worker per Hour per Worker per Hour

Boston 3 3

Chicago 2 1

a. Without trade, what is the price of white socks

(in terms of red socks) in Boston? What is the

price in Chicago?

b. Which city has an absolute advantage in the

production of each color sock? Which city has a

comparative advantage in the production of each

color sock?

c. If the cities trade with each other, which color sock

will each export?

d. What is the range of prices at which trade can

occur?

7. A German worker takes 400 hours to produce a car

and 2 hours to produce a case of wine. A French

worker takes 600 hours to produce a car and X hours to produce a case of wine.

a. For what values of X will gains from trade be possible? Explain.

b. For what values of X will Germany export cars and import wine? Explain.

8. Suppose that in a year an American worker

can produce 100 shirts or 20 computers and a

Chinese worker can produce 100 shirts or

10 computers.

a. For each country, graph the production possi-

bilities frontier. Suppose that without trade the

workers in each country spend half their time

producing each good. Identify this point in your

graphs.

b. If these countries were open to trade, which coun-

try would export shirts? Give a specific numerical

example and show it on your graphs. Which

country would benefit from trade? Explain.

c. Explain at what price of computers (in terms

of shirts) the two countries might trade.

d. Suppose that China catches up with American

productivity so that a Chinese worker can produce

100 shirts or 20 computers. What pattern of trade

would you predict now? How does this advance

in Chinese productivity affect the economic well-

being of the two countries’ citizens?

9. Are the following statements true or false? Explain in

each case.

a. “Two countries can achieve gains from trade even

if one of the countries has an absolute advantage

in the production of all goods.”

b. “Certain talented people have a comparative

advantage in everything they do.”

c. “If a certain trade is good for one person, it can’t

be good for the other one.”

d. “If a certain trade is good for one person, it is

always good for the other one.”

e. “If trade is good for a country, it must be good

for everyone in the country.”

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

PART II

How Markets Work

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CHAPTER

4 The Market Forces of Supply and Demand

W hen a cold snap hits Florida, the price of orange juice rises in supermarkets throughout the country. When the weather turns warm in New England every summer, the price of hotel rooms in the Caribbean plummets. When

a war breaks out in the Middle East, the price of gasoline in the United States rises and the price of a used Cadillac falls. What do these events have in common? They all show the workings of supply and demand.

Supply and demand are the two words economists use most often—and for good reason. Supply and demand are the forces that make market economies work. They determine the quantity of each good produced and the price at which it

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66 PART II HOW MARKETS WORK

is sold. If you want to know how any event or policy will affect the economy, you must think first about how it will affect supply and demand.

This chapter introduces the theory of supply and demand. It considers how buyers and sellers behave and how they interact with one another. It shows how supply and demand determine prices in a market economy and how prices, in turn, allocate the economy’s scarce resources.

4-1 Markets and Competition The terms supply and demand refer to the behavior of people as they interact with one another in competitive markets. Before discussing how buyers and sellers behave, let’s first consider more fully what we mean by the terms market and competition.

4-1a What Is a Market? A market is a group of buyers and sellers of a particular good or service. The buy- ers as a group determine the demand for the product, and the sellers as a group determine the supply of the product.

Markets take many forms. Some markets are highly organized, such as the mar- kets for many agricultural commodities. In these markets, buyers and sellers meet at a specific time and place where an auctioneer helps set prices and arrange sales.

More often, markets are less organized. For example, consider the market for ice cream in a particular town. Buyers of ice cream do not meet together at any one time. The sellers of ice cream are in different locations and offer somewhat different products. There is no auctioneer calling out the price of ice cream. Each seller posts a price for an ice-cream cone, and each buyer decides how much ice cream to buy at each store. Nonetheless, these consumers and producers of ice cream are closely connected. The ice-cream buyers are choosing from the various ice-cream sellers to satisfy their cravings, and the ice-cream sellers are all trying to appeal to the same ice-cream buyers to make their businesses successful. Even though it is not as orga- nized, the group of ice-cream buyers and ice-cream sellers forms a market.

4-1b What Is Competition? The market for ice cream, like most markets in the economy, is highly competi- tive. Each buyer knows that there are several sellers from which to choose, and each seller is aware that his product is similar to that offered by other sellers. As a result, the price and quantity of ice cream sold are not determined by any single buyer or seller. Rather, price and quantity are determined by all buyers and sellers as they interact in the marketplace.

Economists use the term competitive market to describe a market in which there are so many buyers and so many sellers that each has a negligible impact on the market price. Each seller of ice cream has limited control over the price because other sellers are offering similar products. A seller has little reason to charge less than the going price, and if he charges more, buyers will make their purchases elsewhere. Similarly, no single buyer of ice cream can influence the price of ice cream because each buyer purchases only a small amount.

In this chapter, we assume that markets are perfectly competitive. To reach this highest form of competition, a market must have two characteristics: (1) The goods offered for sale are all exactly the same, and (2) the buyers and sellers are so numerous that no single buyer or seller has any influence over the market price.

market

a group of buyers and

sellers of a particular

good or service

competitive market

a market in which there

are many buyers and

many sellers so that each

has a negligible impact

on the market price

67CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

Because buyers and sellers in perfectly competitive markets must accept the price the market determines, they are said to be price takers. At the market price, buyers can buy all they want, and sellers can sell all they want.

There are some markets in which the assumption of perfect competition applies perfectly. In the wheat market, for example, there are thousands of farmers who sell wheat and millions of consumers who use wheat and wheat products. Be- cause no single buyer or seller can influence the price of wheat, each takes the market price as given.

Not all goods and services, however, are sold in perfectly competitive markets. Some markets have only one seller, and this seller sets the price. Such a seller is called a monopoly. Your local cable television company, for instance, may be a monopoly. Res- idents of your town probably have only one company from which to buy cable ser- vice. Other markets fall between the extremes of perfect competition and monopoly.

Despite the diversity of market types we find in the world, assuming perfect competition is a useful simplification and, therefore, a natural place to start. Per- fectly competitive markets are the easiest to analyze because everyone partic- ipating in the market takes the price as given by market conditions. Moreover, because some degree of competition is present in most markets, many of the les- sons that we learn by studying supply and demand under perfect competition apply in more complicated markets as well.

What is a market? What are the characteristics of a perfectly competi-

tive market?

4-2 Demand We begin our study of markets by examining the behavior of buyers. To focus our thinking, let’s keep in mind a particular good—ice cream.

4-2a The Demand Curve: The Relationship between Price and Quantity Demanded

The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase. As we will see, many things determine the quantity demanded of any good, but in our analysis of how markets work, one determi- nant plays a central role: the price of the good. If the price of ice cream rose to $20 per scoop, you would buy less ice cream. You might buy frozen yogurt instead. If the price of ice cream fell to $0.20 per scoop, you would buy more. This relationship between price and quantity demanded is true for most goods in the economy and, in fact, is so pervasive that economists call it the law of demand: Other things being equal, when the price of a good rises, the quantity demanded of the good falls, and when the price falls, the quantity demanded rises.

The table in Figure 1 shows how many ice-cream cones Catherine buys each month at different prices. If ice cream is free, Catherine eats 12 cones per month. At $0.50 per cone, Catherine buys 10 cones each month. As the price rises further, she buys fewer and fewer cones. When the price reaches $3.00, Catherine doesn’t buy any cones at all. This table is a demand schedule, a table that shows the relation- ship between the price of a good and the quantity demanded, holding constant everything else that influences how much of the good consumers want to buy.

The graph in Figure 1 uses the numbers from the table to illustrate the law of demand. By convention, the price of ice cream is on the vertical axis, and the

quantity demanded

the amount of a good that

buyers are willing and

able to purchase

law of demand

the claim that, other

things being equal, the

quantity demanded of a

good falls when the price

of the good rises

demand schedule

a table that shows the

relationship between the

price of a good and the

quantity demanded

QuickQuiz

68 PART II HOW MARKETS WORK

quantity of ice cream demanded is on the horizontal axis. The line relating price and quantity demanded is called the demand curve. The demand curve slopes downward because, other things being equal, a lower price means a greater quan- tity demanded.

4-2b Market Demand versus Individual Demand The demand curve in Figure 1 shows an individual’s demand for a product. To analyze how markets work, we need to determine the market demand, the sum of all the individual demands for a particular good or service.

The table in Figure 2 shows the demand schedules for ice cream of the two individuals in this market—Catherine and Nicholas. At any price, Catherine’s demand schedule tells us how much ice cream she buys, and Nicholas’s demand schedule tells us how much ice cream he buys. The market demand at each price is the sum of the two individual demands.

The graph in Figure 2 shows the demand curves that correspond to these demand schedules. Notice that we sum the individual demand curves horizontally to obtain the market demand curve. That is, to find the total quantity demanded at any price, we add the individual quantities, which are found on the horizontal axis of the individual demand curves. Because we are interested in analyzing how markets function, we work most often with the market demand curve. The market demand curve shows how the total quantity demanded of a good varies as the price of the good varies, while all other factors that affect how much consumers want to buy are held constant.

demand curve

a graph of the relationship

between the price of a

good and the quantity

demanded

FIGURE 1

Catherine’s Demand Schedule

and Demand Curve

Price of Ice-Cream Cone

2.50

2.00

1.50

1.00

0.50

1 2 3 4 5 6 7 8 9 10 11 Quantity of Ice-Cream Cones

$3.00

1. A decrease in price . . .

2. . . . increases quantity of cones demanded.

Demand curve

The demand schedule is a table that shows the quantity demanded at each price.

The demand curve, which graphs the demand schedule, illustrates how the quantity

demanded of the good changes as its price varies. Because a lower price increases

the quantity demanded, the demand curve slopes downward.

Price of

Ice-Cream Cone

Quantity of

Cones Demanded

$0.00

0.50

1.00

1.50

2.00

2.50

3.00

12 cones

69CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

4-2c Shifts in the Demand Curve Because the market demand curve holds other things constant, it need not be stable over time. If something happens to alter the quantity demanded at any given price, the demand curve shifts. For example, suppose the American Medical Association discovered that people who regularly eat ice cream live longer, healthier lives. The discovery would raise the demand for ice cream. At any given price, buyers would now want to purchase a larger quantity of ice cream, and the demand curve for ice cream would shift.

Figure 3 illustrates shifts in demand. Any change that increases the quantity demanded at every price, such as our imaginary discovery by the American Medical Association, shifts the demand curve to the right and is called an increase in demand. Any change that reduces the quantity demanded at every price shifts the demand curve to the left and is called a decrease in demand.

There are many variables that can shift the demand curve. Let’s consider the most important.

Income What would happen to your demand for ice cream if you lost your job one summer? Most likely, it would fall. A lower income means that you have

FIGURE 2

Market Demand as the Sum

of Individual Demands

Price of Ice-Cream

Cone

Price of Ice-Cream

Cone

Price of Ice-Cream

Cone $3.00

2.50

2.00

1.50

1.00

0.50

0 1 2 3 4 5 6 Quantity of Ice-Cream Cones

DCatherine

7 8 9 10 11 12

Catherine’s Demand Nicholas’s Demand Market Demand+ =

$3.00

2.50

2.00

1.50

1.00

0.50

0 1 2 3 4 5 6 Quantity of Ice-Cream Cones

7 8 9 10 11 12

$3.00

2.50

2.00

1.50

1.00

0.50

0 2 4 6 Quantity of Ice-Cream Cones

8 10 12 14 16 18

DNicholas DMarket

The quantity demanded in a market is the sum of the quantities demanded

by all the buyers at each price. Thus, the market demand curve is found

by adding horizontally the individual demand curves. At a price of $2.00,

Catherine demands 4 ice-cream cones and Nicholas demands 3 ice-cream

cones. The quantity demanded in the market at this price is 7 cones.

Price of Ice-Cream Cone Catherine Nicholas Market

$0.00 12 1 7 5 19 cones

0.50 10 6 16

1.00 8 5 13

1.50 6 4 10

2.00 4 3 7

2.50 2 2 4

3.00 0 1 1

70 PART II HOW MARKETS WORK

less to spend in total, so you would have to spend less on some—and probably most—goods. If the demand for a good falls when income falls, the good is called a normal good.

Normal goods are the norm, but not all goods are normal goods. If the demand for a good rises when income falls, the good is called an inferior good. An exam- ple of an inferior good might be bus rides. As your income falls, you are less likely to buy a car or take a cab and more likely to ride a bus.

Prices of Related Goods Suppose that the price of frozen yogurt falls. The law of demand says that you will buy more frozen yogurt. At the same time, you will probably buy less ice cream. Because ice cream and frozen yogurt are both cold, sweet, creamy desserts, they satisfy similar desires. When a fall in the price of one good reduces the demand for another good, the two goods are called substitutes. Substitutes are often pairs of goods that are used in place of each other, such as hot dogs and hamburgers, sweaters and sweatshirts, and cinema tickets and film streaming services.

Now suppose that the price of hot fudge falls. According to the law of demand, you will buy more hot fudge. Yet in this case, you will likely buy more ice cream as well because ice cream and hot fudge are often used together. When a fall in the price of one good raises the demand for another good, the two goods are called complements. Complements are often pairs of goods that are used together, such as gasoline and automobiles, computers and software, and peanut butter and jelly.

Tastes The most obvious determinant of your demand is your tastes. If you like ice cream, you buy more of it. Economists normally do not try to explain peo- ple’s tastes because tastes are based on historical and psychological forces that are beyond the realm of economics. Economists do, however, examine what happens when tastes change.

Expectations Your expectations about the future may affect your demand for a good or service today. If you expect to earn a higher income next month, you may

normal good

a good for which, other

things being equal, an

increase in income leads

to an increase in demand

inferior good

a good for which, other

things being equal, an

increase in income leads

to a decrease in demand

substitutes

two goods for which an

increase in the price of

one leads to an increase in

the demand for the other

complements

two goods for which an

increase in the price of

one leads to a decrease in

the demand for the other

FIGURE 3

Shifts in the Demand Curve

Any change that raises the quantity that

buyers wish to purchase at any given

price shifts the demand curve to the

right. Any change that lowers the quantity

that buyers wish to purchase at any given

price shifts the demand curve to the left.

Price of Ice-Cream

Cone

Quantity of Ice-Cream Cones

Increase in demand

Decrease in demand

Demand curve, D3

Demand curve, D1

Demand curve, D2

71CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

choose to save less now and spend more of your current income buying ice cream. If you expect the price of ice cream to fall tomorrow, you may be less willing to buy an ice-cream cone at today’s price.

Number of Buyers In addition to the preceding factors, which influence the behavior of individual buyers, market demand depends on the number of these buyers. If Peter were to join Catherine and Nicholas as another consumer of ice cream, the quantity demanded in the market would be higher at every price, and market demand would increase.

Summary The demand curve shows what happens to the quantity demanded of a good when its price varies, holding constant all the other variables that influence buyers. When one of these other variables changes, the demand curve shifts. Table 1 lists the variables that influence how much of a good consumers choose to buy.

If you have trouble remembering whether you need to shift or move along the demand curve, it helps to recall a lesson from the appendix to Chapter 2. A curve shifts when there is a change in a relevant variable that is not measured on either axis. Because the price is on the vertical axis, a change in price represents a move- ment along the demand curve. By contrast, income, the prices of related goods, tastes, expectations, and the number of buyers are not measured on either axis, so a change in one of these variables shifts the demand curve.

CASE STUDY

TABLE 1

Variables That Influence Buyers

This table lists the variables that affect how

much of any good consumers choose to buy.

Notice the special role that the price of the

good plays: A change in the good’s price

represents a movement along the demand

curve, whereas a change in one of the other

variables shifts the demand curve.

Variable A Change in This Variable . . .

Price of the good itself Represents a movement along the demand

curve

Income Shifts the demand curve

Prices of related goods Shifts the demand curve

Tastes Shifts the demand curve

Expectations Shifts the demand curve

Number of buyers Shifts the demand curve

TWO WAYS TO REDUCE THE QUANTITY OF SMOKING DEMANDED Because smoking can lead to various illnesses, public policymakers often want to reduce the amount that people smoke. There are two ways that they can attempt to achieve this goal.

One way to reduce smoking is to shift the demand curve for cigarettes and other tobacco products. Public service announcements, mandatory health warnings on cigarette packages, and the prohibition of cigarette advertising on television are all policies aimed at reducing the quantity of cigarettes demanded at any given price. If successful, these policies shift the demand curve for cigarettes to the left, as in panel (a) of Figure 4.

Alternatively, policymakers can try to raise the price of cigarettes. If the gov- ernment taxes the manufacture of cigarettes, for example, cigarette companies pass much of this tax on to consumers in the form of higher prices. A higher price encourages smokers to reduce the numbers of cigarettes they smoke. In this case, the reduced amount of smoking does not represent a shift in the demand curve.

72 PART II HOW MARKETS WORK

Instead, it represents a movement along the same demand curve to a point with a higher price and lower quantity, as in panel (b) of Figure 4.

How much does the amount of smoking respond to changes in the price of cigarettes? Economists have attempted to answer this question by studying what happens when the tax on cigarettes changes. They have found that a 10 percent increase in the price causes a 4 percent reduction in the quantity demanded. Teenagers are especially sensitive to the price of cigarettes: A 10 percent increase in the price causes a 12 percent drop in teenage smoking.

A related question is how the price of cigarettes affects the demand for illicit drugs, such as marijuana. Opponents of cigarette taxes often argue that tobacco and marijuana are substitutes so that high cigarette prices encourage marijuana use. By contrast, many experts on substance abuse view tobacco as a “gateway drug” leading young people to experiment with other harmful substances. Most studies of the data are consistent with this latter view: They find that lower cigarette prices are associated with greater use of marijuana. In other words, tobacco and marijuana appear to be complements rather than substitutes. ●

Make up an example of a monthly demand schedule for pizza, and graph

the implied demand curve. Give an example of something that would shift

this demand curve, and briefly explain your reasoning. Would a change in the price of pizza

shift this demand curve?

FIGURE 4

Shifts in the Demand

Curve versus Movements

along the Demand Curve

0 10 20

$4.00 B A

(a) A Shift in the Demand Curve

A policy to discourage smoking shifts the demand curve to the left.

Number of Cigarettes Smoked per Day

Price of Cigarettes,

per Pack

0 12 20

4.00

$8.00 C

(b) A Movement along the Demand Curve

Number of Cigarettes Smoked per Day

Price of Cigarettes,

per Pack

A tax that raises the price of cigarettes results in a movement along the demand curve.

If warnings on cigarette packages convince smokers to smoke less, the demand curve

for cigarettes shifts to the left. In panel (a), the demand curve shifts from D 1 to D

2 .

At a price of $4.00 per pack, the quantity demanded falls from 20 to 10 cigarettes per

day, as reflected by the shift from point A to point B. By contrast, if a tax raises the price

of cigarettes, the demand curve does not shift. Instead, we observe a movement to a differ-

ent point on the demand curve. In panel (b), when the price rises from $4.00 to $8.00,

the quantity demanded falls from 20 to 12 cigarettes per day, as reflected by the

movement from point A to point C.

QuickQuiz

ED YT

A P

AW LO

W SK

A /S

H U

TT ER

ST O

CK .C

O M

What is the best way to stop this?

73CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

4-3 Supply We now turn to the other side of the market and examine the behavior of sellers. Once again, to focus our thinking, let’s consider the market for ice cream.

4-3a The Supply Curve: The Relationship between Price and Quantity Supplied

The quantity supplied of any good or service is the amount that sellers are will- ing and able to sell. There are many determinants of quantity supplied, but once again, price plays a special role in our analysis. When the price of ice cream is high, selling ice cream is profitable, and so the quantity supplied is large. Sell- ers of ice cream work long hours, buy many ice-cream machines, and hire many workers. By contrast, when the price of ice cream is low, the business is less prof- itable, so sellers produce less ice cream. At a low price, some sellers may even choose to shut down, and their quantity supplied falls to zero. This relationship between price and quantity supplied is called the law of supply: Other things being equal, when the price of a good rises, the quantity supplied of the good also rises, and when the price falls, the quantity supplied falls as well.

The table in Figure 5 shows the quantity of ice-cream cones supplied each month by Ben, an ice-cream seller, at various prices of ice cream. At a price below $1.00, Ben does not supply any ice cream at all. As the price rises, he supplies a greater and greater quantity. This is the supply schedule, a table that shows the relationship between the price of a good and the quantity supplied, holding con- stant everything else that influences how much of the good producers want to sell.

quantity supplied

the amount of a good

that sellers are willing

and able to sell

law of supply

the claim that, other

things being equal, the

quantity supplied of a

good rises when the price

of the good rises

supply schedule

a table that shows the

relationship between the

price of a good and the

quantity supplied

FIGURE 5

Ben’s Supply Schedule

and Supply Curve

Price of Ice-Cream

Cone

2.50

2.00

1.50

1.00

1 2 3 4 5 6 7 8 9 10 11 Quantity of Ice-Cream Cones

$3.00

0.50

1. An increase in price . . .

2. . . . increases quantity of cones supplied.

Supply curve

The supply schedule is a table that shows the quantity supplied at each price. This

supply curve, which graphs the supply schedule, illustrates how the quantity supplied

of the good changes as its price varies. Because a higher price increases the quantity

supplied, the supply curve slopes upward.

Price of

Ice-Cream Cone

Quantity of

Cones Demanded

$0.00

0.50

1.00

1.50

2.00

2.50

3.00

0 cones

74 PART II HOW MARKETS WORK

The graph in Figure 5 uses the numbers from the table to illustrate the law of supply. The curve relating price and quantity supplied is called the supply curve. The supply curve slopes upward because, other things being equal, a higher price means a greater quantity supplied.

4-3b Market Supply versus Individual Supply Just as market demand is the sum of the demands of all buyers, market supply is the sum of the supplies of all sellers. The table in Figure 6 shows the supply schedules for the two ice-cream producers in the market—Ben and Jerry. At any price, Ben’s supply schedule tells us the quantity of ice cream that Ben supplies, and Jerry’s supply schedule tells us the quantity of ice cream that Jerry supplies. The market supply is the sum of the two individual supplies.

The graph in Figure 6 shows the supply curves that correspond to the supply schedules. As with demand curves, we sum the individual supply curves horizon- tally to obtain the market supply curve. That is, to find the total quantity supplied at any price, we add the individual quantities, which are found on the horizontal axis of the individual supply curves. The market supply curve shows how the total quantity supplied varies as the price of the good varies, holding constant all other factors that influence producers’ decisions about how much to sell.

supply curve

a graph of the relationship

between the price of a

good and the quantity

supplied

FIGURE 6

Market Supply as the Sum

of Individual Supplies

$3.00

2.50

2.00

1.50

1.00

0.50

0 1 2 3 4 5 6 Quantity of Ice-Cream Cones

7 8 9 10 11 12

Ben’s Supply Jerry’s Supply Market Supply+ = Price of

Ice-Cream Cone

Price of Ice-Cream

Cone

Price of Ice-Cream

Cone $3.00

2.50

2.00

1.50

1.00

0.50

0 1 2 3 4 5 6 Quantity of Ice-Cream Cones

7 8 9 10 11 12

$3.00

2.50

2.00

1.50

1.00

0.50

0 1 2 3 4 5 6 Quantity of Ice-Cream Cones

7 8 9 10 11 12

S Ben S Jerry

S Market

The quantity supplied in a market is the sum of the quantities supplied by all

the sellers at each price. Thus, the market supply curve is found by adding

horizontally the individual supply curves. At a price of $2.00, Ben supplies

3 ice-cream cones and Jerry supplies 4 ice-cream cones. The quantity supplied

in the market at this price is 7 cones.

Price of Ice-Cream Cone Ben Jerry Market

$0.00 0 1 0 5 0 cones

0.50 0 0 0

1.00 1 0 1

1.50 2 2 4

2.00 3 4 7

2.50 4 6 10

3.00 5 8 13

75CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

4-3c Shifts in the Supply Curve Because the market supply curve is drawn holding other things constant, when one of these factors changes, the supply curve shifts. For example, suppose the price of sugar falls. Sugar is an input in the production of ice cream, so the fall in the price of sugar makes selling ice cream more profitable. This raises the supply of ice cream: At any given price, sellers are now willing to produce a larger quan- tity. As a result, the supply curve for ice cream shifts to the right.

Figure 7 illustrates shifts in supply. Any change that raises quantity supplied at every price, such as a fall in the price of sugar, shifts the supply curve to the right and is called an increase in supply. Any change that reduces the quantity supplied at every price shifts the supply curve to the left and is called a decrease in supply.

There are many variables that can shift the supply curve. Let’s consider the most important.

Input Prices To produce their output of ice cream, sellers use various inputs: cream, sugar, flavoring, ice-cream machines, the buildings in which the ice cream is made, and the labor of workers who mix the ingredients and operate the machines. When the price of one or more of these inputs rises, producing ice cream is less profitable, and firms supply less ice cream. If input prices rise sub- stantially, a firm might shut down and supply no ice cream at all. Thus, the supply of a good is negatively related to the price of the inputs used to make the good.

Technology The technology for turning inputs into ice cream is another deter- minant of supply. The invention of the mechanized ice-cream machine, for exam- ple, reduced the amount of labor necessary to make ice cream. By reducing firms’ costs, the advance in technology raised the supply of ice cream.

Expectations The amount of ice cream a firm supplies today may depend on its expectations about the future. For example, if a firm expects the price of ice cream to rise in the future, it will put some of its current production into storage and supply less to the market today.

FIGURE 7

Shifts in the Supply Curve

Any change that raises the quantity that

sellers wish to produce at any given price

shifts the supply curve to the right. Any

change that lowers the quantity that

sellers wish to produce at any given price

shifts the supply curve to the left.

Price of Ice-Cream

Cone

Quantity of Ice-Cream Cones

Increase in supply

Decrease in supply

Supply curve, S3 Supply

curve, S1 Supply

curve, S2

76 PART II HOW MARKETS WORK

Number of Sellers In addition to the preceding factors, which influence the behavior of individual sellers, market supply depends on the number of these sellers. If Ben or Jerry were to retire from the ice-cream business, the supply in the market would fall.

Summary The supply curve shows what happens to the quantity supplied of a good when its price varies, holding constant all the other variables that influence sellers. When one of these other variables changes, the supply curve shifts. Table 2 lists the variables that influence how much of a good producers choose to sell.

Once again, to remember whether you need to shift or move along the supply curve, keep in mind that a curve shifts only when there is a change in a relevant variable that is not named on either axis. The price is on the vertical axis, so a change in price represents a movement along the supply curve. By contrast, because input prices, technology, expectations, and the number of sellers are not measured on either axis, a change in one of these variables shifts the supply curve.

Make up an example of a monthly supply schedule for pizza, and graph

the implied supply curve. Give an example of something that would shift

this supply curve, and briefly explain your reasoning. Would a change in the price of pizza

shift this supply curve?

QuickQuiz

TABLE 2

Variables That Influence Sellers

This table lists the variables that affect how

much of any good producers choose to sell.

Notice the special role that the price of the

good plays: A change in the good’s price

represents a movement along the supply

curve, whereas a change in one of the other

variables shifts the supply curve.

Variable A Change in This Variable . . .

Price of the good itself Represents a movement along the supply

curve

Input prices Shifts the supply curve

Technology Shifts the supply curve

Expectations Shifts the supply curve

Number of sellers Shifts the supply curve

4-4 Supply and Demand Together Having analyzed supply and demand separately, we now combine them to see how they determine the price and quantity of a good sold in a market.

4-4a Equilibrium Figure 8 shows the market supply curve and market demand curve together. Notice that there is one point at which the supply and demand curves intersect. This point is called the market’s equilibrium. The price at this intersection is called the equilibrium price, and the quantity is called the equilibrium quan- tity. Here the equilibrium price is $2.00 per cone, and the equilibrium quantity is 7 ice-cream cones.

The dictionary defines the word equilibrium as a situation in which various forces are in balance. This definition applies to a market’s equilibrium as well. At the equilibrium price, the quantity of the good that buyers are willing and able to buy exactly balances the quantity that sellers are willing and able to sell. The equilibrium price is sometimes called the market-clearing price because, at this price, everyone

equilibrium

a situation in which the

market price has reached

the level at which quan-

tity supplied equals

quantity demanded

equilibrium price

the price that balances

quantity supplied and

quantity demanded

equilibrium quantity

the quantity supplied

and the quantity demanded

at the equilibrium price

77CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

in the market has been satisfied: Buyers have bought all they want to buy, and sellers have sold all they want to sell.

The actions of buyers and sellers naturally move markets toward the equilib- rium of supply and demand. To see why, consider what happens when the mar- ket price is not equal to the equilibrium price.

Suppose first that the market price is above the equilibrium price, as in panel (a) of Figure 9. At a price of $2.50 per cone, the quantity of the good sup- plied (10 cones) exceeds the quantity demanded (4 cones). There is a surplus of the good: Suppliers are unable to sell all they want at the going price. A surplus is sometimes called a situation of excess supply. When there is a surplus in the ice-cream market, sellers of ice cream find their freezers increasingly full of ice cream they would like to sell but cannot. They respond to the surplus by cutting their prices. Falling prices, in turn, increase the quantity demanded and decrease the quantity supplied. These changes represent movements along the supply and demand curves, not shifts in the curves. Prices continue to fall until the market reaches the equilibrium.

Suppose now that the market price is below the equilibrium price, as in panel (b) of Figure 9. In this case, the price is $1.50 per cone, and the quantity of the good demanded exceeds the quantity supplied. There is a shortage of the good: Demanders are unable to buy all they want at the going price. A shortage is sometimes called a situation of excess demand. When a shortage occurs in the ice- cream market, buyers have to wait in long lines for a chance to buy one of the few cones available. With too many buyers chasing too few goods, sellers can respond to the shortage by raising their prices without losing sales. These price increases cause the quantity demanded to fall and the quantity supplied to rise. Once again, these changes represent movements along the supply and demand curves, and they move the market toward the equilibrium.

Thus, regardless of whether the price starts off too high or too low, the activities of the many buyers and sellers automatically push the market price toward the equilibrium price. Once the market reaches its equilibrium, all buyers and sellers

surplus

a situation in which

quantity supplied is

greater than quantity

demanded

shortage

a situation in which

quantity demanded is

greater than quantity

supplied

FIGURE 8

The Equilibrium of Supply

and Demand

The equilibrium is found

where the supply and

demand curves intersect.

At the equilibrium price, the

quantity supplied equals

the quantity demanded. Here

the equilibrium price is $2.00:

At this price, 7 ice-cream cones

are supplied and 7 ice-cream

cones are demanded.

Price of Ice-Cream

Cone

$2.00

0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Ice-Cream Cones

Equilibrium quantity

Equilibrium price

Equilibrium

Supply

Demand

78 PART II HOW MARKETS WORK

are satisfied, and there is no upward or downward pressure on the price. How quickly equilibrium is reached varies from market to market depending on how quickly prices adjust. In most free markets, surpluses and shortages are only tem- porary because prices eventually move toward their equilibrium levels. Indeed, this phenomenon is so pervasive that it is called the law of supply and de- mand: The price of any good adjusts to bring the quantity supplied and quantity demanded for that good into balance.

4-4b Three Steps to Analyzing Changes in Equilibrium So far, we have seen how supply and demand together determine a market’s equi- librium, which in turn determines the price and quantity of the good that buyers

law of supply and

demand

the claim that the price

of any good adjusts to

bring the quantity sup-

plied and the quantity

demanded for that good

into balance

FIGURE 9

Markets Not in Equilibrium

In panel (a), there is a surplus. Because the market price of $2.50 is above the equilibrium

price, the quantity supplied (10 cones) exceeds the quantity demanded (4 cones). Suppliers

try to increase sales by cutting the price of a cone, and this moves the price toward its equi-

librium level. In panel (b), there is a shortage. Because the market price of $1.50 is below

the equilibrium price, the quantity demanded (10 cones) exceeds the quantity supplied

(4 cones). With too many buyers chasing too few goods, suppliers can take advantage of the

shortage by raising the price. Hence, in both cases, the price adjustment moves the market

toward the equilibrium of supply and demand.

Price of Ice-Cream

Cone

Price of Ice-Cream

Cone

2.00

$2.50

0 4 7 10

Supply

Demand

(a) Excess Supply

Quantity demanded

Quantity supplied

Surplus

$2.00

1.50

0 4 7 10Quantity of Ice-Cream

Cones

Quantity of Ice-Cream

Cones

Supply

Demand

(b) Excess Demand

Quantity supplied

Quantity demanded

Shortage

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79CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

purchase and sellers produce. The equilibrium price and quantity depend on the position of the supply and demand curves. When some event shifts one of these curves, the equilibrium in the market changes, resulting in a new price and a new quantity exchanged between buyers and sellers.

When analyzing how some event affects the equilibrium in a market, we pro- ceed in three steps. First, we decide whether the event shifts the supply curve, the demand curve, or, in some cases, both. Second, we decide whether the curve shifts to the right or to the left. Third, we use the supply-and-demand diagram to compare the initial equilibrium with the new one, which shows how the shift affects the equilibrium price and quantity. Table 3 summarizes these three steps. To see how this recipe is used, let’s consider various events that might affect the market for ice cream.

1. Decide whether the event shifts the supply or demand curve (or perhaps both).

2. Decide in which direction the curve shifts.

3. Use the supply-and-demand diagram to see how the shift changes the equilibrium

price and quantity.

TABLE 3

Three Steps for Analyzing

Changes in Equilibrium

Example: A Change in Market Equilibrium Due to a Shift in Demand Suppose that one summer the weather is very hot. How does this event affect the market for ice cream? To answer this question, let’s follow our three steps.

1. The hot weather affects the demand curve by changing people’s taste for ice cream. That is, the weather changes the amount of ice cream that people want to buy at any given price. The supply curve is unchanged because the weather does not directly affect the firms that sell ice cream.

2. Because hot weather makes people want to eat more ice cream, the demand curve shifts to the right. Figure 10 shows this increase in demand as a shift in the demand curve from D

1 to D

2 . This shift indicates that the quantity of ice

cream demanded is higher at every price. 3. At the old price of $2, there is now an excess demand for ice cream, and this

shortage induces firms to raise the price. As Figure 10 shows, the increase in demand raises the equilibrium price from $2.00 to $2.50 and the equilibrium quantity from 7 to 10 cones. In other words, the hot weather increases both the price of ice cream and the quantity of ice cream sold.

Shifts in Curves versus Movements along Curves Notice that when hot weather increases the demand for ice cream and drives up the price, the quantity of ice cream that firms supply rises, even though the supply curve remains the same. In this case, economists say there has been an increase in “quantity supplied” but no change in “supply.”

Supply refers to the position of the supply curve, whereas the quantity sup- plied refers to the amount suppliers wish to sell. In this example, supply does not change because the weather does not alter firms’ desire to sell at any given price. Instead, the hot weather alters consumers’ desire to buy at any given price and thereby shifts the demand curve to the right. The increase in demand

80 PART II HOW MARKETS WORK

causes the equilibrium price to rise. When the price rises, the quantity supplied rises. This increase in quantity supplied is represented by the movement along the supply curve.

To summarize, a shift in the supply curve is called a “change in supply,” and a shift in the demand curve is called a “change in demand.” A movement along a fixed supply curve is called a “change in the quantity supplied,” and a movement along a fixed demand curve is called a “change in the quantity demanded.”

Example: A Change in Market Equilibrium Due to a Shift in Supply Suppose that during another summer, a hurricane destroys part of the sugarcane crop and drives up the price of sugar. How does this event affect the market for ice cream? Once again, to answer this question, we follow our three steps.

1. The change in the price of sugar, an input for making ice cream, affects the supply curve. By raising the costs of production, it reduces the amount of ice cream that firms produce and sell at any given price. The demand curve does not change because the higher cost of inputs does not directly affect the amount of ice cream consumers wish to buy.

2. The supply curve shifts to the left because, at every price, the total amount that firms are willing and able to sell is reduced. Figure 11 illustrates this decrease in supply as a shift in the supply curve from S

1 to S

2 .

3. At the old price of $2, there is now an excess demand for ice cream, and this shortage causes firms to raise the price. As Figure 11 shows, the shift in the supply curve raises the equilibrium price from $2.00 to $2.50 and

FIGURE 10

How an Increase in Demand

Affects the Equilibrium

An event that raises quantity

demanded at any given price

shifts the demand curve to the

right. The equilibrium price and

the equilibrium quantity both

rise. Here an abnormally hot

summer causes buyers to demand

more ice cream. The demand

curve shifts from D 1 to D

2 , which

causes the equilibrium price to

rise from $2.00 to $2.50 and the

equilibrium quantity to rise from

7 to 10 cones.

Price of Ice-Cream

Cone

2.00

$2.50

0 7 10 Quantity of Ice-Cream Cones

Supply

New equilibrium

Initial equilibrium

3. . . . and a higher quantity sold.

2. . . . resulting in a higher price . . .

1. Hot weather increases the demand for ice cream . . .

81CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

lowers the equilibrium quantity from 7 to 4 cones. As a result of the sugar price increase, the price of ice cream rises, and the quantity of ice cream sold falls.

Example: Shifts in Both Supply and Demand Now suppose that the heat wave and the hurricane occur during the same summer. To analyze this combination of events, we again follow our three steps.

1. We determine that both curves must shift. The hot weather affects the demand curve because it alters the amount of ice cream that consumers want to buy at any given price. At the same time, when the hurricane drives up sugar prices, it alters the supply curve for ice cream because it changes the amount of ice cream that firms want to sell at any given price.

2. The curves shift in the same directions as they did in our previous analysis: The demand curve shifts to the right, and the supply curve shifts to the left. Figure 12 illustrates these shifts.

3. As Figure 12 shows, two possible outcomes might result depending on the relative size of the demand and supply shifts. In both cases, the equilibrium price rises. In panel (a), where demand increases substantially while supply falls just a little, the equilibrium quantity also rises. By contrast, in panel (b), where supply falls substantially while demand rises just a little, the equilibrium quantity falls. Thus, these events certainly raise the price of ice cream, but their impact on the amount of ice cream sold is ambiguous (that is, it could go either way).

FIGURE 11

How a Decrease in Supply

Affects the Equilibrium

An event that reduces quantity

supplied at any given price shifts

the supply curve to the left.

The equilibrium price rises, and

the equilibrium quantity falls.

Here an increase in the price of

sugar (an input) causes sellers

to supply less ice cream. The

supply curve shifts from S 1 to

S 2 , which causes the equilibrium

price of ice cream to rise

from $2.00 to $2.50 and the

equilibrium quantity to fall from

7 to 4 cones.

Price of Ice-Cream

Cone

2.00

$2.50

0 4 7 Quantity of Ice-Cream Cones

Demand

New equilibrium

Initial equilibrium

2. . . . resulting in a higher price of ice cream . . .

1. An increase in the price of sugar reduces the supply of ice cream . . .

3. . . . and a lower quantity sold.

82 PART II HOW MARKETS WORK

Summary We have just seen three examples of how to use supply and demand curves to analyze a change in equilibrium. Whenever an event shifts the supply curve, the demand curve, or perhaps both curves, you can use these tools to pre- dict how the event will alter the price and quantity sold in equilibrium. Table 4 shows the predicted outcome for any combination of shifts in the two curves. To make sure you understand how to use the tools of supply and demand, pick a few entries in this table and make sure you can explain to yourself why the table con- tains the prediction that it does.

FIGURE 12

A Shift in Both Supply

and Demand

Here we observe a simultaneous increase in demand and decrease in supply. Two outcomes

are possible. In panel (a), the equilibrium price rises from P 1 to P

2 , and the equilibrium

quantity rises from Q 1 to Q

2 . In panel (b), the equilibrium price again rises from P

1 to P

2 ,

but the equilibrium quantity falls from Q 1 to Q

2 .

(b) Price Rises, Quantity Falls

New equilibrium

Initial equilibrium

(a) Price Rises, Quantity Rises

Quantity of Ice-Cream Cones

New equilibrium

Initial equilibrium

D1 D1

D2 D2

Q1 Q2Q2 Q1

Large increase in demand

Small decrease in supply

Small increase in demand

Large decrease in supply

Price of Ice-Cream

Cone

Price of Ice-Cream

Cone

TABLE 4

What Happens to Price and Quantity When

Supply or Demand Shifts?

As a quick quiz, make sure you can explain

at least a few of the entries in this table

using a supply-and-demand diagram.

No Change An Increase A Decrease

in Supply in Supply in Supply

No Change P same P down P up

in Demand Q same Q up Q down

An Increase P up P ambiguous P up

in Demand Q up Q up Q ambiguous

A Decrease P down P down P ambiguous

in Demand Q down Q ambiguous Q down

83CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

On the appropriate diagram, show what happens to the market for pizza if

the price of tomatoes rises. On a separate diagram, show what happens

to the market for pizza if the price of hamburgers falls.

4-5 Conclusion: How Prices Allocate Resources

This chapter has analyzed supply and demand in a single market. Our discus- sion has centered on the market for ice cream, but the lessons learned here apply to most other markets as well. Whenever you go to a store to buy something, you are contributing to the demand for that item. Whenever you look for a job, you are contributing to the supply of labor services. Because supply and demand are such pervasive eco- nomic phenomena, the model of supply and demand is a pow- erful tool for analysis. We use this model repeatedly in the following chapters.

One of the Ten Principles of Economics discussed in Chapter 1 is that markets are usually a good way to organize economic activity. Although it is still too early to judge whether market outcomes are good or bad, in this chapter we have begun to see how markets work. In any economic system, scarce resources have to be allocated among competing uses. Market economies harness the forces of supply and demand to serve that end. Sup- ply and demand together determine the prices of the economy’s many different goods and services; prices in turn are the signals that guide the allocation of resources.

For example, consider the allocation of beachfront land. Be- cause the amount of this land is limited, not everyone can enjoy the luxury of living by the beach. Who gets this resource? The answer is whoever is willing and able to pay the price. The price of beachfront land adjusts until the quantity of land demanded exactly balances the quantity supplied. Thus, in market econo- mies, prices are the mechanism for rationing scarce resources.

Similarly, prices determine who produces each good and how much is produced. For instance, consider farming. Because we need food to survive, it is crucial that some people work on

“Two dollars” “—and seventy-five cents.”

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QuickQuiz

“Connecticut should pass its Senate Bill 60, which states that

during a ‘severe weather event emergency, no person within the

chain of distribution of consumer goods and services shall sell

or offer to sell consumer goods or services for a price that is

unconscionably excessive.’”

Source: IGM Economic Experts Panel, May 2, 2012.

Price Gouging

ASK THE EXPERTS

77% disagree

What do economists say?

16% uncertain7% agree

84 PART II HOW MARKETS WORK

When a disaster such as a hurricane

strikes a region, many goods expe-

rience an increase in demand or a

decrease in supply, putting upward

pressure on prices. Policymakers often

object to these price hikes, but this

opinion piece endorses the market’s

natural response.

Is Price Gouging Reverse

Looting?

By John Carney

F our dollars for a can of coke. Five hundred

dollars a night for a hotel in downtown

Brooklyn. A pair of D-batteries for $6.99.

These are just a few of the examples of

price hikes I or friends of mine have person-

ally come across in the run-up and aftermath

of hurricane Sandy. Price gouging, as this is

often called, is a common occurrence during

emergencies.

Price gouging around natural disasters

is one of the things politicians on the left and

right agree is a terrible, no good, very bad thing.

New York Attorney General Eric Schneiderman

sent out a press release warning “against

price inflation of necessary goods and services

during hurricane Sandy.” New Jersey Governor

Chris Christie issued a “forceful reminder” that

price gouging “will result in significant penal-

ties.” Hotlines have been established to allow

consumers to report gouging.

New Jersey’s law is very specific. Price

increases of more than 10 percent during a

declared state of emergency are considered

excessive. A New Jersey gas station paid a

$50,000 fine last year for hiking gasoline prices

by 16 percent during tropical storm Irene.

New York’s law may be even stricter.

According to AG Schneiderman’s release,

all price increases on “necessary goods and

items” count as gouging.

“General Business Law prohibits such

increase in costs of essential items like

food, water, gas, generators, batteries and

flashlights, and services like transportation,

during natural disasters or other events that

disrupt the market,” the NY AG release said.

These laws are built on the quite conven-

tional view that it is unethical for a business

to take advantage of a disaster in pursuit

of profits. It just seems wrong for business

owners to make money on the misery of their

neighbors. Merchants earning larger profits

because of a disaster seem to be rewarded for

doing nothing more than raising their prices.

“It’s reverse looting,” a neighbor of mine

in Brooklyn said about the price of batteries

at a local electronic store.

Unfortunately, ethics runs into economics

in a way that can make these laws positively

harmful. Price gouging can occur only when

there is a shortage of the goods in demand.

If there were no shortage, normal market pro-

cesses would prevent sudden price spikes.

A deli owner charging $4 for a can of Pepsi

would discover he was just driving custom-

ers to the deli a block away, which charges

a buck.

But when everyone starts suddenly buy-

ing batteries or bottles of water for fear of

a blackout, shortages can arise. Sometimes

there simply is not enough of a particular

good to satisfy a sharp spike in demand.

And so the question arises: how do we decide

Price Increases after Disasters

IN THE NEWS

farms. What determines who is a farmer and who is not? In a free society, there is no government planning agency making this decision and ensuring an adequate supply of food. Instead, the allocation of workers to farms is based on the job deci- sions of millions of workers. This decentralized system works well because these decisions depend on prices. The prices of food and the wages of farmworkers (the price of their labor) adjust to ensure that enough people choose to be farmers.

If a person had never seen a market economy in action, the whole idea might seem preposterous. Economies are enormous groups of people engaged in a multitude of interdependent activities. What prevents decentralized decision making from degenerating into chaos? What coordinates the actions of the millions of people with their varying abilities and desires? What ensures that what needs to be done is in fact done? The answer, in a word, is prices. If an invisible hand guides market economies, as Adam Smith famously suggested, then the price system is the baton that the invisible hand uses to conduct the economic orchestra.

85CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

Source: CNBC.com, Oct 31, 2012.

which customers get the batteries, the gro-

ceries, the gasoline?

We could hold a lottery. Perhaps people

could receive a ticket at the grocery store.

Winners would get to shop at the usual prices.

Losers would just go hungry. Or, more likely,

they would be forced to buy the food away

from the lottery winners—at elevated prices

no doubt, since no one would buy food just

to sell it at the same price. So the gouging

would just pass from merchant to lottery win-

ning customer.

We could have some sort of rationing pro-

gram. Each person could be assigned a por-

tion of the necessary goods according to their

household need. This is something the U.S.

resorted to during World War II. The problem is

that rationing requires an immense amount of

planning—and an impossible level of knowl-

edge. The rationing bureaucrat would have to

know precisely how much of each good was

available in a given area and how many peo-

ple would need it. Good luck getting that in

place as a hurricane bears down on your city.

We could simply sell goods on a first

come, first serve basis. This is, in fact, what

anti-gouging laws encourage. The result is

all too familiar. People hoard goods. Store

shelves are emptied. And you have to wonder,

why is a first to the register race a fairer sys-

tem than the alternative of market prices?

Speed seems a poor proxy for justice.

Allowing prices to rise at times of extreme

demand discourages overconsumption. Peo-

ple consider their purchases more carefully.

Instead of buying a dozen batteries (or bot-

tles of water or gallons of gas), perhaps

they buy half that. The result is that goods

under extreme demand are available to more

customers. The market process actually

results in a more equitable distribution than

the anti-gouging laws.

Once we understand this, it’s easy to see

that merchants aren’t really profiting from

disaster. They are profiting from managing their

prices, which has the socially beneficial effect

of broadening distribution and discouraging

hoarding. In short, they are being justly rewarded

for performing an important public service.

One objection is that a system of free-

floating, legal gouging would allow the wealthy to

buy everything and leave the poor out altogether.

But this concern is overrated. For the most part,

price hikes during disasters do not actually put

necessary goods and services out of reach of even

the poorest people. They just put the budgets of

the poor under additional strain. This is a prob-

lem better resolved through transfer payments to

alleviate the household budgetary effects of the

prices after the fact, rather than trying to control

the price in the first place….

Instead of cracking down on price goug-

ers, we should be using our experience of

shortages during this time of crisis to spark

a reform of our counter-productive laws. Next

time disaster strikes, we should hope for a

bit more gouging and a lot fewer empty store

shelves. ■

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Would you pay $4 for this?

CHAPTER QuickQuiz

1. A change in which of the following will NOT shift the

demand curve for hamburgers?

a. the price of hot dogs

b. the price of hamburgers

c. the price of hamburger buns

d. the income of hamburger consumers

2. An increase in ________ will cause a movement along

a given demand curve, which is called a change in

________.

a. supply, demand

b. supply, quantity demanded

c. demand, supply

d. demand, quantity supplied

3. Movie tickets and film streaming services are

substitutes. If the price of film streaming increases,

what happens in the market for movie tickets?

a. The supply curve shifts to the left.

b. The supply curve shifts to the right.

c. The demand curve shifts to the left.

d. The demand curve shifts to the right.

4. The discovery of a large new reserve of crude oil will

shift the ________ curve for gasoline, leading to a

________ equilibrium price.

a. supply, higher

b. supply, lower

c. demand, higher

d. demand, lower

86 PART II HOW MARKETS WORK

5. If the economy goes into a recession and

incomes fall, what happens in the markets for

inferior goods?

a. Prices and quantities both rise.

b. Prices and quantities both fall.

c. Prices rise and quantities fall.

d. Prices fall and quantities rise.

6. Which of the following might lead to an increase in

the equilibrium price of jelly and a decrease in the

equilibrium quantity of jelly sold?

a. an increase in the price of peanut better,

a complement to jelly

b. an increase in the price of Marshmallow Fluff,

a substitute for jelly

c. an increase in the price of grapes, an input into jelly

d. an increase in consumers’ incomes,

as long as jelly is a normal good

SUMMARY

Economists use the model of supply and demand to

analyze competitive markets. In a competitive market,

there are many buyers and sellers, each of whom has

little or no influence on the market price.

The demand curve shows how the quantity of a good

demanded depends on the price. According to the law

of demand, as the price of a good falls, the quantity

demanded rises. Therefore, the demand curve slopes

downward.

In addition to price, other determinants of how much

consumers want to buy include income, the prices of

substitutes and complements, tastes, expectations, and

the number of buyers. If one of these factors changes,

the demand curve shifts.

The supply curve shows how the quantity of a good

supplied depends on the price. According to the law

of supply, as the price of a good rises, the quantity sup-

plied rises. Therefore, the supply curve slopes upward.

In addition to price, other determinants of how much

producers want to sell include input prices, technol-

ogy, expectations, and the number of sellers. If one of

these factors changes, the supply curve shifts.

The intersection of the supply and demand curves

determines the market equilibrium. At the equilibrium

price, the quantity demanded equals the quantity

supplied.

The behavior of buyers and sellers naturally drives

markets toward their equilibrium. When the market

price is above the equilibrium price, there is a sur-

plus of the good, which causes the market price to

fall. When the market price is below the equilibrium

price, there is a shortage, which causes the market

price to rise.

To analyze how any event influences a market, we use

the supply-and-demand diagram to examine how the

event affects the equilibrium price and quantity. To do

this, we follow three steps. First, we decide whether

the event shifts the supply curve or the demand curve

(or both). Second, we decide in which direction the

curve shifts. Third, we compare the new equilibrium

with the initial equilibrium.

In market economies, prices are the signals that

guide economic decisions and thereby allocate scarce

resources. For every good in the economy, the price

ensures that supply and demand are in balance. The

equilibrium price then determines how much of the

good buyers choose to consume and how much sellers

choose to produce.

KEY CONCEPTS

market, p. 66

competitive market, p. 66

quantity demanded, p. 67

law of demand, p. 67

demand schedule, p. 67

demand curve, p. 68

normal good, p. 70

inferior good, p. 70

substitutes, p. 70

complements, p. 70

quantity supplied, p. 73

law of supply, p. 73

supply schedule, p. 73

supply curve, p. 74

equilibrium, p. 76

equilibrium price, p. 76

equilibrium quantity, p. 76

surplus, p. 77

shortage, p. 77

law of supply and demand, p. 78

87CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND

1. What is a competitive market? Briefly describe a type

of market that is not perfectly competitive.

2. What are the demand schedule and the demand

curve, and how are they related? Why does the

demand curve slope downward?

3. Does a change in consumers’ tastes lead to a

movement along the demand curve or to a shift in

the demand curve? Does a change in price lead to a

movement along the demand curve or to a shift in

the demand curve? Explain your answers.

4. Harry’s income declines, and as a result, he buys more

pumpkin juice. Is pumpkin juice an inferior or a nor-

mal good? What happens to Harry’s demand curve

for pumpkin juice?

5. What are the supply schedule and the supply curve,

and how are they related? Why does the supply curve

slope upward?

6. Does a change in producers’ technology lead to a

movement along the supply curve or to a shift in the

supply curve? Does a change in price lead to a move-

ment along the supply curve or to a shift in the supply

curve?

7. Define the equilibrium of a market. Describe the forces

that move a market toward its equilibrium.

8. Beer and pizza are complements because they are

often enjoyed together. When the price of beer rises,

what happens to the supply, demand, quantity sup-

plied, quantity demanded, and price in the market for

pizza?

9. Describe the role of prices in market economies.

QUESTIONS FOR REVIEW

PROBLEMS AND APPLICATIONS

1. Explain each of the following statements using

supply-and-demand diagrams.

a. “When a cold snap hits Florida, the price

of orange juice rises in supermarkets throughout

the country.”

b. “When the weather turns warm in New England

every summer, the price of hotel rooms in

Caribbean resorts plummets.”

c. “When a war breaks out in the Middle East, the

price of gasoline rises and the price of a used

Cadillac falls.”

2. “An increase in the demand for notebooks raises the

quantity of notebooks demanded but not the quantity

supplied.” Is this statement true or false? Explain.

3. Consider the market for minivans. For each of the

events listed here, identify which of the determinants

of demand or supply are affected. Also indicate

whether demand or supply increases or decreases.

Then draw a diagram to show the effect on the price

and quantity of minivans.

a. People decide to have more children.

b. A strike by steelworkers raises steel prices.

c. Engineers develop new automated machinery

for the production of minivans.

d. The price of sports utility vehicles rises.

e. A stock market crash lowers people’s wealth.

4. Consider the markets for film streaming services,

TV screens, and tickets at movie theaters.

a. For each pair, identify whether they are

complements or substitutes:

Film streaming and TV screens

Film streaming and movie tickets

TV screens and movie tickets

b. Suppose a technological advance reduces the cost

of manufacturing TV screens. Draw a diagram to

show what happens in the market for TV screens.

c. Draw two more diagrams to show how the

change in the market for TV screens affects the

markets for film streaming and movie tickets.

5. Over the past 40 years, technological advances

have reduced the cost of computer chips. How do

you think this has affected the market for computers?

For computer software? For typewriters?

6. Using supply-and-demand diagrams, show the effect

of the following events on the market for sweatshirts.

a. A hurricane in South Carolina damages the

cotton crop.

b. The price of leather jackets falls.

c. All colleges require morning exercise in

appropriate attire.

d. New knitting machines are invented.

88 PART II HOW MARKETS WORK

7. Ketchup is a complement (as well as a condiment) for

hot dogs. If the price of hot dogs rises, what happens

in the market for ketchup? For tomatoes? For tomato

juice? For orange juice?

8. The market for pizza has the following demand and

supply schedules:

Price Quantity Demanded Quantity Supplied

$4 135 pizzas 26 pizzas

5 104 53

6 81 81

7 68 98

8 53 110

9 39 121

a. Graph the demand and supply curves. What are

the equilibrium price and quantity in this market?

b. If the actual price in this market were above the equilibrium price, what would drive the market

toward the equilibrium?

c. If the actual price in this market were below the equilibrium price, what would drive the market

toward the equilibrium?

9. Consider the following events: Scientists reveal that

eating oranges decreases the risk of diabetes, and at

the same time, farmers use a new fertilizer that makes

orange trees produce more oranges. Illustrate and

explain what effect these changes have on the

equilibrium price and quantity of oranges.

10. Because bagels and cream cheese are often eaten

together, they are complements.

a. We observe that both the equilibrium price of cream

cheese and the equilibrium quantity of bagels have

risen. What could be responsible for this pattern—a

fall in the price of flour or a fall in the price of milk?

Illustrate and explain your answer.

b. Suppose instead that the equilibrium price of

cream cheese has risen but the equilibrium

quantity of bagels has fallen. What could be

responsible for this pattern—a rise in the price of

flour or a rise in the price of milk? Illustrate and

explain your answer.

11. Suppose that the price of basketball tickets at your

college is determined by market forces. Currently, the

demand and supply schedules are as follows:

Price Quantity Demanded Quantity Supplied

$4 10,000 tickets 8,000 tickets

8 8,000 8,000

12 6,000 8,000

16 4,000 8,000

20 2,000 8,000

a. Draw the demand and supply curves. What is

unusual about this supply curve? Why might this

be true?

b. What are the equilibrium price and quantity of

tickets?

c. Your college plans to increase total enrollment

next year by 5,000 students. The additional stu-

dents will have the following demand schedule:

Price Quantity Demanded

$4 4,000 tickets

8 3,000

12 2,000

16 1,000

20 0

Now add the old demand schedule and the

demand schedule for the new students to

calculate the new demand schedule for the

entire college. What will be the new

equilibrium price and quantity?

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

CHAPTER

5Elasticity and Its Application

I magine that some event drives up the price of gasoline in the United States. It could be a war in the Middle East that disrupts the world supply of oil, a boom- ing Chinese economy that boosts the world demand for oil, or a new tax on gaso-

line passed by Congress. How would U.S. consumers respond to the higher price? It is easy to answer this question in a broad fashion: Consumers would buy

less. This conclusion follows from the law of demand, which we learned in the previous chapter. But you might want a precise answer. By how much would con- sumption of gasoline fall? This question can be answered using a concept called elasticity, which we develop in this chapter.

90 PART II HOW MARKETS WORK

Elasticity is a measure of how much buyers and sellers respond to changes in market conditions. When studying how some event or policy affects a market, we can discuss not only the direction of the effects but also their magnitude. Elasticity is useful in many applications, as we see toward the end of this chapter.

Before proceeding, however, you might be curious about the answer to the gasoline question. Many studies have examined consumers’ response to changes in gasoline prices, and they typically find that the quantity demanded responds more in the long run than it does in the short run. A 10 percent increase in gaso- line prices reduces gasoline consumption by about 2.5 percent after a year and by about 6 percent after 5 years. About half of the long-run reduction in quantity demanded arises because people drive less, and half arises because they switch to more fuel-efficient cars. Both responses are reflected in the demand curve and its elasticity.

5-1 The Elasticity of Demand When we introduced demand in Chapter 4, we noted that consumers usually buy more of a good when its price is lower, when their incomes are higher, when the prices of its substitutes are higher, or when the prices of its complements are lower. Our discussion of demand was qualitative, not quantitative. That is, we discussed the direction in which quantity demanded moves but not the size of the change. To measure how much consumers respond to changes in these variables, economists use the concept of elasticity.

5-1a The Price Elasticity of Demand and Its Determinants The law of demand states that a fall in the price of a good raises the quantity demanded. The price elasticity of demand measures how much the quantity demanded responds to a change in price. Demand for a good is said to be elastic if the quantity demanded responds substantially to changes in the price. Demand is said to be inelastic if the quantity demanded responds only slightly to changes in the price.

The price elasticity of demand for any good measures how willing consum- ers are to buy less of the good as its price rises. Because a demand curve reflects the many economic, social, and psychological forces that shape consumer pref- erences, there is no simple, universal rule for what determines a demand curve’s elasticity. Based on experience, however, we can state some rules of thumb about what influences the price elasticity of demand.

Availability of Close Substitutes Goods with close substitutes tend to have more elastic demand because it is easier for consumers to switch from that good to others. For example, butter and margarine are easily substitutable. A small increase in the price of butter, assuming the price of margarine is held fixed, causes the quantity of butter sold to fall by a large amount. By contrast, because eggs are a food without a close substitute, the demand for eggs is less elastic than the demand for butter. A small increase in the price of eggs does not cause a sizable drop in the quantity of eggs sold.

Necessities versus Luxuries Necessities tend to have inelastic demands, whereas luxuries have elastic demands. When the price of a doctor ’s visit rises, people do not dramatically reduce the number of times they go to the doctor, although they

elasticity

a measure of the

responsiveness of

quantity demanded

or quantity supplied

to a change in one

of its determinants

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

91CHAPTER 5 ELASTICITY AND ITS APPLICATION

might go somewhat less often. By contrast, when the price of sailboats rises, the quantity of sailboats demanded falls substantially. The reason is that most people view doctor visits as a necessity and sailboats as a luxury. Whether a good is a necessity or a luxury depends not on the intrinsic properties of the good but on the preferences of the buyer. For avid sailors with little concern about their health, sailboats might be a necessity with inelastic demand and doctor visits a luxury with elastic demand.

Definition of the Market The elasticity of demand in any market depends on how we draw the boundaries of the market. Narrowly defined markets tend to have more elastic demand than broadly defined markets because it is easier to find close substitutes for narrowly defined goods. For example, food, a broad category, has a fairly inelastic demand because there are no good substitutes for food. Ice cream, a narrower category, has a more elastic demand because it is easy to substitute other desserts for ice cream. Vanilla ice cream, a very narrow cat- egory, has a very elastic demand because other flavors of ice cream are almost perfect substitutes for vanilla.

Time Horizon Goods tend to have more elastic demand over longer time horizons. When the price of gasoline rises, the quantity of gasoline demanded falls only slightly in the first few months. Over time, however, people buy more fuel-efficient cars, switch to public transportation, and move closer to where they work. Within several years, the quantity of gasoline demanded falls more substantially.

5-1b Computing the Price Elasticity of Demand Now that we have discussed the price elasticity of demand in general terms, let’s be more precise about how it is measured. Economists compute the price elastic- ity of demand as the percentage change in the quantity demanded divided by the percentage change in the price. That is,

price elasticity of demand 5 percentage change in quantity demanded

percentage change in price

For example, suppose that a 10 percent increase in the price of an ice-cream cone causes the amount of ice cream you buy to fall by 20 percent. We calculate your elasticity of demand as

price elasticity of demand 5 20 percent

5 2 10 percent

In this example, the elasticity is 2, reflecting that the change in the quantity demanded is proportionately twice as large as the change in the price.

Because the quantity demanded of a good is negatively related to its price, the percentage change in quantity will always have the opposite sign as the percent- age change in price. In this example, the percentage change in price is a positive 10 percent (reflecting an increase), and the percentage change in quantity demanded is a negative 20 percent (reflecting a decrease). For this reason, price elasticities of demand are sometimes reported as negative numbers. In this book, we follow the common practice of dropping the minus sign and reporting all price

92 PART II HOW MARKETS WORK

elasticities of demand as positive numbers. (Mathematicians call this the absolute value.) With this convention, a larger price elasticity implies a greater responsive- ness of quantity demanded to changes in price.

5-1c The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities

If you try calculating the price elasticity of demand between two points on a demand curve, you will quickly notice an annoying problem: The elasticity from point A to point B seems different from the elasticity from point B to point A. For example, consider these numbers:

point A: price 5 $4 quantity 5 120 point B: price 5 $6 quantity 5 80

Going from point A to point B, the price rises by 50 percent and the quantity falls by 33 percent, indicating that the price elasticity of demand is 33/50, or 0.66. Going from point B to point A, the price falls by 33 percent and the quan- tity rises by 50 percent, indicating that the price elasticity of demand is 50/33, or 1.5. This difference arises because the percentage changes are calculated from a different base.

One way to avoid this problem is to use the midpoint method for calculating elasticities. The standard procedure for computing a percentage change is to divide the change by the initial level. By contrast, the midpoint method computes a percentage change by dividing the change by the midpoint (or average) of the initial and final levels. For instance, $5 is the midpoint between $4 and $6. There- fore, according to the midpoint method, a change from $4 to $6 is considered a 40 percent rise because (6 2 4) / 5 3 100 5 40. Similarly, a change from $6 to $4 is considered a 40 percent fall.

Because the midpoint method gives the same answer regardless of the direc- tion of change, it is often used when calculating the price elasticity of demand between two points. In our example, the midpoint between point A and point B is:

midpoint: price 5 $5 quantity 5 100

According to the midpoint method, when going from point A to point B, the price rises by 40 percent and the quantity falls by 40 percent. Similarly, when going from point B to point A, the price falls by 40 percent and the quantity rises by 40 percent. In both directions, the price elasticity of demand equals 1.

The following formula expresses the midpoint method for calculating the price elasticity of demand between two points, denoted (Q

1 , P

1 ) and (Q

2 , P

2 ):

price elasticity of demand 5 (Q

2 2 Q

1 ) / [(Q

2 1 Q

1 ) / 2]

(P 2 2 P

1 ) / [(P

2 1 P

1 ) / 2]

The numerator is the percentage change in quantity computed using the mid- point method, and the denominator is the percentage change in price computed using the midpoint method. If you ever need to calculate elasticities, you should use this formula.

In this book, however, we rarely perform such calculations. For most of our purposes, what elasticity represents—the responsiveness of quantity demanded to a change in price—is more important than how it is calculated.

93CHAPTER 5 ELASTICITY AND ITS APPLICATION

5-1d The Variety of Demand Curves Economists classify demand curves according to their elasticity. Demand is con- sidered elastic when the elasticity is greater than 1, which means the quantity moves proportionately more than the price. Demand is considered inelastic when the elasticity is less than 1, which means the quantity moves proportionately less than the price. If the elasticity is exactly 1, the percentage change in quantity equals the percentage change in price, and demand is said to have unit elasticity.

Because the price elasticity of demand measures how much quantity demanded responds to changes in the price, it is closely related to the slope of the demand curve. The following rule of thumb is a useful guide: The flatter the demand curve that passes through a given point, the greater the price elasticity of demand. The steeper the demand curve that passes through a given point, the smaller the price elasticity of demand.

Figure 1 shows five cases. In the extreme case of a zero elasticity, shown in panel (a), demand is perfectly inelastic, and the demand curve is vertical. In this case, regardless of the price, the quantity demanded stays the same. As the elas- ticity rises, the demand curve gets flatter and flatter, as shown in panels (b), (c), and (d). At the opposite extreme, shown in panel (e), demand is perfectly elastic. This occurs as the price elasticity of demand approaches infinity and the demand curve becomes horizontal, reflecting the fact that very small changes in the price lead to huge changes in the quantity demanded.

Finally, if you have trouble keeping straight the terms elastic and inelastic, here’s a memory trick for you: Inelastic curves, such as in panel (a) of Figure 1, look like the letter I. This is not a deep insight, but it might help on your next exam.

A Few Elasticities from the Real World

W e have talked about what elasticity means, what determines it, and

how it is calculated. Beyond these general ideas, you might ask for

a specific number. How much, precisely, does the price of a particular

good influence the quantity demanded?

To answer such a question, economists collect data from market out-

comes and apply statistical techniques to estimate the price elasticity

of demand. Here are some price elasticities of demand, obtained from

various studies, for a range of goods:

These kinds of numbers are

fun to think about, and they

can be useful when compar-

ing markets.

N o n e t h e l e s s , o n e

should take these estimates

with a grain of salt. One rea-

son is that the statistical techniques used to obtain them require some

assumptions about the world, and these assumptions might not be true

in practice. (The details of these techniques are beyond the scope of this

book, but you will encounter them if you take a course in econometrics.)

Another reason is that the price elasticity of demand need not be the

same at all points on a demand curve, as we will see shortly in the case

of a linear demand curve. For both reasons, you should not be surprised

if different studies report different price elasticities of demand for the

same good. ■

F Y I

Eggs 0.1

Healthcare 0.2

Cigarettes 0.4

Rice 0.5

Housing 0.7

Beef 1.6

Peanut Butter 1.7

Restaurant Meals 2.3

Mountain Dew 4.4

94 PART II HOW MARKETS WORK

FIGURE 1

The Price Elasticity of Demand

The price elasticity of demand determines whether the demand curve is steep or flat.

Note that all percentage changes are calculated using the midpoint method.

2. . . . leads to a 22% decrease in quantity demanded.

(a) Perfectly Inelastic Demand: Elasticity Equals 0

Demand

Quantity1000

(b) Inelastic Demand: Elasticity Is Less Than 1

Quantity1000 90

Demand

Quantity1000

Price

1. An increase in price . . .

2. . . . leaves the quantity demanded unchanged.

1. A 22% increase in price . . .

Price Price

2. . . . leads to an 11% decrease in quantity demanded.

1. A 22% increase in price . . .

(d) Elastic Demand: Elasticity Is Greater Than 1

4 Demand

Quantity1000

Price

(e) Perfectly Elastic Demand: Elasticity Equals Infinity

Quantity0

Price

Demand

1. A 22% increase in price . . .

2. . . . leads to a 67% decrease in quantity demanded. 3. At a price below $4, quantity demanded is infinite.

2. At exactly $4, consumers will buy any quantity.

1. At any price above $4, quantity demanded is zero.

95CHAPTER 5 ELASTICITY AND ITS APPLICATION

5-1e Total Revenue and the Price Elasticity of Demand When studying changes in supply or demand in a market, one variable we often want to study is total revenue, the amount paid by buyers and received by sellers of a good. In any market, total revenue is P 3 Q, the price of the good times the quantity of the good sold. We can show total revenue graphically, as in Figure 2. The height of the box under the demand curve is P, and the width is Q. The area of this box, P 3 Q, equals the total revenue in this market. In Figure 2, where P 5 $4 and Q 5 100, total revenue is $4 3 100, or $400.

How does total revenue change as one moves along the demand curve? The answer depends on the price elasticity of demand. If demand is inelastic, as in panel (a) of Figure 3, then an increase in the price causes an increase in total revenue. Here an increase in price from $4 to $5 causes the quantity demanded to fall from 100 to 90, so total revenue rises from $400 to $450. An increase in price raises P 3 Q because the fall in Q is proportionately smaller than the rise in P. In other words, the extra revenue from selling units at a higher price (represented by area A in the figure) more than offsets the decline in revenue from selling fewer units (represented by area B).

We obtain the opposite result if demand is elastic: An increase in the price causes a decrease in total revenue. In panel (b) of Figure 3, for instance, when the price rises from $4 to $5, the quantity demanded falls from 100 to 70, so total rev- enue falls from $400 to $350. Because demand is elastic, the reduction in the quan- tity demanded is so great that it more than offsets the increase in the price. That is, an increase in price reduces P 3 Q because the fall in Q is proportionately greater than the rise in P. In this case, the extra revenue from selling units at a higher price (area A) is smaller than the decline in revenue from selling fewer units (area B).

The examples in this figure illustrate some general rules:

When demand is inelastic (a price elasticity less than 1), price and total revenue move in the same direction: If the price increases, total revenue also increases.

total revenue

the amount paid by buyers

and received by sellers of

a good, computed as the

price of the good times

the quantity sold

FIGURE 2

Total Revenue

The total amount paid by buyers, and

received as revenue by sellers, equals

the area of the box under the demand

curve, P 3 Q. Here, at a price of $4,

the quantity demanded is 100 and

total revenue is $400. $4

Demand

Quantity

Price

P 3 Q 5 $400 (revenue)

100

96 PART II HOW MARKETS WORK

When demand is elastic (a price elasticity greater than 1), price and total revenue move in opposite directions: If the price increases, total revenue decreases. If demand is unit elastic (a price elasticity exactly equal to 1), total revenue remains constant when the price changes.

5-1f Elasticity and Total Revenue along a Linear Demand Curve Let’s examine how elasticity varies along a linear demand curve, as shown in Figure 4. We know that a straight line has a constant slope. Slope is defined as “rise over run,” which here is the ratio of the change in price (“rise”) to the change in quantity (“run”). This particular demand curve’s slope is constant because each $1 increase in price causes the same 2-unit decrease in the quantity demanded.

Even though the slope of a linear demand curve is constant, the elasticity is not. This is true because the slope is the ratio of changes in the two variables, whereas the elasticity is the ratio of percentage changes in the two variables. You can see this by looking at the table in Figure 4, which shows the demand schedule for the

FIGURE 3

How Total Revenue Changes

When Price Changes

The impact of a price change on total revenue (the product of price and quantity)

depends on the elasticity of demand. In panel (a), the demand curve is inelastic.

In this case, an increase in the price leads to a decrease in quantity demanded that

is proportionately smaller, so total revenue increases. Here an increase in the price

from $4 to $5 causes the quantity demanded to fall from 100 to 90. Total revenue

rises from $400 to $450. In panel (b), the demand curve is elastic. In this case,

an increase in the price leads to a decrease in quantity demanded that is proportion-

ately larger, so total revenue decreases. Here an increase in the price from $4 to

$5 causes the quantity demanded to fall from 100 to 70. Total revenue falls from

$400 to $350.

Price

Quantity

0 10090

Demand

Price

Quantity

0 10070

Demand

(a) The Case of Inelastic Demand (b) The Case of Elastic Demand

1. When the demand curve is inelastic . . .

1. When the demand curve is elastic . . .

3. . . . is greater than the lost revenue from selling fewer units.

3. . . . is less than the lost revenue from selling fewer units.

2. . . . the extra revenue from selling at a higher price . . .

97CHAPTER 5 ELASTICITY AND ITS APPLICATION

linear demand curve in the graph. The table uses the midpoint method to calcu- late the price elasticity of demand. The table illustrates the following: At points with a low price and high quantity, the demand curve is inelastic. At points with a high price and low quantity, the demand curve is elastic.

The explanation for this fact comes from the arithmetic of percentage changes. When the price is low and consumers are buying a lot, a $1 price increase and 2-unit reduction in quantity demanded constitute a large percentage increase in the price and a small percentage decrease in quantity demanded, resulting in a small elasticity. When the price is high and consumers are not buying much, the same $1 price increase and 2-unit reduction in quantity demanded constitute a small percentage increase in the price and a large percentage decrease in quantity demanded, resulting in a large elasticity.

The table also presents total revenue at each point on the demand curve. These numbers illustrate the relationship between total revenue and elasticity. When the price is $1, for instance, demand is inelastic and a price increase to $2 raises total revenue. When the price is $5, demand is elastic and a price increase to $6 reduces total revenue. Between $3 and $4, demand is exactly unit elastic and total revenue is the same at these two prices.

FIGURE 4

Elasticity along a Linear Demand Curve

The slope of a linear demand curve is constant, but its

elasticity is not. The price elasticity of demand is calculated

using the demand schedule in the table and the midpoint

method. At points with a low price and high quantity, the

demand curve is inelastic. At points with a high price and

low quantity, the demand curve is elastic.

Quantity 122 4 6 8 10 140

Price Elasticity is larger than 1.

Elasticity is smaller than 1.

Percentage Percentage

Total Revenue Change Change in

Price Quantity (Price × Quantity) in Price Quantity Elasticity Description

$7 0 $0

6 2 12

5 4 20

4 6 24

3 8 24

2 10 20

1 12 12

0 14 0

15 200 13.0 Elastic

18 67 3.7 Elastic

22 40 1.8 Elastic

29 29 1.0 Unit elastic

40 22 0.6 Inelastic

67 18 0.3 Inelastic

200 15 0.1 Inelastic

98 PART II HOW MARKETS WORK

The linear demand curve illustrates that the price elasticity of demand need not be the same at all points on a demand curve. A constant elasticity is possible, but it is not always the case.

5-1g Other Demand Elasticities In addition to the price elasticity of demand, economists use other elasticities to describe the behavior of buyers in a market.

The Income Elasticity of Demand The income elasticity of demand measures how the quantity demanded changes as consumer income changes. It is calcu- lated as the percentage change in quantity demanded divided by the percentage change in income. That is,

income elasticity of demand 5 percentage change in quantity demanded

percentage change in income

As we discussed in Chapter 4, most goods are normal goods: Higher income raises the quantity demanded. Because quantity demanded and income move in the same direction, normal goods have positive income elasticities. A few goods, such as bus rides, are inferior goods: Higher income lowers the quantity demanded. Because quantity demanded and income move in opposite directions, inferior goods have negative income elasticities.

Even among normal goods, income elasticities vary substantially in size. Necessities, such as food and clothing, tend to have small income elasticities because consumers choose to buy some of these goods even when their incomes are low. Luxuries, such as caviar and diamonds, tend to have large income elasticities because consumers feel that they can do without these goods altogether if their incomes are too low.

The Cross-Price Elasticity of Demand The cross-price elasticity of demand mea- sures how the quantity demanded of one good responds to a change in the price of another good. It is calculated as the percentage change in quantity demanded of good 1 divided by the percentage change in the price of good 2. That is,

cross-price elasticity of demand 5 percentage change in quantity demanded of good 1

percentage change in the price of good 2

Whether the cross-price elasticity is a positive or negative number depends on whether the two goods are substitutes or complements. As we discussed in Chapter 4, substitutes are goods that are typically used in place of one another, such as hamburgers and hot dogs. An increase in hot dog prices induces peo- ple to grill hamburgers instead. Because the price of hot dogs and the quantity of hamburgers demanded move in the same direction, the cross-price elasticity is positive. Conversely, complements are goods that are typically used together, such as computers and software. In this case, the cross-price elasticity is nega- tive, indicating that an increase in the price of computers reduces the quantity of software demanded.

Define the price elasticity of demand. Explain the relationship between

total revenue and the price elasticity of demand.

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

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

price of the second good

QuickQuiz

99CHAPTER 5 ELASTICITY AND ITS APPLICATION

5-2 The Elasticity of Supply When we introduced supply in Chapter 4, we noted that producers of a good offer to sell more of it when the price of the good rises. To turn from qualitative to quantita- tive statements about quantity supplied, we once again use the concept of elasticity.

5-2a The Price Elasticity of Supply and Its Determinants The law of supply states that higher prices raise the quantity supplied. The price elasticity of supply measures how much the quantity supplied responds to changes in the price. Supply of a good is said to be elastic if the quantity supplied responds substantially to changes in the price. Supply is said to be inelastic if the quantity supplied responds only slightly to changes in the price.

The price elasticity of supply depends on the flexibility of sellers to change the amount of the good they produce. For example, beachfront land has an inelas- tic supply because it is almost impossible to produce more of it. Manufactured goods, such as books, cars, and televisions, have elastic supplies because firms that produce them can run their factories longer in response to a higher price.

In most markets, a key determinant of the price elasticity of supply is the time period being considered. Supply is usually more elastic in the long run than in the short run. Over short periods of time, firms cannot easily change the size of their factories to make more or less of a good. Thus, in the short run, the quantity sup- plied is not very responsive to the price. Over longer periods of time, firms can build new factories or close old ones. In addition, new firms can enter a market, and old firms can exit. Thus, in the long run, the quantity supplied can respond substantially to price changes.

5-2b Computing the Price Elasticity of Supply Now that we have a general understanding about the price elasticity of supply, let’s be more precise. Economists compute the price elasticity of supply as the percentage change in the quantity supplied divided by the percentage change in the price. That is,

price elasticity of supply 5 percentage change in quantity supplied

percentage change in price

For example, suppose that an increase in the price of milk from $2.85 to $3.15 a gal- lon raises the amount that dairy farmers produce from 9,000 to 11,000 gallons per month. Using the midpoint method, we calculate the percentage change in price as

percentage change in price 5 (3.15 2 2.85) / 3.00 3 100 5 10 percent

Similarly, we calculate the percentage change in quantity supplied as:

Percentage change in quantity supplied 5 (11,000 2 9,000) / 10,000 3 100 5 20 percent.

In this case, the price elasticity of supply is

price elasticity of supply 5 20 percent

5 2 10 percent

In this example, the elasticity of 2 indicates that the quantity supplied changes proportionately twice as much as the 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

100 PART II HOW MARKETS WORK

5-2c The Variety of Supply Curves Because the price elasticity of supply measures the responsiveness of quantity supplied to changes in price, it is reflected in the appearance of the supply curve. Figure 5 (on the facing page) shows five cases. In the extreme case of zero elasticity, as shown in panel (a), supply is perfectly inelastic and the supply curve is verti- cal. In this case, the quantity supplied is the same regardless of the price. As the elasticity rises, the supply curve gets flatter, which shows that the quantity sup- plied responds more to changes in the price. At the opposite extreme, shown in panel (e), supply is perfectly elastic. This occurs as the price elasticity of supply approaches infinity and the supply curve becomes horizontal, meaning that very small changes in the price lead to very large changes in the quantity supplied.

In some markets, the elasticity of supply is not constant but varies over the sup- ply curve. Figure 6 (presented below) shows a typical case for an industry in which firms have factories with a limited capacity for production. For low levels of quantity supplied, the elasticity of supply is high, indicating that firms respond substantially to changes in the price. In this region, firms have capacity for production that is not be- ing used, such as plants and equipment that are idle for all or part of the day. Small increases in price make it profitable for firms to begin using this idle capacity. As the quantity supplied rises, firms begin to reach capacity. Once capacity is fully used, fur- ther increases in production require the construction of new plants. To induce firms to incur this extra expense, the price must rise substantially, so supply becomes less elastic.

Figure 6 presents a numerical example of this phenomenon. When the price rises from $3 to $4 (a 29 percent increase, according to the midpoint method), the quantity supplied rises from 100 to 200 (a 67 percent increase). Because quan- tity supplied changes proportionately more than the price, the supply curve has an elasticity greater than 1. By contrast, when the price rises from $12 to $15 (a 22 percent increase), the quantity supplied rises from 500 to 525 (a 5 percent increase). In this case, quantity supplied moves proportionately less than the price, so the elasticity is less than 1.

Define the price elasticity of supply. Explain why the price elasticity of

supply might be different in the long run than in the short run. QuickQuiz

FIGURE 6

How the Price Elasticity of Supply Can Vary

Because firms often have a maximum capacity for

production, the elasticity of supply may be very high

at low levels of quantity supplied and very low at

high levels of quantity supplied. Here an increase in

price from $3 to $4 increases the quantity supplied

from 100 to 200. Because the 67 percent increase

in quantity supplied (computed using the midpoint

method) is larger than the 29 percent increase in

price, the supply curve is elastic in this range. By

contrast, when the price rises from $12 to $15,

the quantity supplied rises only from 500 to 525.

Because the 5 percent increase in quantity supplied

is smaller than the 22 percent increase in price, the

supply curve is inelastic in this range.

$15

Quantity100 200 5000

Price

525

Elasticity is small (less than 1).

Elasticity is large (greater than 1).

101CHAPTER 5 ELASTICITY AND ITS APPLICATION

FIGURE 5

The Price Elasticity of Supply

The price elasticity of supply determines whether the supply curve is steep or flat.

Note that all percentage changes are calculated using the midpoint method.

100 110

100 125

(a) Perfectly Inelastic Supply: Elasticity Equals 0

Supply

Quantity1000

(b) Inelastic Supply: Elasticity Is Less Than 1

Quantity0

Price

1. An increase in price . . .

2. . . . leaves the quantity supplied unchanged.

2. . . . leads to a 22% increase in quantity supplied.

1. A 22% increase in price . . .

Price Price

2. . . . leads to a 10% increase in quantity supplied.

1. A 22% increase in price . . .

(d) Elastic Supply: Elasticity Is Greater Than 1

Quantity0

Price (e) Perfectly Elastic Supply: Elasticity Equals Infinity

Quantity0

Price

Supply

1. A 22% increase in price . . .

2. . . . leads to a 67% increase in quantity supplied. 3. At a price below $4, quantity supplied is zero.

Supply

100 200

Supply

2. At exactly $4, producers will supply any quantity.

1. At any price above $4, quantity supplied is infinite.

102 PART II HOW MARKETS WORK

5-3 Three Applications of Supply, Demand, and Elasticity Can good news for farming be bad news for farmers? Why did OPEC, the in- ternational oil cartel, fail to keep the price of oil high? Does drug interdiction increase or decrease drug-related crime? At first, these questions might seem to have little in common. Yet all three questions are about markets, and all mar- kets are subject to the forces of supply and demand. Here we apply the versa- tile tools of supply, demand, and elasticity to answer these seemingly complex questions.

5-3a Can Good News for Farming Be Bad News for Farmers? Imagine you’re a Kansas wheat farmer. Because you earn all your income from selling wheat, you devote much effort to making your land as productive as pos- sible. You monitor weather and soil conditions, check your fields for pests and disease, and study the latest advances in farm technology. You know that the more wheat you grow, the more you will have to sell after the harvest, and the higher your income and standard of living will be.

One day, Kansas State University announces a major discovery. Researchers in its agronomy department have devised a new hybrid of wheat that raises the amount farmers can produce from each acre of land by 20 percent. How should you react to this news? Does this discovery make you better off or worse off than you were before?

Recall from Chapter 4 that we answer such questions in three steps. First, we examine whether the supply or demand curve shifts. Second, we consider the direction in which the curve shifts. Third, we use the supply-and-demand diagram to see how the market equilibrium changes.

In this case, the discovery of the new hybrid affects the supply curve. Because the hybrid increases the amount of wheat that can be produced on each acre of land, farmers are now willing to supply more wheat at any given price. In other words, the supply curve shifts to the right. The demand curve remains the same because consumers’ desire to buy wheat products at any given price is not affected by the introduction of a new hybrid. Figure 7 shows an example of such a change. When the supply curve shifts from S

1 to S

2 , the quantity of

wheat sold increases from 100 to 110 and the price of wheat falls from $3 to $2.

Does this discovery make farmers better off? As a first cut to answering this question, consider what happens to the total revenue received by farmers. Farmers’ total revenue is P 3 Q, the price of the wheat times the quantity sold. The discovery affects farmers in two conflicting ways. The hybrid allows farm- ers to produce more wheat (Q rises), but now each bushel of wheat sells for less (P falls).

The price elasticity of demand determines whether total revenue rises or falls. In practice, the demand for basic foodstuffs such as wheat is usually inelastic because these items are relatively inexpensive and have few good substitutes. When the demand curve is inelastic, as it is in Figure 7, a decrease in price causes total revenue to fall. You can see this in the figure: The price of wheat falls sub- stantially, whereas the quantity of wheat sold rises only slightly. Total revenue falls from $300 to $220. Thus, the discovery of the new hybrid lowers the total revenue that farmers receive from the sale of their crops.

103CHAPTER 5 ELASTICITY AND ITS APPLICATION

If farmers are made worse off by the discovery of this new hybrid, one might wonder why they adopt it. The answer goes to the heart of how competitive markets work. Because each farmer is only a small part of the market for wheat, she takes the price of wheat as given. For any given price of wheat, it is better to use the new hybrid to produce and sell more wheat. Yet when all farmers do this, the supply of wheat increases, the price falls, and farmers are worse off.

This example may at first seem hypothetical, but it helps to explain a major change in the U.S. economy over the past century. Two hundred years ago, most Americans lived on farms. Knowledge about farm methods was sufficiently prim- itive that most Americans had to be farmers to produce enough food to feed the nation’s population. But over time, advances in farm technology increased the amount of food that each farmer could produce. This increase in food supply, together with the inelastic demand for food, caused farm revenues to fall, which in turn encouraged people to leave farming.

A few numbers show the magnitude of this historic change. As recently as 1950, 10 million people worked on farms in the United States, representing 17 percent of the labor force. Today, fewer than 3 million people work on farms, or 2 percent of the labor force. This change coincided with tremendous advances in farm productivity: Despite the large drop in the number of farmers, U.S. farms now produce about five times as much output as they did in 1950.

This analysis of the market for farm products also explains a seeming paradox of public policy: Certain farm programs try to help farmers by inducing them not to plant crops on all of their land. The purpose of these programs is to reduce the supply of farm products and thereby raise prices. With inelastic demand for their products, farmers as a group receive greater total revenue if they supply a smaller crop to the market. No single farmer would choose to leave her land fallow on her own because each takes the market price as given. But if all farmers do so together, they can all be better off.

FIGURE 7

An Increase in Supply in the Market for Wheat

When an advance in farm technology increases the

supply of wheat from S 1 to S

2 , the price of wheat

falls. Because the demand for wheat is inelastic, the

increase in the quantity sold from 100 to 110 is

proportionately smaller than the decrease in the price

from $3 to $2. As a result, farmers’ total revenue

falls from $300 ($3 3 100) to $220 ($2 3 110).

Quantity of Wheat

1000

Price of Wheat

3. . . . and a proportionately smaller increase in quantity sold. As a result, revenue falls from $300 to $220.

110

Demand

S1 S2

2. . . . leads to a large fall in price . . .

1. When demand is inelastic, an increase in supply . . .

104 PART II HOW MARKETS WORK

When analyzing the effects of farm technology or farm policy, it is important to keep in mind that what is good for farmers is not necessarily good for society as a whole. Improvement in farm technology can be bad for farmers because it makes farmers increasingly unnecessary, but it is surely good for consumers who pay less for food. Similarly, a policy aimed at reducing the supply of farm products may raise the incomes of farmers, but it does so at the expense of consumers.

5-3b Why Did OPEC Fail to Keep the Price of Oil High? Many of the most disruptive events for the world’s economies over the past sev- eral decades have originated in the world market for oil. In the 1970s, members of the Organization of the Petroleum Exporting Countries (OPEC) decided to raise the world price of oil to increase their incomes. These countries accomplished this goal by agreeing to jointly reduce the amount of oil they supplied. As a result, the price of oil (adjusted for overall inflation) rose more than 50 percent from 1973 to 1974. Then, a few years later, OPEC did the same thing again. From 1979 to 1981, the price of oil approximately doubled.

Yet OPEC found it difficult to maintain such a high price. From 1982 to 1985, the price of oil steadily declined about 10 percent per year. Dissatisfaction and disarray soon prevailed among the OPEC countries. In 1986, cooperation among OPEC members completely broke down, and the price of oil plunged 45 percent. In 1990, the price of oil (adjusted for overall inflation) was back to where it be- gan in 1970, and it stayed at that low level throughout most of the 1990s. (In the first decade and a half of the 21st century, the price of oil fluctuated substantially once again, but the main driving force was not OPEC supply restrictions. Instead, booms and busts in economies around the world caused demand to fluctuate, while advances in fracking technology caused large increases in supply.)

The OPEC episodes of the 1970s and 1980s show how supply and demand can behave differently in the short run and in the long run. In the short run, both the supply and demand for oil are relatively inelastic. Supply is inelastic because the quantity of known oil reserves and the capacity for oil extraction cannot be changed quickly. Demand is inelastic because buying habits do not respond im- mediately to changes in price. Thus, as panel (a) of Figure 8 shows, the short-run

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105CHAPTER 5 ELASTICITY AND ITS APPLICATION

supply and demand curves are steep. When the supply of oil shifts from S 1 to S

2 ,

the price increase from P 1 to P

2 is large.

The situation is very different in the long run. Over long periods of time, pro- ducers of oil outside OPEC respond to high prices by increasing oil exploration and by building new extraction capacity. Consumers respond with greater conser- vation, such as by replacing old inefficient cars with newer efficient ones. Thus, as panel (b) of Figure 8 shows, the long-run supply and demand curves are more elastic. In the long run, the shift in the supply curve from S

1 to S

2 causes a much

smaller increase in the price. This analysis shows why OPEC succeeded in maintaining a high price of oil

only in the short run. When OPEC countries agreed to reduce their production of oil, they shifted the supply curve to the left. Even though each OPEC member sold less oil, the price rose by so much in the short run that OPEC incomes rose. In the long run, however, supply and demand are more elastic. As a result, the same reduction in supply, measured by the horizontal shift in the supply curve, caused a smaller increase in the price. Thus, OPEC’s coordinated reduction in supply proved less profitable in the long run. The cartel learned that raising prices is eas- ier in the short run than in the long run.

5-3c Does Drug Interdiction Increase or Decrease Drug-Related Crime?

A persistent problem facing our society is the use of illegal drugs, such as heroin, cocaine, ecstasy, and methamphetamine. Drug use has several adverse effects. One is that drug dependence can ruin the lives of drug users and their families.

FIGURE 8

A Reduction in Supply in

the World Market for Oil

Quantity of Oil0

Price of Oil

Demand

S2 S1

(a) The Oil Market in the Short Run

Quantity of Oil0

Price of Oil

Demand

S2 S1

(b) The Oil Market in the Long Run

2. . . . leads to a large increase in price.

1. In the long run, when supply and demand are elastic, a shift in supply . . .

2. . . . leads to a small increase in price.

1. In the short run, when supply and demand are inelastic, a shift in supply . . .

When the supply of oil falls, the response depends on the time horizon. In the short run,

supply and demand are relatively inelastic, as in panel (a). Thus, when the supply curve

shifts from S 1 to S

2 , the price rises substantially. In the long run, however, supply and

demand are relatively elastic, as in panel (b). In this case, the same size shift in the

supply curve (S 1 to S

2 ) causes a smaller increase in the price.

106 PART II HOW MARKETS WORK

Another is that drug addicts often turn to robbery and other violent crimes to obtain the money needed to support their habit. To discourage the use of illegal drugs, the U.S. government devotes billions of dollars each year to reducing the flow of drugs into the country. Let’s use the tools of supply and demand to exam- ine this policy of drug interdiction.

Suppose the government increases the number of federal agents devoted to the war on drugs. What happens in the market for illegal drugs? As usual, we answer this question in three steps. First, we consider whether the supply or demand curve shifts. Second, we consider the direction of the shift. Third, we see how the shift affects the equilibrium price and quantity.

Although the purpose of drug interdiction is to reduce drug use, its direct impact is on the sellers of drugs rather than on the buyers. When the government stops some drugs from entering the country and arrests more smugglers, it raises the cost of selling drugs and, therefore, reduces the quantity of drugs supplied at any given price. The demand for drugs—the amount buyers want at any given price—remains the same. As panel (a) of Figure 9 shows, interdiction shifts the supply curve to the left from S

1 to S

2 without changing the demand curve. The

equilibrium price of drugs rises from P 1 to P

2 , and the equilibrium quantity falls

from Q 1 to Q

2 . The fall in the equilibrium quantity shows that drug interdiction

does reduce drug use. But what about the amount of drug-related crime? To answer this question,

consider the total amount that drug users pay for the drugs they buy. Because few

FIGURE 9

Policies to Reduce the

Use of Illegal Drugs

Quantity of Drugs0 Q2 Q1

Price of Drugs

Demand

Q2 Q1

(a) Drug Interdiction

Quantity of Drugs0

Price of Drugs

Supply

D2 D1

(b) Drug Education

3. . . . and reduces the quantity sold.

2. . . . which raises the price . . .

2. . . . which reduces the price . . .

1. Drug interdiction reduces the supply of drugs . . .

1. Drug education reduces the demand for drugs . . .

3. . . . and reduces the quantity sold.

Drug interdiction reduces the supply of drugs from S 1 to S

2 , as in panel (a). If the demand

for drugs is inelastic, then the total amount paid by drug users rises, even as the amount of

drug use falls. By contrast, drug education reduces the demand for drugs from D 1 to D

2 , as

in panel (b). Because both price and quantity fall, the amount paid by drug users falls.

107CHAPTER 5 ELASTICITY AND ITS APPLICATION

drug addicts are likely to break their destructive habits in response to a higher price, it is likely that the demand for drugs is inelastic, as it is drawn in the figure. If demand is inelastic, then an increase in price raises total revenue in the drug market. That is, because drug interdiction raises the price of drugs proportion- ately more than it reduces drug use, it raises the total amount of money that drug users pay for drugs. Addicts who already had to steal to support their habits would have an even greater need for quick cash. Thus, drug interdiction could increase drug-related crime.

Because of this adverse effect of drug interdiction, some analysts argue for alternative approaches to the drug problem. Rather than trying to reduce the sup- ply of drugs, policymakers might try to reduce the demand by pursuing a policy of drug education. Successful drug education has the effects shown in panel (b) of Figure 9. The demand curve shifts to the left from D

1 to D

2 . As a result, the

equilibrium quantity falls from Q 1 to Q

2 , and the equilibrium price falls from P

to P 2 . Total revenue, P 3 Q, also falls. Thus, in contrast to drug interdiction, drug

education can reduce both drug use and drug-related crime. Advocates of drug interdiction might argue that the long-run effects of this pol-

icy are different from the short-run effects because the elasticity of demand depends on the time horizon. The demand for drugs is probably inelastic over short periods because higher prices do not substantially affect drug use by estab- lished addicts. But demand may be more elastic over longer periods because higher prices would discourage experimentation with drugs among the young and, over time, lead to fewer drug addicts. In this case, drug interdiction would increase drug-related crime in the short run but decrease it in the long run.

How might a drought that destroys half of all farm crops be good for farm-

ers? If such a drought is good for farmers, why don’t farmers destroy their

own crops in the absence of a drought?

5-4 Conclusion According to an old quip, even a parrot can become an economist simply by learn- ing to say “supply and demand.” These last two chapters should have convinced you that there is much truth to this statement. The tools of supply and demand allow you to analyze many of the most important events and policies that shape the economy. You are now well on your way to becoming an economist (or at least a well-educated parrot).

QuickQuiz

CHAPTER QuickQuiz

1. A life-saving medicine without any close substitutes

will tend to have

a. a small elasticity of demand.

b. a large elasticity of demand.

c. a small elasticity of supply.

d. a large elasticity of supply.

2. The price of a good rises from $8 to $12, and the

quantity demanded falls from 110 to 90 units.

Calculated with the midpoint method, the price

elasticity of demand is

a. 1/5.

b. 1/2.

c. 2.

d. 5.

108 PART II HOW MARKETS WORK

3. A linear, downward-sloping demand curve is

a. inelastic

b. unit elastic.

c. elastic.

d. inelastic at some points, and elastic at others.

4. The ability of firms to enter and exit a market over

time means that, in the long run,

a. the demand curve is more elastic.

b. the demand curve is less elastic.

c. the supply curve is more elastic.

d. the supply curve is less elastic.

5. An increase in the supply of a good will decrease the

total revenue producers receive if

a. the demand curve is inelastic.

b. the demand curve is elastic.

c. the supply curve is inelastic.

d. the supply curve is elastic.

6. Over time, technological advance increases consumers’

incomes and reduces the price of smartphones. Each

of these forces increases the amount consumers spend

on smartphones if the income elasticity of demand

is greater than ________ and if the price elasticity of

demand is greater than ________.

a. zero, zero

b. zero, one

c. one, zero

d. one, one

SUMMARY

The price elasticity of demand measures how much the

quantity demanded responds to changes in the price.

Demand tends to be more elastic if close substitutes are

available, if the good is a luxury rather than a necessity,

if the market is narrowly defined, or if buyers have

substantial time to react to a price change.

The price elasticity of demand is calculated as the

percentage change in quantity demanded divided by

the percentage change in price. If quantity demanded

moves proportionately less than the price, then the

elasticity is less than 1 and demand is said to be inelas-

tic. If quantity demanded moves proportionately more

than the price, then the elasticity is greater than 1 and

demand is said to be elastic.

Total revenue, the total amount paid for a good,

equals the price of the good times the quantity sold.

For inelastic demand curves, total revenue moves in

the same direction as the price. For elastic demand

curves, total revenue moves in the opposite direction

as the price.

The income elasticity of demand measures how

much the quantity demanded responds to changes

in consumers’ income. The cross-price elasticity of

demand measures how much the quantity demanded

of one good responds to changes in the price of

another good.

The price elasticity of supply measures how much the

quantity supplied responds to changes in the price.

This elasticity often depends on the time horizon

under consideration. In most markets, supply is more

elastic in the long run than in the short run.

The price elasticity of supply is calculated as the per-

centage change in quantity supplied divided by the

percentage change in price. If quantity supplied moves

proportionately less than the price, then the elasticity is

less than 1 and supply is said to be inelastic. If quantity

supplied moves proportionately more than the price,

then the elasticity is greater than 1 and supply is said

to be elastic.

The tools of supply and demand can be applied in

many different kinds of markets. This chapter uses

them to analyze the market for wheat, the market for

oil, and the market for illegal drugs.

KEY CONCEPTS

elasticity, p. 90

price elasticity of demand, p. 90

total revenue, p. 95

income elasticity of demand, p. 98

cross-price elasticity of demand, p. 98

price elasticity of supply, p. 99

109CHAPTER 5 ELASTICITY AND ITS APPLICATION

1. For each of the following pairs of goods, which

good would you expect to have more elastic

demand and why?

a. required textbooks or mystery novels

b. Beethoven recordings or classical music

recordings in general

c. subway rides during the next 6 months or subway

rides during the next 5 years

d. root beer or water

2. Suppose that business travelers and vacationers have

the following demand for airline tickets from New

York to Boston:

Quantity Demanded Quantity Demanded

Price (business travelers) (vacationers)

$150 2,100 tickets 1,000 tickets

200 2,000 800

250 1,900 600

300 1,800 400

a. As the price of tickets rises from $200 to $250, what

is the price elasticity of demand for (i) business

travelers and (ii) vacationers? (Use the midpoint

method in your calculations.)

b. Why might vacationers have a different elasticity

from business travelers?

3. Suppose the price elasticity of demand for heating oil

is 0.2 in the short run and 0.7 in the long run.

a. If the price of heating oil rises from $1.80 to $2.20

per gallon, what happens to the quantity of heating

oil demanded in the short run? In the long run?

(Use the midpoint method in your calculations.)

b. Why might this elasticity depend on the time

horizon?

4. A price change causes the quantity demanded of a

good to decrease by 30 percent, while the total revenue

of that good increases by 15 percent. Is the demand

curve elastic or inelastic? Explain.

5. Cups of coffee and donuts are complements. Both

have inelastic demand. A hurricane destroys half the

coffee bean crop. Use appropriately labeled diagrams

to answer the following questions.

a. What happens to the price of coffee beans?

b. What happens to the price of a cup of coffee? What

happens to total expenditure on cups of coffee?

c. What happens to the price of donuts? What

happens to total expenditure on donuts?

6. The price of coffee rose sharply last month, while the

quantity sold remained the same. Five people suggest

various explanations:

Leonard: Demand increased, but supply was per-

fectly inelastic.

Sheldon: Demand increased, but it was perfectly

inelastic.

Penny: Demand increased, but supply

decreased at the same time.

Howard: Supply decreased, but demand was unit

elastic.

Raj: Supply decreased, but demand was per-

fectly inelastic.

Who could possibly be right? Use graphs to explain

your answer.

QUESTIONS FOR REVIEW

1. Define the price elasticity of demand and the income

elasticity of demand.

2. List and explain the four determinants of the price

elasticity of demand discussed in the chapter.

3. If the elasticity is greater than 1, is demand elastic

or inelastic? If the elasticity equals zero, is demand

perfectly elastic or perfectly inelastic?

4. On a supply-and-demand diagram, show equilibrium

price, equilibrium quantity, and the total revenue

received by producers.

5. If demand is elastic, how will an increase in price

change total revenue? Explain.

6. What do we call a good with an income elasticity less

than zero?

7. How is the price elasticity of supply calculated?

Explain what it measures.

8. If a fixed quantity of a good is available, and no more

can be made, what is the price elasticity of supply?

9. A storm destroys half the fava bean crop. Is this event

more likely to hurt fava bean farmers if the demand

for fava beans is very elastic or very inelastic? Explain.

PROBLEMS AND APPLICATIONS

110 PART II HOW MARKETS WORK

7. Suppose that your demand schedule for pizza is as

follows:

Quantity Demanded Quantity Demanded

Price (income 5 $20,000) (income 5 $24,000)

$8 40 pizza 50 pizza

10 32 45

12 24 30

14 16 20

16 8 12

a. Use the midpoint method to calculate your price

elasticity of demand as the price of pizza increases

from $8 to $10 if (i) your income is $20,000 and

(ii) your income is $24,000.

b. Calculate your income elasticity of demand as

your income increases from $20,000 to $24,000 if

(i) the price is $12 and (ii) the price is $16.

8. The New York Times reported (Feb. 17, 1996) that subway ridership declined after a fare increase:

“There were nearly four million fewer riders in

December 1995, the first full month after the price of a

token increased 25 cents to $1.50, than in the previous

December, a 4.3 percent decline.”

a. Use these data to estimate the price elasticity of

demand for subway rides.

b. According to your estimate, what happens to the

Transit Authority’s revenue when the fare rises?

c. Why might your estimate of the elasticity be

unreliable?

9. Two drivers, Walt and Jessie, each drive up to a gas

station. Before looking at the price, each places an

order. Walt says, “I’d like 10 gallons of gas.” Jessie

says, “I’d like $10 worth of gas.” What is each driver’s

price elasticity of demand?

10. Consider public policy aimed at smoking.

a. Studies indicate that the price elasticity of demand

for cigarettes is about 0.4. If a pack of cigarettes

currently costs $5 and the government wants

to reduce smoking by 20 percent, by how much

should it increase the price?

b. If the government permanently increases the price

of cigarettes, will the policy have a larger effect on

smoking 1 year from now or 5 years from now?

c. Studies also find that teenagers have a higher

price elasticity of demand than adults. Why might

this be true?

11. You are the curator of a museum. The museum is run-

ning short of funds, so you decide to increase revenue.

Should you increase or decrease the price of admis-

sion? Explain.

12. Explain why the following might be true: A drought

around the world raises the total revenue that farmers

receive from the sale of grain, but a drought only in

Kansas reduces the total revenue that Kansas farmers

receive.

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

CHAPTER

6 Supply, Demand, and Government Policies

E conomists have two roles. As scientists, they develop and test theories to explain the world around them. As policy advisers, they use these theo- ries to help change the world for the better. The focus of the preceding two

chapters has been scientific. We have seen how supply and demand determine the price of a good and the quantity of the good sold. We have also seen how various events shift supply and demand, thereby changing the equilibrium price and quantity. And we have developed the concept of elasticity to gauge the size of these changes.

112 PART II HOW MARKETS WORK

This chapter offers our first look at policy. Here we analyze various types of government policy using only the tools of supply and demand. As you will see, the analysis yields some surprising insights. Policies often have effects that their architects did not intend or anticipate.

We begin by considering policies that directly control prices. For example, rent-control laws set a maximum rent that landlords may charge tenants. Minimum-wage laws set the lowest wage that firms may pay workers. Price controls are usually enacted when policymakers believe that the market price of a good or service is unfair to buyers or sellers. Yet, as we will see, these policies can generate inequities of their own.

After discussing price controls, we consider the impact of taxes. Policymakers use taxes to raise revenue for public purposes and to influence market outcomes. Although the prevalence of taxes in our economy is obvious, their effects are not. For example, when the government levies a tax on the amount that firms pay their workers, do the firms or the workers bear the burden of the tax? The answer is not at all clear—until we apply the powerful tools of supply and demand.

6-1 Controls on Prices To see how price controls affect market outcomes, let’s look once again at the mar- ket for ice cream. As we saw in Chapter 4, if ice cream is sold in a competitive market free of government regulation, the price of ice cream adjusts to balance supply and demand: At the equilibrium price, the quantity of ice cream that buy- ers want to buy exactly equals the quantity that sellers want to sell. To be concrete, let’s suppose that the equilibrium price is $3 per cone.

Some people may not be happy with the outcome of this free-market process. The American Association of Ice-Cream Eaters complains that the $3 price is too high for everyone to enjoy a cone a day (their recommended daily allowance). Meanwhile, the National Organization of Ice-Cream Makers complains that the $3 price—the result of “cutthroat competition”—is too low and is depressing the incomes of its members. Each of these groups lobbies the government to pass laws that alter the market outcome by directly controlling the price of an ice-cream cone.

Because buyers of any good always want a lower price while sellers want a higher price, the interests of the two groups conflict. If the Ice-Cream Eaters are successful in their lobbying, the government imposes a legal maximum on the price at which ice-cream cones can be sold. Because the price is not allowed to rise above this level, the legislated maximum is called a price ceiling. By contrast, if the Ice-Cream Makers are successful, the government imposes a legal minimum on the price. Because the price cannot fall below this level, the legislated mini- mum is called a price floor. Let us consider the effects of these policies in turn.

6-1a How Price Ceilings Affect Market Outcomes When the government, moved by the complaints and campaign contributions of the Ice-Cream Eaters, imposes a price ceiling in the market for ice cream, two outcomes are possible. In panel (a) of Figure 1, the government imposes a price ceiling of $4 per cone. In this case, because the price that balances supply and demand ($3) is below the ceiling, the price ceiling is not binding. Market forces naturally move the economy to the equilibrium, and the price ceiling has no effect on the price or the quantity sold.

price ceiling

a legal maximum on the

price at which a good can

be sold

price floor

a legal minimum on the

price at which a good can

be sold

113CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

Panel (b) of Figure 1 shows the other, more interesting, possibility. In this case, the government imposes a price ceiling of $2 per cone. Because the equilibrium price of $3 is above the price ceiling, the ceiling is a binding constraint on the mar- ket. The forces of supply and demand tend to move the price toward the equilib- rium price, but when the market price hits the ceiling, it cannot, by law, rise any further. Thus, the market price equals the price ceiling. At this price, the quantity of ice cream demanded (125 cones in the figure) exceeds the quantity supplied (75 cones). Because of this excess demand of 50 cones, some people who want to buy ice cream at the going price are unable to do so. In other words, there is a shortage of ice cream.

In response to this shortage, some mechanism for rationing ice cream will naturally develop. The mechanism could be long lines: Buyers who are willing to arrive early and wait in line get a cone, while those unwilling to wait do not. Alternatively, sellers could ration ice-cream cones according to their own personal biases, selling them only to friends, relatives, or members of their own racial or ethnic group. Notice that even though the price ceiling was motivated by a desire to help buyers of ice cream, not all buyers benefit from the policy. Some buyers do get to pay a lower price, although they may have to wait in line to do so, but other buyers cannot get any ice cream at all.

This example in the market for ice cream shows a general result: When the government imposes a binding price ceiling on a competitive market, a shortage of the good arises, and sellers must ration the scarce goods among the large number of potential

FIGURE 1

A Market with a Price Ceiling

In panel (a), the government imposes a price ceiling of $4. Because the price ceiling is

above the equilibrium price of $3, the price ceiling has no effect, and the market can reach

the equilibrium of supply and demand. In this equilibrium, quantity supplied and quantity

demanded both equal 100 cones. In panel (b), the government imposes a price ceiling

of $2. Because the price ceiling is below the equilibrium price of $3, the market price

equals $2. At this price, 125 cones are demanded and only 75 are supplied, so there

is a shortage of 50 cones.

(a) A Price Ceiling That Is Not Binding

Quantity of Ice-Cream

Cones

Price of Ice-Cream

Cone

100

Equilibrium quantity

(b) A Price Ceiling That Is Binding

Quantity of Ice-Cream

Cones

Price of Ice-Cream

Cone

Price ceiling

Demand

Supply

Price ceilingShortage

Quantity supplied

125

Quantity demanded

Equilibrium price

Demand

Supply

114 PART II HOW MARKETS WORK

buyers. The rationing mechanisms that develop under price ceilings are rarely desirable. Long lines are inefficient because they waste buyers’ time. Discrimina- tion according to seller bias is both inefficient (because the good may not go to the buyer who values it most highly) and often unfair. By contrast, the rationing mechanism in a free, competitive market is both efficient and impersonal. When the market for ice cream reaches its equilibrium, anyone who wants to pay the market price can get a cone. Free markets ration goods with prices.

CASE STUDY

LINES AT THE GAS PUMP As we discussed in Chapter 5, in 1973 the Organization of Petro- leum Exporting Countries (OPEC) reduced production of crude oil, thereby increasing its price in world oil markets. Because crude oil is

the major input used to make gasoline, the higher oil prices reduced the supply of gasoline. Long lines at gas stations became commonplace, and motorists often had to wait for hours to buy only a few gallons of gas.

What was responsible for the long gas lines? Most people blame OPEC. Surely, if OPEC had not reduced production of crude oil, the shortage of gasoline would not have occurred. Yet economists blame the U.S. government regulations that limited the price oil companies could charge for gasoline.

Figure 2 reveals what happened. As panel (a) shows, before OPEC raised the price of crude oil, the equilibrium price of gasoline, P

1 , was below the price ceiling.

The price regulation, therefore, had no effect. When the price of crude oil rose, how- ever, the situation changed. The increase in the price of crude oil raised the cost of

Panel (a) shows the gasoline market when the price ceiling is not binding because the equilib-

rium price, P 1 , is below the ceiling. Panel (b) shows the gasoline market after an increase in

the price of crude oil (an input into making gasoline) shifts the supply curve to the left from

S 1 to S

2 . In an unregulated market, the price would have risen from P

1 to P

2 . The price ceiling,

however, prevents this from happening. At the binding price ceiling, consumers are willing to

buy Q D , but producers of gasoline are willing to sell only Q

S . The difference between quantity

demanded and quantity supplied, Q D – Q

S , measures the gasoline shortage.

FIGURE 2

The Market for Gasoline

with a Price Ceiling

(a) The Price Ceiling on Gasoline Is Not Binding

Quantity of Gasoline

Price of Gasoline

(b) The Price Ceiling on Gasoline Is Binding

Quantity of Gasoline

Price of Gasoline

Q1QD

Demand

Price ceiling

4. . . . resulting in a shortage.

3. . . . the price ceiling becomes binding . . .

2. . . . but when supply falls . . .

1. Initially, the price ceiling is not binding . . . Price ceiling

Demand

Supply, S1

115CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

producing gasoline, and this reduced the supply of gasoline. As panel (b) shows, the supply curve shifted to the left from S

1 to S

2 . In an unregulated market, this

shift in supply would have raised the equilibrium price of gasoline from P 1 to P

2 ,

and no shortage would have resulted. Instead, the price ceiling prevented the price from rising to the equilibrium level. At the price ceiling, producers were willing to sell QS, but consumers were willing to buy QD. Thus, the shift in supply caused a severe shortage at the regulated price.

Eventually, the laws regulating the price of gasoline were repealed. Lawmakers came to understand that they were partly responsible for the many hours Americans lost waiting in line to buy gasoline. Today, when the price of crude oil changes, the price of gasoline can adjust to bring supply and demand into equilibrium. ●

CASE STUDY

RENT CONTROL IN THE SHORT RUN AND THE LONG RUN One common example of a price ceiling is rent control. In many cities, the local government places a ceiling on rents that landlords may charge their tenants. The goal of this policy is to help the poor

by making housing more affordable. Economists often criticize rent control, arguing that it is a highly inefficient way to help the poor raise their standard of living. One economist called rent control “the best way to destroy a city, other than bombing.”

The adverse effects of rent control are less apparent to the general population because these effects occur over many years. In the short run, landlords have a fixed number of apartments to rent, and they cannot adjust this number quickly as market conditions change. Moreover, the number of people searching for housing in a city may not be highly responsive to rents in the short run because people take time to adjust their housing arrangements. Therefore, the short-run supply and demand for housing are relatively inelastic.

Panel (a) of Figure 3 shows the short-run effects of rent control on the hous- ing market. As with any binding price ceiling, rent control causes a shortage. But because supply and demand are inelastic in the short run, the initial shortage caused by rent control is small. The primary effect in the short run is to reduce rents.

The long-run story is very different because the buyers and sellers of rental housing respond more to market conditions as time passes. On the supply side, landlords respond to low rents by not building new apartments and by failing to maintain existing ones. On the demand side, low rents encourage people to find their own apartments (rather than living with their parents or sharing apartments with roommates) and induce more people to move into the city. Therefore, both supply and demand are more elastic in the long run.

Panel (b) of Figure 3 illustrates the housing market in the long run. When rent control depresses rents below the equilibrium level, the quantity of apart- ments supplied falls substantially and the quantity of apartments demanded rises substantially. The result is a large shortage of housing.

In cities with rent control, landlords use various mechanisms to ration housing. Some landlords keep long waiting lists. Others give preference to tenants without children. Still others discriminate on the basis of race. Sometimes apartments are allocated to those willing to offer under-the-table payments to building superin- tendents. In essence, these bribes bring the total price of an apartment closer to the equilibrium price.

To understand fully the effects of rent control, we have to remember one of the Ten Principles of Economics from Chapter 1: People respond to incentives. In free

116 PART II HOW MARKETS WORK

markets, landlords try to keep their buildings clean and safe because desirable apartments command higher prices. By con- trast, when rent control creates shortages and waiting lists, land- lords lose their incentive to respond to tenants’ concerns. Why should a landlord spend money to maintain and improve the property when people are waiting to move in as it is? In the end, tenants get lower rents, but they also get lower-quality housing.

Policymakers often react to the effects of rent control by imposing additional regulations. For example, various laws make racial discrimination in housing illegal and require landlords to provide minimally adequate living conditions. These laws, how- ever, are difficult and costly to enforce. By contrast, when rent control is eliminated and a market for housing is regulated by the forces of competition, such laws are less necessary. In a free mar- ket, the price of housing adjusts to eliminate the shortages that give rise to undesirable landlord behavior. ●

6-1b How Price Floors Affect Market Outcomes To examine the effects of another kind of government price con- trol, let’s return to the market for ice cream. Imagine now that the government is persuaded by the pleas of the National Or- ganization of Ice-Cream Makers whose members feel that the $3 equilibrium price is too low. In this case, the government might institute a price floor. Price floors, like price ceilings, are an attempt by the government to maintain prices at other than

Panel (a) shows the short-run effects of rent control: Because the supply and demand curves for

apartments are relatively inelastic, the price ceiling imposed by a rent-control law causes only

a small shortage of housing. Panel (b) shows the long-run effects of rent control: Because the

supply and demand curves for apartments are more elastic, rent control causes a large shortage.

FIGURE 3

Rent Control in the Short

Run and in the Long Run

(a) Rent Control in the Short Run (supply and demand are inelastic)

(b) Rent Control in the Long Run (supply and demand are elastic)

Quantity of Apartments

Supply

Controlled rent

Shortage

Rental Price of

Apartment

Rental Price of

Apartment

Quantity of Apartments

Demand

Supply

Controlled rent

Shortage

Demand

“Local ordinances that limit rent increases for some rental

housing units, such as in New York and San Francisco, have

had a positive impact over the past three decades on the

amount and quality of broadly affordable rental housing in cit-

ies that have used them.”

Source: IGM Economic Experts Panel, February 7, 2012.

Rent Control

ASK THE EXPERTS

What do economists say?

95% disagree

4% uncertain 1% agree

117CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

equilibrium levels. Whereas a price ceiling places a legal maximum on prices, a price floor places a legal minimum.

When the government imposes a price floor on the ice-cream market, two out- comes are possible. If the government imposes a price floor of $2 per cone when the equilibrium price is $3, we obtain the outcome in panel (a) of Figure 4. In this case, because the equilibrium price is above the floor, the price floor is not bind- ing. Market forces naturally move the economy to the equilibrium, and the price floor has no effect.

Panel (b) of Figure 4 shows what happens when the government imposes a price floor of $4 per cone. In this case, because the equilibrium price of $3 is below the floor, the price floor is a binding constraint on the market. The forces of sup- ply and demand tend to move the price toward the equilibrium price, but when the market price hits the floor, it can fall no further. The market price equals the price floor. At this floor, the quantity of ice cream supplied (120 cones) exceeds the quantity demanded (80 cones). Because of this excess supply of 40 cones, some people who want to sell ice cream at the going price are unable to. Thus, a binding price floor causes a surplus.

Just as the shortages resulting from price ceilings can lead to undesirable rationing mechanisms, so can the surpluses resulting from price floors. The sellers who appeal to the personal biases of the buyers, perhaps due to racial or familial ties, may be better able to sell their goods than those who do not. By contrast, in a free market, the price serves as the rationing mechanism, and sellers can sell all they want at the equilibrium price.

In panel (a), the government imposes a price floor of $2. Because this is below the

equilibrium price of $3, the price floor has no effect. The market price adjusts to balance

supply and demand. At the equilibrium, quantity supplied and quantity demanded both

equal 100 cones. In panel (b), the government imposes a price floor of $4, which is above

the equilibrium price of $3. Therefore, the market price equals $4. Because 120 cones

are supplied at this price and only 80 are demanded, there is a surplus of 40 cones.

FIGURE 4

A Market with a

Price Floor

(a) A Price Floor That Is Not Binding

Quantity of Ice-Cream

Cones

Price of Ice-Cream

Cone

100

Equilibrium quantity

(b) A Price Floor That Is Binding

Quantity of Ice-Cream

Cones

Price of Ice-Cream

Cone

3 Price floor

Demand

Supply

Price floor

Quantity demanded

120

Quantity supplied

Equilibrium price

Demand

Supply

Surplus

118 PART II HOW MARKETS WORK

CASE STUDY

THE MINIMUM WAGE An important example of a price floor is the minimum wage. Mini- mum-wage laws dictate the lowest price for labor that any employer may pay. The U.S. Congress first instituted a minimum wage with

the Fair Labor Standards Act of 1938 to ensure workers a minimally adequate standard of living. In 2015, the minimum wage according to federal law was $7.25 per hour. (Some states mandate minimum wages above the federal level.) Many European nations have minimum-wage laws as well, sometimes significantly higher than in the United States. For example, even though the average income in France is almost 30 percent lower than it is in the United States, the French mini- mum wage is more than 30 percent higher.

To examine the effects of a minimum wage, we must consider the market for labor. Panel (a) of Figure 5 shows the labor market, which, like all markets, is sub- ject to the forces of supply and demand. Workers determine the supply of labor, and firms determine the demand. If the government doesn’t intervene, the wage normally adjusts to balance labor supply and labor demand.

Panel (b) of Figure 5 shows the labor market with a minimum wage. If the minimum wage is above the equilibrium level, as it is here, the quantity of labor supplied exceeds the quantity demanded. The result is unemployment. Thus, while the minimum wage raises the incomes of those workers who have jobs, it lowers the incomes of workers who cannot find jobs.

To fully understand the minimum wage, keep in mind that the economy con- tains not a single labor market but many labor markets for different types of work- ers. The impact of the minimum wage depends on the skill and experience of the worker. Highly skilled and experienced workers are not affected because their equilibrium wages are well above the minimum. For these workers, the minimum wage is not binding.

Panel (a) shows a labor market in which the wage adjusts to balance labor supply and labor

demand. Panel (b) shows the impact of a binding minimum wage. Because the minimum

wage is a price floor, it causes a surplus: The quantity of labor supplied exceeds the quantity

demanded. The result is unemployment.

FIGURE 5

How the Minimum Wage

Affects the Labor Market

(a) A Free Labor Market

Quantity of Labor

Wage

Equilibrium employment

(b) A Labor Market with a Binding Minimum Wage

Quantity of Labor

Wage

Quantity demanded

Quantity supplied

Labor supply

Labor demand

Minimum wage

Labor surplus (unemployment)

Equilibrium wage

Labor demand

Labor supply

119CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

The minimum wage has its greatest impact on the market for teenage labor. The equilibrium wages of teenagers are low because teenagers are among the least skilled and least experienced members of the labor force. In addition, teen- agers are often willing to accept a lower wage in exchange for on-the-job training. (Some teenagers, including many college students, are willing to work as interns for no pay at all. Because internships pay nothing, minimum-wage laws often do not apply to them. If they did, these internship opportunities might not exist.) As a result, the minimum wage is binding more often for teenagers than for other members of the labor force.

Many economists have studied how minimum-wage laws affect the teenage labor market. These researchers compare the changes in the minimum wage over time with the changes in teenage employment. Although there is some debate about how much the minimum wage affects employment, the typical study finds that a 10 percent increase in the minimum wage depresses teenage employment by 1 to 3 percent. In interpreting this estimate, note that a 10 percent increase in the minimum wage does not raise the average wage of teenagers by 10 percent. A change in the law does not directly affect those teenagers who are already paid well above the minimum, and enforcement of minimum-wage laws is not perfect. Thus, the estimated drop in employment of 1 to 3 percent is significant.

In addition to altering the quantity of labor demanded, the minimum wage alters the quantity supplied. Because the minimum wage raises the wage that teenagers can earn, it increases the number of teenagers who choose to look for jobs. Studies have found that a higher minimum wage influences which teenagers are employed. When the minimum wage rises, some teenagers who are still attending high school choose to drop out and take jobs. With more people vying for the available jobs, some of these new dropouts displace other teenagers who had already dropped out of school and now become unemployed.

The minimum wage is a frequent topic of debate. Advo- cates of the minimum wage view the policy as one way to raise the income of the working poor. They correctly point out that workers who earn the minimum wage can afford only a meager standard of living. In 2015, for instance, when the minimum wage was $7.25 per hour, two adults working 40 hours a week for every week of the year at minimum-wage jobs had a total annual income of only $30,160. This amount was 24 percent above the official poverty line for a family of four but was less than half of the median family income in the United States. Many advocates of the minimum wage admit that it has some adverse effects, including unemploy- ment, but they believe that these effects are small and that, all things considered, a higher minimum wage makes the poor better off.

Opponents of the minimum wage contend that it is not the best way to combat poverty. They note that a high minimum wage causes unemployment, encourages teenagers to drop out of school, and prevents some unskilled workers from get- ting on-the-job training. Moreover, opponents of the minimum wage point out that it is a poorly targeted policy. Not all minimum-wage workers are heads of households trying to help their families escape poverty. In fact, less than a third of minimum-wage earners are in families with incomes below the

“If the federal minimum wage is raised gradually to $15-per-hour

by 2020, the employment rate for low-wage U.S. workers will be

substantially lower than it would be under the status quo.”

Source: IGM Economic Experts Panel, September 22, 2015.

The Minimum Wage

ASK THE EXPERTS

37% uncertain

34% agree

29% disagree

What do economists say?

120 PART II HOW MARKETS WORK

poverty line. Many are teenagers from middle-class homes working at part-time jobs for extra spending money. ●

6-1c Evaluating Price Controls One of the Ten Principles of Economics discussed in Chapter 1 is that markets are usually a good way to organize economic activity. This principle explains why economists usually oppose price ceilings and price floors. To economists, prices are not the outcome of some haphazard process. Prices, they contend, are the result of the millions of business and consumer decisions that lie behind the supply and demand curves. Prices have the crucial job of balancing supply and demand and, thereby, coordinating economic activity. When policymakers set prices by legal decree, they obscure the signals that normally guide the allocation of society’s resources.

Another one of the Ten Principles of Economics is that governments can some- times improve market outcomes. Indeed, policymakers are motivated to control prices because they view the market’s outcome as unfair. Price controls are often aimed at helping the poor. For instance, rent-control laws try to make housing affordable for everyone, and minimum-wage laws try to help people escape poverty.

Yet price controls often hurt those they are trying to help. Rent control may keep rents low, but it also discourages landlords from maintaining their buildings and makes housing hard to find. Minimum-wage laws may raise the incomes of some workers, but they also cause other workers to become unemployed.

Helping those in need can be accomplished in ways other than controlling prices. For instance, the government can make housing more affordable by paying a fraction of the rent for poor families. Unlike rent control, such rent subsidies do not reduce the quantity of housing supplied and, therefore, do not lead to hous- ing shortages. Similarly, wage subsidies raise the living standards of the working poor without discouraging firms from hiring them. An example of a wage sub- sidy is the earned income tax credit, a government program that supplements the incomes of low-wage workers.

Although these alternative policies are often better than price controls, they are not perfect. Rent and wage subsidies cost the government money and, therefore, require higher taxes. As we see in the next section, taxation has costs of its own.

QuickQuiz Define price ceiling and price floor and give an example of each. Which

leads to a shortage? Which leads to a surplus? Why?

All governments—from national governments around the world to local governments in small towns—use taxes to raise revenue for public projects, such as roads, schools, and national defense. Because taxes are such an important policy instrument and affect our lives in many ways, we return to the study of taxes several times throughout this book. In this section, we begin our study of how taxes affect the economy.

To set the stage for our analysis, imagine that a local government decides to hold an annual ice-cream celebration—with a parade, fireworks, and speeches by town officials. To raise revenue to pay for the event, the town decides to place a $0.50 tax on the sale of ice-cream cones. When the plan is announced, our two

6-2 Taxes

121CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

lobbying groups swing into action. The American Association of Ice-Cream Eaters claims that consumers of ice cream are having trouble making ends meet, and it argues that sellers of ice cream should pay the tax. The National Organization of Ice-Cream Makers claims that its members are struggling to survive in a compet- itive market, and it argues that buyers of ice cream should pay the tax. The town mayor, hoping to reach a compromise, suggests that half the tax be paid by the buyers and half be paid by the sellers.

To analyze these proposals, we need to address a simple but subtle question: When the government levies a tax on a good, who actually bears the burden of the tax? The people buying the good? The people selling the good? Or if buyers and sellers share the tax burden, what determines how the burden is divided? Can the government simply legislate the division of the burden, as the mayor is suggest- ing, or is the division determined by more fundamental market forces? The term tax incidence refers to how the burden of a tax is distributed among the various people who make up the economy. As we will see, some surprising lessons about tax incidence can be learned by applying the tools of supply and demand.

6-2a How Taxes on Sellers Affect Market Outcomes We begin by considering a tax levied on sellers of a good. Suppose the local government passes a law requiring sellers of ice-cream cones to send $0.50 to the government for every cone they sell. How does this law affect the buyers and sellers of ice cream? To answer this question, we can follow the three steps in Chapter 4 for analyzing supply and demand: (1) We decide whether the law affects the supply curve or the demand curve. (2) We decide which way the curve shifts. (3) We examine how the shift affects the equilibrium price and quantity.

Step One The immediate impact of the tax is on the sellers of ice cream. Because the tax is not levied on buyers, the quantity of ice cream demanded at any given price is the same; thus, the demand curve does not change. By contrast, the tax on sellers makes the ice-cream business less profitable at any given price, so it shifts the supply curve.

Step Two Because the tax on sellers raises the cost of producing and selling ice cream, it reduces the quantity supplied at every price. The supply curve shifts to the left (or, equivalently, upward).

In addition to determining the direction in which the supply curve moves, we can also be precise about the size of the shift. For any market price of ice cream, the effective price to sellers—the amount they get to keep after paying the tax—is $0.50 lower. For example, if the market price of a cone happened to be $2.00, the effective price received by sellers would be $1.50. Whatever the market price, sellers will supply a quantity of ice cream as if the price were $0.50 lower than it is. Put differently, to induce sellers to supply any given quantity, the market price must now be $0.50 higher to compensate for the effect of the tax. Thus, as shown in Figure 6, the supply curve shifts upward from S

1 to S

2 by the exact size of the

tax ($0.50).

Step Three Having determined how the supply curve shifts, we can now com- pare the initial and the new equilibriums. Figure 6 shows that the equilibrium price of ice cream rises from $3.00 to $3.30, and the equilibrium quantity falls from 100 to 90 cones. Because sellers sell less and buyers buy less in the new equilib- rium, the tax reduces the size of the ice-cream market.

tax incidence

the manner in which the

burden of a tax is shared

among participants in a

market

122 PART II HOW MARKETS WORK

Implications We can now return to the question of tax incidence: Who pays the tax? Although sellers send the entire tax to the government, buyers and sellers share the burden. Because the market price rises from $3.00 to $3.30 when the tax is introduced, buyers pay $0.30 more for each ice-cream cone than they did with- out the tax. Thus, the tax makes buyers worse off. Sellers get a higher price ($3.30) from buyers than they did previously, but what they get to keep after paying the tax is only $2.80 ($3.30 2 $0.50 5 $2.80), compared with $3.00 before the tax. Thus, the tax also makes sellers worse off.

To sum up, this analysis yields two lessons:

Taxes discourage market activity. When a good is taxed, the quantity of the good sold is smaller in the new equilibrium. Buyers and sellers share the burden of taxes. In the new equilibrium, buyers pay more for the good, and sellers receive less.

6-2b How Taxes on Buyers Affect Market Outcomes Now consider a tax levied on buyers of a good. Suppose that our local govern- ment passes a law requiring buyers of ice-cream cones to send $0.50 to the gov- ernment for each ice-cream cone they buy. What are the effects of this law? Again, we apply our three steps.

Step One The initial impact of the tax is on the demand for ice cream. The sup- ply curve is not affected because, for any given price of ice cream, sellers have the same incentive to provide ice cream to the market. By contrast, buyers now have to pay a tax to the government (as well as the price to the sellers) whenever they buy ice cream. Thus, the tax shifts the demand curve for ice cream.

Step Two Next, we determine the direction of the shift. Because the tax on buy- ers makes buying ice cream less attractive, buyers demand a smaller quantity of

FIGURE 6

A Tax on Sellers

When a tax of $0.50 is levied on

sellers, the supply curve shifts up by

$0.50 from S 1 to S

2 . The equilibrium

quantity falls from 100 to 90 cones.

The price that buyers pay rises from

$3.00 to $3.30. The price that sellers

receive (after paying the tax) falls from

$3.00 to $2.80. Even though the tax

is levied on sellers, buyers and sellers

share the burden of the tax.

$3.30 3.00 2.80

Quantity of Ice-Cream Cones

Price of Ice-Cream

Cone

Price without

tax

Price sellers receive

10090

Equilibrium with tax

Equilibrium without tax

Tax ($0.50)

Price buyers

pay S1

Demand, D1

A tax on sellers shifts the supply curve upward by the size of the tax ($0.50).

123CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

ice cream at every price. As a result, the demand curve shifts to the left (or, equiv- alently, downward), as shown in Figure 7.

Once again, we can be precise about the size of the shift. Because of the $0.50 tax levied on buyers, the effective price to buyers is now $0.50 higher than the market price (whatever the market price happens to be). For example, if the mar- ket price of a cone happened to be $2.00, the effective price to buyers would be $2.50. Because buyers look at their total cost including the tax, they demand a quantity of ice cream as if the market price were $0.50 higher than it actually is. In other words, to induce buyers to demand any given quantity, the market price must now be $0.50 lower to make up for the effect of the tax. Thus, the tax shifts the demand curve downward from D

1 to D

2 by the exact size of the tax ($0.50).

Step Three Having determined how the demand curve shifts, we can now see the effect of the tax by comparing the initial equilibrium and the new equilibrium. You can see in Figure 7 that the equilibrium price of ice cream falls from $3.00 to $2.80, and the equilibrium quantity falls from 100 to 90 cones. Once again, the tax on ice cream reduces the size of the ice-cream market. And once again, buyers and sellers share the burden of the tax. Sellers get a lower price for their product; buy- ers pay a lower market price to sellers than they did previously, but the effective price (including the tax buyers have to pay) rises from $3.00 to $3.30.

Implications If you compare Figures 6 and 7, you will notice a surprising conclu- sion: Taxes levied on sellers and taxes levied on buyers are equivalent. In both cases, the tax places a wedge between the price that buyers pay and the price that sellers receive. The wedge between the buyers’ price and the sellers’ price is the same, regardless of whether the tax is levied on buyers or sellers. In either case, the wedge shifts the relative position of the supply and demand curves. In the new equilibrium, buyers and sellers share the burden of the tax. The only difference between a tax levied on sellers and a tax levied on buyers is who sends the money to the government.

$3.30 3.00 2.80

Quantity of Ice-Cream Cones

Price of Ice-Cream

Cone

Price without

tax

Price sellers receive

10090

Equilibrium with tax

Equilibrium without tax Tax ($0.50)

Price buyers

pay

D1 D2

Supply, S1

A tax on buyers shifts the demand curve downward by the size of the tax ($0.50).

FIGURE 7

A Tax on Buyers

When a tax of $0.50 is levied on

buyers, the demand curve shifts

down by $0.50 from D 1 to D

2 .

The equilibrium quantity falls

from 100 to 90 cones. The price

that sellers receive falls from

$3.00 to $2.80. The price that

buyers pay (including the tax)

rises from $3.00 to $3.30. Even

though the tax is levied on buy-

ers, buyers and sellers share the

burden of the tax.

124 PART II HOW MARKETS WORK

The equivalence of these two taxes is easy to understand if we imagine that the government collects the $0.50 ice-cream tax in a bowl on the counter of each ice- cream store. When the government levies the tax on sellers, the seller is required to place $0.50 in the bowl after the sale of each cone. When the government levies the tax on buyers, the buyer is required to place $0.50 in the bowl every time a cone is bought. Whether the $0.50 goes directly from the buyer ’s pocket into the bowl, or indirectly from the buyer’s pocket into the seller’s hand and then into the bowl, does not matter. Once the market reaches its new equilibrium, buyers and sellers share the burden, regardless of how the tax is levied.

CASE STUDY

CAN CONGRESS DISTRIBUTE THE BURDEN OF A PAYROLL TAX? If you have ever received a paycheck, you probably noticed that taxes were deducted from the amount you earned. One of these taxes is called FICA, an acronym for the Federal Insurance Contri-

butions Act. The federal government uses the revenue from the FICA tax to pay for Social Security and Medicare, the income support and healthcare programs for the elderly. FICA is an example of a payroll tax, which is a tax on the wages that firms pay their workers. In 2015, the total FICA tax for the typical worker was 15.3 percent of earnings.

Who do you think bears the burden of this payroll tax—firms or workers? When Congress passed this legislation, it tried to mandate a division of the tax burden. According to the law, half of the tax is paid by firms, and half is paid by workers. That is, half of the tax is paid out of firms’ revenues, and half is deducted from workers’ paychecks. The amount that shows up as a deduction on your pay stub is the worker contribution.

Our analysis of tax incidence, however, shows that lawmakers cannot dictate the distribution of a tax burden so easily. To illustrate, we can analyze a payroll tax as merely a tax on a good, where the good is labor and the price is the wage. The key feature of the payroll tax is that it places a wedge between the wage that firms pay and the wage that workers receive. Figure 8 shows the outcome. When a payroll tax is enacted, the wage received by workers falls, and the wage paid by firms rises. In the end, workers and firms share the burden of the tax, much as the legislation requires. Yet this division of the tax burden between workers and firms has nothing to do with the legislated division: The division of the burden in Figure 8 is not nec- essarily fifty-fifty, and the same outcome would prevail if the law levied the entire tax on workers or if it levied the entire tax on firms.

This example shows that the most basic lesson of tax incidence is often over- looked in public debate. Lawmakers can decide whether a tax comes from the buy- er ’s pocket or from the seller ’s, but they cannot legislate the true burden of a tax. Rather, tax incidence depends on the forces of supply and demand. ●

6-2c Elasticity and Tax Incidence When a good is taxed, buyers and sellers of the good share the burden of the tax. But how exactly is the tax burden divided? Only rarely will it be shared equally. To see how the burden is divided, consider the impact of taxation in the two markets in Figure 9. In both cases, the figure shows the initial demand curve, the initial supply curve, and a tax that drives a wedge between the amount paid by buyers and the amount received by sellers. (Not drawn in either panel of the figure is the new supply or demand curve. Which curve shifts depends on whether the tax is levied on buyers or sellers. As we have seen, this is irrelevant for determining the

125CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

incidence of the tax.) The difference in the two panels is the relative elasticity of supply and demand.

Panel (a) of Figure 9 shows a tax in a market with very elastic supply and rela- tively inelastic demand. That is, sellers are very responsive to changes in the price of the good (so the supply curve is relatively flat), whereas buyers are not very responsive (so the demand curve is relatively steep). When a tax is imposed on a market with these elasticities, the price received by sellers does not fall by much, so sellers bear only a small burden. By contrast, the price paid by buyers rises sub- stantially, indicating that buyers bear most of the burden of the tax.

Panel (b) of Figure 9 shows a tax in a market with relatively inelastic supply and very elastic demand. In this case, sellers are not very responsive to changes in the price (so the supply curve is steeper), whereas buyers are very responsive (so the demand curve is flatter). The figure shows that when a tax is imposed, the price paid by buyers does not rise by much, but the price received by sellers falls substantially. Thus, sellers bear most of the burden of the tax.

The two panels of Figure 9 show a general lesson about how the burden of a tax is divided: A tax burden falls more heavily on the side of the market that is less elas- tic. Why is this true? In essence, the elasticity measures the willingness of buyers or sellers to leave the market when conditions become unfavorable. A small elas- ticity of demand means that buyers do not have good alternatives to consuming this particular good. A small elasticity of supply means that sellers do not have good alternatives to producing this particular good. When the good is taxed, the side of the market with fewer good alternatives is less willing to leave the market and, therefore, bears more of the burden of the tax.

We can apply this logic to the payroll tax discussed in the previous case study. Most labor economists believe that the supply of labor is much less elastic than the demand. This means that workers, rather than firms, bear most of the burden of the payroll tax. In other words, the distribution of the tax burden is far from the fifty-fifty split that lawmakers intended.

Wage without tax

Quantity of Labor

Wage

Labor demand

Labor supply

Tax wedge

Wage workers receive

Wage firms pay

FIGURE 8

A Payroll Tax

A payroll tax places a wedge between

the wage that workers receive and

the wage that firms pay. Comparing

wages with and without the tax, you

can see that workers and firms share

the tax burden. This division of the

tax burden between workers and

firms does not depend on whether

the government levies the tax on

workers, levies the tax on firms, or

divides the tax equally between the

two groups.

126 PART II HOW MARKETS WORK

CASE STUDY

WHO PAYS THE LUXURY TAX? In 1990, Congress adopted a new luxury tax on items such as yachts, private airplanes, furs, jewelry, and expensive cars. The goal of the tax was to raise revenue from those who could most easily afford to

pay. Because only the rich could afford to buy such extravagances, taxing luxuries seemed a logical way of taxing the rich.

Yet, when the forces of supply and demand took over, the outcome was quite different from the one Congress intended. Consider, for example, the market for yachts. The demand for yachts is quite elastic. A millionaire can easily not buy a

Price without tax

Quantity0

Price

Demand

Supply

Tax

Price sellers receive

Price buyers pay

(a) Elastic Supply, Inelastic Demand

Price without tax

Quantity0

Price

Demand

Supply

Tax

Price sellers receive

Price buyers pay

(b) Inelastic Supply, Elastic Demand

2. . . . the incidence of the tax falls more heavily on consumers . . .

1. When supply is more elastic than demand . . .

3. . . . than on producers.

2. . . . the incidence of the tax falls more heavily on producers . . .

3. . . . than on consumers.

1. When demand is more elastic than supply . . .

FIGURE 9

How the Burden of a Tax Is Divided

In panel (a), the supply curve is

elastic, and the demand curve is

inelastic. In this case, the price

received by sellers falls only slightly,

while the price paid by buyers rises

substantially. Thus, buyers bear

most of the burden of the tax. In

panel (b), the supply curve is inelas-

tic, and the demand curve is elastic.

In this case, the price received by

sellers falls substantially, while

the price paid by buyers rises only

slightly. Thus, sellers bear most of

the burden of the tax.

127CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

yacht; he can use the money to buy a bigger house, take a European vacation, or leave a larger bequest to his heirs. By contrast, the supply of yachts is relatively inelastic, at least in the short run. Yacht factories are not easily converted to alterna- tive uses, and workers who build yachts are not eager to change careers in response to changing market conditions.

Our analysis makes a clear prediction in this case. With elastic demand and inelastic supply, the burden of a tax falls largely on the suppliers. That is, a tax on yachts places a burden largely on the firms and workers who build yachts because they end up getting a significantly lower price for their product. The workers, how- ever, are not wealthy. Thus, the burden of a luxury tax falls more on the middle class than on the rich.

The mistaken assumptions about the incidence of the luxury tax quickly became apparent after the tax went into effect. Suppliers of luxuries made their congres- sional representatives well aware of the economic hardship they experienced, and Congress repealed most of the luxury tax in 1993. ●

QuickQuiz In a supply-and-demand diagram, show how a tax on car buyers of $1,000

per car affects the quantity of cars sold and the price of cars. In another

diagram, show how a tax on car sellers of $1,000 per car affects the quantity of cars sold

and the price of cars. In both of your diagrams, show the change in the price paid by car

buyers and the change in the price received by car sellers.

6-3 Conclusion The economy is governed by two kinds of laws: the laws of supply and demand and the laws enacted by governments. In this chapter, we have begun to see how these laws interact. Price controls and taxes are common in various markets in the economy, and their effects are frequently debated in the press and among policy- makers. Even a little bit of economic knowledge can go a long way toward under- standing and evaluating these policies.

In subsequent chapters, we analyze many government policies in greater detail. We examine the effects of taxation more fully and consider a broader range of policies than we considered here. Yet the basic lessons of this chapter will not change: When analyzing government policies, supply and demand are the first and most useful tools of analysis.

“If this boat were any more expensive, we’d be playing golf.”

BL EN

D IM

A G

ES /G

ET TY

IM A

G ES

1. When the government imposes a binding price floor,

it causes

a. the supply curve to shift to the left.

b. the demand curve to shift to the right.

c. a shortage of the good to develop.

d. a surplus of the good to develop.

2. In a market with a binding price ceiling, an increase

in the ceiling will ________ the quantity supplied,

________ the quantity demanded, and reduce the

________.

a. increase, decrease, surplus

b. decrease, increase, surplus

c. increase, decrease, shortage

d. decrease, increase, shortage

CHAPTER QuickQuiz

128 PART II HOW MARKETS WORK

3. A $1 per unit tax levied on consumers of a good is

equivalent to

a. a $1 per unit tax levied on producers of the good.

b. a $1 per unit subsidy paid to producers of the good.

c. a price floor that raises the good’s price by

$1 per unit.

d. a price ceiling that raises the good’s price by

$1 per unit.

4. Which of the following would increase quantity

supplied, decrease quantity demanded, and increase

the price that consumers pay?

a. the imposition of a binding price floor

b. the removal of a binding price floor

c. the passage of a tax levied on producers

d. the repeal of a tax levied on producers

5. Which of the following would increase quantity

supplied, increase quantity demanded, and decrease

the price that consumers pay?

a. the imposition of a binding price floor

b. the removal of a binding price floor

c. the passage of a tax levied on producers

d. the repeal of a tax levied on producers

6. When a good is taxed, the burden of the tax falls

mainly on consumers if

a. the tax is levied on consumers.

b. the tax is levied on producers.

c. supply is inelastic, and demand is elastic.

d. supply is elastic, and demand is inelastic.

SUMMARY

A price ceiling is a legal maximum on the price of a

good or service. An example is rent control. If the price

ceiling is below the equilibrium price, then the price

ceiling is binding, and the quantity demanded exceeds

the quantity supplied. Because of the resulting short-

age, sellers must in some way ration the good or ser-

vice among buyers.

A price floor is a legal minimum on the price of a

good or service. An example is the minimum wage.

If the price floor is above the equilibrium price, then

the price floor is binding, and the quantity supplied

exceeds the quantity demanded. Because of the result-

ing surplus, buyers’ demands for the good or service

must in some way be rationed among sellers.

When the government levies a tax on a good, the equi-

librium quantity of the good falls. That is, a tax on a

market shrinks the size of the market.

A tax on a good places a wedge between the price paid

by buyers and the price received by sellers. When the

market moves to the new equilibrium, buyers pay

more for the good and sellers receive less for it. In this

sense, buyers and sellers share the tax burden. The

incidence of a tax (that is, the division of the tax bur-

den) does not depend on whether the tax is levied on

buyers or sellers.

The incidence of a tax depends on the price elasticities

of supply and demand. Most of the burden falls on the

side of the market that is less elastic because that side

of the market cannot respond as easily to the tax by

changing the quantity bought or sold.

KEY CONCEPTS

price ceiling, p. 112 price floor, p. 112 tax incidence, p. 121

QUESTIONS FOR REVIEW

1. Give an example of a price ceiling and an example of

a price floor.

2. Which causes a shortage of a good—a price ceiling or

a price floor? Justify your answer with a graph.

3. What mechanisms allocate resources when the price

of a good is not allowed to bring supply and demand

into equilibrium?

4. Explain why economists usually oppose controls on

prices.

5. Suppose the government removes a tax on buyers of a

good and levies a tax of the same size on sellers of the

good. How does this change in tax policy affect the price

that buyers pay sellers for this good, the amount buy-

ers are out of pocket (including any tax payments they

129CHAPTER 6 SUPPLY, DEMAND, AND GOVERNMENT POLICIES

make), the amount sellers receive (net of any tax pay-

ments they make), and the quantity of the good sold?

6. How does a tax on a good affect the price paid by buy-

ers, the price received by sellers, and the quantity sold?

7. What determines how the burden of a tax is divided

between buyers and sellers? Why?

PROBLEMS AND APPLICATIONS

1. Lovers of classical music persuade Congress to impose

a price ceiling of $40 per concert ticket. As a result of

this policy, do more or fewer people attend classical

music concerts? Explain.

2. The government has decided that the free-market

price of cheese is too low.

a. Suppose the government imposes a binding price

floor in the cheese market. Draw a supply-and-

demand diagram to show the effect of this policy

on the price of cheese and the quantity of cheese

sold. Is there a shortage or surplus of cheese?

b. Producers of cheese complain that the price floor

has reduced their total revenue. Is this possible?

Explain.

c. In response to cheese producers’ complaints, the

government agrees to purchase all the surplus

cheese at the price floor. Compared to the basic

price floor, who benefits from this new policy?

Who loses?

3. A recent study found that the demand-and-supply

schedules for Frisbees are as follows:

Price per Quantity Quantity

Frisbee Demanded Supplied

$11 1 million Frisbees 15 million Frisbees

10 2 12

9 4 9

8 6 6

7 8 3

6 10 1

a. What are the equilibrium price and quantity of

Frisbees?

b. Frisbee manufacturers persuade the government

that Frisbee production improves scientists’ un-

derstanding of aerodynamics and thus is import-

ant for national security. A concerned Congress

votes to impose a price floor $2 above the equilib-

rium price. What is the new market price? How

many Frisbees are sold?

c. Irate college students march on Washington and

demand a reduction in the price of Frisbees. An

even more concerned Congress votes to repeal the

price floor and impose a price ceiling $1 below the

former price floor. What is the new market price?

How many Frisbees are sold?

4. Suppose the federal government requires beer drink-

ers to pay a $2 tax on each case of beer purchased. (In

fact, both the federal and state governments impose

beer taxes of some sort.)

a. Draw a supply-and-demand diagram of the mar-

ket for beer without the tax. Show the price paid

by consumers, the price received by producers,

and the quantity of beer sold. What is the differ-

ence between the price paid by consumers and the

price received by producers?

b. Now draw a supply-and-demand diagram for the

beer market with the tax. Show the price paid by

consumers, the price received by producers, and

the quantity of beer sold. What is the difference

between the price paid by consumers and the

price received by producers? Has the quantity of

beer sold increased or decreased?

5. A senator wants to raise tax revenue and make work-

ers better off. A staff member proposes raising the

payroll tax paid by firms and using part of the extra

revenue to reduce the payroll tax paid by workers.

Would this accomplish the senator’s goal? Explain.

6. If the government places a $500 tax on luxury cars,

will the price paid by consumers rise by more than

$500, less than $500, or exactly $500? Explain.

7. Congress and the president decide that the United

States should reduce air pollution by reducing its use

of gasoline. They impose a $0.50 tax on each gallon of

gasoline sold.

a. Should they impose this tax on producers

or consumers? Explain carefully using a

supply-and-demand diagram.

b. If the demand for gasoline were more elastic,

would this tax be more effective or less effective

in reducing the quantity of gasoline consumed?

Explain with both words and a diagram.

c. Are consumers of gasoline helped or hurt by this

tax? Why?

d. Are workers in the oil industry helped or hurt by

this tax? Why?

130 PART II HOW MARKETS WORK

8. A case study in this chapter discusses the federal

minimum-wage law.

a. Suppose the minimum wage is above the equi-

librium wage in the market for unskilled labor.

Using a supply-and-demand diagram of the mar-

ket for unskilled labor, show the market wage,

the number of workers who are employed, and

the number of workers who are unemployed.

Also show the total wage payments to unskilled

workers.

b. Now suppose the secretary of labor proposes an

increase in the minimum wage. What effect would

this increase have on employment? Does the

change in employment depend on the elasticity of

demand, the elasticity of supply, both elasticities,

or neither?

c. What effect would this increase in the minimum

wage have on unemployment? Does the change

in unemployment depend on the elasticity of

demand, the elasticity of supply, both elasticities,

or neither?

d. If the demand for unskilled labor were inelastic,

would the proposed increase in the minimum

wage raise or lower total wage payments to

unskilled workers? Would your answer change if

the demand for unskilled labor were elastic?

9. At Fenway Park, home of the Boston Red Sox,

seating is limited to about 38,000. Hence, the number

of tickets issued is fixed at that figure. Seeing a golden

opportunity to raise revenue, the City of Boston levies

a per ticket tax of $5 to be paid by the ticket buyer.

Boston sports fans, a famously civic-minded lot,

dutifully send in the $5 per ticket. Draw a well-labeled

graph showing the impact of the tax. On whom does

the tax burden fall—the team’s owners, the fans, or

both? Why?

10. A market is described by the following supply and

demand curves:

QS 5 2P QD 5 300 2 P

a. Solve for the equilibrium price and quantity.

b. If the government imposes a price ceiling of $90,

does a shortage or surplus (or neither) develop?

What are the price, quantity supplied, quantity

demanded, and size of the shortage or surplus?

c. If the government imposes a price floor of $90,

does a shortage or surplus (or neither) develop?

What are the price, quantity supplied, quantity

demanded, and size of the shortage or surplus?

d. Instead of a price control, the government levies

a tax on producers of $30. As a result, the new

supply curve is:

QS 5 2(P − 30).

Does a shortage or surplus (or neither) develop?

What are the price, quantity supplied, quantity de-

manded, and size of the shortage or surplus?

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

PART III

Markets and Welfare

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CHAPTER

7 Consumers, Producers, and the Efficiency of Markets

W hen consumers go to grocery stores to buy food for Thanksgiving dinner, they may be disappointed see the high price of turkey. At the same time, when farmers bring to market the turkeys they have raised, they probably

wish that the price of turkey were even higher. These views are not surprising: Buyers always want to pay less, and sellers always want to be paid more. But is there a “right price” for turkey from the standpoint of society as a whole?

In previous chapters, we saw how, in market economies, the forces of supply and demand determine the prices of goods and services and the quantities sold.

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134 PART III MARKETS AND WELFARE

So far, however, we have described the way markets allocate scarce resources without directly addressing the question of whether these market allocations are desirable. In other words, our analysis has been positive (what is) rather than nor- mative (what should be). We know that the price of turkey adjusts to ensure that the quantity of turkey supplied equals the quantity of turkey demanded. But at this equilibrium, is the quantity of turkey produced and consumed too small, too large, or just right?

In this chapter, we take up the topic of welfare economics, the study of how the allocation of resources affects economic well-being. We begin by examining the benefits that buyers and sellers receive from engaging in market transactions. We then examine how society can make these benefits as large as possible. This analysis leads to a profound conclusion: In any market, the equilibrium of sup- ply and demand maximizes the total benefits received by all buyers and sellers combined.

As you may recall from Chapter 1, one of the Ten Principles of Economics is that markets are usually a good way to organize economic activity. The study of wel- fare economics explains this principle more fully. It also answers our question about the right price of turkey: The price that balances the supply and demand for turkey is, in a particular sense, the best one because it maximizes the total welfare of turkey consumers and turkey producers. No consumer or producer of turkeys aims to achieve this goal, but their joint action directed by market prices moves them toward a welfare-maximizing outcome, as if led by an invisible hand.

welfare economics

the study of how the

allocation of resources

affects economic

well-being

7-1 Consumer Surplus We begin our study of welfare economics by looking at the benefits buyers receive from participating in a market.

7-1a Willingness to Pay Imagine that you own a mint-condition recording of Elvis Presley’s first album. Because you are not an Elvis Presley fan, you decide to sell it. One way to do so is to hold an auction.

Four Elvis fans show up for your auction: Taylor, Carrie, Rihanna, and Gaga. They would all like to own the album, but each of them has a limit on the amount she is willing to pay for it. Table 1 shows the maximum price that each of the four possible buyers would pay. A buyer’s maximum is called her willingness to pay, and it measures how much that buyer values the good. Each buyer would be eager to buy the album at a price less than her willingness to pay, and she would refuse to buy the album at a price greater than her willingness to pay. At a price

willingness to pay

the maximum amount

that a buyer will pay for

a good

TABLE 1

Four Possible Buyers’ Willingness to Pay

Buyer Willingness to Pay

Taylor $100

Carrie 80

Rihanna 70

Gaga 50

135CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

equal to her willingness to pay, the buyer would be indifferent about buying the good: If the price is exactly the same as the value she places on the album, she would be equally happy buying it or keeping her money.

To sell your album, you begin the bidding process at a low price, say, $10. Because all four buyers are willing to pay much more, the price rises quickly. The bidding stops when Taylor bids $80 (or slightly more). At this point, Carrie, Rihanna, and Gaga have all dropped out of the bidding because they are unwill- ing to bid any more than $80. Taylor pays you $80 and gets the album. Note that the album has gone to the buyer who values it most highly.

What benefit does Taylor receive from buying the Elvis Presley album? In a sense, Taylor has found a real bargain: She is willing to pay $100 for the album but pays only $80. We say that Taylor receives consumer surplus of $20. Consumer surplus is the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it.

Consumer surplus measures the benefit buyers receive from participating in a market. In this example, Taylor receives a $20 benefit from participating in the auction because she pays only $80 for a good she values at $100. Carrie, Rihanna, and Gaga get no consumer surplus from participating in the auction because they left without the album and without paying anything.

Now consider a somewhat different example. Suppose that you had two iden- tical Elvis Presley albums to sell. Again, you auction them off to the four possible buyers. To keep things simple, we assume that both albums are to be sold for the same price and that no one is interested in buying more than one album. There- fore, the price rises until two buyers are left.

In this case, the bidding stops when Taylor and Carrie bid $70 (or slightly higher). At this price, Taylor and Carrie are each happy to buy an album, and Rihanna and Gaga are not willing to bid any higher. Taylor and Carrie each receive consumer surplus equal to her willingness to pay minus the price. Taylor’s consumer surplus is $30, and Carrie’s is $10. Taylor ’s consumer surplus is higher now than in the previous example because she gets the same album but pays less for it. The total consumer surplus in the market is $40.

7-1b Using the Demand Curve to Measure Consumer Surplus Consumer surplus is closely related to the demand curve for a product. To see how they are related, let’s continue our example and consider the demand curve for this rare Elvis Presley album.

We begin by using the willingness to pay of the four possible buyers to find the market demand schedule for the album. The table in Figure 1 shows the demand schedule that corresponds to Table 1. If the price is above $100, the quantity demanded in the market is 0 because no buyer is willing to pay that much. If the price is between $80 and $100, the quantity demanded is 1 because only Taylor is willing to pay such a high price. If the price is between $70 and $80, the quantity demanded is 2 because both Taylor and Carrie are willing to pay the price. We can continue this analysis for other prices as well. In this way, the demand schedule is derived from the willingness to pay of the four possible buyers.

The graph in Figure 1 shows the demand curve that corresponds to this demand schedule. Note the relationship between the height of the demand curve and the buyers’ willingness to pay. At any quantity, the price given by the demand curve shows the willingness to pay of the marginal buyer, the buyer who would leave the market first if the price were any higher. At a quantity of 4 albums, for instance, the demand curve has a height of $50, the price that Gaga

consumer surplus

the amount a buyer is

willing to pay for a good

minus the amount the

buyer actually pays for it

136 PART III MARKETS AND WELFARE

(the marginal buyer) is willing to pay for an album. At a quantity of 3 albums, the demand curve has a height of $70, the price that Rihanna (who is now the marginal buyer) is willing to pay.

Because the demand curve reflects buyers’ willingness to pay, we can also use it to measure consumer surplus. Figure 2 uses the demand curve to compute consumer surplus in our two examples. In panel (a), the price is $80 (or slightly above) and the quantity demanded is 1. Note that the area above the price and below the demand curve equals $20. This amount is exactly the consumer surplus we computed earlier when only 1 album is sold.

Panel (b) of Figure 2 shows consumer surplus when the price is $70 (or slightly above). In this case, the area above the price and below the demand curve equals the total area of the two rectangles: Taylor ’s consumer surplus at this price is $30 and Carrie’s is $10. This area equals a total of $40. Once again, this amount is the consumer surplus we computed earlier.

The lesson from this example holds for all demand curves: The area below the demand curve and above the price measures the consumer surplus in a market. This is true because the height of the demand curve represents the value buyers place on the good, as measured by their willingness to pay for it. The difference between this willingness to pay and the market price is each buyer ’s consumer surplus. Thus, the total area below the demand curve and above the price is the sum of the consumer surplus of all buyers in the market for a good or service.

7-1c How a Lower Price Raises Consumer Surplus Because buyers always want to pay less for the goods they buy, a lower price makes buyers of a good better off. But how much does buyers’ well-being rise in response to a lower price? We can use the concept of consumer surplus to answer this question precisely.

FIGURE 1

The Demand Schedule and

the Demand Curve

Price of Album

$100

Quantity of Albums

Demand

1 2 3 4

Taylor’s willingness to pay

Carrie’s willingness to pay

Rihanna’s willingness to pay

Gaga’s willingness to pay

Quantity

Price Buyers Demanded

More than $100 None 0

$80 to $100 Taylor 1

$70 to $80 Taylor, Carrie 2

$50 to $70 Taylor, Carrie, 3

Rihanna

$50 or less Taylor, Carrie, 4

Rihanna, Gaga

The table shows the demand schedule for the buyers (listed in Table 1) of the mint-condition

copy of Elvis Presley’s first album. The graph shows the corresponding demand curve. Note

that the height of the demand curve reflects the buyers’ willingness to pay.

137CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

Figure 3 shows a typical demand curve. You may notice that this curve grad- ually slopes downward instead of taking discrete steps as in the previous two figures. In a market with many buyers, the resulting steps from each buyer drop- ping out are so small that they form a smooth curve. Although this curve has a different shape, the ideas we have just developed still apply: Consumer surplus is the area above the price and below the demand curve. In panel (a), consumer surplus at a price of P

1 is the area of triangle ABC.

Now suppose that the price falls from P 1 to P

2 , as shown in panel (b). The con-

sumer surplus now equals area ADF. The increase in consumer surplus attribut- able to the lower price is the area BCFD.

This increase in consumer surplus is composed of two parts. First, those buy- ers who were already buying Q

1 of the good at the higher price P

1 are better off

because now they pay less. The increase in consumer surplus of existing buy- ers is the reduction in the amount they pay; it equals the area of the rectangle BCED. Second, some new buyers enter the market because they are willing to buy the good at the lower price. As a result, the quantity demanded in the market increases from Q

1 to Q

2 . The consumer surplus these newcomers receive is the

area of the triangle CEF.

7-1d What Does Consumer Surplus Measure? Our goal in developing the concept of consumer surplus is to make judgments about the desirability of market outcomes. Now that you have seen what con- sumer surplus is, let’s consider whether it is a good measure of economic well-being.

Imagine that you are a policymaker trying to design a good economic system. Would you care about the amount of consumer surplus? Consumer

FIGURE 2

Measuring Consumer Surplus

with the Demand Curve

(b) Price = $70 Price of Album

$100

Demand

1 2 3 4

Total consumer surplus ($40)

Quantity of Albums

Taylor’s consumer surplus ($30)

Carrie’s consumer surplus ($10)

(a) Price = $80

Price of Album

$100

Demand

1 2 3 4 Quantity of Albums

Taylor’s consumer surplus ($20)

In panel (a), the price of the good is $80 and the consumer surplus is $20.

In panel (b), the price of the good is $70 and the consumer surplus is $40.

138 PART III MARKETS AND WELFARE

surplus, the amount that buyers are willing to pay for a good minus the amount they actually pay for it, measures the benefit that buyers receive from a good as the buyers themselves perceive it. Thus, consumer surplus is a good measure of economic well- being if policymakers want to satisfy the prefer- ences of buyers.

In some circumstances, policymakers might choose to disregard consumer sur- plus because they do not respect the preferences that drive buyer behavior. For example, drug addicts are willing to pay a high price for heroin. Yet we would not say that addicts get a large benefit from being able to buy heroin at a low price (even though addicts might say they do). From the standpoint of society, will- ingness to pay in this instance is not a good measure of the buyers’ benefit, and consumer surplus is not a good measure of economic well-being, because addicts are not looking after their own best interests.

In most markets, however, consumer surplus does reflect economic well- being. Economists normally assume that buyers are rational when they make decisions. Rational people do the best they can to achieve their objectives, given their opportunities. Economists also normally assume that people’s preferences should be respected. In this case, consumers are the best judges of how much benefit they receive from the goods they buy.

QuickQuiz Draw a demand curve for turkey. In your diagram, show a price of turkey

and the consumer surplus at that price. Explain in words what this con-

sumer surplus measures.

FIGURE 3

How Price Affects

Consumer Surplus

Quantity

(a) Consumer Surplus at Price 1

Price

Demand

B C

Consumer surplus

Q1 Quantity

(b) Consumer Surplus at Price 2

Price

Demand

Initial consumer surplus

E F

Q1 Q2

Consumer surplus to new consumers

Additional consumer surplus to initial consumers

P P

In panel (a), the price is P 1 , the quantity demanded is Q

1 , and consumer surplus equals the area

of the triangle ABC. When the price falls from P 1 to P

2 , as in panel (b), the quantity demanded

rises from Q 1 to Q

2 and the consumer surplus rises to the area of the triangle ADF. The increase

in consumer surplus (area BCFD) occurs in part because existing consumers now pay less (area

BCED) and in part because new consumers enter the market at the lower price (area CEF).

139CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

7-2 Producer Surplus We now turn to the other side of the market and consider the benefits sellers receive from participating in a market. As you will see, our analysis of sellers’ welfare is similar to our analysis of buyers’ welfare.

7-2a Cost and the Willingness to Sell Imagine now that you are a homeowner and want to get your house painted. You turn to four sellers of painting services: Vincent, Claude, Pablo, and Andy. Each painter is willing to do the work for you if the price is right. You decide to take bids from the four painters and auction off the job to the painter who will do the work for the lowest price.

Each painter is willing to take the job if the price he would receive exceeds his cost of doing the work. Here the term cost should be interpreted as the paint- ers’ opportunity cost: It includes the painters’ out-of-pocket expenses (for paint, brushes, and so on) as well as the value that the painters place on their own time. Table 2 shows each painter ’s cost. Because a painter ’s cost is the lowest price he would accept for his work, cost is a measure of his willingness to sell his services. Each painter would be eager to sell his services at a price greater than his cost and would refuse to sell his services at a price less than his cost. At a price exactly equal to his cost, he would be indifferent about selling his services: He would be equally happy getting the job or using his time and energy for another purpose.

When you take bids from the painters, the price might start high, but it quickly falls as the painters compete for the job. Once Andy has bid $600 (or slightly less), he is the sole remaining bidder. Andy is happy to do the job for this price because his cost is only $500. Vincent, Claude, and Pablo are unwilling to do the job for less than $600. Note that the job goes to the painter who can do the work at the lowest cost.

What benefit does Andy receive from getting the job? Because he is willing to do the work for $500 but gets $600 for doing it, we say that he receives producer surplus of $100. Producer surplus is the amount a seller is paid minus the cost of production. Producer surplus measures the benefit sellers receive from participat- ing in a market.

Now consider a somewhat different example. Suppose that you have two houses that need painting. Again, you auction off the jobs to the four painters. To keep things simple, let’s assume that no painter is able to paint both houses and that you will pay the same amount to paint each house. Therefore, the price falls until two painters are left.

In this case, the bidding stops when Andy and Pablo each offer to do the job for a price of $800 (or slightly less). Andy and Pablo are willing to do the work at this price, while Vincent and Claude are not willing to bid a lower price. At a price of

cost

the value of everything

a seller must give up to

produce a good

producer surplus

the amount a seller is

paid for a good minus the

seller’s cost of providing it

TABLE 2

The Costs of Four Possible Sellers

Seller Cost

Vincent $900

Claude 800

Pablo 600

Andy 500

140 PART III MARKETS AND WELFARE

$800, Andy receives producer surplus of $300 and Pablo receives producer sur- plus of $200. The total producer surplus in the market is $500.

7-2b Using the Supply Curve to Measure Producer Surplus Just as consumer surplus is closely related to the demand curve, producer surplus is closely related to the supply curve. To see how, let’s continue with our example.

We begin by using the costs of the four painters to find the supply sched- ule for painting services. The table in Figure 4 shows the supply schedule that corresponds to the costs in Table 2. If the price is below $500, none of the four painters is willing to do the job, so the quantity supplied is zero. If the price is between $500 and $600, only Andy is willing to do the job, so the quantity sup- plied is 1. If the price is between $600 and $800, Andy and Pablo are willing to do the job, so the quantity supplied is 2, and so on. Thus, the supply schedule is derived from the costs of the four painters.

The graph in Figure 4 shows the supply curve that corresponds to this supply schedule. Note that the height of the supply curve is related to the sellers’ costs. At any quantity, the price given by the supply curve shows the cost of the marginal seller, the seller who would leave the market first if the price were any lower. At a quantity of 4 houses, for instance, the supply curve has a height of $900, the cost that Vincent (the marginal seller) incurs to provide his painting services. At a quantity of 3 houses, the supply curve has a height of $800, the cost that Claude (who is now the marginal seller) incurs.

Because the supply curve reflects sellers’ costs, we can use it to measure pro- ducer surplus. Figure 5 uses the supply curve to compute producer surplus in our two examples. In panel (a), we assume that the price is $600 (or slightly less). In this case, the quantity supplied is 1. Note that the area below the price and above

FIGURE 4

The Supply Schedule and

the Supply Curve

Price of House

Painting

500

800

$900

0 Quantity of Houses Painted

600

1 2 3 4

Supply

Vincent’s cost

Claude’s cost

Pablo’s cost

Andy’s cost

Quantity

Price Sellers Demanded

$900 or more Vincent, Claude, 4

Pablo, Andy

$800 to $900 Claude, Pablo, 3

Andy

$600 to $800 Pablo, Andy 2

$500 to $600 Andy 1

Less than $500 None 0

The table shows the supply schedule for the sellers (listed in Table 2) of painting services.

The graph shows the corresponding supply curve. Note that the height of the supply curve

reflects the sellers’ costs.

141CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

the supply curve equals $100. This amount is exactly the producer surplus we computed earlier for Andy.

Panel (b) of Figure 5 shows producer surplus at a price of $800 (or slightly less). In this case, the area below the price and above the supply curve equals the total area of the two rectangles. This area equals $500, the producer surplus we com- puted earlier for Pablo and Andy when two houses needed painting.

The lesson from this example applies to all supply curves: The area below the price and above the supply curve measures the producer surplus in a market. The logic is straightforward: The height of the supply curve measures sellers’ costs, and the difference between the price and the cost of production is each seller ’s producer surplus. Thus, the total area is the sum of the producer surplus of all sellers.

7-2c How a Higher Price Raises Producer Surplus You will not be surprised to hear that sellers always want to receive a higher price for the goods they sell. But how much does sellers’ well-being rise in response to a higher price? The concept of producer surplus offers a precise answer to this question.

Figure 6 shows a typical upward-sloping supply curve that would arise in a market with many sellers. Although this supply curve differs in shape from the previous figure, we measure producer surplus in the same way: Producer surplus is the area below the price and above the supply curve. In panel (a), the price is P

and producer surplus is the area of triangle ABC.

FIGURE 5

Measuring Producer Surplus

with the Supply Curve

Quantity of Houses Painted

Price of House

Painting

500

800

$900

Supply

600

1 2 3 4

(b) Price = $800

Price of House

Painting

500

800

$900

600

1 2 3 4

(a) Price = $600

Supply

Andy’s producer surplus ($100)

Pablo’s producer surplus ($200)

Total producer surplus ($500)

Andy’s producer surplus ($300)

In panel (a), the price of the good is $600 and the producer surplus is $100.

In panel (b), the price of the good is $800 and the producer surplus is $500.

142 PART III MARKETS AND WELFARE

Panel (b) shows what happens when the price rises from P 1 to P

2 . Producer sur-

plus now equals area ADF. This increase in producer surplus has two parts. First, those sellers who were already selling Q

1 of the good at the lower price P

1 are

better off because they now get more for what they sell. The increase in producer surplus for existing sellers equals the area of the rectangle BCED. Second, some new sellers enter the market because they are willing to produce the good at the higher price, resulting in an increase in the quantity supplied from Q

1 to Q

2 . The

producer surplus of these newcomers is the area of the triangle CEF. As this analysis shows, we use producer surplus to measure the well-being of

sellers in much the same way as we use consumer surplus to measure the well- being of buyers. Because these two measures of economic welfare are so similar, it is natural to use them together. Indeed, that is exactly what we do in the next section.

QuickQuiz Draw a supply curve for turkey. In your diagram, show a price of turkey

and the producer surplus at that price. Explain in words what this pro-

ducer surplus measures.

FIGURE 6

How Price Affects Producer

Surplus

Quantity

(b) Producer Surplus at Price 2

Quantity

(a) Producer Surplus at Price 1

Price

Supply

C Producer surplus

Price

P1 B

C P1

Supply

Initial producer surplus

E F

Q1 Q2

Producer surplus to new producers

Additional producer surplus to initial producers

P P

In panel (a), the price is P 1 , the quantity supplied is Q

1 , and producer surplus equals

the area of the triangle ABC. When the price rises from P 1 to P

2 , as in panel (b), the

quantity supplied rises from Q 1 to Q

2 and the producer surplus rises to the area of the

triangle ADF. The increase in producer surplus (area BCFD) occurs in part because

existing producers now receive more (area BCED) and in part because new producers

enter the market at the higher price (area CEF).

7-3 Market Efficiency Consumer surplus and producer surplus are the basic tools that economists use to study the welfare of buyers and sellers in a market. These tools can help us address a fundamental economic question: Is the allocation of resources deter- mined by free markets desirable?

143CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

7-3a The Benevolent Social Planner To evaluate market outcomes, we introduce into our analysis a new, hypothetical character called the benevolent social planner. The benevolent social planner is an all-knowing, all-powerful, well-intentioned dictator. The planner wants to max- imize the economic well-being of everyone in society. What should this planner do? Should she just leave buyers and sellers at the equilibrium that they reach naturally on their own? Or can she increase economic well-being by altering the market outcome in some way?

To answer this question, the planner must first decide how to measure the eco- nomic well-being of a society. One possible measure is the sum of consumer and producer surplus, which we call total surplus. Consumer surplus is the benefit that buyers receive from participating in a market, and producer surplus is the benefit that sellers receive. It is therefore natural to use total surplus as a measure of soci- ety’s economic well-being.

To better understand this measure of economic well-being, recall how we mea- sure consumer and producer surplus. We define consumer surplus as

Consumer surplus 5 Value to buyers 2 Amount paid by buyers.

Similarly, we define producer surplus as

Producer surplus 5 Amount received by sellers 2 Cost to sellers.

When we add consumer and producer surplus together, we obtain

Total surplus 5 (Value to buyers 2 Amount paid by buyers) 1 (Amount received by sellers 2 Cost to sellers).

The amount paid by buyers equals the amount received by sellers, so the middle two terms in this expression cancel each other. As a result, we can write total sur- plus as

Total surplus 5 Value to buyers 2 Cost to sellers.

Total surplus in a market is the total value to buyers of the goods, as measured by their willingness to pay, minus the total cost to sellers of providing those goods.

If an allocation of resources maximizes total surplus, we say that the allocation exhibits efficiency. If an allocation is not efficient, then some of the potential gains from trade among buyers and sellers are not being realized. For example, an allocation is inefficient if a good is not being produced by the sellers with lowest cost. In this case, moving production from a high-cost pro- ducer to a low-cost producer will lower the total cost to sellers and raise total surplus. Similarly, an allocation is inefficient if a good is not being consumed by the buyers who value it most highly. In this case, moving consumption of the good from a buyer with a low valuation to a buyer with a high valuation will raise total surplus.

In addition to efficiency, the social planner might also care about equality— that is, whether the various buyers and sellers in the market have a similar level of economic well-being. In essence, the gains from trade in a market are like a pie to be shared among the market participants. The question of efficiency con- cerns whether the pie is as big as possible. The question of equality concerns how

efficiency

the property of a resource

allocation of maximizing

the total surplus received

by all members of society

equality

the property of

distributing economic

prosperity uniformly

among the members

of society

144 PART III MARKETS AND WELFARE

the pie is sliced and how the portions are distributed among members of society. In this chapter, we concentrate on efficiency as the social planner ’s goal. Keep in mind, however, that real policymakers often care about equality as well.

7-3b Evaluating the Market Equilibrium Figure 7 shows consumer and producer surplus when a market reaches the equi- librium of supply and demand. Recall that consumer surplus equals the area above the price and under the demand curve and producer surplus equals the area below the price and above the supply curve. Thus, the total area between the supply and demand curves up to the point of equilibrium represents the total surplus in this market.

Is this equilibrium allocation of resources efficient? That is, does it maximize total surplus? To answer this question, recall that when a market is in equilibrium, the price determines which buyers and sellers participate in the market. Those buyers who value the good more than the price (represented by the segment AE on the demand curve) choose to buy the good; buyers who value it less than the price (represented by the segment EB) do not. Similarly, those sellers whose costs are less than the price (represented by the segment CE on the supply curve) choose to produce and sell the good; sellers whose costs are greater than the price (represented by the segment ED) do not.

These observations lead to two insights about market outcomes:

1. Free markets allocate the supply of goods to the buyers who value them most highly, as measured by their willingness to pay.

2. Free markets allocate the demand for goods to the sellers who can produce them at the lowest cost.

FIGURE 7

Consumer and Producer Surplus

in the Market Equilibrium

Total surplus—the sum of consumer

and producer surplus—is the area

between the supply and demand

curves up to the equilibrium quantity.

Price

Equilibrium price

0 QuantityEquilibrium quantity

Supply

B Demand

Producer surplus

Consumer surplus

145CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

Thus, given the quantity produced and sold in a market equilibrium, the social planner cannot increase economic well-being by changing the allocation of con- sumption among buyers or the allocation of production among sellers.

But can the social planner raise total economic well-being by increasing or decreasing the quantity of the good? The answer is no, as stated in this third insight about market outcomes:

3. Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus.

Figure 8 illustrates why this is true. To interpret this figure, keep in mind that the demand curve reflects the value to buyers and the supply curve reflects the cost to sellers. At any quantity below the equilibrium level, such as Q

1 , the value to the

marginal buyer exceeds the cost to the marginal seller. As a result, increasing the quantity produced and consumed raises total surplus. This continues to be true until the quantity reaches the equilibrium level. Similarly, at any quantity beyond the equilibrium level, such as Q

2 , the value to the marginal buyer is less than the

cost to the marginal seller. In this case, decreasing the quantity raises total sur- plus, and this continues to be true until quantity falls to the equilibrium level. To maximize total surplus, the social planner would choose the quantity where the supply and demand curves intersect.

Together, these three insights tell us that the market outcome makes the sum of consumer and producer surplus as large as it can be. In other words, the equilib- rium outcome is an efficient allocation of resources. The benevolent social planner can, therefore, leave the market outcome just as she finds it. This policy of leaving well enough alone goes by the French expression laissez faire, which literally trans- lates to “leave to do” but is more broadly interpreted as “let people do as they will.”

FIGURE 8

The Efficiency of the Equilibrium Quantity

At quantities less than the equilibrium quantity, such

as Q 1 , the value to buyers exceeds the cost to sellers.

At quantities greater than the equilibrium quantity,

such as Q 2 , the cost to sellers exceeds the value to

buyers. Therefore, the market equilibrium maximizes

the sum of producer and consumer surplus.

Quantity

Price

0 Equilibrium quantity

Supply

Demand

Cost to

sellers

Cost to

sellers

Value to

buyers

Value to

buyers

Value to buyers is greater than cost to sellers.

Value to buyers is less than cost to sellers.

Q1 Q2

146 PART III MARKETS AND WELFARE

Society is lucky that the planner doesn’t need to intervene. Although it has been a useful exercise imagining what an all-knowing, all-powerful, well- intentioned dictator would do, let’s face it: Such characters are hard to come by. Dictators are rarely benevolent, and even if we found someone so virtuous, she would lack crucial information.

Suppose our social planner tried to choose an efficient allocation of resources on her own, instead of relying on market forces. To do so, she would need to know the value of a particular good to every potential consumer in the market and the cost for every potential producer. And she would need this information not only for this market but for every one of the many thousands of markets in the econ- omy. The task is practically impossible, which explains why centrally planned economies never work very well.

The planner ’s job becomes easy, however, once she takes on a partner: Adam Smith’s invisible hand of the marketplace. The invisible hand takes all the infor- mation about buyers and sellers into account and guides everyone in the market to the best outcome as judged by the standard of economic efficiency. It is a truly remarkable feat. That is why economists so often advocate free markets as the best way to organize economic activity.

In many cities, finding an available

parking spot on the street seems about

as likely as winning the lottery. But

if local governments relied more on

the price system, they might be able to

achieve a more efficient allocation of

this scarce resource.

A Meter So Expensive,

It Creates Parking Spots

By Michael Cooper and

Jo Craven McGinty

S AN FRANCISCO—The maddening quest

for street parking is not just a tribulation

for drivers, but a trial for cities. As much as

a third of the traffic in some areas has been

attributed to drivers circling as they hunt for

spaces. The wearying tradition takes a toll

in lost time, polluted air and, when drivers

despair, double-parked cars that clog traffic

even more.

But San Francisco is trying to shorten the

hunt with an ambitious experiment that aims

to make sure that there is always at least one

empty parking spot available on every block

that has meters. The program, which uses new

technology and the law of supply and demand,

raises the price of parking on the city’s most

crowded blocks and lowers it on its emptiest

blocks. While the new prices are still being

phased in—the most expensive spots have

risen to $4.50 an hour, but could reach $6—

preliminary data suggests that the change

may be having a positive effect in some areas.

Change can already be seen on a stretch

of Drumm Street downtown near the Embar-

cadero and the popular restaurants at the

Ferry Building. Last summer it was nearly

impossible to find spots there. But after the

city gradually raised the price of parking to

$4.50 an hour from $3.50, high-tech sensors

embedded in the street showed that spots

were available a little more often—leaving

a welcome space the other day for the silver

Toyota Corolla driven by Victor Chew, a sales-

man for a commercial dishwasher company

who frequently parks in the area.

“There are more spots available now,”

said Mr. Chew, 48. “Now I don’t have to walk

half a mile.”

San Francisco’s parking experiment is the

latest major attempt to improve the uneasy

relationship between cities and the internal

combustion engine—a century-long saga

that has seen cities build highways and tear

them down, widen streets and narrow them,

and make more parking available at some

times and discourage it at others, all to try to

make their downtowns accessible but not too

congested.

The program here is being closely watched

by cities around the country. With the help of a

federal grant, San Francisco installed parking

sensors and new meters at roughly a quarter

of its 26,800 metered spots to track when and

where cars are parked. And beginning last

The Invisible Hand Can Park Your Car

IN THE NEWS

147CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

CASE STUDY

SHOULD THERE BE A MARKET FOR ORGANS? Some years ago, the front page of The Boston Globe ran the head- line “How a Mother ’s Love Helped Save Two Lives.” The newspa- per told the story of Susan Stephens, a woman whose son needed

a kidney transplant. When the doctor learned that the mother ’s kidney was not compatible, he proposed a novel solution: If Stephens donated one of her kidneys to a stranger, her son would move to the top of the kidney waiting list. The mother accepted the deal, and soon two patients had the transplants they were waiting for.

The ingenuity of the doctor’s proposal and the nobility of the mother’s act can- not be doubted. But the story raises some intriguing questions. If the mother could trade a kidney for a kidney, would the hospital allow her to trade a kidney for an expensive, experimental cancer treatment that she could not otherwise afford? Should she be allowed to exchange her kidney for free tuition for her son at the hospital’s medical school? Should she be able to sell her kidney and use the cash to trade in her old Chevy for a new Lexus?

As a matter of public policy, our society makes it illegal for people to sell their organs. In essence, in the market for organs, the government has imposed a price

Source: New York Times, March 15, 2012.

summer, the city began tweaking its prices

every two months—giving it the option of

raising them 25 cents an hour, or lowering

them by as much as 50 cents—in the hope of

leaving each block with at least one available

spot. The city also has cut prices at many of

the garages and parking lots it manages, to

lure cars off the street….

The program is the biggest test yet of

the theories of Donald Shoup, a professor of

urban planning at the University of California,

Los Angeles. His 2005 book, “The High Cost of

Free Parking,” made him something of a cult

figure to city planners—a Facebook group, The

Shoupistas, has more than a thousand mem-

bers. “I think the basic idea is that we will see

a lot of benefits if we get the price of curbside

parking right, which is the lowest price a city

can charge and still have one or two vacant

spaces available on every block,” he said.

But raising prices is rarely popular. A

chapter in Mr. Shoup’s book opens with a quote

from George Costanza, the “Seinfeld” char-

acter: “My father didn’t pay for parking, my

mother, my brother, nobody. It’s like going to

a prostitute. Why should I pay when, if I apply

myself, maybe I can get it for free?” Some San

Francisco neighborhoods recently objected to

a proposal to install meters on streets where

parking is now free. And raising prices in the

most desirable areas raises concerns that it

will make them less accessible to the poor.

That was on the minds of some parkers on

Drumm Street, where the midday occupancy rate

on one block fell to 86 percent from 98 percent

after prices rose. Edward Saldate, 55, a hairstyl-

ist who paid nearly $17 for close to four hours of

parking there, called it “a big rip-off.”

Tom Randlett, 69, an accountant, said

that he was pleased to be able to find a spot

there for the first time, but acknowledged

that the program was “complicated on the

social equity level.”

Officials note that parking rates are cut

as often as they are raised. And Professor

Shoup said that the program would benefit

many poor people, including the many San

Franciscans who do not have cars, because

all parking revenues are used for mass tran-

sit and any reduction in traffic will speed

the buses many people here rely on. And he

imagined a day when drivers will no lon-

ger attribute good parking spots to luck or

karma.

“It will be taken for granted,” he said,

“the way you take it for granted that when

you go to a store you can get fresh bananas

or apples.” ■ CR

IS TI

N A

M U

RA CA

/S H

U TT

ER ST

O CK

.C O

The new San Francisco electronic parking meter

helps equilibrate supply and demand.

148 PART III MARKETS AND WELFARE

ceiling of zero. The result, as with any binding price ceiling, is a shortage of the good. The deal in the Stephens case did not fall under this prohibition because no cash changed hands.

Many economists believe that there would be large benefits to allowing a free market for organs. People are born with two kidneys, but they usually need only one. Mean- while, some people suffer from illnesses that leave them without any working kidney. Despite the obvious gains from trade, the current situation is dire: The typical patient has to wait several years for a kidney transplant, and every year thousands of people die because a compatible kidney can- not be found. If those needing a kidney were allowed to buy one from those who have two, the price would rise to bal- ance supply and demand. Sellers would be better off with the extra cash in their pockets. Buyers would be better off with the organ they need to save their lives. The shortage of kidneys would disappear.

Such a market would lead to an efficient allocation of resources, but critics of this plan worry about fairness. A market for organs, they argue, would benefit the rich at the expense of the poor because organs would then be allocated to those most willing and able to pay. But you can also question the fairness of the current system. Now, most of us walk around with an extra organ that we don’t really need, while some of our fellow citizens are dying to get one. Is that fair? ●

QuickQuiz Draw the supply and demand curves for turkey. In the equilibrium, show

producer and consumer surplus. Explain why producing more turkeys

would lower total surplus.

“A market that allows payment for human kidneys should be

established on a trial basis to help extend the lives of patients

with kidney disease.”

Source: IGM Economic Experts Panel, March 11, 2014.

Supplying Kidneys

ASK THE EXPERTS

7-4 Conclusion: Market Efficiency and Market Failure This chapter introduced the basic tools of welfare economics—consumer and producer surplus—and used them to evaluate the efficiency of free markets. We showed that the forces of supply and demand allocate resources effi- ciently. That is, even though each buyer and seller in a market is concerned only about her own welfare, together they are guided by an invisible hand to an equilibrium that maximizes the total benefits to buyers and sellers.

A word of warning is in order. To conclude that markets are efficient, we made several assumptions about how markets work. When these assumptions do not hold, our conclusion that the market equilibrium is efficient may no longer be true. As we close this chapter, let’s briefly consider two of the most important assumptions we made.

First, our analysis assumed that markets are perfectly competitive. In actual economies, however, competition is sometimes far from perfect. In some mar- kets, a single buyer or seller (or a small group of them) may be able to con- trol market prices. This ability to influence prices is called market power. Market power can cause markets to be inefficient because it keeps the price and quan- tity away from the levels determined by the equilibrium of supply and demand.

Second, our analysis assumed that the outcome in a market matters only to the buyers and sellers who participate in that market. Yet sometimes the decisions of

27% uncertain

57% agree

16% disagree

What do economists say?

149CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

buyers and sellers affect people who are not participants in the market at all. Pol- lution is the classic example. The use of agricultural pesticides, for instance, affects not only the manufacturers who make them and the farmers who use them but also many others who breathe the air or drink the water contaminated by these pesticides. When a market exhibits such side effects, called externalities, the welfare implications of market activity depend on more than just the value obtained by the buyers and the cost incurred by the sellers. Because buyers and sellers may ignore these side effects when deciding how much to consume and produce, the equilib- rium in a market can be inefficient from the standpoint of society as a whole.

Market power and externalities are examples of a general phenomenon called market failure—the inability of some unregulated markets to allocate resources efficiently. When markets fail, public policy can potentially remedy the problem and increase economic efficiency. Microeconomists devote much effort to study- ing when market failures are likely and how they are best corrected. As you con- tinue your study of economics, you will see that the tools of welfare economics developed here are readily adapted to that endeavor.

Despite the possibility of market failure, the invisible hand of the marketplace is extraordinarily important. In many markets, the assumptions we made in this chapter work well and the conclusion of market efficiency applies directly. More- over, we can use our analysis of welfare economics and market efficiency to shed light on the effects of various government policies. In the next two chapters, we apply the tools we have just developed to study two important policy issues—the welfare effects of taxation and of international trade.

1. Jen values her time at $60 an hour. She spends

2 hours giving Colleen a massage. Colleen was

willing to pay as much at $300 for the massage, but

they negotiate a price of $200. In this transaction,

a. consumer surplus is $20 larger than producer

surplus.

b. consumer surplus is $40 larger than producer

surplus.

c. producer surplus is $20 larger than consumer

surplus.

d. producer surplus is $40 larger than consumer

surplus.

2. The demand curve for cookies is downward-sloping.

When the price of cookies is $2, the quantity

demanded is 100. If the price rises to $3,

what happens to consumer surplus?

a. It falls by less than $100.

b. It falls by more than $100.

c. It rises by less than $100.

d. It rises by more than $100.

3. John has been working as a tutor for $300 a

semester. When the university raises the price it pays

tutors to $400, Jasmine enters the market and begins

tutoring as well. How much does producer surplus

rise as a result of this price increase?

a. by less than $100

b. between $100 and $200

c. between $200 and $300

d. by more than $300

4. An efficient allocation of resources maximizes

a. consumer surplus.

b. producer surplus.

c. consumer surplus plus producer surplus.

d. consumer surplus minus producer surplus.

5. When a market is in equilibrium, the buyers are those

with the ________ willingness to pay and the sellers

are those with the ________ costs.

a. highest, highest

b. highest, lowest

c. lowest, highest

d. lowest, lowest

6. Producing a quantity larger than the equilibrium

of supply and demand is inefficient because the

marginal buyer’s willingness to pay is

a. negative.

b. zero.

c. positive but less than the marginal seller’s cost.

d. positive and greater than the marginal seller’s cost.

CHAPTER QuickQuiz

150 PART III MARKETS AND WELFARE

SUMMARY

Consumer surplus equals buyers’ willingness to pay

for a good minus the amount they actually pay, and

it measures the benefit buyers get from participating

in a market. Consumer surplus can be computed by

finding the area below the demand curve and above

the price.

Producer surplus equals the amount sellers receive

for their goods minus their costs of production, and

it measures the benefit sellers get from participat-

ing in a market. Producer surplus can be computed

by finding the area below the price and above the

supply curve.

An allocation of resources that maximizes total sur-

plus (the sum of consumer and producer surplus) is

said to be efficient. Policymakers are often concerned

with the efficiency, as well as the equality, of economic

outcomes.

The equilibrium of supply and demand maximizes

total surplus. That is, the invisible hand of the mar-

ketplace leads buyers and sellers to allocate resources

efficiently.

Markets do not allocate resources efficiently in the

presence of market failures such as market power or

externalities.

KEY CONCEPTS

welfare economics, p. 134

willingness to pay, p. 134

consumer surplus, p. 135

cost, p. 139

producer surplus, p. 139

efficiency, p. 143

equality, p. 143

QUESTIONS FOR REVIEW

1. Explain how buyers’ willingness to pay, consumer

surplus, and the demand curve are related.

2. Explain how sellers’ costs, producer surplus, and the

supply curve are related.

3. In a supply-and-demand diagram, show producer and

consumer surplus at the market equilibrium.

4. What is efficiency? Is it the only goal of economic

policymakers?

5. Name two types of market failure. Explain why each

may cause market outcomes to be inefficient.

PROBLEMS AND APPLICATIONS

1. Melissa buys an iPhone for $240 and gets consumer

surplus of $160.

a. What is her willingness to pay?

b. If she had bought the iPhone on sale for $180,

what would her consumer surplus have been?

c. If the price of an iPhone were $500, what would

her consumer surplus have been?

2. An early freeze in California sours the lemon crop.

Explain what happens to consumer surplus in

the market for lemons. Explain what happens to

consumer surplus in the market for lemonade.

Illustrate your answers with diagrams.

3. Suppose the demand for French bread rises. Explain

what happens to producer surplus in the market for

French bread. Explain what happens to producer

surplus in the market for flour. Illustrate your answers

with diagrams.

4. It is a hot day, and Bert is thirsty. Here is the value he

places on each bottle of water:

Value of first bottle $7

Value of second bottle $5

Value of third bottle $3

Value of fourth bottle $1

151CHAPTER 7 CONSUMERS, PRODUCERS, AND THE EFFICIENCY OF MARKETS

a. From this information, derive Bert’s demand

schedule. Graph his demand curve for bottled

water.

b. If the price of a bottle of water is $4, how many

bottles does Bert buy? How much consumer

surplus does Bert get from his purchases? Show

Bert’s consumer surplus in your graph.

c. If the price falls to $2, how does quantity

demanded change? How does Bert’s consumer

surplus change? Show these changes in

your graph.

5. Ernie owns a water pump. Because pumping large

amounts of water is harder than pumping small

amounts, the cost of producing a bottle of water

rises as he pumps more. Here is the cost he incurs to

produce each bottle of water:

Cost of first bottle $1

Cost of second bottle $3

Cost of third bottle $5

Cost of fourth bottle $7

a. From this information, derive Ernie’s supply

schedule. Graph his supply curve for bottled

water.

b. If the price of a bottle of water is $4, how many

bottles does Ernie produce and sell? How much

producer surplus does Ernie get from these sales?

Show Ernie’s producer surplus in your graph.

c. If the price rises to $6, how does quantity sup-

plied change? How does Ernie’s producer surplus

change? Show these changes in your graph.

6. Consider a market in which Bert from problem 4 is the

buyer and Ernie from problem 5 is the seller.

a. Use Ernie’s supply schedule and Bert’s demand

schedule to find the quantity supplied and quan-

tity demanded at prices of $2, $4, and $6. Which

of these prices brings supply and demand into

equilibrium?

b. What are consumer surplus, producer surplus,

and total surplus in this equilibrium?

c. If Ernie produced and Bert consumed one fewer

bottle of water, what would happen to total

surplus?

d. If Ernie produced and Bert consumed one addi-

tional bottle of water, what would happen to total

surplus?

7. The cost of producing flat-screen TVs has fallen over

the past decade. Let’s consider some implications of

this fact.

a. Draw a supply-and-demand diagram to show the

effect of falling production costs on the price and

quantity of flat-screen TVs sold.

b. In your diagram, show what happens to con-

sumer surplus and producer surplus.

c. Suppose the supply of flat-screen TVs is very

elastic. Who benefits most from falling production

costs—consumers or producers of these TVs?

8. There are four consumers willing to pay the following

amounts for haircuts:

Gloria: $35 Jay: $10 Claire: $40 Phil: $25

There are four haircutting businesses with the

following costs:

Firm A: $15 Firm B: $30 Firm C: $20 Firm D: $10

Each firm has the capacity to produce only one hair-

cut. To achieve efficiency, how many haircuts should

be given? Which businesses should cut hair and which

consumers should have their hair cut? How large is

the maximum possible total surplus?

9. One of the largest changes in the economy

over the past several decades is that technolog-

ical advances have reduced the cost of making

computers.

a. Draw a supply-and-demand diagram to show

what happened to price, quantity, consumer

surplus, and producer surplus in the market for

computers.

b. Forty years ago, students used typewriters to

prepare papers for their classes; today they

use computers. Does that make computers and

typewriters complements or substitutes? Use

a supply-and-demand diagram to show what

happened to price, quantity, consumer surplus,

and producer surplus in the market for type-

writers. Should typewriter producers have been

happy or sad about the technological advance in

computers?

c. Are computers and software complements or

substitutes? Draw a supply-and-demand diagram

to show what happened to price, quantity,

consumer surplus, and producer surplus in the

market for software. Should software producers

have been happy or sad about the technological

advance in computers?

d. Does this analysis help explain why software

producer Bill Gates is one of the world’s richest

people?

10. A friend of yours is considering two cell phone service

providers. Provider A charges $120 per month for

the service regardless of the number of phone calls

made. Provider B does not have a fixed service fee but

instead charges $1 per minute for calls. Your friend’s

152 PART III MARKETS AND WELFARE

monthly demand for minutes of calling is given

by the equation QD 5 150 2 50P, where P is the price of a minute.

a. With each provider, what is the cost to your friend

of an extra minute on the phone?

b. In light of your answer to (a), how many minutes

with each provider would your friend talk on the

phone?

c. How much would she end up paying each pro-

vider every month?

d. How much consumer surplus would she obtain

with each provider? (Hint: Graph the demand curve and recall the formula for the area of a

triangle.)

e. Which provider would you recommend that your

friend choose? Why?

11. Consider how health insurance affects the quantity

of healthcare services performed. Suppose that the

typical medical procedure has a cost of $100, yet a

person with health insurance pays only $20 out of

pocket. Her insurance company pays the remaining

$80. (The insurance company recoups the $80 through

premiums, but the premium a person pays does not

depend on how many procedures that person chooses

to undertake.)

a. Draw the demand curve in the market for medical

care. (In your diagram, the horizontal axis should

represent the number of medical procedures.)

Show the quantity of procedures demanded if

each procedure has a price of $100.

b. On your diagram, show the quantity of proce-

dures demanded if consumers pay only $20 per

procedure. If the cost of each procedure to society

is truly $100, and if individuals have health in-

surance as described above, will the number of

procedures performed maximize total surplus?

Explain.

c. Economists often blame the health insurance sys-

tem for excessive use of medical care. Given your

analysis, why might the use of care be viewed as

“excessive”?

d. What sort of policies might prevent this

excessive use?

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

CHAPTER

8 Application: The Costs of Taxation

T axes are often a source of heated political debate. In 1776, the anger of the American colonists over British taxes sparked the American Revolution. More than two centuries later, the American political parties still debate the proper

size and shape of the tax system. Yet no one would deny that some level of tax- ation is necessary. As Oliver Wendell Holmes, Jr., once said, “Taxes are what we pay for civilized society.”

Because taxation has such a major impact on the modern economy, we return to the topic several times throughout this book as we expand the set of tools we have

154 PART III MARKETS AND WELFARE

at our disposal. We began our study of taxes in Chapter 6. There we saw how a tax on a good affects its price and quantity sold and how the forces of supply and demand divide the burden of a tax between buyers and sellers. In this chapter, we extend this analysis and look at how taxes affect welfare, the economic well-being of participants in a market. In other words, we see how high the price of civilized society can be.

The effects of taxes on welfare might at first seem obvious. The government enacts taxes to raise revenue, and this revenue must come out of someone’s pocket. As we saw in Chapter 6, both buyers and sellers are worse off when a good is taxed: A tax raises the price buyers pay and lowers the price sellers receive. Yet to fully understand how taxes affect economic well-being, we must compare the reduced welfare of buyers and sellers to the amount of revenue the government raises. The tools of consumer and producer surplus allow us to make this comparison. Our analysis will show that the cost of taxes to buyers and sell- ers typically exceeds the revenue raised by the government.

8-1 The Deadweight Loss of Taxation We begin by recalling one of the surprising lessons from Chapter 6: The impact of a tax on a market outcome is the same whether the tax is levied on buyers or sell- ers of a good. When a tax is levied on buyers, the demand curve shifts downward by the size of the tax; when it is levied on sellers, the supply curve shifts upward by that amount. In either case, when the tax is enacted, the price paid by buyers rises, and the price received by sellers falls. In the end, the elasticities of supply and demand determine how the tax burden is distributed between producers and consumers. This distribution is the same regardless of how the tax is levied.

Figure 1 shows these effects. To simplify our discussion, this figure does not show a shift in either the supply or demand curve, although one curve must shift. Which curve shifts depends on whether the tax is levied on sellers (the supply

FIGURE 1

The Effects of a Tax

A tax on a good places a wedge

between the price that buyers

pay and the price that sellers

receive. The quantity of the

good sold falls.

Price buyers pay

Size of tax

Price without tax

QuantityQuantity with tax

Price

Price sellers receive

Quantity without tax

Demand

Supply

155CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

curve shifts) or buyers (the demand curve shifts). In this chapter, we keep the analysis general and simplify the graphs by not showing the shift. For our pur- poses here, the key result is that the tax places a wedge between the price buyers pay and the price sellers receive. Because of this tax wedge, the quantity sold falls below the level that would be sold without a tax. In other words, a tax on a good causes the size of the market for the good to shrink. These results should be famil- iar from Chapter 6.

8-1a How a Tax Affects Market Participants Let’s use the tools of welfare economics to measure the gains and losses from a tax on a good. To do this, we must take into account how the tax affects buyers, sellers, and the government. The benefit received by buyers in a market is mea- sured by consumer surplus—the amount buyers are willing to pay for the good minus the amount they actually pay for it. The benefit received by sellers in a market is measured by producer surplus—the amount sellers receive for the good minus their costs. These are precisely the measures of economic welfare we used in Chapter 7.

What about the third interested party, the government? If T is the size of the tax and Q is the quantity of the good sold, then the government gets total tax revenue of T 3 Q. It can use this tax revenue to provide services, such as roads, police, and public education, or to help the needy. Therefore, to analyze how taxes affect economic well-being, we use the government’s tax revenue to measure the public benefit from the tax. Keep in mind, however, that this benefit actually accrues not to the government but to those on whom the revenue is spent.

Figure 2 shows that the government’s tax revenue is represented by the rect- angle between the supply and demand curves. The height of this rectangle is the size of the tax, T, and the width of the rectangle is the quantity of the good sold, Q. Because a rectangle’s area is its height multiplied by its width, this rectangle’s area is T 3 Q, which equals the tax revenue.

.B . H

A N

D EL

SM A

N /T

H E

N EW

Y O

RK ER

C O

LL EC

TI O

N /W

W W

.C A

RT O

O N

BA N

K. CO

“You know, the idea of taxation with representa- tion doesn’t appeal to me very much, either.”

FIGURE 2

Tax Revenue

The tax revenue that the gov-

ernment collects equals T 3 Q,

the size of the tax T times the

quantity sold Q. Thus, tax reve-

nue equals the area of the rect-

angle between the supply and

demand curves.

Price buyers pay

Size of tax (T )

Quantity sold (Q)

Tax revenue (T � Q )

QuantityQuantity with tax

Price

Price sellers receive

Quantity without tax

Demand

Supply

156 PART III MARKETS AND WELFARE

Welfare without a Tax To see how a tax affects welfare, we begin by consider- ing welfare before the government imposes a tax. Figure 3 shows the supply-and- demand diagram with the key areas marked by the letters A through F.

Without a tax, the equilibrium price and quantity are found at the intersection of the supply and demand curves. The price is P

1 , and the quantity sold is Q

1 .

Because the demand curve reflects buyers’ willingness to pay, consumer surplus is the area between the demand curve and the price, A 1 B 1 C. Similarly, because the supply curve reflects sellers’ costs, producer surplus is the area between the supply curve and the price, D 1 E 1 F. In this case, because there is no tax, tax revenue is zero.

Total surplus, the sum of consumer and producer surplus, equals the area A 1 B 1 C 1 D 1 E 1 F. In other words, as we saw in Chapter 7, total surplus is the area between the supply and demand curves up to the equilibrium quantity. The first column of the table in Figure 3 summarizes these conclusions.

Welfare with a Tax Now consider welfare after the tax is enacted. The price paid by buyers rises from P

1 to P

B , so consumer surplus now equals only area A (the

A tax on a good reduces consumer surplus (by the area B 1 C) and producer surplus (by

the area D 1 E). Because the fall in producer and consumer surplus exceeds tax revenue

(area B 1 D), the tax is said to impose a deadweight loss (area C 1 E).

FIGURE 3

How a Tax Affects Welfare

Without Tax With Tax Change

Consumer Surplus A 1 B 1 C A 2 (B 1 C)

Producer Surplus D 1 E 1 F F 2 (D 1 E)

Tax Revenue None B 1 D 1 (B 1 D)

Total Surplus A 1 B 1 C 1 D 1 E 1 F A 1 B 1 D 1 F 2 (C 1 E)

The area C 1 E shows the fall in total surplus and is the deadweight loss of the tax.

� PB

E � P1

QuantityQ20

Price

� PS

Demand

Supply Price

buyers pay

Price without tax

Price sellers receive

157CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

area below the demand curve and above the buyers’ price). The price received by sellers falls from P

1 to P

S , so producer surplus now equals only area F (the area

above the supply curve and below the sellers’ price). The quantity sold falls from Q

1 to Q

2 , and the government collects tax revenue equal to the area B 1 D.

To compute total surplus with the tax, we add consumer surplus, producer sur- plus, and tax revenue. Thus, we find that total surplus is area A 1 B 1 D 1 F. The second column of the table summarizes these results.

Changes in Welfare We can now see the effects of the tax by comparing welfare before and after the tax is enacted. The third column of the table in Figure 3 shows the changes. Consumer surplus falls by the area B 1 C, and producer surplus falls by the area D 1 E. Tax revenue rises by the area B 1 D. Not surprisingly, the tax makes buyers and sellers worse off and the government better off.

The change in total welfare includes the change in consumer surplus (which is negative), the change in producer surplus (which is also negative), and the change in tax revenue (which is positive). When we add these three pieces together, we find that total surplus in the market falls by the area C 1 E. Thus, the losses to buy- ers and sellers from a tax exceed the revenue raised by the government. The fall in total surplus that results when a tax (or some other policy) distorts a market outcome is called a deadweight loss. The area C 1 E measures the size of the deadweight loss.

To understand why taxes cause deadweight losses, recall one of the Ten Principles of Economics in Chapter 1: People respond to incentives. In Chapter 7, we saw that free markets normally allocate scarce resources efficiently. That is, in the absence of any tax, the equilibrium of supply and demand maximizes the total surplus of buyers and sellers in a market. When the government imposes a tax, it raises the price buyers pay and lowers the price sellers receive, giving buyers an incentive to consume less and sellers an incentive to produce less. As buyers and sellers respond to these incentives, the size of the market shrinks below its optimum (as shown in the figure by the movement from Q

1 to Q

2 ). Thus, because

taxes distort incentives, they cause markets to allocate resources inefficiently.

8-1b Deadweight Losses and the Gains from Trade To better understand why taxes cause deadweight losses, consider an example. Imagine that Mike cleans Mei’s house each week for $100. The opportunity cost of Mike’s time is $80, and the value of a clean house to Mei is $120. Thus, Mike and Mei each receive a $20 benefit from their deal. The total surplus of $40 measures the gains from trade in this particular transaction.

Now suppose that the government levies a $50 tax on the providers of cleaning services. There is now no price that Mei can pay Mike that will leave both of them better off. The most Mei would be willing to pay is $120, but then Mike would be left with only $70 after paying the tax, which is less than his $80 opportunity cost. Con- versely, for Mike to receive his opportunity cost of $80, Mei would need to pay $130, which is above the $120 value she places on a clean house. As a result, Mei and Mike cancel their arrangement. Mike loses the income, and Mei lives in a dirtier house.

The tax has made Mike and Mei worse off by a total of $40 because they have each lost $20 of surplus. But note that the government collects no revenue from Mike and Mei because they decide to cancel their arrangement. The $40 is pure deadweight loss: It is a loss to buyers and sellers in a market that is not offset by an increase in government revenue. From this example, we can see the ultimate source of deadweight losses: Taxes cause deadweight losses because they prevent buy- ers and sellers from realizing some of the gains from trade.

deadweight loss

the fall in total surplus

that results from a market

distortion, such as a tax

158 PART III MARKETS AND WELFARE

The area of the triangle between the supply and demand curves created by the tax wedge (area C 1 E in Figure 3) measures these losses. This conclusion can be seen more easily in Figure 4 by recalling that the demand curve reflects the value of the good to consumers and that the supply curve reflects the costs of producers. When the tax raises the price buyers pay to P

B and lowers the price sellers receive

to P S , the marginal buyers and sellers leave the market, so the quantity sold falls

from Q 1 to Q

2 . Yet as the figure shows, the value of the good to these buyers still

exceeds the cost to these sellers. At every quantity between Q 1 and Q

2 , the situation

is the same as in our example with Mike and Mei. The gains from trade—the dif- ference between buyers’ value and sellers’ cost—are less than the tax. As a result, these trades are not made once the tax is imposed. The deadweight loss is the sur- plus that is lost because the tax discourages these mutually advantageous trades.

QuickQuiz Draw the supply and demand curves for cookies. If the government im-

poses a tax on cookies, show what happens to the price paid by buyers,

the price received by sellers, and the quantity of cookies sold. In your diagram, show the

deadweight loss from the tax. Explain the meaning of the deadweight loss.

FIGURE 4

The Source of a

Deadweight Loss

When the government imposes

a tax on a good, the quantity

sold falls from Q 1 to Q

2 .

At every quantity between

Q 1 and Q

2 , the potential gains

from trade among buyers and

sellers are not realized. These

lost gains from trade create the

deadweight loss.

Cost to sellersValue to

buyers

Size of tax Price

without tax

QuantityQ20

Price

Demand

SupplyLost gains from trade

Reduction in quantity due to the tax

8-2 The Determinants of the Deadweight Loss What determines whether the deadweight loss from a tax is large or small? The answer is the price elasticities of supply and demand, which measure how much the quantity supplied and quantity demanded respond to changes in the price.

Let’s consider first how the elasticity of supply affects the size of the dead- weight loss. In the top two panels of Figure 5, the demand curve and the size of the tax are the same. The only difference in these figures is the elasticity of the supply curve. In panel (a), the supply curve is relatively inelastic: Quantity sup- plied responds only slightly to changes in the price. In panel (b), the supply curve is relatively elastic: Quantity supplied responds substantially to changes in the

159CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

FIGURE 5

Tax Distortions and Elasticities

In panels (a) and (b), the demand curve and the size of the tax are the same, but the price

elasticity of supply is different. Notice that the more elastic the supply curve, the larger the

deadweight loss of the tax. In panels (c) and (d), the supply curve and the size of the tax

are the same, but the price elasticity of demand is different. Notice that the more elastic the

demand curve, the larger the deadweight loss of the tax.

(a) Inelastic Supply (b) Elastic Supply

Price

0 Quantity

Price

0 Quantity

Demand

Supply

Price

0 Quantity

Price

0 Quantity

Size of tax

Demand

Supply

Demand Demand

Supply

SupplySize of tax

Size of tax

When supply is relatively inelastic, the deadweight loss of a tax is small.

When supply is relatively elastic, the deadweight loss of a tax is large.

When demand is relatively elastic, the deadweight loss of a tax is large.

When demand is relatively inelastic, the deadweight loss of a tax is small.

price. Notice that the deadweight loss, the area of the triangle between the supply and demand curves, is larger when the supply curve is more elastic.

Similarly, the bottom two panels of Figure 5 show how the elasticity of demand affects the size of the deadweight loss. Here the supply curve and the size of the tax are held constant. In panel (c), the demand curve is relatively inelastic, and the deadweight loss is small. In panel (d), the demand curve is more elastic, and the deadweight loss from the tax is larger.

The lesson from this figure is apparent. A tax has a deadweight loss because it induces buyers and sellers to change their behavior. The tax raises the price

160 PART III MARKETS AND WELFARE

paid by buyers, so they consume less. At the same time, the tax lowers the price received by sellers, so they produce less. Because of these changes in behavior, the equilibrium quantity in the market shrinks below the optimal quantity. The more responsive buyers and sellers are to changes in the price, the more the equilibrium quantity shrinks. Hence, the greater the elasticities of supply and demand, the greater the deadweight loss of a tax.

CASE STUDY

THE DEADWEIGHT LOSS DEBATE Supply, demand, elasticity, deadweight loss—all this economic the- ory is enough to make your head spin. But believe it or not, these ideas are at the heart of a profound political question: How big

should the government be? The debate hinges on these concepts because the larger the deadweight loss of taxation, the larger the cost of any government program. If taxation entails large deadweight losses, then these losses are a strong argument for a leaner government that does less and taxes less. But if taxes impose small deadweight losses, then government programs are less costly than they otherwise might be, which in turn argues for a more expansive government.

So how big are the deadweight losses of taxation? Economists disagree on the answer to this question. To see the nature of this disagreement, consider the most important tax in the U.S. economy: the tax on labor. The Social Security tax, the Medicare tax, and much of the federal income tax are labor taxes. Many state gov- ernments also tax labor earnings through state income taxes. A labor tax places a wedge between the wage that firms pay and the wage that workers receive. For a typical worker, if all forms of labor taxes are added together, the marginal tax rate on labor income—the tax on the last dollar of earnings—is about 40 percent.

The size of the labor tax is easy to determine, but calculating the deadweight loss of this tax is less straightforward. Economists disagree about whether this 40 percent labor tax has a small or a large deadweight loss. This disagreement arises because economists hold different views about the elasticity of labor supply.

Economists who argue that labor taxes do not greatly distort market outcomes believe that labor supply is fairly inelastic. Most people, they claim, would work full-time regardless of the wage. If so, the labor supply curve is almost vertical, and a tax on labor has a small deadweight loss. Some evidence suggests that this may be the case for workers who are in their prime working years and who are the main breadwinners of their families.

Economists who argue that labor taxes are highly distortionary believe that labor supply is more elastic. While admitting that some groups of workers may not change the quantity of labor they supply by very much in response to changes in labor taxes, these economists claim that many other groups respond more to incen- tives. Here are some examples:

Some workers can adjust the number of hours they work—for instance, by working overtime. The higher the wage, the more hours they choose to work. Many families have second earners—often married women with children— with some discretion over whether to do unpaid work at home or paid work in the marketplace. When deciding whether to take a job, these second earn- ers compare the benefits of being at home (including savings on the cost of child care) with the wages they could earn. Many of the elderly can choose when to retire, and their decisions are partly based on the wage. Once they are retired, the wage determines their incen- tive to work part-time.

161CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

Some people consider engaging in illegal economic activity, such as the drug trade, or working at jobs that pay “under the table” to evade taxes. Economists call this the underground economy. In deciding whether to work in the under- ground economy or at a legitimate job, these potential criminals compare what they can earn by breaking the law with the wage they can earn legally.

In each of these cases, the quantity of labor supplied responds to the wage (the price of labor). Thus, these workers’ decisions are distorted when their labor earn- ings are taxed. Labor taxes encourage workers to work fewer hours, second earn- ers to stay at home, the elderly to retire early, and the unscrupulous to enter the underground economy.

The debate over the distortionary effects of labor taxation persists to this day. Indeed, whenever you see two political candidates debating whether the govern- ment should provide more services or reduce the tax burden, keep in mind that part of the disagreement may rest on different views about the elasticity of labor supply and the deadweight loss of taxation. ●

QuickQuiz The demand for beer is more elastic than the demand for milk. Would a

tax on beer or a tax on milk have a larger deadweight loss? Why?

“What’s your position on the elasticity of labor supply?”

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8-3 Deadweight Loss and Tax Revenue as Taxes Vary Taxes rarely stay the same for long periods of time. Policymakers in local, state, and federal governments are always considering raising one tax or lowering another. Here we consider what happens to the deadweight loss and tax revenue when the size of a tax changes.

Figure 6 shows the effects of a small, medium, and large tax, holding constant the market’s supply and demand curves. The deadweight loss—the reduction in total surplus that results when the tax reduces the size of a market below the optimum— equals the area of the triangle between the supply and demand curves. For the small tax in panel (a), the area of the deadweight loss triangle is quite small. But as the size of the tax rises in panels (b) and (c), the deadweight loss grows larger and larger.

Indeed, the deadweight loss of a tax rises even more rapidly than the size of the tax. This occurs because the deadweight loss is the area of a triangle, and the area of a triangle depends on the square of its size. If we double the size of a tax, for instance, the base and height of the triangle double, so the deadweight loss rises by a factor of 4. If we triple the size of a tax, the base and height triple, so the deadweight loss rises by a factor of 9.

The government’s tax revenue is the size of the tax times the amount of the good sold. As the first three panels of Figure 6 show, tax revenue equals the area of the rectangle between the supply and demand curves. For the small tax in panel (a), tax revenue is small. As the size of the tax increases from panel (a) to panel (b), tax revenue grows. But as the size of the tax increases further from panel (b) to panel (c), tax revenue falls because the higher tax drastically reduces the size of the market. For a very large tax, no revenue would be raised because people would stop buying and selling the good altogether.

The last two panels of Figure 6 summarize these results. In panel (d), we see that as the size of a tax increases, its deadweight loss quickly gets larger. By con- trast, panel (e) shows that tax revenue first rises with the size of the tax, but as the tax increases further, the market shrinks so much that tax revenue starts to fall.

162 PART III MARKETS AND WELFARE

The deadweight loss is the reduction in total surplus due to the tax. Tax revenue is the

amount of the tax multiplied by the amount of the good sold. In panel (a), a small tax has a

small deadweight loss and raises a small amount of revenue. In panel (b), a somewhat larger

tax has a larger deadweight loss and raises a larger amount of revenue. In panel (c), a very

large tax has a very large deadweight loss, but because it has reduced the size of the market

so much, the tax raises only a small amount of revenue. Panels (d) and (e) summarize these

conclusions. Panel (d) shows that as the size of a tax grows larger, the deadweight loss grows

larger. Panel (e) shows that tax revenue first rises and then falls. This relationship is called

the Laffer curve.

FIGURE 6

How Deadweight Loss and

Tax Revenue Vary with the

Size of a Tax

(d) From panel (a) to panel (c), deadweight loss continually increases.

(e) From panel (a) to panel (c), tax revenue first increases, then decreases.

Deadweight Loss

0 Tax Size

Tax Revenue

0 Tax Size

Demand

Supply

Tax revenue

QuantityQ20

Price

(b) Medium Tax

Deadweight loss

PSDemand

Supply

Tax revenue

QuantityQ20

Price

(a) Small Tax

Deadweight loss

Demand

Supply

Ta x

re ve

nu e

QuantityQ20

Price

Deadweight loss

Laffer curve

CASE STUDY

THE LAFFER CURVE AND SUPPLY-SIDE ECONOMICS One day in 1974, economist Arthur Laffer sat in a Washington restau- rant with some prominent journalists and politicians. He took out a napkin and drew a figure on it to show how tax rates affect tax rev-

enue. It looked much like panel (e) of our Figure 6. Laffer then suggested that the United States was on the downward-sloping side of this curve. Tax rates were so high, he argued, that reducing them might actually increase tax revenue.

Most economists were skeptical of Laffer ’s suggestion. They accepted the idea that a cut in tax rates could increase tax revenue as a matter of economic theory,

163CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

“A cut in federal income tax rates in the United States right now

would lead to higher national income within five years than with-

out the tax cut.”

“A cut in federal income tax rates in the United States right now

would raise taxable income enough so that the annual total tax rev-

enue would be higher within five years than without the tax cut.”

The Laffer Curve

ASK THE EXPERTS

48% uncertain43% agree

9% disagree

What do economists say?

4% uncertain0% agree

96% disagree

What do economists say?

but they doubted whether it would do so in practice. There was scant evidence for Laffer’s view that U.S. tax rates had in fact reached such extreme levels.

Nonetheless, the Laffer curve (as it became known) captured the imagination of Ronald Reagan. David Stockman, budget director in the first Reagan administra- tion, offers the following story:

[Reagan] had once been on the Laffer curve himself. “I came into the Big Money making pictures during World War II,” he would always say. At that time the wartime income surtax hit 90 percent. “You could only make four pictures and then you were in the top bracket,” he would continue. “So we all quit work- ing after four pictures and went off to the country.” High tax rates caused less work. Low tax rates caused more. His experience proved it.

When Reagan ran for president in 1980, he made cutting taxes part of his platform. Reagan argued that taxes were so high that they were discouraging hard work and thereby depressing incomes. He argued that lower taxes would give people more incentive to work, which in turn would raise economic well-being. He suggested that incomes could rise by so much that tax revenue might increase, despite the lower tax rates. Because the cut in tax rates was intended to encourage people to in- crease the quantity of labor they supplied, the views of Laffer and Reagan became known as supply-side economics.

Economists continue to debate Laffer ’s argument. Many believe that subsequent history refuted Laffer ’s conjecture that lower tax rates would raise tax revenue. Yet because history is open to alternative interpretations, other economists view the events of the 1980s as more favorable to the supply siders. To evaluate Laffer’s hypothesis definitively, we would need to rerun history without the Reagan tax cuts and see if tax revenues would have been higher or lower. Unfortunately, that experiment is impossible.

Some economists take an intermediate position on this issue. They believe that while an overall cut in tax rates normally reduces revenue, some taxpayers may occasionally find them- selves on the wrong side of the Laffer curve. Other things being equal, a tax cut is more likely to raise tax revenue if the cut applies to those taxpayers facing the highest tax rates. In addition, Laffer ’s argument may be more compelling for countries with much higher tax rates than the United States. In Sweden in the early 1980s, for instance, the typical worker faced a marginal tax rate of about 80 percent. Such a high tax rate provides a substantial disincentive to work. Studies have suggested that Sweden would have indeed raised more tax revenue if it had lowered its tax rates.

Economists disagree about these issues in part because there is no consensus about the size of the relevant elasticities. The more elastic supply and demand are in any market, the more taxes dis- tort behavior, and the more likely it is that a tax cut will increase tax revenue. There is no debate, however, about the general les- son: How much revenue the government gains or loses from a tax change cannot be computed just by looking at tax rates. It also depends on how the tax change affects people’s behavior. ●

QuickQuiz If the government doubles the tax on gasoline, can you

be sure that revenue from the gasoline tax will rise? Can

you be sure that the deadweight loss from the gasoline tax will rise? Explain. Source: IGM Economic Experts Panel, June 26, 2012.

164 PART III MARKETS AND WELFARE

8-4 Conclusion In this chapter, we have used the tools developed in the previous chapter to fur- ther our understanding of taxes. One of the Ten Principles of Economics discussed in Chapter 1 is that markets are usually a good way to organize economic activity. In Chapter 7, we used the concepts of producer and consumer surplus to make this principle more precise. Here we have seen that when the government imposes taxes on buyers or sellers of a good, society loses some of the benefits of market efficiency. Taxes are costly to market participants not only because taxes transfer resources from those participants to the government but also because they alter incentives and distort market outcomes.

The analysis presented here and in Chapter 6 should give you a good basis for understanding the economic impact of taxes, but this is not the end of the story. Microeconomists study how best to design a tax system, including how to strike the right balance between equality and efficiency. Macroeconomists study how taxes influence the overall economy and how policymakers can use the tax system to stabilize economic activity and to achieve more rapid economic growth. So as you continue your study of economics, don’t be surprised when the subject of taxation comes up yet again.

1. A tax on a good has a deadweight loss if

a. the reduction in consumer and producer surplus is

greater than the tax revenue.

b. the tax revenue is greater than the reduction in

consumer and producer surplus.

c. the reduction in consumer surplus is greater than

the reduction in producer surplus.

d. the reduction in producer surplus is greater than

the reduction in consumer surplus.

2. Sofia pays Sam $50 to mow her lawn every week. When

the government levies a mowing tax of $10 on Sam, he

raises his price to $60. Sofia continues to hire him at

the higher price. What is the change in producer sur-

plus, change in consumer surplus, and deadweight loss?

a. $0, $0, $10

b. $0, 2$10, $0 c. 1$10, 2$10, $10 d. 1$10, 2$10, $0

3. Eggs have a supply curve that is linear and

upward-sloping and a demand curve that is linear and

downward-sloping. If a 2 cent per egg tax is increased

to 3 cents, the deadweight loss of the tax

a. increases by less than 50 percent and may even

decline.

b. increases by exactly 50 percent.

c. increases by more than 50 percent.

d. The answer depends on whether supply or demand

is more elastic.

4. Peanut butter has an upward-sloping supply curve

and a downward-sloping demand curve. If a 10 cent

per pound tax is increased to 15 cents, the govern-

ment’s tax revenue

a. increases by less than 50 percent and may even

decline.

b. increases by exactly 50 percent.

c. increases by more than 50 percent.

d. The answer depends on whether supply or demand

is more elastic.

5. The Laffer curve illustrates that, in some circum-

stances, the government can reduce a tax on a good

and increase the

a. deadweight loss.

b. government’s tax revenue.

c. equilibrium quantity.

d. price paid by consumers.

6. If a policymaker wants to raise revenue by taxing

goods while minimizing the deadweight losses, he

should look for goods with ________ elasticities of

demand and ________ elasticities of supply.

a. small, small

b. small, large

c. large, small

d. large, large

CHAPTER QuickQuiz

165CHAPTER 8 APPLICATION: THE COSTS OF TAXATION

A tax on a good reduces the welfare of buyers and sell-

ers of the good, and the reduction in consumer and

producer surplus usually exceeds the revenue raised

by the government. The fall in total surplus—the

sum of consumer surplus, producer surplus, and tax

revenue—is called the deadweight loss of the tax.

Taxes have deadweight losses because they cause buy-

ers to consume less and sellers to produce less, and

these changes in behavior shrink the size of the market

below the level that maximizes total surplus. Because

the elasticities of supply and demand measure how

much market participants respond to market condi-

tions, larger elasticities imply larger deadweight losses.

As a tax grows larger, it distorts incentives more, and its

deadweight loss grows larger. Because a tax reduces the

size of the market, however, tax revenue does not con-

tinually increase. It first rises with the size of a tax, but

if the tax gets large enough, tax revenue starts to fall.

SUMMARY

deadweight loss, p. 157

KEY CONCEPT

1. What happens to consumer and producer surplus

when the sale of a good is taxed? How does the

change in consumer and producer surplus compare to

the tax revenue? Explain.

2. Draw a supply-and-demand diagram with a tax on

the sale of a good. Show the deadweight loss. Show

the tax revenue.

3. How do the elasticities of supply and demand affect

the deadweight loss of a tax? Why do they have this

effect?

4. Why do experts disagree about whether labor taxes

have small or large deadweight losses?

5. What happens to the deadweight loss and tax revenue

when a tax is increased?

QUESTIONS FOR REVIEW

1. The market for pizza is characterized by a

downward-sloping demand curve and an

upward-sloping supply curve.

a. Draw the competitive market equilibrium. Label

the price, quantity, consumer surplus, and producer

surplus. Is there any deadweight loss? Explain.

b. Suppose that the government forces each pizzeria

to pay a $1 tax on each pizza sold. Illustrate the

effect of this tax on the pizza market, being sure

to label the consumer surplus, producer surplus,

government revenue, and deadweight loss. How

does each area compare to the pre-tax case?

c. If the tax were removed, pizza eaters and sellers

would be better off, but the government would

lose tax revenue. Suppose that consumers and pro-

ducers voluntarily transferred some of their gains

to the government. Could all parties (including the

government) be better off than they were with a

tax? Explain using the labeled areas in your graph.

2. Evaluate the following two statements. Do you agree?

Why or why not?

a. “A tax that has no deadweight loss cannot raise

any revenue for the government.”

b. “A tax that raises no revenue for the government

cannot have any deadweight loss.”

3. Consider the market for rubber bands.

a. If this market has very elastic supply and

very inelastic demand, how would the burden

of a tax on rubber bands be shared between

consumers and producers? Use the tools of

consumer surplus and producer surplus in your

answer.

b. If this market has very inelastic supply and very

elastic demand, how would the burden of a tax

on rubber bands be shared between consumers

and producers? Contrast your answer with your

answer to part (a).

PROBLEMS AND APPLICATIONS

166 PART III MARKETS AND WELFARE

4. Suppose that the government imposes a tax on heat-

ing oil.

a. Would the deadweight loss from this tax likely be

greater in the first year after it is imposed or in the

fifth year? Explain.

b. Would the revenue collected from this tax likely

be greater in the first year after it is imposed or in

the fifth year? Explain.

5. After economics class one day, your friend suggests

that taxing food would be a good way to raise revenue

because the demand for food is quite inelastic. In what

sense is taxing food a “good” way to raise revenue? In

what sense is it not a “good” way to raise revenue?

6. Daniel Patrick Moynihan, the late senator from

New York, once introduced a bill that would levy a

10,000 percent tax on certain hollow-tipped bullets.

a. Do you expect that this tax would raise much

revenue? Why or why not?

b. Even if the tax would raise no revenue, why

might Senator Moynihan have proposed it?

7. The government places a tax on the purchase of socks.

a. Illustrate the effect of this tax on equilibrium price

and quantity in the sock market. Identify the fol-

lowing areas both before and after the imposition

of the tax: total spending by consumers, total reve-

nue for producers, and government tax revenue.

b. Does the price received by producers rise or fall?

Can you tell whether total receipts for producers

rise or fall? Explain.

c. Does the price paid by consumers rise or fall? Can

you tell whether total spending by consumers

rises or falls? Explain carefully. (Hint: Think about elasticity.) If total consumer spending falls, does

consumer surplus rise? Explain.

8. This chapter analyzed the welfare effects of a tax on a

good. Now consider the opposite policy. Suppose that

the government subsidizes a good: For each unit of the good sold, the government pays $2 to the buyer. How

does the subsidy affect consumer surplus, producer

surplus, tax revenue, and total surplus? Does a sub-

sidy lead to a deadweight loss? Explain.

9. Hotel rooms in Smalltown go for $100, and 1,000

rooms are rented on a typical day.

a. To raise revenue, the mayor decides to charge

hotels a tax of $10 per rented room. After the tax

is imposed, the going rate for hotel rooms rises to

$108, and the number of rooms rented falls to 900.

Calculate the amount of revenue this tax raises

for Smalltown and the deadweight loss of the tax.

(Hint: The area of a triangle is ½ 3 base 3 height.)

b. The mayor now doubles the tax to $20. The price

rises to $116, and the number of rooms rented falls

to 800. Calculate tax revenue and deadweight loss

with this larger tax. Are they double, more than

double, or less than double? Explain.

10. Suppose that a market is described by the following

supply and demand equations:

QS 5 2P

QD 5 300 2 P

a. Solve for the equilibrium price and the equilib-

rium quantity.

b. Suppose that a tax of T is placed on buyers, so the new demand equation is

QD 5 300 2 (P 1 T)

Solve for the new equilibrium. What happens to

the price received by sellers, the price paid by buy-

ers, and the quantity sold?

c. Tax revenue is T 3 Q. Use your answer from part (b) to solve for tax revenue as a function of T. Graph this relationship for T between 0 and 300.

d. The deadweight loss of a tax is the area of the

triangle between the supply and demand curves.

Recalling that the area of a triangle is ½ 3 base 3 height, solve for deadweight loss as a function

of T. Graph this relationship for T between 0 and 300. (Hint: Looking sideways, the base of the deadweight loss triangle is T, and the height is the difference between the quantity sold with the

tax and the quantity sold without the tax.)

e. The government now levies a tax of $200 per unit

on this good. Is this a good policy? Why or why

not? Can you propose a better policy?

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

Application: International Trade

CHAPTER

9 I

f you check the labels on the clothes you are wearing, you will probably find that some were made in another country. A century ago, the textile and clothing industry was a major part of the U.S. economy, but that is no longer the case.

Faced with foreign competitors that can produce quality goods at low cost, many U.S. firms found it increasingly difficult to produce and sell textiles and clothing at a profit. As a result, they laid off their workers and shut down their factories. Today, most of the textiles and clothing that Americans consume are imported.

The story of the textile industry raises important questions for economic pol- icy: How does international trade affect economic well-being? Who gains and who loses from free trade among countries, and how do the gains compare to the losses?

168 PART III MARKETS AND WELFARE

Chapter 3 introduced the study of international trade by applying the principle of comparative advantage. According to this principle, all countries can benefit from trading with one another because trade allows each country to specialize in doing what it does best. But the analysis in Chapter 3 was incomplete. It did not explain how the international marketplace achieves these gains from trade or how the gains are distributed among the various economic participants.

We now return to the study of international trade to tackle these questions. Over the past several chapters, we have developed many tools for analyzing how markets work: supply, demand, equilibrium, consumer surplus, producer surplus, and so on. With these tools, we can learn more about how international trade affects economic well-being.

9-1 The Determinants of Trade Consider the market for textiles. The textile market is well suited to studying the gains and losses from international trade: Textiles are made in many countries around the world, and there is much world trade in textiles. Moreover, the textile market is one in which policymakers often consider (and sometimes implement) trade restrictions to protect domestic producers from foreign competitors. Here we examine the textile market in the imaginary country of Isoland.

9-1a The Equilibrium without Trade As our story begins, the Isolandian textile market is isolated from the rest of the world. By government decree, no one in Isoland is allowed to import or export textiles, and the penalty for violating the decree is so large that no one dares try.

Because there is no international trade, the market for textiles in Isoland consists solely of Isolandian buyers and sellers. As Figure 1 shows, the domestic price adjusts to balance the quantity supplied by domestic sellers and the quantity demanded by domestic buyers. The figure shows the consumer and producer surplus in the equi- librium without trade. The sum of consumer and producer surplus measures the total benefits that buyers and sellers receive from participating in the textile market.

FIGURE 1

The Equilibrium without

International Trade

When an economy cannot trade

in world markets, the price

adjusts to balance domestic

supply and demand. This figure

shows consumer and producer

surplus in an equilibrium with-

out international trade for the

textile market in the imaginary

country of Isoland.

Price of Textiles

Equilibrium price

0 Quantity of Textiles

Equilibrium quantity

Domestic supply

Domestic demand

Producer surplus

Consumer surplus

169CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

Now suppose that, in a political upset, Isoland elects a new president. The president campaigned on a platform of “change” and promised the voters bold new ideas. Her first act is to assemble a team of economists to evaluate Isolandian trade policy. She asks them to report on three questions:

If the government allows Isolandians to import and export textiles, what will happen to the price of textiles and the quantity of textiles sold in the domes- tic textile market? Who will gain from free trade in textiles and who will lose, and will the gains exceed the losses? Should a tariff (a tax on textile imports) be part of the new trade policy?

After reviewing supply and demand in their favorite textbook (this one, of course), the Isolandian economics team begins its analysis.

9-1b The World Price and Comparative Advantage The first issue our economists take up is whether Isoland is likely to become a textile importer or a textile exporter. In other words, if free trade is allowed, will Isolandians end up buying or selling textiles in world markets?

To answer this question, the economists compare the current Isolandian price of textiles to the price of textiles in other countries. We call the price prevailing in world markets the world price. If the world price of textiles is higher than the domestic price, then Isoland will export textiles once trade is permitted. Isolandian textile producers will be eager to receive the higher prices available abroad and will start selling their textiles to buyers in other countries. Conversely, if the world price of textiles is lower than the domestic price, then Isoland will import textiles. Because foreign sellers offer a better price, Isolandian textile consumers will quickly start buying textiles from other countries.

In essence, comparing the world price with the domestic price before trade reveals whether Isoland has a comparative advantage in producing textiles. The domestic price reflects the opportunity cost of textiles: It tells us how much an Isolandian must give up to obtain one unit of textiles. If the domestic price is low, the cost of producing textiles in Isoland is low, suggesting that Isoland has a comparative advantage in producing textiles relative to the rest of the world. If the domestic price is high, then the cost of producing textiles in Isoland is high, suggesting that foreign countries have a comparative advantage in pro- ducing textiles.

As we saw in Chapter 3, trade among nations is ultimately based on compara- tive advantage. That is, trade is beneficial because it allows each nation to special- ize in doing what it does best. By comparing the world price with the domestic price before trade, we can determine whether Isoland is better or worse than the rest of the world at producing textiles.

QuickQuiz The country Autarka does not allow international trade. In Autarka, you

can buy a wool suit for 3 ounces of gold. Meanwhile, in neighboring coun-

tries, you can buy the same suit for 2 ounces of gold. If Autarka were to allow free trade,

would it import or export wool suits? Why?

world price

the price of a good that

prevails in the world

market for that good

170 PART III MARKETS AND WELFARE

To analyze the welfare effects of free trade, the Isolandian economists begin with the assumption that Isoland is a small economy compared to the rest of the world. This small-economy assumption means that Isoland’s actions have little effect on world markets. Specifically, any change in Isoland’s trade policy will not affect the world price of textiles. The Isolandians are said to be price takers in the world economy. That is, they take the world price of textiles as given. Isoland can be an exporting country by selling textiles at this price or an importing country by buy- ing textiles at this price.

The small-economy assumption is not necessary to analyze the gains and losses from international trade. But the Isolandian economists know from experience (and from reading Chapter 2 of this book) that making simplifying assumptions is a key part of building a useful economic model. The assumption that Isoland is a small economy simplifies the analysis, and the basic lessons do not change in the more complicated case of a large economy.

9-2a The Gains and Losses of an Exporting Country Figure 2 shows the Isolandian textile market when the domestic equilibrium price before trade is below the world price. Once trade is allowed, the domestic price rises to equal the world price. No seller of textiles would accept less than the world price, and no buyer would pay more than the world price.

9-2 The Winners and Losers from Trade

FIGURE 2

International Trade in an

Exporting Country

Once trade is allowed, the

domestic price rises to equal

the world price. The supply

curve shows the quantity of

textiles produced domesti-

cally, and the demand curve

shows the quantity consumed

domestically. Exports from

Isoland equal the differ-

ence between the domestic

quantity supplied and the

domestic quantity demanded

at the world price. Sellers are

better off (producer surplus

rises from C to B 1 C 1 D),

and buyers are worse off

( consumer surplus falls from

A 1 B to A). Total surplus rises

by an amount equal to area D,

indicating that trade raises the

economic well- being of the

country as a whole.

Before Trade After Trade Change

Consumer Surplus A 1 B A 2B

Producer Surplus C B 1 C 1 D 1 (B 1 D)

Total Surplus A 1 B 1 C A 1 B 1 C 1 D 1 D

The area D shows the increase in total surplus

and represents the gains from trade.

B D

Price of Textiles

Price before trade

Price after trade

0 Quantity of Textiles

Domestic supply

World price

Domestic demand

Exports

Domestic quantity

demanded

Domestic quantity supplied

171CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

After the domestic price has risen to equal the world price, the domestic quantity supplied differs from the domestic quantity demanded. The supply curve shows the quantity of textiles supplied by Isolandian sellers. The demand curve shows the quantity of textiles demanded by Isolandian buyers. Because the domestic quantity supplied is greater than the domestic quantity demanded, Isoland sells textiles to other countries. Thus, Isoland becomes a textile exporter.

Although domestic quantity supplied and domestic quantity demanded differ, the textile market is still in equilibrium because there is now another participant in the market: the rest of the world. One can view the horizontal line at the world price as representing the rest of the world’s demand for textiles. This demand curve is perfectly elastic because Isoland, as a small economy, can sell as many textiles as it wants at the world price.

Consider the gains and losses from opening up trade. Clearly, not everyone benefits. Trade forces the domestic price to rise to the world price. Domestic pro- ducers of textiles are better off because they can now sell textiles at a higher price, but domestic consumers of textiles are worse off because they now have to buy textiles at a higher price.

To measure these gains and losses, we look at the changes in consumer and producer surplus. Before trade is allowed, the price of textiles adjusts to balance domestic supply and domestic demand. Consumer surplus, the area between the demand curve and the before-trade price, is area A 1 B. Producer surplus, the area between the supply curve and the before-trade price, is area C. Total surplus be fore trade, the sum of consumer and producer surplus, is area A 1 B 1 C.

After trade is allowed, the domestic price rises to the world price. Con- sumer surplus shrinks to area A (the area between the demand curve and the world price). Producer surplus increases to area B 1 C 1 D (the area between the supply curve and the world price). Thus, total surplus with trade is area A 1 B 1 C 1 D.

These welfare calculations show who wins and who loses from trade in an exporting country. Sellers benefit because producer surplus increases by the area B 1 D. Buyers are worse off because consumer surplus decreases by the area B. Because the gains of sellers exceed the losses of buyers by the area D, total surplus in Isoland increases.

This analysis of an exporting country yields two conclusions:

When a country allows trade and becomes an exporter of a good, domestic producers of the good are better off, and domestic consumers of the good are worse off. Trade raises the economic well-being of a nation in the sense that the gains of the winners exceed the losses of the losers.

9-2b The Gains and Losses of an Importing Country Now suppose that the domestic price before trade is above the world price. Once again, after trade is allowed, the domestic price must equal the world price. As Figure 3 shows, the domestic quantity supplied is less than the domestic quan- tity demanded. The difference between the domestic quantity demanded and the domestic quantity supplied is bought from other countries, and Isoland becomes a textile importer.

In this case, the horizontal line at the world price represents the supply of the rest of the world. This supply curve is perfectly elastic because Isoland is a small economy and, therefore, can buy as many textiles as it wants at the world price.

172 PART III MARKETS AND WELFARE

Once again, consider the gains and losses from trade. As in the previous case, not everyone benefits, but here the winners and losers are reversed. When trade forces the domestic price to fall, domestic consumers are better off (they can now buy textiles at a lower price), and domestic producers are worse off (they now have to sell textiles at a lower price). Changes in consumer and producer surplus measure the size of the gains and losses. Before trade, consumer surplus is area A, producer surplus is area B 1 C, and total surplus is area A 1 B 1 C. After trade is allowed, consumer surplus is area A 1 B 1 D, producer surplus is area C, and total surplus is area A 1 B 1 C 1 D.

These welfare calculations show who wins and who loses from trade in an importing country. Buyers benefit because consumer surplus increases by the area B 1 D. Sellers are worse off because producer surplus falls by the area B. The gains of buyers exceed the losses of sellers, and total surplus increases by the area D.

This analysis of an importing country yields two conclusions parallel to those for an exporting country:

When a country allows trade and becomes an importer of a good, domestic consumers of the good are better off, and domestic producers of the good are worse off. Trade raises the economic well-being of a nation in the sense that the gains of the winners exceed the losses of the losers.

FIGURE 3

International Trade in an

Importing Country

Once trade is allowed, the do-

mestic price falls to equal the

world price. The supply curve

shows the amount produced

domestically, and the demand

curve shows the amount con-

sumed domestically. Imports

equal the difference between

the domestic quantity de-

manded and the domestic

quantity supplied at the world

price. Buyers are better off

(consumer surplus rises from

A to A 1 B 1 D), and sellers

are worse off (producer sur-

plus falls from B 1 C to C). To-

tal surplus rises by an amount

equal to area D, indicating

that trade raises the economic

well-being of the country as a

whole.

Before Trade After Trade Change

Consumer Surplus A A 1 B 1 D 1 (B 1 D)

Producer Surplus B 1 C C 2B

Total Surplus A 1 B 1 C A 1 B 1 C 1 D 1 D

The area D shows the increase in total surplus

and represents the gains from trade.

B D

A Price

before trade

Domestic supply

Domestic demand

Price after trade

World price

Imports

Domestic quantity supplied

Domestic quantity

demanded

Price of Textiles

Quantity of Textiles

173CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

Having completed our analysis of trade, we can better understand one of the Ten Principles of Economics in Chapter 1: Trade can make everyone better off. If Isoland opens its textile market to international trade, the change creates winners and losers, regardless of whether Isoland ends up exporting or importing textiles. In either case, however, the gains of the winners exceed the losses of the losers, so the winners could compensate the losers and still be better off. In this sense, trade can make everyone better off. But will trade make everyone better off? Probably not. In practice, compensation for the losers from international trade is rare. With- out such compensation, opening an economy to international trade is a policy that expands the size of the economic pie, but it can leave some participants in the economy with a smaller slice.

We can now see why the debate over trade policy is often contentious. When- ever a policy creates winners and losers, the stage is set for a political battle. Nations sometimes fail to enjoy the gains from trade because the losers from free trade are better organized than the winners. The losers may turn their cohesiveness into political clout and lobby for trade restrictions such as tariffs or import quotas.

9-2c Effects of a Tariff The Isolandian economists next consider the effects of a tariff—a tax on imported goods. The economists quickly realize that a tariff on textiles will have no effect if Isoland becomes a textile exporter. If no one in Isoland is interested in importing textiles, a tax on textile imports is irrelevant. The tariff matters only if Isoland becomes a textile importer. Concentrating their attention on this case, the econo- mists compare welfare with and without the tariff.

Figure 4 shows the Isolandian market for textiles. Under free trade, the domestic price equals the world price. A tariff raises the price of imported textiles above the world price by the amount of the tariff. Domestic suppliers of textiles, who compete with suppliers of imported textiles, can now sell their textiles for the world price plus the amount of the tariff. Thus, the price of textiles—both imported and domestic—rises by the amount of the tariff and is, therefore, closer to the price that would prevail without trade.

The change in price affects the behavior of domestic buyers and sellers. Because the tariff raises the price of textiles, it reduces the domestic quantity demanded from Q

1 D to Q

2 D and raises the domestic quantity supplied from Q

1 S to Q

2 S. Thus, the

tariff reduces the quantity of imports and moves the domestic market closer to its equilib- rium without trade.

Now consider the gains and losses from the tariff. Because the tariff raises the domestic price, domestic sellers are better off, and domestic buyers are worse off. In addition, the government raises revenue. To measure these gains and losses, we look at the changes in consumer surplus, producer surplus, and government revenue. These changes are summarized in the table in Figure 4.

Before the tariff, the domestic price equals the world price. Consumer surplus, the area between the demand curve and the world price, is area A 1 B 1 C 1 D 1 E 1 F. Producer surplus, the area between the supply curve and the world price, is area G. Government revenue equals zero. Total surplus, the sum of consumer surplus, pro- ducer surplus, and government revenue, is area A 1 B 1 C 1 D 1 E 1 F 1 G.

Once the government imposes a tariff, the domestic price exceeds the world price by the amount of the tariff. Consumer surplus is now area A 1 B. Producer surplus is area C 1 G. Government revenue, which is the size of the tariff multi- plied by the quantity of after-tariff imports, is the area E. Thus, total surplus with the tariff is area A 1 B 1 C 1 E 1 G.

tariff

a tax on goods produced

abroad and sold

domestically

174 PART III MARKETS AND WELFARE

A tariff, a tax on imports, reduces the quantity of imports and moves a market closer to

the equilibrium that would exist without trade. Total surplus falls by an amount equal to

area D 1 F. These two triangles represent the deadweight loss from the tariff.

FIGURE 4

The Effects of a Tariff

Before Tariff After Tariff Change

Consumer Surplus A 1 B 1 C 1 D 1 E 1 F A 1 B 2(C 1 D 1 E 1 F)

Producer Surplus G C 1 G 1 C

Government Revenue None E 1 E

Total Surplus A 1 B 1 C 1 D 1 E 1 F 1 G A 1 B 1 C 1 E 1 G 2(D 1 F)

The area D 1 F shows the fall in total surplus and represents the deadweight loss of the tariff.

D E F C

Domestic supply

Domestic demand

Price with tariff Tariff

Imports without tariff

Equilibrium without trade

Price without tariff

World priceImports

with tariff

2Q S

1Q S

2Q D

1Q D

Price of Textiles

Quantity of Textiles

To determine the total welfare effects of the tariff, we add the change in con- sumer surplus (which is negative), the change in producer surplus (positive), and the change in government revenue (positive). We find that total surplus in the market decreases by the area D 1 F. This fall in total surplus is called the dead- weight loss of the tariff.

A tariff causes a deadweight loss because a tariff is a type of tax. Like most taxes, it distorts incentives and pushes the allocation of scarce resources away from the optimum. In this case, we can identify two effects. First, when the tariff raises the domestic price of textiles above the world price, it encourages domestic producers to increase production from Q

1 S to Q

2 S. Even though the cost of making

these incremental units exceeds the cost of buying them at the world price, the tariff makes it profitable for domestic producers to manufacture them nonethe- less. Second, when the tariff raises the price that domestic textile consumers have

175CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

to pay, it encourages them to reduce their consumption of textiles from Q 1 D to Q

2 D.

Even though domestic consumers value these incremental units at more than the world price, the tariff induces them to cut back their purchases. Area D represents the deadweight loss from the overproduction of textiles, and area F represents the deadweight loss from the underconsumption of textiles. The total deadweight loss of the tariff is the sum of these two triangles.

9-2d The Lessons for Trade Policy The team of Isolandian economists can now write to the new president:

Dear Madam President,

You asked us three questions about opening up trade. After much hard work, we have the answers.

Question: If the government allows Isolandians to import and export textiles, what will happen to the price of textiles and the quantity of textiles sold in the domestic textile market?

Answer: Once trade is allowed, the Isolandian price of textiles will be driven to equal the price prevailing around the world.

If the world price is now higher than the Isolandian price, our price will rise. The higher price will reduce the amount of textiles Isolandians consume and raise the amount of textiles that Isolandians produce. Isoland will, therefore, become a textile exporter. This occurs because, in this case, Isoland has a com- parative advantage in producing textiles.

Import Quotas: Another Way to Restrict Trade

B eyond tariffs, another way that nations sometimes restrict inter-

national trade is by putting limits on how much of a good can be

imported. In this book, we will not analyze such a policy, other than to

point out the conclusion: Import quotas are much like tariffs. Both tariffs

and import quotas reduce the quantity of imports, raise the domestic

price of the good, decrease the welfare of domestic consumers, increase

the welfare of domestic producers, and cause deadweight losses.

There is only one difference between these two types of trade

restriction: A tariff raises revenue for the government, whereas an import

quota creates surplus for those who obtain the licenses to import. The

profit for the holder of an import license is the difference between the

domestic price (at which she sells the imported good) and the world

price (at which she buys it).

Tariffs and import quotas are even more similar if the government

charges a fee for the import licenses. Suppose the government sets

the license fee equal to the difference between the domestic price and

the world price. In this case, the entire profit of license holders is paid

to the government in li-

cense fees, and the import

quota works exactly like a

tariff. Consumer surplus,

producer surplus, and gov-

ernment revenue are precisely

the same under the two policies.

In practice, however, countries that restrict trade with import

quotas rarely do so by selling the import licenses. For example, the U.S.

government has at times pressured Japan to “voluntarily” limit the sale

of Japanese cars in the United States. In this case, the Japanese govern-

ment allocates the import licenses to Japanese firms, and the surplus

from these licenses accrues to those firms. From the standpoint of U.S.

welfare, this kind of import quota is worse than a U.S. tariff on imported

cars. Both a tariff and an import quota raise prices, restrict trade, and

cause deadweight losses, but at least the tariff produces revenue for the

U.S. government rather than profit for foreign producers. ■

F Y I

176 PART III MARKETS AND WELFARE

Conversely, if the world price is now lower than the Isolandian price, our price will fall. The lower price will raise the amount of textiles that Isolandians consume and lower the amount of textiles that Isolandians produce. Isoland will, therefore, become a textile importer. This occurs because, in this case, other countries have a comparative advantage in producing textiles.

Question: Who will gain from free trade in textiles and who will lose, and will the gains exceed the losses?

Answer: The answer depends on whether the price rises or falls when trade is allowed. If the price rises, producers of textiles gain, and consumers of tex- tiles lose. If the price falls, consumers gain, and producers lose. In both cases, the gains are larger than the losses. Thus, free trade raises the total welfare of Isolandians.

Question: Should a tariff be part of the new trade policy?

Answer: A tariff has an impact only if Isoland becomes a textile importer. In this case, a tariff moves the economy closer to the no-trade equilibrium and, like most taxes, causes deadweight losses. A tariff improves the welfare of domestic producers and raises revenue for the government, but these gains are more than offset by the losses suffered by consumers. The best policy, from the standpoint of economic efficiency, would be to allow trade without a tariff.

We hope you find these answers helpful as you decide on your new policy.

Your faithful servants, Isolandian economics team

9-2e Other Benefits of International Trade The conclusions of the Isolandian economics team are based on the standard anal- ysis of international trade. Their analysis uses the most fundamental tools in the economist’s toolbox: supply, demand, and producer and consumer surplus. It shows that there are winners and losers when a nation opens itself up to trade, but the gains of the winners exceed the losses of the losers.

The case for free trade can be made even stronger, however, because there are several other economic benefits of trade beyond those emphasized in the stan- dard analysis. In a nutshell, here are some of these other benefits:

Increased variety of goods. Goods produced in different countries are not exactly the same. German beer, for instance, is not the same as Amer- ican beer. Free trade gives consumers in all countries greater variety to choose from. Lower costs through economies of scale. Some goods can be produced at low cost only if they are produced in large quantities—a phenomenon called economies of scale. A firm in a small country cannot take full advantage of economies of scale if it can sell only in a small domestic market. Free trade gives firms access to larger world markets and allows them to realize econo- mies of scale more fully. Increased competition. A company shielded from foreign competitors is more likely to have market power, which in turn gives it the ability to raise prices above competitive levels. This is a type of market failure. Opening up trade fos- ters competition and gives the invisible hand a better chance to work its magic.

177CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

Free international trade can help the

world’s poorest citizens.

Andy Warhol’s Guide to Public

Policy

By Arthur C. Brooks

I often ask people in my business — public pol-

icy — where they get their inspiration. Liberals

often point to John F. Kennedy. Conservatives

usually cite Ronald Reagan. Personally, I prefer

the artist Andy Warhol, who famously declared,

“I like boring things.” He was referring to art, of

course. But the sentiment provides solid public

policy guidance as well.

Warhol’s work exalted the everyday “bor-

ing” items that display the transcendental

beauty of life itself. The canonical example is

his famous paintings of Campbell Soup cans.

Some people sneered, but those willing to look

closely could see what he was doing. It is the

same idea expressed in an old Zen saying,

often attributed to the eighth-century Chinese

Buddhist philosopher Layman Pang: “How

wondrously supernatural and miraculous! I

draw water and I carry wood!”

Warhol’s critical insight is usually lost on

most of the world. This is not because people

are stupid, but because our brains are wired to

filter out the mundane and focus on the novel.

This turns out to be an important survival adap-

tation. To discern a predator, you must filter out

the constant rustling of leaves and notice the

strange snap of a twig.

Warhol believed that defeating this cognitive

bias led to greater appreciation of beauty. It also

leads to better public policy, especially in reliev-

ing poverty. For example, while our attention is

naturally drawn to the latest fascinating and

expensive innovations in tropical public health,

many experts insist it is cheap, boring mosquito

bed nets that best protect against malaria.

Despite their lifesaving utility, these boring nets

tend to be chronically underprovided.

We can look closer to home, too. People love

to find ways to get fancy technology into poor

schoolchildren’s hands, but arguably the best

way to help children falling behind in school is

simply to devise ways to get them to show up.

But the very best example of the Warhol

principle in policy is international trade. If it

is progress against poverty that we’re pur-

suing, trade beats the pants off every fancy

development program ever devised. The sim-

ple mundane beauty of making things and

exchanging them freely is the best anti- poverty

achievement in history.

For more than two decades, the global

poverty rate has been decreasing by roughly

1 percent a year. To put this in perspective, that

comes to about 70 million people — equivalent

to the whole population of Turkey or Thailand —

climbing out of poverty annually. Add it up, and

around a billion people have escaped destitution

since 1990.

Why? It isn’t the United Nations or for-

eign aid. It is, in the words of the publication

YaleGlobal Online, “High growth spillovers orig-

inating from large open emerging economies

that utilize cross-border supply chains.” For

readers who don’t have tenure, that means free

trade in poor countries.

That mug in your hand that says “Made in

China” is part of the reason that 680 million

Chinese have been pulled out of absolute pov-

erty since the 1980s. No giant collaboration

among transnational technocrats or lending

initiatives did that. It was because of economic

reforms in China, of people making stuff, put-

ting it on boats, and sending it to be sold in

America — to you. Critics of free trade often

argue that open economies lead to exploitation

or environmental degradation. These are serious

issues, but protectionism is never the answer.

Curbing trade benefits entrenched domestic

interests and works against the world’s poor.

And what of claims that trade increases

global income inequality? They are false. Econ-

omists at the World Bank and at LIS (formerly

known as the Luxembourg Income Study Cen-

ter) have shown that, for the world as a whole,

income inequality has fallen for most of the

past 20 years. This is chiefly because of rising

incomes from globalization in the developing

world. . . .

Fortunately, President Obama appreciates

the benefits of trade and is currently fight-

ing for the latest international trade pact, the

Trans-Pacific Partnership (T.P.P.). It would knock

down barriers between North American, South

American and East Asian nations, benefiting

rich and poor people and countries alike. Admi-

rably, the president is standing up to critics in

his own party (as well as some in the opposi-

tion) who oppose the deal. With luck, T.P.P. will

make its way through the House and Senate this

spring or summer, and receive the president’s

signature.

Trade doesn’t solve every problem, of course.

The world needs democracy, security and many

other expressions of American values and lead-

ership as well. But in a policy world crowded

with outlandish, wasteful boondoggles, free

trade is just the kind of beautifully boring War-

holian strategy we need. Americans dedicated to

helping others ought to support it without com-

promise or apology. ■

Source: New York Times, April 12, 2015.

Trade as a Tool for Economic Development

IN THE NEWS

178 PART III MARKETS AND WELFARE

Enhanced flow of ideas. The transfer of technological advances around the world is often thought to be linked to the trading of the goods that embody those advances. The best way for a poor agricultural nation to learn about the computer revolution, for instance, is to buy some computers from abroad rather than trying to make them domestically.

Thus, free international trade increases variety for consumers, allows firms to take advantage of economies of scale, makes markets more competitive, and facilitates the spread of technology. If the Isolandian economists also took these effects into account, their advice to the president would be even more forceful.

QuickQuiz Draw a supply-and-demand diagram for wool suits in the country of

Autarka. When trade is allowed, the price of a suit falls from 3 to 2 ounces

of gold. In your diagram, show the change in consumer surplus, the change in producer sur-

plus, and the change in total surplus. How would a tariff on suit imports alter these effects?

9-3 The Arguments for Restricting Trade The letter from the economics team starts to persuade the new president of Isoland to consider allowing trade in textiles. She notes that the domestic price is now high compared to the world price. Free trade would, therefore, cause the price of textiles to fall and hurt domestic textile producers. Before implementing the new policy, she asks Isolandian textile companies to comment on the econo- mists’ advice.

Not surprisingly, the textile companies oppose free trade in textiles. They believe that the government should protect the domestic textile industry from for- eign competition. Let’s consider some of the arguments they might give to sup- port their position and how the economics team would respond.

9-3a The Jobs Argument Opponents of free trade often argue that trade with other countries destroys domestic jobs. In our example, free trade in textiles would cause the price of

“You like protectionism as a ‘working man.’ How about as a consumer?”

BE RR

Y’ S

W O

RL D

R EP

RI N

TE D

B Y

PE RM

IS SI

O N

O F

U N

IT ED

F EA

TU RE

S YN

D IC

AT E,

IN C.

179CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

Politicians and pundits often say that

the government should help workers

made worse off by international trade

by, for example, paying for their retrain-

ing. In this opinion piece, an economist

makes the opposite case.

What to Expect When You’re Free

Trading

By Steven E. Landsburg

A ll economists know that when American jobs

are outsourced, Americans as a group are

net winners. What we lose through lower wages

is more than offset by what we gain through

lower prices. In other words, the winners can

more than afford to compensate the losers. Does

that mean they ought to? Does it create a moral

mandate for taxpayer- subsidized retraining pro-

grams?. . .

Um, no. Even if you’ve just lost your job,

there’s something fundamentally churlish about

blaming the very phenomenon that’s elevated

you above the subsistence level since the day

you were born. If the world owes you compensa-

tion for enduring the downside of trade, what do

you owe the world for enjoying the upside?

I doubt there’s a human being on earth

who hasn’t benefited from the opportunity to

trade freely with his neighbors. Imagine what

your life would be like if you had to grow your

own food, make your own clothes and rely on

your grandmother’s home remedies for health

care. Access to a trained physician might

reduce the demand for grandma’s home reme-

dies, but—especially at her age—she’s still

got plenty of reason to be thankful for having a

doctor.

Some people suggest, however, that it makes

sense to isolate the moral effects of a single

new trading opportunity or free trade agreement.

Surely we have fellow citizens who are hurt by

those agreements, at least in the limited sense

that they’d be better off in a world where trade

flourishes, except in this one instance. What do

we owe those fellow citizens?

One way to think about that is to ask what

your moral instincts tell you in analogous situ-

ations. Suppose, after years of buying shampoo

at your local pharmacy, you discover you can

order the same shampoo for less money on the

Web. Do you have an obligation to compensate

your pharmacist? If you move to a cheaper

apartment, should you compensate your land-

lord? When you eat at McDonald’s, should you

compensate the owners of the diner next door?

Public policy should not be designed to advance

moral instincts that we all reject every day of our

lives.

In what morally relevant way, then, might

displaced workers differ from displaced phar-

macists or displaced landlords? You might

argue that pharmacists and landlords have

a l w a y s f a c e d c u t t h r o a t c o m p e t i t i o n a n d

therefore knew what they were getting into,

while decades of tariffs and quotas have led

manufacturing workers to expect a modicum of

protection. That expectation led them to develop

certain skills, and now it’s unfair to pull the rug

out from under them.

Once again, that argument does not mesh

with our everyday instincts. For many decades,

schoolyard bullying has been a profitable occu-

pation. All across America, bullies have built up

skills so they can take advantage of that oppor-

tunity. If we toughen the rules to make bullying

unprofitable, must we compensate the bullies?

Bullying and protectionism have a lot in

common. They both use force (either directly or

through the power of the law) to enrich someone

else at your involuntary expense. If you’re forced

to pay $20 an hour to an American for goods

you could have bought from a Mexican for $5

an hour, you’re being extorted. When a free trade

agreement allows you to buy from the Mexican

after all, rejoice in your liberation. ■

Mr. Landsburg is a professor of economics at the

University of Rochester.

Source: New York Times, January 16, 2008.

Should the Winners from Free Trade Compensate the Losers?

textiles to fall, reducing the quantity of textiles produced in Isoland and thus re- ducing employment in the Isolandian textile industry. Some Isolandian textile workers would lose their jobs.

Yet free trade creates jobs at the same time that it destroys them. When Iso- landians buy textiles from other countries, those countries obtain the resources to buy other goods from Isoland. Isolandian workers would move from the textile

IN THE NEWS

180 PART III MARKETS AND WELFARE

industry to those industries in which Isoland has a comparative advantage. The transition may impose hardship on some workers in the short run, but it allows Isolandians as a whole to enjoy a higher standard of living.

Opponents of trade are often skeptical that trade creates jobs. They might respond that everything can be produced more cheaply abroad. Under free trade, they might argue, Isolandians could not be profitably employed in any industry. As Chapter 3 explains, however, the gains from trade are based on comparative advantage, not absolute advantage. Even if one country is better than another country at producing everything, each country can still gain from trading with the other. Workers in each country will eventually find jobs in an industry in which that country has a comparative advantage.

9-3b The National-Security Argument When an industry is threatened with competition from other countries, oppo- nents of free trade often argue that the industry is vital to national security. For example, if Isoland were considering free trade in steel, domestic steel companies might point out that steel is used to make guns and tanks. Free trade would allow Isoland to become dependent on foreign countries to supply steel. If a war later broke out and the foreign supply was interrupted, Isoland might be unable to produce enough steel and weapons to defend itself.

Economists acknowledge that protecting key industries may be appropriate when there are legitimate concerns over national security. Yet they fear that this argument may be used too quickly by producers eager to gain at consumers’ expense.

One should be wary of the national-security argument when it is made by rep- resentatives of industry rather than the defense establishment. Companies have an incentive to exaggerate their role in national defense to obtain protection from foreign competition. A nation’s generals may see things very differently. Indeed, when the military is a consumer of an industry’s output, it would benefit from imports. Cheaper steel in Isoland, for example, would allow the Isolandian mili- tary to accumulate a stockpile of weapons at lower cost.

9-3c The Infant-Industry Argument New industries sometimes argue for temporary trade restrictions to help them get started. After a period of protection, the argument goes, these industries will mature and be able to compete with foreign firms. Similarly, older industries sometimes argue that they need temporary protection to help them adjust to new conditions.

Economists are often skeptical about such claims, largely because the infant- industry argument is difficult to implement in practice. To apply protection suc- cessfully, the government would need to decide which industries will eventually be profitable and decide whether the benefits of establishing these industries exceed the costs of this protection to consumers. Yet “picking winners” is extraor- dinarily difficult. It is made even more difficult by the political process, which often awards protection to those industries that are politically powerful. And once a powerful industry is protected from foreign competition, the “temporary” pol- icy is sometimes hard to remove.

In addition, many economists are skeptical about the infant-industry argu- ment in principle. Suppose, for instance, that an industry is young and unable to compete profitably against foreign rivals, but there is reason to believe that the industry can be profitable in the long run. In this case, firm owners should be

181CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

willing to incur temporary losses to obtain the eventual profits. Protection is not necessary for an infant industry to grow. History shows that start-up firms often incur temporary losses and succeed in the long run, even without protection from competition.

9-3d The Unfair-Competition Argument A common argument is that free trade is desirable only if all countries play by the same rules. If firms in different countries are subject to different laws and regulations, then it is unfair (the argument goes) to expect the firms to compete in the international marketplace. For instance, suppose that the government of Neighborland subsidizes its textile industry by giving textile companies large tax breaks. The Isolandian textile industry might argue that it should be protected from this foreign competition because Neighborland is not competing fairly.

Would it, in fact, hurt Isoland to buy textiles from another country at a subsi- dized price? Certainly, Isolandian textile producers would suffer, but Isolandian textile consumers would benefit from the low price. The case for free trade is the same as before: The gains of the consumers from buying at the low price would exceed the losses of the producers. Neighborland’s subsidy to its textile indus- try may be a bad policy, but it is the taxpayers of Neighborland who bear the burden. Isoland can benefit from the opportunity to buy textiles at a subsidized price. Rather than objecting to the foreign subsidies, perhaps Isoland should send Neighborland a thank-you note.

9-3e The Protection-as-a-Bargaining-Chip Argument Another argument for trade restrictions concerns the strategy of bargaining. Many policymakers claim to support free trade but, at the same time, argue that trade restrictions can be useful when we bargain with our trading partners. They claim that the threat of a trade restriction can help remove a trade restriction already im- posed by a foreign government. For example, Isoland might threaten to impose a tariff on textiles unless Neighborland removes its tariff on wheat. If Neighborland responds to this threat by removing its tariff, the result can be freer trade.

The problem with this bargaining strategy is that the threat may not work. If it doesn’t work, the country faces a choice between two bad options. It can carry out its threat and implement the trade restriction, which would reduce its own economic welfare. Or it can back down from its threat, which would cause it to lose prestige in international affairs. Faced with this choice, the country would probably wish that it had never made the threat in the first place.

CASE STUDY

TRADE AGREEMENTS AND THE WORLD TRADE ORGANIZATION A country can take one of two approaches to achieving free trade. It can take a unilateral approach and remove its trade restrictions on its own. This is the approach that Great Britain took in the 19th century

and that Chile and South Korea have taken in recent years. Alternatively, a coun- try can take a multilateral approach and reduce its trade restrictions while other countries do the same. In other words, it can bargain with its trading partners in an attempt to reduce trade restrictions around the world.

One important example of the multilateral approach is the North American Free Trade Agreement (NAFTA), which in 1993 lowered trade barriers among the United States, Mexico, and Canada. Another is the General Agreement on Tariffs and Trade (GATT), which is a continuing series of negotiations among many of the world’s countries with the goal of promoting free trade. The United States helped

182 PART III MARKETS AND WELFARE

to found GATT after World War II in response to the high tar- iffs imposed during the Great Depression of the 1930s. Many economists believe that the high tariffs contributed to the world- wide economic hardship of that period. GATT has successfully reduced the average tariff among member countries from about 40 percent after World War II to about 5 percent today.

The rules established under GATT are now enforced by an international institution called the World Trade Organization (WTO). The WTO was established in 1995 and has its headquar- ters in Geneva, Switzerland. As of 2015, 162 countries have joined the organization, accounting for more than 97 percent of world trade. The functions of the WTO are to administer trade agree- ments, provide a forum for negotiations, and handle disputes among member countries.

What are the pros and cons of the multilateral approach to free trade? One advantage is that the multilateral approach has the potential to result in freer trade than a unilateral approach because it can reduce trade restrictions abroad as well as at home. If international negotiations fail, however, the result could be more restricted trade than under a unilateral approach.

In addition, the multilateral approach may have a political advantage. In most markets, producers are fewer and better organized than consumers—and thus wield greater political influence. Reducing the Isolandian tariff on textiles, for example, may be politically difficult if considered by itself. The textile com- panies would oppose free trade, and the buyers of textiles who would benefit are so numerous that organizing their support would be difficult. Yet suppose that Neighborland promises to reduce its tariff on wheat at the same time that Isoland reduces its tariff on textiles. In this case, the Isolandian wheat farmers, who are also politically powerful, would back the agreement. Thus, the multilateral approach to free trade can sometimes win politi- cal support when a unilateral approach cannot. ●

QuickQuiz The textile industry of Autarka advocates a ban on the

import of wool suits. Describe five arguments its lob-

byists might make. Give a response to each of these arguments.

“Past major trade deals have benefited most Americans.”

“Refusing to liberalize trade unless partner countries adopt new la-

bor or environmental rules is a bad policy, because even if the new

standards would reduce distortions on some dimensions, such a

policy involves threatening to maintain large distortions in the form

of restricted trade.”

26% uncertain

49% agree

25% disagree

What do economists say?

Trade Deals

ASK THE EXPERTS

9-4 Conclusion Economists and the public often disagree about free trade. In 2015, NBC News and The Wall Street Journal asked the American public, “In general, do you think that free trade between the United States and foreign countries has helped the United States, has hurt the United States, or has not made much of a difference either way?” Only 29 percent of those polled said free international trade helped, whereas 34 percent thought it hurt. (The rest thought it made no difference or were unsure.) By contrast, economists overwhelmingly support free international trade. They view free trade as a way of allocating production efficiently and rais- ing living standards both at home and abroad.

7% uncertain

93% agree

0% disagree

What do economists say?

Source: IGM Economic Experts Panel, November 11, 2014 and March 27, 2013.

183CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

Economists view the United States as an ongoing experiment that confirms the virtues of free trade. Throughout its history, the United States has allowed unre- stricted trade among the states, and the country as a whole has benefited from the specialization that trade allows. Florida grows oranges, Alaska pumps oil, California makes wine, and so on. Americans would not enjoy the high standard of living they do today if people could consume only those goods and services produced in their own states. The world could similarly benefit from free trade among countries.

To better understand economists’ view of trade, let’s continue our parable. Suppose that the president of Isoland, after reading the latest poll results, ignores the advice of her economics team and decides not to allow free trade in textiles. The country remains in the equilibrium without international trade.

Then, one day, some Isolandian inventor discovers a new way to make tex- tiles at very low cost. The process is quite mysterious, however, and the inventor insists on keeping it a secret. What is odd is that the inventor doesn’t need tradi- tional inputs such as cotton or wool. The only material input he needs is wheat. And even more oddly, to manufacture textiles from wheat, he hardly needs any labor input at all.

The inventor is hailed as a genius. Because everyone buys clothing, the lower cost of textiles allows all Isolandians to enjoy a higher standard of living. Work- ers who had previously produced textiles experience some hardship when their factories close, but they eventually find work in other industries. Some become farmers and grow the wheat that the inventor turns into textiles. Others enter new industries that emerge as a result of higher Isolandian living standards. Everyone understands that the displacement of workers in outmoded industries is an inevi- table part of technological progress and economic growth.

After several years, a newspaper reporter decides to investigate this mysteri- ous new textiles process. She sneaks into the inventor ’s factory and learns that the inventor is a fraud. The inventor has not been making textiles at all. Instead, he has been smuggling wheat abroad in exchange for textiles from other coun- tries. The only thing that the inventor had discovered was the gains from inter- national trade.

When the truth is revealed, the government shuts down the inventor ’s oper- ation. The price of textiles rises, and workers return to jobs in textile factories. Living standards in Isoland fall back to their former levels. The inventor is jailed and held up to public ridicule. After all, he was no inventor. He was just an economist.

1. If a nation that does not allow international trade in

steel has a domestic price of steel lower than the

world price, then

a. the nation has a comparative advantage in produc-

ing steel and would become a steel exporter if it

opened up trade.

b. the nation has a comparative advantage in produc-

ing steel and would become a steel importer if it

opened up trade.

c. the nation does not have a comparative advan-

tage in producing steel and would become a steel

exporter if it opened up trade.

d. the nation does not have a comparative advan-

tage in producing steel and would become a steel

importer if it opened up trade.

CHAPTER QuickQuiz

184 PART III MARKETS AND WELFARE

2. When the nation of Ectenia opens itself to world trade

in coffee beans, the domestic price of coffee beans

falls. Which of the following describes the situation?

a. Domestic production of coffee rises, and Ectenia

becomes a coffee importer.

b. Domestic production of coffee rises, and Ectenia

becomes a coffee exporter.

c. Domestic production of coffee falls, and Ectenia

becomes a coffee importer.

d. Domestic production of coffee falls, and Ectenia

becomes a coffee exporter.

3. When a nation opens itself to trade in a good and be-

comes an importer,

a. producer surplus decreases, but consumer surplus

and total surplus both increase.

b. producer surplus decreases, consumer surplus

increases, and so the impact on total surplus is

ambiguous.

c. producer surplus and total surplus increase, but

consumer surplus decreases.

d. producer surplus, consumer surplus, and total sur-

plus all increase.

4. If a nation that imports a good imposes a tariff, it will

increase

a. the domestic quantity demanded.

b. the domestic quantity supplied.

c. the quantity imported from abroad.

d. all of the above.

5. Which of the following trade policies would benefit

producers, hurt consumers, and increase the amount

of trade?

a. the increase of a tariff in an importing country

b. the reduction of a tariff in an importing country

c. starting to allow trade when the world price is

greater than the domestic price

d. starting to allow trade when the world price is less

than the domestic price

6. The main difference between imposing a tariff and

handing out licenses under an import quota is that a

tariff increases

a. consumer surplus.

b. producer surplus.

c. international trade.

d. government revenue.

The effects of free trade can be determined by com-

paring the domestic price before trade with the world

price. A low domestic price indicates that the country

has a comparative advantage in producing the good

and that the country will become an exporter. A high

domestic price indicates that the rest of the world has

a comparative advantage in producing the good and

that the country will become an importer.

When a country allows trade and becomes an exporter

of a good, producers of the good are better off, and

consumers of the good are worse off. When a country

allows trade and becomes an importer of a good, con-

sumers are better off, and producers are worse off. In

both cases, the gains from trade exceed the losses.

A tariff—a tax on imports—moves a market closer

to the equilibrium that would exist without trade

a n d , t h e re f o re , re d u c e s t h e g a i n s f ro m t r a d e .

Although domestic producers are better off and the

government raises revenue, the losses to consumers

exceed these gains.

There are various arguments for restricting trade:

protecting jobs, defending national security, helping

infant industries, preventing unfair competition, and

responding to foreign trade restrictions. Although

some of these arguments have merit in some cases,

most economists believe that free trade is usually the

better policy.

world price, p. 169 tariff, p. 173ff

SUMMARY

KEY CONCEPTS

1. What does the domestic price that prevails without in-

ternational trade tell us about a nation’s comparative

advantage?

2. When does a country become an exporter of a good?

An importer?

QUESTIONS FOR REVIEW

185CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

3. Draw the supply-and-demand diagram for an import-

ing country. Identify consumer surplus and producer

surplus before trade is allowed. Identify consumer

surplus and producer surplus with free trade. What is

the change in total surplus?

4. Describe what a tariff is and its economic effects.

5. List five arguments often given to support trade

restrictions. How do economists respond to these

arguments?

6. What is the difference between the unilateral and mul-

tilateral approaches to achieving free trade? Give an

example of each.

1. The world price of wine is below the price that would

prevail in Canada in the absence of trade.

a. Assuming that Canadian imports of wine are a

small part of total world wine production, draw

a graph for the Canadian market for wine under

free trade. Identify consumer surplus, producer

surplus, and total surplus in an appropriate table.

b. Now suppose that an unusual shift of the Gulf

Stream leads to an unseasonably cold summer

in Europe, destroying much of the grape har-

vest there. What effect does this shock have on

the world price of wine? Using your graph and

table from part (a), show the effect on consumer

surplus, producer surplus, and total surplus

in Canada. Who are the winners and losers?

Is Canada as a whole better or worse off?

2. Suppose that Congress imposes a tariff on imported

automobiles to protect the U.S. auto industry from

foreign competition. Assuming that the United States

is a price taker in the world auto market, show the

following on a diagram: the change in the quantity of

imports, the loss to U.S. consumers, the gain to U.S.

manufacturers, government revenue, and the dead-

weight loss associated with the tariff. The loss to con-

sumers can be decomposed into three pieces: a gain to

domestic producers, revenue for the government, and

a deadweight loss. Use your diagram to identify these

three pieces.

3. When China’s clothing industry expands, the increase

in world supply lowers the world price of clothing.

a. Draw an appropriate diagram to analyze how this

change in price affects consumer surplus, pro-

ducer surplus, and total surplus in a nation that

imports clothing, such as the United States.

b. Now draw an appropriate diagram to show how

this change in price affects consumer surplus, pro-

ducer surplus, and total surplus in a nation that

exports clothing, such as the Dominican Republic.

c. Compare your answers to parts (a) and (b). What

are the similarities and what are the differences?

Which country should be concerned about the

expansion of the Chinese textile industry? Which

country should be applauding it? Explain.

4. Consider the arguments for restricting trade.

a. Imagine that you are a lobbyist for timber, an

established industry suffering from low-priced

foreign competition, and you are trying to get

Congress to pass trade restrictions. Which two

or three of the five arguments discussed in the

chapter do you think would be most persuasive

to the average member of Congress? Explain your

reasoning.

b. Now assume you are an astute student of econom-

ics (not a hard assumption, we hope). Although

all the arguments for restricting trade have their

shortcomings, name the two or three arguments

that seem to make the most economic sense to

you. For each, describe the economic rationale for

and against these arguments for trade restrictions.

5. The nation of Textilia does not allow imports of

clothing. In its equilibrium without trade, a T-shirt

costs $20, and the equilibrium quantity is 3 million

T-shirts. One day, after reading Adam Smith’s The Wealth of Nations while on vacation, the president decides to open the Textilian market to international

trade. The market price of a T-shirt falls to the world

price of $16. The number of T-shirts consumed in

Textilia rises to 4 million, while the number of T-shirts

produced declines to 1 million.

a. Illustrate the situation just described in a graph.

Your graph should show all the numbers.

b. Calculate the change in consumer surplus, pro-

ducer surplus, and total surplus that results from

opening up trade. (Hint: Recall that the area of a triangle is ½ 3 base 3 height.)

6. China is a major producer of grains, such as wheat,

corn, and rice. Some years ago, the Chinese govern-

ment, concerned that grain exports were driving up

food prices for domestic consumers, imposed a tax on

grain exports.

a. Draw the graph that describes the market for

grain in an exporting country. Use this graph

as the starting point to answer the following

questions.

b. How does an export tax affect domestic grain

prices?

d h f d

PROBLEMS AND APPLICATIONS

186 PART III MARKETS AND WELFARE

c. How does it affect the welfare of domestic con-

sumers, the welfare of domestic producers, and

government revenue?

d. What happens to total welfare in China, as mea-

sured by the sum of consumer surplus, producer

surplus, and tax revenue?

7. Consider a country that imports a good from abroad.

For each of following statements, state whether it is

true or false. Explain your answer.

a. “The greater the elasticity of demand, the greater

the gains from trade.”

b. “If demand is perfectly inelastic, there are no

gains from trade.”

c. “If demand is perfectly inelastic, consumers do

not benefit from trade.”

8. Having rejected a tariff on textiles (a tax on imports),

the president of Isoland is now considering the same-

sized tax on textile consumption (including both

imported and domestically produced textiles).

a. Using Figure 4, identify the quantity consumed

and the quantity produced in Isoland under a tex-

tile consumption tax.

b. Construct a table similar to that in Figure 4 for the

textile consumption tax.

c. Which raises more revenue for the government—

the consumption tax or the tariff? Which has a

smaller deadweight loss? Explain.

9. Assume the United States is an importer of televisions

and there are no trade restrictions. U.S. consumers

buy 1 million televisions per year, of which 400,000 are

produced domestically and 600,000 are imported.

a. Suppose that a technological advance among

Japanese television manufacturers causes the

world price of televisions to fall by $100. Draw a

graph to show how this change affects the welfare

of U.S. consumers and U.S. producers and how it

affects total surplus in the United States.

b. After the fall in price, consumers buy 1.2 million

televisions, of which 200,000 are produced domes-

tically and 1 million are imported. Calculate the

change in consumer surplus, producer surplus,

and total surplus from the price reduction.

c. If the government responded by putting a

$100 tariff on imported televisions, what would

this do? Calculate the revenue that would be

raised and the deadweight loss. Would it be a

good policy from the standpoint of U.S. welfare?

Who might support the policy?

d. Suppose that the fall in price is attributable not

to technological advance but to a $100 per tele-

vision subsidy from the Japanese government to

Japanese industry. How would this affect your

analysis?

10. Consider a small country that exports steel. Suppose

that a “pro-trade” government decides to subsidize

the export of steel by paying a certain amount for each

ton sold abroad. How does this export subsidy affect

the domestic price of steel, the quantity of steel pro-

duced, the quantity of steel consumed, and the quan-

tity of steel exported? How does it affect consumer

surplus, producer surplus, government revenue, and

total surplus? Is it a good policy from the standpoint

of economic efficiency? (Hint: The analysis of an export subsidy is similar to the analysis of a tariff.)

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

The Economics of the Public Sector

PART IV

CHAPTER

10Externalities

F irms that make and sell paper also create, as a by-product of the manufactur- ing process, a chemical called dioxin. Scientists believe that once dioxin enters the environment, it raises the population’s risk of cancer, birth defects, and

other health problems. Is the production and release of dioxin a problem for society? In Chapters 4

through 9, we examined how markets allocate scarce resources with the forces of supply and demand, and we saw that the equilibrium of supply and demand is typically an efficient allocation of resources. To use Adam Smith’s famous

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190 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

metaphor, the “invisible hand” of the marketplace leads self-interested buyers and sellers in a market to maximize the total benefit that society derives from that market. This insight is the basis for one of the Ten Principles of Economics in Chapter 1: Markets are usually a good way to organize economic activity. Should we conclude, therefore, that the invisible hand prevents firms in the paper market from emitting too much dioxin?

Markets do many things well, but they do not do everything well. In this chapter, we begin our study of another of the Ten Principles of Economics: Government action can sometimes improve upon market outcomes. We examine why markets sometimes fail to allocate resources efficiently, how government policies can potentially improve the market’s allocation, and what kinds of policies are likely to work best.

The market failures examined in this chapter fall under a general category called externalities. An externality arises when a person engages in an activity that influences the well-being of a bystander but neither pays nor receives compensation for that effect. If the impact on the bystander is adverse, it is called a negative externality. If it is beneficial, it is called a positive externality. In the presence of externalities, society’s interest in a market outcome extends beyond the well-being of buyers and sellers who participate in the market to include the well-being of bystanders who are affected indirectly. Because buyers and sellers neglect the external effects of their actions when deciding how much to demand or supply, the market equilibrium is not efficient when there are externalities. That is, the equilibrium fails to maximize the total benefit to society as a whole. The release of dioxin into the environment, for instance, is a negative externality. Self- interested paper firms will not consider the full cost of the pollution they create in their production process, and consumers of paper will not consider the full cost of the pollution they contribute to as a result of their purchasing decisions. Therefore, the firms will emit too much pollution unless the government prevents or discourages them from doing so.

Externalities come in many varieties, as do the policy responses that try to deal with the market failure. Here are some examples:

The exhaust from automobiles is a negative externality because it creates smog that other people have to breathe. Because drivers may ignore this externality when deciding what cars to buy and how much to use them, they tend to pollute too much. The federal government addresses this problem by setting emission standards for cars. It also taxes gasoline to reduce the amount that people drive. Restored historic buildings convey a positive externality because people who walk or ride by them can enjoy the beauty and sense of history that these buildings provide. Building owners do not get the full benefit of res- toration and, therefore, tend to tear down older buildings too quickly. Many local governments respond to this problem by regulating the destruction of historic buildings and by providing tax breaks to owners who restore them. Barking dogs create a negative externality because neighbors are disturbed by the noise. Dog owners do not bear the full cost of the noise and, there- fore, tend to take too few precautions to prevent their dogs from barking. Local governments address this problem by making it illegal to “disturb the peace.” Research into new technologies provides a positive externality because it cre- ates knowledge that other people can use. If individual inventors, firms, and

externality

the uncompensated

impact of one person’s

actions on the well-being

of a bystander

191CHAPTER 10 EXTERNALITIES

universities cannot capture the benefits of their inventions, they will devote too few resources to research. The federal government addresses this prob- lem partially through the patent system, which gives inventors exclusive use of their inventions for a limited time.

In each of these cases, some decision maker fails to take into account the external effects of his behavior. The government responds by trying to influence this behavior to protect the interests of bystanders.

10-1 Externalities and Market Inefficiency In this section, we use the tools of welfare economics developed in Chapter 7 to examine how externalities affect economic well-being. The analysis shows pre- cisely why externalities cause markets to allocate resources inefficiently. Later in the chapter, we examine various ways private individuals and public policymak- ers can remedy this type of market failure.

10-1a Welfare Economics: A Recap We begin by recalling the key lessons of welfare economics from Chapter 7. To make our analysis concrete, we consider a specific market—the market for alumi- num. Figure 1 shows the supply and demand curves in the market for aluminum.

Recall from Chapter 7 that the supply and demand curves contain important information about costs and benefits. The demand curve for aluminum reflects the value of aluminum to consumers, as measured by the prices they are willing to pay. At any given quantity, the height of the demand curve shows the will- ingness to pay of the marginal buyer. In other words, it shows the value to the consumer of the last unit of aluminum bought. Similarly, the supply curve reflects the costs of producing aluminum. At any given quantity, the height of the supply curve shows the cost to the marginal seller. In other words, it shows the cost to the producer of the last unit of aluminum sold.

FIGURE 1

The Market for Aluminum

The demand curve reflects the value

to buyers, and the supply curve reflects

the costs of sellers. The equilibrium

quantity, Q MARKET

, maximizes the total

value to buyers minus the total costs of

sellers. In the absence of externalities,

therefore, the market equilibrium is

efficient.

Equilibrium

Quantity of Aluminum

Price of Aluminum

QMARKET

Demand (private value)

Supply (private cost)

192 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

In the absence of government intervention, the price adjusts to balance the supply and demand for aluminum. The quantity produced and consumed in the market equilibrium, shown as Q

MARKET in Figure 1, is efficient in the sense

that it maximizes the sum of producer and consumer surplus. That is, the market allocates resources in a way that maximizes the total value to the consumers who buy and use aluminum minus the total costs to the producers who make and sell aluminum.

10-1b Negative Externalities Now let’s suppose that aluminum factories emit pollution: For each unit of alu- minum produced, a certain amount of smoke enters the atmosphere. Because this smoke creates a health risk for those who breathe the air, it is a negative externality. How does this externality affect the efficiency of the market outcome?

Because of the externality, the cost to society of producing aluminum is larger than the cost to the aluminum producers. For each unit of aluminum produced, the social cost includes the private costs of the aluminum producers plus the costs to those bystanders affected adversely by the pollution. Figure 2 shows the social cost of producing aluminum. The social-cost curve is above the supply curve because it takes into account the external costs imposed on society by aluminum production. The difference between these two curves reflects the cost of the pollu- tion emitted.

What quantity of aluminum should be produced? To answer this question, we once again consider what a benevolent social planner would do. The planner wants to maximize the total surplus derived from the market—the value to con- sumers of aluminum minus the cost of producing aluminum. The planner under- stands, however, that the cost of producing aluminum includes the external costs of the pollution.

“All I can say is that if being a leading manufacturer means being a leading polluter, so be it.”

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FIGURE 2

Pollution and the

Social Optimum

In the presence of a

negative externality, such

as pollution, the social cost

of the good exceeds the

private cost. The optimal

quantity, Q OPTIMUM

, is

therefore smaller than

the equilibrium quantity,

Q MARKET

Equilibrium

Quantity of Aluminum

Price of Aluminum

QMARKET

Demand (private value)

Supply (private cost)

Social cost (private cost and external cost)

QOPTIMUM

Optimum

External cost

193CHAPTER 10 EXTERNALITIES

The planner would choose the level of aluminum production at which the demand curve crosses the social-cost curve. This intersection determines the optimal amount of aluminum from the standpoint of society as a whole. Below this level of production, the value of the aluminum to consumers (as measured by the height of the demand curve) exceeds the social cost of producing it (as measured by the height of the social-cost curve). Above this level of production, the social cost of producing additional aluminum exceeds the value to consumers.

Note that the equilibrium quantity of aluminum, Q MARKET

, is larger than the socially optimal quantity, Q

OPTIMUM . This inefficiency occurs because the market

equilibrium reflects only the private costs of production. In the market equilib- rium, the marginal consumer values aluminum at less than the social cost of pro- ducing it. That is, at Q

MARKET , the demand curve lies below the social-cost curve.

Thus, reducing aluminum production and consumption below the market equi- librium level raises total economic well-being.

How can the social planner achieve the optimal outcome? One way would be to tax aluminum producers for each ton of aluminum sold. The tax would shift the supply curve for aluminum upward by the size of the tax. If the tax accu- rately reflected the external cost of pollutants released into the atmosphere, the new supply curve would coincide with the social-cost curve. In the new market equilibrium, aluminum producers would produce the socially optimal quantity of aluminum.

The use of such a tax is called internalizing the externality because it gives buyers and sellers in the market an incentive to take into account the external effects of their actions. Aluminum producers would, in essence, take the costs of pollution into account when deciding how much aluminum to supply because the tax would make them pay for these external costs. And, because the market price would reflect the tax on producers, consumers of aluminum would have an incentive to buy a smaller quantity. The policy is based on one of the Ten Principles of Economics: People respond to incentives. Later in this chapter, we consider in more detail how policymakers can deal with externalities.

10-1c Positive Externalities Although some activities impose costs on third parties, others yield benefits. Consider education, for example. To a large extent, the benefit of education is private: The consumer of education becomes a more productive worker and thus reaps much of the benefit in the form of higher wages. Beyond these private ben- efits, however, education also yields positive externalities. One externality is that a more educated population leads to more informed voters, which means better government for everyone. Another externality is that a more educated population tends to result in lower crime rates. A third externality is that a more educated population may encourage the development and dissemination of technologi- cal advances, leading to higher productivity and wages for everyone. Because of these three positive externalities, a person may prefer to have neighbors who are well educated.

The analysis of positive externalities is similar to the analysis of negative externalities. As Figure 3 shows, the demand curve does not reflect the value to society of the good. Because the social value is greater than the private value, the social-value curve lies above the demand curve. The optimal quantity is found where the social-value curve and the supply curve intersect. Hence, the socially optimal quantity is greater than the quantity that the private market would natu- rally reach on its own.

internalizing the

externality

altering incentives so that

people take into account

the external effects of

their actions

194 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

Once again, the government can correct the market failure by inducing market participants to internalize the externality. The appropriate response in the case of positive externalities is exactly the opposite to the case of negative externalities. To move the market equilibrium closer to the social optimum, a positive externality requires a subsidy. In fact, that is exactly the policy the government follows: Edu- cation is heavily subsidized through public schools and government scholarships.

To summarize: Negative externalities lead markets to produce a larger quantity than is socially desirable. Positive externalities lead markets to produce a smaller quantity than is socially desirable. To remedy the problem, the government can internalize the exter- nality by taxing goods that have negative externalities and subsidizing goods that have positive externalities.

CASE STUDY

TECHNOLOGY SPILLOVERS, INDUSTRIAL POLICY, AND PATENT PROTECTION A potentially important type of positive externality is called a tech- nology spillover—the impact of one firm’s research and production

efforts on other firms’ access to technological advance. For example, consider the market for industrial robots. Robots are at the frontier of a rapidly changing tech- nology. Whenever a firm builds a robot, there is some chance that the firm will discover a new and better design. This new design may benefit not only this firm but also society as a whole because the design will enter society’s pool of tech- nological knowledge. That is, the new design may have positive externalities for other producers in the economy.

In this case, the government can internalize the externality by subsidizing the production of robots. If the government paid firms a subsidy for each robot pro- duced, the supply curve would shift down by the amount of the subsidy, and this shift would increase the equilibrium quantity of robots. To ensure that the market equilibrium equals the social optimum, the subsidy should equal the value of the technology spillover.

FIGURE 3

Education and the

Social Optimum

In the presence of a

positive externality, the

social value of the good

exceeds the private value.

The optimal quantity,

Q OPTIMUM

, is therefore

larger than the equilibrium

quantity, Q MARKET

Quantity of Education

Price of Education

QMARKET

Demand (private value)

Social value (private value and external benefit)

QOPTIMUM

Supply (private cost)

External benefit Optimum

Equilibrium

195CHAPTER 10 EXTERNALITIES

How large are technology spillovers, and what do they imply for public policy? This is an important question because technological progress is the key to raising living standards over time. Yet it is also a difficult question about which economists often disagree.

Some economists believe that technology spillovers are pervasive and that the government should encourage those industries that yield the largest spillovers. For instance, these economists argue that if making computer chips yields greater spill- overs than making potato chips, the government should encourage the production of computer chips relative to the production of potato chips. The U.S. tax code does this in a limited way by offering special tax breaks for expenditures on research and development. Some nations go further by subsidizing specific industries that supposedly yield large technology spillovers. Government intervention that aims to promote technology-enhancing industries is sometimes called industrial policy.

Other economists are skeptical about industrial policy. Even if technology spill- overs are common, pursuing an industrial policy requires the government to gauge the size of the spillovers from different markets. This measurement problem is difficult at best. Without accurate measurements, the political system may end up subsidizing industries with the most political clout rather than those that yield the largest positive externalities.

Another way to deal with technology spillovers is patent protection. The pat- ent laws protect the rights of inventors by giving them exclusive use of their inventions for a period of time. When a firm makes a technological break- through, it can patent the idea and capture much of the economic benefit for itself. The patent internalizes the externality by giving the firm a property right over its invention. If other firms want to use the new technology, they have to obtain permission from the inventing firm and pay it a royalty. Thus, the patent system gives firms a greater incentive to engage in research and other activities that advance technology. ●

QuickQuiz Give an example of a negative externality and a positive externality. Explain

why market outcomes are inefficient in the presence of these externalities.

10-2 Public Policies toward Externalities We have discussed why externalities lead markets to allocate resources ineffi- ciently but have mentioned only briefly how this inefficiency can be remedied. In practice, both public policymakers and private individuals respond to externali- ties in various ways. All of the remedies share the goal of moving the allocation of resources closer to the social optimum.

This section considers governmental solutions. As a general matter, the govern- ment can respond to externalities in one of two ways. Command-and-control policies regulate behavior directly. Market-based policies provide incentives so that private decision makers will choose to solve the problem on their own.

10-2a Command-and-Control Policies: Regulation The government can remedy an externality by either requiring or forbidding cer- tain behaviors. For example, it is a crime to dump poisonous chemicals into the water supply. In this case, the external costs to society far exceed the benefits to the polluter. The government therefore institutes a command-and-control policy that prohibits this act altogether.

196 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

In most cases of pollution, however, the situation is not this simple. Despite the stated goals of some environmentalists, it would be impossible to prohibit all polluting activity. For example, virtually all forms of transportation—even the horse— produce some undesirable polluting by-products. But it would not be sensible for the government to ban all transportation. As a result, instead of trying to eradicate pollution entirely, society has to weigh the costs and benefits to decide the kinds and quantities of pollution it will allow. In the United States, the Environmental Protection Agency (EPA) is the government agency tasked with developing and enforcing regulations aimed at protecting the environment.

Environmental regulations can take many forms. Sometimes the EPA dictates a maximum level of pollution that a factory may emit. Other times the EPA requires that firms adopt a particular technology to reduce emissions. In all cases, to design good rules, the government regulators need to know the details about spe- cific industries and about the alternative technologies that those industries could adopt. This information is often difficult for gov- ernment regulators to obtain.

10-2b Market-Based Policy 1: Corrective Taxes and Subsidies

Instead of regulating behavior in response to an externality, the government can use market-based policies to align private incentives with social efficiency. For instance, as we saw earlier, the government can internalize the externality by taxing activities that have negative externalities and subsidizing activities that have positive externalities. Taxes enacted to deal with the effects of negative externalities are called corrective taxes. They are also called Pigovian taxes after economist Arthur Pigou (1877–1959), an early advocate of their use. An ideal corrective tax would equal the external cost from an activity with negative externalities, and an ideal corrective subsidy would equal the external benefit from an activity with positive externalities.

Economists usually prefer corrective taxes to regulations as a way to deal with pollution because they can reduce pollution at a

lower cost to society. To see why, let us consider an example. Suppose that two factories—a paper mill and a steel mill—are each dumping

500 tons of glop into a river every year. The EPA decides that it wants to reduce the amount of pollution. It considers two solutions:

Regulation: The EPA could tell each factory to reduce its pollution to 300 tons of glop per year. Corrective tax: The EPA could levy a tax on each factory of $50,000 for each ton of glop it emits.

The regulation would dictate a level of pollution, whereas the tax would give fac- tory owners an economic incentive to reduce pollution. Which solution do you think is better?

corrective tax

a tax designed to induce

private decision makers

to take into account

the social costs that

arise from a negative

externality

“Declining to be vaccinated against contagious diseases such

as measles imposes costs on other people, which is a negative

externality.”

“Considering the costs of restricting free choice, and the share

of people in the US who choose not to vaccinate their children for

measles, the social benefit of mandating measles vaccines for all

Americans (except those with compelling medical reasons) would

exceed the social cost.”

Vaccines

ASK THE EXPERTS

0% uncertain

100% agree

0% disagree

What do economists say?

5% uncertain

89% agree

6% disagree

What do economists say?

Source: IGM Economic Experts Panel, March 10, 2015.

197CHAPTER 10 EXTERNALITIES

Most economists prefer the tax. To explain this preference, they would first point out that a tax is just as effective as regulation in reducing the overall level of pollution. The EPA can achieve whatever level of pollution it wants by setting the tax at the appropriate level. The higher the tax, the larger the reduction in pollu- tion. If the tax is high enough, the factories will close down altogether, reducing pollution to zero.

Although regulation and corrective taxes are both capable of reducing pollu- tion, the tax accomplishes this goal more efficiently. The regulation requires each factory to reduce pollution by the same amount. An equal reduction, however, is not necessarily the least expensive way to clean up the water. It is possible that the paper mill can reduce pollution at lower cost than the steel mill. If so, the paper mill would respond to the tax by reducing pollution substantially to avoid the tax, whereas the steel mill would respond by reducing pollution less and paying the tax.

In essence, the corrective tax places a price on the right to pollute. Just as markets allocate goods to those buyers who value them most highly, a correc- tive tax allocates pollution to those factories that face the highest cost of reduc- ing it. Thus, the EPA can achieve any level of pollution at the lowest total cost by using a tax.

Economists also argue that corrective taxes are better for the environment. Under the command-and-control policy of regulation, the factories have no rea- son to reduce emission further once they have reached the target of 300 tons of glop. By contrast, the tax gives the factories an incentive to develop cleaner technologies because a cleaner technology would reduce the amount of tax the factory has to pay.

Corrective taxes are unlike most other taxes. As we discussed in Chapter 8, most taxes distort incentives and move the allocation of resources away from the social optimum. The reduction in economic well-being—that is, in consumer and producer surplus—exceeds the amount of revenue the government raises, result- ing in a deadweight loss. By contrast, when externalities are present, society also cares about the well-being of the affected bystanders. Corrective taxes alter incen- tives that market participants face to account for the presence of externalities and thereby move the allocation of resources closer to the social optimum. Thus, while corrective taxes raise revenue for the government, they also enhance economic efficiency.

CASE STUDY

WHY IS GASOLINE TAXED SO HEAVILY? In many nations, gasoline is among the most heavily taxed goods. The gas tax can be viewed as a corrective tax aimed at addressing three negative externalities associated with driving:

Congestion: If you have ever been stuck in bumper-to-bumper traffic, you have probably wished that there were fewer cars on the road. A gasoline tax keeps congestion down by encouraging people to take public transportation, carpool more often, and live closer to work. Accidents: Whenever people buy large cars or sport utility vehicles, they may make themselves safer but they certainly put their neighbors at risk. According to the National Highway Traffic Safety Administration, a person driving a typical car is five times as likely to die if hit by a sport utility vehicle than if hit by another car. The gas tax is an indirect way of making

Arthur Pigou

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A LA

M Y

198 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

people pay when their large, gas-guzzling vehicles impose risk on others. It would induce them to take this risk into account when choosing what vehicle to purchase. Pollution: Cars cause smog. Moreover, the burning of fossil fuels such as gasoline is widely believed to be the primary cause of global warming. Experts disagree about how dangerous this threat is, but there is no doubt that the gas tax reduces the threat by discouraging the use of gasoline.

So the gas tax, rather than causing deadweight losses like most taxes, actually makes the economy work better. It means less traffic congestion, safer roads, and a cleaner environment.

How high should the tax on gasoline be? Most European countries impose gas- oline taxes that are much higher than those in the United States. Many observers have suggested that the United States should also tax gasoline more heavily. A 2007 study published in the Journal of Economic Literature summarized the research on the size of the various externalities associated with driving. It concluded that the optimal corrective tax on gasoline was $2.28 per gallon in 2005 dollars; af- ter adjusting for inflation, that amount is equivalent to about $2.78 per gallon in 2015 dollars. By contrast, the actual tax in the United States in 2015 was only about 50 cents per gallon.

The tax revenue from a gasoline tax could be used to lower taxes that distort incentives and cause deadweight losses, such as income taxes. In addition, some of the burdensome government regulations that require automakers to produce more fuel-efficient cars would prove unnecessary. This idea, however, has never been politically popular. ●

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199CHAPTER 10 EXTERNALITIES

Many policy analysts believe that taxing

carbon is the best approach to dealing

with global climate change.

The Most Sensible Tax of All

By Yoram Bauman and Shi-Ling Hsu

O n Sunday, the best climate policy in the

world got even better: British Columbia’s

carbon tax—a tax on the carbon content of all

fossil fuels burned in the province—increased

from $25 to $30 per metric ton of carbon diox-

ide, making it more expensive to pollute.

T h i s w a s g o o d n e w s n o t o n l y f o r t h e

environment but for nearly everyone who pays

taxes in British Columbia, because the carbon

tax is used to reduce taxes for individuals and

businesses. Thanks to this tax swap, British

Columbia has lowered its corporate income tax

rate to 10 percent from 12 percent, a rate that

is among the lowest in the Group of 8 wealthy

nations. Personal income taxes for people earn-

ing less than $119,000 per year are now the low-

est in Canada, and there are targeted rebates

for low-income and rural households.

The only bad news is that this is the last

increase scheduled in British Columbia. In our

view, the reason is simple: the province is wait-

ing for the rest of North America to catch up so

that its tax system will not become unbalanced

or put energy-intensive industries at a competi-

tive disadvantage.

The United States should jump at the chance

to adopt a similar revenue-neutral tax swap. It’s

an opportunity to reduce existing taxes, clean up

the environment and increase personal freedom

and energy security.

Let’s start with the economics. Substituting

a carbon tax for some of our current taxes—on

payroll, on investment, on businesses and on

workers—is a no-brainer. Why tax good things

when you can tax bad things, like emissions?

The idea has support from economists across

the political spectrum, from Arthur B. Laffer

and N. Gregory Mankiw on the right to Peter

Orszag and Joseph E. Stiglitz on the left. That’s

because economists know that a carbon tax

swap can reduce the economic drag created by

our current tax system and increase long-run

growth by nudging the economy away from con-

sumption and borrowing and toward saving and

investment.

Of course, carbon taxes also lower car-

bon emissions. Economic theory suggests that

putting a price on pollution reduces emissions

more affordably and more effectively than any

other measure. This conclusion is supported by

empirical evidence from previous market-based

policies, like those in the 1990 amendments to

the Clean Air Act that targeted sulfur dioxide

emissions. British Columbia’s carbon tax is only

four years old, but preliminary data show that

greenhouse gas emissions are down 4.5 percent

even as population and gross domestic product

have been growing. Sales of motor gasoline have

fallen by 2 percent since 2007, compared with a

5 percent increase for Canada as a whole.

What would a British Columbia-style carbon

tax look like in the United States? According

to our calculations, a British Columbia-style

$30 carbon tax would generate about $145 billion

a year in the United States. That could be used

to reduce individual and corporate income taxes

by 10 percent, and afterward there would still be

$35 billion left over. If recent budget deals are

any guide, Congress might choose to set aside

half of that remainder to reduce estate taxes (to

please Republicans) and the other half to offset

the impacts of higher fuel and electricity prices

resulting from the carbon tax on low-income

households through refundable tax credits or

a targeted reduction in payroll taxes (to please

Democrats).

Revenue from a carbon tax would most likely

decline over time as Americans reduce their

carbon emissions, but for many years to come

it could pay for big reductions in existing taxes.

It would also promote energy conservation and

steer investment into clean technology and other

productive economic activities.

Lastly, the carbon tax would actually give

Americans more control over how much they pay

in taxes. Households and businesses could reduce

their carbon tax payments simply by reducing

their use of fossil fuels. Americans would trim

their carbon footprints—and their tax burdens—

by investing in energy efficiency at home and at

work, switching to less- polluting vehicles and

pursuing countless other innovations. All of this

would be driven not by government mandates but

by Adam Smith’s invisible hand.

A carbon tax makes sense whether you are

a Republican or a Democrat, a climate change

skeptic or a believer, a conservative or a conser-

vationist (or both). We can move past the par-

tisan fireworks over global warming by turning

British Columbia’s carbon tax into a made-in-

America solution. ■

Mr. Bauman, an environmental economist, is a fel-

low at Sightline Institute in Seattle. Mr. Hsu, a law

professor at Florida State University, is the author

of “The Case for a Carbon Tax.”

Source: New York Times, July 5, 2012.

What Should We Do about Climate Change?

IN THE NEWS

200 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

10-2c Market-Based Policy 2: Tradable Pollution Permits

Returning to our example of the paper mill and the steel mill, let us suppose that, despite the advice of its economists, the EPA adopts the regulation and requires each factory to reduce its pol- lution to 300 tons of glop per year. Then one day, after the regu- lation is in place and both mills have complied, the two firms go to the EPA with a proposal. The steel mill wants to increase its emission of glop from 300 to 400 tons. The paper mill has agreed to reduce its emission from 300 to 200 tons if the steel mill pays it $5 million. The total emission of glop would remain at 600 tons. Should the EPA allow the two factories to make this deal?

From the standpoint of economic efficiency, allowing the deal is good policy. The deal must make the owners of the two facto- ries better off because they are voluntarily agreeing to it. More- over, the deal does not have any external effects because the total amount of pollution stays the same. Thus, social welfare is enhanced by allowing the paper mill to sell its pollution rights to the steel mill.

The same logic applies to any voluntary transfer of the right to pollute from one firm to another. If the EPA allows firms to make these deals, it will, in essence, create a new scarce resource: pol- lution permits. A market to trade these permits will eventually develop, and that market will be governed by the forces of supply and demand. The invisible hand will ensure that this new market allocates the right to pollute efficiently. That is, the permits will end up in the hands of those firms that value them most highly, as judged by their willingness to pay. A firm’s willingness to pay for the right to pollute, in turn, will depend on its cost of reducing pollution: The more costly it is for a firm to cut back on pollution, the more it will be willing to pay for a permit.

An advantage of allowing a market for pollution permits is that the initial allocation of pollution permits among firms does not matter from the standpoint of economic efficiency. Those firms that can reduce pollution at a low cost will sell whatever permits they get, while firms that can reduce pollution only at a high cost will buy whatever permits they need. As long as there is a free market for the pollution rights, the final allocation will be efficient regardless of the initial allocation.

Reducing pollution using pollution permits may seem very different from using corrective taxes, but the two policies have

much in common. In both cases, firms pay for their pollution. With corrective taxes, polluting firms must pay a tax to the government. With pollution permits, polluting firms must pay to buy the permits. (Even firms that already own per- mits must pay to pollute: The opportunity cost of polluting is what they could have received by selling their permits on the open market.) Both corrective taxes and pollution permits internalize the externality of pollution by making it costly for firms to pollute.

The similarity of the two policies can be seen by considering the market for pollution. Both panels in Figure 4 show the demand curve for the right to pollute.

“The Brookings Institution recently described a U.S. carbon tax

of $20 per ton, increasing at 4 percent per year, which would

raise an estimated $150 billion per year in federal revenues

over the next decade. Given the negative externalities created

by carbon dioxide emissions, a federal carbon tax at this rate

would involve fewer harmful net distortions to the U.S. economy

than a tax increase that generated the same revenue by raising

marginal tax rates on labor income across the board.”

“A tax on the carbon content of fuels would be a less expen-

sive way to reduce carbon-dioxide emissions than would a

collection of policies such as ‘corporate average fuel economy’

requirements for automobiles.”

Carbon Taxes

ASK THE EXPERTS

2% uncertain

98% agree

0% disagree

What do economists say?

3% uncertain

95% agree

2% disagree

What do economists say?

Source: IGM Economic Experts Panel, December 4, 2012 and December 20, 2011.

201CHAPTER 10 EXTERNALITIES

This curve shows that the lower the price of polluting, the more firms will choose to pollute. In panel (a), the EPA uses a corrective tax to set a price for pollution. In this case, the supply curve for pollution rights is perfectly elastic (because firms can pollute as much as they want by paying the tax), and the position of the demand curve determines the quantity of pollution. In panel (b), the EPA sets a quantity of pollution by issuing pollution permits. In this case, the supply curve for pollution rights is perfectly inelastic (because the quantity of pollution is fixed by the number of permits), and the position of the demand curve determines the price of pollution. Hence, the EPA can achieve any point on a given demand curve either by setting a price with a corrective tax or by setting a quantity with pollu- tion permits.

In some circumstances, however, selling pollution permits may be better than levying a corrective tax. Suppose the EPA wants no more than 600 tons of glop dumped into the river. But because the EPA does not know the demand curve for pollution, it is not sure what size tax would achieve that goal. In this case, it can simply auction off 600 pollution permits. The auction price would yield the appropriate size of the corrective tax.

The idea of the government auctioning off the right to pollute may at first sound like a creature of some economist’s imagination. And in fact, that is how the idea began. But increasingly, the EPA has used this system as a way to control pollution. A notable success story has been the case of sulfur dioxide (SO

2 ), a lead-

ing cause of acid rain. In 1990, amendments to the Clean Air Act required power plants to reduce SO

2 emissions substantially. At the same time, the amendments

FIGURE 4

The Equivalence of Corrective

Taxes and Pollution Permits

In panel (a), the EPA sets a price on pollution by levying a corrective tax, and the demand

curve determines the quantity of pollution. In panel (b), the EPA limits the quantity of

pollution by limiting the number of pollution permits, and the demand curve determines

the price of pollution. The price and quantity of pollution are the same in the two cases.

Quantity of Pollution

Price of Pollution

Demand for pollution rights

Corrective tax

(a) Corrective Tax

Quantity of Pollution

0 Q

Demand for pollution rights

Supply of pollution permits

(b) Pollution Permits

Price of Pollution

2. . . . which, together with the demand curve, determines the quantity of pollution.

2. . . . which, together with the demand curve, determines the price of pollution.

1. A corrective tax sets the price of pollution . . .

1. Pollution permits set the quantity of pollution . . .

202 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

set up a system that allowed plants to trade their SO 2 allowances. Initially, both

industry representatives and environmentalists were skeptical of the proposal, but over time the system reduced pollution with minimal disruption. Pollution permits, like corrective taxes, are now widely viewed as a cost-effective way to keep the environment clean.

10-2d Objections to the Economic Analysis of Pollution “We cannot give anyone the option of polluting for a fee.” This comment from the late Senator Edmund Muskie reflects the view of some environmentalists. Clean air and clean water, they argue, are fundamental human rights that should not be debased by considering them in economic terms. How can you put a price on clean air and clean water? The environment is so important, they claim, that we should protect it as much as possible, regardless of the cost.

Economists have little sympathy for this type of argument. To economists, good environmental policy begins by acknowledging the first of the Ten Principles of Economics in Chapter 1: People face trade-offs. Certainly, clean air and clean water have value. But their value must be compared to their opportunity cost—that is, to what one must give up to obtain them. Eliminating all pollution is impossi- ble. Trying to eliminate all pollution would reverse many of the technological advances that allow us to enjoy a high standard of living. Few people would be willing to accept poor nutrition, inadequate medical care, or shoddy housing to make the environment as clean as possible.

Economists argue that some environmental activists hurt their own cause by not thinking in economic terms. A clean environment can be viewed as simply another good. Like all normal goods, it has a positive income elasticity: Rich countries can afford a cleaner environment than poor ones and, therefore, usually have more rigorous environmental protection. In addition, like most other goods, clean air and clean water obey the law of demand: The lower the price of environ- mental protection, the more the public will want. The economic approach of using pollution permits and corrective taxes reduces the cost of environmental protec- tion and should, therefore, increase the public’s demand for a clean environment.

QuickQuiz A glue factory and a steel mill emit smoke containing a chemical that is

harmful if inhaled in large amounts. Describe three ways the town govern-

ment might respond to this externality. What are the pros and cons of each solution?

10-3 Private Solutions to Externalities

Although externalities tend to cause markets to be inefficient, government action is not always needed to solve the problem. In some circumstances, people can develop private solutions.

10-3a The Types of Private Solutions Sometimes the problem of externalities is solved with moral codes and social sanc- tions. Consider, for instance, why most people do not litter. Although there are laws against littering, these laws are not rigorously enforced. Most people choose not to litter just because it is the wrong thing to do. The Golden Rule taught to most children says, “Do unto others as you would have them do unto you.” This moral injunction tells us to take account of how our actions affect other people. In economic terms, it tells us to internalize externalities.

203CHAPTER 10 EXTERNALITIES

Another private solution to externalities involves charities. For example, the Sierra Club, whose goal is to protect the environment, is a nonprofit organiza- tion funded with private donations. As another example, colleges and universities receive gifts from alumni, corporations, and foundations in part because educa- tion has positive externalities for society. The government encourages this private solution to externalities through the tax system by allowing an income tax deduc- tion for charitable donations.

The private market can often solve the problem of externalities by relying on the self-interest of the relevant parties. Sometimes the solution takes the form of integrating different types of businesses. For example, consider an apple grower and a beekeeper who are located next to each other. Each business confers a posi- tive externality on the other: By pollinating the flowers on the trees, the bees help the orchard produce apples, while the bees use the nectar they get from the apple trees to produce honey. Nonetheless, when the apple grower is deciding how many trees to plant and the beekeeper is deciding how many bees to keep, they neglect the positive externality. As a result, the apple grower plants too few trees and the beekeeper keeps too few bees. These externalities could be internalized if the beekeeper bought the apple orchard or if the apple grower bought the bee- hives: Both activities would then take place within the same firm, and this single firm could choose the optimal number of trees and bees. Internalizing external- ities is one reason that some firms are involved in multiple types of businesses.

Another way for the private market to deal with external effects is for the inter- ested parties to enter into a contract. In the foregoing example, a contract between the apple grower and the beekeeper can solve the problem of too few trees and too few bees. The contract can specify the number of trees, the number of bees, and perhaps a payment from one party to the other. By setting the right number of trees and bees, the contract can solve the inefficiency that normally arises from these externalities and make both parties better off.

10-3b The Coase Theorem How effective is the private market in dealing with externalities? A famous result, called the Coase theorem after economist Ronald Coase, suggests that it can be very effective in some circumstances. According to the Coase theorem, if private parties can bargain over the allocation of resources at no cost, then the private mar- ket will always solve the problem of externalities and allocate resources efficiently.

To see how the Coase theorem works, consider an example. Suppose that Dick owns a dog named Spot. Spot barks and disturbs Jane, Dick’s neighbor. Dick gets a benefit from owning the dog, but the dog confers a negative externality on Jane. Should Dick be forced to send Spot to the pound, or should Jane have to suffer sleepless nights because of Spot’s barking?

Consider first what outcome is socially efficient. A social planner, considering the two alternatives, would compare the benefit that Dick gets from the dog to the cost that Jane bears from the barking. If the benefit exceeds the cost, it is effi- cient for Dick to keep the dog and for Jane to live with the barking. Yet if the cost exceeds the benefit, then Dick should get rid of the dog.

According to the Coase theorem, the private market will reach the efficient out- come on its own. How? Jane can simply offer to pay Dick to get rid of the dog. Dick will accept the deal if the amount of money Jane offers is greater than the benefit of keeping the dog.

By bargaining over the price, Dick and Jane can always reach the efficient out- come. For instance, suppose that Dick gets a $500 benefit from the dog and Jane

Coase theorem

the proposition that

if private parties can

bargain without cost

over the allocation of

resources, they can solve

the problem of externali-

ties on their own

204 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

bears an $800 cost from the barking. In this case, Jane can offer Dick $600 to get rid of the dog, and Dick will gladly accept. Both parties are better off than they were before, and the efficient outcome is reached.

It is possible, of course, that Jane would not be willing to offer any price that Dick would accept. For instance, suppose that Dick gets a $1,000 benefit from the dog and Jane bears an $800 cost from the barking. In this case, Dick would turn down any offer below $1,000, while Jane would not offer any amount above $800. Therefore, Dick ends up keeping the dog. Given these costs and benefits, how- ever, this outcome is efficient.

So far, we have assumed that Dick has the legal right to keep a barking dog. In other words, we have assumed that Dick can keep Spot unless Jane pays him enough to induce him to give up the dog voluntarily. But how different would the outcome be if Jane had the legal right to peace and quiet?

According to the Coase theorem, the initial distribution of rights does not mat- ter for the market’s ability to reach the efficient outcome. For instance, suppose that Jane can legally compel Dick to get rid of the dog. Having this right works to Jane’s advantage, but it probably will not change the outcome. In this case, Dick can offer to pay Jane to allow him to keep the dog. If the benefit of the dog to Dick exceeds the cost of the barking to Jane, then Dick and Jane will strike a bargain in which Dick keeps the dog.

Although Dick and Jane can reach the efficient outcome regardless of how rights are initially distributed, the distribution of rights is not irrelevant: It determines the distribution of economic well-being. Whether Dick has the right to a barking dog or Jane the right to peace and quiet determines who pays whom in the final bargain. But in either case, the two parties can bargain with each other and solve the externality problem. Dick will end up keeping the dog only if his benefit exceeds Jane’s cost.

To sum up: The Coase theorem says that private economic actors can potentially solve the problem of externalities among themselves. Whatever the initial distribution of rights, the interested parties can reach a bargain in which everyone is better off and the outcome is efficient.

10-3c Why Private Solutions Do Not Always Work Despite the appealing logic of the Coase theorem, private individuals on their own often fail to resolve the problems caused by externalities. The Coase theorem applies only when the interested parties have no trouble reaching and enforcing an agreement. In the real world, however, bargaining does not always work, even when a mutually beneficial agreement is possible.

Sometimes the interested parties fail to solve an externality problem because of transaction costs, the costs that parties incur in the process of agreeing to and following through on a bargain. In our example, imagine that Dick and Jane speak different languages so that, to reach an agreement, they need to hire a translator. If the benefit of solving the barking problem is less than the cost of the transla- tor, Dick and Jane might choose to leave the problem unsolved. In more realistic examples, the transaction costs are the expenses not of translators but of lawyers required to draft and enforce contracts.

At other times, bargaining simply breaks down. The recurrence of wars and labor strikes shows that reaching agreement can be difficult and that failing to reach agreement can be costly. The problem is often that each party tries to hold out for a better deal. For example, suppose that Dick gets a $500 benefit from having the dog and Jane bears an $800 cost from the barking. Although it is efficient for Jane to pay

transaction costs

the costs that parties

incur during the process

of agreeing to and follow-

ing through on a bargain

205CHAPTER 10 EXTERNALITIES

Whenever people come in close contact,

externalities abound.

Don’t Want Me to Recline My

Airline Seat? You Can Pay Me

By Josh Barro

I fly a lot. When I fly, I recline. I don’t feel guilty

about it. And I’m going to keep doing it, unless

you pay me to stop.

I bring this up because of a dispute you

may have heard about: On Sunday, a United

Airlines flight from Newark to Denver made an

unscheduled stop in Chicago to discharge two

passengers who had a dispute over seat reclin-

ing. According to The Associated Press, a man

in a middle seat installed the Knee Defender, a

$21.95 device that keeps a seat upright, on the

seatback in front of him.

A flight attendant asked him to remove the

device. He refused. The woman seated in front of

him turned around and threw water at him. The

pilot landed the plane and booted both passen-

gers off the flight.

Obviously, it’s improper to throw water

at another passenger on a flight, even if he

deserves it. But I’ve seen a distressing amount

of sympathy for Mr. Knee Defender, who wasn’t

just instigating a fight but usurping his fellow

passenger’s property rights. When you buy an

airline ticket, one of the things you’re buying is

the right to use your seat’s reclining function. If

this passenger so badly wanted the passenger

in front of him not to recline, he should have

paid her to give up that right.

I wrote an article to that effect in 2011, not-

ing that airline seats are an excellent case study

for the Coase Theorem. This is an economic theory

holding that it doesn’t matter very much who is ini-

tially given a property right; so long as you clearly

define it and transaction costs are low, people will

trade the right so that it ends up in the hands of

whoever values it most. That is, I own the right to

recline, and if my reclining bothers you, you can pay

me to stop. We could (but don’t) have an alterna-

tive system in which the passenger sitting behind

me owns the reclining rights. In that circumstance,

if I really care about being allowed to recline, I

could pay him to let me.

Donald Marron, a former director of the Con-

gressional Budget Office, agrees with this anal-

ysis, but with a caveat. Recline negotiations do

involve some transaction costs — passengers

don’t like bargaining over reclining positions

with their neighbors, perhaps because that

sometimes ends with water being thrown in

someone’s face.

Mr. Marron says we ought to allocate the

initial property right to the person likely to

care most about reclining, in order to reduce

the number of transactions that are necessary.

He further argues that it’s probably the person

sitting behind, as evidenced by the fact people

routinely pay for extra-legroom seats.

Mr. Marron is wrong about this last point. I

understand people don’t like negotiating with

strangers, but in hundreds of flights I have

taken, I have rarely had anyone complain to

me about my seat recline, and nobody has ever

offered me money, or anything else of value, in

exchange for sitting upright.

If sitting behind my reclined seat was such

misery, if recliners like me are “monsters,” as

Mark Hemingway of The Weekly Standard puts it,

why is nobody willing to pay me to stop? Peo-

ple talk a big game on social media about the

terribleness of reclining, but then people like to

complain about all sorts of things; if they really

cared that much, someone would have opened

his wallet and paid me by now. ■

Source: New York Times, April 27, 2014.

The Coase Theorem in Action

IN THE NEWS

TH E

IM A

G E

BA N

K/ G

ET TY

IM A

G ES

Dick to find another home for the dog, there are many prices that could lead to this outcome. Dick might demand $750, and Jane might offer only $550. As they haggle over the price, the inefficient outcome with the barking dog persists.

Reaching an efficient bargain is especially difficult when the number of inter- ested parties is large, because coordinating everyone is costly. For example, con- sider a factory that pollutes the water of a nearby lake. The pollution confers a negative externality on the local fishermen. According to the Coase theorem, if the pollution is inefficient, then the factory and the fishermen could reach a bargain in which the fishermen pay the factory not to pollute. If there are many fishermen,

206 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

however, trying to coordinate them all to bargain with the factory may be almost impossible.

When private bargaining does not work, the government can sometimes play a role. The government is an institution designed for collective action. In this exam- ple, the government can act on behalf of the fishermen, even when it is impracti- cal for the fishermen to act for themselves.

QuickQuiz Give an example of a private solution to an externality. What is the

Coase theorem? Why are private economic participants sometimes

unable to solve the problems caused by an externality?

10-4 Conclusion

The invisible hand is powerful but not omnipotent. A market’s equilibrium maxi- mizes the sum of producer and consumer surplus. When the buyers and sellers in the market are the only interested parties, this outcome is efficient from the stand- point of society as a whole. But when there are external effects, such as pollution, evaluating a market outcome requires taking into account the well-being of third parties as well. In this case, the invisible hand of the marketplace may fail to allo- cate resources efficiently.

In some cases, people can solve the problem of externalities on their own. The Coase theorem suggests that the interested parties can bargain among themselves and agree on an efficient solution. Sometimes, however, an efficient outcome can- not be reached, perhaps because the large number of interested parties makes bar- gaining difficult.

When people cannot solve the problem of externalities privately, the govern- ment often steps in. Yet even with government intervention, society should not abandon market forces entirely. Rather, the government can address the problem by requiring decision makers to bear the full costs of their actions. Pollution per- mits and corrective taxes on emissions, for instance, are designed to internalize the externality of pollution. These are increasingly the policies of choice for those interested in protecting the environment. Market forces, properly redirected, are often the best remedy for market failure.

1. Which of the following is an example of a positive

externality?

a. Dev mows Hillary’s lawn and is paid $100 for per-

forming the service.

b. While mowing the lawn, Dev’s lawnmower spews

out smoke that Hillary’s neighbor Kristen has to

breathe.

c. Hillary’s newly cut lawn makes her neighborhood

more attractive.

d. Hillary’s neighbors pay her if she promises to get

her lawn cut on a regular basis.

2. If the production of a good yields a negative exter-

nality, then the social-cost curve lies ________ the

supply curve, and the socially optimal quantity is

________ than the equilibrium quantity.

a. above, greater

b. above, less

c. below, greater

d. below, less

CHAPTER QuickQuiz

207CHAPTER 10 EXTERNALITIES

3. When the government levies a tax on a good equal

to the external cost associated with the good’s

production, it ________ the price paid by consumers

and makes the market outcome ________ efficient.

a. increases, more

b. increases, less

c. decreases, more

d. decreases, less

4. Which of the following statements about corrective

taxes is generally NOT true?

a. Economists prefer them to command-and-control

regulation.

b. They raise government revenue.

c. They cause deadweight losses.

d. They reduce the quantity sold in a market.

5. The government auctions off 500 units of pollution

rights. They sell for $50 per unit, raising total revenue

of $25,000. This policy is equivalent to a corrective

tax of _____ per unit of pollution.

a. $10

b. $50

c. $450

d. $500

6. The Coase theorem does NOT apply if

a. there is a significant externality between two

parties.

b. the court system vigorously enforces all contracts.

c. transaction costs make negotiating difficult.

d. both parties understand the externality fully.

SUMMARY

When a transaction between a buyer and seller directly

affects a third party, the effect is called an external-

ity. If an activity yields negative externalities, such as

pollution, the socially optimal quantity in a market is

less than the equilibrium quantity. If an activity yields

positive externalities, such as technology spillovers,

the socially optimal quantity is greater than the equi-

librium quantity.

Governments pursue various policies to remedy the

inefficiencies caused by externalities. Sometimes the

government prevents socially inefficient activity by

regulating behavior. Other times it internalizes an ex-

ternality using corrective taxes. Another public policy

is to issue permits. For example, the government could

protect the environment by issuing a limited number

of pollution permits. The result of this policy is similar

to imposing corrective taxes on polluters.

Those affected by externalities can sometimes solve

the problem privately. For instance, when one business

imposes an externality on another business, the two

businesses can internalize the externality by merging.

Alternatively, the interested parties can solve the prob-

lem by negotiating a contract. According to the Coase

theorem, if people can bargain without cost, then they

can always reach an agreement in which resources are

allocated efficiently. In many cases, however, reaching

a bargain among the many interested parties is diffi-

cult, so the Coase theorem does not apply.

KEY CONCEPTS

externality, p. 190

internalizing the externality, p. 193

corrective tax, p. 196

Coase theorem, p. 203

transaction costs, p. 204

QUESTIONS FOR REVIEW

1. Give an example of a negative externality and an

example of a positive externality.

2. Draw a supply-and-demand diagram to explain

the effect of a negative externality that occurs

as a result of a firm’s production process.

3. In what way does the patent system help society

solve an externality problem?

4. What are corrective taxes? Why do economists

prefer them to regulations as a way to protect

the environment from pollution?

208 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

5. List some of the ways that the problems caused by

externalities can be solved without government

intervention.

6. Imagine that you are a nonsmoker sharing a room

with a smoker. According to the Coase theorem,

what determines whether your roommate smokes in

the room? Is this outcome efficient? How do you and

your roommate reach this solution?

PROBLEMS AND APPLICATIONS

1. Consider two ways to protect your car from theft. The

Club (a steering wheel lock) makes it difficult for a

car thief to take your car. Lojack (a tracking system)

makes it easier for the police to catch the car thief who

has stolen it. Which of these methods conveys a nega-

tive externality on other car owners? Which conveys a

positive externality? Do you think there are any policy

implications of your analysis?

2. Consider the market for fire extinguishers.

a. Why might fire extinguishers exhibit positive

externalities?

b. Draw a graph of the market for fire extinguishers,

labeling the demand curve, the social-value curve,

the supply curve, and the social-cost curve.

c. Indicate the market equilibrium level of output

and the efficient level of output. Give an intuitive

explanation for why these quantities differ.

d. If the external benefit is $10 per extinguisher,

describe a government policy that would yield the

efficient outcome.

3. Greater consumption of alcohol leads to more motor

vehicle accidents and, thus, imposes costs on people

who do not drink and drive.

a. Illustrate the market for alcohol, labeling the

demand curve, the social-value curve, the supply

curve, the social-cost curve, the market equilib-

rium level of output, and the efficient level of

output.

b. On your graph, shade the area corresponding to

the deadweight loss of the market equilibrium.

(Hint: The deadweight loss occurs because some units of alcohol are consumed for which the social

cost exceeds the social value.) Explain.

4. Many observers believe that the levels of pollution in

our society are too high.

a. If society wishes to reduce overall pollution by a

certain amount, why is it efficient to have different

amounts of reduction at different firms?

b. Command-and-control approaches often rely on

uniform reductions among firms. Why are these

approaches generally unable to target the firms

that should undertake bigger reductions?

c. Economists argue that appropriate corrective

taxes or tradable pollution rights will result

in efficient pollution reduction. How do these

approaches target the firms that should undertake

bigger reductions?

5. The many identical residents of Whoville love

drinking Zlurp. Each resident has the following

willingness to pay for the tasty refreshment:

First bottle $5

Second bottle 4

Third bottle 3

Fourth bottle 2

Fifth bottle 1

Further bottles 0

a. The cost of producing Zlurp is $1.50, and the

competitive suppliers sell it at this price. (The

supply curve is horizontal.) How many bottles

will each Whovillian consume? What is each

person’s consumer surplus?

b. Producing Zlurp creates pollution. Each bottle has

an external cost of $1. Taking this additional cost

into account, what is total surplus per person in

the allocation you described in part (a)?

c. Cindy Lou Who, one of the residents of Whoville,

decides on her own to reduce her consumption

of Zlurp by one bottle. What happens to Cindy’s

welfare (her consumer surplus minus the cost of

pollution she experiences)? How does Cindy’s

decision affect total surplus in Whoville?

d. Mayor Grinch imposes a $1 tax on Zlurp. What

is consumption per person now? Calculate con-

sumer surplus, the external cost, government

revenue, and total surplus per person.

e. Based on your calculations, would you support

the mayor’s policy? Why or why not?

6. Bruno loves playing rock ‘n’ roll music at high

volume. Placido loves opera and hates rock ‘n’ roll.

Unfortunately, they are next-door neighbors in an

apartment building with paper-thin walls.

a. What is the externality here?

b. What command-and-control policy might the

landlord impose? Could such a policy lead to an

inefficient outcome?

c. Suppose the landlord lets the tenants do what-

ever they want. According to the Coase theorem,

209CHAPTER 10 EXTERNALITIES

how might Bruno and Placido reach an efficient

outcome on their own? What might prevent them

from reaching an efficient outcome?

7. Figure 4 shows that for any given demand curve

for the right to pollute, the government can achieve

the same outcome either by setting a price with a

corrective tax or by setting a quantity with pollution

permits. Suppose there is a sharp improvement in the

technology for controlling pollution.

a. Using graphs similar to those in Figure 4, illus-

trate the effect of this development on the demand

for pollution rights.

b. What is the effect on the price and quantity of

pollution under each regulatory system? Explain.

8. Suppose that the government decides to issue tradable

permits for a certain form of pollution.

a. Does it matter for economic efficiency whether the

government distributes or auctions the permits?

Why or why not?

b. If the government chooses to distribute the

permits, does the allocation of permits among

firms matter for efficiency? Explain.

9. There are three industrial firms in Happy Valley.

Initial Pollution Cost of Reducing

Firm Level Pollution by 1 Unit

A 30 units $20

B 40 units $30

C 20 units $10

The government wants to reduce pollution to 60 units,

so it gives each firm 20 tradable pollution permits.

a. Who sells permits and how many do they sell?

Who buys permits and how many do they buy?

Briefly explain why the sellers and buyers are

each willing to do so. What is the total cost of

pollution reduction in this situation?

b. How much higher would the costs of pollution

reduction be if the permits could not be traded?

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

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CHAPTER

11 Public Goods and Common Resources

A n old song lyric maintains that “the best things in life are free.” A moment’s thought reveals a long list of goods that the songwriter could have had in mind. Nature provides some of them, such as rivers, mountains, beaches,

lakes, and oceans. The government provides others, such as playgrounds, parks, and parades. In each case, people often do not pay a fee when they choose to enjoy the benefit of the good.

Goods without prices provide a special challenge for economic analysis. Most goods in our economy are allocated through markets, in which buyers pay for what they receive and sellers are paid for what they provide. For these goods,

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212 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

prices are the signals that guide the decisions of buyers and sellers, and these decisions lead to an efficient allocation of resources. When goods are available free of charge, however, the market forces that normally allocate resources in our economy are absent.

In this chapter, we examine the problems that arise for the allocation of resources when there are goods without market prices. Our analysis will shed light on one of the Ten Principles of Economics in Chapter 1: Governments can some- times improve market outcomes. When a good does not have a price attached to it, private markets cannot ensure that the good is produced and consumed in the proper amounts. In such cases, government policy can potentially remedy the market failure and increase economic well-being.

11-1 The Different Kinds of Goods How well do markets work in providing the goods that people want? The answer to this question depends on the good being considered. As we discussed in Chapter 7, a market can provide the efficient number of ice-cream cones: The price of ice-cream cones adjusts to balance supply and demand, and this equilibrium maximizes the sum of producer and consumer surplus. Yet as we discussed in Chapter 10, the market cannot be counted on to prevent aluminum manufacturers from polluting the air we breathe: Buyers and sellers in a market typically do not take into account the external effects of their decisions. Thus, markets work well if the good is ice cream, but they don’t if the good is clean air.

When thinking about the various goods in the economy, it is useful to group them according to two characteristics:

• Is the good excludable? That is, can people be prevented from using the good?

• Is the good rival in consumption? That is, does one person’s use of the good reduce another person’s ability to use it?

Using these two characteristics, Figure 1 divides goods into four categories:

1. Private goods are both excludable and rival in consumption. Consider an ice-cream cone, for example. An ice-cream cone is excludable because it is possible to prevent someone from eating one—you just don’t give it to her. An ice-cream cone is rival in consumption because if one person eats an ice-cream cone, another person cannot eat the same cone. Most goods in the economy are private goods like ice-cream cones: You don’t get one unless you pay for it, and once you have it, you are the only person who benefits. When we analyzed supply and demand in Chapters 4, 5, and 6 and the effi- ciency of markets in Chapters 7, 8, and 9, we implicitly assumed that goods were both excludable and rival in consumption.

2. Public goods are neither excludable nor rival in consumption. That is, peo- ple cannot be prevented from using a public good, and one person’s use of a public good does not reduce another person’s ability to use it. For example, a tornado siren in a small town is a public good. Once the siren sounds, it is impossible to prevent any single person from hearing it (so it is not exclud- able). Moreover, when one person gets the benefit of the warning, she does not reduce the benefit to anyone else (so it is not rival in consumption).

excludability

the property of a good

whereby a person can be

prevented from using it

rivalry in consumption

the property of a good

whereby one person’s

use diminishes other

people’s use

private goods

goods that are both

excludable and rival in

consumption

public goods

goods that are neither

excludable nor rival in

consumption

213CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES

FIGURE 1

Four Types of Goods

Goods can be grouped into four

categories according to two

characteristics: (1) A good is

excludable if people can be pre-

vented from using it. (2) A good

is rival in consumption if one

person’s use of the good dimin-

ishes other people’s use of it.

This diagram gives examples of

goods in each category.

Rival in consumption?

Yes

• Ice-cream cones • Clothing • Congested toll roads

• Fire protection • Cable TV • Uncongested toll roads

Private Goods Club Goods

Excludable?

• Fish in the ocean • The environment • Congested nontoll roads

• Tornado siren • National defense • Uncongested nontoll roads

Common Resources Public Goods

3. Common resources are rival in consumption but not excludable. For example, fish in the ocean are rival in consumption: When one person catches fish, there are fewer fish for the next person to catch. But these fish are not an excludable good because it is difficult to stop fishermen from taking fish out of a vast ocean.

4. Club goods are excludable but not rival in consumption. For instance, consider fire protection in a small town. It is easy to exclude someone from using this good: The fire department can just let her house burn down. But fire protection is not rival in consumption: Once a town has paid for the fire department, the additional cost of protecting one more house is small. (We discuss club goods again in Chapter 15, where we see that they are one type of a natural monopoly.)

Although Figure 1 offers a clean separation of goods into four categories, the boundaries between the categories are sometimes fuzzy. Whether goods are excludable or rival in consumption is often a matter of degree. Fish in an ocean may not be excludable because monitoring fishing is so difficult, but a large enough coast guard could make fish at least partly excludable. Similarly, although fish are generally rival in consumption, this would be less true if the population of fishermen were small relative to the population of fish. (Think of North American fishing waters before the arrival of European settlers.) For purposes of our analy- sis, however, it will be helpful to group goods into these four categories.

In this chapter, we examine goods that are not excludable: public goods and common resources. Because people cannot be prevented from using these goods, they are available to everyone free of charge. The study of public goods and common resources is closely related to the study of externalities. For both of these types of goods, externalities arise because something of value has no price attached to it. If one person were to provide a public good, such as a tornado siren, other people would be better off. They would receive a benefit without paying for it—a positive externality. Similarly, when one person uses a common resource such as the fish in the ocean, other people are worse off because there are fewer fish to catch. They suffer a loss but are not compensated for it—a negative externality. Because of these external effects, private decisions about consumption and production can lead to an inefficient allocation of resources, and government intervention can potentially raise economic well-being.

QuickQuiz Define public goods and common resources and give an example of

each.

common resources

goods that are rival in

consumption but not

excludable

club goods

goods that are

excludable but not rival

in consumption

214 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

11-2 Public Goods To understand how public goods differ from other goods and why they present problems for society, let’s consider an example: a fireworks display. This good is not excludable because it is impossible to prevent someone from seeing fireworks, and it is not rival in consumption because one person’s enjoyment of fireworks does not reduce anyone else’s enjoyment of them.

11-2a The Free-Rider Problem The citizens of Smalltown, U.S.A., like seeing fireworks on the Fourth of July. Each of the town’s 500 residents places a $10 value on the experience for a total benefit of $5,000. The cost of putting on a fireworks display is $1,000. Because the $5,000 benefit exceeds the $1,000 cost, it is efficient for Smalltown to have a fire- works display on the Fourth of July.

Would the private market produce the efficient outcome? Probably not. Imag- ine that Ella, a Smalltown entrepreneur, decided to put on a fireworks display. Ella would surely have trouble selling tickets to the event because her potential customers would quickly figure out that they could see the fireworks even with- out a ticket. Because fireworks are not excludable, people have an incentive to be free riders. A free rider is a person who receives the benefit of a good but does not pay for it. Because people would have an incentive to be free riders rather than ticket buyers, the market would fail to provide the efficient outcome.

One way to view this market failure is that it arises because of an externality. If Ella puts on the fireworks display, she confers an external benefit on those who see the display without paying for it. When deciding whether to put on the display, however, Ella does not take the external benefits into account. Even though the fireworks display is socially desirable, it is not profitable. As a result, Ella makes the privately rational but socially inefficient decision not to put on the display.

Although the private market fails to supply the fireworks display demanded by Smalltown residents, the solution to Smalltown’s problem is obvious: The local government can sponsor a Fourth of July celebration. The town council can raise everyone’s taxes by $2 and use the revenue to hire Ella to produce the fireworks. Everyone in Smalltown is better off by $8—the $10 at which residents value the fireworks minus the $2 tax bill. Ella can help Smalltown reach the effi- cient outcome as a public employee even though she could not do so as a private entrepreneur.

The story of Smalltown is simplified but realistic. In fact, many local govern- ments in the United States pay for fireworks on the Fourth of July. Moreover, the story shows a general lesson about public goods: Because public goods are not excludable, the free-rider problem prevents the private market from supplying them. The government, however, can remedy the problem. If the government decides that the total benefits of a public good exceed its costs, it can provide the public good, pay for it with tax revenue, and potentially make everyone better off.

11-2b Some Important Public Goods There are many examples of public goods. Here we consider three of the most important.

National Defense The defense of a country from foreign aggressors is a classic example of a public good. Once the country is defended, it is impossible to pre- vent any single person from enjoying the benefit of this defense. And when one

free rider

a person who receives

the benefit of a good but

avoids paying for it

215CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES

person enjoys the benefit of national defense, she does not reduce the ben- efit to anyone else. Thus, national defense is neither excludable nor rival in consumption.

National defense is also one of the most expensive public goods. In 2014, the U.S. federal government spent a total of $748 billion on national defense, more than $2,346 per person. People disagree about whether this amount is too small or too large, but almost no one doubts that some gov- ernment spending for national defense is necessary. Even economists who advocate small government agree that national defense is a public good the government should provide.

Basic Research Knowledge is created through research. In evaluating the appropriate public policy toward knowledge creation, it is important to distinguish general knowledge from specific technological knowledge. Spe- cific technological knowledge, such as the invention of a longer-lasting battery, a smaller microchip, or a better digital music player, can be patented. The pat- ent gives the inventor the exclusive right to the knowledge she has created for a period of time. Anyone else who wants to use the patented information must pay the inventor for the right to do so. In other words, the patent makes the knowl- edge created by the inventor excludable.

By contrast, general knowledge is a public good. For example, a mathema- tician cannot patent a theorem. Once a theorem is proven, the knowledge is not excludable: The theorem enters society’s general pool of knowledge that anyone can use without charge. The theorem is also not rival in consumption: One person’s use of the theorem does not prevent any other person from using the theorem.

Profit-seeking firms spend a lot on research trying to develop new products that they can patent and sell, but they do not spend much on basic research. Their incentive, instead, is to free ride on the general knowledge created by others. As a result, in the absence of any public policy, society would devote too few resources to creating new knowledge.

The government tries to provide the public good of general knowledge in var- ious ways. Government agencies, such as the National Institutes of Health and the National Science Foundation, subsidize basic research in medicine, mathe- matics, physics, chemistry, biology, and even economics. Some people justify gov- ernment funding of the space program on the grounds that it adds to society’s pool of knowledge. Determining the appropriate level of government support for these endeavors is difficult because the benefits are hard to measure. Moreover, the members of Congress who appropriate funds for research usually have little expertise in science and, therefore, are not in the best position to judge what lines of research will produce the largest benefits. So, while basic research is surely a public good, we should not be surprised if the public sector fails to pay for the right amount and the right kinds.

Fighting Poverty Many government programs are aimed at helping the poor. The welfare system (officially called TANF, Temporary Assistance for Needy Families) provides a small income for some poor families. Food stamps (officially called SNAP, Supplemental Nutrition Assistance Program) subsidize the purchase of food for those with low incomes. And various government housing programs make shelter more affordable. These antipoverty programs are financed by taxes paid by families that are financially more successful.

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“I like the concept if we can do it with no new taxes.”

216 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

Economists disagree among themselves about what role the government should play in fighting poverty. We discuss this debate more fully in Chapter 20, but here we note one important argument: Advocates of antipoverty programs claim that fighting poverty is a public good. Even if everyone prefers living in a society without poverty, fighting poverty is not a “good” that private actions will adequately provide.

To see why, suppose someone tried to organize a group of wealthy individuals to try to eliminate poverty. They would be providing a public good. This good would not be rival in consumption: One person’s enjoyment of living in a society without poverty would not reduce anyone else’s enjoyment of it. The good would not be excludable: Once poverty is eliminated, no one can be prevented from tak- ing pleasure in this fact. As a result, there would be a tendency for people to free ride on the generosity of others, enjoying the benefits of poverty elimination with- out contributing to the cause.

Because of the free-rider problem, eliminating poverty through private charity will probably not work. Yet government action can solve this problem. Taxing the wealthy to raise the living standards of the poor can potentially make everyone better off. The poor are better off because they now enjoy a higher standard of living, and those pay- ing the taxes are better off because they enjoy living in a society with less poverty.

CASE STUDY

ARE LIGHTHOUSES PUBLIC GOODS? Some goods can switch between being public goods and being private goods depending on the circumstances. For example, a fireworks display is a public good if performed in a town with many residents. Yet if performed

at a private amusement park, such as Walt Disney World, a fireworks display is more like a private good because visitors to the park pay for admission.

Another example is a lighthouse. Economists have long used lighthouses as an example of a public good. Lighthouses mark specific locations along the coast so

that passing ships can avoid treacherous waters. The benefit that the lighthouse provides to the ship captain is neither excludable nor rival in consumption, so each captain has an incentive to free ride by using the lighthouse to navigate without paying for the service. Because of this free-rider problem, private markets usually fail to provide the light- houses that ship captains need. As a result, most lighthouses today are operated by the government.

In some cases, however, lighthouses have been closer to private goods. On the coast of England in the 19th century, for example, some lighthouses were privately owned and operated. Instead of trying to charge ship captains for the service, however, the owner of the lighthouse charged the owner of the nearby port. If the port owner did not pay, the lighthouse owner turned off the light, and ships avoided that port.

In deciding whether something is a public good, one must determine who the beneficiaries are and whether these beneficiaries can be excluded from using the good. A free-rider problem arises when the number of beneficiaries is large and exclusion of any one of them is impossible. If a lighthouse benefits many ship captains, it is a public good. If it primarily benefits a single port owner, it is more like a private good. ●

11-2c The Difficult Job of Cost–Benefit Analysis So far we have seen that the government provides public goods because the private market on its own will not produce an efficient quantity. Yet deciding that the government must play a role is only the What kind of good is this?

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217CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES

first step. The government must then determine what kinds of public goods to provide and in what quantities.

Suppose that the government is considering a public project, such as building a new highway. To judge whether to build the highway, it must compare the total benefits for all those who would use it to the costs of building and maintaining it. To make this decision, the government might hire a team of economists and engi- neers to conduct a study, called a cost–benefit analysis, to estimate the total costs and benefits of the project to society as a whole.

Cost–benefit analysts have a tough job. Because the highway will be available to everyone free of charge, there is no price with which to judge the value of the highway. Simply asking people how much they would value the highway is not reliable: Quantifying benefits is difficult using the results from a questionnaire, and respondents have little incentive to tell the truth. Those who would use the highway have an incentive to exaggerate the benefit they receive to get the high- way built. Those who would be harmed by the highway have an incentive to exaggerate the costs to them to prevent the highway from being built.

The efficient provision of public goods is, therefore, intrinsically more difficult than the efficient provision of private goods. When buyers of a private good enter a market, they reveal the value they place on it through the prices they are will- ing to pay. At the same time, sellers reveal their costs with the prices they are willing to accept. The equilibrium is an efficient allocation of resources because it reflects all this information. By contrast, cost–benefit analysts do not have any price signals to observe when evaluating whether the government should provide a public good and how much to provide. Their findings on the costs and benefits of public projects are rough approximations at best.

CASE STUDY

HOW MUCH IS A LIFE WORTH? Imagine that you have been elected to serve as a member of your local town council. The town engineer comes to you with a proposal: The town can spend $10,000 to install and operate a traffic light at a town

intersection that now has only a stop sign. The benefit of the traffic light is increased safety. The engineer estimates, based on data from similar intersections, that the traf- fic light would reduce the risk of a fatal traffic accident over the lifetime of the traffic light from 1.6 to 1.1 percent. Should you spend the money for the new light?

To answer this question, you turn to cost–benefit analysis. But you quickly run into an obstacle: The costs and benefits must be measured in the same units if you are to compare them meaningfully. The cost is measured in dollars, but the benefit—the possibility of saving a person’s life—is not directly monetary. To make your decision, you have to put a dollar value on a human life.

At first, you may be tempted to conclude that a human life is priceless. After all, there is probably no amount of money that you could be paid to voluntarily give up your life or that of a loved one. This suggests that a human life has an infinite dollar value.

For the purposes of cost–benefit analysis, however, this answer leads to nonsen- sical results. If we truly placed an infinite value on human life, we should place traffic lights on every street corner, and we should all drive large cars loaded with the latest safety features. Yet traffic lights are not at every corner, and people some- times choose to pay less for smaller cars without safety options such as side-impact air bags or antilock brakes. In both our public and private decisions, we are at times willing to risk our lives to save some money.

Once we have accepted the idea that a person’s life has an implicit dollar value, how can we determine what that value is? One approach, sometimes used by

cost–benefit analysis

a study that compares

the costs and benefits

to society of providing

a public good

218 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

courts to award damages in wrongful-death suits, is to look at the total amount of money a person would have earned if she had lived. Economists are often critical of this approach because it ignores other opportunity costs of losing one’s life. It thus has the bizarre implication that the life of a retired or disabled person has no value.

A better way to value human life is to look at the risks that people are volun- tarily willing to take and how much they must be paid for taking them. For exam- ple, mortality risk varies across jobs. Construction workers in high-rise buildings face greater risk of death on the job than office workers do. By comparing wages in risky and less risky occupations, controlling for education, experience, and other determinants of wages, economists can get some sense about what value people put on their own lives. Studies using this approach conclude that the value of a human life is about $10 million.

We can now return to our original example and respond to the town engineer. The traffic light reduces the risk of fatality by 0.5 percentage points. Thus, the expected benefit from installing the traffic light is 0.005 3 $10 million, or $50,000. This estimate of the benefit exceeds the cost of $10,000, so you should approve the project. ●

QuickQuiz What is the free-rider problem? Why does the free-rider problem induce

the government to provide public goods? • How should the government

decide whether to provide a public good?

11-3 Common Resources Common resources, like public goods, are not excludable: They are available free of charge to anyone who wants to use them. Common resources are, how- ever, rival in consumption: One person’s use of the common resource reduces other people’s ability to use it. Thus, common resources give rise to a new problem: Once the good is provided, policymakers need to be concerned about how much it is used. This problem is best understood from the classic parable called the Tragedy of the Commons.

11-3a The Tragedy of the Commons Consider life in a small medieval town. Of the many economic activities that take place in the town, one of the most important is raising sheep. Many of the town’s families own flocks of sheep and support themselves by selling the sheep’s wool, which is used to make clothing.

As our story begins, the sheep spend much of their time grazing on the land surrounding the town, called the Town Common. No family owns the land. Instead, the town residents own the land collectively, and all the residents are allowed to graze their sheep on it. Collective ownership works well because land is plentiful. As long as everyone can get all the good grazing land they want, the Town Common is not rival in consumption, and allowing residents’ sheep to graze for free causes no problems. Everyone in the town is happy.

As the years pass, the population of the town grows, and so does the number of sheep grazing on the Town Common. With a growing number of sheep and a fixed amount of land, the land starts to lose its ability to replenish itself. Even- tually, the land is grazed so heavily that it becomes barren. With no grass left on the Town Common, raising sheep is impossible, and the town’s once prosperous wool industry disappears. Many families lose their source of livelihood.

Tragedy of the Commons

a parable that illustrates

why common resources are

used more than is desir-

able from the standpoint

of society as a whole

219CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES

What causes the tragedy? Why do the shepherds allow the sheep population to grow so large that it destroys the Town Common? The reason is that social and private incentives differ. Avoiding the destruction of the grazing land depends on the collective action of the shepherds. If the shepherds acted together, they could reduce the sheep population to a size that the Town Common can support. Yet no single family has an incentive to reduce the size of its own flock because each flock represents only a small part of the problem.

In essence, the Tragedy of the Commons arises because of an externality. When one family’s flock grazes on the common land, it reduces the quality of the land available for other families. Because people neglect this negative externality when deciding how many sheep to own, the result is an excessive number of sheep.

If the tragedy had been foreseen, the town could have solved the problem in various ways. It could have regulated the number of sheep in each family’s flock, internalized the externality by taxing sheep, or auctioned off a limited number of sheep-grazing permits. That is, the medieval town could have dealt with the problem of overgrazing in the way that modern society deals with the problem of pollution.

In the case of land, however, there is a simpler solution. The town can divide the land among town families. Each family can enclose its parcel of land with a fence and then protect it from excessive grazing. In this way, the land becomes a private good rather than a common resource. This outcome in fact occurred during the enclosure movement in England during the 17th century.

The Tragedy of the Commons is a story with a general lesson: When one person uses a common resource, she diminishes other people’s enjoyment of it. Because of this negative externality, common resources tend to be used excessively. The government can solve the problem by using regulation or taxes to reduce con- sumption of the common resource. Alternatively, the government can sometimes turn the common resource into a private good.

This lesson has been known for thousands of years. The ancient Greek philos- opher Aristotle pointed out the problem with common resources: “What is com- mon to many is taken least care of, for all men have greater regard for what is their own than for what they possess in common with others.”

11-3b Some Important Common Resources There are many examples of common resources. In almost all cases, the same problem arises as in the Tragedy of the Com- mons: Private decision makers use the common resource too much. As a result, governments often regulate behavior or im- pose fees to mitigate the problem of overuse.

Clean Air and Water As we discussed in Chapter 10, markets do not adequately protect the environment. Pollution is a negative ex- ternality that can be remedied with regulations or with corrective taxes on polluting activities. One can view this market failure as an example of a common-resource problem. Clean air and clean water are common resources like open grazing land, and excessive pollution is like excessive grazing. Environmental degradation is a modern Tragedy of the Commons.

Congested Roads Roads can be either public goods or com- mon resources. If a road is not congested, then one person’s use does not affect anyone else. In this case, use is not rival in

“In general, using more congestion charges in crowded trans-

portation networks — such as higher tolls during peak travel

times in cities, and peak fees for airplane takeoff and landing

slots — and using the proceeds to lower other taxes would

make citizens on average better off.”

2% uncertain

98% agree

0% disagree

What do economists say?

Congestion Pricing

ASK THE EXPERTS

Source: IGM Economic Experts Panel, January 11, 2012.

220 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

Many economists think drivers should

be charged more for using roads. Here

is why.

Why You’ll Love Paying for

Roads That Used to Be Free

By Eric A. Morris

T o end the scourge of traffic congestion,

Julius Caesar banned most carts from

the streets of Rome during daylight hours.

It didn’t work—traffic jams just shifted to

dusk. Two thousand years later, we have

put a man on the moon and developed gar-

ments infinitely more practical than the

toga, but we seem little nearer to solving

the congestion problem.

If you live in a city, particularly a large

one, you probably need little convincing that

traffic congestion is frustrating and wasteful.

According to the Texas Transportation Insti-

tute, the average American urban traveler

lost 38 hours, nearly one full work week, to

congestion in 2005. And congestion is getting

worse, not better; urban travelers in 1982

were delayed only 14 hours that year.

Americans want action, but unfortunately

there aren’t too many great ideas about what that

action might be. As Anthony Downs’s excellent

book Still Stuck in Traffic: Coping With Peak-Hour

Traffic Congestion chronicles, most of the proposed

solutions are too difficult to implement, won’t work,

or both.

Fortunately, there is one remedy which is

both doable and largely guaranteed to suc-

ceed. In the space of a year or two we could

have you zipping along the 405 or the LIE

at the height of rush hour at a comfortable

55 miles per hour.

There’s just one small problem with this

silver bullet for congestion: many people

seem to prefer the werewolf. Despite its mer-

its, this policy, which is known as “congestion

pricing,” “value pricing,” or “variable toll-

ing,” is not an easy political sell.

For decades, economists and other trans-

portation thinkers have advocated imposing

tolls that vary with congestion levels on

roadways. Simply put, the more congestion,

the higher the toll, until the congestion

goes away.

To many people, this sounds like a scheme

by mustache-twirling bureaucrats and their

academic apologists to fleece drivers out of

their hard-earned cash. Why should drivers

have to pay to use roads their tax dollars have

already paid for? Won’t the remaining free

roads be swamped as drivers are forced off

the tolled roads? Won’t the working-class and

poor be the victims here, as the tolled routes

turn into “Lexus lanes”?

And besides, adopting this policy would

mean listening to economists, and who wants

to do that?

There’s a real problem with this logic,

which is that, on its own terms, it makes per-

fect sense (except for the listening to econo-

mists part). Opponents of tolls are certainly

not stupid, and their arguments deserve

serious consideration. But in the end, their

concerns are largely overblown, and the bene-

fits of tolling swamp the potential costs.

Unfortunately, it can be hard to convey this

because the theory behind tolling is somewhat

complex and counterintuitive. This is too bad,

because variable tolling is an excellent public

policy. Here’s why: the basic economic theory is

that when you give out something valuable—in

this case, road space—for less than its true

value, shortages result.

Ultimately, there’s no free lunch; instead

of paying with money, you pay with the effort

The Case for Toll Roads

IN THE NEWS

consumption, and the road is a public good. Yet if a road is congested, then use of that road yields a negative externality. When one person drives on the road, it becomes more crowded, and other people must drive more slowly. In this case, the road is a common resource.

One way for the government to address the problem of road congestion is to charge drivers a toll. A toll is, in essence, a corrective tax on the externality of con- gestion. Sometimes, as in the case of local roads, tolls are not a practical solution because the cost of collecting them is too high. But several major cities, including London and Stockholm, have found increasing tolls to be a very effective way to reduce congestion.

Sometimes congestion is a problem only at certain times of day. If a bridge is heavily traveled only during rush hour, for instance, the congestion externality is largest during this time. The efficient way to deal with these externalities is

221CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES

and time needed to acquire the good. Think of

Soviet shoppers spending their lives in end-

less queues to purchase artificially low-priced

but exceedingly scarce goods. Then think of

Americans who can fulfill nearly any consum-

erist fantasy quickly but at a monetary cost.

Free but congested roads have left us shiver-

ing on the streets of Moscow.

To consider it another way, delay is an

externality imposed by drivers on their peers.

By driving onto a busy road and contribut-

ing to congestion, drivers slow the speeds of

others—but they never have to pay for it, at

least not directly. In the end, of course, every-

body pays, because as we impose congestion

on others, others impose it on us. This degen-

erates into a game that nobody can win.

Markets work best when externalities

are internalized: i.e., you pay for the hassle

you inflict on others…. Using tolls to help

internalize the congestion externality would

somewhat reduce the number of trips made

on the most congested roads at the peak

usage periods; some trips would be moved to

less congested times and routes, and others

would be foregone entirely. This way we would

cut down on the congestion costs we impose

on each other.

Granted, tolls cannot fully cope with

accidents and other incidents, which are

major causes of delay. But pricing can largely

eliminate chronic, recurring congestion. No

matter how high the demand for a road, there

is a level of toll that will keep it flowing freely.

To make tolling truly effective, the price

must be right. Too high a price drives away

too many cars and the road does not function

at its capacity. Too low a price and congestion

isn’t licked.

The best solution is to vary the tolls in

real time based on an analysis of current

traffic conditions. Pilot toll projects on roads

(like the I-394 in Minnesota and the I-15 in

Southern California) use sensors embedded

in the pavement to monitor the number and

speeds of vehicles on the facility.

A s i m p l e c o m p u t e r p r o g r a m t h e n

determines the number of cars that should be

allowed in. The computer then calculates the

level of toll that will attract that number of

cars—and no more. Prices are then updated

every few minutes on electronic message

signs. Hi-tech transponders and antenna

arrays make waiting at toll booths a thing of

the past.

The bottom line is that speeds are kept

high (over 45 m.p.h.) so that throughput

is higher than when vehicles are allowed to

crowd all at once onto roadways at rush hour,

slowing traffic to a crawl.

To maximize efficiency, economists would

like to price all travel, starting with the

freeways. But given that elected officials have

no burning desire to lose their jobs, a more

realistic option, for now, is to toll just some

freeway lanes that are either new capacity

or underused carpool lanes. The other lanes

would be left free—and congested. Drivers

will then have a choice: wait or pay. Granted,

neither is ideal. But right now drivers have no

choice at all.

What’s the bottom line here? The state of

Washington recently opened congestion-priced

lanes on its State Route 167. The peak toll in

the first month of operation (reached on the

evening of Wednesday, May 21) was $5.75.

I know, I know, you would never pay such an

exorbitant amount when America has taught

you that free roads are your birthright. But that

money bought Washington drivers a 27- minute

time savings. Is a half hour of your time

worth $6?

I think I already know the answer, and it

is “it depends.” Most people’s value of time

varies widely depending on their activities

on any given day. Late for picking the kids

up from daycare? Paying $6 to save a half

hour is an incredible bargain. Have to clean

the house? The longer your trip home takes,

the better. Tolling will introduce a new level

of flexibility and freedom into your life, giving

you the power to tailor your travel costs to fit

your schedule. ■

Source: Freakonomics blog, January 6, 2009.

to charge higher tolls during rush hour. This toll would provide an incentive for drivers to alter their schedules, reducing traffic when congestion is greatest.

Another policy that responds to the problem of road congestion (discussed in the previous chapter) is the tax on gasoline. A higher gasoline tax increases the price of gasoline, reduces the amount that people drive, and reduces road conges- tion. The gasoline tax is an imperfect solution to congestion, however, because it affects other decisions besides the amount of driving on congested roads. In par- ticular, the tax also discourages driving on uncongested roads, even though there is no congestion externality for these roads.

Fish, Whales, and Other Wildlife Many species of animals are common resources. Fish and whales, for instance, have commercial value, and anyone can go to the ocean and catch whatever is available. Each person has little incentive

222 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

to maintain the species for the next year. Just as excessive grazing can destroy the Town Common, excessive fishing and whaling can destroy commercially valu- able marine populations.

Oceans remain one of the least regulated common resources. Two problems prevent an easy solution. First, many countries have access to the oceans, so any solution would require international cooperation among countries that hold dif- ferent values. Second, because the oceans are so vast, enforcing any agreement is difficult. As a result, fishing rights have been a frequent source of international tension among normally friendly countries.

Within the United States, various laws aim to manage the use of fish and other wildlife. For example, the government charges for fishing and hunting licenses, and it restricts the lengths of the fishing and hunting seasons. Fishermen are often required to throw back small fish, and hunters can kill only a limited number of animals. All these laws reduce the use of a common resource and help maintain animal populations.

CASE STUDY

WHY THE COW IS NOT EXTINCT Throughout history, many species of animals have been threatened with extinction. When Europeans first arrived in North America, more than 60 million buffalo roamed the continent. Unfortunately,

however, hunting the buffalo was so popular during the 19th century that by 1900 the animal’s population had fallen to about 400 before the government stepped in to protect the species. In some African countries today, elephants face a similar challenge, as poachers kill them for the ivory in their tusks.

Yet not all animals with commercial value face this threat. The cow, for exam- ple, is a valuable source of food, but no one worries that the cow will soon be extinct. Indeed, the great demand for beef seems to ensure that the species will continue to thrive.

Why does the commercial value of ivory threaten the elephant, while the com- mercial value of beef protects the cow? The reason is that elephants are a common resource, whereas cows are a private good. Elephants roam freely without any owners. Each poacher has a strong incentive to kill as many elephants as she can find. Because poachers are numerous, each poacher has only a slight incentive to preserve the elephant population. By contrast, cattle live on ranches that are pri- vately owned. Each rancher makes a great effort to maintain the cattle population on her ranch because she reaps the benefit.

Governments have tried to solve the elephant’s problem in two ways. Some countries, such as Kenya, Tanzania, and Uganda, have made it illegal to kill el- ephants and sell their ivory. Yet these laws have been hard to enforce, and the battle between the authorities and the poachers has become increasingly violent. Meanwhile, elephant populations have continued to dwindle. By contrast, other countries, such as Botswana, Malawi, Namibia, and Zimbabwe, have made ele- phants a private good by allowing people to kill elephants, but only those on their own property. Landowners now have an incentive to preserve the species on their own land, and as a result, elephant populations have started to rise. With pri- vate ownership and the profit motive now on its side, the African elephant might someday be as safe from extinction as the cow. ●

QuickQuiz Why do governments try to limit the use of common resources?

“Will the market protect me?”

VI CE

N TE

B A

RC EL

O V

A RO

N A

/S H

U TT

ER ST

O CK

.C O

223CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES

11-4 Conclusion: The Importance of Property Rights

In this and the previous chapter, we have seen there are some “goods” that the market does not provide adequately. Markets do not ensure that the air we breathe is clean or that our country is defended from foreign aggressors. Instead, societies rely on the government to protect the environment and to provide for the national defense.

The problems we considered in these chapters arise in many different markets, but they share a common theme. In all cases, the market fails to allocate resources efficiently because property rights are not well established. That is, some item of value does not have an owner with the legal authority to control it. For example, although no one doubts that the “good” of clean air or national defense is valu- able, no one has the right to attach a price to it and profit from its use. A factory pollutes too much because no one charges the factory for the pollution it emits. The market does not provide for national defense because no one can charge those who are defended for the benefit they receive.

When the absence of property rights causes a market failure, the government can potentially solve the problem. Sometimes, as in the sale of pollution permits, the solution is for the government to help define property rights and thereby unleash market forces. Other times, as in restricted hunting seasons, the solution is for the government to regulate private behavior. Still other times, as in the pro- vision of national defense, the solution is for the government to use tax revenue to supply a good that the market fails to supply. In each of these cases, if the policy is well planned and well run, it can make the allocation of resources more efficient and thus raise economic well-being.

1. Which categories of goods are excludable?

a. private goods and club goods

b. private goods and common resources

c. public goods and club goods

d. public goods and common resources

2. Which categories of goods are rival in consumption?

a. private goods and club goods

b. private goods and common resources

c. public goods and club goods

d. public goods and common resources

3. Which of the following is an example of a public

good?

a. residential housing

b. national defense

c. restaurant meals

d. fish in the ocean

4. Which of the following is an example of a common

resource?

a. residential housing

b. national defense

c. restaurant meals

d. fish in the ocean

5. Public goods are

a. efficiently provided by market forces.

b. underprovided in the absence of government.

c. overused in the absence of government.

d. a type of natural monopoly.

6. Common resources are

a. efficiently provided by market forces.

b. underprovided in the absence of government.

c. overused in the absence of government.

d. a type of natural monopoly.

CHAPTER QuickQuiz

• Goods differ in whether they are excludable and

whether they are rival in consumption. A good is

excludable if it is possible to prevent someone from

using it. A good is rival in consumption if one person’s

use of the good reduces others’ ability to use the same

unit of the good. Markets work best for private goods,

which are both excludable and rival in consumption.

Markets do not work as well for other types of goods.

• Public goods are neither rival in consumption nor

excludable. Examples of public goods include

fireworks displays, national defense, and the discovery

of fundamental knowledge. Because people are not

charged for their use of the public good, they have

an incentive to free ride, making private provision of

the good untenable. Therefore, governments provide

public goods, basing their decision about the quantity

of each good on cost–benefit analysis.

• Common resources are rival in consumption but not

excludable. Examples include common grazing land,

clean air, and congested roads. Because people are not

charged for their use of common resources, they tend

to use them excessively. Therefore, governments use

various methods, such as regulations and corrective

taxes, to limit the use of common resources.

excludability, p. 212

rivalry in consumption, p. 212

private goods, p. 212

public goods, p. 212

common resources, p. 213

club goods, p. 213

free rider, p. 214

cost–benefit analysis, p. 217

Tragedy of the Commons, p. 218

SUMMARY

KEY CONCEPTS

1. Explain what is meant by a good being “excludable.”

Explain what is meant by a good being “rival in con-

sumption.” Is a slice of pizza excludable? Is it rival in

consumption?

2. Define and give an example of a public good. Can the

private market provide this good on its own? Explain.

3. What is cost–benefit analysis of public goods? Why is

it important? Why is it hard?

4. Define and give an example of a common resource.

Without government intervention, will people use this

good too much or too little? Why?

QUESTIONS FOR REVIEW

PART IV THE ECONOMICS OF THE PUBLIC SECTOR224

1. Think about the goods and services provided by your

local government.

a. Using the classification in Figure 1, explain which

category each of the following goods falls into:

• police protection

• snow plowing

• education

• rural roads

• city streets

b. Why do you think the government provides items

that are not public goods?

2. Both public goods and common resources involve

externalities.

a. Are the externalities associated with public goods

generally positive or negative? Use examples in

your answer. Is the free-market quantity of public

goods generally greater or less than the efficient

quantity?

b. Are the externalities associated with common

resources generally positive or negative? Use

examples in your answer. Is the free-market use of

common resources generally greater or less than

the efficient use?

3. Fredo loves watching Downton Abbey on his local pub- lic TV station, but he never sends any money to sup-

port the station during its fund-raising drives.

a. What name do economists have for people like

Fredo?

b. How can the government solve the problem

caused by people like Fredo?

c. Can you think of ways the private market can

solve this problem? How does the existence of

cable TV alter the situation?

PROBLEMS AND APPLICATIONS

225CHAPTER 11 PUBLIC GOODS AND COMMON RESOURCES

4. Wireless, high-speed Internet is provided for free in

the airport of the city of Communityville.

a. At first, only a few people use the service. What

type of a good is this and why?

b. Eventually, as more people find out about the

service and start using it, the speed of the connec-

tion begins to fall. Now what type of a good is the

wireless Internet service?

c. What problem might result and why? What is one

possible way to correct this problem?

5. Four roommates are planning to spend the weekend

in their dorm room watching old movies, and they are

debating how many to watch. Here is their willingness

to pay for each film:

Steven Peter James Christopher

First film $7 $5 $3 $2

Second film 6 4 2 1

Third film 5 3 1 0

Fourth film 4 2 0 0

Fifth film 3 1 0 0

a. Within the dorm room, is the showing of a movie

a public good? Why or why not?

b. If it costs $8 to rent a movie, how many movies should

the roommates rent to maximize total surplus?

c. If they choose the optimal number from part (b)

and then split the cost of renting the movies

equally, how much surplus does each person

obtain from watching the movies?

d. Is there any way to split the cost to ensure that

everyone benefits? What practical problems does

this solution raise?

e. Suppose they agree in advance to choose the ef-

ficient number and to split the cost of the movies

equally. When Steven is asked his willingness to

pay, will he have an incentive to tell the truth? If

so, why? If not, what will he be tempted to say?

f. What does this example teach you about the opti-

mal provision of public goods?

6. Some economists argue that private firms will not

undertake the efficient amount of basic scientific

research.

a. Explain why this might be so. In your answer,

classify basic research in one of the categories

shown in Figure 1.

b. What sort of policy has the United States adopted

in response to this problem?

c. It is often argued that this policy increases the tech-

nological capability of American producers relative

to that of foreign firms. Is this argument consistent

with your classification of basic research in part (a)?

(Hint: Can excludability apply to some potential beneficiaries of a public good and not others?)

7. Two towns, each with three members, are deciding

whether to put on a fireworks display to celebrate the

New Year. Fireworks cost $360. In each town, some

people enjoy fireworks more than others.

a. In the town of Bayport, each of the residents val-

ues the public good as follows:

Frank $50

Joe $100

Callie $300

Would fireworks pass a cost–benefit analysis?

Explain.

b. The mayor of Bayport proposes to decide by

majority rule and, if the fireworks referendum

passes, to split the cost equally among all

residents. Who would vote in favor, and who

would vote against? Would the vote yield the

same answer as the cost–benefit analysis?

c. In the town of River Heights, each of the residents

values the public good as follows:

Nancy $20

Bess $140

Ned $160

Would fireworks pass a cost–benefit analysis?

Explain.

d. The mayor of River Heights also proposes to

decide by majority rule and, if the fireworks

referendum passes, to split the cost equally among

all residents. Who would vote in favor, and who

would vote against? Would the vote yield the

same answer as the cost–benefit analysis?

e. What do you think these examples say about the

optimal provision of public goods?

8. There is often litter along highways but rarely in

people’s yards. Provide an economic explanation for

this fact.

9. Many transportation systems, such as the Wash-

ington, D.C., Metro (subway), charge higher fares

during rush hours than during the rest of the day.

Why might they do this?

10. High-income people are willing to pay more than

lower-income people to avoid the risk of death. For

example, they are more likely to pay for safety features

on cars. Do you think cost–benefit analysts should take

this fact into account when evaluating public projects?

Consider, for instance, a rich town and a poor town,

both of which are considering the installation of a traffic

light. Should the rich town use a higher dollar value for

a human life in making this decision? Why or why not?

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

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CHAPTER

12The Design of the Tax System

A l “Scarface” Capone, the notorious 1920s gangster and crime boss, was never convicted for his many violent crimes. Yet, eventually, he did go to jail—for tax evasion. He had neglected to heed Ben Franklin’s observation that “in this

world nothing is certain but death and taxes.” When Franklin made this claim in 1789, the average American paid less than

5 percent of his income in taxes, and that remained true for the next hundred years. Over the course of the 20th century, however, taxes became ever more important in the life of the typical U.S. citizen. Today, all taxes taken together—including personal income taxes, corporate income taxes, payroll taxes, sales taxes, and property taxes—use up more than a quarter of the average American’s income. In many European countries, the tax bite is even larger.

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228 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

Taxes are inevitable because citizens expect their governments to provide them with various goods and services. One of the Ten Principles of Economics from Chapter 1 is that markets are usually a good way to organize economic activity. But market economies rely on property rights and the rule of law, and so the gov- ernment provides police and courts. Another of the Ten Principles of Economics is that the government can sometimes improve market outcomes. When the govern- ment remedies an externality (such as air pollution), provides a public good (such as national defense), or regulates the use of a common resource (such as fish in a public lake), it can raise economic well-being. But these activities can be costly. For the government to perform these and its many other functions, it needs to raise revenue through taxation.

We began our study of taxation in earlier chapters, where we saw how a tax on a good affects the supply and demand for that good. In Chapter 6, we saw that a tax reduces the quantity sold in a market, and we examined how the burden of a tax is shared by buyers and sellers depending on the elasticities of supply and demand. In Chapter 8, we examined how taxes affect economic well-being. We learned that taxes can cause deadweight losses: The reduction in consumer and producer surplus resulting from a tax exceeds the revenue raised by the government.

In this chapter, we build on these lessons to discuss the design of a tax system. We begin with some basic facts about how the U.S. government raises money. We then discuss the fundamental principles of taxation. Most people agree that taxes should impose as small a cost on society as possible and that the burden of taxes should be distributed fairly. That is, the tax system should be both efficient and equitable. As we will see, however, stating these goals is easier than achieving them.

12-1 An Overview of U.S. Taxation How much of the nation’s income does the government collect as taxes? Figure 1 shows government revenue, including federal, state, and local, as a percentage of total income for the U.S. economy. It shows that the role of government has grown substantially over the past century. In 1902, the government collected only 7 percent of total income; in recent years, government has collected almost 30 percent. In other words, as the economy’s income has grown, the government’s revenue from taxation has grown even more.

Figure 2 compares the tax burden for several major countries, as measured by the government’s tax revenue as a percentage of the nation’s total income. The United States has a low tax burden compared to most other advanced economies. Many European nations have much higher taxes, which finance a more gener- ous social safety net, including more substantial income support for the poor and unemployed.

12-1a Taxes Collected by the Federal Government The U.S. federal government collects about two-thirds of the taxes in our econ- omy. Table 1 shows the receipts of the federal government in 2014. Total receipts that year were $3.3 trillion, a number so large that it is hard to comprehend. To bring this astronomical number down to earth, we can divide it by the size of the U.S. population, which was about 319 million in 2014. We then find that the aver- age American paid $10,235 to the federal government.

229CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

This figure shows revenue of the federal government and of state and local governments as a per-

centage of gross domestic product (GDP), which measures total income in the economy. It shows

that the government plays a large role in the U.S. economy and that its role has grown over time.

Source: Historical Statistics of the United States; Bureau of Economic Analysis; and author’s calculations.

FIGURE 1

Government Revenue as

a Percentage of GDP:

Changes over Time

Total government

35%

1929192219131902 1941 1951 1961 1971 1981 1991 2001 2011

Revenue as Percent of

GDP

State and local

Federal

FIGURE 2

Government

Revenue as a

Percentage of

GDP: International

Comparisons

50 Total government

tax revenue (% of GDP)

49%

45% 43% 43%

37% 34% 33% 33%

31% 29%

27% 25%

20% 20%

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d S tat

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The percentage of income that governments take in taxes varies substantially from country to country.

Source: OECD. Data are for 2013.

230 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

TABLE 1

Receipts of the Federal

Government: 2014

Source: Bureau of Economic Analysis.

Columns may not sum to total due to

rounding.

Tax Amount (billions) Amount per Person Percent of Receipts

Personal income taxes $1,397 $4,379 43%

Social insurance taxes 1145 3,589 35

Corporate income taxes 418 1,310 13

Other 305 956 9

Total $3,265 $10,235 100%

TABLE 2

The Federal Income Tax Rates: 2014

This table shows the marginal tax rates for

an unmarried taxpayer. The taxes owed by

a taxpayer depend on all the marginal tax

rates up to his income level. For example,

a taxpayer with income of $25,000 pays

10 percent of the first $9,075 of income,

and then 15 percent of the rest.

On Taxable Income . . . The Tax Rate Is . . .

From $0 to $9,075 10%

From $9,076 to $36,900 15%

From $36,901 to $89,350 25%

From $89,351 to $186,350 28%

From $186,351 to $405,100 33%

From $405,101 to $406,750 35%

From $406,751 and above 39.6%

Personal Income Taxes The largest source of revenue for the federal govern- ment is the personal income tax. As April 15 approaches each year, almost every American family fills out a tax form to determine the income tax it owes the government. Each family is required to report its income from all sources: wages from working, interest on savings, dividends from corporations in which it owns shares, profits from any small businesses it operates, and so on. The family’s tax liability (how much it owes) is based on its total income.

A family’s income tax liability is not simply proportional to its income. Instead, the law requires a more complicated calculation. Taxable income is computed as total income minus an amount based on the number of dependents (primarily children) and minus certain expenses that policymakers have deemed “deduct- ible” (such as mortgage interest payments, state and local tax payments, and charitable giving). Then the tax liability is calculated from taxable income using a schedule like the one shown in Table 2.

This table presents the marginal tax rate—the tax rate applied to each additional dollar of income. Because the marginal tax rate rises as income rises, higher- income families pay a larger percentage of their income in taxes. Note that each tax rate in the table applies only to income within the associated range, not to a person’s entire income. For example, a person with an income of $1 million still pays only 10 percent of the first $9,075. (Later in this chapter we discuss the con- cept of the marginal tax rate more fully.)

Payroll Taxes Almost as important to the federal government as the personal income tax are payroll taxes. A payroll tax is a tax on the wages that a firm pays its

231CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

workers. Table 1 calls this revenue social insurance taxes because the revenue from these taxes is mostly earmarked to pay for Social Security and Medicare. Social Security is an income-support program designed primarily to maintain the living standards of the elderly. Medicare is the government health program for the elderly. In 2014, the total payroll tax was 15.3 percent for annual earnings up to $117,000 and 2.9 percent of earnings above $117,000, together with an additional 0.9 percent for taxpayers with high income (above $200,000 if single, $250,000 if married). For many middle-income households, the payroll tax is the largest tax they pay.

Corporate Income Taxes Next in magnitude, but much smaller than either personal income taxes or social insurance taxes, is the corporate income tax. A corporation is a business set up to have its own legal existence, distinct and sepa- rate from its owners. The government taxes each corporation based on its profit— the amount the corporation receives for the goods or services it sells minus the costs of producing those goods or services. Notice that corporate profits are, in essence, taxed twice. They are taxed once by the corporate income tax when the corporation earns the profits, and they are taxed again by the personal income tax when the corporation uses its profits to pay dividends to its shareholders. In part to compensate for this double taxation, policymakers have decided to tax divi- dend income at lower rates than other types of income: In 2014, the top marginal tax rate on dividend income was only 20 percent (plus a 3.8 percent Medicare tax), compared with the top marginal tax rate on ordinary income of 39.6 percent (plus the same 3.8 percent).

Other Taxes The last category, labeled “other” in Table 1, makes up 9 percent of receipts. This category includes excise taxes, which are taxes on specific goods like gasoline, cigarettes, and alcoholic beverages. It also includes various small items, such as estate taxes and customs duties.

12-1b Taxes Collected by State and Local Governments State and local governments collect about a third of all taxes paid. Table 3 shows the receipts of U.S. state and local governments. Total receipts for 2014 were $2,225 billion, or $6,975 per person. The table also shows how this total is broken down into different kinds of taxes.

The two most important taxes for state and local governments are sales taxes and property taxes. Sales taxes are levied as a percentage of the total amount spent

TABLE 3

Receipts of State and

Local Governments: 2014

Source: Bureau of Economic Analysis.

Columns may not sum to total due to rounding.

Tax Amount (billions) Amount per Person Percent of Receipts

Sales taxes $525 $1,646 24%

Property taxes 456 1,429 20

Personal income taxes 383 1,201 17

Corporate income taxes 58 182 3

Federal government 495 1,552 22

Other 308 966 14

Total $2,225 $6,975 100%

232 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

at retail stores. Every time a customer buys something, he pays the storekeeper an extra amount that the storekeeper remits to the government. (Some states exclude certain items that are considered necessities, such as food and clothing.) Prop- erty taxes are levied on property owners as a percentage of the estimated value of land and structures. Together, these two taxes make up more than 40 percent of all receipts of state and local governments.

State and local governments also levy individual and corporate income taxes. In many cases, state and local income taxes are similar to federal income taxes. In other cases, they are quite different. For example, some states tax income from wages less heavily than income earned in the form of interest and dividends. Some states do not tax income at all.

State and local governments also receive substantial funds from the federal government. To some extent, the federal government’s policy of sharing its rev- enue with state governments redistributes funds from high-income states (which pay more taxes) to low-income states (which receive more benefits). Often, these funds are tied to specific programs that the federal government wants to subsidize. For example, Medicaid provides healthcare for the poor; this program is managed by the states but much of the funding comes from the federal government.

Finally, state and local governments receive receipts from various sources included in the “other” category in Table 3. These include fees for fishing and hunt- ing licenses, tolls from roads and bridges, and fares for public buses and subways.

QuickQuiz What are the two most important sources of tax revenue for the federal

government? • What are the two most important sources of tax revenue

for state and local governments?

12-2 Taxes and Efficiency Now that we have seen how various levels of the U.S. government raise money in practice, let’s consider how one might design a good tax system in principle. The primary aim of a tax system is to raise revenue for the government, but there are many ways to raise any given amount of money. When choosing among the many alternative taxes, policymakers have two objectives: efficiency and equity.

One tax system is more efficient than another if it raises the same amount of reve- nue at a smaller cost to taxpayers. What are the costs of taxes to taxpayers? The most obvious cost is the tax payment itself. This transfer of money from the taxpayer to the government is an inevitable feature of any tax system. Yet taxes also impose two other costs, which well-designed tax policy tries to avoid or, at least, minimize:

• The deadweight losses that result when taxes distort the decisions people make;

• The administrative burdens that taxpayers bear as they comply with the tax laws.

An efficient tax system is one that imposes small deadweight losses and small administrative burdens.

12-2a Deadweight Losses One of the Ten Principles of Economics is that people respond to incentives, and this includes incentives provided by the tax system. If the government taxes ice

233CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

cream, people eat less ice cream and more frozen yogurt. If the government taxes housing, people live in smaller houses and spend more of their income on other things. If the government taxes labor earnings, people work less and enjoy more leisure.

Because taxes distort incentives, they entail deadweight losses. As we first dis- cussed in Chapter 8, the deadweight loss of a tax is the reduction in economic well-being of taxpayers in excess of the amount of revenue raised by the govern- ment. The deadweight loss is the inefficiency that a tax creates as people allocate resources according to the tax incentive rather than the true costs and benefits of the goods and services that they buy and sell.

To recall how taxes cause deadweight losses, consider an example. Sup- pose that Jake places an $8 value on a pizza and Jane places a $6 value on it. If there is no tax on pizza, the price of pizza will reflect the cost of making it. Let’s suppose that the price of pizza is $5, so both Jake and Jane choose to buy one. Both consumers get some surplus of value over the amount paid. Jake gets consumer surplus of $3, and Jane gets consumer surplus of $1. Total surplus is $4.

Now suppose that the government levies a $2 tax on pizza and the price of pizza rises to $7. (This occurs if supply is perfectly elastic.) Jake still buys a pizza, but now he has consumer surplus of only $1. Jane now decides not to buy a pizza because its price is higher than its value to her. The government collects tax reve- nue of $2 on Jake’s pizza. Total consumer surplus has fallen by $3 (from $4 to $1). Because total surplus has fallen by more than the tax revenue, the tax has a dead- weight loss. In this case, the deadweight loss is $1.

Notice that the deadweight loss comes not from Jake, the person who pays the tax, but from Jane, the person who doesn’t. The reduction of $2 in Jake’s surplus exactly offsets the amount of revenue the government collects. The deadweight loss arises because the tax causes Jane to alter her behavior. When the tax raises the price of pizza, Jane is worse off, and yet there is no offsetting revenue to the government. This reduction in Jane’s welfare is the deadweight loss of the tax.

CASE STUDY

SHOULD INCOME OR CONSUMPTION BE TAXED? When taxes cause people to change their behavior—such as induc- ing Jane to buy less pizza—the taxes cause deadweight losses and make the allocation of resources less efficient. As we have already

seen, much government revenue comes from the personal income tax. In a case study in Chapter 8, we discussed how this tax discourages people from working as hard as they otherwise might. Another inefficiency caused by this tax is that it discourages people from saving.

Consider a 25-year-old deciding whether to save $1,000. If he puts this money in a savings account that earns 8 percent and leaves it there, he will have $21,720 when he retires at age 65. Yet if the government taxes one-fourth of his interest income each year, the effective interest rate is only 6 percent. After 40 years of earning 6 percent, the $1,000 grows to only $10,290, less than half of what it would have been without taxation. Thus, because interest income is taxed, saving is much less attractive.

Some economists advocate eliminating the current tax system’s disincentive toward saving by changing the basis of taxation. Rather than taxing the amount of income that people earn, the government could tax the amount that people spend. Under this proposal, all income that is saved would not be taxed until the saving

“I was gonna fix the place up, but if I did, the city would just raise my taxes!”

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234 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

is later spent. This alternative system, called a consumption tax, would not distort people’s saving decisions.

Various provisions of current law already make the tax system a bit like a con- sumption tax. Taxpayers can put a limited amount of their income into special savings accounts, such as Individual Retirement Accounts and 401(k) plans, and this income and the accumulated interest it earns escape taxation until the money is withdrawn at retirement. For people who do most of their saving through these retirement accounts, their tax bill is, in effect, based on their consumption rather than their income.

European countries tend to rely more on consumption taxes than does the United States. Most of them raise a significant amount of government revenue through a value-added tax, or a VAT. A VAT is like the retail sales tax that many U.S. states use. But rather than collecting all of the tax at the retail level when the consumer buys the final good, the government collects the tax in stages as the good is being produced (that is, as value is added by firms along the chain of production).

Various U.S. policymakers have proposed that the tax code move further in the direction of taxing consumption rather than income. In 2005, economist Alan Greenspan, then Chairman of the Federal Reserve, offered this advice to a presi- dential commission on tax reform: “As you know, many economists believe that a consumption tax would be best from the perspective of promoting economic growth—particularly if one were designing a tax system from scratch—because a consumption tax is likely to encourage saving and capital formation. However, getting from the current tax system to a consumption tax raises a challenging set of transition issues.” ●

12-2b Administrative Burden If you ask the typical person on April 15 for an opinion about the tax system, you might get an earful (perhaps peppered with expletives) about the headache of filling out tax forms. The administrative burden of any tax system is part of the inefficiency it creates. This burden includes not only the time spent in early April filling out forms but also the time spent throughout the year keeping records for tax purposes and the resources the government uses to enforce the tax laws.

Many taxpayers—especially those in higher tax brackets—hire tax lawyers and accountants to help them with their taxes. These experts in the complex tax laws fill out tax forms for their clients and help them arrange their affairs in a way that reduces the amount of taxes owed. This behavior is legal tax avoidance, which is different from illegal tax evasion.

Critics of our tax system say that these advisers help their clients avoid taxes by abusing some of the detailed provisions of the tax code, often dubbed “loop- holes.” In some cases, loopholes are congressional mistakes: They arise from ambiguities or omissions in the tax laws. More often, they arise because Congress has chosen to give special treatment to specific types of behavior. For example, the U.S. federal tax code gives preferential treatment to investors in municipal bonds because Congress wanted to make it easier for state and local governments to borrow money. To some extent, this provision benefits states and localities, and to some extent, it benefits high-income taxpayers. Most loopholes are well known by those in Congress who make tax policy, but what looks like a loophole to one taxpayer may look like a justifiable tax deduction to another.

235CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

The resources devoted to complying with the tax laws are a type of deadweight loss. The government gets only the amount of taxes paid. By contrast, the tax- payer loses not only this amount but also the time and money spent document- ing, computing, and avoiding taxes.

The administrative burden of the tax system could be reduced by simplifying the tax laws. Yet simplification is often politically difficult. Most people are ready to simplify the tax code by eliminating the loopholes that benefit others, but few are eager to give up the loopholes that they benefit from themselves. In the end, the complexity of the tax law results from the political process as various taxpay- ers with their own special interests lobby for their causes.

12-2c Marginal Tax Rates versus Average Tax Rates When discussing the efficiency and equity of income taxes, economists distin- guish between two notions of the tax rate: the average and the marginal. The average tax rate is total taxes paid divided by total income. The marginal tax rate is the amount by which taxes increase from an additional dollar of income.

For example, suppose that the government taxes 20 percent of the first $50,000 of income and 50 percent of all income above $50,000. Under this tax, a person who makes $60,000 pays a tax of $15,000: 20 percent of the first $50,000 (0.20 3 $50,000 5 $10,000) plus 50 percent of the remaining $10,000 (0.50 3 $10,000 5 $5,000). For this person, the average tax rate is $15,000 / $60,000, or 25 percent. But the marginal tax rate is 50 percent. If the taxpayer earned an additional dollar of income, that dollar would be subject to the 50 percent tax rate, so the amount the taxpayer would owe to the government would rise by $0.50.

The marginal and average tax rates each contain a useful piece of informa- tion. If we are trying to gauge the sacrifice made by a taxpayer, the average tax rate is more appropriate because it measures the fraction of income paid in taxes. By contrast, if we are trying to gauge how the tax system distorts incentives, the marginal tax rate is more meaningful. One of the Ten Principles of Economics in Chapter 1 is that rational people think at the margin. A corollary to this principle is that the marginal tax rate measures how much the tax system discourages peo- ple from working. If you are thinking of working an extra few hours, the marginal tax rate determines how much the government takes of your additional earnings. It is the marginal tax rate, therefore, that determines the deadweight loss of an income tax.

12-2d Lump-Sum Taxes Suppose the government imposes a tax of $4,000 on everyone. That is, everyone owes the same amount, regardless of earnings or any actions that a person might take. Such a tax is called a lump-sum tax.

A lump-sum tax shows clearly the difference between average and marginal tax rates. For a taxpayer with income of $20,000, the average tax rate of a $4,000 lump-sum tax is 20 percent; for a taxpayer with income of $40,000, the average tax rate is 10 percent. For both taxpayers, the marginal tax rate is zero because no tax is owed on an additional dollar of income.

A lump-sum tax is the most efficient tax possible. Because a person’s deci- sions do not alter the amount owed, the tax does not distort incentives and, therefore, does not cause deadweight losses. Because everyone can easily com- pute the amount owed and because there is no benefit to hiring tax lawyers

average tax rate

total taxes paid divided

by total income

marginal tax rate

the amount by which

taxes increase from

an additional dollar of

income

lump-sum tax

a tax that is the same

amount for every person

236 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

and accountants, the lump-sum tax imposes a minimal administrative burden on taxpayers.

If lump-sum taxes are so efficient, why do we rarely observe them in the real world? The reason is that efficiency is only one goal of the tax system. A lump-sum tax would take the same amount from the poor and the rich, an outcome most people would view as unfair. To understand the tax systems that we observe, we must therefore consider the other major goal of tax policy: equity.

QuickQuiz What is meant by the efficiency of a tax system? • What can make a tax

system inefficient?

benefits principle

the idea that people

should pay taxes based

on the benefits they

receive from government

services

12-3 Taxes and Equity Ever since American colonists dumped imported tea into Boston harbor to protest high British taxes, tax policy has generated some of the most heated debates in American politics. The heat is rarely fueled by questions of efficiency. Instead, it arises from disagreements over how the tax burden should be distributed. Sena- tor Russell Long once mimicked the public debate with this ditty:

Don’t tax you. Don’t tax me. Tax that fella behind the tree.

Of course, if we rely on the government to provide some of the goods and services we want, then someone must pay taxes to fund those goods and services. In this section, we consider the equity of a tax system. How should the burden of taxes be divided among the population? How do we evaluate whether a tax system is fair? Everyone agrees that the tax system should be equitable, but there is much disagreement about how to judge the equity of a tax system.

12-3a The Benefits Principle One principle of taxation, called the benefits principle, states that people should pay taxes based on the benefits they receive from government services. This principle tries to make public goods similar to private goods. It seems fair that a person who often goes to the movies pays more in total for movie tickets than a person who rarely goes. Similarly, a person who gets great benefit from a public good should pay more for it than a person who gets little benefit.

The gasoline tax, for instance, is sometimes justified using the benefits princi- ple. In some states, revenues from the gasoline tax are used to build and main- tain roads. Because those who buy gasoline are the same people who use the roads, the gasoline tax might be viewed as a fair way to pay for this government service.

The benefits principle can also be used to argue that wealthy citizens should pay higher taxes than poorer ones. Why? Simply because the wealthy benefit more from public services. Consider, for example, the benefits of police protection from theft. Citizens with much to protect benefit more from police than do those with less to protect. Therefore, according to the benefits principle, the wealthy should contribute more than the poor to the cost of maintaining the police force.

237CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

The same argument can be used for many other public services, such as fire pro- tection, national defense, and the court system.

It is even possible to use the benefits principle to argue for antipoverty pro- grams funded by taxes on the wealthy. As we discussed in Chapter 11, people may prefer living in a society without poverty, suggesting that antipoverty pro- grams are a public good. If the wealthy place a greater dollar value on this pub- lic good than members of the middle class do, perhaps just because the wealthy have more to spend, then according to the benefits principle, they should be taxed more heavily to pay for these programs.

12-3b The Ability-to-Pay Principle Another way to evaluate the equity of a tax system is called the ability-to-pay principle, which states that taxes should be levied on a person according to how well that person can shoulder the burden. This principle is sometimes justified by the claim that all citizens should make an “equal sacrifice” to support the govern- ment. The magnitude of a person’s sacrifice, however, depends not only on the size of his tax payment but also on his income and other circumstances: A $1,000 tax paid by a poor person may require a larger sacrifice than a $10,000 tax paid by a rich one.

The ability-to-pay principle leads to two corollary notions of equity: vertical equity and horizontal equity. Vertical equity states that taxpayers with a greater ability to pay should contribute a larger amount. Horizontal equity states that taxpayers with similar abilities to pay should contribute the same amount. These notions of equity are widely accepted, but applying them to evaluate a tax system is rarely straightforward.

Vertical Equity If taxes are based on ability to pay, then richer taxpayers should pay more than poorer taxpayers. But how much more should the rich pay? The debate over tax policy often focuses on this question.

Consider the three tax systems in Table 4. In each case, taxpayers with higher incomes pay more. Yet the systems differ in how quickly taxes rise with income. The first system is called proportional because all taxpayers pay the same fraction of income. The second system is called regressive because high-income taxpayers pay a smaller fraction of their income, even though they pay a larger amount. The third system is called progressive because high-income taxpayers pay a larger fraction of their income.

Which of these three tax systems is most fair? There is no obvious answer, and economic theory does not offer any help in trying to find one. Equity, like beauty, is in the eye of the beholder.

ability-to-pay principle

the idea that taxes should

be levied on a person

according to how well

that person can shoulder

the burden

vertical equity

the idea that taxpayers

with a greater ability to

pay taxes should pay

larger amounts

horizontal equity

the idea that taxpayers

with similar abilities to

pay taxes should pay the

same amount

proportional tax

a tax for which high-

income and low-income

taxpayers pay the same

fraction of income

regressive tax

a tax for which high-

income taxpayers pay a

smaller fraction of their

income than do low-

income taxpayers

progressive tax

a tax for which high-

income taxpayers pay a

larger fraction of their

income than do low-

income taxpayers

Proportional Tax Regressive Tax Progressive Tax

Income

Amount

of Tax

Percent

of Income

Amount

of Tax

Percent

of Income

Amount

of Tax

Percent

of Income

$50,000 $12,500 25% $15,000 30% $10,000 20%

100,000 25,000 25 25,000 25 25,000 25

200,000 50,000 25 40,000 20 60,000 30

TABLE 4

Three Tax Systems

238 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

TABLE 5

The Burden of Federal

Taxes

Source: Congressional Budget Office. Figures

are for 2011.

Quintile

Average

Income

Taxes as a Percentage

of Income

Percentage

of All Income

Percentage

of All Taxes

Lowest $24,600 1.9% 5.3% 0.6%

Second 45,300 7.0 9.6 3.8

Middle 66,400 11.2 14.1 8.9

Fourth 97,500 15.2 20.4 17.6

Highest 245,700 23.4 51.9 68.7

Top 1% 1,453,100 29.0 14.6 24.0

CASE STUDY

HOW THE TAX BURDEN IS DISTRIBUTED The debate over tax policy often concerns whether the wealthy pay their fair share. There is no objective way to make this judgment. In evaluating the issue for yourself, however, it is useful to know how

much families with different incomes pay under the current tax system. Table 5 presents some data on how federal taxes are distributed among income

classes. These figures are for 2011, the most recent year available as this book was going to press, and were tabulated by the Congressional Budget Office (CBO). They include all federal taxes—personal income taxes, payroll taxes, corporate income taxes, and excise taxes—but not state and local taxes. When calculating a household’s tax burden, the CBO allocates corporate income taxes to the owners of capital and payroll taxes to workers.

To construct the table, households are ranked according to their income and placed into five groups of equal size, called quintiles. The table also presents data on the richest 1 percent of Americans. The second column of the table shows the average income of each group. Income includes both market income (income that households have earned from their work and savings) and transfer payments from government programs, such as Social Security and welfare. The poorest one- fifth of households had average income of $24,600, and the richest one-fifth had average income of $245,700. The richest 1 percent had average income of over $1.4 million.

The third column of the table shows total taxes as a percentage of income. As you can see, the U.S. federal tax system is progressive. The poorest fifth of households paid 1.9 percent of their incomes in taxes, and the richest fifth paid 23.4 percent. The top 1 percent paid 29.0 percent of their incomes.

The fourth and fifth columns compare the distribution of income with the dis- tribution of taxes. The poorest quintile earned 5.3 percent of all income and paid 0.6 percent of all taxes. The richest quintile earned 51.9 percent of all income and paid 68.7 percent of all taxes. The richest 1 percent (which, remember, is ½0 the size of each quintile) earned 14.6 percent of all income and paid 24.0 percent of all taxes.

These numbers on taxes paid are a good starting point for understanding how the burden of government is distributed, but they give an incomplete picture. Money flows not only from households to the government in the form of taxes but also from the government back to households in the form of transfer pay- ments. In some ways, transfer payments are the opposite of taxes. Including trans- fers as negative taxes substantially changes the distribution of the tax burden.

239CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

The richest quintile of households still pays about one-quarter of its income to the government, even after transfers are subtracted, and the top 1 percent still pays almost 30 percent. By contrast, the average tax rate for the poorest quintile becomes a sizeable negative number. That is, typical households in the bottom of the income distribution receive substantially more in transfers than they pay in taxes. The lesson is clear: To understand fully the progressivity of government policies, one must take into account both what people pay and what they receive.

Finally, it is worth noting that the numbers in Table 5 are a bit out of date. In late 2012, the U.S. Congress passed and President Obama signed a tax bill that increased taxes significantly from those that prevailed previously, particularly for taxpayers at the top of the income distribution. As a result, the tax system in place for 2013 and beyond is more progressive than the one shown in the table. The Con- gressional Budget Office projects that for the top 1 percent, taxes as a percentage of income increased from 29.0 to 33.3 percent. ●

Horizontal Equity If taxes are based on ability to pay, then similar taxpayers should pay similar amounts of taxes. But what determines if two taxpayers are similar? Families differ in many ways. To evaluate whether a tax code is horizon- tally equitable, one must determine which differences are relevant for a family’s ability to pay and which differences are not.

Suppose the Smith and Jones families each have income of $100,000. The Smiths have no children, but Mr. Smith has an illness that results in medical expenses of $40,000. The Joneses are in good health, but they have four children. Two of the Jones children are in college, generating tuition bills of $60,000. Would it be fair for these two families to pay the same tax because they have the same income? Would it be fair to give the Smiths a tax break to help them offset their high med- ical expenses? Would it be fair to give the Joneses a tax break to help them with their tuition expenses?

There are no easy answers to these questions. In practice, the U.S. tax code is filled with special provisions that alter a family’s tax obligations based on its spe- cific circumstances.

12-3c Tax Incidence and Tax Equity Tax incidence—the study of who bears the burden of taxes—is central to evaluat- ing tax equity. As we first saw in Chapter 6, the person who bears the burden of a tax is not always the person who gets the tax bill from the government. Because taxes alter supply and demand, they alter equilibrium prices. As a result, they affect people beyond those who, according to statute, actually pay the tax. When evaluating the vertical and horizontal equity of any tax, it is important to take these indirect effects into account.

Many discussions of tax equity ignore the indirect effects of taxes and are based on what economists mockingly call the flypaper theory of tax incidence. According to this theory, the burden of a tax, like a fly on flypaper, sticks wherever it first lands. This assumption, however, is rarely valid.

For example, a person not trained in economics might argue that a tax on expensive fur coats is vertically equitable because most buyers of furs are wealthy. Yet if these buyers can easily substitute other luxuries for furs, then a tax on furs might only reduce the sale of furs. In the end, the burden of the tax will fall more on those who make and sell furs than on those who buy them. Because most workers who make furs are not wealthy, the equity of a fur tax could be quite dif- ferent from what the flypaper theory indicates.

240 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

CASE STUDY

WHO PAYS THE CORPORATE INCOME TAX? The corporate income tax provides a good example of the importance of tax incidence for tax policy. The corporate tax is popular among voters. After all, corporations are not people. Voters are always eager

to get a tax cut and let some impersonal corporation pick up the tab. But before deciding that the corporate income tax is a good way for the govern-

ment to raise revenue, we should consider who bears the burden of the corporate tax. This is a difficult question on which economists disagree, but one thing is certain: People pay all taxes. When the government levies a tax on a corporation, the corporation is more like a tax collector than a taxpayer. The burden of the tax ultimately falls on people—the owners, customers, or workers of the corporation.

Many economists believe that workers and customers bear much of the burden of the corporate income tax. To see why, consider an example. Suppose that the U.S. government decides to raise the tax on the income earned by car companies. At first, this tax hurts the owners of the car companies, who receive less profit.

Tax reformers and deficit hawks of-

ten suggest reducing the deductions,

credits, and exclusions that narrow

the tax base.

The Blur between Spending

and Taxes

By N. Gregory Mankiw

S hould the government cut spending or

raise taxes to deal with its long-term fis-

cal imbalance? As President Obama’s deficit

commission rolls out its final report in the

coming weeks, this issue will most likely

divide the political right and left. But, in many

ways, the question is the wrong one. The dis-

tinction between spending and taxation is

often murky and sometimes meaningless.

Imagine that there is some activity—say,

snipe hunting—that members of Congress

want to encourage. Senator Porkbelly proposes

a government subsidy. “America needs more

snipe hunters,” he says. “I propose that every

time an American bags a snipe, the federal

government should pay him or her $100.”

“No, no,” says Congressman Blowhard.

“The Porkbelly plan would increase the size of

an already bloated government. Let’s instead

reduce the burden of taxation. I propose that

every time an American tracks down a snipe,

the hunter should get a $100 credit to reduce

his or her tax liabilities.”

To be sure, government accountants may

treat the Porkbelly and Blowhard plans differ-

ently. They would likely deem the subsidy to

be a spending increase and the credit to be a

tax cut. Moreover, the rhetoric of the two poli-

ticians about spending and taxes may appeal

to different political bases.

But it hardly takes an economic genius to

see how little difference there is between the

two plans. Both policies enrich the nation’s

snipe hunters. And because the government

must balance its books, at least in the long

run, the gains of the snipe hunters must come

at the cost of higher taxes or lower govern-

ment benefits for the rest of us.

Economists call the Blowhard plan a “tax

expenditure.” The tax code is filled with them

—although not yet one for snipe hunting.

Every time a politician promises a “targeted

tax cut,” he or she is probably offering up a

form of government spending in disguise.

Erskine B. Bowles and Alan K. Simpson,

the chairmen of President Obama’s deficit

reduction commission, have taken at hard look

at these tax expenditures —and they don’t like

what they see. In their draft proposal, released

earlier this month, they proposed doing away

with tax expenditures, which together cost the

Treasury over $1 trillion a year.

Such a drastic step would allow Mr. Bowles

and Mr. Simpson to move the budget toward

fiscal sustainability, while simultaneously

reducing all income tax rates. Under their

plan, the top tax rate would fall to 23 percent

from the 35 percent in today’s law (and the

39.6 percent currently advocated by Demo-

cratic leadership).

This approach has long been the basic rec-

ipe for tax reform. By broadening the tax base

and lowering tax rates, we can increase gov-

ernment revenue and distort incentives less.

That should command widespread applause

across the ideological spectrum. Unfortu-

nately, the reaction has been less enthusiastic.

Pundits on the left are suspicious of any

plan that reduces marginal tax rates on the

rich. But, as Mr. Bowles and Mr. Simpson point

Tax Expenditures

IN THE NEWS

241CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

out, tax expenditures disproportionately ben-

efit those at the top of the economic ladder.

According to their figures, tax expenditures

increase the after-tax income of those in the

bottom quintile by about 6 percent. Those in the

top 1 percent of the income distribution enjoy

about twice that gain. Progressives who are

concerned about the gap between rich and poor

should be eager to scale back tax expenditures.

Pundits on the right, meanwhile, are sus-

picious of anything that increases government

revenue. But they should recognize that tax

expenditures are best viewed as a hidden form

of spending. If we eliminate tax expenditures

and reduce marginal tax rates, as Mr. Bowles

and Mr. Simpson propose, we are essentially

doing what economic conservatives have long

advocated: cutting spending and taxes.

Yet another political problem is that each

tax expenditure has its own political constit-

uency. If Congressman Blowhard ever got his

way, the snipe hunters of the world would

surely fight to keep their tax break.

One major tax expenditure that the

Bowles-Simpson plan would curtail or elim-

inate is the mortgage interest deduction.

Without doubt, many homeowners and the

real estate industry will object. But they won’t

have the merits on their side.

This subsidy to homeownership is neither

economically efficient nor particularly equita-

ble. Economists have long pointed out that tax

subsidies to housing, together with the high

taxes on corporations, cause too much of the

economy’s capital stock to be tied up in res-

idential structures and too little in corporate

capital. This misallocation of resources results

in lower productivity and reduced real wages.

Moreover, there is nothing particularly

ignoble about renting that deserves the scorn

of the tax code. But let’s face it: subsidizing

homeowners is the same as penalizing renters.

In the end, someone has to pick up the tab.

There are certain tax expenditures that I

like. My personal favorite is the deduction for

charitable giving. It encourages philanthropy

and, thus, private rather than governmental

solutions to society’s problems.

But I know that solving the long-term fiscal

problem won’t be easy. Everyone will have to

give a little, and perhaps even more than a lit-

tle. I am willing to give up my favorite tax expen-

diture if everyone else is willing to give up theirs.

The Bowles-Simpson proposal is not per-

fect, but it is far better than the status quo.

The question ahead is whether we can get

Senator Porkbelly and Congressman Blowhard

to agree. ■

Source: New York Times, November 21, 2010.

TH E

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Y O

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IM ES

, N O

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21 , 2

01 0/

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IS T

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But over time, these owners will respond to the tax. Because pro- ducing cars is less profitable, they invest less in building new car factories. Instead, they invest their wealth in other ways—for example, by buying larger houses or by building factories in other industries or other countries. With fewer car factories, the supply of cars declines, as does the demand for autoworkers. Thus, a tax on corporations making cars causes the price of cars to rise and the wages of autoworkers to fall.

The corporate income tax shows how dangerous the flypaper theory of tax incidence can be. The corporate income tax is popular in part because it appears to be paid by rich corporations. Yet those who bear the ultimate burden of the tax—the customers and workers of corporations—are often not rich. If the true incidence of the cor- porate tax were more widely known, this tax might be less popular among voters. ● This worker pays part of the corporate income tax.

BI LL

P U

G LI

A N

O /G

ET TY

IM A

G ES

242 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

QuickQuiz Explain the benefits principle and the ability-to-pay principle. • What are

vertical equity and horizontal equity? • Why is studying tax incidence

important for determining the equity of a tax system?

12-4 Conclusion: The Trade-off between Equity and Efficiency Almost everyone agrees that equity and efficiency are the two most important goals of a tax system. But these two goals often conflict, especially when equity is judged by the progressivity of the tax system. People often disagree about tax policy because they attach different weights to these goals.

The recent history of tax policy shows how political leaders differ in their views on equity and efficiency. When Ronald Reagan was elected president in 1980, the marginal tax rate on the earnings of the richest Americans was 50 percent. On interest income, the marginal tax rate was 70 percent. Reagan argued that such high tax rates greatly distorted economic incentives to work and save. In other words, he claimed that these high tax rates cost too much in terms of economic efficiency. Tax reform was, therefore, a high priority of his administration. Reagan signed into law large cuts in tax rates in 1981 and then again in 1986. When Reagan left office in 1989, the richest Americans faced a marginal tax rate of only 28 percent.

The pendulum of political debate swings both ways. When Bill Clinton ran for president in 1992, he argued that the rich were not paying their fair share of taxes. In other words, the low tax rates on the rich violated his view of vertical equity. In 1993, President Clinton signed into law a bill that raised the tax rates on the richest Americans to about 40 percent. When George W. Bush ran for president, he reprised many of Reagan’s themes, and as president he reversed part of the Clinton tax in- crease, reducing the highest tax rate to 35 percent. Barack Obama pledged during the 2008 presidential campaign that he would raise taxes on high-income house- holds, and starting in 2013 the top marginal tax rate was back at about 40 percent.

Economics alone cannot determine the best way to balance the goals of effi- ciency and equity. This issue involves political philosophy as well as economics. But economists have an important role in this debate: They can shed light on the trade-offs that society inevitably faces when designing the tax system and can help us avoid policies that sacrifice efficiency without any benefit in terms of equity.

1. The two largest sources of tax revenue for the U.S.

federal government are

a. personal and corporate income taxes.

b. personal income taxes and payroll taxes for social

insurance.

c. corporate income taxes and payroll taxes for social

insurance.

d. payroll taxes for social insurance and property taxes.

2. Aiden gives piano lessons. He has an opportunity cost

of $50 per lesson and charges $60. He has two stu-

dents: Brandon, who has a willingness to pay of $70,

and Chloe, who has a willingness to pay of $90. When

the government puts a $20 tax on piano lessons and

Aiden raises his price to $80, the deadweight loss is

_____ and the tax revenue is _____.

a. $10, $20

b. $10, $40

c. $20, $20

d. $20, $40

CHAPTER QuickQuiz

243CHAPTER 12 THE DESIGN OF THE TAX SYSTEM

3. If the tax code exempts the first $20,000 of income

from taxation and then taxes 25 percent of all income

above that level, then a person who earns $50,000

has an average tax rate of _____ percent and a mar-

ginal tax rate of _____ percent.

a. 15, 25

b. 25, 15

c. 25, 30

d. 30, 25

4. A toll is a tax on citizens who use toll roads. This pol-

icy can be viewed as an application of

a. the benefits principle.

b. horizontal equity.

c. vertical equity.

d. tax progressivity.

5. In the United States, taxpayers in the top 1 percent

of the income distribution pay about _____ percent of

their income in federal taxes.

a. 5

b. 10

c. 20

d. 30

6. If the corporate income tax induces businesses to

reduce their capital investment, then

a. the tax does not have any deadweight loss.

b. corporate shareholders benefit from the tax.

c. workers bear some of the burden of the tax.

d. the tax achieves the goal of vertical equity.

average tax rate, p. 235

marginal tax rate, p. 235

lump-sum tax, p. 235

benefits principle, p. 236

ability-to-pay principle, p. 237

vertical equity, p. 237

horizontal equity, p. 237

proportional tax, p. 237

regressive tax, p. 237

progressive tax, p. 237

KEY CONCEPTS

SUMMARY

• The U.S. government raises revenue using various

taxes. The most important taxes for the federal gov-

ernment are personal income taxes and payroll taxes

for social insurance. The most important taxes for

state and local governments are sales taxes and prop-

erty taxes.

• The efficiency of a tax system refers to the costs it

imposes on taxpayers. There are two costs of taxes

beyond the transfer of resources from the taxpayer to

the government. The first is the deadweight loss that

arises as taxes alter incentives and distort the allocation

of resources. The second is the administrative burden

of complying with the tax laws.

• The equity of a tax system concerns whether the

tax burden is distributed fairly among the popula-

tion. According to the benefits principle, it is fair for

people to pay taxes based on the benefits they receive

from the government. According to the ability-to-pay

principle, it is fair for people to pay taxes based on

their capability to handle the financial burden. When

evaluating the equity of a tax system, it is important

to remember a lesson from the study of tax incidence:

The distribution of tax burdens is not the same as the

distribution of tax bills.

• When considering changes in the tax laws, policy-

makers often face a trade-off between efficiency and

equity. Much of the debate over tax policy arises

because people give different weights to these two

goals.

244 PART IV THE ECONOMICS OF THE PUBLIC SECTOR

1. The information in many of the tables in this chapter

can be found in the Economic Report of the President, which appears annually. Using a recent issue of the

report at your library or on the Internet, answer the

following questions and provide some numbers

to support your answers. (Hint: The website of the Government Printing Office is http://www.gpo.gov.)

a. Figure 1 shows that government revenue as a per-

centage of total income has increased over time. Is

this increase primarily attributable to changes in

federal government revenue or in state and local

government revenue?

b. Looking at the combined revenue of the federal

government and state and local governments,

how has the composition of total revenue changed

over time? Are personal income taxes more or

less important? Social insurance taxes? Corporate

profits taxes?

2. Suppose you are a typical person in the U.S. economy.

You pay 4 percent of your income in a state income

tax and 15.3 percent of your labor earnings in federal

payroll taxes (employer and employee shares com-

bined). You also pay federal income taxes as in Table 2.

How much tax of each type do you pay if you earn

$30,000 a year? Taking all taxes into account, what are

your average and marginal tax rates? What happens

to your tax bill and to your average and marginal tax

rates if your income rises to $60,000?

3. Some states exclude necessities, such as food and

clothing, from their sales tax. Other states do not.

Discuss the merits of this exclusion. Consider both

efficiency and equity.

4. When someone owns an asset (such as a share of

stock) that rises in value, he has an “accrued” capital

gain. If he sells the asset, he “realizes” the gains that

have previously accrued. Under the U.S. income tax

system, realized capital gains are taxed, but accrued

gains are not.

a. Explain how individuals’ behavior is affected by

this rule.

b. Some economists believe that cuts in capital gains

tax rates, especially temporary ones, can raise tax

revenue. How might this be so?

c. Do you think it is a good rule to tax realized but

not accrued capital gains? Why or why not?

5. Suppose that your state raises its sales tax from

5 percent to 6 percent. The state revenue commissioner

forecasts a 20 percent increase in sales tax revenue.

Is this plausible? Explain.

6. The Tax Reform Act of 1986 eliminated the deduct-

ibility of interest payments on consumer debt (mostly

credit cards and auto loans) but maintained the

deductibility of interest payments on mortgages and

home equity loans. What do you think happened to

the relative amounts of borrowing through consumer

debt and home equity debt?

7. Categorize each of the following funding schemes as

examples of the benefits principle or the ability-to-pay

principle.

a. Visitors to many national parks pay an

entrance fee.

b. Local property taxes support elementary and

secondary schools.

c. An airport trust fund collects a tax on each

plane ticket sold and uses the money to improve

airports and the air traffic control system.

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

PROBLEMS AND APPLICATIONS

1. Over the past century, has the government’s tax rev-

enue grown more or less slowly than the rest of the

economy?

2. Explain how corporate profits are taxed twice.

3. Why is the burden of a tax to taxpayers greater than

the revenue received by the government?

4. Why do some economists advocate taxing

consumption rather than income?

5. What is the marginal tax rate on a lump-sum tax?

How is this related to the efficiency of the tax?

6. Give two arguments why wealthy taxpayers should

pay more taxes than poor taxpayers.

7. What is the concept of horizontal equity and why is it

hard to apply?

QUESTIONS FOR REVIEW

Firm Behavior and the Organization of Industry

PART V

CHAPTER

13The Costs of Production

T he economy is made up of thousands of firms that produce the goods and services you enjoy every day: General Motors produces automobiles, General Electric produces lightbulbs, and General Mills produces breakfast cereals.

Some firms, such as these three, are large; they employ thousands of workers and have thousands of stockholders who share the firms’ profits. Other firms, such as the local barbershop or café, are small; they employ only a few workers and are owned by a single person or family.

In previous chapters, we used the supply curve to summarize firms’ produc- tion decisions. According to the law of supply, firms are willing to produce

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248 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

and sell a greater quantity of a good when the price of the good is higher. This response leads to a supply curve that slopes upward. For analyzing many ques- tions, the law of supply is all you need to know about firm behavior.

In this chapter and the ones that follow, we examine firm behavior in more detail. This topic will give you a better understanding of the decisions behind the supply curve. In addition, it will introduce you to a part of economics called industrial organization—the study of how firms’ decisions about prices and quan- tities depend on the market conditions they face. The town in which you live, for instance, may have several pizzerias but only one cable television company. This raises a key question: How does the number of firms affect the prices in a market and the efficiency of the market outcome? The field of industrial organization addresses exactly this question.

Before turning to these issues, we need to discuss the costs of production. All firms, from Delta Air Lines to your local deli, incur costs while making the goods and services that they sell. As we will see in the coming chapters, a firm’s costs are a key determinant of its production and pricing decisions. In this chapter, we define some of the variables that economists use to measure a firm’s costs, and we consider the relationships among these variables.

A word of warning: This topic is dry and technical. To be honest, one might even call it boring. But this material provides a crucial foundation for the fascinat- ing topics that follow.

13-1 What Are Costs? We begin our discussion of costs at Caroline’s Cookie Factory. Caroline, the owner of the firm, buys flour, sugar, chocolate chips, and other cookie ingredients. She also buys the mixers and ovens and hires workers to run this equipment. She then sells the cookies to consumers. By examining some of the issues that Caroline faces in her business, we can learn some lessons about costs that apply to all firms in an economy.

13-1a Total Revenue, Total Cost, and Profit We begin with the firm’s objective. To understand the decisions a firm makes, we must understand what it is trying to do. Although it is conceivable that Caroline started her firm because of an altruistic desire to provide the world with cookies or, perhaps, out of love for the cookie business, it is more likely that she started the business to make money. Economists normally assume that the goal of a firm is to maximize profit, and they find that this assumption works well in most cases.

What is a firm’s profit? The amount that the firm receives for the sale of its out- put (cookies) is called total revenue. The amount that the firm pays to buy inputs (flour, sugar, workers, ovens, and so forth) is called total cost. Caroline gets to keep any revenue that is not needed to cover costs. Profit is a firm’s total revenue minus its total cost:

Profit 5 Total revenue 2 Total cost

Caroline’s objective is to make her firm’s profit as large as possible. To see how a firm goes about maximizing profit, we must consider fully how to

measure its total revenue and its total cost. Total revenue is the easy part: It equals the quantity of output the firm produces multiplied by the price at which it sells its

total revenue

the amount a firm

receives for the sale

of its output

total cost

the market value

of the inputs a firm

uses in production

profit

total revenue minus

total cost

249CHAPTER 13 THE COSTS OF PRODUCTION

output. If Caroline produces 10,000 cookies and sells them at $2 a cookie, her total revenue is $20,000. The measurement of a firm’s total cost, however, is more subtle.

13-1b Costs as Opportunity Costs When measuring costs at Caroline’s Cookie Factory or any other firm, it is import- ant to keep in mind one of the Ten Principles of Economics from Chapter 1: The cost of something is what you give up to get it. Recall that the opportunity cost of an item refers to all the things that must be forgone to acquire that item. When econ- omists speak of a firm’s cost of production, they include all the opportunity costs of making its output of goods and services.

While some of a firm’s opportunity costs of production are obvious, others are less so. When Caroline pays $1,000 for flour, that $1,000 is an opportunity cost because Caroline can no longer use that $1,000 to buy something else. Similarly, when Caroline hires workers to make the cookies, the wages she pays are part of the firm’s costs. Because these opportunity costs require the firm to pay out some money, they are called explicit costs. By contrast, some of a firm’s opportunity costs, called implicit costs, do not require a cash outlay. Imagine that Caroline is skilled with computers and could earn $100 per hour working as a program- mer. For every hour that Caroline works at her cookie factory, she gives up $100 in income, and this forgone income is also part of her costs. The total cost of Caroline’s business is the sum of her explicit and implicit costs.

The distinction between explicit and implicit costs highlights an important difference between how economists and accountants analyze a business. Econo- mists are interested in studying how firms make production and pricing decisions. Because these decisions are based on both explicit and implicit costs, economists include both when measuring a firm’s costs. By contrast, accountants have the job of keeping track of the money that flows into and out of firms. As a result, they measure the explicit costs but usually ignore the implicit costs.

The difference between the methods of economists and accountants is easy to see in the case of Caroline’s Cookie Factory. When Caroline gives up the oppor- tunity to earn money as a computer programmer, her accountant will not count this as a cost of her cookie business. Because no money flows out of the business to pay for this cost, it never shows up on the accountant’s financial statements. An economist, however, will count the forgone income as a cost because it will affect the decisions that Caroline makes in her cookie business. For example, if Caroline’s wage as a computer programmer rises from $100 to $500 per hour, she might decide that running her cookie business is too costly. She might choose to shut down the factory so she can take a job as a programmer.

13-1c The Cost of Capital as an Opportunity Cost An important implicit cost of almost every business is the opportunity cost of the financial capital that has been invested in the business. Suppose, for instance, that Caroline used $300,000 of her savings to buy the cookie factory from its previous owner. If Caroline had instead left this money in a savings account that pays an interest rate of 5 percent, she would have earned $15,000 per year. To own her cookie factory, therefore, Caroline has given up $15,000 a year in interest income. This forgone $15,000 is one of the implicit opportunity costs of Caroline’s business.

As we have already noted, economists and accountants treat costs differently, and this is especially true in their treatment of the cost of capital. An economist views the $15,000 in interest income that Caroline gives up every year as an

explicit costs

input costs that require

an outlay of money by

the firm

implicit costs

input costs that do not

require an outlay of

money by the firm

250 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

implicit cost of her business. Caroline’s accountant, however, will not show this $15,000 as a cost because no money flows out of the business to pay for it.

To further explore the difference between the methods of economists and accountants, let’s change the example slightly. Suppose now that Caroline did not have the entire $300,000 to buy the factory but, instead, used $100,000 of her own savings and borrowed $200,000 from a bank at an interest rate of 5 percent. Caroline’s accountant, who only measures explicit costs, will now count the $10,000 interest paid on the bank loan every year as a cost because this amount of money now flows out of the firm. By contrast, according to an economist, the opportunity cost of owning the business is still $15,000. The opportunity cost equals the interest on the bank loan (an explicit cost of $10,000) plus the forgone interest on savings (an implicit cost of $5,000).

13-1d Economic Profit versus Accounting Profit Now let’s return to the firm’s objective: profit. Because economists and accoun- tants measure costs differently, they also measure profit differently. An econo- mist measures a firm’s economic profit as the firm’s total revenue minus all the opportunity costs (explicit and implicit) of producing the goods and services sold. An accountant measures the firm’s accounting profit as the firm’s total revenue minus only the firm’s explicit costs.

Figure 1 summarizes this difference. Notice that because the accountant ignores the implicit costs, accounting profit is usually larger than economic profit. For a business to be profitable from an economist’s standpoint, total revenue must exceed all the opportunity costs, both explicit and implicit.

Economic profit is an important concept because it motivates the firms that supply goods and services. As we will see, a firm making positive economic profit will stay in business. It is covering all its opportunity costs and has some reve- nue left to reward the firm owners. When a firm is making economic losses (that is, when economic profits are negative), the business owners are failing to earn enough revenue to cover all the costs of production. Unless conditions change,

economic profit

total revenue minus total

cost, including both

explicit and implicit costs

accounting profit

total revenue minus total

explicit cost

FIGURE 1

Economists versus Accountants

Economists include all opportunity

costs when analyzing a firm, whereas

accountants measure only explicit

costs. Therefore, economic profit is

smaller than accounting profit.

Revenue

Total opportunity costs

How an Economist Views a Firm

Economic profit

Implicit costs

Explicit costs

Accounting profit

How an Accountant Views a Firm

Revenue

251CHAPTER 13 THE COSTS OF PRODUCTION

the firm owners will eventually close down the business and exit the industry. To understand business decisions, we need to keep an eye on economic profit.

QuickQuiz Farmer McDonald gives banjo lessons for $20 an hour. One day, he spends

10 hours planting $100 worth of seeds on his farm. What opportunity

cost has he incurred? What cost would his accountant measure? If these seeds yield $200

worth of crops, does McDonald earn an accounting profit? Does he earn an economic profit?

13-2 Production and Costs Firms incur costs when they buy inputs to produce the goods and services that they plan to sell. In this section, we examine the link between a firm’s production process and its total cost. Once again, we consider Caroline’s Cookie Factory.

In the analysis that follows, we make an important simplifying assumption: We assume that the size of Caroline’s factory is fixed and that Caroline can vary the quantity of cookies produced only by changing the number of workers she employs. This assumption is realistic in the short run but not in the long run. That is, Caroline cannot build a larger factory overnight, but she could do so over the next year or two. This analysis, therefore, describes the production decisions that Caroline faces in the short run. We examine the relationship between costs and time horizon more fully later in the chapter.

13-2a The Production Function Table 1 shows how the quantity of cookies produced per hour at Caroline’s factory depends on the number of workers. As you can see in columns (1) and (2), if there are no workers in the factory, Caroline produces no cookies.

(1)

Number

of Workers

(2)

Output (quantity

of cookies

produced per

hour)

(3)

Marginal

Product of

Labor

(4)

Cost of

Factory

(5)

Cost of

Workers

(6)

Total Cost of Inputs

(cost of factory +

cost of workers)

0 0 $30 $0 $30

1 50 30 10 40

2 90 30 20 50

3 120 30 30 60

4 140 30 40 70

5 150 30 50 80

6 155 30 60 90

TABLE 1

A Production Function

and Total Cost: Caroline’s

Cookie Factory

252 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

When there is 1 worker, she produces 50 cookies. When there are 2 workers, she produces 90 cookies and so on. Panel (a) of Figure 2 presents a graph of these two columns of numbers. The number of workers is on the horizontal axis, and the number of cookies produced is on the vertical axis. This relation- ship between the quantity of inputs (workers) and quantity of output (cookies) is called the production function.

One of the Ten Principles of Economics introduced in Chapter 1 is that ratio- nal people think at the margin. As we will see in future chapters, this idea is the key to understanding the decisions a firm makes about how many workers to hire and how much output to produce. To take a step toward understanding these decisions, column (3) in the table gives the marginal product of a worker. The marginal product of any input in the production process is the increase in the quantity of output obtained from one additional unit of that input. When the number of workers goes from 1 to 2, cookie production increases from 50 to 90, so the marginal product of the second worker is 40 cookies. And when the number of

production function

the relationship between

the quantity of inputs

used to make a good and

the quantity of output of

that good

marginal product

the increase in output

that arises from an

additional unit of input

FIGURE 2

Caroline’s Production

Function and Total-Cost

Curve

The production function in panel (a) shows the relationship between the number of workers

hired and the quantity of output produced. Here the number of workers hired (on the horizon-

tal axis) is from column (1) in Table 1, and the quantity of output produced (on the vertical

axis) is from column (2). The production function gets flatter as the number of workers

increases, reflecting diminishing marginal product. The total-cost curve in panel (b) shows

the relationship between the quantity of output produced and total cost of production.

Here the quantity of output produced (on the horizontal axis) is from column (2) in Table 1,

and the total cost (on the vertical axis) is from column (6). The total-cost curve gets steeper

as the quantity of output increases because of diminishing marginal product.

Quantity of Output

(cookies per hour)

140

120

100

160

Number of Workers Hired

0 1 2 3 4 5 6

Production function

(a) Production function

Total Cost

$90

Quantity of Output

(cookies per hour)

0 20 16040 1401201008060

(b) Total-cost curve

Total-cost curve

253CHAPTER 13 THE COSTS OF PRODUCTION

workers goes from 2 to 3, cookie production increases from 90 to 120, so the mar- ginal product of the third worker is 30 cookies. In the table, the marginal product is shown halfway between two rows because it represents the change in output as the number of workers increases from one level to another.

Notice that as the number of workers increases, the marginal product declines. The second worker has a marginal product of 40 cookies, the third worker has a marginal product of 30 cookies, and the fourth worker has a marginal prod- uct of 20 cookies. This property is called diminishing marginal product. At first, when only a few workers are hired, they have easy access to Caroline’s kitchen equipment. As the number of workers increases, additional workers have to share equipment and work in more crowded conditions. Eventually, the kitchen becomes so overcrowded that workers often get in each other ’s way. Hence, as more workers are hired, each additional worker contributes fewer additional cookies to total production.

Diminishing marginal product is also apparent in Figure 2. The produc- tion function’s slope (“rise over run”) tells us the change in Caroline’s output of cookies (“rise”) for each additional input of labor (“run”). That is, the slope of the production function measures the marginal product. As the number of workers increases, the marginal product declines, and the production function becomes flatter.

13-2b From the Production Function to the Total-Cost Curve Columns (4), (5), and (6) in Table 1 show Caroline’s cost of producing cookies. In this example, the cost of Caroline’s factory is $30 per hour, and the cost of a worker is $10 per hour. If she hires 1 worker, her total cost is $40 per hour. If she hires 2 workers, her total cost is $50 per hour, and so on. With this information, the table now shows how the number of workers Caroline hires is related to the quantity of cookies she produces and to her total cost of production.

Our goal in the next several chapters is to study firms’ production and pricing decisions. For this purpose, the most important relationship in Table 1 is between quantity produced [in column (2)] and total cost [in column (6)]. Panel (b) of Figure 2 graphs these two columns of data with quantity produced on the horizontal axis and total cost on the vertical axis. This graph is called the total-cost curve.

Now compare the total-cost curve in panel (b) with the production function in panel (a). These two curves are opposite sides of the same coin. The total-cost curve gets steeper as the amount produced rises, whereas the production function gets flatter as production rises. These changes in slope occur for the same rea- son. High production of cookies means that Caroline’s kitchen is crowded with many workers. Because the kitchen is crowded, each additional worker adds less to production, reflecting diminishing marginal product. Therefore, the production function is relatively flat. But now turn this logic around: When the kitchen is crowded, producing an additional cookie requires a lot of additional labor and is thus very costly. Therefore, when the quantity produced is large, the total-cost curve is relatively steep.

QuickQuiz If Farmer Jones plants no seeds on her farm, she gets no harvest. If she

plants 1 bag of seeds, she gets 3 bushels of wheat. If she plants 2 bags,

she gets 5 bushels. If she plants 3 bags, she gets 6 bushels. A bag of seeds costs $100,

and seeds are her only cost. Use these data to graph the farmer’s production function and

total-cost curve. Explain their shapes.

diminishing marginal

product

the property whereby

the marginal product

of an input declines as

the quantity of the input

increases

254 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

Our analysis of Caroline’s Cookie Factory demonstrated how a firm’s total cost reflects its production function. From data on a firm’s total cost, we can derive several related measures of cost, which will turn out to be useful when we ana- lyze production and pricing decisions in future chapters. To see how these related measures are derived, we consider the example in Table 2. This table presents cost data on Caroline’s neighbor—Conrad’s Coffee Shop.

Column (1) in the table shows the number of cups of coffee that Conrad might produce, ranging from 0 to 10 cups per hour. Column (2) shows Conrad’s total cost of producing coffee. Figure 3 plots Conrad’s total-cost curve. The quantity of coffee [from column (1)] is on the horizontal axis, and total cost [from column (2)] is on the vertical axis. Conrad’s total-cost curve has a shape similar to Caroline’s. In particular, it becomes steeper as the quantity produced rises, which (as we have discussed) reflects diminishing marginal product.

13-3 The Various Measures of Cost

(1)

Output

(cups of

coffee per

hour)

(2)

Total

Cost

(3)

Fixed

Cost

(4)

Variable

Cost

(5)

Average

Fixed

Cost

(6)

Average

Variable

Cost

(7)

Average

Total

Cost

(8)

Marginal

Cost

0 $3.00 $3.00 $0.00 — — —

$0.30

1 3.30 3.00 0.30 $3.00 $0.30 $3.30

0.50

2 3.80 3.00 0.80 1.50 0.40 1.90

0.70

3 4.50 3.00 1.50 1.00 0.50 1.50

0.90

4 5.40 3.00 2.40 0.75 0.60 1.35

1.10

5 6.50 3.00 3.50 0.60 0.70 1.30

1.30

6 7.80 3.00 4.80 0.50 0.80 1.30

1.50

7 9.30 3.00 6.30 0.43 0.90 1.33

1.70

8 11.00 3.00 8.00 0.38 1.00 1.38

1.90

9 12.90 3.00 9.90 0.33 1.10 1.43

2.10

10 15.00 3.00 12.00 0.30 1.20 1.50

TABLE 2

The Various Measures of

Cost: Conrad’s Coffee Shop

255CHAPTER 13 THE COSTS OF PRODUCTION

13-3a Fixed and Variable Costs Conrad’s total cost can be divided into two types. Some costs, called fixed costs, do not vary with the quantity of output produced. They are incurred even if the firm produces nothing at all. Conrad’s fixed costs include any rent he pays because this cost is the same regardless of how much coffee he produces. Sim- ilarly, if Conrad needs to hire a full-time bookkeeper to pay bills, regardless of the quantity of coffee produced, the bookkeeper ’s salary is a fixed cost. The third column in Table 2 shows Conrad’s fixed cost, which in this example is $3.00.

Some of the firm’s costs, called variable costs, change as the firm alters the quan- tity of output produced. Conrad’s variable costs include the cost of coffee beans, milk, sugar, and paper cups: The more cups of coffee Conrad makes, the more of these items he needs to buy. Similarly, if Conrad has to hire more workers to make more cups of coffee, the salaries of these workers are variable costs. Column (4) in the table shows Conrad’s variable cost. The variable cost is 0 if he produces noth- ing, $0.30 if he produces 1 cup of coffee, $0.80 if he produces 2 cups, and so on.

A firm’s total cost is the sum of fixed and variable costs. In Table 2, total cost in column (2) equals fixed cost in column (3) plus variable cost in column (4).

13-3b Average and Marginal Cost As the owner of his firm, Conrad has to decide how much to produce. One issue he will want to consider when making this decision is how the level of production affects his firm’s costs. Conrad might ask his production supervisor the following two questions about the cost of producing coffee:

• How much does it cost to make the typical cup of coffee? • How much does it cost to increase production of coffee by 1 cup?

fixed costs

costs that do not vary

with the quantity of

output produced

variable costs

costs that vary with

the quantity of output

produced

FIGURE 3

Conrad’s Total-Cost Curve

Here the quantity of output produced (on the

horizontal axis) is from column (1) in Table 2,

and the total cost (on the vertical axis) is from

column (2). As in Figure 2, the total-cost curve

gets steeper as the quantity of output increases

because of diminishing marginal product.

Total Cost $15.00

14.00

13.00

12.00

11.00

10.00

9.00

8.00

7.00

6.00

5.00

4.00

3.00

2.00

1.00

Quantity of Output

(cups of coffee per hour)

0 1 432 765 98 10

Total-cost curve

256 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

These two questions might seem to have the same answer, but they do not. Both answers are important for understanding how firms make production decisions.

To find the cost of the typical unit produced, we divide the firm’s costs by the quantity of output it produces. For example, if the firm produces 2 cups of coffee per hour, its total cost is $3.80, and the cost of the typical cup is $3.80/2, or $1.90. Total cost divided by the quantity of output is called average total cost. Because total cost is the sum of fixed and variable costs, average total cost can be expressed as the sum of average fixed cost and average variable cost. Average fixed cost is the fixed cost divided by the quantity of output, and average variable cost is the variable cost divided by the quantity of output.

Average total cost tells us the cost of the typical unit, but it does not tell us how much total cost will change as the firm alters its level of production. Column (8) in Table 2 shows the amount that total cost rises when the firm increases production by 1 unit of output. This number is called marginal cost. For example, if Conrad increases production from 2 to 3 cups, total cost rises from $3.80 to $4.50, so the marginal cost of the third cup of coffee is $4.50 minus $3.80, or $0.70. In the table, the marginal cost appears halfway between any two rows because it represents the change in total cost as quantity of output increases from one level to another.

It may be helpful to express these definitions mathematically:

Average total cost 5 Total cost/Quantity

ATC 5 TC/Q,

and

Marginal cost 5 Change in total cost/Change in quantity

MC 5 ΔTC/ΔQ

Here Δ, the Greek letter delta, represents the change in a variable. These equa- tions show how average total cost and marginal cost are derived from total cost. Average total cost tells us the cost of a typical unit of output if total cost is divided evenly over all the units produced. Marginal cost tells us the increase in total cost that arises from producing an additional unit of output. As we will see more fully in the next chapter, business managers like Conrad need to keep in mind the concepts of average total cost and marginal cost when deciding how much of their product to supply to the market.

13-3c Cost Curves and Their Shapes Just as we found graphs of supply and demand useful when analyzing the behav- ior of markets in previous chapters, we will find graphs of average and marginal cost useful when analyzing the behavior of firms. Figure 4 graphs Conrad’s costs using the data from Table 2. The horizontal axis measures the quantity the firm produces, and the vertical axis measures marginal and average costs. The graph shows four curves: average total cost (ATC), average fixed cost (AFC), average variable cost (AVC), and marginal cost (MC).

The cost curves shown here for Conrad’s Coffee Shop have some features that are common to the cost curves of many firms in the economy. Let’s exam- ine three features in particular: the shape of the marginal-cost curve, the shape of the average-total-cost curve, and the relationship between marginal cost and average total cost.

average total cost

total cost divided by the

quantity of output

average fixed cost

fixed cost divided by the

quantity of output

average variable cost

variable cost divided by

the quantity of output

marginal cost

the increase in total cost

that arises from an extra

unit of production

257CHAPTER 13 THE COSTS OF PRODUCTION

Rising Marginal Cost Conrad’s marginal cost rises as the quantity of output pro- duced increases. This upward slope reflects the property of diminishing marginal product. When Conrad produces a small quantity of coffee, he has few workers, and much of his equipment is not used. Because he can easily put these idle resources to use, the marginal product of an extra worker is large, and the mar- ginal cost of an extra cup of coffee is small. By contrast, when Conrad produces a large quantity of coffee, his shop is crowded with workers, and most of his equipment is fully utilized. Conrad can produce more coffee by adding workers, but these new workers have to work in crowded conditions and may have to wait to use the equipment. Therefore, when the quantity of coffee produced is already high, the marginal product of an extra worker is low, and the marginal cost of an extra cup of coffee is large.

U-Shaped Average Total Cost Conrad’s average-total-cost curve is U-shaped, as shown in Figure 4. To understand why, remember that average total cost is the sum of average fixed cost and average variable cost. Average fixed cost always declines as output rises because the fixed cost is getting spread over a larger num- ber of units. Average variable cost usually rises as output increases because of diminishing marginal product.

Average total cost reflects the shapes of both average fixed cost and average variable cost. At very low levels of output, such as 1 or 2 cups per hour, average total cost is very high. Even though average variable cost is low, average fixed cost is high because the fixed cost is spread over only a few units. As output

FIGURE 4

Conrad’s Average-Cost and

Marginal-Cost Curves

This figure shows the average total

cost (ATC), average fixed cost (AFC),

average variable cost (AVC), and

marginal cost (MC) for Conrad’s

Coffee Shop. All of these curves

are obtained by graphing the data

in Table 2. These cost curves show

three common features: (1) Marginal

cost rises with the quantity of out-

put. (2) The average-total-cost curve

is U-shaped. (3) The marginal-cost

curve crosses the average-total-cost

curve at the minimum of average

total cost.

Costs

$3.50

3.25

3.00

2.75

2.50

2.25

2.00

1.75

1.50

1.25

1.00

0.75

0.50

0.25

Quantity of Output

(cups of coffee per hour)

0 1 432 765 98 10

ATC

AVC

AFC

258 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

increases, the fixed cost is spread over more units. Average fixed cost declines, rapidly at first and then more slowly. As a result, average total cost also declines until the firm’s output reaches 5 cups of coffee per hour, when average total cost is $1.30 per cup. When the firm produces more than 6 cups per hour, however, the increase in average variable cost becomes the dominant force, and average total cost starts rising. The tug of war between average fixed cost and average variable cost generates the U-shape in average total cost.

The bottom of the U-shape occurs at the quantity that minimizes average total cost. This quantity is sometimes called the efficient scale of the firm. For Conrad, the efficient scale is 5 or 6 cups of coffee per hour. If he produces more or less than this amount, his average total cost rises above the minimum of $1.30. At lower levels of output, average total cost is higher than $1.30 because the fixed cost is spread over so few units. At higher levels of output, average total cost is higher than $1.30 because the marginal product of inputs has diminished significantly. At the efficient scale, these two forces are balanced to yield the lowest average total cost.

The Relationship between Marginal Cost and Average Total Cost If you look at Figure 4 (or back at Table 2), you will see something that may be surprising at first. Whenever marginal cost is less than average total cost, average total cost is falling. Whenever marginal cost is greater than average total cost, average total cost is rising. This feature of Conrad’s cost curves is not a coincidence from the particular num- bers used in the example: It is true for all firms.

To see why, consider an analogy. Average total cost is like your cumulative grade point average. Marginal cost is like the grade you get in the next course you take. If your grade in your next course is less than your grade point average, your grade point average will fall. If your grade in your next course is higher than your grade point average, your grade point average will rise. The mathematics of average and marginal costs is exactly the same as the mathematics of average and marginal grades.

This relationship between average total cost and marginal cost has an import- ant corollary: The marginal-cost curve crosses the average-total-cost curve at its min- imum. Why? At low levels of output, marginal cost is below average total cost, so average total cost is falling. But after the two curves cross, marginal cost rises above average total cost. As a result, average total cost must start to rise at this level of output. Hence, this point of intersection is the minimum of average total cost. As we will see in the next chapter, minimum average total cost plays a key role in the analysis of competitive firms.

13-3d Typical Cost Curves In the examples we have studied so far, the firms have exhibited diminishing marginal product and, therefore, rising marginal cost at all levels of output. This simplifying assumption was useful because it allowed us to focus on the key features of cost curves that are useful in analyzing firm behavior. Yet actual firms are usually more complicated than this. In many firms, marginal product does not start to fall immediately after the first worker is hired. Depending on the production process, the second or third worker might have a higher marginal product than the first because a team of workers can divide tasks and work more productively than a single worker. Firms exhibiting this pattern would experience increasing marginal product for a while before diminishing marginal product set in.

efficient scale

the quantity of output

that minimizes average

total cost

259CHAPTER 13 THE COSTS OF PRODUCTION

Figure 5 shows the cost curves for such a firm, including average total cost (ATC), average fixed cost (AFC), average variable cost (AVC), and marginal cost (MC). At low levels of output, the firm experiences increasing marginal prod- uct, and the marginal-cost curve falls. Eventually, the firm starts to experience diminishing marginal product, and the marginal-cost curve starts to rise. This combination of increasing then diminishing marginal product also makes the average-variable-cost curve U-shaped.

Despite these differences from our previous example, the cost curves in Figure 5 share the three properties that are most important to remember:

• Marginal cost eventually rises with the quantity of output. • The average-total-cost curve is U-shaped. • The marginal-cost curve crosses the average-total-cost curve at the minimum

of average total cost.

QuickQuiz Suppose Honda’s total cost of producing 4 cars is $225,000 and its total

cost of producing 5 cars is $250,000. What is the average total cost of

producing 5 cars? What is the marginal cost of the fifth car? • Draw the marginal-cost curve

and the average-total-cost curve for a typical firm, and explain why these curves cross where

they do.

13-4 Costs in the Short Run and in the Long Run We noted earlier in this chapter that a firm’s costs might depend on the time horizon under consideration. Let’s examine more precisely why this might be the case.

FIGURE 5

Cost Curves for a Typical Firm

Many firms experience increasing

marginal product before diminishing

marginal product. As a result, they

have cost curves shaped like those

in this figure. Notice that marginal

cost and average variable cost fall

for a while before starting to rise.

Quantity of Output

Costs

$3.00

2.50

2.00

1.50

1.00

0.50

0 42 6 8 141210

ATC

AVC

AFC

260 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

13-4a The Relationship between Short-Run and Long-Run Average Total Cost

For many firms, the division of total costs between fixed and variable costs depends on the time horizon. Consider, for instance, a car manufacturer such as Ford Motor Company. Over a period of only a few months, Ford cannot adjust the number or sizes of its car factories. The only way it can produce additional cars is to hire more workers at the factories it already has. The cost of these factories is, therefore, a fixed cost in the short run. By contrast, over a period of several years, Ford can expand the size of its factories, build new factories, or close old ones. Thus, the cost of its factories is a variable cost in the long run.

Because many decisions are fixed in the short run but variable in the long run, a firm’s long-run cost curves differ from its short-run cost curves. Figure 6 shows an example. The figure presents three short-run average-total-cost curves—for a small, medium, and large factory. It also presents the long-run average-total-cost curve. As the firm moves along the long-run curve, it is adjusting the size of the factory to the quantity of production.

This graph shows how short-run and long-run costs are related. The long-run average-total-cost curve has a much flatter U-shape than the short-run average- total-cost curve. In addition, all the short-run curves lie on or above the long-run curve. These properties arise because firms have greater flexibility in the long run. In essence, in the long run, the firm gets to choose which short-run curve it wants to use. But in the short run, it has to use whatever short-run curve it has, based on decisions it has made in the past.

The figure shows an example of how a change in production alters costs over different time horizons. When Ford wants to increase production from 1,000 to 1,200 cars per day, it has no choice in the short run but to hire more workers at its existing medium-sized factory. Because of diminishing marginal product, average total cost rises from $10,000 to $12,000 per car. In the long run, however, Ford can expand both the size of the factory and its workforce, and average total cost returns to $10,000.

FIGURE 6

Average Total Cost in the

Short and Long Runs

Because fixed costs are variable in

the long run, the average-total-cost

curve in the short run differs from

the average-total-cost curve in the

long run.

Quantity of Cars per Day

0 1,2001,000

Average Total Cost

$12,000

10,000

Economies of

scale

ATC in short run with

small factory

ATC in short run with

medium factory

ATC in short run with

large factory ATC in long run

Diseconomies of

scale

Constant returns to

scale

261CHAPTER 13 THE COSTS OF PRODUCTION

How long does it take a firm to get to the long run? The answer depends on the firm. It can take a year or more for a major manufacturing firm, such as a car company, to build a larger factory. By contrast, a person running a coffee shop can buy another coffee maker within a few days. There is, therefore, no single answer to the question of how long it takes a firm to adjust its production facilities.

13-4b Economies and Diseconomies of Scale The shape of the long-run average-total-cost curve conveys important informa- tion about the production processes that a firm has available for manufacturing a good. In particular, it tells us how costs vary with the scale—that is, the size—of a firm’s operations. When long-run average total cost declines as output increases, there are said to be economies of scale. When long-run average total cost rises as output increases, there are said to be diseconomies of scale. When long-run aver- age total cost does not vary with the level of output, there are said to be constant returns to scale. As we can see in Figure 6, Ford has economies of scale at low levels of output, constant returns to scale at intermediate levels of output, and diseconomies of scale at high levels of output.

What might cause economies or diseconomies of scale? Economies of scale often arise because higher production levels allow specialization among workers, which permits each worker to become better at a specific task. For instance, if Ford hires a large number of workers and produces a large number of cars, it can reduce costs using modern assembly-line production. Diseconomies of scale can arise because of coordination problems that are inherent in any large organization. The more cars Ford produces, the more stretched the management team becomes, and the less effective the managers become at keeping costs down.

economies of scale

the property whereby

long-run average total

cost falls as the quantity

of output increases

diseconomies of scale

the property whereby

long-run average total

cost rises as the quantity

of output increases

constant returns to scale

the property whereby

long-run average total

cost stays the same as

the quantity of output

changes

Lessons from a Pin Factory

“J ack of all trades, master of none.” This well-known adage sheds

light on the nature of cost curves. A person who tries to do everything

usually ends up doing nothing very well. If a firm wants its workers to be

as productive as they can be, it is often best to give each worker a limited

task that she can master. But this organization of work is possible only

if a firm employs many workers and produces a large quantity of output.

In his celebrated book An Inquiry into the Nature and Causes of the

Wealth of Nations, Adam Smith described a visit he made to a pin factory.

Smith was impressed by the specialization among the workers and the

resulting economies of scale. He wrote,

One man draws out the wire, another straightens it, a third cuts it, a

fourth points it, a fifth grinds it at the top for receiving the head; to

make the head requires two or three distinct operations; to put it on is

a peculiar business; to whiten it is another; it is even a trade by itself

to put them into paper.

Smith reported that because of this specialization, the pin factory pro-

duced thousands of pins per worker every day. He conjectured that if the

workers had chosen to

work separately, rather

than as a team of spe-

cialists, “they certainly

could not each of them

make twenty, perhaps not

one pin a day.” In other words,

because of specialization, a large pin factory could achieve higher output

per worker and lower average cost per pin than a small pin factory.

The specialization that Smith observed in the pin factory is preva-

lent in the modern economy. If you want to build a house, for instance,

you could try to do all the work yourself. But most people turn to a

builder, who in turn hires carpenters, plumbers, electricians, painters,

and many other types of workers. These workers focus their training and

experience in particular jobs, and as a result, they become better at

their jobs than if they were generalists. Indeed, the use of specialization

to achieve economies of scale is one reason modern societies are as

prosperous as they are. ■

F Y I

262 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

This analysis shows why long-run average-total-cost curves are often U-shaped. At low levels of production, the firm benefits from increased size because it can take advantage of greater specialization. Coordination problems, meanwhile, are not yet acute. By contrast, at high levels of production, the benefits of specialization have already been realized, and coordination problems become more severe as the firm grows larger. Thus, long-run average total cost is falling at low levels of production because of increasing specialization and rising at high levels of production because of growing coordination problems.

QuickQuiz If Boeing produces 9 jets per month, its long-run total cost is $9.0 million

per month. If it produces 10 jets per month, its long-run total cost is

$9.5 million per month. Does Boeing exhibit economies or diseconomies of scale?

TABLE 3

The Many Types

of Cost: A Summary

Mathematical

Term Definition Description

Explicit costs Costs that require an outlay

of money by the firm

Implicit costs Costs that do not require an outlay

of money by the firm

Fixed costs Costs that do not vary with the FC

quantity of output produced

Variable costs Costs that vary with the quantity VC

of output produced

Total cost The market value of all the inputs TC 5 FC 1 VC that a firm uses in production

Average fixed cost Fixed cost divided by the quantity AFC 5 FC / Q of output

Average variable cost Variable cost divided by the quantity AVC 5 VC / Q of output

Average total cost Total cost divided by the quantity of ATC 5 TC / Q output

Marginal cost The increase in total cost that arises MC 5 ∆TC / ∆Q from an extra unit of production

13-5 Conclusion The purpose of this chapter has been to develop some tools to study how firms make production and pricing decisions. You should now understand what econ- omists mean by the term costs and how costs vary with the quantity of output a firm produces. To refresh your memory, Table 3 summarizes some of the defini- tions we have encountered.

By themselves, a firm’s cost curves do not tell us what decisions the firm will make. But they are a key component of that decision, as we will see in the next chapter.

263CHAPTER 13 THE COSTS OF PRODUCTION

• The goal of firms is to maximize profit, which equals

total revenue minus total cost.

• When analyzing a firm’s behavior, it is important to

include all the opportunity costs of production. Some of

the opportunity costs, such as the wages a firm pays its

workers, are explicit. Other opportunity costs, such as the

wages the firm owner gives up by working at the firm

rather than taking another job, are implicit. Economic

profit takes both explicit and implicit costs into account,

whereas accounting profit considers only explicit costs.

• A firm’s costs reflect its production process. A typical

firm’s production function gets flatter as the quantity

of an input increases, displaying the property of dimin-

ishing marginal product. As a result, a firm’s total-cost

curve gets steeper as the quantity produced rises.

• A firm’s total costs can be divided into fixed costs and

variable costs. Fixed costs are costs that do not change

when the firm alters the quantity of output produced.

Variable costs are costs that change when the firm

alters the quantity of output produced.

• From a firm’s total cost, two related measures of cost

are derived. Average total cost is total cost divided by

the quantity of output. Marginal cost is the amount by

which total cost rises if output increases by 1 unit.

• When analyzing firm behavior, it is often useful to

graph average total cost and marginal cost. For a

typical firm, marginal cost rises with the quantity

of output. Average total cost first falls as output

increases and then rises as output increases further.

The marginal-cost curve always crosses the average-

total-cost curve at the minimum of average total cost.

• A firm’s costs often depend on the time horizon con-

sidered. In particular, many costs are fixed in the short

run but variable in the long run. As a result, when the

firm changes its level of production, average total cost

may rise more in the short run than in the long run.

1. Xavier opens up a lemonade stand for two hours.

He spends $10 for ingredients and sells $60 worth

of lemonade. In the same two hours, he could have

mowed his neighbor’s lawn for $40. Xavier has an

accounting profit of _____ and an economic profit of

____.

a. $50, $10

b. $90, $50

c. $10, $50

d. $50, $90

2. Diminishing marginal product explains why, as a

firm’s output increases,

a. the production function and total-cost curve both

get steeper.

b. the production function and total-cost curve both

get flatter.

c. the production function gets steeper, while the

total-cost curve gets flatter.

d. the production function gets flatter, while the

total-cost curve gets steeper.

3. A firm is producing 1,000 units at a total cost

of $5,000. If it were to increase production to

1,001 units, its total cost would rise to $5,008.

What does this information tell you about the firm?

a. Marginal cost is $5, and average variable cost is $8.

b. Marginal cost is $8, and average variable cost is $5.

c. Marginal cost is $5, and average total cost is $8.

d. Marginal cost is $8, and average total cost is $5.

4. A firm is producing 20 units with an average total

cost of $25 and a marginal cost of $15. If it were to

increase production to 21 units, which of the follow-

ing must occur?

a. Marginal cost would decrease.

b. Marginal cost would increase.

c. Average total cost would decrease.

d. Average total cost would increase.

5. The government imposes a $1,000 per year license

fee on all pizza restaurants. As a result, which cost

curves shift?

a. average total cost and marginal cost

b. average total cost and average fixed cost

c. average variable cost and marginal cost

d. average variable cost and average fixed cost

6. If a higher level of production allows workers to

specialize in particular tasks, a firm will likely exhibit

________ of scale and ________ average total cost.

a. economies, falling

b. economies, rising

c. diseconomies, falling

d. diseconomies, rising

CHAPTER QuickQuiz

SUMMARY

264 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

1. What is the relationship between a firm’s total

revenue, profit, and total cost?

2. Give an example of an opportunity cost that an

accountant would not count as a cost. Why would the

accountant ignore this cost?

3. What is marginal product, and what does it mean if it

is diminishing?

4. Draw a production function that exhibits diminishing

marginal product of labor. Draw the associated

total-cost curve. (In both cases, be sure to label the axes.)

Explain the shapes of the two curves you have drawn.

5. Define total cost, average total cost, and marginal cost. How are they related?

6. Draw the marginal-cost and average-total-cost

curves for a typical firm. Explain why the curves have

the shapes that they do and why they intersect where

they do.

7. How and why does a firm’s average-total-cost curve

differ in the short run compared with the long run?

8. Define economies of scale and explain why they might arise. Define diseconomies of scale and explain why they might arise.

KEY CONCEPTS

total revenue, p. 248

total cost, p. 248

profit, p. 248

explicit costs, p. 249

implicit costs, p. 249

economic profit, p. 250

accounting profit, p. 250

production function, p. 252

marginal product, p. 252

diminishing marginal product, p. 253

fixed costs, p. 255

variable costs, p. 255

average total cost, p. 256

average fixed cost, p. 256

average variable cost, p. 256

marginal cost, p. 256

efficient scale, p. 258

economies of scale, p. 261

diseconomies of scale, p. 261

constant returns to scale, p. 261

QUESTIONS FOR REVIEW

PROBLEMS AND APPLICATIONS

1. This chapter discusses many types of costs:

opportunity cost, total cost, fixed cost, variable cost,

average total cost, and marginal cost. Fill in the type of

cost that best completes each sentence:

a. What you give up in taking some action is called

the ______.

b. _____ is falling when marginal cost is below it and

rising when marginal cost is above it.

c. A cost that does not depend on the quantity

produced is a(n) ______.

d. In the ice-cream industry in the short run, ______

includes the cost of cream and sugar but not the

cost of the factory.

e. Profits equal total revenue minus ______.

f. The cost of producing an extra unit of output is

the ______.

2. Your aunt is thinking about opening a hardware store.

She estimates that it would cost $500,000 per year to

rent the location and buy the stock. In addition, she

would have to quit her $50,000 per year job as an

accountant.

a. Define opportunity cost. b. What is your aunt’s opportunity cost of running

the hardware store for a year? If your aunt thinks

she can sell $510,000 worth of merchandise in a

year, should she open the store? Explain.

3. A commercial fisherman notices the following rela-

tionship between hours spent fishing and the quantity

of fish caught:

Quantity of Fish

Hours (in pounds)

0 hours 0 lb.

1 10

2 18

3 24

4 28

5 30

a. What is the marginal product of each hour spent

fishing?

265CHAPTER 13 THE COSTS OF PRODUCTION

b. Use these data to graph the fisherman’s

production function. Explain its shape.

c. The fisherman has a fixed cost of $10 (his pole).

The opportunity cost of his time is $5 per hour.

Graph the fisherman’s total-cost curve. Explain

its shape.

4. Nimbus, Inc., makes brooms and then sells them door-

to-door. Here is the relationship between the number

of workers and Nimbus’s output during a given day:

Average

Marginal Total Total Marginal

Workers Output Product Cost Cost Cost

0 0 ___ ___

___ ___

1 20 ___ ___

___ ___

2 50 ___ ___

___ ___

3 90 ___ ___

___ ___

4 120 ___ ___

___ ___

5 140 ___ ___

___ ___

6 150 ___ ___

___ ___

7 155 ___ ___

a. Fill in the column of marginal products. What

pattern do you see? How might you explain it?

b. A worker costs $100 a day, and the firm has fixed

costs of $200. Use this information to fill in the

column for total cost.

c. Fill in the column for average total cost. (Recall

that ATC 5 TC/Q.) What pattern do you see? d. Now fill in the column for marginal cost. (Recall

that MC 5 ΔTC/ΔQ.) What pattern do you see? e. Compare the column for marginal product

with the column for marginal cost. Explain the

relationship.

f. Compare the column for average total cost

with the column for marginal cost. Explain the

relationship.

5. You are the chief financial officer for a firm that sells

digital music players. Your firm has the following

average-total-cost schedule:

Quantity Average Total Cost

600 players $300

601 301

Your current level of production is 600 devices,

all of which have been sold. Someone calls, desperate

to buy one of your music players. The caller offers

you $550 for it. Should you accept the offer?

Why or why not?

6. Consider the following cost information for a pizzeria:

Quantity Total Cost Variable Cost

0 dozen pizzas $300 $ 0

1 350 50

2 390 90

3 420 120

4 450 150

5 490 190

6 540 240

a. What is the pizzeria’s fixed cost?

b. Construct a table in which you calculate

the marginal cost per dozen pizzas using the

information on total cost. Also, calculate the

marginal cost per dozen pizzas using the infor-

mation on variable cost. What is the relationship

between these sets of numbers? Explain.

7. Your cousin Vinnie owns a painting company with

fixed costs of $200 and the following schedule for

variable costs:

Quantity

of Houses 1 2 3 4 5 6 7

Painted

per Month

Variable $10 $20 $40 $80 $160 $320 $640

Costs

Calculate average fixed cost, average variable cost,

and average total cost for each quantity. What is the

efficient scale of the painting company?

8. The city government is considering two

tax proposals:

• A lump-sum tax of $300 on each producer of

hamburgers.

• A tax of $1 per burger, paid by producers of

hamburgers.

a. Which of the following curves—average fixed

cost, average variable cost, average total cost,

and marginal cost—would shift as a result of the

lump-sum tax? Why? Show this in a graph. Label

the graph as precisely as possible.

b. Which of these same four curves would shift as

a result of the per-burger tax? Why? Show this

in a new graph. Label the graph as precisely as

possible.

266 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

9. Jane’s Juice Bar has the following cost schedules:

Quantity Variable Cost Total Cost

0 vats of juice $ 0 $ 30

1 10 40

2 25 55

3 45 75

4 70 100

5 100 130

6 135 165

a. Calculate average variable cost, average total

cost, and marginal cost for each quantity.

b. Graph all three curves. What is the relationship

between the marginal-cost curve and the

average-total-cost curve? Between the

marginal-cost curve and the average-variable-

cost curve? Explain.

10. Consider the following table of long-run total costs for

three different firms:

Quantity 1 2 3 4 5 6 7

Firm A $60 $70 $80 $90 $100 $110 $120

Firm B 11 24 39 56 75 96 119

Firm C 21 34 49 66 85 106 129

Does each of these firms experience economies of scale

or diseconomies of scale?

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

Firms in Competitive Markets

CHAPTER

14 I

f your local gas station raised its price for gasoline by 20 percent, it would see a large drop in the amount of gasoline it sold. Its customers would quickly switch to buying their gasoline at other gas stations. By contrast, if your local water com-

pany raised the price of water by 20 percent, it would see only a small decrease in the amount of water it sold. People might water their lawns less often and buy more water-efficient showerheads, but they would be hard-pressed to reduce water con- sumption greatly or to find another supplier. The difference between the gasoline market and the water market is that many firms supply gasoline to the local mar- ket, but only one firm supplies water. As you might expect, this difference in market structure shapes the pricing and production decisions of the firms that operate in these markets.

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268 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

In this chapter, we examine the behavior of competitive firms, such as your local gas station. You may recall that a market is competitive if each buyer and seller is small compared to the size of the market and, therefore, has little ability to influence market prices. By contrast, if a firm can influence the market price of the good it sells, it is said to have market power. Later in the book, we examine the behavior of firms with market power, such as your local water company.

Our analysis of competitive firms in this chapter sheds light on the decisions that lie behind the supply curve in a competitive market. Not surprisingly, we find that a market supply curve is tightly linked to firms’ costs of production. Less obvious, however, is the question of which among a firm’s many types of cost—fixed, variable, average, and marginal—are most relevant for its supply decisions. We see that all these measures of cost play important and interre- lated roles.

14-1 What Is a Competitive Market? Our goal in this chapter is to examine how firms make production decisions in competitive markets. As a background for this analysis, we begin by reviewing what a competitive market is.

14-1a The Meaning of Competition A competitive market, sometimes called a perfectly competitive market, has two characteristics:

• There are many buyers and many sellers in the market. • The goods offered by the various sellers are largely the same.

As a result of these conditions, the actions of any single buyer or seller in the mar- ket have a negligible impact on the market price. Each buyer and seller takes the market price as given.

As an example, consider the market for milk. No single consumer of milk can influence the price of milk because each buys a small amount relative to the size of the market. Similarly, each dairy farmer has limited control over the price because many other sellers are offering milk that is essentially identical. Because each seller can sell all he wants at the going price, he has little reason to charge less, and if he charges more, buyers will go elsewhere. Buyers and sellers in com- petitive markets must accept the price the market determines and, therefore, are said to be price takers.

In addition to the previous two conditions for competition, a third condition is sometimes thought to characterize perfectly competitive markets:

• Firms can freely enter or exit the market.

If, for instance, anyone can start a dairy farm, and if any existing dairy farmer can leave the dairy business, then the dairy industry satisfies this condition. Much of the analysis of competitive firms does not require the assumption of free entry and exit because this condition is not necessary for firms to be price takers. Yet, as we see later in this chapter, when there is free entry and exit in a competitive market, it is a powerful force shaping the long-run equilibrium.

competitive market

a market with many

buyers and sellers trading

identical products so that

each buyer and seller is a

price taker

269CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

14-1b The Revenue of a Competitive Firm A firm in a competitive market, like most other firms in the economy, tries to max- imize profit (total revenue minus total cost). To see how it does this, we first con- sider the revenue of a competitive firm. To keep matters concrete, let’s consider a specific firm: the Vaca Family Dairy Farm.

The Vaca Farm produces a quantity of milk, Q, and sells each unit at the market price, P. The farm’s total revenue is P 3 Q. For example, if a gallon of milk sells for $6 and the farm sells 1,000 gallons, its total revenue is $6,000.

Because the Vaca Farm is small compared to the world market for milk, it takes the price as given by market conditions. This means, in particular, that the price of milk does not depend on the number of gallons that the Vaca Farm produces and sells. If the Vacas double the amount of milk they produce to 2,000 gallons, the price of milk remains the same, and their total revenue doubles to $12,000. As a result, total revenue is proportional to the amount of output.

Table 1 shows the revenue for the Vaca Family Dairy Farm. Columns (1) and (2) show the amount of output the farm produces and the price at which it sells its output. Column (3) is the farm’s total revenue. The table assumes that the price of milk is $6 a gallon, so total revenue is $6 times the number of gallons.

Just as the concepts of average and marginal were useful in the preceding chapter when analyzing costs, they are also useful when analyzing revenue. To see what these concepts tell us, consider these two questions:

• How much revenue does the farm receive for the typical gallon of milk? • How much additional revenue does the farm receive if it increases

production of milk by 1 gallon?

Columns (4) and (5) in Table 1 answer these questions.

(1)

Quantity

(Q)

(2)

Price

(P )

(3)

Total Revenue

(TR 5 P 3 Q)

(4)

Average Revenue

(AR 5 TR / Q)

(5)

Marginal Revenue

(MR 5 ∆TR / ∆Q)

1 gallon $6 $6 $6

2 6 12 6

3 6 18 6

4 6 24 6

5 6 30 6

6 6 36 6

7 6 42 6

8 6 48 6

TABLE 1

Total, Average, and

Marginal Revenue for

a Competitive Firm

270 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

Column (4) in the table shows average revenue, which is total revenue [from column (3)] divided by the amount of output [from column (1)]. Average revenue tells us how much revenue a firm receives for the typical unit sold. In Table 1, you can see that average revenue equals $6, the price of a gallon of milk. This illus- trates a general lesson that applies not only to competitive firms but to other firms as well. Average revenue is total revenue (P 3 Q) divided by the quantity (Q). Therefore, for all types of firms, average revenue equals the price of the good.

Column (5) shows marginal revenue, which is the change in total revenue from the sale of each additional unit of output. In Table 1, marginal revenue equals $6, the price of a gallon of milk. This result illustrates a lesson that applies only to competitive firms. Total revenue is P 3 Q, and P is fixed for a competitive firm. Therefore, when Q rises by 1 unit, total revenue rises by P dollars. For competitive firms, marginal revenue equals the price of the good.

QuickQuiz When a competitive firm doubles the amount it sells, what happens to the

price of its output and its total revenue?

average revenue

total revenue divided by

the quantity sold

marginal revenue

the change in total

revenue from an

additional unit sold

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

The goal of a firm is to maximize profit, which equals total revenue minus total cost. We have just discussed the competitive firm’s revenue, and in the preceding chapter, we discussed the firm’s costs. We are now ready to examine how a competitive firm maximizes profit and how that decision determines its supply curve.

14-2a A Simple Example of Profit Maximization Let’s begin our analysis of the firm’s supply decision with the example in Table 2. Column (1) in the table shows the number of gallons of milk the Vaca Family Dairy Farm produces. Column (2) shows the farm’s total revenue, which is $6 times the number of gallons. Column (3) shows the farm’s total cost. Total cost includes fixed costs, which are $3 in this example, and variable costs, which depend on the quantity produced.

Column (4) shows the farm’s profit, which is computed by subtracting total cost from total revenue. If the farm produces nothing, it has a loss of $3 (its fixed cost). If it produces 1 gallon, it has a profit of $1. If it produces 2 gallons, it has a profit of $4 and so on. Because the Vaca family’s goal is to maximize profit, it chooses to produce the quantity of milk that makes profit as large as possible. In this example, profit is maximized when the farm produces either 4 or 5 gallons of milk, for a profit of $7.

There is another way to look at Vaca Farm’s decision: The Vacas can find the profit-maximizing quantity by comparing the marginal revenue and marginal cost from each unit produced. Columns (5) and (6) in Table 2 compute marginal revenue and marginal cost from the changes in total revenue and total cost, and column (7) shows the change in profit for each additional gallon produced. The first gallon of milk the farm produces has a marginal revenue of $6 and a marginal cost of $2; hence, producing that gallon increases profit by $4 (from 2$3 to $1). The second gallon produced has a marginal revenue of $6 and a marginal cost of $3, so that gallon increases profit by $3 (from $1 to $4). As long as marginal

271CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

(1)

Quantity

(Q)

(2)

Total

Revenue

(TR)

(3)

Total

Cost

(TC)

(4)

Profit

(TR 2 TC)

(5)

Marginal

Revenue

(MR 5 ∆TR / ∆Q)

(6)

Marginal

Cost

(MC 5 ∆TR / ∆Q)

(7)

Change

in Profit

(MR 2 MC )

0 gallons $ 0 $ 3 2$3

$6 $2 $4

1 6 5 1

6 3 3

2 12 8 4

6 4 2

3 18 12 6

6 5 1

4 24 17 7

6 6 0

5 30 23 7

6 7 21

6 36 30 6

6 8 22

7 42 38 4

6 9 23

8 48 47 1

TABLE 2

Profit Maximization:

A Numerical Example

revenue exceeds marginal cost, increasing the quantity produced raises profit. Once the Vaca Farm has reached 5 gallons of milk, however, the situation changes. The sixth gallon would have a marginal revenue of $6 and a marginal cost of $7, so producing it would reduce profit by $1 (from $7 to $6). As a result, the Vacas would not produce beyond 5 gallons.

One of the Ten Principles of Economics in Chapter 1 is that rational people think at the margin. We now see how the Vaca Family Dairy Farm can apply this prin- ciple. If marginal revenue is greater than marginal cost—as it is at 1, 2, and 3 gallons—the Vacas should increase the production of milk because it will put more money in their pockets (marginal revenue) than it takes out (marginal cost). If marginal revenue is less than marginal cost—as it is at 6, 7, and 8 gallons— the Vacas should decrease production. If the Vacas think at the margin and make incremental adjustments to the level of production, they end up producing the profit-maximizing quantity.

14-2b The Marginal-Cost Curve and the Firm’s Supply Decision To extend this analysis of profit maximization, consider the cost curves in Figure 1. These cost curves have the three features that, as we discussed in the previous chapter, are thought to describe most firms: The marginal-cost curve (MC) is upward-sloping. The average-total-cost curve (ATC) is U-shaped. And the marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost. The figure also shows a horizontal line at the market price (P). The price line is horizontal because a competitive firm is a price taker: The price

272 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

This figure shows the marginal-cost curve (MC), the average-total-cost curve (ATC), and

the average-variable-cost curve (AVC). It also shows the market price (P), which for a

competitive firm equals both marginal revenue (MR) and average revenue (AR). At the

quantity Q 1 , marginal revenue MR

1 exceeds marginal cost MC

1 , so raising production

increases profit. At the quantity Q 2 , marginal cost MC

2 is above marginal revenue MR

2 , so

reducing production increases profit. The profit-maximizing quantity Q MAX

is found where

the horizontal line representing the price intersects the marginal-cost curve.

FIGURE 1

Profit Maximization for

a Competitive Firm

Quantity0

Costs and

Revenue

ATC

AVC

MC2

MC1

Q1 Q2QMAX

P = MR1 = MR2 P = AR = MR

The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue.

of the firm’s output is the same regardless of the quantity that the firm decides to produce. Keep in mind that, for a competitive firm, the price equals both the firm’s average revenue (AR) and its marginal revenue (MR).

We can use Figure 1 to find the quantity of output that maximizes profit. Imag- ine that the firm is producing at Q

1 . At this level of output, the marginal-revenue

curve is above the marginal-cost curve, showing that marginal revenue is greater than marginal cost. This means that if the firm were to raise production by 1 unit, the additional revenue (MR

1 ) would exceed the additional cost (MC

1 ). Profit,

which equals total revenue minus total cost, would increase. Hence, if marginal revenue is greater than marginal cost, as it is at Q

1 , the firm can increase profit by

increasing production. A similar argument applies when output is at Q

2 . In this case, the marginal-cost

curve is above the marginal-revenue curve, showing that marginal cost is greater than marginal revenue. If the firm were to reduce production by 1 unit, the costs saved (MC

2 ) would exceed the revenue lost (MR

2 ). Therefore, if marginal revenue

is less than marginal cost, as it is at Q 2 , the firm can increase profit by reducing

production. Where do these marginal adjustments to production end? Regardless of

whether the firm begins with production at a low level (such as Q 1 ) or at a

high level (such as Q 2 ), the firm will eventually adjust production until the

273CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

quantity produced reaches Q MAX

. This analysis yields three general rules for profit maximization:

• If marginal revenue is greater than marginal cost, the firm should increase its output.

• If marginal cost is greater than marginal revenue, the firm should decrease its output.

• At the profit-maximizing level of output, marginal revenue and marginal cost are exactly equal.

These rules are the key to rational decision making by any profit-maximizing firm. They apply not only to competitive firms but, as we will see in the next chapter, to other types of firms as well.

We can now see how the competitive firm decides what quantity of its good to supply to the market. Because a competitive firm is a price taker, its marginal revenue equals the market price. For any given price, the competitive firm’s profit-maximizing quantity of output is found by looking at the intersection of the price with the marginal-cost curve. In Figure 1, that quantity of output is Q

MAX .

Suppose that the price prevailing in this market rises, perhaps because of an increase in market demand. Figure 2 shows how a competitive firm responds to the price increase. When the price is P

1 , the firm produces quantity Q

1 , the quan-

tity that equates marginal cost to the price. When the price rises to P 2 , the firm

finds that marginal revenue is now higher than marginal cost at the previous level of output, so the firm increases production. The new profit-maximizing quan- tity is Q

2 , at which marginal cost equals the new, higher price. In essence, because

the firm’s marginal-cost curve determines the quantity of the good the firm is willing to supply at any price, the marginal-cost curve is also the competitive firm’s supply curve. There are, however, some caveats to this conclusion, which we examine next.

14-2c The Firm’s Short-Run Decision to Shut Down So far, we have been analyzing the question of how much a competitive firm will produce. In certain circumstances, however, the firm will decide to shut down and not produce anything at all.

FIGURE 2

Marginal Cost as the

Competitive Firm’s Supply

Curve

An increase in the price

from P 1 to P

2 leads to

an increase in the firm’s

profit-maximizing quantity

from Q 1 to Q

2 . Because the

marginal-cost curve shows

the quantity supplied by

the firm at any given price,

it is the firm’s supply

curve.

Quantity0

Price

ATC

AVC

Q1 Q2

274 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

Here we need to distinguish between a temporary shutdown of a firm and the permanent exit of a firm from the market. A shutdown refers to a short-run decision not to produce anything during a specific period of time because of cur- rent market conditions. Exit refers to a long-run decision to leave the market. The short-run and long-run decisions differ because most firms cannot avoid their fixed costs in the short run but can do so in the long run. That is, a firm that shuts down temporarily still has to pay its fixed costs, whereas a firm that exits the mar- ket does not have to pay any costs at all, fixed or variable.

For example, consider the production decision that a farmer faces. The cost of the land is one of the farmer’s fixed costs. If the farmer decides not to produce any crops one season, the land lies fallow, and he cannot recover this cost. When making the short-run decision of whether to shut down for a season, the fixed cost of land is said to be a sunk cost. By contrast, if the farmer decides to leave farming altogether, he can sell the land. When making the long-run decision of whether to exit the mar- ket, the cost of land is not sunk. (We return to the issue of sunk costs shortly.)

Now let’s consider what determines a firm’s shutdown decision. If the firm shuts down, it loses all revenue from the sale of its product. At the same time, it saves the variable costs of making its product (but must still pay the fixed costs). Thus, the firm shuts down if the revenue that it would earn from producing is less than its variable costs of production.

A bit of mathematics can make this shutdown rule more useful. If TR stands for total revenue and VC stands for variable cost, then the firm’s decision can be written as

Shut down if TR , VC.

The firm shuts down if total revenue is less than variable cost. By dividing both sides of this inequality by the quantity Q, we can write it as

Shut down if TR/Q , VC/Q.

The left side of the inequality, TR/Q, is total revenue P 3 Q divided by quantity Q, which is average revenue, most simply expressed as the good’s price, P. The right side of the inequality, VC/Q, is average variable cost, AVC. Therefore, the firm’s shutdown rule can be restated as

Shut down if P , AVC.

That is, a firm chooses to shut down if the price of the good is less than the aver- age variable cost of production. This rule is intuitive: When choosing to produce, the firm compares the price it receives for the typical unit to the average vari- able cost that it must incur to produce the typical unit. If the price doesn’t cover the average variable cost, the firm is better off stopping production altogether. The firm still loses money (because it has to pay fixed costs), but it would lose even more money by staying open. The firm can reopen in the future if conditions change so that price exceeds average variable cost.

We now have a full description of a competitive firm’s profit-maximizing strat- egy. If the firm produces anything, it produces the quantity at which marginal cost equals the good’s price, which the firm takes as given. Yet if the price is less than average variable cost at that quantity, the firm is better off shutting down temporarily and not producing anything. These results are illustrated in Figure 3. The competitive firm’s short-run supply curve is the portion of its marginal-cost curve that lies above average variable cost.

275CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

FIGURE 3

The Competitive Firm’s

Short-Run Supply Curve

In the short run, the

competitive firm’s supply

curve is its marginal-cost

curve (MC) above average

variable cost (AVC). If the

price falls below average

variable cost, the firm is

better off shutting down

temporarily.

Quantity

ATC

Costs

AVC

1. In the short run, the firm produces on the MC curve if P . AVC,...

2. ...but shuts down if P , AVC.

14-2d Spilt Milk and Other Sunk Costs Sometime in your life you may have been told, “Don’t cry over spilt milk,” or “Let bygones be bygones.” These adages hold a deep truth about rational decision making. Economists say that a cost is a sunk cost when it has already been com- mitted and cannot be recovered. Because nothing can be done about sunk costs, you should ignore them when making decisions about various aspects of life, including business strategy.

Our analysis of the firm’s shutdown decision is one example of the irrelevance of sunk costs. We assume that the firm cannot recover its fixed costs by tempo- rarily stopping production. That is, regardless of the quantity of output supplied (even if it is zero), the firm still has to pay its fixed costs. As a result, the fixed costs are sunk in the short run, and the firm should ignore them when decid- ing how much to produce. The firm’s short-run supply curve is the part of the marginal-cost curve that lies above average variable cost, and the size of the fixed cost does not matter for this supply decision.

The irrelevance of sunk costs is also important when making personal deci- sions. Imagine, for instance, that you place a $15 value on seeing a newly released movie. You buy a ticket for $10, but before entering the theater, you lose the ticket. Should you buy another ticket? Or should you now go home and refuse to pay a total of $20 to see the movie? The answer is that you should buy another ticket. The benefit of seeing the movie ($15) still exceeds the opportunity cost (the $10 for the second ticket). The $10 you paid for the lost ticket is a sunk cost. As with spilt milk, there is no point in crying about it.

CASE STUDY

NEAR-EMPTY RESTAURANTS AND OFF-SEASON MINIATURE GOLF Have you ever walked into a restaurant for lunch and found it almost empty? Why, you might have asked, does the restaurant even bother to stay open? It might seem that the revenue from so few customers

could not possibly cover the cost of running the restaurant. In making the decision of whether to open for lunch, a restaurant owner

must keep in mind the distinction between fixed and variable costs. Many of

sunk cost

a cost that has already

been committed and

cannot be recovered

276 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

a restaurant’s costs—the rent, kitchen equipment, tables, plates, silverware, and so on—are fixed. Shutting down during lunch would not reduce these costs. In other words, these costs are sunk in the short run. When the owner is deciding whether to serve lunch, only the variable costs—the price of the additional food and the wages of the extra staff—are relevant. The owner shuts down the restau- rant at lunchtime only if the revenue from the few lunchtime customers would fail to cover the restaurant’s variable costs.

An operator of a miniature-golf course in a summer resort community faces a similar decision. Because revenue varies substantially from season to season, the firm must decide when to open and when to close. Once again, the fixed costs—the costs of buying the land and building the course—are irrelevant in making this short-run decision. The miniature-golf course should be open for business only during those times of year when its revenue exceeds its variable costs. ●

14-2e The Firm’s Long-Run Decision to Exit or Enter a Market A firm’s long-run decision to exit a market is similar to its shutdown decision. If the firm exits, it will again lose all revenue from the sale of its product, but now it will save not only its variable costs of production but also its fixed costs. Thus, the firm exits the market if the revenue it would get from producing is less than its total cost.

We can again make this rule more useful by writing it mathematically. If TR stands for total revenue and TC stands for total cost, then the firm’s exit rule can be written as

Exit if TR , TC.

Staying open can be profitable, even with many tables empty.

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277CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

FIGURE 4

The Competitive Firm’s

Long-Run Supply Curve

In the long run, the com-

petitive firm’s supply

curve is its marginal-cost

curve (MC) above average

total cost (ATC). If the

price falls below average

total cost, the firm is better

off exiting the market.

Quantity

ATC

Costs

1. In the long run, the firm produces on the MC curve if P . ATC,...

2. ...but exits if P , ATC.

The firm exits if total revenue is less than total cost. By dividing both sides of this inequality by quantity Q, we can write it as

Exit if TR/Q , TC/Q.

We can simplify this further by noting that TR/Q is average revenue, which equals the price P, and that TC/Q is average total cost, ATC. Therefore, the firm’s exit rule is

Exit if P , ATC.

That is, a firm chooses to exit if the price of its good is less than the average total cost of production.

A parallel analysis applies to an entrepreneur who is considering starting a firm. He will enter the market if starting the firm would be profitable, which occurs if the price of the good exceeds the average total cost of production. The entry rule is

Enter if P . ATC.

The rule for entry is exactly the opposite of the rule for exit. We can now describe a competitive firm’s long-run profit-maximizing strat-

egy. If the firm produces anything, it chooses the quantity at which marginal cost equals the price of the good. Yet if the price is less than the average total cost at that quantity, the firm chooses to exit (or not enter) the market. These results are illustrated in Figure 4. The competitive firm’s long-run supply curve is the portion of its marginal-cost curve that lies above average total cost.

14-2f Measuring Profit in Our Graph for the Competitive Firm As we study exit and entry, it is useful to analyze the firm’s profit in more detail. Recall that profit equals total revenue (TR) minus total cost (TC):

Profit 5 TR 2 TC.

278 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

The area of the shaded box between price and average total cost represents the firm’s

profit. The height of this box is price minus average total cost (P 2 ATC), and the

width of the box is the quantity of output (Q). In panel (a), price is above average total

cost, so the firm has positive profit. In panel (b), price is less than average total cost,

so the firm incurs a loss.

FIGURE 5

Profit as the Area between

Price and Average Total

Cost

(a) A Firm with Profits (b) A Firm with Losses

Quantity0

Price

Quantity0

Price

P = AR = MR

Profit ATCMC

ATC ATC

Q (profit-maximizing quantity)

P = AR = MR

Loss

ATCMC

Q (loss-minimizing quantity)

We can rewrite this definition by multiplying and dividing the right side by Q:

Profit 5 (TR/Q 2 TC/Q) 3 Q.

Note that TR/Q is average revenue, which is the price, P, and TC/Q is average total cost, ATC. Therefore,

Profit 5 (P 2 ATC) 3 Q.

This way of expressing the firm’s profit allows us to measure profit in our graphs. Panel (a) of Figure 5 shows a firm earning positive profit. As we have already

discussed, the firm maximizes profit by producing the quantity at which price equals marginal cost. Now look at the shaded rectangle. The height of the rectan- gle is P 2 ATC, the difference between price and average total cost. The width of the rectangle is Q, the quantity produced. Therefore, the area of the rectangle is (P 2 ATC) 3 Q, which is the firm’s profit.

Similarly, panel (b) of this figure shows a firm with losses (negative profit). In this case, maximizing profit means minimizing losses, a task accomplished once again by producing the quantity at which price equals marginal cost. Now con- sider the shaded rectangle. The height of the rectangle is ATC 2 P, and the width is Q. The area is (ATC 2 P) 3 Q, which is the firm’s loss. Because a firm in this sit- uation is not making enough revenue on each unit to cover its average total cost, it would choose to exit the market in the long run.

QuickQuiz How does a competitive firm determine its profit-maximizing level of out-

put? Explain. • When does a profit-maximizing competitive firm decide to

shut down? When does it decide to exit a market?

279CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

14-3 The Supply Curve in a Competitive Market Now that we have examined the supply decision of a single firm, we can discuss the supply curve for a market. There are two cases to consider. First, we examine a market with a fixed number of firms. Second, we examine a market in which the number of firms can change as old firms exit the market and new firms enter. Both cases are important, for each applies to a specific time horizon. Over short periods of time, it is often difficult for firms to enter and exit, so the assumption of a fixed number of firms is appropriate. But over long periods of time, the number of firms can adjust to changing market conditions.

14-3a The Short Run: Market Supply with a Fixed Number of Firms Consider a market with 1,000 identical firms. For any given price, each firm sup- plies a quantity of output so that its marginal cost equals the price, as shown in panel (a) of Figure 6. That is, as long as price is above average variable cost, each firm’s marginal-cost curve is its supply curve. The quantity of output supplied to the market equals the sum of the quantities supplied by each of the 1,000 individ- ual firms. Thus, to derive the market supply curve, we add the quantity supplied by each firm in the market. As panel (b) of Figure 6 shows, because the firms are identical, the quantity supplied to the market is 1,000 times the quantity supplied by each firm.

14-3b The Long Run: Market Supply with Entry and Exit Now consider what happens if firms are able to enter and exit the market. Let’s suppose that everyone has access to the same technology for producing the good

In the short run, the number of firms in the market is fixed. As a result, the market supply

curve, shown in panel (b), reflects the individual firms’ marginal-cost curves, shown in

panel (a). Here, in a market of 1,000 firms, the quantity of output supplied to the market is

1,000 times the quantity supplied by each firm.

FIGURE 6

Short-Run Market Supply

(a) Individual Firm Supply

Quantity (firm)0

Price

$2.00

1.00

100 200

(b) Market Supply

Quantity (market)0

Price

Supply

$2.00

1.00

100,000 200,000

280 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

and access to the same markets to buy the inputs for production. Therefore, all current and potential firms have the same cost curves.

Decisions about entry and exit in a market of this type depend on the incen- tives facing the owners of existing firms and the entrepreneurs who could start new firms. If firms already in the market are profitable, then new firms will have an incentive to enter the market. This entry will expand the number of firms, increase the quantity of the good supplied, and drive down prices and profits. Conversely, if firms in the market are making losses, then some existing firms will exit the market. Their exit will reduce the number of firms, decrease the quantity of the good supplied, and drive up prices and profits. At the end of this process of entry and exit, firms that remain in the market must be making zero economic profit.

Recall that we can write a firm’s profit as

Profit 5 (P 2 ATC) 3 Q.

This equation shows that an operating firm has zero profit if and only if the price of the good equals the average total cost of producing that good. If price is above average total cost, profit is positive, which encourages new firms to enter. If price is less than average total cost, profit is negative, which encourages some firms to exit. The process of entry and exit ends only when price and average total cost are driven to equality.

This analysis has a surprising implication. We noted earlier in the chapter that competitive firms maximize profits by choosing a quantity at which price equals marginal cost. We just noted that free entry and exit force price to equal average total cost. But if price is to equal both marginal cost and average total cost, these two measures of cost must equal each other. Marginal cost and average total cost are equal, however, only when the firm is operating at the minimum of average total cost. Recall from the preceding chapter that the level of production with low- est average total cost is called the firm’s efficient scale. Therefore, in the long-run equilibrium of a competitive market with free entry and exit, firms must be operating at their efficient scale.

Panel (a) of Figure 7 shows a firm in such a long-run equilibrium. In this figure, price P equals marginal cost MC, so the firm is maximizing profit. Price also equals average total cost ATC, so profit is zero. New firms have no incentive to enter the market, and existing firms have no incentive to leave the market.

From this analysis of firm behavior, we can determine the long-run supply curve for the market. In a market with free entry and exit, there is only one price consistent with zero profit—the minimum of average total cost. As a result, the long-run market supply curve must be horizontal at this price, as illustrated by the perfectly elastic supply curve in panel (b) of Figure 7. Any price above this level would generate profit, leading to entry and an increase in the total quantity supplied. Any price below this level would generate losses, leading to exit and a decrease in the total quantity supplied. Eventually, the number of firms in the market adjusts so that price equals the minimum of average total cost, and there are enough firms to satisfy all the demand at this price.

14-3c Why Do Competitive Firms Stay in Business If They Make Zero Profit?

At first, it might seem odd that competitive firms earn zero profit in the long run. After all, people start businesses to make a profit. If entry eventually drives profit to zero, there might seem to be little reason to stay in business.

281CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

To understand the zero-profit condition more fully, recall that profit equals total revenue minus total cost and that total cost includes all the opportunity costs of the firm. In particular, total cost includes the time and money that the firm owners devote to the business. In the zero-profit equilibrium, the firm’s revenue must compensate the owners for these opportunity costs.

Consider an example. Suppose that, to start his farm, a farmer had to invest $1 million, which otherwise he could have deposited in a bank and earned $50,000 a year in interest. In addition, he had to give up another job that would have paid him $30,000 a year. Then the farmer ’s opportunity cost of farming includes both the interest he could have earned and the forgone wages—a total of $80,000. Even if his profit is driven to zero, his revenue from farming compensates him for these opportunity costs.

Keep in mind that accountants and economists measure costs differently. As we discussed in the previous chapter, accountants keep track of explicit costs but not implicit costs. That is, they measure costs that require an outflow of money from the firm, but they do not include the opportunity costs of production that do not involve an outflow of money. As a result, in the zero-profit equilibrium, eco- nomic profit is zero, but accounting profit is positive. Our farmer’s accountant, for instance, would conclude that the farmer earned an accounting profit of $80,000, which is enough to keep the farmer in business.

14-3d A Shift in Demand in the Short Run and Long Run Now that we have a more complete understanding of how firms make supply decisions, we can better explain how markets respond to changes in demand. Because firms can enter and exit in the long run but not in the short run, the response of a market to a change in demand depends on the time horizon. To see this, let’s trace the effects of a shift in demand over time.

In the long run, firms will enter or exit the market until profit is driven to zero. As a result,

price equals the minimum of average total cost, as shown in panel (a). The number of

firms adjusts to ensure that all demand is satisfied at this price. The long-run market

supply curve is horizontal at this price, as shown in panel (b).

FIGURE 7

Long-Run Market Supply

(a) Firm’s Zero-Profit Condition

Quantity (firm)0

Price

P = minimum ATC

(b) Market Supply

Quantity (market)

Price

Supply

ATC

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282 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

Suppose the market for milk begins in a long-run equilibrium. Firms are earn- ing zero profit, so price equals the minimum of average total cost. Panel (a) of Figure 8 shows this situation. The long-run equilibrium is point A, the quantity sold in the market is Q

1 , and the price is P

1 .

Now suppose scientists discover that milk has miraculous health benefits. As a result, the quantity of milk demanded at every price increases, and the demand curve for milk shifts outward from D

1 to D

2 , as in panel (b). The short-

run equilibrium moves from point A to point B; as a result, the quantity rises from Q

1 to Q

2 , and the price rises from P

1 to P

2 . All of the existing firms respond

to the higher price by raising the amount they produce. Because each firm’s supply curve reflects its marginal-cost curve, how much each firm increases production is determined by the marginal-cost curve. In the new short-run equilibrium, the price of milk exceeds average total cost, so the firms are mak- ing positive profit.

Over time, the profit generated in this market encourages new firms to enter. Some farmers may switch to producing milk instead of other farm products, for example. As the number of firms grows, the quantity supplied at every price in- creases, the short-run supply curve shifts to the right from S

1 to S

2 , as in panel (c),

and this shift causes the price of milk to fall. Eventually, the price is driven back down to the minimum of average total cost, profits are zero, and firms stop en- tering. Thus, the market reaches a new long-run equilibrium, point C. The price of milk has returned to P

1 , but the quantity produced has risen to Q

3 . Each firm is

again producing at its efficient scale, but because more firms are in the dairy busi- ness, the quantity of milk produced and sold is higher.

14-3e Why the Long-Run Supply Curve Might Slope Upward So far, we have seen that entry and exit can cause the long-run market supply curve to be perfectly elastic. The essence of our analysis is that there are a large number of potential entrants, each of which faces the same costs. As a result, the long-run market supply curve is horizontal at the minimum of average total cost. When the demand for the good increases, the long-run result is an increase in the number of firms and in the total quantity supplied, without any change in the price.

There are, however, two reasons that the long-run market supply curve might slope upward. The first is that some resources used in production may be avail- able only in limited quantities. For example, consider the market for farm prod- ucts. Anyone can choose to buy land and start a farm, but the quantity of land is limited. As more people become farmers, the price of farmland is bid up, which raises the costs of all farmers in the market. Thus, an increase in demand for farm products cannot induce an increase in quantity supplied without also in- ducing a rise in farmers’ costs, which in turn means a rise in price. The result is a long-run market supply curve that is upward-sloping, even with free entry into farming.

A second reason for an upward-sloping supply curve is that firms may have different costs. For example, consider the market for painters. Anyone can enter the market for painting services, but not everyone has the same costs. Costs vary in part because some people work faster than others and in part because some people have better alternative uses of their time than others. For any given price, those with lower costs are more likely to enter than those with higher costs. To increase the quantity of painting services supplied, additional entrants must be encouraged to enter the market. Because these new entrants have higher costs,

283CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

The market starts in a long-run equilibrium, shown as point A in panel (a). In this equilibrium,

each firm makes zero profit, and the price equals the minimum average total cost. Panel (b)

shows what happens in the short run when demand rises from D 1 to D

2 . The equilibrium goes

from point A to point B, price rises from P 1 to P

2 , and the quantity sold in the market rises from

Q 1 to Q

2 . Because price now exceeds average total cost, each firm now makes a profit, which over

time encourages new firms to enter the market. This entry shifts the short-run supply curve to the

right from S 1 to S

2 , as shown in panel (c). In the new long-run equilibrium, point C, price has re-

turned to P 1 but the quantity sold has increased to Q

3 . Profits are again zero, and price is back to

the minimum of average total cost, but the market has more firms to satisfy the greater demand.

FIGURE 8

An Increase in Demand

in the Short Run and

Long Run

(a) Initial Condition

(b) Short-Run Response

Firm

Quantity (firm)0

Price

Firm

Quantity (firm)0

Price

MC ATC

Firm

Quantity (firm)0

Price

MC ATC

Market

Quantity (market)

Long-run supply

Price

Demand, D1

Short-run supply, S1

P1 A

Quantity (market)

Long-run supply

Price

P2 A

Market

Quantity (market)

Price

Q1 Q2

Long-run supply

1. A market begins in long-run equilibrium…

2. …with the firm earning zero profit.

3. But then an increase in demand raises the price…

4. …leading to short-run profits.

6. …restoring long- run equilibrium.

5. When profits induce entry, supply increases and the price falls,…

284 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

1. A perfectly competitive firm

a. chooses its price to maximize profits.

b. sets its price to undercut other firms selling similar

products.

c. takes its price as given by market conditions.

d. picks the price that yields the largest market share.

2. A competitive firm maximizes profit by choosing the

quantity at which

a. average total cost is at its minimum.

b. marginal cost equals the price.

c. average total cost equals the price.

d. marginal cost equals average total cost.

CHAPTER QuickQuiz

the price must rise to make entry profitable for them. Thus, the long-run market supply curve for painting services slopes upward even with free entry into the market.

Notice that if firms have different costs, some firms earn profit even in the long run. In this case, the price in the market reflects the average total cost of the marginal firm—the firm that would exit the market if the price were any lower. This firm earns zero profit, but firms with lower costs earn positive profit. Entry does not eliminate this profit because would-be entrants have higher costs than firms already in the market. Higher-cost firms will enter only if the price rises, making the market profitable for them.

Thus, for these two reasons, a higher price may be necessary to induce a larger quantity supplied, in which case the long-run supply curve is upward-sloping rather than horizontal. Nonetheless, the basic lesson about entry and exit remains true. Because firms can enter and exit more easily in the long run than in the short run, the long-run supply curve is typically more elastic than the short-run supply curve.

QuickQuiz In the long run with free entry and exit, is the price in a market equal to

marginal cost, average total cost, both, or neither? Explain with a diagram.

14-4 Conclusion: Behind the Supply Curve We have been discussing the behavior of profit-maximizing firms that supply goods in perfectly competitive markets. You may recall from Chapter 1 that one of the Ten Principles of Economics is that rational people think at the margin. This chapter has applied this idea to the competitive firm. Marginal analysis has given us a theory of the supply curve in a competitive market and, as a result, a deeper understanding of market outcomes.

We have learned that when you buy a good from a firm in a competitive mar- ket, you can be assured that the price you pay is close to the cost of producing that good. In particular, if firms are competitive and profit-maximizing, the price of a good equals the marginal cost of making that good. In addition, if firms can freely enter and exit the market, the price also equals the lowest possible average total cost of production.

Although we have assumed throughout this chapter that firms are price takers, many of the tools developed here are also useful for studying firms in less competitive markets. We now turn to examining the behavior of firms with market power. Marginal analysis will again be useful, but it will have quite different implications for a firm’s production decisions and for the nature of market outcomes.

285CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

3. A competitive firm’s short-run supply curve is its

________ cost curve above its ________ cost curve.

a. average total, marginal

b. average variable, marginal

c. marginal, average total

d. marginal, average variable

4. If a profit-maximizing, competitive firm is producing

a quantity at which marginal cost is between average

variable cost and average total cost, it will

a. keep producing in the short run but exit the market

in the long run.

b. shut down in the short run but return to production

in the long run.

c. shut down in the short run and exit the market in

the long run.

d. keep producing both in the short run and in the

long run.

5. In the long-run equilibrium of a competitive market

with identical firms, what are the relationships

among price P, marginal cost MC, and average total

cost ATC?

a. P . MC and P . ATC. b. P . MC and P 5 ATC. c. P 5 MC and P . ATC. d. P 5 MC and P 5 ATC.

6. Pretzel stands in New York City are a perfectly

competitive industry in long-run equilibrium. One day,

the city starts imposing a $100 per month tax on

each stand. How does this policy affect the number of

pretzels consumed in the short run and the long run?

a. down in the short run, no change in the long run

b. up in the short run, no change in the long run

c. no change in the short run, down in the long run

d. no change in the short run, up in the long run

• Because a competitive firm is a price taker, its revenue

is proportional to the amount of output it produces.

The price of the good equals both the firm’s average

revenue and its marginal revenue.

• To maximize profit, a firm chooses a quantity of out-

put such that marginal revenue equals marginal cost.

Because marginal revenue for a competitive firm

equals the market price, the firm chooses quantity

so that price equals marginal cost. Thus, the firm’s

marginal-cost curve is its supply curve.

• In the short run when a firm cannot recover its fixed

costs, the firm will choose to shut down temporarily if

the price of the good is less than average variable cost.

In the long run when the firm can recover both fixed

and variable costs, it will choose to exit if the price is

less than average total cost.

• In a market with free entry and exit, profit is driven

to zero in the long run. In this long-run equilibrium,

all firms produce at the efficient scale, price equals the

minimum of average total cost, and the number of firms

adjusts to satisfy the quantity demanded at this price.

• Changes in demand have different effects over dif-

ferent time horizons. In the short run, an increase in

demand raises prices and leads to profits, and a de-

crease in demand lowers prices and leads to losses. But

if firms can freely enter and exit the market, then in

the long run, the number of firms adjusts to drive the

market back to the zero-profit equilibrium.

SUMMARY

competitive market, p. 268

average revenue, p. 270

marginal revenue, p. 270 sunk cost, p. 275

KEY CONCEPTS

1. What are the main characteristics of a competitive

market?

2. Explain the difference between a firm’s revenue and

its profit. Which do firms maximize?

3. Draw the cost curves for a typical firm. Explain how

a competitive firm chooses the level of output that

maximizes profit. At that level of output, show on

your graph the firm’s total revenue and total cost.

4. Under what conditions will a firm shut down

temporarily? Explain.

5. Under what conditions will a firm exit a market?

Explain.

QUESTIONS FOR REVIEW

286 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

6. Does a competitive firm’s price equal its marginal cost

in the short run, in the long run, or both? Explain.

7. Does a competitive firm’s price equal the minimum of

its average total cost in the short run, in the long run,

or both? Explain.

8. Are market supply curves typically more elastic in the

short run or in the long run? Explain.

1. Many small boats are made of fiberglass and a resin

derived from crude oil. Suppose that the price of

oil rises.

a. Using diagrams, show what happens to the cost

curves of an individual boat-making firm and to

the market supply curve.

b. What happens to the profits of boat makers in the

short run? What happens to the number of boat

makers in the long run?

2. Bob’s lawn-mowing service is a profit-maximizing,

competitive firm. Bob mows lawns for $27 each. His

total cost each day is $280, of which $30 is a fixed cost.

He mows 10 lawns a day. What can you say about

Bob’s short-run decision regarding shutdown and his

long-run decision regarding exit?

3. Consider total cost and total revenue given in the fol-

lowing table:

Quantity 0 1 2 3 4 5 6 7

Total cost $8 9 10 11 13 19 27 37

Total revenue $0 8 16 24 32 40 48 56

a. Calculate profit for each quantity. How much

should the firm produce to maximize profit?

b. Calculate marginal revenue and marginal cost

for each quantity. Graph them. (Hint: Put the points between whole numbers. For example, the

marginal cost between 2 and 3 should be graphed

at 2½.) At what quantity do these curves cross?

How does this relate to your answer to part (a)?

c. Can you tell whether this firm is in a competitive

industry? If so, can you tell whether the industry

is in a long-run equilibrium?

4. Ball Bearings, Inc., faces costs of production as follows:

Quantity Total Fixed Cost Total Variable Cost

0 $100 $0

1 100 50

2 100 70

3 100 90

4 100 140

5 100 200

6 100 360

a. Calculate the company’s average fixed cost, aver-

age variable cost, average total cost, and marginal

cost at each level of production.

b. The price of a case of ball bearings is $50. Seeing

that he can’t make a profit, the chief executive

officer (CEO) decides to shut down operations.

What is the firm’s profit/loss? Was this a wise

decision? Explain.

c. Vaguely remembering his introductory economics

course, the chief financial officer tells the CEO

it is better to produce 1 case of ball bearings,

because marginal revenue equals marginal cost

at that quantity. What is the firm’s profit/loss

at that level of production? Was this the best

decision? Explain.

5. Suppose the book-printing industry is competitive

and begins in a long-run equilibrium.

a. Draw a diagram showing the average total cost,

marginal cost, marginal revenue, and supply

curve of the typical firm in the industry.

b. Hi-Tech Printing Company invents a new process

that sharply reduces the cost of printing books.

What happens to Hi-Tech’s profits and to the

price of books in the short run when Hi-Tech’s

patent prevents other firms from using the new

technology?

c. What happens in the long run when the patent

expires and other firms are free to use the

technology?

6. A firm in a competitive market receives $500 in total

revenue and has marginal revenue of $10. What

is the average revenue, and how many units were

sold?

7. A profit-maximizing firm in a competitive market is

currently producing 100 units of output. It has average

revenue of $10, average total cost of $8, and fixed cost

of $200.

a. What is its profit?

b. What is its marginal cost?

c. What is its average variable cost?

d. Is the efficient scale of the firm more than, less

than, or exactly 100 units?

PROBLEMS AND APPLICATIONS

287CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

8. The market for fertilizer is perfectly competitive.

Firms in the market are producing output but are cur-

rently incurring economic losses.

a. How does the price of fertilizer compare to the av-

erage total cost, the average variable cost, and the

marginal cost of producing fertilizer?

b. Draw two graphs, side by side, illustrating the

present situation for the typical firm and for the

market.

c. Assuming there is no change in either demand or

the firms’ cost curves, explain what will happen

in the long run to the price of fertilizer, marginal

cost, average total cost, the quantity supplied by

each firm, and the total quantity supplied to the

market.

9. The market for apple pies in the city of Ectenia is com-

petitive and has the following demand schedule:

Price Quantity Demanded

$1 1,200 pies

2 1,100

3 1,000

4 900

5 800

6 700

7 600

8 500

9 400

10 300

11 200

12 100

13 0

Each producer in the market has fixed costs of $9 and

the following marginal cost:

Quantity Marginal Cost

1 pie $2

2 4

3 6

4 8

5 10

6 12

a. Compute each producer’s total cost and average

total cost for 1 to 6 pies.

b. The price of a pie is now $11. How many pies are

sold? How many pies does each producer make?

How many producers are there? How much profit

does each producer earn?

c. Is the situation described in part (b) a long-run

equilibrium? Why or why not?

d. Suppose that in the long run there is free entry

and exit. How much profit does each producer

earn in the long-run equilibrium? What is the

market price? How many pies does each producer

make? How many pies are sold in the market?

How many pie producers are operating?

10. An industry currently has 100 firms, each of which

has fixed cost of $16 and average variable cost as

follows:

Quantity Average Variable Cost

1 $1

2 2

3 3

4 4

5 5

6 6

a. Compute a firm’s marginal cost and average total

cost for each quantity from 1 to 6.

b. The equilibrium price is currently $10. How much

does each firm produce? What is the total quantity

supplied in the market?

c. In the long run, firms can enter and exit the mar-

ket, and all entrants have the same costs as above.

As this market makes the transition to its long-run

equilibrium, will the price rise or fall? Will the

quantity demanded rise or fall? Will the quantity

supplied by each firm rise or fall? Explain your

answers.

d. Graph the long-run supply curve for this

market, with specific numbers on the axes as

relevant.

11. Suppose that each firm in a competitive industry has

the following costs:

Total cost: TC 5 50 1 ½ q2

Marginal cost: MC 5 q

where q is an individual firm’s quantity produced. The market demand curve for this product is

Demand: QD 5 120 2 P

where P is the price and Q is the total quantity of the good. Currently, there are 9 firms in the market.

a. What is each firm’s fixed cost? What is its variable

cost? Give the equation for average total cost.

b. Graph average-total-cost curve and the

marginal-cost curve for q from 5 to 15. At what quantity is average-total-cost curve at its

288 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

minimum? What is marginal cost and average

total cost at that quantity?

c. Give the equation for each firm’s supply curve.

d. Give the equation for the market supply curve for

the short run in which the number of firms is fixed.

e. What is the equilibrium price and quantity for this

market in the short run?

f. In this equilibrium, how much does each firm

produce? Calculate each firm’s profit or loss. Is

there incentive for firms to enter or exit?

g. In the long run with free entry and exit, what is

the equilibrium price and quantity in this market?

h. In this long-run equilibrium, how much does

each firm produce? How many firms are in the

market?

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

Monopoly CHAPTER

15 I

f you own a personal computer, it probably uses some version of Windows, the operating system sold by the Microsoft Corporation. When Microsoft first designed Windows many years ago, it applied for and received a copyright

from the government. The copyright gives Microsoft the exclusive right to make and sell copies of the Windows operating system. If a person wants to buy a copy of Windows, she has little choice but to give Microsoft the approximately $100 that the firm has decided to charge for its product. Microsoft is said to have a monopoly in the market for Windows.

Microsoft’s business decisions are not well described by the model of firm behavior we developed in the previous chapter. In that chapter,

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290 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

we analyzed competitive markets, in which many firms offer essentially identical products, so each firm has little influence over the price it receives. By contrast, a monopoly such as Microsoft has no close competitors and, therefore, has the power to influence the market price of its product. Whereas a competitive firm is a price taker, a monopoly firm is a price maker.

In this chapter, we examine the implications of this market power. We will see that market power alters the relationship between a firm’s costs and the price at which it sells its product. A competitive firm takes the price of its output as given by the market and then chooses the quantity it will supply so that price equals marginal cost. By contrast, a monopoly charges a price that exceeds marginal cost. Sure enough, we observe this practice in the case of Microsoft’s Windows. The marginal cost of Windows—the extra cost that Microsoft incurs by downloading one more copy of the program onto a CD—is only a few dollars. The market price of Windows is many times its marginal cost.

It is not surprising that monopolies charge high prices for their products. Cus- tomers of monopolies might seem to have little choice but to pay whatever the monopoly charges. But if so, why does a copy of Windows not cost $1,000? Or $10,000? The reason is that if Microsoft were to set the price that high, fewer peo- ple would buy the product. People would buy fewer computers, switch to other operating systems, or make illegal copies. A monopoly firm can control the price of the good it sells, but because a high price reduces the quantity that its custom- ers buy, the monopoly’s profits are not unlimited.

As we examine the production and pricing decisions of monopolies, we also consider the implications of monopoly for society as a whole. Monopoly firms, like competitive firms, aim to maximize profit. But this goal has very differ- ent ramifications for competitive and monopoly firms. In competitive markets, self-interested consumers and producers reach an equilibrium that promotes gen- eral economic well-being, as if guided by an invisible hand. By contrast, because monopoly firms are unchecked by competition, the outcome in a market with a monopoly is often not in the best interest of society.

One of the Ten Principles of Economics in Chapter 1 is that governments can some- times improve market outcomes. The analysis in this chapter sheds more light on this principle. As we examine the problems that monopolies raise for society, we discuss the various ways in which government policymakers might respond to these problems. The U.S. government, for example, keeps a close eye on Microsoft’s business decisions. In 1994, it blocked Microsoft from buying Intuit, a leading seller of personal finance software, on the grounds that combining the two firms would concentrate too much market power. Similarly, in 1998, the U.S. Department of Jus- tice objected when Microsoft started integrating its Internet browser into its Win- dows operating system, claiming that this addition would extend the firm’s market power into new areas. In recent years, regulators in the United States and abroad have shifted their focus to firms with growing market power, such as Google and Samsung, but continue to monitor Microsoft’s compliance with the antitrust laws.

15-1 Why Monopolies Arise A firm is a monopoly if it is the sole seller of its product and if its product does not have any close substitutes. The fundamental cause of monopoly is barriers to entry: A monopoly remains the only seller in its market because other firms cannot enter the market and compete with it. Barriers to entry, in turn, have three main sources:

monopoly

a firm that is the sole

seller of a product with-

out any close substitutes

291CHAPTER 15 MONOPOLY

• Monopoly resources: A key resource required for production is owned by a single firm.

• Government regulation: The government gives a single firm the exclusive right to produce some good or service.

• The production process: A single firm can produce output at a lower cost than can a larger number of firms.

Let’s briefly discuss each of these.

15-1a Monopoly Resources The simplest way for a monopoly to arise is for a single firm to own a key resource. For example, consider the market for water in a small town. If dozens of town residents have working wells, the model of competitive markets discussed in the preceding chapter describes the behavior of sell- ers. Competition among suppliers drives the price of a gallon of water to equal the marginal cost of pumping an extra gallon. But if there is only one well in town and it is impossible to get water from anywhere else, then the owner of the well has a monopoly on water. Not surprisingly, the monopolist has much greater market power than any single firm in a competitive market. In the case of a necessity like water, the monopolist can command quite a high price, even if the marginal cost of pumping an extra gallon is low.

A classic example of market power arising from the ownership of a key resource is DeBeers, the South African diamond company. Founded in 1888 by Cecil Rhodes, an English businessman (and benefactor of the Rhodes scholar- ship), DeBeers has at times controlled up to 80 percent of the production from the world’s diamond mines. Because its market share is less than 100 percent, DeBeers is not exactly a monopoly, but the company has nonetheless exerted sub- stantial influence over the market price of diamonds.

Although exclusive ownership of a key resource is a potential cause of monopoly, in practice monopolies rarely arise for this reason. Economies are large, and resources are owned by many people. The natural scope of many markets is worldwide, because goods are often traded internationally. There are, therefore, few examples of firms that own a resource for which there are no close substitutes.

15-1b Government-Created Monopolies In many cases, monopolies arise because the government has given one person or firm the exclusive right to sell some good or service. Sometimes the monopoly arises from the sheer political clout of the would-be monopolist. Kings, for exam- ple, once granted exclusive business licenses to their friends and allies. At other times, the government grants a monopoly because doing so is viewed to be in the public interest.

The patent and copyright laws are two important examples. When a pharma- ceutical company discovers a new drug, it can apply to the government for a pat- ent. If the government deems the drug to be truly original, it approves the patent, which gives the company the exclusive right to manufacture and sell the drug for 20 years. Similarly, when a novelist finishes a book, she can copyright it. The copyright is a government guarantee that no one can print and sell the work with- out the author’s permission. The copyright makes the novelist a monopolist in the sale of her novel.

The effects of patent and copyright laws are easy to see. Because these laws give one producer a monopoly, they lead to higher prices than would occur under

“Rather than a monopoly, we like to consider ourselves ‘the only game in town.’”

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292 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

competition. But by allowing these monopoly producers to charge higher prices and earn higher profits, the laws also encourage some desirable behavior. Drug companies are allowed to be monopolists in the drugs they discover to encour- age research. Authors are allowed to be monopolists in the sale of their books to encourage them to write more and better books.

Thus, the laws governing patents and copyrights have both benefits and costs. The benefits of the patent and copyright laws are the increased incentives for cre- ative activity. These benefits are offset, to some extent, by the costs of monopoly pricing, which we examine later in this chapter.

15-1c Natural Monopolies An industry is a natural monopoly when a single firm can supply a good or ser- vice to an entire market at a lower cost than could two or more firms. A natural monopoly arises when there are economies of scale over the relevant range of out- put. Figure 1 shows the average total costs of a firm with economies of scale. In this case, a single firm can produce any amount of output at the lowest cost. That is, for any given amount of output, a larger number of firms leads to less output per firm and higher average total cost.

An example of a natural monopoly is the distribution of water. To provide water to residents of a town, a firm must build a network of pipes throughout the town. If two or more firms were to compete in the provision of this service, each firm would have to pay the fixed cost of building a network. Thus, the average total cost of water is lowest if a single firm serves the entire market.

We saw other examples of natural monopolies when we discussed public goods and common resources in Chapter 11. We noted that club goods are exclud- able but not rival in consumption. An example is a bridge used so infrequently that it is never congested. The bridge is excludable because a toll collector can prevent someone from using it. The bridge is not rival in consumption because use of the bridge by one person does not diminish the ability of others to use it. Because there is a large fixed cost of building the bridge and a negligible marginal cost of additional users, the average total cost of a trip across the bridge (the total cost divided by the number of trips) falls as the number of trips rises. Hence, the bridge is a natural monopoly.

natural monopoly

a type of monopoly that

arises because a single

firm can supply a good

or service to an entire

market at a lower cost

than could two or

more firms

FIGURE 1

Economies of Scale as a Cause of Monopoly

When a firm’s average-total-cost curve continually declines, the

firm has what is called a natural monopoly. In this case, when

production is divided among more firms, each firm produces

less, and average total cost rises. As a result, a single firm can

produce any given amount at the lowest cost.

Quantity of Output

Average total cost

Cost

293CHAPTER 15 MONOPOLY

When a firm is a natural monopoly, it is less concerned about new entrants eroding its monopoly power. Normally, a firm has trouble maintaining a monop- oly position without ownership of a key resource or protection from the govern- ment. The monopolist’s profit attracts entrants into the market, and these entrants make the market more competitive. By contrast, entering a market in which another firm has a natural monopoly is unattractive. Would-be entrants know that they cannot achieve the same low costs that the monopolist enjoys because, after entry, each firm would have a smaller piece of the market.

In some cases, the size of the market is one determinant of whether an industry is a natural monopoly. Again, consider a bridge across a river. When the popula- tion is small, the bridge may be a natural monopoly. A single bridge can satisfy the entire demand for trips across the river at the lowest cost. Yet as the popula- tion grows and the bridge becomes congested, satisfying the entire demand may require two or more bridges across the same river. Thus, as a market expands, a natural monopoly can evolve into a more competitive market.

QuickQuiz What are the three reasons that a market might have a monopoly? • Give

two examples of monopolies and explain the reason for each.

15-2 How Monopolies Make Production and Pricing Decisions

Now that we know how monopolies arise, we can consider how a monopoly firm decides how much of its product to make and what price to charge for it. The analysis of monopoly behavior in this section is the starting point for evaluating whether monopolies are desirable and what policies the government might pur- sue in monopoly markets.

15-2a Monopoly versus Competition The key difference between a competitive firm and a monopoly is the monopoly’s ability to influence the price of its output. A competitive firm is small relative to the market in which it operates and, therefore, has no power to influence the price of its output. It takes the price as given by market conditions. By contrast, because a monopoly is the sole producer in its market, it can alter the price of its good by adjusting the quantity it supplies to the market.

One way to view this difference between a competitive firm and a monopoly is to consider the demand curve that each firm faces. When we analyzed profit maximization by competitive firms in the preceding chapter, we drew the market price as a horizontal line. Because a competitive firm can sell as much or as little as it wants at this price, the competitive firm faces a horizontal demand curve, as in panel (a) of Figure 2. In effect, because the competitive firm sells a product with many perfect substitutes (the products of all the other firms in its market), the demand curve that any one firm faces is perfectly elastic.

By contrast, because a monopoly is the sole producer in its market, its demand curve is the market demand curve. Thus, the monopolist’s demand curve slopes downward, as in panel (b) of Figure 2. If the monopolist raises the price of its good, consumers buy less of it. Looked at another way, if the monopolist reduces the quantity of output it produces and sells, the price of its output increases.

The market demand curve provides a constraint on a monopoly’s ability to profit from its market power. A monopolist would prefer, if it were possible, to

294 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

charge a high price and sell a large quantity at that high price. The market demand curve makes that outcome impossible. In particular, the market demand curve describes the combinations of price and quantity that are available to a monopoly firm. By adjusting the quantity produced (or equivalently, the price charged), the monopolist can choose any point on the demand curve, but it cannot choose a point off the demand curve.

What price and quantity of output will the monopolist choose? As with com- petitive firms, we assume that the monopolist’s goal is to maximize profit. Because the firm’s profit is total revenue minus total costs, our next task in explaining monopoly behavior is to examine a monopolist’s revenue.

15-2b A Monopoly’s Revenue Consider a town with a single producer of water. Table 1 shows how the mono- poly’s revenue might depend on the amount of water produced.

Columns (1) and (2) show the monopolist’s demand schedule. If the monopolist produces 1 gallon of water, it can sell that gallon for $10. If it produces 2 gallons, it must lower the price to $9 to sell both gallons. If it produces 3 gallons, it must lower the price to $8. And so on. If you graphed these two columns of numbers, you would get a typical downward-sloping demand curve.

Column (3) of the table presents the monopolist’s total revenue. It equals the quantity sold [from column (1)] times the price [from column (2)]. Column (4) computes the firm’s average revenue, the amount of revenue the firm receives per unit sold. We compute average revenue by taking the number for total revenue in column (3) and dividing it by the quantity of output in column (1). As we dis- cussed in the previous chapter, average revenue always equals the price of the good. This is true for monopolists as well as for competitive firms.

FIGURE 2

Demand Curves for Competitive

and Monopoly Firms

Quantity of Output

Demand

(a) A Competitive Firm’s Demand Curve (b) A Monopolist’s Demand Curve

Price

Quantity of Output0

Price

Demand

Because competitive firms are price takers, they face horizontal demand curves,

as in panel (a). Because a monopoly firm is the sole producer in its market, it faces

the downward-sloping market demand curve, as in panel (b). As a result, the monopoly

has to accept a lower price if it wants to sell more output.

295CHAPTER 15 MONOPOLY

Column (5) of Table 1 computes the firm’s marginal revenue, the amount of rev- enue that the firm receives for each additional unit of output. We compute mar- ginal revenue by taking the change in total revenue when output increases by 1 unit. For example, when the firm is producing 3 gallons of water, it receives total revenue of $24. Raising production to 4 gallons increases total revenue to $28. Thus, marginal revenue from the sale of the fourth gallon is $28 minus $24, or $4.

Table 1 shows a result that is important for understanding monopoly behavior: A monopolist’s marginal revenue is less than the price of its good. For example, if the firm raises production of water from 3 to 4 gallons, it increases total revenue by only $4, even though it sells each gallon for $7. For a monopoly, marginal revenue is lower than price because a monopoly faces a downward-sloping demand curve. To increase the amount sold, a monopoly firm must lower the price it charges to all customers. Hence, to sell the fourth gallon of water, the monopolist must earn $1 less revenue for each of the first 3 gallons. This $3 loss accounts for the differ- ence between the price of the fourth gallon ($7) and the marginal revenue of that fourth gallon ($4).

Marginal revenue for monopolies is very different from marginal revenue for competitive firms. When a monopoly increases the amount it sells, this action has two effects on total revenue (P 3 Q):

• The output effect: More output is sold, so Q is higher, which tends to increase total revenue.

• The price effect: The price falls, so P is lower, which tends to decrease total revenue.

TABLE 1

A Monopoly’s Total, Average,

and Marginal Revenue

(1) (2) (3) (4) (5)

Quantity

Water Price Total Revenue Average Revenue Marginal Revenue

(Q ) (P ) (TR 5 P 3 Q ) (AR 5 TR / Q ) (MR 5 ∆TR / ∆Q )

0 gallons $11 $ 0 —

$10

1 10 10 $10

2 9 18 9

3 8 24 8

4 7 28 7

5 6 30 6

6 5 30 5

22 7 4 28 4

24 8 3 24 3

296 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

Because a competitive firm can sell all it wants at the market price, there is no price effect. When it increases production by 1 unit, it receives the market price for that unit, and it does not receive any less for the units it was already selling. That is, because the competitive firm is a price taker, its marginal revenue equals the price of its good. By contrast, when a monopoly increases production by 1 unit, it must reduce the price it charges for every unit it sells, and this cut in price reduces revenue on the units it was already selling. As a result, a monopoly’s marginal revenue is less than its price.

Figure 3 graphs the demand curve and the marginal-revenue curve for a monopoly firm. (Because the firm’s price equals its average revenue, the demand curve is also the average-revenue curve.) These two curves always start at the same point on the vertical axis because the marginal revenue of the first unit sold equals the price of the good. But for the reason we just discussed, the monopo- list’s marginal revenue on all units after the first is less than the price of the good. Thus, a monopoly’s marginal-revenue curve lies below its demand curve.

You can see in Figure 3 (as well as in Table 1) that marginal revenue can even become negative. Marginal revenue is negative when the price effect on revenue is greater than the output effect. In this case, when the firm produces an extra unit of output, the price falls by enough to cause the firm’s total revenue to decline, even though the firm is selling more units.

15-2c Profit Maximization Now that we have considered the revenue of a monopoly firm, we are ready to examine how such a firm maximizes profit. Recall from Chapter 1 that one of the Ten Principles of Economics is that rational people think at the margin. This lesson is as true for monopolists as it is for competitive firms. Here we apply the logic of marginal analysis to the monopolist’s decision about how much to produce.

Figure 4 graphs the demand curve, the marginal-revenue curve, and the cost curves for a monopoly firm. All these curves should seem familiar: The demand and marginal-revenue curves are like those in Figure 3, and the cost curves are like those we encountered in the last two chapters. These curves contain all the

FIGURE 3

Demand and Marginal-Revenue Curves

for a Monopoly

The demand curve shows how the quantity

sold affects the price of the good. The

marginal-revenue curve shows how the

firm’s revenue changes when the quantity

increases by 1 unit. Because the price on

all units sold must fall if the monopoly

increases production, marginal revenue is

less than the price.

Quantity of Water

Price

$11 10 9 8 7 6 5 4 3 2 1 0

21 22 23 24

Demand (average revenue)

Marginal revenue

1 2 3 4 5 6 7 8

297CHAPTER 15 MONOPOLY

information we need to determine the level of output that a profit-maximizing monopolist will choose.

Suppose, first, that the firm is producing at a low level of output, such as Q 1 .

In this case, marginal cost is less than marginal revenue. If the firm increased pro- duction by 1 unit, the additional revenue would exceed the additional costs, and profit would rise. Thus, when marginal cost is less than marginal revenue, the firm can increase profit by producing more units.

A similar argument applies at high levels of output, such as Q 2 . In this case,

marginal cost is greater than marginal revenue. If the firm reduced production by 1 unit, the costs saved would exceed the revenue lost. Thus, if marginal cost is greater than marginal revenue, the firm can raise profit by reducing production.

In the end, the firm adjusts its level of production until the quantity reaches Q MAX

, at which marginal revenue equals marginal cost. Thus, the monopolist’s profit-maximizing quantity of output is determined by the intersection of the marginal- revenue curve and the marginal-cost curve. In Figure 4, this intersection occurs at point A.

You might recall from the previous chapter that competitive firms also choose the quantity of output at which marginal revenue equals marginal cost. In follow- ing this rule for profit maximization, competitive firms and monopolies are alike. But there is also an important difference between these types of firms: The mar- ginal revenue of a competitive firm equals its price, whereas the marginal revenue of a monopoly is less than its price. That is,

For a competitive firm: P 5 MR 5 MC.

For a monopoly firm: P . MR 5 MC.

The equality of marginal revenue and marginal cost determines the profit- maximizing quantity for both types of firm. What differs is how the price is related to marginal revenue and marginal cost.

FIGURE 4

Profit Maximization for a Monopoly

A monopoly maximizes profit by choosing

the quantity at which marginal revenue

equals marginal cost (point A). It then uses

the demand curve to find the price that

will induce consumers to buy that quantity

(point B).

Monopoly price

QuantityQ1 Q2QMAX0

Costs and Revenue

Demand

Average total cost

Marginal revenue

Marginal cost

1. The intersection of the marginal-revenue curve and the marginal-cost curve determines the profit-maximizing quantity . . .

2. . . . and then the demand curve shows the price consistent with this quantity.

298 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

How does the monopoly find the profit-maximizing price for its product? The demand curve answers this question because the demand curve relates the amount that customers are willing to pay to the quantity sold. Thus, after the monopoly firm chooses the quantity of output that equates marginal revenue and marginal cost, it uses the demand curve to find the highest price it can charge for that quantity. In Figure 4, the profit-maximizing price is found at point B.

We can now see a key difference between markets with competitive firms and markets with a monopoly firm: In competitive markets, price equals marginal cost. In monopolized markets, price exceeds marginal cost. As we will see in a moment, this finding is crucial to understanding the social cost of monopoly.

15-2d A Monopoly’s Profit How much profit does a monopoly make? To see a monopoly firm’s profit in a graph, recall that profit equals total revenue (TR) minus total costs (TC):

Profit 5 TR 2 TC.

We can rewrite this as

Profit 5 (TR/Q 2 TC/Q) 3 Q.

TR/Q is average revenue, which equals the price, P, and TC/Q is average total cost, ATC. Therefore,

Profit 5 (P 2 ATC) 3 Q.

This equation for profit (which also holds for competitive firms) allows us to mea- sure the monopolist’s profit in our graph.

Consider the shaded box in Figure 5. The height of the box (the segment BC) is price minus average total cost, P – ATC, which is the profit on the typical unit sold. The width of the box (the segment DC) is the quantity sold, Q

MAX . Therefore,

the area of this box is the monopoly firm’s total profit.

Why a Monopoly Does Not Have a Supply Curve

Y ou may have noticed that we have analyzed the price in a monopoly

market using the market demand curve and the firm’s cost curves.

We have not made any mention of the market supply curve. By contrast,

when we analyzed prices in competitive markets beginning in Chapter 4,

the two most important words were always supply and demand.

What happened to the supply curve? Although monopoly firms make

decisions about what quantity to supply, a monopoly does not have a sup-

ply curve. A supply curve tells us the quantity that firms choose to sup-

ply at any given price. This concept makes sense when we are analyzing

competitive firms, which are price takers. But a monopoly firm is a price

maker, not a price taker. It is not meaningful to ask what amount such a

firm would produce at any given price because it cannot take the price

as given. Instead, when the firm chooses the quantity to supply, that

decision (along with the

demand curve) determines

the price.

Indeed, the monopolist’s

decision about how much

to supply is impossible to

separate from the demand curve

it faces. The shape of the demand curve determines the shape of the

marginal-revenue curve, which in turn determines the monopolist’s

profit-maximizing quantity. In a competitive market, each firm’s sup-

ply decisions can be analyzed without knowing the demand curve, but

that is not true in a monopoly market. Therefore, we never talk about a

monopoly’s supply curve. ■

F Y I

299CHAPTER 15 MONOPOLY

CASE STUDY

MONOPOLY DRUGS VERSUS GENERIC DRUGS According to our analysis, prices are determined differently in monopolized markets and competitive markets. A natural place to test this theory is the market for pharmaceutical drugs because this

market takes on both market structures. When a firm discovers a new drug, pat- ent laws give the firm a monopoly on the sale of that drug. But eventually, the firm’s patent runs out, and any company can make and sell the drug. At that time, the market switches from being monopolistic to being competitive.

What should happen to the price of a drug when the patent runs out? Figure 6 shows the market for a typical drug. In this figure, the marginal cost of producing the drug is constant. (This is approximately true for many drugs.) During the life of the patent, the monopoly firm maximizes profit by producing the quantity at which marginal revenue equals marginal cost and charging a price well above mar- ginal cost. But when the patent runs out, the profit from making the drug should encourage new firms to enter the market. As the market becomes more competi- tive, the price should fall to equal marginal cost.

Experience is, in fact, consistent with our theory. When the patent on a drug expires, other companies quickly enter and begin selling generic products that are chemically identical to the former monopolist’s brand-name product. Just as our analysis predicts, the price of the competitively produced generic drug is well below the price that the monopolist was charging.

The expiration of a patent, however, does not cause the monopolist to lose all of its market power. Some consumers remain loyal to the brand-name drug, per- haps out of fear that the new generic drugs are not actually the same as the drug they have been using for years. As a result, the former monopolist can continue to charge a price above the price charged by its new competitors.

For example, one of the most widely used antidepressants is the drug fluoxetine, which is taken by millions of Americans. Because the patent on this drug expired in 2001, a consumer today has the choice between the original drug, sold under the

FIGURE 5

The Monopolist’s Profit

The area of the box BCDE equals the

profit of the monopoly firm. The height

of the box (BC) is price minus average

total cost, which equals profit per unit

sold. The width of the box (DC) is the

number of units sold.

Monopoly price

Average total cost

QuantityQMAX0

Costs and Revenue

Demand

Marginal cost

Marginal revenue

Monopoly profit

Average total cost

300 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

brand name Prozac, and a generic version of the same medicine. Prozac sells for about three times the price of generic fluoxetine. This price differential can persist because some consumers are not convinced that the two pills are perfect substitutes. ●

QuickQuiz Explain how a monopolist chooses the quantity of output to produce and

the price to charge.

FIGURE 6

The Market for Drugs

When a patent gives a firm a monopoly

over the sale of a drug, the firm charges

the monopoly price, which is well above

the marginal cost of making the drug.

When the patent on a drug runs out, new

firms enter the market, making it more

competitive. As a result, the price falls

from the monopoly price to marginal cost.

Price during

patent life

Price after patent expires

QuantityMonopoly quantity

Competitive quantity

Costs and Revenue

Demand

Marginal cost

Marginal revenue

15-3 The Welfare Cost of Monopolies Is monopoly a good way to organize a market? We have seen that a monopoly, in contrast to a competitive firm, charges a price above marginal cost. From the standpoint of consumers, this high price makes monopoly undesirable. At the same time, however, the monopoly is earning profit from charging this high price. From the standpoint of the owners of the firm, the high price makes monopoly very desirable. Is it possible that the benefits to the firm’s owners exceed the costs imposed on consumers, making monopoly desirable from the standpoint of soci- ety as a whole?

We can answer this question using the tools of welfare economics. Recall from Chapter 7 that total surplus measures the economic well-being of buyers and sellers in a market. Total surplus is the sum of consumer surplus and producer surplus. Consumer surplus is consumers’ willingness to pay for a good minus the amount they actually pay for it. Producer surplus is the amount producers receive for a good minus their costs of producing it. In this case, there is a single producer—the monopolist.

You can probably guess the result of this analysis. In Chapter 7, we concluded that the equilibrium of supply and demand in a competitive market is not only a natural outcome but also a desirable one. The invisible hand of the market leads to an allocation of resources that makes total surplus as large as it can be. Because a monopoly leads to an allocation of resources different from that in a competitive market, the outcome must, in some way, fail to maximize total economic well-being.

301CHAPTER 15 MONOPOLY

15-3a The Deadweight Loss We begin by considering what the monopoly firm would do if it were run by a benevolent social planner. The social planner cares not only about the profit earned by the firm’s owners but also about the benefits received by the firm’s consumers. The planner tries to maximize total surplus, which equals producer surplus (profit) plus consumer surplus. Keep in mind that total surplus equals the value of the good to consumers minus the costs of making the good incurred by the monopoly producer.

Figure 7 analyzes how a benevolent social planner would choose the monop- oly’s level of output. The demand curve reflects the value of the good to con- sumers, as measured by their willingness to pay for it. The marginal-cost curve reflects the costs of the monopolist. Thus, the socially efficient quantity is found where the demand curve and the marginal-cost curve intersect. Below this quantity, the value of an extra unit to consumers exceeds the cost of providing it, so increasing out- put would raise total surplus. Above this quantity, the cost of producing an extra unit exceeds the value of that unit to consumers, so decreasing output would raise total surplus. At the optimal quantity, the value of an extra unit to consumers exactly equals the marginal cost of production.

If the social planner were running the monopoly, the firm could achieve this efficient outcome by charging the price found at the intersection of the demand and marginal-cost curves. Thus, like a competitive firm and unlike a profit- maximizing monopoly, a social planner would charge a price equal to marginal cost. Because this price would give consumers an accurate signal about the cost of producing the good, consumers would buy the efficient quantity.

We can evaluate the welfare effects of monopoly by comparing the level of out- put that the monopolist chooses to the level of output that a social planner would

FIGURE 7

The Efficient Level of Output

A benevolent social planner maximizes

total surplus in the market by choosing the

level of output where the demand curve

and marginal-cost curve intersect. Below

this level, the value of the good to the

marginal buyer (as reflected in the demand

curve) exceeds the marginal cost of making

the good. Above this level, the value to the

marginal buyer is less than marginal cost.

Quantity0

Price

Demand (value to buyers)

Efficient quantity

Marginal cost

Value to buyers is greater than cost to seller.

Value to buyers is less than cost to seller.

Cost to

monopolist

Cost to

monopolist

Value to

buyers

Value to

buyers

302 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

choose. As we have seen, the monopolist chooses to produce and sell the quantity of output at which the marginal-revenue and marginal-cost curves intersect; the social planner would choose the quantity at which the demand and marginal-cost curves intersect. Figure 8 shows the comparison. The monopolist produces less than the socially efficient quantity of output.

We can also view the inefficiency of monopoly in terms of the monopolist’s price. Because the market demand curve describes a negative relationship between the price and quantity of the good, a quantity that is inefficiently low is equivalent to a price that is inefficiently high. When a monopolist charges a price above marginal cost, some potential consumers value the good at more than its marginal cost but less than the monopolist’s price. These consumers do not buy the good. Because the value these consumers place on the good is greater than the cost of providing it to them, this result is inefficient. Thus, monopoly pricing pre- vents some mutually beneficial trades from taking place.

The inefficiency of monopoly can be measured with a deadweight loss tri- angle, as illustrated in Figure 8. Because the demand curve reflects the value to consumers and the marginal-cost curve reflects the costs to the monopoly pro- ducer, the area of the deadweight loss triangle between the demand curve and the marginal-cost curve equals the total surplus lost because of monopoly pricing. It represents the reduction in economic well-being that results from the monopoly’s use of its market power.

The deadweight loss caused by a monopoly is similar to the deadweight loss caused by a tax. Indeed, a monopolist is like a private tax collector. As we saw in Chapter 8, a tax on a good places a wedge between consumers’ willingness to pay (as reflected by the demand curve) and producers’ costs (as reflected by the supply curve). Because a monopoly exerts its market power by charging a price above marginal cost, it creates a similar wedge. In both cases, the wedge causes the quantity sold to fall short of the social optimum. The difference between the two cases is that the government gets the revenue from a tax, whereas a private firm gets the monopoly profit.

FIGURE 8

The Inefficiency of Monopoly

Because a monopoly charges a price above

marginal cost, not all consumers who value

the good at more than its cost buy it. Thus,

the quantity produced and sold by a

monopoly is below the socially efficient

level. The deadweight loss is represented

by the area of the triangle between the

demand curve (which reflects the value

of the good to consumers) and the

marginal-cost curve (which reflects the

costs of the monopoly producer).

Quantity0

Price

Efficient quantity

Monopoly price

Monopoly quantity

Deadweight loss

Demand Marginal revenue

Marginal cost

303CHAPTER 15 MONOPOLY

15-3b The Monopoly’s Profit: A Social Cost? It is tempting to decry monopolies for “profiteering” at the expense of the public. And indeed, a monopoly firm does earn a profit by virtue of its market power. According to the economic analysis of monopoly, however, the firm’s profit is not in itself necessarily a problem for society.

Welfare in a monopolized market, as in all markets, includes the welfare of both consumers and producers. Whenever a consumer pays an extra dollar to a producer because of a monopoly price, the consumer is worse off by a dollar and the producer is better off by the same amount. This transfer from the con- sumers of the good to the owners of the monopoly does not affect the market’s total surplus—the sum of consumer and producer surplus. In other words, the monopoly profit itself represents not a reduction in the size of the economic pie but merely a bigger slice for producers and a smaller slice for consumers. Unless consumers are for some reason more deserving than producers—a normative judgment about equity that goes beyond the realm of economic efficiency—the monopoly profit is not a social problem.

The problem in a monopolized market arises because the firm produces and sells a quantity of output below the level that maximizes total surplus. The deadweight loss measures how much the economic pie shrinks as a result. This inefficiency is connected to the monopoly’s high price: Consumers buy fewer units when the firm raises its price above marginal cost. But keep in mind that the profit earned on the units that continue to be sold is not the problem. The problem stems from the inefficiently low quantity of output. Put differently, if the high monopoly price did not discourage some consumers from buying the good, it would raise producer surplus by exactly the amount it reduced con- sumer surplus, leaving total surplus the same as that achieved by a benevolent social planner.

There is, however, a possible exception to this conclusion. Suppose that a monopoly firm has to incur additional costs to maintain its monopoly position. For example, a firm with a government-created monopoly might need to hire lob- byists to convince lawmakers to continue its monopoly. In this case, the monopoly may use up some of its monopoly profits paying for these additional costs. If so, the social loss from monopoly includes both these costs and the deadweight loss resulting from reduced output.

QuickQuiz How does a monopolist’s quantity of output compare to the quantity of

output that maximizes total surplus? How does this difference relate to

the deadweight loss?

15-4 Price Discrimination So far, we have been assuming that the monopoly firm charges the same price to all customers. Yet in many cases, firms sell the same good to different customers for different prices, even though the costs of producing for the two customers are the same. This practice is called price discrimination.

Before discussing the behavior of a price-discriminating monopolist, we should note that price discrimination is not possible when a good is sold in a competi- tive market. In a competitive market, many firms are selling the same good at the market price. No firm is willing to charge a lower price to any customer because the firm can sell all it wants at the market price. And if any firm tried to charge a

price discrimination

the business practice of

selling the same good at

different prices to differ-

ent customers

304 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

higher price to a customer, that customer would buy from another firm. For a firm to price discriminate, it must have some market power.

15-4a A Parable about Pricing To understand why a monopolist would price discriminate, let’s consider an example. Imagine that you are the president of Readalot Publishing Company. Readalot’s best-selling author has just written a new novel. To keep things simple, let’s imagine that you pay the author a flat $2 million for the exclusive rights to publish the book. Let’s also assume that the cost of printing the book is zero (as it would be, for example, for an e-book). Readalot’s profit, therefore, is the revenue from selling the book minus the $2 million it has paid to the author. Given these assumptions, how would you, as Readalot’s president, decide the book’s price?

Your first step is to estimate the demand for the book. Readalot’s marketing department tells you that the book will attract two types of readers. The book will appeal to the author ’s 100,000 die-hard fans who are willing to pay as much as $30. In addition, it will appeal to about 400,000 less enthusiastic readers who will pay up to $5.

If Readalot charges a single price to all customers, what price maximizes profit? There are two natural prices to consider: $30 is the highest price Read- alot can charge and still get the 100,000 die-hard fans, and $5 is the highest price it can charge and still get the entire market of 500,000 potential readers. Solving Readalot’s problem is a matter of simple arithmetic. At a price of $30, Readalot sells 100,000 copies, has revenue of $3 million, and makes profit of $1 million. At a price of $5, it sells 500,000 copies, has revenue of $2.5 million, and makes profit of $500,000. Thus, Readalot maximizes profit by charging $30 and forgoing the opportunity to sell to the 400,000 less enthusiastic readers.

Notice that Readalot’s decision causes a deadweight loss. There are 400,000 readers willing to pay $5 for the book, and the marginal cost of providing it to them is zero. Thus, $2 million of total surplus is lost when Readalot charges the higher price. This deadweight loss is the inefficiency that arises whenever a mo- nopolist charges a price above marginal cost.

Now suppose that Readalot’s marketing department makes a discovery: These two groups of readers are in separate markets. The die-hard fans live in Australia, and the other readers live in the United States. Moreover, it is hard for readers in one country to buy books in the other.

In response to this discovery, Readalot can change its marketing strategy and increase profits. To the 100,000 Australian readers, it can charge $30 for the book. To the 400,000 American readers, it can charge $5 for the book. In this case, rev- enue is $3 million in Australia and $2 million in the United States, for a total of $5 million. Profit is then $3 million, which is substantially greater than the $1 million the company could earn charging the same $30 price to all customers. Not surprisingly, Readalot chooses to follow this strategy of price discrimination.

The story of Readalot Publishing is hypothetical, but it describes the business practice of many publishing companies. Consider the price differential between hardcover books and paperbacks. When a publisher has a new novel, it initially releases an expensive hardcover edition and later releases a cheaper paperback edition. The difference in price between these two editions far exceeds the differ- ence in printing costs. The publisher is price discriminating by selling the hard- cover to die-hard fans and the paperback to less enthusiastic readers, thereby increasing its profit.

305CHAPTER 15 MONOPOLY

15-4b The Moral of the Story Like any parable, the story of Readalot Publishing is stylized. Yet also like any parable, it teaches some general lessons. In this case, three lessons can be learned about price discrimination.

The first and most obvious lesson is that price discrimination is a rational strategy for a profit-maximizing monopolist. That is, by charging different prices to different customers, a monopolist can increase its profit. In essence, a price- discriminating monopolist charges each customer a price closer to her willingness to pay than is possible with a single price.

The second lesson is that price discrimination requires the ability to separate customers according to their willingness to pay. In our example, customers were separated geographically. But sometimes monopolists choose other differences, such as age or income, to distinguish among customers.

A corollary to this second lesson is that certain market forces can prevent firms from price discriminating. In particular, one such force is arbitrage, the process of buying a good in one market at a low price and selling it in another market at a higher price to profit from the price difference. In our example, if Australian bookstores could buy the book in the United States and resell it to Australian readers, the arbitrage would prevent Readalot from price discriminating, because no Australian would buy the book at the higher price.

The third lesson from our parable is the most surprising: Price discrimination can raise economic welfare. Recall that a deadweight loss arises when Readalot charges a single $30 price because the 400,000 less enthusiastic readers do not end up with the book, even though they value it at more than its marginal cost of pro- duction. By contrast, when Readalot price discriminates, all readers get the book and the outcome is efficient. Thus, price discrimination can eliminate the ineffi- ciency inherent in monopoly pricing.

Note that in this example the increase in welfare from price discrimination shows up as higher producer surplus rather than higher consumer surplus. Con- sumers are no better off for having bought the book: The price they pay exactly equals the value they place on the book, so they receive no consumer surplus. The entire increase in total surplus from price discrimination accrues to Readalot Publishing in the form of higher profit.

15-4c The Analytics of Price Discrimination Let’s consider a bit more formally how price discrimination affects economic wel- fare. We begin by assuming that the monopolist can price discriminate perfectly. Perfect price discrimination describes a situation in which the monopolist knows exactly each customer’s willingness to pay and can charge each customer a differ- ent price. In this case, the monopolist charges each customer exactly her willing- ness to pay, and the monopolist gets the entire surplus in every transaction.

Figure 9 illustrates producer and consumer surplus with and without price dis- crimination. To keep things simple, this figure is drawn assuming constant per unit costs—that is, marginal cost and average total cost are constant and equal. Without price discrimination, the firm charges a single price above marginal cost, as shown in panel (a). Because some potential customers who value the good at more than marginal cost do not buy it at this high price, the monopoly causes a deadweight loss. Yet when a firm can perfectly price discriminate, as shown in panel (b), each customer who values the good at more than marginal cost buys the good and is charged her willingness to pay. All mutually beneficial trades take

306 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

place, no deadweight loss occurs, and the entire surplus derived from the market goes to the monopoly producer in the form of profit.

In reality, of course, price discrimination is not perfect. Customers do not walk into stores with signs displaying their willingness to pay. Instead, firms price dis- criminate by dividing customers into groups: young versus old, weekday versus weekend shoppers, Americans versus Australians, and so on. Unlike those in our parable of Readalot Publishing, customers within each group differ in their will- ingness to pay for the product, making perfect price discrimination impossible.

How does this imperfect price discrimination affect welfare? The analysis of these pricing schemes is complicated, and it turns out that there is no general answer to this question. Compared with the single-price monopoly outcome, imperfect price discrimination can raise, lower, or leave unchanged the total sur- plus in a market. The only certain conclusion is that price discrimination raises the monopoly’s profit; otherwise, the firm would choose to charge all customers the same price.

15-4d Examples of Price Discrimination Firms in our economy use various business strategies aimed at charging different prices to different customers. Now that we understand the economics of price dis- crimination, let’s consider some examples.

Movie Tickets Many movie theaters charge a lower price for children and senior citizens than for other patrons. This fact is hard to explain in a competitive mar- ket. In a competitive market, price equals marginal cost, and the marginal cost of providing a seat for a child or senior citizen is the same as the marginal cost

FIGURE 9

Welfare with and without

Price Discrimination

(a) Monopolist with Single Price

Price

0 QuantityQuantity sold Quantity sold

(b) Monopolist with Perfect Price Discrimination

Price

0 Quantity

Monopoly price

Profit Profit

Deadweight loss

Demand Demand

Marginal cost

Marginal revenue

Consumer surplus

Marginal cost

Panel (a) shows a monopoly that charges the same price to all customers. Total surplus in this

market equals the sum of profit (producer surplus) and consumer surplus. Panel (b) shows a

monopoly that can perfectly price discriminate. Because consumer surplus equals zero, total

surplus now equals the firm’s profit. Comparing these two panels, you can see that perfect

price discrimination raises profit, raises total surplus, and lowers consumer surplus.

307CHAPTER 15 MONOPOLY

of providing a seat for anyone else. Yet the differential pricing is easily explained if movie theaters have some local monopoly power and if chil- dren and senior citizens have a lower willingness to pay for a ticket. In this case, movie theaters raise their profit by price discriminating.

Airline Prices Seats on airplanes are sold at many different prices. Most airlines charge a lower price for a round-trip ticket between two cities if the traveler stays over a Saturday night. At first, this seems odd. Why should it matter to the airline whether a passenger stays over a Saturday night? The reason is that this rule provides a way to separate business travelers and leisure travelers. A passenger on a business trip has a high willingness to pay and, most likely, does not want to stay over a Saturday night. By con- trast, a passenger traveling for personal reasons has a lower willingness to pay and is more likely to be willing to stay over a Saturday night. Thus, the airlines can successfully price discriminate by charging a lower price for passengers who stay over a Saturday night.

Discount Coupons Many companies offer discount coupons to the public in newspapers, magazines, or online. A buyer simply has to clip the coupon to get $0.50 off her next purchase. Why do companies offer these coupons? Why don’t they just cut the price of the product by $0.50?

The answer is that coupons allow companies to price discriminate. Compa- nies know that not all customers are willing to spend time clipping coupons. Moreover, the willingness to clip coupons is related to the customer ’s willing- ness to pay for the good. A rich and busy executive is unlikely to spend her time clipping discount coupons out of the newspaper, and she is probably willing to pay a higher price for many goods. A person who is unemployed is more likely to clip coupons and to have a lower willingness to pay. Thus, by charging a lower price only to those customers who clip coupons, firms can successfully price discriminate.

Financial Aid Many colleges and universities give financial aid to needy stu- dents. One can view this policy as a type of price discrimination. Wealthy stu- dents have greater financial resources and, therefore, a higher willingness to pay than needy students. By charging high tuition and selectively offering financial aid, schools in effect charge prices to customers based on the value they place on going to that school. This behavior is similar to that of any price-discriminating monopolist.

Quantity Discounts So far in our examples of price discrimination, the monopolist charges different prices to different customers. Sometimes, however, monopolists price discriminate by charging different prices to the same customer for different units that the customer buys. For example, many firms offer lower prices to customers who buy large quantities. A bakery might charge $0.50 for each donut but $5 for a dozen. This is a form of price discrimination because the customer pays a higher price for the first unit she buys than for the twelfth. Quan- tity discounts are often a successful way of price discriminating because a cus- tomer’s willingness to pay for an additional unit declines as she buys more units.

QuickQuiz Give two examples of price discrimination. • Explain how perfect price

discrimination affects consumer surplus, producer surplus, and total

surplus.

“Would it bother you to hear how little I paid for this flight?”

H A

M ILT

O N

N IV

ER SA

L PR

ES S

SY N

D IC

AT E.

308 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

Colleges and universities are

increasingly charging different prices

to different students, which makes

data on the cost of education harder

to interpret.

Misconceptions 101: Why

College Costs Aren’t Soaring

By Evan Soltas

C onventional wisdom suggests that U.S.

colleges and universities have become

sharply more expensive in recent years.

“When kids do graduate, the most daunt-

ing challenge can be the cost of college,”

President Barack Obama said in his 2012

State of the Union address. “We can’t just

keep subsidizing skyrocketing tuition; we’ll

run out of money.”

At first, the view that the cost of col-

lege is rising appears to have data on its

side. Published tuition prices and fees at

colleges have risen three times faster than

the rate of Consumer Price Index inflation

since 1978, according to the Bureau of Labor

Statistics….

Real tuition and fees have increased, to

be sure, but hardly as significantly as the

media often report or the data suggest at face

value. The inflation-adjusted net price of col-

lege has risen only modestly over the last two

decades, according to data from the College

Board’s Annual Survey of Colleges.

What has happened is a shift toward price

discrimination—offering multiple prices for

the same product. Universities have offset

the increase in sticker price for most families

through an expansion of grant-based financial

aid and scholarships. That has caused the BLS

measure to rise without increasing the net cost.

Wealthier families now pay more than

ever to send their children to college. But for

much of the middle class, the real net cost

of college has not changed significantly; for

much of the poor, the expansion of aid has

increased the accessibility and affordability

of a college education….

The nation’s most selective institutions

are leading the trend toward income-based

price discrimination. For example, at Harvard

University, the majority of students receive

financial aid: In 2012, one year of undergrad-

uate education had a sticker price of $54,496

and came with an average grant of roughly

$41,000.

In other words, the cost burden of college

has become significantly more progressive

since the 1990s. Students from wealthier

families not only now pay more for their own

educations but also have come to heavily

subsidize the costs of the less fortunate. ■

Source: Bloomberg.com, November 27, 2012.

Price Discrimination in Higher Education

IN THE NEWS

M IC

H A

EL JU

N G

/S H

U TT

ER ST

O CK

We have seen that monopolies, in contrast to competitive markets, fail to allocate resources efficiently. Monopolies produce less than the socially desirable quantity of output and charge prices above marginal cost. Policymakers in the government can respond to the problem of monopoly in one of four ways:

• By trying to make monopolized industries more competitive • By regulating the behavior of the monopolies • By turning some private monopolies into public enterprises • By doing nothing at all

15-5a Increasing Competition with Antitrust Laws If Coca-Cola and PepsiCo wanted to merge, the deal would be closely examined by the federal government before it went into effect. The lawyers and economists in the Department of Justice might well decide that a merger between these two

15-5 Public Policy toward Monopolies

309CHAPTER 15 MONOPOLY

large soft-drink companies would make the U.S. soft-drink market substan- tially less competitive and, as a result, would reduce the economic well-being of the country as a whole. If so, the Department of Justice would challenge the merger in court, and if the judge agreed, the two companies would not be al- lowed to merge. It is precisely this kind of challenge that prevented software giant Microsoft from buying Intuit in 1994. Similarly, in 2011, the government blocked the phone giant AT&T from buying its competitor T-Mobile.

The government derives this power over private industry from the an- titrust laws, a collection of statutes aimed at curbing monopoly power. The first and most important of these laws was the Sherman Antitrust Act, which Congress passed in 1890 to reduce the market power of the large and powerful “trusts” that were viewed as dominating the economy at the time. The Clayton Antitrust Act, passed in 1914, strengthened the government’s powers and authorized private lawsuits. As the U.S. Supreme Court once put it, the antitrust laws are “a comprehensive charter of economic liberty aimed at preserving free and unfettered competition as the rule of trade.”

The antitrust laws give the government various ways to promote compe- tition. They allow the government to prevent mergers, such as the merger between AT&T and T-Mobile. At times, they allow the government to break up a large company into a group of smaller ones. Finally, the antitrust laws prevent com- panies from coordinating their activities in ways that make markets less competitive.

Antitrust laws have costs as well as benefits. Sometimes companies merge not to reduce competition but to lower costs through more efficient joint production. These benefits from mergers are sometimes called synergies. For example, many U.S. banks have merged in recent years and, by combining operations, have been able to reduce administrative staff. The airline industry has experienced a similar consoli- dation. If antitrust laws are to raise social welfare, the government must be able to determine which mergers are desirable and which are not. That is, it must be able to measure and compare the social benefit from synergies with the social costs of reduced competition. Critics of the antitrust laws are skeptical that the government can perform the neces- sary cost–benefit analysis with sufficient accuracy. In the end, the application of antitrust laws is often controversial, even among the experts.

15-5b Regulation Another way the government deals with the problem of monopoly is by regulating the behavior of monopolists. This solution is common in the case of natural monopolies, such as water and electric companies. These companies are not allowed to charge any price they want. Instead, government agencies regulate their prices.

What price should the government set for a natural monop- oly? This question is not as easy as it might at first appear. One might conclude that the price should equal the monopolist’s marginal cost. If price equals marginal cost, customers will buy the quantity of the monopolist’s output that maximizes total surplus and the allocation of resources will be efficient.

There are, however, two practical problems with marginal- cost pricing as a regulatory system. The first arises from the logic of cost curves. By definition, natural monopolies have

“But if we do merge with Amalgamated, we’ll have enough resources to fight the antitrust violation caused by the merger.”

SC IE

N CE

CA RT

O O

N SP

LU S.

CO M

“If regulators had not approved mergers in the past decade

between major networked airlines, travelers would be better off

today.”

45% uncertain 29% agree

26% disagree

What do economists say?

Airline Mergers

ASK THE EXPERTS

Source: IGM Economic Experts Panel, August 28, 2013.

310 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

declining average total cost. As we first discussed in Chapter 13, when average total cost is declining, marginal cost is less than average total cost. This situation is illustrated in Figure 10, which shows a firm with a large fixed cost and then constant marginal cost thereafter. If regulators were to set price equal to marginal cost, that price would be less than the firm’s average total cost and the firm would lose money. Instead of charging such a low price, the monopoly firm would just exit the industry.

Regulators can respond to this problem in various ways, none of which is per- fect. One way is to subsidize the monopolist. In essence, the government picks up the losses inherent in marginal-cost pricing. Yet to pay for the subsidy, the gov- ernment needs to raise money through taxation, which involves its own dead- weight losses. Alternatively, the regulators can allow the monopolist to charge a price higher than marginal cost. If the regulated price equals average total cost, the monopolist earns exactly zero economic profit. Yet average-cost pricing leads to deadweight losses because the monopolist’s price no longer reflects the mar- ginal cost of producing the good. In essence, average-cost pricing is like a tax on the good the monopolist is selling.

The second problem with marginal-cost pricing as a regulatory system (and with average-cost pricing as well) is that it gives the monopolist no incentive to reduce costs. Each firm in a competitive market tries to reduce its costs because lower costs mean higher profits. But if a regulated monopolist knows that regu- lators will reduce prices whenever costs fall, the monopolist will not benefit from lower costs. In practice, regulators deal with this problem by allowing monopo- lists to keep some of the benefits from lower costs in the form of higher profit, a practice that requires some departure from marginal-cost pricing.

15-5c Public Ownership The third policy used by the government to deal with monopoly is public own- ership. That is, rather than regulating a natural monopoly that is run by a pri- vate firm, the government can run the monopoly itself. This solution is common in many European countries, where the government owns and operates utilities

FIGURE 10

Marginal-Cost Pricing for a Natural

Monopoly

Because a natural monopoly has declining

average total cost, marginal cost is less

than average total cost. Therefore, if regu-

lators require a natural monopoly to charge

a price equal to marginal cost, price will be

below average total cost, and the monopoly

will lose money.

Average total cost

Regulated price

Quantity0

Loss

Price

Demand

Marginal cost

Average total cost

311CHAPTER 15 MONOPOLY

such as telephone, water, and electric companies. In the United States, the gov- ernment runs the Postal Service. The delivery of ordinary first-class mail is often thought to be a natural monopoly.

Economists usually prefer private to public ownership of natural monopolies. The key issue is how the ownership of the firm affects the costs of production. Private owners have an incentive to minimize costs as long as they reap part of the benefit in the form of higher profit. If the firm’s managers are doing a bad job of keeping costs down, the firm’s owners will fire them. By contrast, if the govern- ment bureaucrats who run a monopoly do a bad job, the losers are the customers and taxpayers, whose only recourse is the political system. The bureaucrats may become a special-interest group and attempt to block cost-reducing reforms. Put simply, as a way of ensuring that firms are well run, the voting booth is less reli- able than the profit motive.

15-5d Doing Nothing Each of the foregoing policies aimed at reducing the problem of monopoly has drawbacks. As a result, some economists argue that it is often best for the gov- ernment not to try to remedy the inefficiencies of monopoly pricing. Here is the assessment of economist George Stigler, who won the Nobel Prize for his work in industrial organization:

A famous theorem in economics states that a competitive enterprise economy will produce the largest possible income from a given stock of resources. No real economy meets the exact conditions of the theorem, and all real economies will fall short of the ideal economy—a difference called “market failure.” In my view, however, the degree of “market failure” for the American economy is much smaller than the “political failure” arising from the imperfections of economic policies found in real political systems.

As this quotation makes clear, determining the proper role of the government in the economy requires judgments about politics as well as economics.

QuickQuiz Describe the ways policymakers can respond to the inefficiencies caused by

monopolies. List a potential problem with each of these policy responses.

15-6 Conclusion: The Prevalence of Monopolies This chapter has discussed the behavior of firms that have control over the prices they charge. We have seen that these firms behave very differently from the competitive firms studied in the previous chapter. Table 2 summarizes some of the key similarities and differences between competitive and monopoly markets.

From the standpoint of public policy, a crucial result is that a monopolist pro- duces less than the socially efficient quantity and charges a price above marginal cost. As a result, a monopoly causes deadweight losses. In some cases, these inefficiencies can be mitigated through price discrimination by the monopolist. But other times, they call for policymakers to take an active role.

How prevalent are the problems of monopoly? There are two answers to this question.

In one sense, monopolies are common. Most firms have some control over the prices they charge. They are not forced to charge the market price for their goods

312 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

because their goods are not exactly the same as those offered by other firms. A Ford Taurus is not the same as a Toyota Camry. Ben and Jerry’s ice cream is not the same as Breyer ’s. Each of these goods has a downward-sloping demand curve, which gives each producer some degree of monopoly power.

Yet firms with substantial monopoly power are rare. Few goods are truly unique. Most have substitutes that, even if not exactly the same, are similar. Ben and Jerry can raise the price of their ice cream a little without losing all their sales, but if they raise it a lot, sales will fall substantially as their customers switch to other brands.

In the end, monopoly power is a matter of degree. It is true that many firms have some monopoly power. It is also true that their monopoly power is usually limited. In such a situation, we will not go far wrong assuming that firms operate in competitive markets, even if that is not precisely the case.

TABLE 2

Competition versus Monopoly:

A Summary Comparison

Competition Monopoly

Similarities

Goal of firms Maximize profits Maximize profits

Rule for maximizing MR 5 MC MR 5 MC

Can earn economic profits

in the short run? Yes Yes

Differences

Number of firms Many One

Marginal revenue MR 5 P MR , P

Price P 5 MC P . MC

Produces welfare-maximizing

level of output? Yes No

Entry in the long run? Yes No

Can earn economic profits

in the long run? No Yes

Price discrimination

possible? No Yes

1. A firm is a natural monopoly if it exhibits the follow-

ing as its output increases:

a. decreasing marginal revenue.

b. increasing marginal cost.

c. decreasing average revenue.

d. decreasing average total cost.

2. For a profit-maximizing monopoly that charges the

same price to all consumers, what is the relationship

between price P, marginal revenue MR, and marginal

cost MC?

a. P = MR and MR = MC.

b. P > MR and MR = MC.

c. P = MR and MR > MC

d. P > MR and MR > MC.

CHAPTER QuickQuiz

313CHAPTER 15 MONOPOLY

3. If a monopoly’s fixed costs increase, its price will

_____ and its profit will _____.

a. increase, decrease

b. decrease, increase

c. increase, stay the same

d. stay the same, decrease

4. Compared to the social optimum, a monopoly firm

chooses

a. a quantity that is too low and a price that is

too high.

b. a quantity that is too high and a price that is

too low.

c. a quantity and a price that are both too high.

d. a quantity and a price that are both too low.

5. The deadweight loss from monopoly arises because

a. the monopoly firm makes higher profits than a

competitive firm would.

b. some potential consumers who forgo buying the

good value it more than its marginal cost.

c. consumers who buy the good have to pay more

than marginal cost, reducing their consumer

surplus.

d. the monopoly firm chooses a quantity that fails to

equate price and average revenue.

6. When a monopolist switches from charging a single

price to practicing perfect price discrimination, it

reduces

a. the quantity produced.

b. the firm’s profit.

c. consumer surplus.

d. total surplus.

SUMMARY

• A monopoly is a firm that is the sole seller in its market. A

monopoly arises when a single firm owns a key resource,

when the government gives a firm the exclusive right to

produce a good, or when a single firm can supply the

entire market at a lower cost than many firms could.

• Because a monopoly is the sole producer in its mar-

ket, it faces a downward-sloping demand curve for

its product. When a monopoly increases production

by 1 unit, it causes the price of its good to fall, which

reduces the amount of revenue earned on all units pro-

duced. As a result, a monopoly’s marginal revenue is

always below the price of its good.

• Like a competitive firm, a monopoly firm maximizes

profit by producing the quantity at which marginal

revenue equals marginal cost. The monopoly then sets

the price at which that quantity is demanded. Unlike a

competitive firm, a monopoly firm’s price exceeds its

marginal revenue, so its price exceeds marginal cost.

• A monopolist’s profit-maximizing level of output is

below the level that maximizes the sum of consumer

and producer surplus. That is, when the monopoly

charges a price above marginal cost, some consumers

who value the good more than its cost of production

do not buy it. As a result, monopoly causes dead-

weight losses similar to those caused by taxes.

• A monopolist can often increase profits by charging

different prices for the same good based on a buyer ’s

willingness to pay. This practice of price discrimination

can raise economic welfare by getting the good to some

consumers who would otherwise not buy it. In the

extreme case of perfect price discrimination, the dead-

weight loss of monopoly is completely eliminated and

the entire surplus in the market goes to the monopoly

producer. More generally, when price discrimination is

imperfect, it can either raise or lower welfare compared

to the outcome with a single monopoly price.

• Policymakers can respond to the inefficiency of

monopoly behavior in four ways. They can use

the antitrust laws to try to make the industry more

competitive. They can regulate the prices that the

monopoly charges. They can turn the monopolist into

a government-run enterprise. Or, if the market failure

is deemed small compared to the inevitable imperfec-

tions of policies, they can do nothing at all.

KEY CONCEPTS

monopoly, p. 290 natural monopoly, p. 292 price discrimination, p. 303

314 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

1. A publisher faces the following demand schedule for

the next novel from one of its popular authors:

Price Quantity Demanded

$100 0 novels

90 100,000

80 200,000

70 300,000

60 400,000

50 500,000

40 600,000

30 700,000

20 800,000

10 900,000

0 1,000,000

The author is paid $2 million to write the book, and

the marginal cost of publishing the book is a constant

$10 per book.

a. Compute total revenue, total cost, and profit

at each quantity. What quantity would a

profit-maximizing publisher choose? What

price would it charge?

b. Compute marginal revenue. (Recall that

MR 5 ΔTR/ΔQ.) How does marginal revenue compare to the price? Explain.

c. Graph the marginal-revenue, marginal-cost, and

demand curves. At what quantity do the margin-

al-revenue and marginal-cost curves cross? What

does this signify?

d. In your graph, shade in the deadweight loss.

Explain in words what this means.

e. If the author were paid $3 million instead of

$2 million to write the book, how would this

affect the publisher’s decision regarding what

price to charge? Explain.

f. Suppose the publisher was not profit-maximizing

but was concerned with maximizing economic

efficiency. What price would it charge for the

book? How much profit would it make at this

price?

2. A small town is served by many competing supermar-

kets, which have the same constant marginal cost.

a. Using a diagram of the market for groceries,

show the consumer surplus, producer surplus,

and total surplus.

b. Now suppose that the independent supermarkets

combine into one chain. Using a new diagram,

show the new consumer surplus, producer

surplus, and total surplus. Relative to the compet-

itive market, what is the transfer from consumers

to producers? What is the deadweight loss?

QUESTIONS FOR REVIEW

1. Give an example of a government-created monopoly.

Is creating this monopoly necessarily bad public

policy? Explain.

2. Define natural monopoly. What does the size of a market have to do with whether an industry is a

natural monopoly?

3. Why is a monopolist’s marginal revenue less than

the price of its good? Can marginal revenue ever be

negative? Explain.

4. Draw the demand, marginal-revenue, average-

total-cost, and marginal-cost curves for a

monopolist. Show the profit-maximizing level

of output, the profit-maximizing price, and the

amount of profit.

5. In your diagram from the previous question, show

the level of output that maximizes total surplus. Show

the deadweight loss from the monopoly. Explain your

answer.

6. Give two examples of price discrimination. In each

case, explain why the monopolist chooses to follow

this business strategy.

7. What gives the government the power to regulate

mergers between firms? Give a good reason and a bad

reason (from the perspective of society’s welfare) that

two firms might want to merge.

8. Describe the two problems that arise when regulators

tell a natural monopoly that it must set a price equal to

marginal cost.

PROBLEMS AND APPLICATIONS

315CHAPTER 15 MONOPOLY

3. Johnny Rockabilly has just finished recording his latest

CD. His record company’s marketing department

determines that the demand for the CD is as follows:

Price Number of CDs

$24 10,000

22 20,000

20 30,000

18 40,000

16 50,000

14 60,000

The company can produce the CD with no fixed cost

and a variable cost of $5 per CD.

a. Find total revenue for quantity equal to 10,000,

20,000, and so on. What is the marginal revenue

for each 10,000 increase in the quantity sold?

b. What quantity of CDs would maximize profit?

What would the price be? What would the

profit be?

c. If you were Johnny’s agent, what recording

fee would you advise Johnny to demand from

the record company? Why?

4. A company is considering building a bridge across a

river. The bridge would cost $2 million to build and

nothing to maintain. The following table shows the

company’s anticipated demand over the lifetime

of the bridge:

Number of Crossings,

Price per Crossing in Thousands

$8 0

7 100

6 200

5 300

4 400

3 500

2 600

1 700

0 800

a. If the company were to build the bridge, what

would be its profit-maximizing price? Would that

be the efficient level of output? Why or why not?

b. If the company is interested in maximizing profit,

should it build the bridge? What would be its

profit or loss?

c. If the government were to build the bridge, what

price should it charge?

d. Should the government build the bridge? Explain.

5. Consider the relationship between monopoly pricing

and price elasticity of demand.

a. Explain why a monopolist will never produce a

quantity at which the demand curve is inelastic.

(Hint: If demand is inelastic and the firm raises its price, what happens to total revenue and total

costs?)

b. Draw a diagram for a monopolist, precisely

labeling the portion of the demand curve that

is inelastic. (Hint: The answer is related to the marginal-revenue curve.)

c. On your diagram, show the quantity and price

that maximize total revenue.

6. You live in a town with 300 adults and 200 children,

and you are thinking about putting on a play to

entertain your neighbors and make some money. A

play has a fixed cost of $2,000, but selling an extra

ticket has zero marginal cost. Here are the demand

schedules for your two types of customer:

Price Adults Children

$10 0 0

9 100 0

8 200 0

7 300 0

6 300 0

5 300 100

4 300 200

3 300 200

2 300 200

1 300 200

0 300 200

a. To maximize profit, what price would you charge

for an adult ticket? For a child’s ticket? How much

profit do you make?

b. The city council passes a law prohibiting you from

charging different prices to different customers.

What price do you set for a ticket now? How

much profit do you make?

c. Who is worse off because of the law prohibiting

price discrimination? Who is better off? (If you

can, quantify the changes in welfare.)

d. If the fixed cost of the play were $2,500 rather than

$2,000, how would your answers to parts (a), (b),

and (c) change?

316 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

7. The residents of the town Ectenia all love economics,

and the mayor proposes building an economics

museum. The museum has a fixed cost of $2,400,000

and no variable costs. There are 100,000 town

residents, and each has the same demand for

museum visits: QD 5 10 2 P, where P is the price of admission.

a. Graph the museum’s average-total-cost curve

and its marginal-cost curve. What kind of market

would describe the museum?

b. The mayor proposes financing the museum with

a lump-sum tax of $24 and then opening the

museum to the public for free. How many times

would each person visit? Calculate the benefit

each person would get from the museum, mea-

sured as consumer surplus minus the new tax.

c. The mayor’s anti-tax opponent says the museum

should finance itself by charging an admission fee.

What is the lowest price the museum can charge

without incurring losses? (Hint: Find the number of visits and museum profits for prices of $2, $3,

$4, and $5.)

d. For the break-even price you found in part (c),

calculate each resident’s consumer surplus.

Compared with the mayor’s plan, who is better

off with this admission fee, and who is worse off?

Explain.

e. What real-world considerations absent in the

problem above might provide reasons to favor an

admission fee?

8. Henry Potter owns the only well in town that pro-

duces clean drinking water. He faces the following

demand, marginal revenue, and marginal cost curves:

Demand: P 5 70 2 Q Marginal Revenue: MR 5 70 2 2Q

Marginal Cost: MC 5 10 1 Q

a. Graph these three curves. Assuming that

Mr. Potter maximizes profit, what quantity does

he produce? What price does he charge? Show

these results on your graph.

b. Mayor George Bailey, concerned about water con-

sumers, is considering a price ceiling that is

10 percent below the monopoly price derived in

part (a). What quantity would be demanded at

this new price? Would the profit-maximizing

Mr. Potter produce that amount? Explain. (Hint: Think about marginal cost.)

c. George’s Uncle Billy says that a price ceiling is a

bad idea because price ceilings cause shortages.

Is he right in this case? What size shortage would

the price ceiling create? Explain.

d. George’s friend Clarence, who is even more con-

cerned about consumers, suggests a price ceiling

50 percent below the monopoly price. What quan-

tity would be demanded at this price? How much

would Mr. Potter produce? In this case, is Uncle

Billy right? What size shortage would the price

ceiling create?

9. Only one firm produces and sells soccer balls in the

country of Wiknam, and as the story begins, interna-

tional trade in soccer balls is prohibited. The following

equations describe the monopolist’s demand, mar-

ginal revenue, total cost, and marginal cost:

Demand: P 5 10 2 Q Marginal Revenue: MR 5 10 2 2Q

Total Cost: TC 5 3 1 Q 1 0.5 Q2

Marginal Cost: MC 5 1 1 Q,

where Q is quantity and P is the price measured in Wiknamian dollars.

a. How many soccer balls does the monopolist pro-

duce? At what price are they sold? What is the

monopolist’s profit?

b. One day, the King of Wiknam decrees that

henceforth there will be free trade—either

imports or exports—of soccer balls at the world

price of $6. The firm is now a price taker in a

competitive market. What happens to domestic

production of soccer balls? To domestic

consumption? Does Wiknam export or import

soccer balls?

c. In our analysis of international trade in Chapter 9,

a country becomes an exporter when the price

without trade is below the world price and an

importer when the price without trade is above

the world price. Does that conclusion hold in your

answers to parts (a) and (b)? Explain.

d. Suppose that the world price was not $6 but,

instead, happened to be exactly the same as the

domestic price without trade as determined in

part (a). Would allowing trade have changed any-

thing in the Wiknamian economy? Explain. How

does the result here compare with the analysis in

Chapter 9?

10. Based on market research, a film production company

in Ectenia obtains the following information about the

demand and production costs of its new DVD:

Demand: P 5 1,000 2 10Q Total Revenue: TR 5 1,000Q 2 10Q2

Marginal Revenue: MR 5 1,000 2 20Q Marginal Cost: MC 5 100 1 10Q,

317CHAPTER 15 MONOPOLY

where Q indicates the number of copies sold and P is the price in Ectenian dollars.

a. Find the price and quantity that maximize the

company’s profit.

b. Find the price and quantity that would maximize

social welfare.

c. Calculate the deadweight loss from monopoly.

d. Suppose, in addition to the costs above, the

director of the film has to be paid. The company is

considering four options:

i. a flat fee of 2,000 Ectenian dollars.

ii. 50 percent of the profits.

iii. 150 Ectenian dollars per unit sold.

iv. 50 percent of the revenue.

For each option, calculate the profit-maximizing

price and quantity. Which, if any, of these compensa-

tion schemes would alter the deadweight loss from

monopoly? Explain.

11. Larry, Curly, and Moe run the only saloon in town.

Larry wants to sell as many drinks as possible without

losing money. Curly wants the saloon to bring in as

much revenue as possible. Moe wants to make the

largest possible profits. Using a single diagram of

the saloon’s demand curve and its cost curves, show

the price and quantity combinations favored by each

of the three partners. Explain. (Hint: Only one of these partners will want to set marginal revenue equal to

marginal cost.)

12. Many schemes for price discrimination involve some

cost. For example, discount coupons take up the time

and resources of both the buyer and the seller. This

question considers the implications of costly price

discrimination. To keep things simple, let’s assume

that our monopolist’s production costs are simply

proportional to output so that average total cost and

marginal cost are constant and equal to each other.

a. Draw the cost, demand, and marginal- revenue

curves for the monopolist. Show the price

the monopolist would charge without price

discrimination.

b. In your diagram, mark the area equal to the mo-

nopolist’s profit and call it X. Mark the area equal to consumer surplus and call it Y. Mark the area equal to the deadweight loss and call it Z.

c. Now suppose that the monopolist can perfectly

price discriminate. What is the monopolist’s

profit? (Give your answer in terms of X, Y, and Z.) d. What is the change in the monopolist’s profit from

price discrimination? What is the change in total

surplus from price discrimination? Which change

is larger? Explain. (Give your answer in terms of

X, Y, and Z.) e. Now suppose that there is some cost associated

with price discrimination. To model this cost, let’s

assume that the monopolist has to pay a fixed cost

C to price discriminate. How would a monopolist make the decision whether to pay this fixed cost?

(Give your answer in terms of X, Y, Z, and C.) f. How would a benevolent social planner, who

cares about total surplus, decide whether the

monopolist should price discriminate? (Give your

answer in terms of X, Y, Z, and C.) g. Compare your answers to parts (e) and (f). How

does the monopolist’s incentive to price discrimi-

nate differ from the social planner’s? Is it possible

that the monopolist will price discriminate even

though doing so is not socially desirable?

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

Monopolistic Competition CHAPTER

16 Y

ou walk into a bookstore to buy a book to read during your next vacation. On the store’s shelves you find a Patricia Cornwell mystery, a Stephen King thriller, a Nathaniel Philbrick history, a Suzanne Collins dystopian survival

romance, and many other choices. When you pick out a book and buy it, what kind of market are you participating in?

On the one hand, the market for books seems competitive. As you look over the shelves at your bookstore, you find many authors and many publishers vying for your attention. A buyer in this market has thousands of competing products from which to choose. And because anyone can enter the industry by writing and publishing a book, the book business is not very profitable. For every highly paid novelist, there are hundreds of struggling ones.

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320 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

On the other hand, the market for books seems monopolistic. Because each book is unique, publishers have some latitude in choosing what price to charge. The sellers in this market are price makers rather than price takers. And indeed, the price of books greatly exceeds marginal cost. The price of a typical hardcover novel, for instance, is about $25, whereas the cost of printing one additional copy of the novel is less than $5.

The market for novels fits neither the competitive nor the monopoly model. Instead, it is best described by the model of monopolistic competition, the subject of this chapter. The term “monopolistic competition” might at first seem to be an oxymoron, like “jumbo shrimp.” But as we will see, monopolistically competitive industries are monopolistic in some ways and competitive in others. The model describes not only the publishing industry but also the market for many other goods and services.

16-1 Between Monopoly and Perfect Competition The previous two chapters analyzed markets with many competitive firms and markets with a single monopoly firm. In Chapter 14, we saw that the price in a perfectly competitive market always equals the marginal cost of production. We also saw that, in the long run, entry and exit drive economic profit to zero, so the price also equals average total cost. In Chapter 15, we saw how monopoly firms can use their market power to keep prices above marginal cost, leading to a pos- itive economic profit for the firm and a deadweight loss for society. Competition and monopoly are extreme forms of market structure. Competition occurs when there are many firms in a market offering essentially identical products; monop- oly occurs when there is only one firm in a market.

Although the cases of perfect competition and monopoly illustrate some important ideas about how markets work, most markets in the economy include elements of both these cases and, therefore, are not completely described by either of them. The typical firm in the economy faces competition, but the competition is not so rigorous that it makes the firm a price taker like the firms analyzed in Chapter 14. The typical firm also has some degree of market power, but its mar- ket power is not so great that the firm can be described exactly by the monopoly model presented in Chapter 15. In other words, many industries fall somewhere between the polar cases of perfect competition and monopoly. Economists call this situation imperfect competition.

One type of imperfectly competitive market is an oligopoly, a market with only a few sellers, each offering a product that is similar or identical to the products offered by other sellers in the market. Economists measure a market’s domination by a small number of firms with a statistic called the concentration ratio, which is the percentage of total output in the market supplied by the four largest firms. In the U.S. economy, most industries have a four-firm concentration ratio under 50 per- cent, but in some industries, the biggest firms play a more dominant role. Highly concentrated industries include the market for major household appliances (which has a concentration ratio of 90 percent), tires (91 percent), light bulbs (92 percent), soda (94 percent), and wireless telecommunications (95 percent). These industries are best described as oligopolies. In the next chapter we see that the small number of firms in oligopolies makes strategic interactions among them a key part of the analysis. That is, in choosing how much to produce and what price to charge, each firm in an oligopoly is concerned not only with what its competitors are doing but also with how its competitors would react to what it might do.

oligopoly

a market structure in

which only a few sellers

offer similar or identical

products

321CHAPTER 16 MONOPOLISTIC COMPETITION

A second type of imperfectly competitive market is called monopolistic competition. This describes a market structure in which there are many firms selling products that are similar but not identical. In a monopolistically competi- tive market, each firm has a monopoly over the product it makes, but many other firms make similar products that compete for the same customers.

To be more precise, monopolistic competition describes a market with the fol- lowing attributes:

• Many sellers: There are many firms competing for the same group of customers. • Product differentiation: Each firm produces a product that is at least slightly

different from those of other firms. Thus, rather than being a price taker, each firm faces a downward-sloping demand curve.

• Free entry and exit: Firms can enter or exit the market without restriction. Thus, the number of firms in the market adjusts until economic profits are driven to zero.

A moment’s thought reveals a long list of markets with these attributes: books, computer games, restaurants, piano lessons, cookies, clothing, and so on.

Monopolistic competition, like oligopoly, is a market structure that lies between the extreme cases of perfect competition and monopoly. But oligopoly and monopolistic competition are quite different. Oligopoly departs from the per- fectly competitive ideal of Chapter 14 because there are only a few sellers in the market. The small number of sellers makes rigorous competition less likely and strategic interactions among them vitally important. By contrast, a monopolisti- cally competitive market has many sellers, each of which is small compared to the market. It departs from the perfectly competitive ideal because each of the sellers offers a somewhat different product.

Figure 1 summarizes the four types of market structure. The first question to ask about any market is how many firms there are. If there is only one firm, the

monopolistic competition

a market structure in

which many firms sell

products that are similar

but not identical

• Tap water • Cable TV

Monopoly (Chapter 15)

• Novels • Movies

• Wheat • Milk

Monopolistic Competition (Chapter 16)

• Tennis balls • Cigarettes

Oligopoly (Chapter 17)

Number of Firms?

Perfect Competition (Chapter 14)

Type of Products?

Identical products

Differentiated products

One firm

Few firms

Many firms

FIGURE 1

The Four Types of Market

Structure

Economists who study industrial

organization divide markets into

four types: monopoly, oligopoly,

monopolistic competition, and

perfect competition.

322 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

market is a monopoly. If there are only a few firms, the market is an oligopoly. If there are many firms, we need to ask another question: Do the firms sell identical or differentiated products? If the many firms sell identical products, the market is perfectly competitive. But if the many firms sell differentiated products, the mar- ket is monopolistically competitive.

Because reality is never as clear-cut as theory, at times you may find it hard to decide what structure best describes a market. There is, for instance, no magic number that separates “few” from “many” when counting the number of firms. (Do the approximately dozen companies that now sell cars in the United States make this market an oligopoly, or is the market more competitive? The answer is open to debate.) Similarly, there is no sure way to determine when products are differentiated and when they are identical. (Are different brands of milk really the same? Again, the answer is debatable.) When analyzing actual markets, economists have to keep in mind the lessons learned from studying all types of market structure and then apply each les- son as it seems appropriate.

Now that we understand how economists define the various types of market structure, we can continue our analysis of each of them. In this chapter we exam- ine monopolistic competition. In the next chapter we analyze oligopoly.

QuickQuiz Define oligopoly and monopolistic competition and give an example of each.

16-2 Competition with Differentiated Products To understand monopolistically competitive markets, we first consider the decisions facing an individual firm. We then examine what happens in the long run as firms enter and exit the industry. Next, we compare the equilibrium under monopolistic competition to the equilibrium under perfect competition that we examined in Chapter 14. Finally, we consider whether the outcome in a monopolistically competitive market is desirable from the standpoint of society as a whole.

16-2a The Monopolistically Competitive Firm in the Short Run Each firm in a monopolistically competitive market is, in many ways, like a monopoly. Because its product is different from those offered by other firms, it faces a downward-sloping demand curve. (By contrast, a perfectly competitive firm faces a horizontal demand curve at the market price.) Thus, the monopo- listically competitive firm follows a monopolist’s rule for profit maximization: It chooses to produce the quantity at which marginal revenue equals marginal cost and then uses its demand curve to find the price at which it can sell that quantity.

Figure 2 shows the cost, demand, and marginal-revenue curves for two typical firms, each in a different monopolistically competitive industry. In both panels of the figure, the profit-maximizing quantity is found at the intersection of the marginal-revenue and marginal-cost curves. The two panels show different out- comes for the firm’s profit. In panel (a), price exceeds average total cost, so the firm makes a profit. In panel (b), price is below average total cost. In this case, the firm is unable to make a positive profit, so the best it can do is to minimize its losses.

323CHAPTER 16 MONOPOLISTIC COMPETITION

All this should seem familiar. A monopolistically competitive firm chooses its quantity and price just as a monopoly does. In the short run, these two types of market structure are similar.

16-2b The Long-Run Equilibrium The situations depicted in Figure 2 do not last long. When firms are making prof- its, as in panel (a), new firms have an incentive to enter the market. This entry increases the number of products from which customers can choose and, there- fore, reduces the demand faced by each firm already in the market. In other words, profit encourages entry, and entry shifts the demand curves faced by the incumbent firms to the left. As the demand for incumbent firms’ products falls, these firms experience declining profit.

Conversely, when firms are making losses, as in panel (b), firms in the mar- ket have an incentive to exit. As firms exit, customers have fewer products from which to choose. This decrease in the number of firms expands the demand faced by those firms that stay in the market. In other words, losses encourage exit, and exit shifts the demand curves of the remaining firms to the right. As the demand for the remaining firms’ products rises, these firms experience rising profits (that is, declining losses).

This process of entry and exit continues until the firms in the market are mak- ing exactly zero economic profit. Figure 3 depicts the long-run equilibrium. Once the market reaches this equilibrium, new firms have no incentive to enter, and existing firms have no incentive to exit.

QuantityProfit- maximizing

quantity

Loss- minimizing

quantity

Price

Demand

Demand MR

ATC

(a) Firm Makes Profit

Quantity0

Price

Price Average

total cost

Average total cost

(b) Firm Makes Losses

Profit

Losses

MC ATC

FIGURE 2

Monopolistic Competitors in the

Short Run

Monopolistic competitors, like monopolists, maximize profit by producing the quantity

at which marginal revenue equals marginal cost. The firm in panel (a) makes a profit

because, at this quantity, price is greater than average total cost. The firm in panel (b)

makes losses because, at this quantity, price is less than average total cost.

324 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

Profit-maximizing quantity

Quantity

Price

P = ATC

Demand MR

ATC

FIGURE 3

A Monopolistic Competitor

in the Long Run

In a monopolistically competitive

market, if firms are making prof-

its, new firms enter, causing the

demand curves for the incumbent

firms to shift to the left. Similarly,

if firms are making losses, some

of the firms in the market exit,

causing the demand curves of the

remaining firms to shift to the right.

Because of these shifts in demand,

monopolistically competitive firms

eventually find themselves in the

long-run equilibrium shown here.

In this long-run equilibrium, price

equals average total cost, and each

firm earns zero profit.

Notice that the demand curve in this figure just barely touches the average- total-cost curve. Mathematically, we say the two curves are tangent to each other. These two curves must be tangent once entry and exit have driven profit to zero. Because profit per unit sold is the difference between price (found on the demand curve) and average total cost, the maximum profit is zero only if these two curves touch each other without crossing. Also note that this point of tangency occurs at the same quantity where marginal revenue equals marginal cost. That these two points line up is not a coincidence: It is required because this particular quantity maximizes profit and the maximum profit is exactly zero in the long run.

To sum up, two characteristics describe the long-run equilibrium in a monopo- listically competitive market:

• As in a monopoly market, price exceeds marginal cost (P . MC). This conclusion arises because profit maximization requires marginal revenue to equal marginal cost (MR 5 MC) and because the downward-sloping demand curve makes marginal revenue less than the price (MR , P).

• As in a competitive market, price equals average total cost (P 5 ATC). This conclusion arises because free entry and exit drive economic profit to zero.

The second characteristic shows how monopolistic competition differs from monopoly. Because a monopoly is the sole seller of a product without close sub- stitutes, it can earn positive economic profit, even in the long run. By contrast, because there is free entry into a monopolistically competitive market, the economic profit of a firm in this type of market is driven to zero.

16-2c Monopolistic versus Perfect Competition Figure 4 compares the long-run equilibrium under monopolistic competition to the long-run equilibrium under perfect competition. (Chapter 14 discussed the

325CHAPTER 16 MONOPOLISTIC COMPETITION

equilibrium with perfect competition.) There are two noteworthy differences between monopolistic and perfect competition: excess capacity and the markup.

Excess Capacity As we have just seen, the process of entry and exit drives each firm in a monopolistically competitive market to a point of tangency between its demand and average-total-cost curves. Panel (a) of Figure 4 shows that the quantity of output at this point is smaller than the quantity that minimizes average total cost. Thus, under monopolistic competition, firms produce on the downward-sloping portion of their average-total-cost curves. In this way, monopolistic competition contrasts starkly with perfect competition. As panel (b) of Figure 4 shows, free entry in competitive markets drives firms to produce at the minimum of average total cost.

The quantity that minimizes average total cost is called the efficient scale of the firm. In the long run, perfectly competitive firms produce at the efficient scale, whereas monopolistically competitive firms produce below this level. Firms are said to have excess capacity under monopolistic competition. In other words, a monopolistically competitive firm, unlike a perfectly competitive firm, could increase the quantity it produces and lower the average total cost of production. The firm forgoes this opportunity because it would need to cut its price to sell the additional output. It is more profitable for a monopolistic competitor to continue operating with excess capacity.

SC IE

N CE

CA RT

O O

N SP

LU S.

CO M

326 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

Markup over Marginal Cost A second difference between perfect competition and monopolistic competition is the relationship between price and marginal cost. For a perfectly competitive firm, such as the one shown in panel (b) of Figure 4, price equals marginal cost. For a monopolistically competitive firm, such as the one shown in panel (a), price exceeds marginal cost because the firm always has some market power.

How is this markup over marginal cost consistent with free entry and zero profit? The zero-profit condition ensures only that price equals average total cost. It does not ensure that price equals marginal cost. Indeed, in the long-run equilib- rium, monopolistically competitive firms operate on the declining portion of their average-total-cost curves, so marginal cost is below average total cost. Thus, for price to equal average total cost, price must be above marginal cost.

In this relationship between price and marginal cost, we see a key behavioral difference between perfect competitors and monopolistic competitors. Imagine that you were to ask a firm the following question: “Would you like to see another customer come through your door ready to buy from you at your current price?” A perfectly competitive firm would answer that it didn’t care. Because price exactly equals marginal cost, the profit from an extra unit sold is zero. By con- trast, a monopolistically competitive firm is always eager to get another customer. Because its price exceeds marginal cost, an extra unit sold at the posted price means more profit.

QuantityQuantity produced

Efficient scale

Quantity produced = Efficient scale

Price

Demand

(a) Monopolistically Competitive Firm

Quantity0

Price

P = MC P = MR (demand

curve)Marginal cost

(b) Perfectly Competitive Firm

Markup

Excess capacity

MC ATC

FIGURE 4

Monopolistic versus Perfect Competition

Panel (a) shows the long-run equilibrium in a monopolistically competitive

market, and panel (b) shows the long-run equilibrium in a perfectly competitive

market. Two differences are notable. (1) The perfectly competitive firm produces

at the efficient scale, where average total cost is minimized. By contrast, the

monopolistically competitive firm produces at less than the efficient scale.

(2) Price equals marginal cost under perfect competition, but price is above

marginal cost under monopolistic competition.

327CHAPTER 16 MONOPOLISTIC COMPETITION

According to an old quip, monopolistically competitive markets are those in which sellers send Christmas cards to the buyers. Trying to attract more custom- ers makes sense only if price exceeds marginal cost.

16-2d Monopolistic Competition and the Welfare of Society Is the outcome in a monopolistically competitive market desirable from the stand- point of society as a whole? Can policymakers improve on the market outcome? In previous chapters we evaluated markets from the standpoint of efficiency by asking whether society is getting the most it can out of its scarce resources. We learned that competitive markets lead to efficient outcomes, unless there are externalities, whereas monopoly markets lead to deadweight losses. Monopolis- tically competitive markets are more complex than either of these polar cases, so evaluating welfare in these markets is a more subtle exercise.

One source of inefficiency in monopolistically competitive markets is the markup of price over marginal cost. Because of the markup, some consumers who value the good at more than the marginal cost of production (but less than the price) will be deterred from buying it. Thus, a monopolistically competitive mar- ket has the normal deadweight loss of monopoly pricing.

This outcome is undesirable compared with the efficient quantity that arises when price equals marginal cost, but policymakers don’t have an easy way to fix the problem. To enforce marginal-cost pricing, they would need to regulate all firms that produce differentiated products. Because such products are so common in the economy, the administrative burden of such regulation would be overwhelming.

Moreover, regulating monopolistic competitors entails all the problems of reg- ulating natural monopolies. In particular, because monopolistic competitors are making zero profits already, requiring them to lower their prices to equal mar- ginal cost would cause them to make losses. To keep these firms in business, the government would need to help them cover these losses. Rather than raise taxes to pay for these subsidies, policymakers often decide it is better to live with the inefficiency of monopolistic pricing.

Another source of inefficiency under monopolistic competition is that the num- ber of firms in the market may not be “ideal.” That is, there may be too much or too little entry. One way to think about this problem is in terms of the externalities associated with entry. Whenever a new firm considers entering the market with a new product, it takes into account only the profit it would make. Yet its entry would also have the following two effects that are external to the firm:

• The product-variety externality: Because consumers get some consumer surplus from the introduction of a new product, the entry of a new firm conveys a positive externality on consumers.

• The business-stealing externality: Because other firms lose customers and profits when faced with a new competitor, the entry of a new firm imposes a negative externality on existing firms.

Thus, in a monopolistically competitive market, the entry of new firms entails both positive and negative externalities. Depending on which externality is larger, a monopolistically competitive market could have either too few or too many products.

Both of these externalities are closely related to the conditions for monopolis- tic competition. The product-variety externality arises because new firms offer products that differ from those of the existing firms. The business-stealing exter- nality arises because firms post a price above marginal cost and, therefore, are

328 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

always eager to sell additional units. Conversely, because perfectly competitive firms produce identical goods and charge a price equal to marginal cost, neither of these externalities exists under perfect competition.

In the end, we can conclude only that monopolistically competitive markets do not have all the desirable welfare properties of perfectly competitive markets. That is, the invisible hand does not ensure that total surplus is maximized under monop- olistic competition. Yet because the inefficiencies are subtle, hard to measure, and hard to fix, there is no easy way for public policy to improve the market outcome.

QuickQuiz List the three key attributes of monopolistic competition. • Draw and

explain a diagram to show the long-run equilibrium in a monopolistically com-

petitive market. How does this equilibrium differ from that in a perfectly competitive market?

16-3 Advertising It is nearly impossible to go through a typical day in a modern economy without being bombarded with advertising. Whether you are surfing the Internet, posting on Facebook, reading a magazine, watching television, or driving down the high- way, some firm will try to convince you to buy its product. Such behavior is a nat- ural feature of monopolistic competition (as well as some oligopolistic industries). When firms sell differentiated products and charge prices above marginal cost, each firm has an incentive to advertise to attract more buyers to its particular product.

The amount of advertising varies substantially across products. Firms that sell highly differentiated consumer goods, such as over-the-counter drugs, perfumes, soft drinks, razor blades, breakfast cereals, and dog food, typically spend between 10 and 20 percent of their revenue on advertising. Firms that sell industrial prod- ucts, such as drill presses and communications satellites, typically spend very lit- tle on advertising. And firms that sell homogeneous products, such as wheat, salt, sugar, and crude oil, spend nothing at all.

For the economy as a whole, about 2 percent of total firm revenue is spent on advertising. This spending takes many forms, including ads on web sites, social media, television, radio, and billboards and in newspapers, magazines, and direct mail.

16-3a The Debate over Advertising Is society wasting the resources it devotes to advertising? Or does advertising serve a valuable purpose? Assessing the social value of advertising is difficult and often gener- ates heated argument among economists. Let’s consider both sides of the debate.

The Critique of Advertising Critics of advertising argue that firms advertise to manipulate people’s tastes. Much advertising is psychological rather than informa- tional. Consider, for example, the typical television commercial for some brand of soft drink. The commercial most likely does not tell the viewer about the product’s price or quality. Instead, it might show a group of happy people at a party on a beach on a beautiful sunny day. In their hands are cans of the soft drink. The goal of the commercial is to convey a subconscious (if not subtle) message: “You too can have many friends and be happy, if you drink our product.” Critics of advertising argue that such a commercial creates a desire that otherwise might not exist.

Critics also argue that advertising impedes competition. Advertising often tries to convince consumers that products are more different than they truly are. By increasing the perception of product differentiation and fostering brand loyalty, advertising makes buyers less concerned with price differences among similar

329CHAPTER 16 MONOPOLISTIC COMPETITION

goods, thereby making the demand for a particular brand less elastic. When a firm faces a less elastic demand curve, it can increase its profits by charging a larger markup over marginal cost.

The Defense of Advertising Defenders of advertising argue that firms use adver- tising to provide information to customers. Advertising conveys the prices of the goods offered for sale, the existence of new products, and the locations of retail outlets. This information allows customers to make better choices about what to buy and, thus, enhances the ability of markets to allocate resources efficiently.

Defenders also argue that advertising fosters competition. Because advertising allows customers to be more fully informed about all the firms in the market, cus- tomers can more easily take advantage of price differences. Thus, each firm has less market power. In addition, advertising allows new firms to enter more easily because it gives entrants a means to attract customers from existing firms.

Over time, policymakers have come to accept the view that advertising can make markets more competitive. One important example is the regulation of advertising for certain professions, such as lawyers, doctors, and pharmacists. In the past, these groups succeeded in getting state governments to prohibit advertis- ing in their fields on the grounds that advertising was “unprofessional.” In recent years, however, the courts have concluded that the primary effect of these restric- tions on advertising was to curtail competition. They have, therefore, overturned many of the laws that prohibit advertising by members of these professions.

ADVERTISING AND THE PRICE OF EYEGLASSES What effect does advertising have on the price of a good? On the one hand, advertising might make consumers view products as being more different than they otherwise would. If so, it would make mar- kets less competitive and firms’ demand curves less elastic, and this

would lead firms to charge higher prices. On the other hand, advertising might make it easier for consumers to find the firms offering the best prices. In this case, it would make markets more competitive and firms’ demand curves more elastic, which would lead to lower prices.

In an article published in The Journal of Law and Economics in 1972, economist Lee Benham tested these two views of advertising. In the United States during the 1960s, the various state governments had vastly different rules about advertising by optometrists. Some states allowed advertising for eyeglasses and eye examinations. Many states, however, prohibited it. For example, the Florida law read as follows:

It is unlawful for any person, firm, or corporation to . . . advertise either directly or indirectly by any means whatsoever any definite or indefinite price or credit terms on prescriptive or corrective lens, frames, complete prescrip- tive or corrective glasses, or any optometric service. . . . This section is passed in the interest of public health, safety, and welfare, and its provisions shall be liberally construed to carry out its objects and purposes.

Professional optometrists enthusiastically endorsed these restrictions on advertising. Benham used the differences in state law as a natural experiment to test the

two views of advertising. The results were striking. In those states that prohibited advertising, the average price paid for a pair of eyeglasses was $33, or $256 in 2015 dollars. In states that did not restrict advertising, the average price was $26, or $202 in 2015 dollars. Thus, advertising reduced average prices by more than 20 percent. In the market for eyeglasses, and probably in many other markets as well, advertis- ing fosters competition and leads to lower prices for consumers. ●

CASE STUDY

330 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

16-3b Advertising as a Signal of Quality Many types of advertising contain little apparent information about the product being advertised. Consider a firm introducing a new breakfast cereal. The firm might saturate the airwaves with advertisements showing some actor eating the cereal and exclaiming how wonderful it tastes. How much information does the advertisement really provide?

The answer is more than you might think. Defenders of advertising argue that even advertising that appears to contain little hard information may in fact tell consumers something about product quality. The willingness of the firm to spend a large amount of money on advertising can itself be a signal to consumers about the quality of the product being offered.

Consider the problem facing two firms—General Mills and Kellogg. Each com- pany has just come up with a recipe for a new cereal, which it would sell for $3 a box. To keep things simple, let’s assume that the marginal cost of making cereal is zero, so the $3 is all profit. Each company knows that if it spends $10 million on advertising, it will get 1 million consumers to try its new cereal. And each company knows that if consumers like the cereal, they will buy it not once but many times.

First consider General Mills’ decision. Based on market research, General Mills knows that its cereal tastes like shredded newspaper with sugar on top. Advertis- ing would sell one box to each of the 1 million consumers, but consumers would quickly learn that the cereal is not very good and stop buying it. General Mills decides it is not worth spending $10 million on advertising to get only $3 million in sales. So it does not bother to advertise. It sends its cooks back to the test kitchen to come up with a better recipe.

Kellogg, on the other hand, knows that its cereal is great. Each person who tries it will buy a box a month for the next year. Thus, the $10 million in advertising will bring in $36 million in sales. Advertising is profitable here because Kellogg has a good product that consumers will buy repeatedly. Thus, Kellogg chooses to advertise.

Now that we have considered the behavior of the two firms, let’s consider the behavior of consumers. We began by asserting that consumers are inclined to try a new cereal that they see advertised. But is this behavior rational? Should a con- sumer try a new cereal just because the seller has chosen to advertise it?

In fact, it may be completely rational for consumers to try new products that they see advertised. In our story, consumers decide to try Kellogg’s new cereal because Kellogg advertises. Kellogg chooses to advertise because it knows that its cereal is quite good, while General Mills chooses not to advertise because it knows that its cereal is not good at all. By its willingness to spend money on advertising, Kellogg signals to consumers the quality of its cereal. Each consumer thinks, quite sensibly, “Boy, if the Kellogg Company is willing to spend so much money advertising this new cereal, it must be really good.”

What is most surprising about this theory of advertising is that the content of the advertisement is irrelevant. Kellogg signals the quality of its product by its willingness to spend money on advertising. What the advertisements say is not as important as the fact that consumers know ads are expensive. By contrast, cheap advertising cannot be effective at signaling quality to consumers. In our example, if an advertising campaign cost less than $3 million, both General Mills and Kellogg would use it to market their new cereals. Because both good and bad cereals would be advertised, consumers could not infer the quality of a new cereal from the fact that it is advertised. Over time, consumers would learn to ignore such cheap advertising.

331CHAPTER 16 MONOPOLISTIC COMPETITION

This theory can explain why firms pay famous actors large amounts of money to make advertisements that, on the surface, appear to convey no information at all. The information is not in the advertisement’s content but simply in its exis- tence and expense.

16-3c Brand Names Advertising is closely related to the existence of brand names. In many markets, there are two types of firms. Some firms sell products with widely recognized brand names, while other firms sell generic substitutes. For example, in a typical drugstore, you can find Bayer aspirin on the shelf next to generic aspirin. In a typical grocery store, you can find Pepsi next to less familiar colas. Most often, the firm with the brand name spends more on advertising and charges a higher price for its product.

Just as there is disagreement about the economics of advertising, there is dis- agreement about the economics of brand names. Let’s consider both sides of the debate.

Critics argue that brand names cause consumers to perceive differences that do not really exist. In many cases, the generic good is almost indistinguishable from the brand-name good. Consumers’ willingness to pay more for the brand-name good, these critics assert, is a form of irrationality fostered by advertising. Economist Edward Chamberlin, one of the early developers of the theory of monopolistic competition, concluded from this argument that brand names were bad for the economy. He proposed that the government discourage their use by refusing to enforce the exclusive trademarks that companies use to identify their products.

More recently, economists have defended brand names as a useful way for consumers to ensure that the goods they buy are of high quality. There are two related arguments. First, brand names provide consumers with information about quality when quality cannot be easily judged in advance of purchase. Second, brand names give firms an incentive to maintain high quality because firms have a financial stake in maintaining the reputation of their brand names.

To see how these arguments work in practice, consider a famous brand name: McDonald’s. Imagine that you are driving through an unfamiliar town and want to stop for lunch. You see a McDonald’s and a local restaurant next to it. Which do you choose? The local restaurant may offer better food at lower prices, but you have no way of knowing that. By contrast, McDonald’s offers a consistent product across many cities. Its brand name is useful to you as a way of judging the quality of what you are about to buy.

Is it rational for consumers to be impressed that Jennifer Aniston is endorsing this product?

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332 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

The McDonald’s brand name also ensures that the company has an incentive to maintain quality. For example, if some customers were to become ill from spoiled food sold at a McDonald’s, the news would be disastrous for the company. McDonald’s would lose much of the valuable reputation that it has built up with years of expensive advertising. As a result, it would lose sales and profit not only in the outlet that sold the bad food but also in many other McDonald’s outlets throughout the country. By contrast, if some customers were to become ill from bad food at a local restaurant, that restaurant might have to close down, but the lost profits would be much smaller. Hence, McDonald’s has a greater incentive to ensure that its food is safe.

The debate over brand names thus centers on the question of whether consum- ers are rational in preferring brand names to generic substitutes. Critics argue that brand names are the result of an irrational consumer response to advertising. Defenders argue that consumers have good reason to pay more for brand-name products because they can be more confident in the quality of these products.

QuickQuiz How might advertising make markets less competitive? How might it make

markets more competitive? • Give the arguments for and against brand names.

TABLE 1

Monopolistic

Competition: Between

Perfect Competition and

Monopoly

Market Structure

Perfect

Competition

Monopolistic

Competition

Monopoly

Features that all three

market structures share

Goal of firms Maximize profits Maximize profits Maximize profits

Rule for maximizing profit MR 5 MC MR 5 MC MR 5 MC Can earn economic profits

in the short run? Yes Yes Yes

Features that monopolistic

competition shares with

monopoly

Price taker? Yes No No

Price P 5 MC P . MC P . MC Produces welfare-maximizing

level of output? Yes No No

Features that monopolistic

competition shares with perfect

competition

Number of firms Many Many One

Entry in the long run? Yes Yes No

Can earn economic profits

in the long run? No No Yes

16-4 Conclusion Monopolistic competition is true to its name: It is a hybrid of monopoly and compe- tition. Like a monopoly, each monopolistic competitor faces a downward-sloping demand curve and, as a result, charges a price above marginal cost. As in a perfectly competitive market, there are many firms, and entry and exit drive the profit of each monopolistic competitor toward zero in the long run. Table 1 summarizes these lessons.

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333CHAPTER 16 MONOPOLISTIC COMPETITION

Because monopolistically competitive firms produce differentiated products, each firm advertises to attract customers to its own brand. To some extent, advertising manipulates consumers’ tastes, promotes irrational brand loyalty, and impedes competition. To a larger extent, advertising provides information, estab- lishes brand names of reliable quality, and fosters competition.

The theory of monopolistic competition seems to describe many markets in the economy. It is somewhat disappointing, therefore, that the theory does not yield simple and compelling advice for public policy. From the standpoint of the eco- nomic theorist, the allocation of resources in monopolistically competitive mar- kets is not perfect. Yet from the standpoint of a practical policymaker, there may be little that can be done to improve it.

1. Which of the following conditions does NOT describe

a firm in a monopolistically competitive market?

a. It sells a product different from its competitors.

b. It takes its price as given by market conditions.

c. It maximizes profit both in the short run and in the

long run.

d. It has the freedom to enter or exit in the long run.

2. Which of the following markets best fits the definition

of monopolistic competition?

a. wheat

b. tap water

c. crude oil

d. haircuts

3. A monopolistically competitive firm will increase its

production if

a. marginal revenue is greater than marginal cost.

b. marginal revenue is greater than average total cost.

c. price is greater than marginal cost.

d. price is greater than average total cost.

4. New firms will enter a monopolistically competitive

market if

a. marginal revenue is greater than marginal cost.

b. marginal revenue is greater than average total cost.

c. price is greater than marginal cost.

d. price is greater than average total cost.

5. What is true of a monopolistically competitive market

in long-run equilibrium?

a. Price is greater than marginal cost.

b. Price is equal to marginal revenue.

c. Firms make positive economic profits.

d. Firms produce at the minimum of average total cost.

6. If advertising makes consumers more loyal to particu-

lar brands, it could ________ the elasticity of demand

and ________ the markup of price over marginal cost.

a. increase, increase

b. increase, decrease

c. decrease, increase

d. decrease, decrease

CHAPTER QuickQuiz

SUMMARY

• A monopolistically competitive market is character-

ized by three attributes: many firms, differentiated

products, and free entry and exit.

• The long-run equilibrium in a monopolistically com-

petitive market differs from that in a perfectly com-

petitive market in two related ways. First, each firm

in a monopolistically competitive market has excess

capacity. That is, it chooses a quantity that puts it

on the downward-sloping portion of the average-

total-cost curve. Second, each firm charges a price

above marginal cost.

• Monopolistic competition does not have all the

desirable properties of perfect competition. There is

the standard deadweight loss of monopoly caused

by the markup of price over marginal cost. In addition,

the number of firms (and thus the variety of products)

can be too large or too small. In practice, the ability of

policymakers to correct these inefficiencies is limited.

• The product differentiation inherent in monopolistic

competition leads to the use of advertising and brand

names. Critics of advertising and brand names argue

that firms use them to manipulate consumers’ tastes

and to reduce competition. Defenders of advertising

and brand names argue that firms use them to inform

consumers and to compete more vigorously on price

and product quality.

334 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

oligopoly, p. 320 monopolistic competition, p. 321

KEY CONCEPTS

1. Describe the three attributes of monopolistic competi-

tion. How is monopolistic competition like monopoly?

How is it like perfect competition?

2. Draw a diagram depicting a firm that is making a

profit in a monopolistically competitive market. Now

show what happens to this firm as new firms enter the

industry.

3. Draw a diagram of the long-run equilibrium in a

monopolistically competitive market. How is price

related to average total cost? How is price related to

marginal cost?

4. Does a monopolistic competitor produce too much or

too little output compared to the most efficient level?

What practical considerations make it difficult for

policymakers to solve this problem?

5. How might advertising reduce economic well-being?

How might advertising increase economic well-being?

6. How might advertising with no apparent infor-

mational content in fact convey information to

consumers?

7. Explain two benefits that might arise from the

existence of brand names.

QUESTIONS FOR REVIEW

1. Among monopoly, oligopoly, monopolistic competi-

tion, and perfect competition, how would you classify

the markets for each of the following drinks?

a. tap water

b. bottled water

c. cola

d. beer

2. Classify the following markets as perfectly competi-

tive, monopolistic, or monopolistically competitive,

and explain your answers.

a. wooden no. 2 pencils

b. copper

c. local electricity service

d. peanut butter

e. lipstick

3. For each of the following characteristics, say whether

it describes a perfectly competitive firm, a monopolis-

tically competitive firm, both, or neither.

a. sells a product differentiated from that of its

competitors

b. has marginal revenue less than price

c. earns economic profit in the long run

d. produces at the minimum of average total cost in

the long run

e. equates marginal revenue and marginal cost

f. charges a price above marginal cost

4. For each of the following characteristics, say whether

it describes a monopoly firm, a monopolistically

competitive firm, both, or neither.

a. faces a downward-sloping demand curve

b. has marginal revenue less than price

c. faces the entry of new firms selling similar

products

d. earns economic profit in the long run

e. equates marginal revenue and marginal cost

f. produces the socially efficient quantity of output

5. You are hired as a consultant to a monopolistically

competitive firm. The firm reports the following

information about its price, marginal cost, and average

total cost. Can the firm possibly be maximizing profit?

If not, what should it do to increase profit? If the

firm is maximizing profit, is the market in a long-run

equilibrium? If not, what will happen to restore

long-run equilibrium?

a. P , MC, P . ATC b. P . MC, P , ATC c. P 5 MC, P . ATC d. P . MC, P 5 ATC

PROBLEMS AND APPLICATIONS

335CHAPTER 16 MONOPOLISTIC COMPETITION

6. Sparkle is one of the many firms in the market for

toothpaste, which is in long-run equilibrium.

a. Draw a diagram showing Sparkle’s demand

curve, marginal-revenue curve, average-total-cost

curve, and marginal-cost curve. Label Sparkle’s

profit-maximizing output and price.

b. What is Sparkle’s profit? Explain.

c. On your diagram, show the consumer surplus

derived from the purchase of Sparkle toothpaste.

Also show the deadweight loss relative to the

efficient level of output.

d. If the government forced Sparkle to produce the

efficient level of output, what would happen

to the firm? What would happen to Sparkle’s

customers?

7. Consider a monopolistically competitive market with

N firms. Each firm’s business opportunities are described by the following equations:

Demand: Q 5 100/N 2 P Marginal Revenue: MR 5 100/N 2 2Q

Total Cost: TC 5 50 1 Q2

Marginal Cost: MC 5 2Q

a. How does N, the number of firms in the market, affect each firm’s demand curve? Why?

b. How many units does each firm produce?

(The answers to this and the next two

questions depend on N.) c. What price does each firm charge?

d. How much profit does each firm make?

e. In the long run, how many firms will exist in this

market?

8. The market for peanut butter in Nutville is monop-

olistically competitive and in long-run equilibrium.

One day, consumer advocate Skippy Jif discovers that

all brands of peanut butter in Nutville are identical.

Thereafter, the market becomes perfectly competitive

and again reaches its long-run equilibrium. Using

an appropriate diagram, explain whether each of the

following variables increases, decreases, or stays the

same for a typical firm in the market.

a. price

b. quantity

c. average total cost

d. marginal cost

e. profit

9. For each of the following pairs of firms, explain which

firm would be more likely to engage in advertising.

a. a family-owned farm or a family-owned

restaurant

b. a manufacturer of forklifts or a manufacturer of cars

c. a company that invented a very comfortable razor

or a company that invented a less comfortable razor

10. Sleek Sneakers Co. is one of many firms in the market

for shoes.

a. Assume that Sleek is currently earning short-run

economic profit. On a correctly labeled diagram,

show Sleek’s profit-maximizing output and price,

as well as the area representing profit.

b. What happens to Sleek’s price, output, and profit

in the long run? Explain this change in words, and

show it on a new diagram.

c. Suppose that over time consumers become more

focused on stylistic differences among shoe

brands. How would this change in attitudes affect

each firm’s price elasticity of demand? In the long

run, how will this change in demand affect Sleek’s

price, output, and profit?

d. At the profit-maximizing price you identified

in part (c), is Sleek’s demand curve elastic or

inelastic? Explain.

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

I f you play tennis, you have probably used balls from one of four producers: Penn, Wilson, Prince, or Dunlop Slazenger (two brands from the same com- pany). These four firms make almost all the tennis balls sold in the United

States. Together they determine the quantity of tennis balls produced and, given the market demand curve, the price at which tennis balls are sold.

The market for tennis balls is an example of an oligopoly. The essence of an oligopolistic market is that there are only a few sellers. As a result, the actions of any one seller in the market can have a large impact on the profits of all the other sellers. Oligopolistic firms are interdependent in a way that competitive firms are not. Our goal in this chapter is to see how this interdependence shapes the firms’ behavior and what problems it raises for public policy.

Oligopoly CHAPTER

oligopoly

a market structure in which

only a few sellers offer similar

or identical products

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338 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

The analysis of oligopoly offers an opportunity to introduce game theory, the study of how people behave in strategic situations. By “strategic” we mean a situ- ation in which a person, when choosing among alternative courses of action, must consider how others might respond to the action she takes. Strategic thinking is crucial not only in checkers, chess, and tic-tac-toe but also in many business deci- sions. Because oligopolistic markets have only a small number of firms, each firm must act strategically. Each firm knows that its profit depends on both how much it produces and how much the other firms produce. In making its production de- cision, each firm in an oligopoly should consider how its decision might affect the production decisions of the other firms in the market.

Game theory is not necessary for understanding competitive or monopoly mar- kets. In a market that is either perfectly competitive or monopolistically competi- tive, each firm is so small compared to the market that strategic interactions with other firms are not important. In a monopolized market, strategic interactions are absent because the market has only one firm. But, as we will see, game theory is useful for understanding oligopolies and many other situations in which a small number of players interact with one another. Game theory helps explain the strat- egies that people choose, whether they are playing tennis or selling tennis balls.

game theory

the study of how people behave

in strategic situations

17-1 Markets with Only a Few Sellers Because an oligopolistic market has only a small group of sellers, a key feature of oligopoly is the tension between cooperation and self-interest. The oligopolists are best off when they cooperate and act like a monopolist—producing a small quantity of output and charging a price above marginal cost. Yet because each oli- gopolist cares only about its own profit, there are powerful incentives at work that hinder a group of firms from maintaining the cooperative outcome.

17-1a A Duopoly Example To understand the behavior of oligopolies, let’s consider an oligopoly with only two members, called a duopoly. Duopoly is the simplest type of oligopoly. Oligop- olies with three or more members face the same problems as duopolies, so we do not lose much by starting with the simpler case.

Imagine a town in which only two residents, Jack and Jill, own wells that pro- duce water safe for drinking. Each Saturday, Jack and Jill decide how many gal- lons of water to pump, bring the water to town, and sell it for whatever price the market will bear. To keep things simple, suppose that Jack and Jill can pump as much water as they want without cost. That is, the marginal cost of water equals zero.

Table 1 shows the town’s demand schedule for water. The first column shows the total quantity demanded, and the second column shows the price. If the two well owners sell a total of 10 gallons of water, water goes for $110 a gallon. If they sell a total of 20 gallons, the price falls to $100 a gallon. And so on. If you graphed these two columns of numbers, you would get a standard downward-sloping demand curve.

The last column in Table 1 shows total revenue from the sale of water. It equals the quantity sold times the price. Because there is no cost to pumping water, the total revenue of the two producers equals their total profit.

Let’s now consider how the organization of the town’s water industry affects the price of water and the quantity sold.

339CHAPTER 17 OLIGOPOLY

17-1b Competition, Monopolies, and Cartels Before considering the price and quantity of water that results from the duopoly of Jack and Jill, let’s discuss briefly what the outcome would be if the water mar- ket were either perfectly competitive or monopolistic. These two polar cases are natural benchmarks.

If the market for water were perfectly competitive, the production decisions of each firm would drive price to equal marginal cost. Because we have assumed that the marginal cost of pumping additional water is zero, the equilibrium price of water under perfect competition would be zero as well. The equilibrium quan- tity would be 120 gallons. The price of water would reflect the cost of producing it, and the efficient quantity of water would be produced and consumed.

Now consider how a monopoly would behave. Table 1 shows that total profit is maximized at a quantity of 60 gallons and a price of $60 a gallon. A profit- maximizing monopolist, therefore, would produce this quantity and charge this price. As is standard for monopolies, price would exceed marginal cost. The result would be inefficient, because the quantity of water produced and consumed would fall short of the socially efficient level of 120 gallons.

What outcome should we expect from our duopolists? One possibility is that Jack and Jill get together and agree on the quantity of water to produce and the price to charge for it. Such an agreement among firms over production and price is called collusion, and the group of firms acting in unison is called a cartel. Once a cartel is formed, the market is in effect served by a monopoly and we can apply our analysis from Chapter 15. That is, if Jack and Jill collude, they will agree on the monopoly outcome because that outcome maximizes their total profit. Our two producers produce a total of 60 gallons, which sell at a price of $60 a gallon. Once again, price exceeds marginal cost, and the outcome is socially inefficient.

A cartel must agree not only on the total level of production but also on the amount produced by each member. In our case, Jack and Jill must agree on how to

TABLE 1

The Demand Schedule

for Water

collusion

an agreement among

firms in a market about

quantities to produce or

prices to charge

cartel

a group of firms acting

in unison

Quantity Price

Total Revenue

(and total profit)

0 gallons $120 $ 0

10 110 1,100

20 100 2,000

30 90 2,700

40 80 3,200

50 70 3,500

60 60 3,600

70 50 3,500

80 40 3,200

90 30 2,700

100 20 2,000

110 10 1,100

120 0 0

340 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

split the monopoly production of 60 gallons. Each member of the cartel will want a larger share of the market because a larger market share means larger profit. If Jack and Jill agree to split the market equally, each produces 30 gallons, the price is $60 a gallon, and each earns a profit of $1,800.

17-1c The Equilibrium for an Oligopoly Oligopolists would like to form cartels and earn monopoly profits, but that is often impossible. Squabbling among cartel members over how to divide the profit in the market can make agreement among members difficult. In addition, anti- trust laws prohibit explicit agreements among oligopolists as a matter of public policy. Even talking about pricing and production restrictions with competitors can be a criminal offense. Let’s therefore consider what happens if Jack and Jill decide separately how much water to produce.

At first, one might expect Jack and Jill to reach the monopoly outcome on their own, because this outcome maximizes their joint profit. In the absence of a bind- ing agreement, however, the monopoly outcome is unlikely. To see why, imagine that Jack expects Jill to produce only 30 gallons (half of the monopoly quantity). Jack would reason as follows:

“I could produce 30 gallons as well. In this case, a total of 60 gallons of water would be sold at a price of $60 a gallon. My profit would be $1,800 (30 gallons 3 $60 a gallon). Alternatively, I could produce 40 gallons. In this case, a total of 70 gallons of water would be sold at a price of $50 a gallon. My profit would be $2,000 (40 gallons 3 $50 a gallon). Even though total profit in the market would fall, my profit would be higher, because I would have a larger share of the market.”

Of course, Jill might reason the same way. If so, Jack and Jill would each bring 40 gallons to town. Total sales would be 80 gallons, and the price would fall to $40. Thus, if the duopolists individually pursue their own self-interest when deciding how much to produce, they produce a total quantity greater than the monopoly quantity, charge a price lower than the monopoly price, and earn total profit less than the monopoly profit.

Although the logic of self-interest increases the duopoly’s output above the monopoly level, it does not push the duopolists all the way to the competitive allocation. Consider what happens when each duopolist produces 40 gallons. The price is $40, and each duopolist makes a profit of $1,600. In this case, Jack’s self- interested logic leads to a different conclusion:

“Right now, my profit is $1,600. Suppose I increase my production to 50 gal- lons. In this case, a total of 90 gallons of water would be sold, and the price would be $30 a gallon. Then my profit would be only $1,500. Rather than increasing pro- duction and driving down the price, I am better off keeping my production at 40 gallons.”

The outcome in which Jack and Jill each produce 40 gallons looks like some sort of equilibrium. In fact, this outcome is called a Nash equilibrium. (It is named af- ter Nobel Prize-winning mathematician and economic theorist John Nash, whose life was portrayed in the book and movie A Beautiful Mind.) A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that the others have chosen. In this case, given that Jill is producing 40 gallons, the best strategy for Jack is also to produce 40 gallons. Similarly, given that Jack is producing 40 gallons, the best strategy for Jill is also to produce 40 gallons. Once they reach this Nash equilibrium, neither Jack nor Jill has an incentive to make a different decision.

Nash equilibrium

a situation in which eco-

nomic actors interacting

with one another each

choose their best strategy

given the strategies that

all the other actors have

chosen

341CHAPTER 17 OLIGOPOLY

This example illustrates the tension between cooperation and self-interest. Oligopolists would be better off cooperating and reaching the monopoly outcome. Yet because they each pursue their own self-interest, they do not end up reaching the monop- oly outcome and, thus, fail to maximize their joint profit. Each oligopolist is tempted to raise production and capture a larger share of the market. As each of them tries to do this, total pro- duction rises, and the price falls.

At the same time, self-interest does not drive the market all the way to the competitive outcome. Like monopolists, oligopo- lists are aware that increasing the amount they produce reduces the price of their product, which in turn affects profits. There- fore, they stop short of following the competitive firm’s rule of producing up to the point where price equals marginal cost.

In summary, when firms in an oligopoly individually choose pro- duction to maximize profit, they produce a quantity of output greater than the level produced by monopoly and less than the level produced by perfect competition. The oligopoly price is less than the monopoly price but greater than the competitive price (which equals marginal cost).

17-1d How the Size of an Oligopoly Affects the Market Outcome

We can use the insights from this analysis of duopoly to discuss how the size of an oligopoly is likely to affect the outcome in a market. Suppose, for instance, that John and Joan suddenly discover water sources on their property and join Jack and Jill in the water oligopoly. The demand schedule in Table 1 remains the same, but now more producers are available to satisfy this demand. How would an increase in the number of sellers from two to four affect the price and quantity of water in the town?

If the sellers of water could form a cartel, they would once again try to maxi- mize total profit by producing the monopoly quantity and charging the monopoly price. Just as when there were only two sellers, the members of the cartel would need to agree on production levels for each member and find some way to enforce the agreement. As the cartel grows larger, however, this outcome is less likely. Reaching and enforcing an agreement becomes more difficult as the size of the group increases.

If the oligopolists do not form a cartel—perhaps because the antitrust laws prohibit it—they must each decide on their own how much water to produce. To see how the increase in the number of sellers affects the outcome, consider the decision facing each seller. At any time, each well owner has the option to raise production by one gallon. In making this decision, the well owner weighs the fol- lowing two effects:

• The output effect: Because price is above marginal cost, selling one more gallon of water at the going price will raise profit.

• The price effect: Raising production will increase the total amount sold, which will lower the price of water and lower the profit on all the other gallons sold.

“Behavior in many complex and seemingly intractable strategic

settings can be understood more clearly by working out what

each party in the game will choose to do if they realize that the

other parties will be solving the same problem. This insight has

helped us understand behavior as diverse as military conflicts,

price setting by competing firms and penalty kicking in soccer.”

0% uncertain

100% agree

0% disagree

What do economists say?

Nash Equilibrium

ASK THE EXPERTS

Source: IGM Economic Experts Panel, June 2, 2015.

342 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

If the output effect is larger than the price effect, the well owner will increase pro- duction. If the price effect is larger than the output effect, the owner will not raise production. (In fact, in this case, it is profitable to reduce production.) Each oli- gopolist continues to increase production until these two marginal effects exactly balance, taking the other firms’ production as given.

Now consider how the number of firms in the industry affects the marginal analysis of each oligopolist. The larger the number of sellers, the less each seller is concerned about her own impact on the market price. That is, as the oligopoly grows in size, the magnitude of the price effect falls. When the oligopoly grows very large, the price effect disappears altogether. In this extreme case, the produc- tion decision of an individual firm no longer affects the market price. Each firm takes the market price as given when deciding how much to produce and, there- fore increases production as long as price is above marginal cost.

We can now see that a large oligopoly is essentially a group of competitive firms. A competitive firm considers only the output effect when deciding how much to produce: Because a competitive firm is a price taker, the price effect is absent. Thus, as the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market. The price approaches marginal cost, and the quantity produced approaches the socially efficient level.

This analysis of oligopoly offers a new perspective on the effects of interna- tional trade. Imagine that Toyota and Honda are the only automakers in Japan, Volkswagen and BMW are the only automakers in Germany, and Ford and General Motors are the only automakers in the United States. If these nations pro- hibited international trade in autos, each would have an auto oligopoly with only two members, and the market outcome would likely depart substantially from the competitive ideal. With international trade, however, the car market is a world market, and the oligopoly in this example has six members. Allowing free trade increases the number of producers from which each consumer can choose, and this increased competition keeps prices closer to marginal cost. Thus, the theory of oligopoly provides another reason, in addition to the theory of comparative advantage discussed in Chapter 3, why countries can benefit from free trade.

QuickQuiz If the members of an oligopoly could agree on a total quantity to produce,

what quantity would they choose? • If the oligopolists do not act together

but instead make production decisions individually, do they produce a total quantity more or

less than in your answer to the previous question? Why?

17-2 The Economics of Cooperation As we have seen, oligopolies would like to reach the monopoly outcome. Doing so, however, requires cooperation, which at times is difficult to establish and maintain. In this section we look more closely at the problems that arise when cooperation among actors is desirable but difficult. To analyze the economics of cooperation, we need to learn a little about game theory.

In particular, we focus on a “game” called the prisoners’ dilemma, which pro- vides insight into why cooperation is difficult. Many times in life, people fail to cooperate with one another even when cooperation would make them all better off. An oligopoly is just one example. The story of the prisoners’ dilemma con- tains a general lesson that applies to any group trying to maintain cooperation among its members.

prisoners’ dilemma

a particular “game”

between two captured

prisoners that illus-

trates why cooperation

is difficult to maintain

even when it is mutually

beneficial

343CHAPTER 17 OLIGOPOLY

17-2a The Prisoners’ Dilemma The prisoners’ dilemma is a story about two criminals who have been captured by the police. Let’s call them Bonnie and Clyde. The police have enough evidence to convict Bonnie and Clyde of the minor crime of carrying an unregistered gun, so that each would spend a year in jail. The police also suspect that the two criminals have committed a bank robbery together, but they lack hard evidence to convict them of this major crime. The police question Bonnie and Clyde in separate rooms and offer each of them the following deal:

“Right now, we can lock you up for 1 year. If you confess to the bank robbery and implicate your partner, however, we’ll give you immunity and you can go free. Your partner will get 20 years in jail. But if you both confess to the crime, we won’t need your testimony and we can avoid the cost of a trial, so you will each get an intermediate sentence of 8 years.”

If Bonnie and Clyde, heartless bank robbers that they are, care only about their own individual sentences, what would you expect them to do? Figure 1 shows their choices. Each prisoner has two strategies: confess or remain silent. The sen- tence each prisoner gets depends on the strategy he or she chooses and the strat- egy chosen by his or her partner in crime.

Consider first Bonnie’s decision. She reasons as follows: “I don’t know what Clyde is going to do. If he remains silent, my best strategy is to confess, because then I’ll go free rather than spending a year in jail. If he confesses, my best strat- egy is still to confess, because then I’ll spend 8 years in jail rather than 20. So, regardless of what Clyde does, I am better off confessing.”

In the language of game theory, a strategy is called a dominant strategy if it is the best strategy for a player to follow regardless of the strategies pursued by other players. In this case, confessing is a dominant strategy for Bonnie. She spends less time in jail if she confesses, regardless of whether Clyde confesses or remains silent.

Now consider Clyde’s decision. He faces the same choices as Bonnie, and he reasons in much the same way. Regardless of what Bonnie does, Clyde can reduce his jail time by confessing. In other words, confessing is also a dominant strategy for Clyde.

Bonnie’s Decision

Confess

Bonnie gets 8 years

Clyde gets 8 years

Bonnie gets 20 years

Clyde goes free

Bonnie goes free

Clyde gets 20 years

Bonnie gets 1 year

Clyde gets 1 year

Remain Silent

Clyde’s Decision

FIGURE 1

The Prisoners’ Dilemma

In this game between two criminals

suspected of committing a crime, the

sentence that each receives depends both

on his or her decision whether to confess

or remain silent and on the decision

made by the other.

dominant strategy

a strategy that is best

for a player in a game

regardless of the strate-

gies chosen by the other

players

344 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

In the end, both Bonnie and Clyde confess, and both spend 8 years in jail. This outcome is a Nash equilibrium: Each criminal is choosing the best strategy avail- able, given the strategy the other is following. Yet, from their standpoint, the out- come is terrible. If they had both remained silent, both of them would have been better off, spending only 1 year in jail on the gun charge. Because each pursues his or her own interests, the two prisoners together reach an outcome that is worse for each of them.

You might have thought that Bonnie and Clyde would have foreseen this sit- uation and planned ahead. But even with advanced planning, they would still run into problems. Imagine that, before the police captured Bonnie and Clyde, the two criminals had made a pact not to confess. Clearly, this agreement would make them both better off if they both lived up to it, because they would each spend only 1 year in jail. But would the two criminals in fact remain silent, sim- ply because they had agreed to? Once they are being questioned separately, the logic of self-interest takes over and leads them to confess. Cooperation between the two prisoners is difficult to maintain, because cooperation is individually irrational.

17-2b Oligopolies as a Prisoners’ Dilemma What does the prisoners’ dilemma have to do with markets and imperfect compe- tition? It turns out that the game oligopolists play in trying to reach the monop- oly outcome is similar to the game that the two prisoners play in the prisoners’ dilemma.

Consider again the choices facing Jack and Jill. After prolonged negotiation, the two suppliers of water agree to keep production at 30 gallons so that the price will be kept high and together they will earn the maximum profit. After they agree on production levels, however, each of them must decide whether to coop- erate and live up to this agreement or to ignore it and produce at a higher level. Figure 2 shows how the profits of the two producers depend on the strategies they choose.

Suppose you are Jack. You might reason as follows: “I could keep production at 30 gallons as we agreed, or I could raise my production and sell 40 gallons. If Jill lives up to the agreement and keeps her production at 30 gallons, then I earn

Jack’s Decision

High Production: 40 Gallons

Jack gets $1,600 profit

Jill gets $1,600 profit

Jill gets $2,000 profit

Jill gets $1,500 profit

Jill gets $1,800 profit

Jack gets $1,500 profit

Jack gets $2,000 profit

Jack gets $1,800 profit

Low Production: 30 Gallons

Jill’s Decision

FIGURE 2

Jack and Jill’s Oligopoly Game

In this game between Jack and Jill, the

profit that each earns from selling water

depends on both the quantity he or she

chooses to sell and the quantity the other

chooses to sell.

345CHAPTER 17 OLIGOPOLY

a profit of $2,000 by selling 40 gallons and $1,800 by selling 30 gallons. In this case, I am better off with the higher-level production. If Jill fails to live up to the agreement and produces 40 gallons, then I earn $1,600 by selling 40 gallons and $1,500 by selling 30 gallons. Once again, I am better off with higher production. So, regardless of what Jill chooses to do, I am better off reneging on our agreement and producing at the higher level.”

Producing 40 gallons is a dominant strategy for Jack. Of course, Jill reasons in exactly the same way, and so both produce at the higher level of 40 gallons. The result is the inferior outcome (from Jack and Jill’s standpoint) with low profits for each of the two producers.

This example illustrates why oligopolies have trouble maintaining monop- oly profits. The monopoly outcome is jointly rational, but each oligopolist has an incentive to cheat. Just as self-interest drives the prisoners in the prisoners’ dilemma to confess, self-interest makes it difficult for the oligopolists to maintain the cooperative outcome with low production, high prices, and monopoly profits.

OPEC AND THE WORLD OIL MARKET Our story about the town’s market for water is fictional, but if we change water to crude oil, and Jack and Jill to Iran and Iraq, the story is close to being true. Much of the world’s oil is produced by

a few countries, mostly in the Middle East. These countries together make up an oligopoly. Their decisions about how much oil to pump are much the same as Jack and Jill’s decisions about how much water to pump.

The countries that produce most of the world’s oil have formed a cartel, called the Organization of the Petroleum Exporting Countries (OPEC). As originally formed in 1960, OPEC included Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. By 1973, eight other nations had joined: Qatar, Indonesia, Libya, the United Arab Emirates, Algeria, Nigeria, Ecuador, and Gabon. These countries control about three-fourths of the world’s oil reserves. Like any cartel, OPEC tries to raise the price of its product through a coordinated reduction in quantity produced. OPEC tries to set production levels for each of the member countries.

The problem that OPEC faces is much the same as the problem that Jack and Jill face in our story. The OPEC countries would like to maintain a high price for oil. But each member of the cartel is tempted to increase its production to get a larger share of the total profit. OPEC members frequently agree to reduce production but then cheat on their agreements.

OPEC was most successful at maintaining cooperation and high prices in the period from 1973 to 1985. The price of crude oil rose from $3 a barrel in 1972 to $11 in 1974 and then to $35 in 1981. But in the mid-1980s, member countries began arguing about production levels, and OPEC became ineffective at maintaining cooperation. By 1986 the price of crude oil had fallen back to $13 a barrel.

In recent years, the members of OPEC have continued to meet regularly, but they have been less successful at reaching and enforcing agreements. As a result, fluctuations in oil prices have been driven more by the natural forces of supply and demand than by the cartel’s artificial restrictions on production. While this lack of cooperation among OPEC nations has reduced the profits of the oil-producing nations below what they might have been, it has benefited consumers around the world. ●

CASE STUDY

346 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

17-2c Other Examples of the Prisoners’ Dilemma We have seen how the prisoners’ dilemma can be used to understand the problem facing oligopolies. The same logic applies to many other situations as well. Here we consider two examples in which self-interest prevents cooperation and leads to an inferior outcome for the parties involved.

Arms Races In the decades after World War II, the world’s two superpowers— the United States and the Soviet Union—were engaged in a prolonged competi- tion over military power. This topic motivated some of the early work on game theory. The game theorists pointed out that an arms race is much like the prison- ers’ dilemma.

To see why, consider the decisions of the United States and the Soviet Union about whether to build new weapons or to disarm. Each country prefers to have more arms than the other because a larger arsenal would give it more influence in world affairs. But each country also prefers to live in a world safe from the other country’s weapons.

Figure 3 shows the deadly game. If the Soviet Union chooses to arm, the United States is better off doing the same to prevent the loss of power. If the Soviet Union chooses to disarm, the United States is better off arming because doing so would make it more powerful. For each country, arming is a dominant strategy. Thus, each country chooses to continue the arms race, resulting in the inferior outcome with both countries at risk.

Throughout the Cold War era from about 1945 to 1991, the United States and the Soviet Union attempted to solve this problem through negotiation and agree- ments over arms control. The problems that the two countries faced were similar to those that oligopolists encounter in trying to maintain a cartel. Just as oligopo- lists argue over production levels, the United States and the Soviet Union argued over the amount of arms that each country would be allowed. And just as cartels have trouble enforcing production levels, the United States and the Soviet Union each feared that the other country would cheat on any agreement. In both arms races and oligopolies, the relentless logic of self-interest drives the participants toward the noncooperative outcome, which is worse for both parties.

FIGURE 3

An Arms-Race Game

In this game between two countries, the

safety and power of each country depend

on both its decision whether to arm and

the decision made by the other country.

Decision of the United States (U.S.)

Arm

U.S. at risk

USSR at risk

U.S. at risk and weak

USSR safe and powerful

U.S. safe and powerful

USSR at risk and weak

U.S. safe

USSR safe

Disarm

Decision of the Soviet Union (USSR)

347CHAPTER 17 OLIGOPOLY

Common Resources In Chapter 11 we saw that people tend to overuse common resources. One can view this problem as an example of the prisoners’ dilemma.

Imagine that two oil companies—Exxon and Texaco—own adjacent oil fields. Under the fields is a common pool of oil worth $12 million. Drilling a well to recover the oil costs $1 million. If each company drills one well, each will get half of the oil and earn a $5 million profit ($6 million in revenue minus $1 million in costs).

Because the pool of oil is a common resource, the companies will not use it efficiently. Suppose that either company could drill a second well. If one company has two of the three wells, that company gets two-thirds of the oil, which yields a profit of $6 million. The other company gets one-third of the oil, for a profit of $3 million. Yet if each company drills a second well, the two companies again split the oil. In this case, each bears the cost of a second well, so profit is only $4 million for each company.

Figure 4 shows the game. Drilling two wells is a dominant strategy for each company. Once again, the self-interest of the two players leads them to an inferior outcome.

17-2d The Prisoners’ Dilemma and the Welfare of Society The prisoners’ dilemma describes many of life’s situations, and it shows that cooperation can be difficult to maintain, even when cooperation would make both players in the game better off. Clearly, this lack of cooperation is a problem for those involved in these situations. But is lack of cooperation a problem from the standpoint of society as a whole? The answer depends on the circumstances.

In some cases, the noncooperative equilibrium is bad for society as well as the players. In the arms-race game in Figure 3, both the United States and the Soviet Union end up at risk. In the common-resources game in Figure 4, the extra wells dug by Texaco and Exxon are pure waste. In both cases, society would be better off if the two players could reach the cooperative outcome.

By contrast, in the case of oligopolists trying to maintain monopoly profits, lack of cooperation is desirable from the standpoint of society as a whole. The monopoly outcome is good for the oligopolists, but it is bad for the consumers

FIGURE 4

A Common-Resources Game

In this game between firms pumping

oil from a common pool, the profit that

each earns depends on both the number

of wells it drills and the number of wells

drilled by the other firm.

Exxon’s Decision

Drill Two Wells

Exxon gets $4 million profit

Texaco gets $4 million profit

Texaco gets $6 million profit

Texaco gets $3 million profit

Texaco gets $5 million profit

Exxon gets $3 million profit

Exxon gets $6 million profit

Exxon gets $5 million profit

Drill One Well

Texaco’s Decision

348 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

of the product. As we first saw in Chapter 7, the competitive outcome is best for society because it maximizes total surplus. When oligopolists fail to cooperate, the quantity they produce is closer to this optimal level. Put differently, the invis- ible hand guides markets to allocate resources efficiently only when markets are competitive, and markets are competitive only when firms in the market fail to cooperate with one another.

Similarly, consider the case of the police questioning two suspects. Lack of cooperation between the suspects is desirable, for it allows the police to convict more criminals. The prisoners’ dilemma is a dilemma for the prisoners, but it can be a boon to everyone else.

17-2e Why People Sometimes Cooperate The prisoners’ dilemma shows that cooperation is difficult. But is it impossible? Not all prisoners, when questioned by the police, decide to turn in their partners in crime. Cartels sometimes manage to maintain collusive arrangements, despite the incentive for individual members to defect. Very often, players can solve the prisoners’ dilemma because they play the game not once but many times.

To see why cooperation is easier to enforce in repeated games, let’s return to our duopolists, Jack and Jill, whose choices were given in Figure 2. Jack and Jill would like to agree to maintain the monopoly outcome in which each produces 30 gallons. Yet, if Jack and Jill are to play this game only once, neither has any incentive to live up to this agreement. Self-interest drives each of them to renege and choose the dominant strategy of 40 gallons.

Now suppose that Jack and Jill know that they will play the same game every week. When they make their initial agreement to keep production low, they can also specify what happens if one party reneges. They might agree, for instance, that once one of them reneges and produces 40 gallons, both of them will produce 40 gallons forever after. This penalty is easy to enforce, for if one party is produc- ing at a high level, the other has every reason to do the same.

The threat of this penalty may be all that is needed to maintain cooperation. Each person knows that defecting would raise his or her profit from $1,800 to $2,000. But this benefit would last for only one week. Thereafter, profit would fall to $1,600 and stay there. As long as the players care enough about future profits, they will choose to forgo the one-time gain from defection. Thus, in a game of repeated prisoners’ dilemma, the two players may well be able to reach the coop- erative outcome.

THE PRISONERS’ DILEMMA TOURNAMENT Imagine that you are playing a game of prisoners’ dilemma with a person being “questioned” in a separate room. Moreover, imagine that you are going to play not once but many times. Your score at the

end of the game is the total number of years in jail. You would like to make this score as small as possible. What strategy would you play? Would you begin by confessing or remaining silent? How would the other player’s actions affect your subsequent decisions about confessing?

Repeated prisoners’ dilemma is a complicated game. To encourage cooperation, players must penalize each other for not cooperating. Yet the strategy described earlier for Jack and Jill’s water cartel—defect forever as soon as the other player defects—is not very forgiving. In a game repeated many times, a strategy that allows players to return to the cooperative outcome after a period of noncooperation may be preferable.

CASE STUDY

349CHAPTER 17 OLIGOPOLY

To see what strategies work best, political scientist Robert Axelrod held a tourna- ment. People entered by submitting computer programs designed to play repeated prisoners’ dilemma. Each program then played the game against all the other pro- grams. The “winner” was the program that received the fewest total years in jail.

The winning program turned out to be a simple strategy called tit-for-tat. According to tit-for-tat, a player should start by cooperating and then do whatever the other player did last time. Thus, a tit-for-tat player cooperates until the other player defects; then she defects until the other player cooperates again. In other words, this strategy starts out friendly, penalizes unfriendly players, and forgives them if warranted. To Axelrod’s surprise, this simple strategy did better than all the more complicated strategies that people had sent in.

The tit-for-tat strategy has a long history. It is essentially the biblical strategy of “an eye for an eye, a tooth for a tooth.” The prisoners’ dilemma tournament sug- gests that this may be a good rule of thumb for playing some of the games of life. ●

QuickQuiz Tell the story of the prisoners’ dilemma. Write down a table showing the

prisoners’ choices and explain which outcome is likely. • What does the

prisoners’ dilemma teach us about oligopolies?

17-3 Public Policy toward Oligopolies One of the Ten Principles of Economics in Chapter 1 is that governments can some- times improve market outcomes. This principle applies directly to oligopolistic markets. As we have seen, cooperation among oligopolists is undesirable from the standpoint of society as a whole because it leads to production that is too low and prices that are too high. To move the allocation of resources closer to the social optimum, policymakers should try to induce firms in an oligopoly to compete rather than cooperate. Let’s consider how policymakers do this and then examine the controversies that arise in this area of public policy.

17-3a Restraint of Trade and the Antitrust Laws One way that policy discourages cooperation is through the common law. Nor- mally, freedom of contract is an essential part of a market economy. Businesses and households use contracts to arrange mutually advantageous trades. In doing this, they rely on the court system to enforce contracts. Yet, for many centuries, judges in England and the United States have deemed agreements among com- petitors to reduce quantities and raise prices to be contrary to the public good. They have therefore refused to enforce such agreements.

The Sherman Antitrust Act of 1890 codified and reinforced this policy:

Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States, or with foreign nations, is declared to be illegal. . . . Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any person or persons to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a misdemeanor, and on conviction thereof, shall be punished by fine not exceeding fifty thousand dollars, or by imprisonment not exceeding one year, or by both said punish- ments, in the discretion of the court.

350 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

The Sherman Act elevated agreements among oligopolists from unenforceable contracts to criminal conspiracies.

The Clayton Act of 1914 further strengthened the antitrust laws. According to this law, if a person could prove that she was damaged by an illegal arrangement to restrain trade, that person could sue and recover three times the damages she sustained. The purpose of this unusual rule of triple damages is to encourage pri- vate lawsuits against conspiring oligopolists.

Today, both the U.S. Justice Department and private parties have the authority to bring legal suits to enforce the antitrust laws. As we discussed in Chapter 15, these laws are used to prevent mergers that would lead to excessive market power in any single firm. In addition, these laws are used to prevent oligopolists from acting together in ways that would make their markets less competitive.

AN ILLEGAL PHONE CALL Firms in oligopolies have a strong incentive to collude in order to reduce production, raise prices, and increase profits. The great 18th-century economist Adam Smith was well aware of this poten-

tial market failure. In The Wealth of Nations he wrote, “People of the same trade sel- dom meet together, but the conversation ends in a conspiracy against the public, or in some diversion to raise prices.”

To see a modern example of Smith’s observation, consider the following excerpt of a phone conversation between two airline executives in the early 1980s. The call was reported in the New York Times on February 24, 1983. Robert Crandall was pres- ident of American Airlines, and Howard Putnam was president of Braniff Airways, a major airline at the time.

crandall: I think it’s dumb as hell . . . to sit here and pound the @#$% out of each other and neither one of us making a #$%& dime.

putnam: Do you have a suggestion for me? crandall: Yes, I have a suggestion for you. Raise your $%*& fares

20 percent. I’ll raise mine the next morning. putnam: Robert, we . . . crandall: You’ll make more money, and I will, too. putnam: We can’t talk about pricing! crandall: Oh @#$%, Howard. We can talk about any &*#@ thing we

want to talk about.

Putnam was right: The Sherman Antitrust Act prohibits competing executives from even talking about fixing prices. When Putnam gave a tape of this conversa- tion to the Justice Department, the Justice Department filed suit against Crandall.

Two years later, Crandall and the Justice Department reached a settlement in which Crandall agreed to various restrictions on his business activities, including his contacts with officials at other airlines. The Justice Department said that the terms of settlement would “protect competition in the airline industry, by prevent- ing American and Crandall from any further attempts to monopolize passenger airline service on any route through discussions with competitors about the prices of airline services.” ●

17-3b Controversies over Antitrust Policy Over time, much controversy has centered on what kinds of behavior the anti- trust laws should prohibit. Most commentators agree that price-fixing agreements

CASE STUDY

351CHAPTER 17 OLIGOPOLY

among competing firms should be illegal. Yet the antitrust laws have been used to condemn some business practices whose effects are not obvious. Here we con- sider three examples.

Resale Price Maintenance One example of a controversial business practice is resale price maintenance. Imagine that Superduper Electronics sells Blu-ray disc players to retail stores for $50. If Superduper requires the retailers to charge customers $75, it is said to engage in resale price maintenance. Any retailer that charged less than $75 would violate its contract with Superduper.

At first, resale price maintenance might seem anticompetitive and, therefore, detrimental to society. Like an agreement among members of a cartel, it prevents the retailers from competing on price. For this reason, the courts have at times viewed resale price maintenance as a violation of the antitrust laws.

Yet some economists defend resale price maintenance on two grounds. First, they deny that it is aimed at reducing competition. If Superduper Electronics wanted to exert its market power, it would do so by raising the wholesale price rather than controlling the resale price. Moreover, Superduper has no incentive to discourage competition among its retailers. Indeed, because a cartel of retailers sells less than a group of competitive retailers, Superduper would be worse off if its retailers were a cartel.

Second, economists believe that resale price maintenance has a legitimate goal. Superduper may want its retailers to provide customers a pleasant showroom and a knowledgeable sales force. Yet, without resale price maintenance, some custom- ers would take advantage of one store’s service to learn about the Blu-ray player’s special features and then buy the item at a discount retailer that does not provide this service. Good customer service can be viewed as a public good among the retailers that sell Superduper products. As we discussed in Chapter 11, when one person provides a public good, others are able to enjoy it without paying for it. In this case, discount retailers would free ride on the service provided by other retailers, leading to less service than is desirable. Resale price maintenance is one way for Superduper to solve this free-rider problem.

The example of resale price maintenance illustrates an important principle: Business practices that appear to reduce competition may in fact have legitimate purposes. This principle makes the application of the antitrust laws all the more difficult. The economists, lawyers, and judges in charge of enforcing these laws must determine what kinds of behavior public policy should prohibit as impeding competition and reducing economic well-being. Often that job is not easy.

Predatory Pricing Firms with market power normally use that power to raise prices above the competitive level. But should policymakers ever be concerned that firms with market power might charge prices that are too low? This question is at the heart of a second debate over antitrust policy.

Imagine that a large airline, call it Coyote Air, has a monopoly on some route. Then Roadrunner Express enters and takes 20 percent of the market, leaving Coyote with 80 percent. In response to this competition, Coyote starts slashing its fares. Some antitrust analysts argue that Coyote’s move could be anticompet- itive: The price cuts may be intended to drive Roadrunner out of the market so Coyote can recapture its monopoly and raise prices again. Such behavior is called predatory pricing.

Although predatory pricing is a common claim in antitrust suits, some econo- mists are skeptical of this argument and believe that predatory pricing is rarely,

352 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

if ever, a profitable business strategy. Why? For a price war to drive out a rival, prices have to be driven below cost. Yet if Coyote starts selling cheap tickets at a loss, it had better be ready to fly more planes, because low fares will attract more customers. Roadrunner, meanwhile, can respond to Coyote’s predatory move by cutting back on flights. As a result, Coyote ends up bearing more than 80 percent of the losses, putting Roadrunner in a good position to survive the price war. As in the old Roadrunner–Coyote cartoons, the predator suffers more than the prey.

Economists continue to debate whether predatory pricing should be a concern for antitrust policymakers. Various questions remain unresolved. Is predatory pricing ever a profitable business strategy? If so, when? Are the courts capable of telling which price cuts are competitive and thus good for consumers and which are predatory? There are no simple answers.

Tying A third example of a controversial business practice is tying. Suppose that Makemoney Movies produces two new films—The Avengers and Hamlet. If Makemoney offers theaters the two films together at a single price, rather than separately, the studio is said to be tying its two products.

When the practice of tying movies was challenged, the Supreme Court banned it. The court reasoned as follows: Imagine that The Avengers is a blockbuster and Hamlet is an unprofitable art film. Then the studio could use the high demand for The Avengers to force theaters to buy Hamlet. It seemed that the studio could use tying as a mechanism for expanding its market power.

Many economists are skeptical of this argument. Imagine that theaters are will- ing to pay $20,000 for The Avengers and nothing for Hamlet. Then the most that a theater would pay for the two movies together is $20,000—the same as it would pay for The Avengers by itself. Forcing the theater to accept a worthless movie as part of the deal does not increase the theater ’s willingness to pay. Makemoney cannot increase its market power simply by bundling the two movies together.

Why, then, does tying exist? One possibility is that it is a form of price discrim- ination. Suppose there are two theaters. City Theater is willing to pay $15,000 for The Avengers and $5,000 for Hamlet. Country Theater is just the opposite: It is will- ing to pay $5,000 for The Avengers and $15,000 for Hamlet. If Makemoney charges separate prices for the two films, its best strategy is to charge $15,000 for each film, and each theater chooses to show only one film. Yet if Makemoney offers the two movies as a bundle, it can charge each theater $20,000 for the movies. Thus, if different theaters value the films differently, tying may allow the stu- dio to increase profit by charging a combined price closer to the buyers’ total willingness to pay.

Tying remains a controversial business practice. The Supreme Court’s argu- ment that tying allows a firm to extend its market power to other goods is not well founded, at least in its simplest form. Yet economists have proposed more elaborate theories for how tying can impede competition. Given our current eco- nomic knowledge, it is unclear whether tying has adverse effects for society as a whole.

THE MICROSOFT CASE A particularly important and controversial antitrust case was the U.S. government’s suit against the Microsoft Corporation, filed in 1998. The case certainly did not lack drama. It pitted one of the

CASE STUDY

353CHAPTER 17 OLIGOPOLY

world’s richest men (Bill Gates) against one of the world’s most powerful regu- latory agencies (the U.S. Justice Department). Testifying for the government was a prominent economist (MIT professor Franklin Fisher). Testifying for Microsoft was another prominent economist (MIT professor Richard Schmalensee). At stake was the future of one of the world’s most valuable companies (Microsoft) in one of the economy’s fastest-growing industries (computer software).

A central issue in the Microsoft case involved tying—in particular, whether Microsoft should be allowed to integrate its Internet browser into its Windows operating system. The government claimed that Microsoft was bundling these two products together to expand its market power in computer operating systems into the unrelated market of Internet browsers. Allowing Microsoft to incorporate such products into its operating system, the government argued, would deter other soft- ware companies from entering the market and offering new products.

Microsoft responded by pointing out that putting new features into old prod- ucts is a natural part of technological progress. Cars today include CD players and air conditioners, which were once sold separately, and cameras come with built-in flashes. The same is true with operating systems. Over time, Microsoft has added many features to Windows that were previously stand-alone products. This has made computers more reliable and easier to use because consumers can be confi- dent that the pieces work together. The integration of Internet technology, Microsoft argued, was the natural next step.

One point of disagreement concerned the extent of Microsoft’s market power. Noting that more than 80 percent of new personal computers used a Microsoft operating system, the government argued that the company had substantial mo- nopoly power, which it was trying to expand. Microsoft replied that the software market is always changing and that Microsoft’s Windows was constantly being challenged by competitors, such as the Apple Mac and Linux operating systems. It also argued that the low price it charged for Windows—about $50, or only 3 percent of the price of a typical computer—was evidence that its market power was severely limited.

Like many large antitrust suits, the Microsoft case became a legal morass. In November 1999, after a long trial, Judge Penfield Jackson ruled that Microsoft had great monopoly power and that it had illegally abused that power. In June 2000, after hearings on possible remedies, he ordered that Microsoft be broken up into two companies—one that sold the operating system and one that sold applica- tions software. A year later, an appeals court overturned Jackson’s breakup order and handed the case to a new judge. In September 2001, the Justice Department announced that it no longer sought a breakup of the company and wanted to settle the case quickly.

A settlement was finally reached in November 2002. Microsoft accepted some restrictions on its business practices, and the government accepted that a browser would remain part of the Windows operating system. But the settlement did not end Microsoft’s antitrust troubles. In recent years, the company has contended with several private antitrust suits, as well as suits brought by the European Union alleging a variety of anticompetitive behaviors. ●

QuickQuiz What kind of agreement is illegal for businesses to make? • Why are the

antitrust laws controversial?

“Me? A monopolist? Now just wait a minute . . .”

A P

PH O

TO /L

A U

RA R

A U

354 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

Oligopolies would like to act like monopolies, but self-interest drives them toward competition. Where oligopolies end up on this spectrum depends on the number of firms in the oligopoly and how cooperative the firms are. The story of the prisoners’ dilemma shows why oligopolies can fail to maintain cooperation, even when cooperation is in their best interest.

Policymakers regulate the behavior of oligopolists through the antitrust laws. The proper scope of these laws is the subject of ongoing debate. Although price fixing among competing firms clearly reduces economic welfare and should be illegal, some business practices that appear to reduce competition may have legitimate if subtle purposes. As a result, policymakers need to be careful when they use the substantial powers of the antitrust laws to place limits on firm behavior.

Google may be the next big target for

antitrust regulators.

EU Files Formal Antitrust Charges

against Google

T he European Commission took direct aim

at Google Inc. Wednesday, charging the

Internet-search giant with skewing results to

favor its comparison-shopping service. But the

formal complaint may only be the opening salvo

in a broader assault that prompts big changes

at Google.

E u r o p e a n a n t i t r u s t c h i e f M a r g r e t h e

Vestager said she continues to examine other

domains, such as travel and local services,

where Google is accused of favoring its own

services over those of others. She also opened

a second front, intensifying a separate probe

of Google’s conduct with its Android mobile-

operating system.

If history is a guide, the European case against

Google will grow. The bloc’s last big case against a

U.S. tech firm began with charges against Microsoft

Corp. in 2000 related to computer servers. The com-

mission later added charges against Microsoft for

bundling its media player, and Web browser, with its

Windows operating system.

The charges could lead to billions of euros

in fines and requirements for Google to change

its business practices. Microsoft ultimately paid

€2.2 billion ($2.3 billion). But people inside and

outside Microsoft say the case also altered the

company’s culture, making it less brash and

more cautious.

“There are certain things you know you

can’t do that other companies can do,” said

Jean-François Bellis, a lawyer who represented

Microsoft against the EU. Being labeled “domi-

nant,” as the EU labeled Google on Wednesday,

means executives now must worry about pleas-

ing regulators, as well as users.

Inside Google on Wednesday, “the amount

of concern over [antitrust enforcement] is enor-

mous,” said one person close to the company….

The complaint marked the first time a regu-

lator has filed formal antitrust charges against

Google. U.S. regulators closed their own investiga-

tion into Google’s search practices two years ago

after the company agreed to voluntary changes.

That European regulators decided to move

against Google when their U.S. counterparts

held back reflects in part the company’s higher

market share on the continent, but also differ-

ent legal standards. Unlike the U.S., European

antitrust law protects competitors, as well as

consumers. ■

Source: The Wall Street Journal, April 15, 2015.

Europe versus Google

IN THE NEWS

17-4 Conclusion

355CHAPTER 17 OLIGOPOLY

• Oligopolists maximize their total profits by forming a

cartel and acting like a monopolist. Yet, if oligopolists

make decisions about production levels individually,

the result is a greater quantity and a lower price than

under the monopoly outcome. The larger the number

of firms in the oligopoly, the closer the quantity and

price will be to the levels that would prevail under per-

fect competition.

• The prisoners’ dilemma shows that self-interest can

prevent people from maintaining cooperation, even

when cooperation is in their mutual interest. The logic

of the prisoners’ dilemma applies in many situations,

including arms races, common-resource problems, and

oligopolies.

• Policymakers use the antitrust laws to prevent oligop-

olies from engaging in behavior that reduces competi-

tion. The application of these laws can be controversial,

because some behavior that can appear to reduce com-

petition may in fact have legitimate business purposes.

SUMMARY

1. The key feature of an oligopolistic market is that

a. each firm produces a different product from other

firms.

b. a single firm chooses a point on the market

demand curve.

c. each firm takes the market price as given.

d. a small number of firms are acting strategically.

2. If an oligopolistic industry organizes itself as a coop-

erative cartel, it will produce a quantity of output that

is ________ the competitive level and ________ the

monopoly level.

a. less than, more than

b. more than, less than

c. less than, equal to

d. equal to, more than

3. If an oligopoly does not cooperate and each firm

chooses its own quantity, the industry will produce a

quantity of output that is ________ the competitive

level and ________ the monopoly level.

a. less than, more than

b. more than, less than

c. less than, equal to

d. equal to, more than

4. As the number of firms in an oligopoly grows large,

the industry approaches a level of output that is

________ the competitive level and ________ the

monopoly level.

a. less than, more than

b. more than, less than

c. less than, equal to

d. equal to, more than

5. The prisoners’ dilemma is a two-person game illus-

trating that

a. the cooperative outcome could be worse for both

people than the Nash equilibrium.

b. even if the cooperative outcome is better than the

Nash equilibrium for one person, it might be worse

for the other.

c. even if cooperation is better than the Nash equilib-

rium, each person might have an incentive not to

cooperate.

d. rational, self-interested individuals will naturally

avoid the Nash equilibrium because it is worse for

both of them.

6. The antitrust laws aim to

a. facilitate cooperation among firms in oligopolistic

industries.

b. encourage mergers to take advantage of economies

of scale.

c. discourage firms from moving production facilities

overseas.

d. prevent firms from acting in ways that reduce

competition.

CHAPTER QuickQuiz

356 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

1. If a group of sellers could form a cartel, what quantity

and price would they try to set?

2. Compare the quantity and price of an oligopoly to

those of a monopoly.

3. Compare the quantity and price of an oligopoly to

those of a competitive market.

4. How does the number of firms in an oligopoly affect

the outcome in the market?

5. What is the prisoners’ dilemma, and what does it have

to do with oligopoly?

6. Give two examples other than oligopoly that show

how the prisoners’ dilemma helps to explain behavior.

7. What kinds of behavior do the antitrust laws prohibit?

QUESTIONS FOR REVIEW

1. A large share of the world supply of diamonds comes

from Russia and South Africa. Suppose that the mar-

ginal cost of mining diamonds is constant at $1,000 per

diamond and the demand for diamonds is described

by the following schedule:

Price Quantity

$8,000 5,000 diamonds

7,000 6,000

6,000 7,000

5,000 8,000

4,000 9,000

3,000 10,000

2,000 11,000

1,000 12,000

a. If there were many suppliers of diamonds, what

would be the price and quantity?

b. If there were only one supplier of diamonds, what

would be the price and quantity?

c. If Russia and South Africa formed a cartel, what

would be the price and quantity? If the countries

split the market evenly, what would be South

Africa’s production and profit? What would hap-

pen to South Africa’s profit if it increased its pro-

duction by 1,000 while Russia stuck to the cartel

agreement?

d. Use your answers to part (c) to explain why cartel

agreements are often not successful.

2. Some years ago, the New York Times reported that “the inability of OPEC to agree last week to cut production

has sent the oil market into turmoil . . . [leading to] the

lowest price for domestic crude oil since June 1990.”

a. Why were the members of OPEC trying to agree

to cut production?

b. Why do you suppose OPEC was unable to agree

on cutting production? Why did the oil market go

into “turmoil” as a result?

c. The newspaper also noted OPEC’s view “that

producing nations outside the organization, like

Norway and Britain, should do their share and

cut production.” What does the phrase “do their

share” suggest about OPEC’s desired relationship

with Norway and Britain?

3. This chapter discusses companies that are oligopolists

in the market for the goods they sell. Many of the

same ideas apply to companies that are oligopolists in

the market for the inputs they buy.

a. If sellers who are oligopolists try to increase the

price of goods they sell, what is the goal of buyers

who are oligopolists?

b. Major league baseball team owners have an oli-

gopoly in the market for baseball players. What is

the owners’ goal regarding players’ salaries? Why

is this goal difficult to achieve?

c. Baseball players went on strike in 1994 because

they would not accept the salary cap that the own-

ers wanted to impose. If the owners were already

colluding over salaries, why did they feel the need

for a salary cap?

PROBLEMS AND APPLICATIONS

oligopoly, p. 337

game theory, p. 338

collusion, p. 339

cartel, p. 339

Nash equilibrium, p. 340

prisoners’ dilemma, p. 342

dominant strategy, p. 343

KEY CONCEPTS

4. Consider trade relations between the United States

and Mexico. Assume that the leaders of the two coun-

tries believe the payoffs to alternative trade policies

are as follows:

United States’s Decision

Low Tariffs

U.S. gains $25 billion

Mexico gains $25 billion

Mexico gains $10 billion

Mexico gains $30 billion

Mexico gains $20 billion

U.S. gains $30 billion

U.S. gains $10 billion

U.S. gains $20 billion

High Tariffs

Mexico’s Decision

a. What is the dominant strategy for the United

States? For Mexico? Explain.

b. Define Nash equilibrium. What is the Nash equilib- rium for trade policy?

c. In 1993, the U.S. Congress ratified the North

American Free Trade Agreement, in which the

United States and Mexico agreed to reduce trade

barriers simultaneously. Do the perceived payoffs

shown here justify this approach to trade policy?

Explain.

d. Based on your understanding of the gains from

trade (discussed in Chapters 3 and 9), do you

think that these payoffs actually reflect a nation’s

welfare under the four possible outcomes?

5. Synergy and Dynaco are the only two firms in a spe-

cific high-tech industry. They face the following payoff

matrix as they decide upon the size of their research

budget:

Synergy’s Decision

Large Budget

Synergy gains $20 million

Dynaco gains $30 million

Dynaco gains $70 million

Dynaco gains zero

Dynaco gains $50 million

Synergy gains zero

Synergy gains $30 million

Synergy gains $40 million

Small Budget

Dynaco’s Decision

a. Does Synergy have a dominant strategy? Explain.

b. Does Dynaco have a dominant strategy? Explain.

c. Is there a Nash equilibrium for this scenario?

Explain. (Hint: Look closely at the definition of Nash equilibrium.)

6. You and a classmate are assigned a project on which

you will receive one combined grade. You each want

to receive a good grade, but you also want to avoid

hard work. In particular, here is the situation:

• If both of you work hard, you both get an A, which

gives each of you 40 units of happiness.

• If only one of you works hard, you both get a B,

which gives each of you 30 units of happiness.

• If neither of you works hard, you both get a D,

which gives each of you 10 units of happiness.

• Working hard costs 25 units of happiness.

a. Fill in the payoffs in the following decision box:

Your Decision

Work

You:

Classmate:

You:

Classmate:

You:

Classmate:

You:

Classmate:

Shirk

Classmate’s Decision

b. What is the likely outcome? Explain your answer.

c. If you get this classmate as your partner on a

series of projects throughout the year, rather than

only once, how might that change the outcome

you predicted in part (b)?

d. Another classmate cares more about good grades:

She gets 50 units of happiness for a B and 80 units

of happiness for an A. If this classmate were your

partner (but your preferences were unchanged),

how would your answers to parts (a) and (b)

change? Which of the two classmates would you

prefer as a partner? Would she also want you as a

partner?

7. A case study in the chapter describes a phone conver-

sation between the presidents of American Airlines

and Braniff Airways. Let’s analyze the game between

the two companies. Suppose that each company can

charge either a high price for tickets or a low price. If

one company charges $300, it earns low profit if the

other company also charges $300 and high profit if

the other company charges $600. On the other hand,

if the company charges $600, it earns very low profit if

the other company charges $300 and medium profit

if the other company also charges $600.

a. Draw the decision box for this game.

b. What is the Nash equilibrium in this game?

Explain.

c. Is there an outcome that would be better than the

Nash equilibrium for both airlines? How could it

be achieved? Who would lose if it were achieved?

357CHAPTER 17 OLIGOPOLY

8. Two athletes of equal ability are competing for a prize

of $10,000. Each is deciding whether to take a danger-

ous performance-enhancing drug. If one athlete takes

the drug and the other does not, the one who takes the

drug wins the prize. If both or neither take the drug,

they tie and split the prize. Taking the drug imposes

health risks that are equivalent to a loss of X dollars. a. Draw a 2 3 2 payoff matrix describing the

decisions the athletes face.

b. For what X is taking the drug the Nash equilibrium?

c. Does making the drug safer (that is, lowering X) make the athletes better or worse off? Explain.

9. Little Kona is a small coffee company that is consid-

ering entering a market dominated by Big Brew. Each

company’s profit depends on whether Little Kona

enters and whether Big Brew sets a high price or a low

price:

Big Brew

Enter

High Price

Brew makes $3 million

Kona makes $2 million

Kona loses $1 million

Kona makes zero

Brew makes $1 million

Brew makes $7 million

Brew makes $2 million

Low Price

Don’t Enter

Little Kona

a. Does either player in this game have a dominant

strategy?

b. Does your answer to part (a) help you figure out

what the other player should do?

c. What is the Nash equilibrium? Is there only one?

d. Big Brew threatens Little Kona by saying, “If you

enter, we’re going to set a low price, so you had

better stay out.” Do you think Little Kona should

believe the threat? Why or why not?

e. If the two firms could collude and agree on how

to split the total profits, what outcome would they

pick?

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

358 PART V FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

PART VI

The Economics of Labor Markets

CHAPTER

18The Markets for the Factors of Production W

hen you finish school, your income will be determined largely by what kind of job you take. If you become a computer programmer, you will earn more than if you become a gas station attendant. This fact is not surprising, but it

is not obvious why it is true. No law requires that computer programmers be paid more than gas station attendants. No ethical principle says that programmers are more deserving. What then determines which job will pay you the higher wage?

Your income, of course, is a small piece of a larger economic picture. In 2015, the total income of all U.S. residents (a statistic called national income) was about $16 trillion. People earned this income in various ways. Workers earned about two-thirds of it in the form of wages and fringe benefits. The rest went to landowners and to the owners of

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362 PART VI THE ECONOMICS OF LABOR MARKETS

capital—the economy’s stock of equipment and structures—in the form of rent, profit, and interest. What determines how much goes to workers? To landown- ers? To the owners of capital? Why do some workers earn higher wages than oth- ers, some landowners higher rental income than others, and some capital owners greater profit than others? Why, in particular, do computer programmers earn more than gas station attendants?

The answers to these questions, like most in economics, hinge on supply and demand. The supply and demand for labor, land, and capital determine the prices paid to workers, landowners, and capital owners. To understand why some peo- ple have higher incomes than others, therefore, we need to look more deeply at the markets for the services they provide. That is our job in this and the next two chapters.

This chapter provides the basic theory for the analysis of factor markets. As you may recall from Chapter 2, the factors of production are the inputs used to produce goods and services. Labor, land, and capital are the three most important factors of production. When a computer firm produces a new software program, it uses programmers’ time (labor), the physical space on which its offices are located (land), and an office building and computer equipment (capital). Similarly, when a gas station sells gas, it uses attendants’ time (labor), the physical space (land), and the gas tanks and pumps (capital).

In many ways factor markets resemble the markets for goods and services we analyzed in previous chapters, but they are different in one important way: The demand for a factor of production is a derived demand. That is, a firm’s demand for a factor of production is derived from its decision to supply a good in another market. The demand for computer programmers is inseparably linked to the sup- ply of computer software, and the demand for gas station attendants is insepara- bly linked to the supply of gasoline.

In this chapter, we analyze factor demand by considering how a competitive, profit-maximizing firm decides how much of any factor to buy. We begin our analysis by examining the demand for labor. Labor is the most important factor of production, because workers receive most of the total income earned in the U.S. economy. Later in the chapter, we will see that our analysis of the labor market also applies to the markets for the other factors of production.

The basic theory of factor markets developed in this chapter takes a large step toward explaining how the income of the U.S. economy is distributed among workers, landowners, and owners of capital. Chapter 19 builds on this analysis to examine in more detail why some workers earn more than others. Chapter 20 examines how much income inequality results from the functioning of factor mar- kets and then considers what role the government should and does play in alter- ing the income distribution.

factors of production

the inputs used to

produce goods and

services

18-1 The Demand for Labor Labor markets, like other markets in the economy, are governed by the forces of supply and demand. This is illustrated in Figure 1. In panel (a), the supply and demand for apples determine the price of apples. In panel (b), the supply and demand for apple pickers determine the price, or wage, of apple pickers.

As we have already noted, labor markets are different from most other mar- kets because labor demand is a derived demand. Most labor services, rather than being final goods ready to be enjoyed by consumers, are inputs into the produc- tion of other goods. To understand labor demand, we need to focus on the firms

363CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

that hire the labor and use it to produce goods for sale. By examining the link be- tween the production of goods and the demand for labor to make those goods, we gain insight into the determination of equilibrium wages.

18-1a The Competitive Profit-Maximizing Firm Let’s look at how a typical firm, such as an apple producer, decides what quantity of labor to demand. The firm owns an apple orchard and each week decides how many apple pickers to hire to harvest its crop. After the firm makes its hiring deci- sion, the workers pick as many apples as they can. The firm then sells the apples, pays the workers, and keeps what is left as profit.

We make two assumptions about our firm. First, we assume that our firm is com- petitive both in the market for apples (where the firm is a seller) and in the market for apple pickers (where the firm is a buyer). A competitive firm is a price taker. Because there are many other firms selling apples and hiring apple pickers, a single firm has little influence over the price it gets for apples or the wage it pays apple pickers. The firm takes the price and the wage as given by market conditions. It only has to decide how many apples to sell and how many workers to hire.

Second, we assume that the firm is profit-maximizing. Thus, the firm does not directly care about the number of workers it employs or the number of apples it produces. It cares only about profit, which equals the total revenue from the sale of apples minus the total cost of producing them. The firm’s supply of apples and its demand for workers are derived from its primary goal of maximizing profit.

18-1b The Production Function and the Marginal Product of Labor To make its hiring decision, a firm must consider how the size of its workforce affects the amount of output produced. In our example, the apple producer must consider how the number of apple pickers affects the quantity of apples it can harvest and

FIGURE 1

The Versatility of Supply and Demand

Quantity of Apples

Price of Apples

Demand

Supply

Demand

Supply

Quantity of Apple Pickers

Wage of Apple

Pickers

(a) The Market for Apples (b) The Market for Apple Pickers

The basic tools of supply and demand apply to goods and to labor services.

Panel (a) shows how the supply and demand for apples determine the price of apples.

Panel (b) shows how the supply and demand for apple pickers determine the wage of

apple pickers.

364 PART VI THE ECONOMICS OF LABOR MARKETS

sell. Table 1 gives a numerical example. Column (1) shows the number of workers. Column (2) shows the quantity of apples the workers harvest each week.

These two columns of numbers describe the firm’s ability to produce apples. Recall that economists use the term production function to describe the relation- ship between the quantity of the inputs used in production and the quantity of output from production. Here the “input” is the apple pickers and the “output” is the apples. The other inputs—the trees themselves, the land, the firm’s trucks and tractors, and so on—are held fixed for now. This firm’s production function shows that if the firm hires 1 worker, that worker will pick 100 bushels of apples per week. If the firm hires 2 workers, the 2 workers together will pick 180 bushels per week. And so on.

Figure 2 graphs the data on labor and output presented in Table 1. The number of workers is on the horizontal axis, and the amount of output is on the vertical axis. This figure illustrates the production function.

One of the Ten Principles of Economics introduced in Chapter 1 is that rational people think at the margin. This idea is the key to understanding how firms decide what quantity of labor to hire. To take a step toward this decision, column (3) in Table 1 shows the marginal product of labor, the increase in the amount of output produced by an additional unit of labor. When the firm increases the num- ber of workers from 1 to 2, for example, the amount of apples produced rises from 100 to 180 bushels. Therefore, the marginal product of the second worker is 80 bushels.

Notice that as the number of workers increases, the marginal product of labor declines. That is, the production process exhibits diminishing marginal product. At first, when only a few workers are hired, they can pick the low-hanging fruit. As the number of workers increases, additional workers have to climb higher up the ladders to find apples to pick. Hence, as more and more workers are hired, each additional worker contributes less to the production of apples. For this rea- son, the production function in Figure 2 becomes flatter as the number of workers rises.

production function

the relationship between

the quantity of inputs

used to make a good and

the quantity of output of

that good

marginal product of labor

the increase in the

amount of output from an

additional unit of labor

diminishing marginal

product

the property whereby

the marginal product

of an input declines as

the quantity of the input

increases

TABLE 1

How the Competitive Firm

Decides How Much Labor

to Hire

(1)

Labor

(2)

Output

(3)

Marginal

Product

of Labor

MPL 5 ∆Q / ∆L

(4)

Value of the

Marginal Product

of Labor

VMPL 5 P 3 MPL

(5)

Wage

(6)

Marginal Profit

∆Profit 5 VMPL 2 W

0 workers 0 bushels

100 bushels $1,000 $500 $500

1 100

80 800 500 300

2 180

60 600 500 100

3 240

40 400 500 2100

4 280

20 200 500 2300

5 300

365CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

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

Our profit-maximizing firm is concerned not about apples themselves but rather about the money it can make by producing and selling them. As a result, when deciding how many workers to hire to pick apples, the firm considers how much profit each worker will bring in. Because profit is total revenue minus total cost, the profit from an addi- tional worker is the worker’s contribution to revenue minus the worker’s wage.

To find the worker ’s contribution to revenue, we must convert the marginal product of labor (which is measured in bushels of apples) into the value of the mar- ginal product (which is measured in dollars). We do this using the price of apples. To continue our example, if a bushel of apples sells for $10 and if an additional worker produces 80 bushels of apples, then the worker produces $800 of revenue.

The value of the marginal product of any input is the marginal product of that input multiplied by the market price of the output. Column (4) in Table 1 shows the value of the marginal product of labor in our example, assuming the price of apples is $10 per bushel. Because the market price is constant for a competi- tive firm while the marginal product declines with more workers, the value of the marginal product diminishes as the number of workers rises. Economists some- times call this column of numbers the firm’s marginal revenue product: It is the extra revenue the firm gets from hiring an additional unit of a factor of production.

Now consider how many workers the firm will hire. Suppose that the market wage for apple pickers is $500 per week. In this case, as you can see in Table 1, the first worker that the firm hires is profitable: The first worker yields $1,000 in revenue, or $500 in profit. Similarly, the second worker yields $800 in additional revenue, or $300 in profit. The third worker produces $600 in additional revenue, or $100 in profit. After the third worker, however, hiring workers is unprofitable. The fourth worker would yield only $400 of additional revenue. Because the worker ’s wage is $500, hiring the fourth worker would mean a $100 reduction in profit. Thus, the firm hires only 3 workers.

Figure 3 graphs the value of the marginal product. This curve slopes down- ward because the marginal product of labor diminishes as the number of workers

value of the marginal

product

the marginal product of

an input times the price

of the output

FIGURE 2

The Production Function

The production function shows how an

input into production (apple pickers)

influences the output from production

(apples). As the quantity of the input

increases, the production function

gets flatter, reflecting the property of

diminishing marginal product.

Quantity of Apple Pickers

Quantity of Apples

300 280

240

180

100

Production function

1 2 3 4 5

366 PART VI THE ECONOMICS OF LABOR MARKETS

rises. The figure also includes a horizontal line at the market wage. To maximize profit, the firm hires workers up to the point where these two curves cross. Below this level of employment, the value of the marginal product exceeds the wage, so hiring another worker increases profit. Above this level of employment, the value of the marginal product is less than the wage, so the marginal worker is unprofit- able. Thus, a competitive, profit-maximizing firm hires workers up to the point at which the value of the marginal product of labor equals the wage.

Now that we understand the profit-maximizing hiring strategy for a com- petitive firm, we can offer a theory of labor demand. Recall that a firm’s labor- demand curve tells us the quantity of labor that a firm decides to hire at any given wage. Figure 3 shows that the firm makes that decision by choosing the quan- tity of labor at which the value of the marginal product equals the wage. As a result, the value-of-marginal-product curve is the labor-demand curve for a competitive, profit-maximizing firm.

18-1d What Causes the Labor-Demand Curve to Shift? We now understand that the labor-demand curve reflects the value of the mar- ginal product of labor. With this insight in mind, let’s consider a few of the things that might cause the labor-demand curve to shift.

The Output Price The value of the marginal product is marginal product times the price of the firm’s output. Thus, when the output price changes, the value of the marginal product changes, and the labor-demand curve shifts. An increase in the price of apples, for instance, raises the value of the marginal product of each worker who picks apples and, therefore, increases labor demand from the firms that supply apples. Conversely, a decrease in the price of apples reduces the value of the marginal product and decreases labor demand.

Technological Change Between 1960 and 2015, the output a typical U.S. worker produced in an hour rose by 195 percent. Why? The most important reason is

FIGURE 3

The Value of the Marginal Product

of Labor

This figure shows how the value of

the marginal product (the marginal

product times the price of the output)

depends on the number of workers.

The curve slopes downward because

of diminishing marginal product. For

a competitive, profit-maximizing firm,

this value-of-marginal-product curve is

also the firm’s labor-demand curve.

0 Quantity of Apple Pickers

Value of the

Marginal Product

Market wage

Profit-maximizing quantity

Value of marginal product (demand curve for labor)

367CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

technological progress: Scientists and engineers are constantly figuring out new and better ways of doing things. This has profound implications for the labor mar- ket. Advances in technology typically raise the marginal product of labor, which in turn increases the demand for labor and shifts the labor-demand curve to the right.

It is also possible for technological change to reduce labor demand. The inven- tion of a cheap industrial robot, for instance, could conceivably reduce the mar- ginal product of labor, shifting the labor-demand curve to the left. Economists call this labor-saving technological change. History suggests, however, that most technological progress is instead labor-augmenting. For example, a carpenter with a nail gun is more productive than a carpenter with only a hammer. Labor- augmenting technological advance explains persistently rising employment in the face of rising wages: Even though wages (adjusted for inflation) increased by 165 percent from 1960 to 2015, firms nonetheless more than doubled the amount of labor they employed.

The Supply of Other Factors The quantity of one factor of production that is available can affect the marginal product of other factors. The productivity of apple pickers depends, for instance, on the availability of ladders. If the supply

Input Demand and Output Supply: Two Sides of the Same Coin

I n Chapter 14, we saw how a competitive, profit-maximizing firm de-

cides how much of its output to sell: It chooses the quantity of output

at which the price of the good equals the marginal cost of production.

We have just seen how such a firm decides how much labor to hire: It

chooses the quantity of labor at which the wage equals the value of the

marginal product. Because the production function links the quantity of

inputs to the quantity of output, you should not be surprised to learn that

the firm’s decision about input demand is closely linked to its decision

about output supply. In fact, these two decisions are two sides of the

same coin.

To see this relationship more fully, let’s consider how the marginal

product of labor (MPL) and marginal cost (MC ) are related. Suppose an

additional worker costs $500 and has a marginal product of 50 bush-

els of apples. In this case, producing 50 more bushels costs $500; the

marginal cost of a bushel is $500/50, or $10. More generally, if W is

the wage, and an extra unit of labor produces MPL units of output, then

the marginal cost of a unit of output is MC 5 W / MPL.

This analysis shows that diminishing marginal product is closely

related to increasing marginal cost. When the apple orchard grows

crowded with workers, each additional worker adds less to the pro-

duction of apples (MPL falls). Similarly, when the apple firm is pro-

ducing a large quantity of apples, the orchard is already crowded with

workers, so it is more costly to produce an additional bushel of apples

(MC rises).

Now consider our cri-

terion for profit maximiza-

tion. We determined earlier

that a profit-maximizing

firm chooses the quantity

of labor so that the value of

the marginal product (P 3 MPL)

equals the wage (W ). We can write this mathematically as

P 3 MPL 5 W.

If we divide both sides of this equation by MPL, we obtain

P 5 W / MPL.

We just noted that W / MPL equals marginal cost, MC. Therefore, we can

substitute to obtain

P 5 MC.

This equation states that the price of the firm’s output equals the mar-

ginal cost of producing a unit of output. Thus, when a competitive firm

hires labor up to the point at which the value of the marginal product

equals the wage, it also produces up to the point at which the price

equals marginal cost. Our analysis of labor demand in this chapter is

just another way of looking at the production decision we first saw in

Chapter 14. ■

F Y I

368 PART VI THE ECONOMICS OF LABOR MARKETS

of ladders declines, the marginal product of apple pickers will decline as well, reducing the demand for apple pickers. We consider the linkage among the factors of production more fully later in the chapter.

QuickQuiz Define marginal product of labor and value of the marginal product of labor. •

Describe how a competitive, profit-maximizing firm decides how many

workers to hire.

18-2 The Supply of Labor Having analyzed labor demand in detail, let’s turn to the other side of the market and consider labor supply. A formal model of labor supply is included in Chapter 21, where we develop the theory of household decision making. Here we infor- mally discuss the decisions that lie behind the labor-supply curve.

18-2a The Trade-off between Work and Leisure One of the Ten Principles of Economics in Chapter 1 is that people face trade-offs. Probably no trade-off in a person’s life is more obvious or more important than the trade-off between work and leisure. The more hours you spend working, the fewer hours you have to watch TV, browse social media, enjoy dinner with friends, or pursue your favorite hobby. The trade-off between labor and leisure lies behind the labor-supply curve.

Another of the Ten Principles of Economics is that the cost of something is what you give up to get it. What do you give up to get an hour of leisure? You give up an hour of work, which in turn means an hour of wages. Thus, if your wage is $15 per hour, the opportunity cost of an hour of leisure is $15. And when you get a raise to $20 per hour, the opportunity cost of enjoying leisure goes up.

The labor-supply curve reflects how workers’ decisions about the labor- leisure trade-off respond to a change in that opportunity cost. An upward-sloping labor-supply curve means that an increase in the wage induces workers to increase the quantity of labor they supply. Because time is limited, more work means less leisure. That is, workers respond to the increase in the opportunity cost of leisure by taking less of it.

It is worth noting that the labor-supply curve need not be upward-sloping. Imagine you got that raise from $15 to $20 per hour. The opportunity cost of leisure is now greater, but you are also richer than you were before. You might decide that with your extra wealth you can now afford to enjoy more leisure. That is, at the higher wage, you might choose to work fewer hours. If so, your labor- supply curve would slope backward. In Chapter 21, we discuss this possibility in terms of conflicting effects on your labor-supply decision (called the income and substitution effects). For now, we ignore the possibility of backward-sloping labor supply and assume that the labor-supply curve is upward-sloping.

18-2b What Causes the Labor-Supply Curve to Shift? The labor-supply curve shifts whenever people change the amount they want to work at a given wage. Let’s now consider some of the events that might cause such a shift.

Changes in Tastes In 1950, 34 percent of women were employed at paid jobs or looking for work. By 2015, that number had risen to 57 percent. Although there

“I really didn’t enjoy working five days a week, fifty weeks a year for forty years, but I needed the money.”

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369CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

are many explanations for this development, one of them is changing tastes, or attitudes toward work. Sixty-five years ago, it was the norm for women to stay at home and raise their children. Today, the typical family size is smaller, and more mothers choose to work. The result is an increase in the supply of labor.

Changes in Alternative Opportunities The supply of labor in any one labor market depends on the opportunities avail- able in other labor markets. If the wage earned by pear pick- ers suddenly rises, some apple pickers may choose to switch occupations, causing the supply of labor in the market for apple pickers to fall.

Immigration Movement of workers from region to region, or country to country, is another important source of shifts in labor supply. When immigrants come to the United States, for instance, the supply of labor in the United States increases and the supply of labor in the immigrants’ home countries falls. In fact, much of the policy debate about immigration centers on its effect on labor supply and, thereby, equilibrium wages in the labor market.

QuickQuiz Who has a greater opportunity cost of enjoying

leisure—a janitor or a brain surgeon? Explain. Can

this help explain why doctors work such long hours?

18-3 Equilibrium in the Labor Market

So far we have established two facts about how wages are deter- mined in competitive labor markets:

• The wage adjusts to balance the supply and demand for labor.

• The wage equals the value of the marginal product of labor.

At first, it might seem surprising that the wage can do both of these things at once. In fact, there is no real puzzle here, but un- derstanding why there is no puzzle is an important step toward understanding wage determination.

Figure 4 shows the labor market in equilibrium. The wage and the quantity of labor have adjusted to balance supply and demand. When the market is in this equilibrium, each firm has bought as much labor as it finds profitable at the equilibrium wage. That is, each firm has followed the rule for profit maxi- mization: It has hired workers until the value of the marginal product equals the wage. Hence, the wage must equal the value of the marginal product of labor once it has brought supply and demand into equilibrium.

“The average US citizen would be better off if a larger number

of highly educated foreign workers were legally allowed to im-

migrate to the US each year.”

“The average US citizen would be better off if a larger number

of low-skilled foreign workers were legally allowed to enter the

US each year.”

27% uncertain

63% agree

10% disagree

What do economists say?

“Unless they were compensated by others, many low-skilled

American workers would be substantially worse off if a larger

number of low-skilled foreign workers were legally allowed to

enter the US each year.”

29% uncertain

60% agree

11% disagree

What do economists say?

Immigration

ASK THE EXPERTS

5% uncertain

95% agree

0% disagree

What do economists say?

Source: IGM Economic Experts Panel, February 12, 2013, December 10, 2013.

370 PART VI THE ECONOMICS OF LABOR MARKETS

This brings us to an important lesson: Any event that changes the supply or demand for labor must change the equilibrium wage and the value of the marginal product by the same amount because these must always be equal. To see how this works, let’s consider some events that shift these curves.

18-3a Shifts in Labor Supply Suppose that immigration increases the number of workers willing to pick apples. As Figure 5 shows, the supply of labor shifts to the right from S1 to S2. At the ini- tial wage W1, the quantity of labor supplied now exceeds the quantity demanded. This surplus of labor puts downward pressure on the wage of apple pickers, and the fall in the wage from W1 to W2 makes it profitable for firms to hire more work- ers. As the number of workers employed in each apple orchard rises, the marginal product of a worker falls, and so does the value of the marginal product. In the new equilibrium, both the wage and the value of the marginal product of labor are lower than they were before the influx of new workers.

An episode from Israel, studied by MIT economist Joshua Angrist, illustrates how a shift in labor supply can alter the equilibrium in a labor market. During most of the 1980s, many thousands of Palestinians regularly commuted from their homes in the Israeli-occupied West Bank and Gaza Strip to jobs in Israel, primar- ily in the construction and agriculture industries. In 1988, however, political un- rest in these occupied areas induced the Israeli government to take steps that, as a by-product, reduced this supply of workers. Curfews were imposed, work per- mits were checked more thoroughly, and a ban on overnight stays of Palestinians in Israel was enforced more rigorously. The economic impact of these steps was exactly as theory predicts: The number of Palestinians with jobs in Israel fell by half, while those who continued to work in Israel enjoyed wage increases of about 50 percent. With a reduced number of Palestinian workers in Israel, the value of the marginal product of the remaining workers was much higher.

When considering the economics of immigration, keep in mind that the econ- omy consists not of a single labor market but rather a variety of labor markets for

FIGURE 4

Equilibrium in a Labor Market

Like all prices, the price of labor

(the wage) depends on supply and

demand. Because the demand curve

reflects the value of the marginal

product of labor, in equilibrium work-

ers receive the value of their marginal

contribution to the production of

goods and services.

Wage (price of

labor)

Equilibrium wage, W

0 Quantity of Labor

Equilibrium employment, L

Supply

Demand

371CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

FIGURE 5

A Shift in Labor Supply

When labor supply increases from

S1 to S2, perhaps because of an immigration wave of new workers, the

equilibrium wage falls from W1 to W2.

At this lower wage, firms hire more

labor, so employment rises from L1 to

L2. The change in the wage reflects a

change in the value of the marginal

product of labor: With more workers,

the added output from an extra worker

is smaller.

Wage (price of

labor)

0 Quantity of Labor

L2L1

Supply, S1

Demand

2. . . . reduces the wage . . .

3. . . . and raises employment.

1. An increase in labor supply . . .

different kinds of workers. A wave of immigration may lower wages in those labor markets in which the new immigrants seek work, but it could have the opposite effect in other labor markets. For example, if the new immigrants look for jobs as apple pickers, the supply of apple pickers increases and the wage of apple pickers declines. But suppose the new immigrants are physicians who use some of their income to buy apples. In this case, the wave of immigration increases the supply of physicians but increases the demand for apples and thus apple pickers. As a result, the wages of physicians decline, and the wages of apple pickers rise. The linkages among various markets—sometimes called general equilibrium effects—make ana- lyzing the full effect of immigration more complex than it first appears.

18-3b Shifts in Labor Demand Now suppose that an increase in the popularity of apples causes their price to rise. This price increase does not change the marginal product of labor for any given number of workers, but it does raise the value of the marginal product. With a higher price for apples, hiring more apple pickers is now profitable. As Figure 6 shows, when the demand for labor shifts to the right from D1 to D2, the equilibrium wage rises from W1 to W2 and equilibrium employment rises from L1 to L2. Once again, the wage and the value of the marginal product of labor move together.

This analysis shows that prosperity for firms in an industry is often linked to prosperity for workers in that industry. When the price of apples rises, apple pro- ducers make greater profit and apple pickers earn higher wages. When the price of apples falls, apple producers earn smaller profit and apple pickers earn lower wages. This lesson is well known to workers in industries with highly volatile prices. Workers in oil fields, for instance, know from experience that their earn- ings are closely linked to the world price of crude oil.

From these examples, you should now have a good understanding of how wages are set in competitive labor markets. Labor supply and labor demand to- gether determine the equilibrium wage, and shifts in the supply or demand curve

372 PART VI THE ECONOMICS OF LABOR MARKETS

Here is an interview with Pia

Orrenius, a senior economist at the

Federal Reserve Bank of Dallas who

studies immigration.

Q: What can you tell us about the size

of the immigrant population in the United

States?

A: Immigrants make up about 13.3 per-

cent of the overall population, which means

about 42 million foreign-born live in the

United States. The commonly accepted 2014

estimate for the unauthorized portion of the

foreign-born population is 11.3 million. Immi-

grants come from all parts of the world, but

we’ve seen big changes in their origins. In the

1950s and 1960s, 75 percent of immigrants

were from Europe. Today, over 80 percent are

from Latin America and Asia. Inflows are also

much larger today, with 1 million to 2 million

newcomers entering each year, although lev-

els were significantly depressed in the after-

math of the Great Recession of 2007–2009,

when the housing bust led to a significant

decline in illegal immigration.

What’s interesting about the United

States is how our economy has been able to

absorb immigrants and put them to work.

U.S. immigrants are much more likely to be

working compared with immigrants in other

developed countries. This is partly because

we don’t set high entry-level wages or have

cumbersome hiring and firing rules. In this

type of flexible system, there are more job

openings. Workers have more opportunities.

Of course, entry-level wages are also lower,

but immigrants at least get their foot in

the door.

Being in the workforce allows immigrants

to interact with the rest of society. They learn

the language faster, pay taxes and become

stakeholders.

Q: Where do immigrants fit into the U.S.

economy?

A: U.S. immigrants are diverse in eco-

nomic terms. We rely on them to fill both high-

and low-skilled jobs. Some immigrants do

medium-skilled work, but more than anything

else they’re found on the low and the high

ends of the education distribution.

The economic effects of immigration are

positive, but the fiscal impact depends on

the group. We have a very important group

of high-skilled immigrants. We rely on them

to fill high-level jobs in health and STEM

[science, technology, engineering, and math-

ematics] occupations. Each year, over one-

third of Ph.D.s in science and engineering are

awarded to students who were born abroad.

Moreover, research shows that foreign-born

workers in STEM fields are more innovative

and entrepreneurial than their U.S.-born

counterparts, which boosts productivity

growth.

High-skilled immigration also contributes

positively to government finances. People

tend to focus on undocumented or low-skilled

immigrants when discussing immigration

and often do not recognize the tremendous

contributions of high-skilled immigrants.

The Economics of Immigration

IN THE NEWS

Wage (price of

labor)

0 Quantity of Labor

L1 L2

Supply

Demand, D1

2. . . . increases the wage . . .

3. . . . and increases employment.

1. An increase in labor demand . . .

FIGURE 6

A Shift in Labor Demand

When labor demand increases from D1

to D2, perhaps because of an increase

in the price of the firm’s output, the

equilibrium wage rises from W1 to

W2 and employment rises from L1 to

L2. The change in the wage reflects a

change in the value of the marginal

product of labor: With a higher output

price, the added output from an extra

worker is more valuable.

373CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

Q: What about the low-skilled immigration?

A: With low-skilled immigration, the eco-

nomic benefits of the added labor, such as

lower prices for consumers and higher returns

to capital, have to be balanced against the

fiscal impact, which is likely negative. The

fiscal impact is the difference between what

families contribute in taxes and what they use

up in the form of publicly provided services.

What makes the fiscal issue more difficult

is the distribution of the burden. The federal

government reaps much of the revenue from

immigrants who work and pay employment

taxes. State and local governments realize

less of that benefit and have to pay more

of the costs associated with low-skilled

immigration— usually education and health

expenses.

Q: Does it matter whether the immigration

is legal or not?

A: Illegal immigration has helped fuel the

U.S. economy for many years. Five percent of

the U.S. workforce is made up of unautho-

rized workers—the outcome of decades of

robust labor demand and, until recently, lax

enforcement. Nevertheless, from an economic

and fiscal perspective, it makes more sense

to differentiate among immigrants of various

skill levels than it does to focus on legal

status.

The economic benefits of low-skilled im-

migrants aren’t typically going to depend on

how they entered the United States. Unau-

thorized immigrants may pay less in taxes,

but they’re also ineligible for most public

programs. Lacking legal status doesn’t mean

these immigrants have a worse fiscal impact.

In fact, a low-skilled unauthorized immigrant

likely creates less fiscal burden than a low-

skilled legal immigrant because the undocu-

mented get almost no government benefits.

Q: How does immigration affect jobs and

earnings for the native-born population?

A: Labor economists have looked long and

hard at this question, namely how immigra-

tion has affected the wages of Americans,

particularly the low-skilled who lack a high

school degree. One reason we worry about this

is that the real wages of less-educated U.S.

men have been falling since the late 1970s.

The studies tend to show that little of the

decline is due to immigration. The consensus

seems to be that wages overall are about

1 to 3 percent lower today as a result of

immigration, although some scholars find

larger effects for low-skilled workers. Still,

labor economists think it’s a bit of a puzzle

that they haven’t been able to systematically

identify larger adverse wage effects.

The reason may be the way the economy

is constantly adjusting to the inflow of immi-

grants. On a geographical basis, for example,

a large influx of immigrants into an area

tends to encourage an inflow of physical cap-

ital or a change in technology or production

processes which puts new workers to use. So

you have an increase in labor supply, but you

also have an increase in labor demand, and

the wage effects are ameliorated. ■

Source: This interview, updated for this edition by Dr. Orrenius, was originally published in Southwest Economy, March/April 2006.

CO U

RT ES

Y O

F FE

D ER

A L

RE SE

RV E

BA N

K O

F D

A LL

A S,

S O

U TH

W ES

T EC

O N

O M

Y, M

A RC

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PR IL

2 00

Pia Orrenius

for labor cause the equilibrium wage to change. At the same time, profit maximi- zation by the firms that demand labor ensures that the equilibrium wage always equals the value of the marginal product of labor.

CASE STUDY

PRODUCTIVITY AND WAGES One of the Ten Principles of Economics in Chapter 1 is that our stan- dard of living depends on our ability to produce goods and services. We can now see how this principle works in the market for labor. In

particular, our analysis of labor demand shows that wages equal productivity as measured by the value of the marginal product of labor. Put simply, highly pro- ductive workers are highly paid, and less productive workers are less highly paid.

This lesson is key to understanding why workers today are better off than work- ers in previous generations. Table 2 presents some data on growth in productivity and growth in real wages (that is, wages adjusted for inflation). From 1960 to 2015, productivity as measured by output per hour of work grew about 2.0 percent per year. Real wages grew at 1.8 percent—almost the same rate. With a growth rate of 2 percent per year, productivity and real wages double about every 35 years.

Productivity growth varies over time. Table 2 also shows the data for three shorter periods that economists have identified as having very different

374 PART VI THE ECONOMICS OF LABOR MARKETS

productivity experiences. Around 1973, the U.S. economy experienced a signif- icant slowdown in productivity growth that lasted until 1995. The cause of this productivity slowdown is yet to be fully explained, but the link between produc- tivity and real wages is exactly as standard theory predicts. The slowdown in pro- ductivity growth from 2.7 to 1.4 percent per year coincided with a slowdown in real wage growth from 2.7 to 1.2 percent per year.

Productivity growth picked up again about 1995, and many observers hailed the arrival of the “new economy.” This productivity acceleration is most often attributed to the spread of computers and information technology. As theory pre- dicts, growth in real wages picked up as well. From 1995 to 2015, productivity grew by 2.1 percent per year and real wages grew by 1.8 percent per year.

The bottom line: Both theory and history confirm the close connection between productivity and real wages. ●

QuickQuiz How does immigration of workers affect labor supply, labor demand, the

marginal product of labor, and the equilibrium wage?

Time Period

Growth Rate

of Productivity

Growth Rate

of Real Wages

1960–2015 2.0% 1.8%

1960–1973 2.7 2.7

1973–1995 1.4 1.2

1995–2015 2.1 1.8

TABLE 2

Productivity and Wage

Growth in the

United States

Source: Bureau of Labor Statistics.

Monopsony

O n the preceding pages, we built our analysis of the labor market with

the tools of supply and demand. In doing so, we assumed that the

labor market was competitive. That is, we assumed that there were many

buyers and sellers of labor, so each buyer or seller had a negligible effect

on the wage.

Yet that assumption doesn’t always apply. Imagine that the labor

market in a small town is dominated by a single, large employer. That

employer can exert a large influence on the going wage, and it can use

its market power to alter the outcome in the labor market. Such a market

in which there is a single buyer is called a monopsony.

A monopsony (a market with one buyer) is in many ways similar to

a monopoly (a market with one seller). Recall from Chapter 15 that a

monopoly firm produces less of the good than would a competitive firm;

by reducing the quantity offered for sale, the monopoly firm moves

along the product’s demand curve, raising the price and also its profit.

Similarly, a monopsony

firm in a labor market

hires fewer workers than

would a competitive firm;

by reducing the number of

jobs available, the monop-

sony firm moves along the labor

supply curve, reducing the wage it pays and raising its profit. Thus, both

monopolists and monopsonists reduce economic activity in a market

below the socially optimal level. In both cases, the existence of market

power distorts the outcome and causes deadweight losses.

This book does not present the formal model of monopsony because

monopsonies are rare. In most labor markets, workers have many pos-

sible employers, and firms compete with one another to attract workers.

In this case, the model of supply and demand is the best one to use. ■

F Y I

375CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

18-4 The Other Factors of Production: Land and Capital

We have seen how firms decide how much labor to hire and how these deci- sions determine workers’ wages. At the same time that firms are hiring workers, they are also deciding about other inputs to production. For example, our apple- producing firm might have to choose the size of its apple orchard and the number of ladders for its apple pickers. We can think of the firm’s factors of production as falling into three categories: labor, land, and capital.

The meaning of the terms labor and land is clear, but the definition of capital is somewhat tricky. Economists use the term capital to refer to the stock of equip- ment and structures used for production. That is, the economy’s capital represents the accumulation of goods produced in the past that are being used in the present to produce new goods and services. For our apple firm, the capital stock includes the ladders used to climb the trees, the trucks used to transport the apples, the buildings used to store the apples, and even the trees themselves.

18-4a Equilibrium in the Markets for Land and Capital What determines how much the owners of land and capital earn for their contri- bution to the production process? Before answering this question, we need to dis- tinguish between two prices: the purchase price and the rental price. The purchase price of land or capital is the price a person pays to own that factor of production indefinitely. The rental price is the price a person pays to use that factor for a lim- ited period of time. It is important to keep this distinction in mind because, as we will see, these prices are determined by somewhat different economic forces.

Having defined these terms, we can now apply the theory of factor demand that we developed for the labor market to the markets for land and capital. Because the wage is the rental price of labor, much of what we have learned about wage deter- mination applies also to the rental prices of land and capital. As Figure 7 illustrates,

capital

the equipment and struc-

tures used to produce

goods and services

Quantity of Land

Rental Price of

Land

Demand

Supply

Demand

Supply

Quantity of Capital

Rental Price of Capital

(a) The Market for Land (b) The Market for Capital

FIGURE 7

The Markets for Land and Capital

Supply and demand determine the compensation paid to the owners of land, as shown

in panel (a), and the compensation paid to the owners of capital, as shown in panel (b).

The demand for each factor, in turn, depends on the value of the marginal product of

that factor.

376 PART VI THE ECONOMICS OF LABOR MARKETS

the rental price of land, shown in panel (a), and the rental price of capital, shown in panel (b), are determined by supply and demand. Moreover, the demand for land and capital is determined just like the demand for labor. That is, when our apple-producing firm is deciding how much land and how many ladders to rent, it follows the same logic as when deciding how many workers to hire. For both land and capital, the firm increases the quantity hired until the value of the factor’s marginal product equals the factor’s price. Thus, the demand curve for each factor reflects the marginal productivity of that factor.

We can now explain how much income goes to labor, how much goes to land- owners, and how much goes to the owners of capital. As long as the firms using the factors of production are competitive and profit-maximizing, each factor ’s rental price must equal the value of the marginal product for that factor. Labor, land, and capital each earn the value of their marginal contribution to the production process.

Now consider the purchase price of land and capital. The rental price and the purchase price are related: Buyers are willing to pay more for a piece of land or capital if it produces a valuable stream of rental income. And as we have just seen, the equilibrium rental income at any point in time equals the value of that factor’s marginal product. Therefore, the equilibrium purchase price of a piece of land or capital depends on both the current value of the marginal product and the value of the marginal product expected to prevail in the future.

What Is Capital Income?

L abor income is an easy concept to understand: It is the paycheck that

workers get from their employers. The income earned by capital, how-

ever, is less obvious.

In our analysis, we have been implicitly assuming that households

own the economy’s stock of capital—ladders, drill presses, warehouses,

and so on—and rent it to the firms that use it. Capital income, in this

case, is the rent that households receive for the use of their capital. This

assumption simplified our analysis of how capital owners are compen-

sated, but it is not entirely realistic. In fact, firms usually own the capital

they use, and therefore, they receive the earnings from this capital.

These earnings from capital, however, are paid to households even-

tually in a variety of forms. Some of the earnings are paid in the form of

interest to those households that have lent money to firms. Bondholders

and bank depositors are two examples of recipients of interest. Thus,

when you receive interest on your bank account, that income is part of

the economy’s capital income.

In addition, some of the earnings from capital are paid to house-

holds in the form of dividends. Dividends are payments by a firm to the

firm’s stockholders. A stockholder is a person who has bought a share in

the ownership of the firm

and, therefore, is entitled

to a portion of the firm’s

profits.

A firm does not have

to pay out all its earnings to

households in the form of inter-

est and dividends. Instead, it can retain some earnings within the firm

and use these earnings to buy additional capital. Unlike dividends, these

retained earnings do not yield a direct cash payment to the firm’s stock-

holders, but the stockholders benefit from them nonetheless. Because

retained earnings increase the amount of capital the firm owns, they tend

to increase future earnings and, thereby, the value of the firm’s stock.

These institutional details are interesting and important, but they

do not alter our conclusion about the income earned by the owners of

capital. Capital is paid according to the value of its marginal product,

regardless of whether this income is transmitted to households in

the form of interest or dividends or whether it is kept within firms as

retained earnings. ■

F Y I

377CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

18-4b Linkages among the Factors of Production We have seen that the price paid for any factor of production—labor, land, or capital—equals the value of the marginal product of that factor. The marginal product of any factor, in turn, depends on the quantity of that factor that is avail- able. Because of diminishing marginal product, a factor in abundant supply has a low marginal product and thus a low price, and a factor in scarce supply has a high marginal product and a high price. As a result, when the supply of a factor falls, its equilibrium price rises.

When the supply of any factor changes, however, the effects are not limited to the market for that factor. In most situations, factors of production are used together in a way that makes the productivity of each factor depend on the quan- tities of the other factors available for use in the production process. Therefore, when some event changes the supply of any one factor of production, it will typi- cally affect not only the earnings of that factor but also the earnings of all the other factors as well.

For example, suppose a hurricane destroys many of the ladders that workers use to pick apples from the orchards. What happens to the earnings of the vari- ous factors of production? Most obviously, when the supply of ladders falls, the equilibrium rental price of ladders rises. Those owners who were lucky enough to avoid damage to their ladders now earn a higher return when they rent out their ladders to the firms that produce apples.

Yet the effects of this event do not stop at the ladder market. Because there are fewer ladders with which to work, the workers who pick apples have a smaller marginal product. Thus, the reduction in the supply of ladders reduces the de- mand for the labor of apple pickers, and this shift in demand causes the equilib- rium wage to fall.

This story shows a general lesson: An event that changes the supply of any factor of production can alter the earnings of all the factors. The change in earnings of any fac- tor can be found by analyzing the impact of the event on the value of the marginal product of that factor.

CASE STUDY

THE ECONOMICS OF THE BLACK DEATH In 14th-century Europe, the bubonic plague wiped out about one-third of the population within a few years. This event, called the Black Death, provides a grisly natural experiment to test the theory

of factor markets that we have just developed. Consider the effects of the Black Death on those who were lucky enough to survive. What do you think happened to the wages earned by workers and the rents earned by landowners?

To answer this question, let’s examine the effects of a reduced population on the marginal product of labor and the marginal product of land. With a smaller supply of workers, the marginal product of labor rises. (This is diminishing mar- ginal product working in reverse.) Thus, we would expect the Black Death to raise wages.

Because land and labor are used together in production, a smaller supply of workers also affects the market for land, the other major factor of production in me- dieval Europe. With fewer workers available to farm the land, an additional unit of land produced less additional output. In other words, the marginal product of land fell. Thus, we would expect the Black Death to lower rents.

In fact, both predictions are consistent with the historical evidence. Wages approximately doubled during this period, and rents declined 50 percent or more.

Workers who survived the plague were lucky in more ways than one.

BE TT

M A

N N

/C O

RB IS

378 PART VI THE ECONOMICS OF LABOR MARKETS

The Black Death led to economic prosperity for the peasant classes and reduced incomes for the landed classes. ●

QuickQuiz What determines the income of the owners of land and capital? • How

would an increase in the quantity of capital affect the incomes of

those who already own capital? How would it affect the incomes of workers?

18-5 Conclusion This chapter has explained how labor, land, and capital are compensated for the roles they play in the production process. The theory developed here is called the neoclassical theory of distribution. According to the neoclassical theory, the amount paid to each factor of production depends on the supply and demand for that factor. The demand, in turn, depends on that particular factor’s marginal produc- tivity. In equilibrium, each factor of production earns the value of its marginal contribution to the production of goods and services.

The neoclassical theory of distribution is widely accepted. Most economists begin with the neoclassical theory when trying to explain how the U.S. econo- my’s $16 trillion of income is distributed among the economy’s various members. In the following two chapters, we consider the distribution of income in more detail. As you will see, the neoclassical theory provides the framework for this discussion.

Even at this point, you can use the theory to answer the question that began this chapter: Why are computer programmers paid more than gas station at- tendants? It is because programmers can produce a good of greater market value than can gas station attendants. People are willing to pay dearly for a good computer game, but they are willing to pay little to have their gas pumped and their windshield washed. The wages of these workers reflect the market prices of the goods they produce. If people suddenly got tired of using computers and decided to spend more time driving, the prices of these goods would change, and so would the equilibrium wages of these two groups of workers.

1. Approximately what percentage of U.S. national

income is paid to workers, as opposed to owners of

capital and land?

a. 25 percent

b. 45 percent

c. 65 percent

d. 85 percent

2. If firms are competitive and profit-maximizing, the

demand curve for labor is determined by

a. the opportunity cost of workers’ time.

b. the value of the marginal product of labor.

c. offsetting income and substitution effects.

d. the value of the marginal product of capital.

3. A bakery operating in competitive markets sells its

output for $20 per cake and hires labor at $10 per

hour. To maximize profit, it should hire labor until the

marginal product of labor is

a. 1/2 cake per hour.

b. 2 cakes per hour.

c. 10 cakes per hour.

d. 15 cakes per hour.

4. A technological advance that increases the marginal

product of labor shifts the labor- ________ curve to

the ________.

a. demand, left

b. demand, right

c. supply, left

d. supply, right

CHAPTER QuickQuiz

379CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

• The economy’s income is distributed in the mar-

kets for the factors of production. The three most

important factors of production are labor, land, and

capital.

• The demand for factors, such as labor, is a derived

demand that comes from firms that use the factors

to produce goods and services. Competitive, profit-

maximizing firms hire each factor up to the point

at which the value of the factor ’s marginal product

equals its price.

• The supply of labor arises from individuals’ trade-

off between work and leisure. An upward-sloping

labor-supply curve means that people respond to

an increase in the wage by working more hours and

enjoying less leisure.

• The price paid to each factor adjusts to balance the

supply and demand for that factor. Because factor

demand reflects the value of the marginal product of

that factor, in equilibrium each factor is compensated

according to its marginal contribution to the produc-

tion of goods and services.

• Because factors of production are used together, the

marginal product of any one factor depends on the

quantities of all factors that are available. As a result,

a change in the supply of one factor alters the equilib-

rium earnings of all the factors.

factors of production, p. 362

production function, p. 364

marginal product of labor, p. 364

diminishing marginal product, p. 364

value of the marginal product, p. 365

capital, p. 375

f f f f

KEY CONCEPTS

SUMMARY

5. Around 1973, the U.S. economy experienced a sig-

nificant ________ in productivity growth, coupled with

a(n) ________ in the growth of real wages.

a. acceleration, acceleration

b. acceleration, slowdown

c. slowdown, acceleration

d. slowdown, slowdown

6. A storm destroys several factories, thereby reducing

the stock of capital. What effect does this event have

on factor markets?

a. Wages and the rental price of capital both rise.

b. Wages and the rental price of capital both fall.

c. Wages rise and the rental price of capital falls.

d. Wages fall and the rental price of capital rises.

1. Explain how a firm’s production function is related to

its marginal product of labor, how a firm’s marginal

product of labor is related to the value of its marginal

product, and how a firm’s value of marginal product

is related to its demand for labor.

2. Give two examples of events that could shift the

demand for labor, and explain why they do so.

3. Give two examples of events that could shift the

supply of labor, and explain why they do so.

4. Explain how the wage can adjust to balance the

supply and demand for labor while simultaneously

equaling the value of the marginal product of labor.

5. If the population of the United States suddenly grew

because of a large wave of immigration, what would

happen to wages? What would happen to the rents

earned by the owners of land and capital?

QUESTIONS FOR REVIEW

380 PART VI THE ECONOMICS OF LABOR MARKETS

1. Suppose that the president proposes a new law

aimed at reducing healthcare costs: All Americans are

required to eat one apple daily.

a. How would this apple-a-day law affect the

demand and equilibrium price of apples?

b. How would the law affect the marginal product and

the value of the marginal product of apple pickers?

c. How would the law affect the demand and

equilibrium wage for apple pickers?

2. Show the effect of each of the following events on

the market for labor in the computer manufacturing

industry.

a. Congress buys personal computers for all U.S.

college students.

b. More college students major in engineering and

computer science.

c. Computer firms build new manufacturing plants.

3. Suppose that labor is the only input used by a

perfectly competitive firm. The firm’s production

function is as follows:

Days of Labor Units of Output

0 days 0 units

1 7

2 13

3 19

4 25

5 28

6 29

7 29

a. Calculate the marginal product for each additional

worker.

b. Each unit of output sells for $10. Calculate the

value of the marginal product of each worker.

c. Compute the demand schedule showing the num-

ber of workers hired for all wages from zero to

$100 a day.

d. Graph the firm’s demand curve.

e. What happens to this demand curve if the price of

output rises from $10 to $12 per unit?

4. Smiling Cow Dairy can sell all the milk it wants for $4

a gallon, and it can rent all the robots it wants to milk

the cows at a capital rental price of $100 a day. It faces

the following production schedule:

Number of Total

Robots Product

0 0 gallons

1 50

2 85

3 115

4 140

5 150

6 155

a. In what kind of market structure does the firm sell

its output? How can you tell?

b. In what kind of market structure does the firm

rent robots? How can you tell?

c. Calculate the marginal product and the value of

the marginal product for each additional robot.

d. How many robots should the firm rent?

Explain.

5. The nation of Ectenia has 20 competitive apple or-

chards, all of which sell apples at the world price of

$2 per apple. The following equations describe the

production function and the marginal product of labor

in each orchard:

Q 5 100L 2 L2

MPL 5 100 2 2L,

where Q is the number of apples produced in a day, L is the number of workers, and MPL is the marginal product of labor.

a. What is each orchard’s labor demand as a function

of the daily wage W? What is the market’s labor demand?

b. Ectenia has 200 workers who supply their labor

inelastically. Solve for the wage W. How many workers does each orchard hire? How much profit

does each orchard owner make?

c. Calculate what happens to the income of workers

and orchard owners if the world price doubles to

$4 per apple.

d. Now suppose the price is back at $2 per apple,

but a hurricane destroys half the orchards. Calcu-

late how the hurricane affects the income of each

worker and of each remaining orchard owner.

What happens to the income of Ectenia as a

whole?

PROBLEMS AND APPLICATIONS

381CHAPTER 18 THE MARKETS FOR THE FACTORS OF PRODUCTION

6. Your enterprising uncle opens a sandwich shop that

employs 7 people. The employees are paid $12 per hour,

and a sandwich sells for $6. If your uncle is maximizing

his profit, what is the value of the marginal product of

the last worker he hired? What is that worker’s mar-

ginal product?

7. Leadbelly Co. sells pencils in a perfectly competitive

product market and hires workers in a perfectly compet-

itive labor market. Assume that the market wage rate for

workers is $150 per day.

a. What rule should Leadbelly follow to hire the

profit-maximizing amount of labor?

b. At the profit-maximizing level of output, the mar-

ginal product of the last worker hired is 30 boxes

of pencils per day. Calculate the price of a box of

pencils.

c. Draw a diagram of the labor market for pencil work-

ers (as in Figure 4 of this chapter) next to a diagram

of the labor supply and demand for Leadbelly Co. (as

in Figure 3). Label the equilibrium wage and quantity

of labor for both the market and the firm. How are

these diagrams related?

d. Suppose some pencil workers switch to jobs in the

growing computer industry. On the side-by-side

diagrams from part (c), show how this change

affects the equilibrium wage and quantity of labor

for both the pencil market and for Leadbelly. How

does this change affect the marginal product of labor

at Leadbelly?

8. Policymakers sometimes propose laws requiring firms to

give workers certain fringe benefits, such as health insur-

ance or paid parental leave. Let’s consider the effects of

such a policy on the labor market.

a. Suppose that a law required firms to give each

worker $3 of fringe benefits for every hour that the

worker is employed by the firm. How does this law

affect the marginal profit that a firm earns from each

worker at a given cash wage? How does the law

affect the demand curve for labor? Draw your answer

on a graph with the cash wage on the vertical axis.

b. If there is no change in labor supply, how would this

law affect employment and wages?

c. Why might the labor-supply curve shift in response to

this law? Would this shift in labor supply raise or lower

the impact of the law on wages and employment?

d. As discussed in Chapter 6, the wages of some work-

ers, particularly the unskilled and inexperienced, are

kept above the equilibrium level by minimum-wage

laws. What effect would a fringe-benefit mandate

have for these workers?

9. Some economists believe that the U.S. economy as a

whole can be modeled with the following production

function, called the Cobb–Douglas production function:

Y 5 AK1/3L2/3,

where Y is the amount of output, K is the amount of capital, L is the amount of labor, and A is a parameter that measures the state of technology. For this production

function, the marginal product of labor is

MPL 5 (2/3) A(K/L)1/3.

Suppose that the price of output P is 2, A is 3, K is 1,000,000, and L is 1,000. The labor market is competitive, so labor is paid the value of its marginal product.

a. Calculate the amount of output produced Y and the dollar value of output PY.

b. Calculate the wage W and the real wage W/P. (Note: The wage is labor compensation measured in dol-

lars, whereas the real wage is labor compensation

measured in units of output.)

c. Calculate the labor share (the fraction of the value of

output that is paid to labor), which is (WL)/(PY). d. Calculate what happens to output Y, the wage W,

the real wage W/P, and the labor share (WL)/(PY) in each of the following scenarios:

i. Inflation increases P from 2 to 3. ii. Technological progress increases A from 3 to 9. iii. Capital accumulation increases K from 1,000,000

to 8,000,000.

iv. A plague decreases L from 1,000 to 125. e. Despite many changes in the U.S. economy over

time, the labor share has been relatively stable. Is

this observation consistent with the Cobb–Douglas

production function? Explain.

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

I n the United States today, the typical physician earns about $200,000 a year, the typical police officer about $60,000, and the typical fast-food cook about $20,000. These examples illustrate the large differences in earnings in our economy.

These differences explain why some people live in mansions, ride in limousines, and vacation on the French Riviera, while other people live in small apartments, ride the bus, and vacation in their own backyards.

Why do earnings vary so much from person to person? Chapter 18, which developed the basic neoclassical theory of the labor market, offers an answer to this question. There we saw that wages are governed by labor supply and labor demand. Labor demand, in turn, reflects the marginal productivity of labor. In equilibrium, each worker is paid the value of her marginal contribution to the economy’s production of goods and services.

Earnings and Discrimination CHAPTER

384 PART VI THE ECONOMICS OF LABOR MARKETS

This theory of the labor market, though widely accepted by economists, is only the beginning of the story. To understand the wide variation in earnings that we observe, we must go beyond this general framework and examine more precisely what determines the supply and demand for different types of labor. That is our goal in this chapter.

19-1 Some Determinants of Equilibrium Wages Workers differ from one another in many ways, as do jobs. In this section, we consider how the characteristics of workers and jobs affect labor supply, labor demand, and equilibrium wages.

19-1a Compensating Differentials When a worker is deciding whether to take a job, the wage is only one of many job attributes that the worker takes into account. Some jobs are easy, fun, and safe, while others are hard, dull, and dangerous. The better the job as gauged by these nonmonetary characteristics, the more people there are who are willing to do the job at any given wage. In other words, the supply of labor for easy, fun, and safe jobs is greater than the supply of labor for hard, dull, and dangerous jobs. As a result, “good” jobs will tend to have lower equilibrium wages than “bad” ones.

For example, imagine you are looking for a summer job in a local beach com- munity. Two kinds of jobs are available. You can take a job as a beach-badge checker, or you can take a job as a garbage collector. The beach-badge checkers take leisurely strolls along the beach during the day and check to make sure the tourists have bought the required beach permits. The garbage collectors wake up before dawn to drive dirty, noisy trucks around town to pick up garbage. Which job would you want? If the two jobs paid the same wage, most people would prefer the badge-checker job. To induce people to become garbage collectors, the town has to offer higher wages to garbage collectors than to beach-badge checkers.

Economists use the term compensating differential to refer to a difference in wages that arises from nonmonetary characteristics of different jobs. Compensat- ing differentials are prevalent in the economy. Here are some examples:

• Coal miners are paid more than other workers with similar levels of educa- tion. Their higher wage compensates them for the dirty and dangerous nature of coal mining, as well as the long-term health problems that coal miners experience.

• Workers who work the night shift at factories are paid more than similar workers who work the day shift. The higher wage compensates them for having to work at night and sleep during the day, a lifestyle that most people find undesirable.

• Professors are paid less than lawyers and doctors, who have similar amounts of education. The higher wages of lawyers and doctors compensate them for missing out on the great intellectual and personal satisfaction that professors’ jobs offer. (Indeed, teaching economics is so much fun that it is surprising economics professors are paid anything at all!)

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compensating differential

a difference in wages that

arises to offset the non-

monetary characteristics

of different jobs

“On the one hand, I know I could make more money if I left public service for the private sector, but, on the other hand, I couldn’t chop off heads.”

385CHAPTER 19 EARNINGS AND DISCRIMINATION

19-1b Human Capital As we discussed in the previous chapter, the word capital usually refers to an econ- omy’s stock of equipment and structures. The capital stock includes the farmer ’s tractor, the manufacturer ’s factory, and the teacher ’s chalkboard. The essence of capital is that it is a factor of production that itself has been produced.

There is another type of capital that, while less tangible than physical capital, is just as important to the economy’s production. Human capital is the accumula- tion of investments in people. The most important type of human capital is edu- cation. Like all forms of capital, education represents an expenditure of resources at one time to raise productivity in the future. But unlike an investment in other forms of capital, an investment in education is tied to a specific person, and this linkage is what makes it human capital.

Not surprisingly, workers with more human capital earn more on average than those with less human capital. College graduates in the United States, for exam- ple, earn almost twice as much as those with only a high school diploma. This large difference has been documented in many countries around the world. It tends to be even larger in less developed countries, where educated workers are in scarce supply.

From the perspective of supply and demand it is easy to see why educa- tion raises wages. Firms—the demanders of labor—are willing to pay more for highly educated workers because these workers have higher marginal products. Workers—the suppliers of labor—are willing to pay the cost of becoming edu- cated only if there is a reward for doing so. In essence, the difference in wages between highly educated workers and less educated workers may be considered a compensating differential for the cost of becoming educated.

human capital

the accumulation of

investments in people,

such as education and

on-the-job training

CASE STUDY

THE INCREASING VALUE OF SKILLS “The rich get richer, and the poor get poorer.” Like many adages, this one is not always true, but it has been in recent years. Many studies have documented that the earnings gap between workers with high

skills and workers with low skills has increased over the past several decades.

Table 1 presents data on the average earnings of college graduates and of high school graduates without any additional education. These data show the increase in the financial reward from education. In 1974, a man on average earned 42 per- cent more with a college degree than without one; by 2014, this figure had risen to 81 percent. For a woman, the reward for attending college rose from a 35 percent increase in earnings in 1974 to a 71 percent increase in 2014. The incentive to stay in school is as great today as it has ever been.

Why has the gap in earnings between skilled and unskilled workers widened in recent years? No one knows for sure, but economists have proposed two hypothe- ses to explain this trend. Both hypotheses suggest that the demand for skilled labor has risen over time relative to the demand for unskilled labor. The shift in demand has led to a corresponding change in the wages of both groups, which in turn has led to greater inequality.

386 PART VI THE ECONOMICS OF LABOR MARKETS

The first hypothesis is that international trade has altered the relative demand for skilled and unskilled labor. In recent years, the amount of trade with other countries has increased substantially. As a percentage of total U.S. production of goods and services, imports have risen from 8 percent in 1974 to 17 percent in 2014, and exports have risen from 8 percent in 1974 to 14 percent in 2014. Because

unskilled labor is plentiful and cheap in many foreign countries, the United States tends to import goods produced with unskilled labor and export goods produced with skilled labor. Thus, when international trade expands, the domestic demand for skilled labor rises and the domestic demand for unskilled labor falls.

The second hypothesis is that changes in technology have altered the relative demand for skilled and unskilled labor. Consider, for instance, the introduction of computers. Comput- ers raise the demand for the skilled workers who can use them and reduce the demand for the unskilled workers whose jobs are replaced by them. For example, many companies now rely more on computer databases, and less on filing cabinets, to keep business records. This change raises the demand for computer programmers and reduces the demand for filing clerks. Thus, as more firms use computers, the demand for skilled labor rises and the demand for unskilled labor falls. Economists call this phe- nomenon skill-biased technological change.

Economists debate the importance of trade, technology, and other forces on the changing distribution of wages. There is likely not a single answer as to why income inequality has increased. Increasing international trade and skill-biased techno- logical change may share responsibility for the changes we have observed in recent decades. In the next chapter, we discuss the issue of increasing inequality in more detail. ●

TABLE 1

Average Annual

Earnings by Educational

Attainment

College graduates have

always earned more

than workers without

the benefit of college,

but the salary gap has

grown even larger over

the past few decades.

1974 2014

Men

High school, no college $52,521 $46,688

College graduates $74,801 $84,567

Percent extra for college grads +42% +81%

Women

High school, no college $30,185 $34,394

College graduates $40,831 $58,894

Percent extra for college grads +35% +71%

Note: Earnings data are adjusted for inflation and are expressed in 2014 dollars. Data apply to full-time, year-round workers age 18 and over. Data for college graduates exclude

workers with additional schooling beyond college, such as a master’s degree or Ph.D.

Source: U.S. Census Bureau and author’s calculations.

“One of the leading reasons for rising U.S. income inequality

over the past three decades is that technological change has

affected workers with some skill sets differently than others.”

8% uncertain

88% agree

4% disagree

What do economists say?

Source: IGM Economic Experts Panel, January 24, 2012.

Inequality and Skills

ASK THE EXPERTS

387CHAPTER 19 EARNINGS AND DISCRIMINATION

An economist makes the case for

increased spending.

Throw More Money

at Education

By Noah Smith

I t’s become almost conventional wisdom that

throwing more money at public education

doesn’t produce results. But what if conven-

tional wisdom is wrong?

A new paper from economists C. Kirabo

Jackson, Rucker Johnson and Claudia Per-

sico suggests that it is. To disentangle cor-

relation from causation, they look at periods

from 1955 through 1985 when courts ordered

governments to spend more on schools, from

kindergarten through 12th grade. They then

track how students in those areas did, up

through 2011. The result is a very detailed

long-term picture of the effect of spending

more money on education.

The economists find that spending works.

Specifically, they find that a 10 percent

increase in spending, on average, leads chil-

dren to complete 0.27 more years of school,

to make wages that are 7.25 percent higher

and to have a substantially reduced chance

of falling into poverty. These are long-term,

durable results. Conclusion: throwing money

at the problem works.

Here’s the hitch: The authors find that

the benefits of increased spending are much

stronger for poor kids than for wealthier ones.

So if you, like me, are in the upper portion of

the U.S. income distribution, you may be read-

ing this and thinking: “Why should I be paying

more for some poor kid to be educated?” After

all, why should one person pay the cost while

another reaps the benefits?

Well, let me try to answer that. There are

several good reasons.

First, if you’re an upper-income American,

you probably do derive some direct benefit. When

poor Americans become better workers, it doesn’t

just boost their wages. It also boosts the profit-

ability of the companies where they work. If you

own stock in such a company (and I hope you do),

the value of those shares will go up if American

worker productivity increases.

There might be even bigger, though less

direct, effects from having a more-educated

populace. The more industries can use U.S.

workers instead of Chinese workers, the more

industries will base their production in the U.S.

This will feed local economies, boosting the

profits of stores and other service businesses.

That also feeds into your stock portfolio.

If you own your own business, you might

need to hire some low-income people. If

those people are better readers, better at

doing simple math, more efficient at everyday

tasks, and just more productive in general,

that cuts down on the time and money you

need to spend fixing their mistakes.

Next, having more educated poor people

makes for a better civil society. Suppose you live

in, say, Chicago, or some other city that hasn’t

enjoyed as big a drop in crime as New York or

Los Angeles. I bet you don’t enjoy having to worry

about driving or walking through unsafe neigh-

borhoods. I also bet you would like to walk around

downtown without fear of getting mugged. It

might also be nice not to have to live behind the

isolating walls of a gated community.

One way to reduce crime, of course, is to pay

for more police and increase incarceration rates.

But another way is to improve education. Econ-

omists Lance Lochner and Enrico Moretti found

in 2003 that education decreases crime. An ed-

ucated populace is a well-socialized populace.

There is also the fact that better education leads

to higher wages for poor people, reducing the in-

centive for them to engage in crime.

At the risk of sounding grandiose, let

me go even further: Education is really the

difference between a cohesive society and a

collection of people who happen to live next

to each other. This was understood well by

Fukuzawa Yukichi, Japan’s version of Ben

Franklin. After Japan opened up to the West

in the mid-1800s, Fukuzawa volunteered for

Japan’s first diplomatic mission to the U.S. He

returned convinced that universal education

was the key to transforming Japan into the

equal of the Western nations. His ideas were

influential, and Japan to this day has one of

the world’s best education systems.

Detractors of our public education system

point out that the U.S. already spends as much

on public education as many other developed

countries—5.5 percent of gross domestic

product, compared with only 3.5 percent in

Japan, 4.9 percent in Canada, 5 percent in

South Korea and 5.9 percent in Finland. Many

view increased education spending as a give-

away to powerful and greedy teachers’ unions.

But maybe the U.S. spends more because it

needs to spend more. The U.S. has more inequal-

ity and more poor people than those countries.

Just as some countries naturally need to spend

more on health care than others, the U.S. might

naturally need more education spending.

The argument for more education spending,

of course, isn’t at odds with the need to make

our schools more efficient. Education-reform

movements such as charter schools—which

are also effective mainly for poor kids—don’t

clash with the idea of higher spending. We can

do both, and each may help the other.

So this is one problem the U.S. really

should consider throwing more money at. ■

Mr. Smith is an economics professor at Stony

Brook University.

Source: Bloomberg View, January 23, 2015.

Schooling as a Public Investment

IN THE NEWS

388 PART VI THE ECONOMICS OF LABOR MARKETS

19-1c Ability, Effort, and Chance Why do major league baseball players get paid more than minor league players? Certainly, the higher wage is not a compensating differential. Playing in the major leagues is not a less pleasant job than playing in the minor leagues; in fact, the opposite is true. The major leagues do not require more years of schooling or more experience. To a large extent, players in the major leagues earn more because they have greater natural ability.

Natural ability is important for workers in all occupations. Because of heredity and upbringing, people differ in their physical and mental attributes. Some peo- ple are strong, others weak. Some people are smart, others less so. Some people are outgoing, others awkward in social situations. These and many other personal characteristics determine how productive workers are and, therefore, play a role in determining the wages they earn.

Closely related to ability is effort. Some people work hard; others are lazy. We should not be surprised to find that those who work hard are more productive and earn higher wages. To some extent, firms reward hard work directly by pay- ing people based on what they produce. Salespeople, for instance, are often paid a percentage of the sales they make. At other times, hard work is rewarded less directly in the form of a higher annual salary or a bonus.

Chance also plays a role in determining wages. If a person attended a trade school to learn how to repair televisions with vacuum tubes and then found this skill made obsolete by the invention of solid-state electronics, she would end up earning a low wage compared to others with similar years of training. The low wage of this worker is due to chance—a phenomenon that economists recognize but do not shed much light on.

How important are ability, effort, and chance in determining wages? It is hard to say because these factors are difficult to measure. But indirect evidence sug- gests that they are very important. When labor economists study wages, they relate a worker ’s wage to those variables that can be measured, such as years of schooling, years of experience, age, and job characteristics. All of these measured variables affect a worker’s wage as theory predicts, but they account for less than half of the variation in wages in our economy. Because so much of the variation in wages is left unexplained, omitted variables—including ability, effort, and chance— must play an important role.

CASE STUDY

THE BENEFITS OF BEAUTY People differ in many ways, one of which is physical attractiveness. The actress Emma Stone, for instance, is a beautiful woman. In part for this reason, her movies attract large audiences. Not surprisingly,

the large audiences mean a large income for Ms. Stone. How prevalent are the economic benefits of beauty? Labor economists Daniel

Hamermesh and Jeff Biddle tried to answer this question in a study published in the December 1994 issue of the American Economic Review. Hamermesh and Biddle examined data from surveys of individuals in the United States and Canada. The interviewers who conducted the survey were asked to rate each respondent’s phys- ical appearance. Hamermesh and Biddle then examined how much the wages of the respondents depended on the standard determinants—education, experience, and so on—and how much they depended on physical appearance.

389CHAPTER 19 EARNINGS AND DISCRIMINATION

Hamermesh and Biddle found that beauty pays. People who are deemed more attractive than average earn 5 percent more than people of average looks, and peo- ple of average looks earn 5 to 10 percent more than people considered less attrac- tive than average. Similar results were found for men and women.

What explains these differences in wages? There are several ways to interpret the “beauty premium.”

One interpretation is that good looks are a type of innate ability determining productivity and wages. Some people are born with the physical attributes of a movie star; other people are not. Good looks are useful in any job in which work- ers present themselves to the public—such as acting, sales, and waiting on tables. In this case, an attractive worker is more valuable to the firm than an unattractive worker. The firm’s willingness to pay more to attractive workers reflects its custom- ers’ preferences.

A second interpretation is that reported beauty is an indirect measure of other types of ability. How attractive a person appears depends on more than just heredity. It also depends on dress, hairstyle, personal demeanor, and other attri- butes that a person can control. Perhaps a person who successfully projects an attractive image in a survey interview is more likely to be an intelligent person who succeeds at other tasks as well.

A third interpretation is that the beauty premium is a type of discrimination, a topic to which we return later. ●

19-1d An Alternative View of Education: Signaling Earlier we discussed the human-capital view of education, according to which schooling raises workers’ wages because it makes them more productive. Although this view is widely accepted, some economists have proposed an alter- native theory, which emphasizes that firms use educational attainment as a way of sorting between high-ability and low-ability workers. According to this alter- native view, when people earn a college degree, for instance, they do not become more productive, but they do signal their high ability to prospective employers. Because it is easier for high-ability people to earn a college degree than it is for low-ability people, more high-ability people get college degrees. As a result, it is rational for firms to interpret a college degree as a signal of ability.

The signaling theory of education is similar to the signaling theory of adver- tising discussed in Chapter 16. In the signaling theory of advertising, the adver- tisement itself contains no real information, but the firm signals the quality of its product to consumers by its willingness to spend money on advertising. In the signaling theory of education, schooling has no real productivity benefit, but the worker signals her innate productivity to employers by her willingness to spend years at school. In both cases, an action is being taken not for its intrinsic bene- fit but because the willingness to take that action conveys private information to someone observing it.

Thus, we now have two views of education: the human-capital theory and the signaling theory. Both views can explain why more educated workers tend to earn more than less educated ones. According to the human-capital view, education makes workers more productive; according to the signaling view, edu- cation is correlated with natural ability. But the two views have radically different predictions for the effects of policies that aim to increase educational attainment. According to the human-capital view, increasing educational levels for all work- ers would raise all workers’ productivity and thereby their wages. According to

Good looks pay.

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390 PART VI THE ECONOMICS OF LABOR MARKETS

the signaling view, education does not enhance productivity, so raising all work- ers’ educational levels would not affect wages.

Most likely, the truth lies somewhere between these two extremes. The bene- fits of education are probably a combination of the productivity-enhancing effects of human capital and the productivity-revealing effects of signaling. The relative size of these two effects is an open question.

19-1e The Superstar Phenomenon Although most actors earn little and often take jobs as waiters to support them- selves, Robert Downey, Jr., earns millions of dollars for each film he makes. Simi- larly, while most people who play tennis do it as a hobby, Maria Sharapova earns millions on the pro tour. Downey and Sharapova are superstars in their fields, and their great public appeal is reflected in astronomical incomes.

Why do Downey and Sharapova earn so much? It is not surprising that in- comes differ within occupations. Good carpenters earn more than mediocre car- penters, and good plumbers earn more than mediocre plumbers. People vary in ability and effort, and these differences lead to differences in income. Yet the best carpenters and plumbers do not earn the many millions that are common among the best actors and athletes. What explains the difference?

To understand the tremendous incomes of Downey and Sharapova, we must examine the special features of the markets in which they sell their services. Superstars arise in markets that have two characteristics:

• Every customer in the market wants to enjoy the good supplied by the best producer.

• The good is produced with a technology that makes it possible for the best producer to supply every customer at low cost.

If Robert Downey, Jr., is the best actor around, then everyone will want to see his next movie; seeing twice as many movies by an actor half as talented is not a good substitute. Moreover, it is possible for everyone to enjoy a performance by Robert Downey, Jr. Because it is easy to make multiple copies of a film, Downey can pro- vide his service to millions of people simultaneously. Similarly, because tennis matches are broadcast on television, millions of fans can enjoy the extraordinary athletic skills of Maria Sharapova.

We can now see why there are no superstar carpenters and plumbers. Other things being equal, everyone prefers to employ the best carpenter, but a carpenter, unlike a movie actor, can provide her services to only a limited number of cus- tomers. Although the best carpenter will be able to command a somewhat higher wage than the average carpenter, the average carpenter will still be able to earn a good living.

19-1f Above-Equilibrium Wages: Minimum-Wage Laws, Unions, and Efficiency Wages

Most analyses of wage differences among workers are based on the equilibrium model of the labor market—that is, wages are assumed to adjust to balance labor supply and labor demand. But this assumption does not always apply. For some workers, wages are set above the level that brings supply and demand into equi- librium. Let’s consider three reasons this might be so.

391CHAPTER 19 EARNINGS AND DISCRIMINATION

One reason for above-equilibrium wages is minimum-wage laws, as we first saw in Chapter 6. Most workers in the economy are not affected by these laws because their equilibrium wages are well above the legal minimum. But for some workers, especially the least skilled and experienced, minimum-wage laws raise wages above the level they would earn in an unregulated labor market.

A second reason that wages might rise above their equilibrium level is the mar- ket power of labor unions. A union is a worker association that bargains with employers over wages and working conditions. Unions often raise wages above the level that would prevail in their absence, perhaps because they can threaten to withhold labor from the firm by calling a strike. Studies suggest that union work- ers earn about 10 to 20 percent more than similar, nonunion workers.

A third reason for above-equilibrium wages is based on the theory of efficiency wages. This theory holds that a firm can find it profitable to pay high wages because doing so increases the productivity of its workers. In particular, high wages may reduce worker turnover, increase worker effort, and raise the quality of workers who apply for jobs at the firm. If this theory is correct, then some firms may choose to pay their workers more than they would normally earn.

Above-equilibrium wages, whether caused by minimum-wage laws, unions, or efficiency wages, have similar effects on the labor market. In particular, push- ing a wage above the equilibrium level raises the quantity of labor supplied and reduces the quantity of labor demanded. The result is a surplus of labor, or un- employment. The study of unemployment and the public policies aimed to deal with it is usually considered a topic within macroeconomics, so it goes beyond the scope of this chapter. But it would be a mistake to ignore these issues completely when analyzing earnings. Although most wage differences can be understood while maintaining the assumption of equilibrium in the labor market, above-equi- librium wages play a role in some cases.

QuickQuiz Define compensating differential and give an example. • Give two reasons

why more educated workers earn more than less educated workers.

19-2 The Economics of Discrimination Another source of differences in wages is discrimination. Discrimination occurs when the marketplace offers different opportunities to similar individuals who differ only by race, ethnic group, sex, age, or other personal characteristics. Dis- crimination reflects some people’s prejudice against certain groups in society. Dis- crimination is an emotionally charged topic that often generates heated debate, but economists try to study the topic objectively to separate myth from reality.

19-2a Measuring Labor-Market Discrimination How much does discrimination in labor markets affect the earnings of different groups of workers? This question is important, but answering it is not easy.

There is no doubt that different groups of workers earn substantially different wages, as Table 2 demonstrates. The median black man in the United States is paid 20 percent less than the median white man, and the median black woman is paid 17 percent less than the median white woman. The differences by sex are also significant. The median white woman is paid 21 percent less than the median white man, and the median black woman is paid 18 percent less than the median

union

a worker association that

bargains with employers

over wages and working

conditions

strike

the organized withdrawal

of labor from a firm by a

union

efficiency wages

above-equilibrium wages

paid by firms to increase

worker productivity

discrimination

the offering of different

opportunities to similar

individuals who differ

only by race, ethnic

group, sex, age, or other

personal characteristics

392 PART VI THE ECONOMICS OF LABOR MARKETS

black man. Taken at face value, these differentials look like evidence that employ- ers discriminate against blacks and women.

Yet there is a potential problem with this inference. Even in a labor market free of discrimination, different people have different wages. People differ in the amount of human capital they have and in the kinds of work they are able and willing to do. The wage differences we observe in an economy are, to some extent, attributable to the determinants of equilibrium wages we discussed in the preceding section. Simply observing differences in wages among broad groups—whites and blacks, men and women—does not prove that employers discriminate.

Consider, for example, the role of human capital. In 2014, among men aged 25 and older, 32 percent of the white population had a college degree, compared with 20 percent of the black population. Among women aged 25 and older, 32 percent of the white population had a college degree, compared with 24 percent of the black population. Thus, at least some of the difference between the wages of whites and the wages of blacks can be traced to differences in educational attainment.

Moreover, human capital may be more important in explaining wage differ- entials than years of schooling suggest. Historically, public schools in predomi- nantly black areas have been of lower quality—as measured by expenditure, class size, and so on—than public schools in predominantly white areas. If we could measure the quality as well as the quantity of education, the differences in human capital among these groups would appear even larger.

Human capital acquired in the form of job experience can also help explain wage differences. In particular, women are more likely to interrupt their careers to raise children. Among the population aged 25 to 44 (when many people have chil- dren at home), only about 75 percent of women are in the labor force, compared to about 90 percent of men. As a result, female workers, especially at older ages, tend to have less job experience than male workers.

Yet another source of wage differences is compensating differentials. Men and women do not always choose the same type of work, and this fact may help explain some of the earnings differential between men and women. For exam- ple, women are more likely to be secretaries, and men are more likely to be truck

TABLE 2

Median Annual Earnings

by Race and Sex

White Black

Percent by Which Earnings

Are Lower for Black Workers

Men $51,022 $40,719 20%

Women $40,439 $33,533 17%

Percent by Which Earnings Are

Lower for Women Workers

21% 18%

Note: Earnings data are for the year 2014 and apply to full-time, year-round workers aged 14 and over. Individuals who report more than one race are excluded from these

data.

Source: U.S. Census Bureau.

393CHAPTER 19 EARNINGS AND DISCRIMINATION

drivers. The relative wages of secretaries and truck drivers depend in part on the working conditions of each job. Because these nonmonetary aspects are hard to measure, it is difficult to gauge the practical importance of compensating differen- tials in explaining the wage differences that we observe.

In the end, the study of wage differences among groups does not establish any clear conclusion about the prevalence of discrimination in U.S. labor markets. Most economists believe that some of the observed wage differentials are attribut- able to discrimination, but there is no consensus about how much. The only con- clusion about which economists are in consensus is a negative one: Because the differences in average wages among groups in part reflect differences in human capital and job characteristics, they do not by themselves say anything about how much discrimination there is in the labor market.

Of course, differences in human capital among groups of workers may also reflect a kind of discrimination. The less rigorous curriculums historically offered to female students, for instance, can be considered a discriminatory practice. Sim- ilarly, the inferior schools historically available to black students may be traced to prejudice on the part of city councils and school boards. But this kind of discrim- ination occurs long before the worker enters the labor market. In this case, the disease is political, even if the symptom is economic.

CASE STUDY

IS EMILY MORE EMPLOYABLE THAN LAKISHA? Although measuring the extent of discrimination from labor- market outcomes is hard, some compelling evidence for the existence of such discrimination comes from a creative “field experiment.” Econ-

omists Marianne Bertrand and Sendhil Mullainathan answered more than 1,300 help-wanted ads run in Boston and Chicago newspapers by sending in nearly 5,000 fake résumés. Half of the résumés had names that were common in the African-American community, such as Lakisha Washington or Jamal Jones. The other half had names that were more common among the white popula- tion, such as Emily Walsh and Greg Baker. Otherwise, the résumés were similar. The results of this experiment were published in the American Economic Review in September 2004.

The researchers found large differences in how employers responded to the two groups of résumés. Job applicants with white names received about 50 per- cent more calls from interested employers than applicants with African-American names. The study found that this discrimination occurred for all types of employ- ers, including those who claimed to be an “Equal Opportunity Employer” in their help-wanted ads. The researchers concluded that “racial discrimination is still a prominent feature of the labor market.” ●

19-2b Discrimination by Employers Let’s now turn from measurement to the economic forces that lie behind dis- crimination in labor markets. If one group in society receives a lower wage than another group, even after controlling for human capital and job characteristics, who is to blame for this differential?

The answer is not obvious. It might seem natural to blame employers for dis- criminatory wage differences. After all, employers make the hiring decisions that determine labor demand and wages. If some groups of workers earn lower wages than they should, then it seems that employers are responsible. Yet many econ- omists are skeptical of this easy answer. They believe that competitive, market

394 PART VI THE ECONOMICS OF LABOR MARKETS

economies provide a natural antidote to employer discrimination. That antidote is called the profit motive.

Imagine an economy in which workers are differentiated by their hair color. Blondes and brunettes have the same skills, experience, and work ethic. Yet because of discrimination, employers prefer to hire workers with brunette hair. Thus, the demand for blondes is lower than it otherwise would be. As a result, blondes earn a lower wage than brunettes.

How long can this wage differential persist? In this economy, there is an easy way for a firm to beat out its competitors: It can hire blonde workers. By hiring blondes, a firm pays lower wages and thus has lower costs than firms that hire brunettes. Over time, more and more “blonde” firms enter the market to take advantage of this cost advantage. The existing “brunette” firms have higher costs and, therefore, begin to lose money when faced with the new competitors. These losses induce the brunette firms to go out of business. Eventually, the entry of blonde firms and the exit of brunette firms cause the demand for blonde workers to rise and the demand for brunette workers to fall. This process continues until the wage differential disappears.

Put simply, business owners who care only about making money are at an advantage when competing against those who also care about discriminating. As a result, firms that do not discriminate tend to replace those that do. In this way, competitive markets have a natural remedy for employer discrimination.

CASE STUDY

SEGREGATED STREETCARS AND THE PROFIT MOTIVE In the early 20th century, streetcars in many southern cities were seg- regated by race. White passengers sat in the front of the streetcars, and black passengers sat in the back. What do you suppose caused

and maintained this discriminatory practice? And how was this prac- tice viewed by the firms that ran the streetcars?

In a 1986 article in the Journal of Economic History, economic historian Jennifer Roback looked at these questions. Roback found that the segregation of races on streetcars was the result of laws that required such segregation. Before these laws were passed, racial discrimination in seating was rare. It was far more common to segregate smokers and nonsmokers.

Moreover, the firms that ran the streetcars often opposed the laws requiring racial segregation. Providing separate seating for different races raised the firms’ costs and reduced their profits. One railroad company manager complained to the city council that, under the segregation laws, “the company has to haul around a good deal of empty space.”

Here is how Roback describes the situation in one southern city:

The railroad company did not initiate the segregation policy and was not at all eager to abide by it. State legislation, public agitation, and a threat to arrest the president of the railroad were all required to induce them to separate the races on their cars. . . . There is no indication that the management was motivated by belief in civil rights or racial equality. The evidence indicates their primary motives were economic; separation was costly. . . . Officials of the company may or may not have disliked blacks, but they were not willing to forgo the profits necessary to indulge such prejudice.

395CHAPTER 19 EARNINGS AND DISCRIMINATION

The story of southern streetcars illustrates a general lesson: Business owners are usually more interested in making profits than in discriminating against a par- ticular group. When firms engage in discriminatory practices, the ultimate source of the discrimination often lies not with the firms themselves but elsewhere. In this particular case, the streetcar companies segregated whites and blacks because discriminatory laws, which the companies opposed, required them to do so. ●

19-2c Discrimination by Customers and Governments The profit motive is a strong force acting to eliminate discriminatory wage dif- ferentials, but there are limits to its corrective abilities. Two important limiting factors are customer preferences and government policies.

To see how customer preferences for discrimination can affect wages, con- sider again our imaginary economy with blondes and brunettes. Suppose that restaurant owners discriminate against blondes when hiring waiters. As a result, blonde waiters earn lower wages than brunette waiters. In this case, a restaurant can open up with blonde waiters and charge lower prices. If customers care only about the quality and price of their meals, the discriminatory firms will be driven out of business, and the wage differential will disappear.

On the other hand, it is possible that customers prefer being served by brunette waiters. If this discriminatory preference is strong, the entry of blonde restau- rants need not succeed in eliminating the wage differential between brunettes and blondes. That is, if customers have discriminatory preferences, a competitive market is consistent with a discriminatory wage differential. An economy with such discrimination would contain two types of restaurants. Blonde restaurants would hire blondes, have lower costs, and charge lower prices. Brunette restau- rants would hire brunettes, have higher costs, and charge higher prices. Custom- ers who did not care about the hair color of their waiters would be attracted to the lower prices at the blonde restaurants. Bigoted customers would go to the bru- nette restaurants and would pay for their discriminatory preference in the form of higher prices.

Another way for discrimination to persist in competitive markets is for the government to mandate discriminatory practices. If, for instance, the government passed a law stating that blondes could wash dishes in restaurants but could not work as waiters, then a wage differential could persist in a competitive market. The example of segregated streetcars in the previous case study is one example of government-mandated discrimination. Similarly, before South Africa abandoned its formal policy of racial segregation called apartheid in 1990, blacks were pro- hibited from working in some jobs. Discriminatory governments pass such laws to suppress the normal equalizing force of free and competitive markets.

To sum up: Competitive markets contain a natural remedy for employer discrimina- tion. The entry of firms that care only about profit tends to eliminate discriminatory wage differentials. These wage differentials persist in competitive markets only when customers are willing to pay to maintain the discriminatory practice or when the government man- dates it.

CASE STUDY

DISCRIMINATION IN SPORTS As we have seen, measuring discrimination is often difficult. To determine whether one group of workers is discriminated against, a researcher must correct for differences in the productivity between

that group and other workers in the economy. Yet in most firms, it is

396 PART VI THE ECONOMICS OF LABOR MARKETS

difficult to measure a particular worker’s contribution to the production of goods and services.

One type of firm in which such measurements are easier is the sports team. Professional teams have many objective measures of productivity. In baseball, for instance, we can measure a player’s batting average, the frequency of home runs, the number of stolen bases, and so on.

Studies of sports teams suggest that racial discrimination has, in fact, been com- mon and that much of the blame lies with customers. One study, published in the Journal of Labor Economics in 1988, examined the salaries of basketball players and found that black players earned 20 percent less than white players of comparable ability. The study also found that attendance at basketball games was larger for teams with a greater proportion of white players. One interpretation of these facts is that, at least at the time of the study, customer discrimination made black players less profitable than white players for team owners. In the presence of such cus- tomer discrimination, a discriminatory wage gap can persist, even if team owners care only about profit.

A similar situation once existed for baseball players. A study using data from the late 1960s showed that black players earned less than comparable white play- ers. Moreover, fewer fans attended games pitched by blacks than games pitched by whites, even though black pitchers had better records than white pitchers. Studies of more recent salaries in baseball, however, have found no evidence of discrimina- tory wage differentials.

Another study, published in the Quarterly Journal of Economics in 1990, examined the market prices of old baseball cards. This study found similar evidence of dis- crimination. The cards of black hitters sold for 10 percent less than the cards of comparable white hitters, and the cards of black pitchers sold for 13 percent less than the cards of comparable white pitchers. These results suggest customer dis- crimination among baseball fans. ●

QuickQuiz Why is it hard to establish whether a group of workers is being discriminated

against? • Explain how profit-maximizing firms tend to eliminate discrimi-

natory wage differentials. • How might a discriminatory wage differential persist?

19-3 Conclusion In competitive markets, workers earn a wage equal to the value of their marginal contribution to the production of goods and services. There are, however, many things that affect the value of the marginal product. Firms pay more for work- ers who are more talented, more diligent, more experienced, and more educated because these workers are more productive. Firms pay less to those workers against whom customers discriminate because these workers contribute less to revenue.

The theory of the labor market we have developed in the last two chapters explains why some workers earn higher wages than other workers. The theory does not say that the resulting distribution of income is equal, fair, or desirable in any way. That is the topic we take up in Chapter 20.

397CHAPTER 19 EARNINGS AND DISCRIMINATION

1. Ted leaves his job as a high school math teacher and

returns to school to study the latest developments

in computer programming, after which he takes

a higher-paying job at a software firm. This is an

example of

a. a compensating differential.

b. human capital.

c. signaling.

d. efficiency wages.

2. Marshall and Lily work at a local department store.

Marshall, who greets customers as they arrive, is paid

less than Lily, who cleans the bathrooms. This is an

example of

a. a compensating differential.

b. human capital.

c. signaling.

d. efficiency wages.

3. Barney runs a small manufacturing company. He

pays his employees about twice as much as other

firms in the area, even though he could pay less and

still recruit all the workers he wants. He believes

that higher wages make his workers more loyal and

hard-working. This is an example of

a. a compensating differential.

b. human capital.

c. signaling.

d. efficiency wages.

4. A business consulting firm hires Robin because she

was a math major in college. Her new job does not

require any of the mathematics she learned, but the

firm believes that anyone who can graduate with a

math degree must be very smart. This is an example of

a. a compensating differential.

b. human capital.

c. signaling.

d. efficiency wages.

5. Measuring to what extent discrimination affects labor

market outcomes is difficult because

a. data on wages are crucial but not readily available.

b. firms misreport the wages they pay to hide dis-

criminatory practices.

c. workers differ in their attributes and the types of

jobs they have.

d. the same minimum-wage law applies to workers in

all groups.

6. The forces of competition in markets with free entry

and exit tend to eliminate wage differentials that arise

from discrimination by

a. employers.

b. customers.

c. government.

d. all of the above.

CHAPTER QuickQuiz

• Workers earn different wages for many reasons. One

reason is that wage differentials play a role compen-

sating workers for job attributes. Other things being

equal, workers in hard, unpleasant jobs are paid more

than workers in easy, pleasant jobs.

• Workers with more human capital are paid more than

workers with less human capital. The return to accu-

mulating human capital is high and has increased over

the past several decades.

• Although years of education, experience, and job char-

acteristics affect earnings as theory predicts, much

variation in earnings cannot be explained by things

that economists can easily measure. The unexplained

variation in earnings is largely attributable to natural

ability, effort, and chance.

• Some economists have suggested that more educated

workers earn higher wages not because education

raises productivity but because workers with high nat-

ural ability use education as a way to signal their high

ability to employers. If this signaling theory is correct,

then increasing the educational attainment of all work-

ers would not raise the overall level of wages.

• Wages are sometimes pushed above the level that

brings supply and demand into balance. Three

explanations of above-equilibrium wages are mini-

mum-wage laws, unions, and efficiency wages.

• Some differences in earnings are attributable to dis-

crimination based on race, sex, or other factors. Mea-

suring the amount of discrimination is difficult,

however, because one must correct for differences in

human capital and job characteristics.

SUMMARY

compensating differential, p. 384

human capital, p. 385

union, p. 391

strike, p. 391

efficiency wages, p. 391

discrimination, p. 391

1. Why are coal miners paid more than other workers

with similar amounts of education?

2. In what sense is education a type of capital?

3. How might education raise a worker’s wage without

raising the worker’s productivity?

4. What conditions lead to highly compensated super-

stars? Would you expect to see superstars in dentistry?

In music? Explain.

5. Give three reasons a worker’s wage might be above

the level that balances supply and demand.

6. What difficulties arise in deciding whether a group of

workers has a lower wage because of discrimination?

7. Do the forces of economic competition tend to exacer-

bate or ameliorate discrimination based on race?

8. Give an example of how discrimination might persist

in a competitive market.

1. College students sometimes work as summer interns

for private firms or the government. Many of these

positions pay little or nothing.

a. What is the opportunity cost of taking such a job?

b. Explain why students are willing to take these

jobs.

c. If you were to compare the earnings later in life

of workers who had worked as interns and those

who had taken summer jobs that paid more, what

would you expect to find?

2. As explained in Chapter 6, a minimum-wage law

distorts the market for low-wage labor. To reduce this

distortion, some economists advocate a two-tiered

minimum-wage system, with a regular minimum

wage for adult workers and a lower, “subminimum”

wage for teenage workers. Give two reasons a single

minimum wage might distort the labor market for

teenage workers more than it would the market for

adult workers.

3. A basic finding of labor economics is that workers

who have more experience in the labor force are paid

more than workers who have less experience (holding

constant the amount of formal education). Why might

this be so? Some studies have also found that expe-

rience at the same job (called job tenure) has an extra positive influence on wages. Explain why this might

occur.

4. At some colleges and universities, economics profes-

sors receive higher salaries than professors in some

other fields.

a. Why might this be true?

• Competitive markets tend to limit the impact of dis-

crimination on wages. If the wages of a group of work-

ers are lower than those of another group for reasons

not related to marginal productivity, then nondiscrim-

inatory firms will be more profitable than discrimina-

tory firms. Profit-maximizing behavior, therefore, can

reduce discriminatory wage differentials. Discrimina-

tion persists in competitive markets, however, if cus-

tomers are willing to pay more to discriminatory firms

or if the government passes laws requiring firms to

discriminate.

398 PART VI THE ECONOMICS OF LABOR MARKETS

KEY CONCEPTS

QUESTIONS FOR REVIEW

PROBLEMS AND APPLICATIONS

399CHAPTER 19 EARNINGS AND DISCRIMINATION

b. Some other colleges and universities have a policy

of paying equal salaries to professors in all fields.

At some of these schools, economics professors

have lighter teaching loads than professors in

some other fields. What role do the differences in

teaching loads play?

5. Imagine that someone offered you a choice: You could

spend four years studying at the world’s best uni-

versity, but you would have to keep your attendance

there a secret. Or you could be awarded an official de-

gree from the world’s best university, but you couldn’t

actually attend. Which choice do you think would

enhance your future earnings more? What does your

answer say about the debate over signaling versus hu-

man capital in the role of education?

6. When recording devices were first invented more than

100 years ago, musicians could suddenly supply their

music to large audiences at low cost. How do you

suppose this development affected the income of the

best musicians? How do you suppose it affected the

income of average musicians?

7. A current debate in education is whether teachers

should be paid on a standard pay scale based solely

upon their years of training and teaching experience,

or whether part of their salary should be based upon

their performance (called “merit pay”).

a. Why might merit pay be desirable?

b. Who might be opposed to a system of merit pay?

c. What is a potential challenge of merit pay?

d. A related issue: Why might a school district de-

cide to pay teachers significantly more than the

salaries offered by surrounding districts?

8. When Alan Greenspan (who would later become

chairman of the Federal Reserve) ran an economic

consulting firm in the 1960s, he primarily hired

female economists. He once told the New York Times, “I always valued men and women equally, and I

found that because others did not, good women

economists were cheaper than men.” Is Greenspan’s

behavior profit-maximizing? Is it admirable or despi-

cable? If more employers were like Greenspan, what

would happen to the wage differential between men

and women? Why might other economic consulting

firms at the time not have followed Greenspan’s busi-

ness strategy?

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

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401

Income Inequality and Poverty

CHAPTER

20 T

he great British Prime Minister Winston Churchill once summarized alter- native economic systems as follows: “The inherent vice of capitalism is the unequal sharing of blessings. The inherent virtue of socialism is the equal

sharing of miseries.” Churchill’s quip draws attention to two important facts. First, nations that use market mechanisms to allocate resources usually achieve greater prosperity than those that do not. This is the result of Adam Smith’s invis- ible hand in action. Second, the prosperity that market economies produce is not shared equally. Incomes can differ greatly between those at the top and those at the bottom of the economic ladder. The gap between rich and poor is a fasci- nating and important topic of study—for the comfortable rich, for the struggling poor, and for the aspiring and worried middle class.

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402 PART VI THE ECONOMICS OF LABOR MARKETS

From the previous two chapters, you should have some understanding about why different people have different incomes. A person’s earnings depend on the supply and demand for that person’s labor, which in turn depend on natural abil- ity, human capital, compensating differentials, discrimination, and so on. Because labor earnings make up about two-thirds of the total income in the U.S. economy, the factors that determine wages are also largely responsible for determining how the economy’s total income is distributed among the various members of society. In other words, they determine who is rich and who is poor.

In this chapter, we discuss the distribution of income—a topic that raises some fundamental questions about the role of economic policy. One of the Ten Principles of Economics introduced in Chapter 1 is that governments can sometimes improve market outcomes. This possibility is particularly important when considering the distribution of income. The invisible hand of the marketplace allocates resources efficiently but does not necessarily allocate them fairly. As a result, many econo- mists—though not all—believe that the government should redistribute income to achieve greater equality. In doing so, however, the government runs into another of the Ten Principles of Economics: People face trade-offs. When the government enacts policies to make the distribution of income more equal, it distorts incen- tives, alters behavior, and makes the allocation of resources less efficient.

Our discussion of the distribution of income proceeds in three steps. First, we assess how much inequality there is in our society. Second, we consider some different views about the role that government should play in altering the dis- tribution of income. Third, we discuss various public policies aimed at helping society’s poorest members.

20-1 The Measurement of Inequality We begin our study of the distribution of income by addressing four questions of measurement:

• How much inequality is there in our society? • How many people live in poverty? • What problems arise in measuring the amount of inequality? • How often do people move between income classes?

These measurement questions are the natural starting point from which to discuss public policies aimed at changing the distribution of income.

20-1a U.S. Income Inequality Imagine that you lined up all the families in the economy according to their annual income. Then you divided the families into five equal groups, called quintiles. Table 1 shows the income ranges for each quintile, as well as for the top 5 percent. You can use this table to find where your family lies in the income distribution.

For examining differences in the income distribution over time, economists find it useful to present the income data as in Table 2. This table shows the share of total income that each group of families received in selected years. In 2014, the bottom quintile received 3.6 percent of all income and the top quintile received 48.9 percent of all income. In other words, even though all the quintiles include the same number of families, the top quintile has more than thirteen times as much income as the bottom quintile.

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“As far as I’m concerned, they can do what they want with the minimum wage, just as long as they keep their hands off the maximum wage.”

403CHAPTER 20 INCOME INEQUALITY AND POVERTY

The last column in the table shows the share of total income received by the very richest families. In 2014, the top 5 percent of families received 20.8 percent of all income, which was greater than the total income of the poorest 40 percent.

Table 2 also shows the distribution of income in various years beginning in 1935. At first glance, the distribution of income appears to have been remarkably stable over time. Throughout the past several decades, the bottom quintile has received about 4 to 5 percent of income, while the top quintile has received about 40 to 50 percent of income. Closer inspection of the table reveals some trends in the degree of inequality. From 1935 to 1970, the distribution gradually became more equal. The share of the bottom quintile rose from 4.1 to 5.4 percent, and the share of the top quintile fell from 51.7 to 40.9 percent. In more recent years, this trend has reversed itself. From 1970 to 2014, the share of the bottom quintile fell from 5.4 to 3.6 percent, and the share of the top quintile rose from 40.9 to 48.9 percent.

In Chapter 19, we discussed some explanations for this recent rise in inequality. Increases in international trade with low-wage countries and changes in technol- ogy have tended to reduce the demand for unskilled labor and raise the demand for skilled labor. As a result, the wages of unskilled workers have fallen relative to the wages of skilled workers, and this change in relative wages has increased inequality in family incomes.

20-1b Inequality around the World How does the amount of inequality in the United States compare to that in other countries? This question is interesting, but answering it is problematic. For some

TABLE 1

The Distribution of Income in

the United States: 2014

Source: U.S. Bureau of the Census.

Group Annual Family Income

Bottom Quintile $29,100 and below

Second Quintile $29,101–$52,697

Middle Quintile $52,698–$82,032

Fourth Quintile $82,033–$129,006

Top Quintile $129,007 and above

Top 5 percent $230,030 and above

TABLE 2

Income Inequality in the United

States

This table shows the

percentage of total before-tax

income received by families in

each fifth of the income distri-

bution and by those families in

the top 5 percent.

Source: U.S. Bureau of the Census.

Bottom Second Middle Fourth Top Top

Year Quintile Quintile Quintile Quintile Quintile 5%

2014 3.6% 9.2% 15.1% 23.2% 48.9% 20.8%

2010 3.8 9.4 15.4 23.5 47.9 20.0

2000 4.3 9.8 15.4 22.7 47.7 21.1

1990 4.6 10.8 16.6 23.8 44.3 17.4

1980 5.3 11.6 17.6 24.4 41.1 14.6

1970 5.4 12.2 17.6 23.8 40.9 15.6

1960 4.8 12.2 17.8 24.0 41.3 15.9

1950 4.5 12.0 17.4 23.4 42.7 17.3

1935 4.1 9.2 14.1 20.9 51.7 26.5

404 PART VI THE ECONOMICS OF LABOR MARKETS

countries, data are not available. Even when they are, not every country collects data in the same way; for example, some countries collect data on individual incomes, whereas other countries collect data on family incomes, and still oth- ers collect data on expenditure and use it as a crude measure of income. As a result, whenever we find a difference between two countries, we can never be sure whether it reflects a true difference in the economies or merely a difference in the way data are collected.

With this warning in mind, consider Figure 1, which compares inequality in twenty major countries. The inequality measure used here is the quintile ratio, which is the income of the richest quintile divided by the income of the poorest quintile. The most equality is found in Sweden, where the top quintile receives 3.7 times as much income as the bottom quintile. The least equality is found in South Africa, where the top group receives 28.5 times as much income as the bottom group. All countries have significant disparities between rich and poor, but the degree of inequality varies substantially around the world.

When countries are ranked by inequality, the United States ends up with more inequality than the typical country. The United States has substantially greater income disparity than most other economically advanced countries, such as Japan and Germany. But it has a more equal income distribution than some developing countries, such as South Africa and Brazil. The United States has about the same degree of inequality as China, the world’s most populous nation.

FIGURE 1

Inequality around the World

Country

Inequality Measure

Less equal

distribution

More equal

distribution

Sw ed

Pa kis

tan

Ba ng

lad es

Ge rm

an y

Ind ia

Fra nc

Eth iop

ia Jap

Ind on

es ia

Ca na

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ite d

Kin gd

Ph ilip

pin es

Ni ge

ria

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es Ch

ina

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az il

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3.7 4.1 4.7 4.7 5.0 5.1 5.3 5.4

5.7 5.8 6.9 7.3 7.6

8.4 9.1 9.8 10.1

11.1

16.9

28.5

This figure shows the ratio of the income of the richest quintile to the income of the poorest

quintile. Among these nations, Sweden and Pakistan have the most equal distribution of eco-

nomic well-being, while South Africa and Brazil have the least equal.

Source: Human Development Report 2015.

405CHAPTER 20 INCOME INEQUALITY AND POVERTY

Source: New York Times, July 20, 2014.

A global perspective reveals some good

news about inequality.

Income Inequality Is Not Rising

Globally. It’s Falling.

By Tyler Cowen

I ncome inequality has surged as a political and

economic issue, but the numbers don’t show

that inequality is rising from a global perspec-

tive. Yes, the problem has become more acute

within most individual nations, yet income

inequality for the world as a whole has been

falling for most of the last 20 years. It’s a fact

that hasn’t been noted often enough.

The finding comes from a recent investi-

gation by Christoph Lakner, a consultant at

the World Bank, and Branko Milanovic, senior

scholar at the Luxembourg Income Study Center.

And while such a framing may sound startling

at first, it should be intuitive upon reflection.

The economic surges of China, India and some

other nations have been among the most egali-

tarian developments in history.

Of course, no one should use this obser-

vation as an excuse to stop helping the less

fortunate. But it can help us see that higher

income inequality is not always the most rel-

evant problem, even for strict egalitarians.

Policies on immigration and free trade, for

example, sometimes increase inequality within

a nation, yet can make the world a better place

and often decrease inequality on the planet as

a whole.

International trade has drastically reduced

poverty within developing nations, as evidenced

by the export-led growth of China and other

countries. Yet contrary to what many economists

had promised, there is now good evidence that

the rise of Chinese exports has held down the

wages of some parts of the American middle

class. This was demonstrated in a recent paper

by the economists David H. Autor of the Massa-

chusetts Institute of Technology, David Dorn of

the Center for Monetary and Financial Studies in

Madrid, and Gordon H. Hanson of the University

of California, San Diego.

A t t h e s a m e t i m e , C h i n e s e e c o n o m i c

growth has probably raised incomes of the

top 1 percent in the United States, through

exports that have increased the value of

companies whose shares are often held by

wealthy Americans. So while Chinese growth

has added to income inequality in the United

States, it has also increased prosperity and

income equality globally.

The evidence also suggests that immigra-

tion of low-skilled workers to the United States

has a modestly negative effect on the wages

of American workers without a high school

diploma, as shown, for instance, in research

by George Borjas, a Harvard economics pro-

fessor. Yet that same immigration greatly ben-

efits those who move to wealthy countries like

the United States. (It probably also helps top

American earners, who can hire household and

child-care workers at cheaper prices.) Again,

income inequality within the nation may rise but

global inequality probably declines, especially if

the new arrivals send money back home.

From a narrowly nationalist point of view,

these developments may not be auspicious for

the United States. But that narrow viewpoint is

the main problem. We have evolved a political

debate where essentially nationalistic concerns

have been hiding behind the gentler cloak of

egalitarianism. To clear up this confusion, one

recommendation would be to preface all discus-

sions of inequality with a reminder that global

inequality has been falling and that, in this

regard, the world is headed in a fundamentally

better direction.

The message from groups like Occupy Wall

Street has been that inequality is up and that

capitalism is failing us. A more correct and

nuanced message is this: Although significant

economic problems remain, we have been living

in equalizing times for the world—a change

that has been largely for the good. That may not

make for convincing sloganeering, but it’s the

truth.

A common view is that high and rising

inequality within nations brings political

trouble, maybe through violence or even revo-

lution. So one might argue that a nationalistic

perspective is important. But it’s hardly obvi-

ous that such predictions of political turmoil

are true, especially for aging societies like the

United States that are showing falling rates

of crime.

Furthermore, public policy can adjust to

accommodate some egalitarian concerns. We can

improve our educational system, for example.

Still, to the extent that political worry

about rising domestic inequality is justified,

it suggests yet another reframing. If our

domestic politics can’t handle changes in

income distribution, maybe the problem isn’t

that capitalism is fundamentally flawed but

rather that our political institutions are inflex-

ible. Our politics need not collapse under the

pressure of a world that, over all, is becoming

wealthier and fairer. ■

Tyler Cowen is professor of economics at George

Mason University.

A Worldwide View of the Income Distribution

IN THE NEWS

406 PART VI THE ECONOMICS OF LABOR MARKETS

20-1c The Poverty Rate A commonly used gauge of the distribution of income is the poverty rate. The poverty rate is the percentage of the population whose family income falls below an absolute level called the poverty line. The poverty line is set by the federal government at roughly three times the cost of providing an adequate diet. This line depends on family size and is adjusted every year to account for changes in the level of prices.

To get some idea about what the poverty rate tells us, consider the data for 2014. In that year, the median family in the United States had an income of $66,632, and the poverty line for a family of four was $24,230. The poverty rate was 14.8 per- cent. In other words, 14.8 percent of the U.S. population were members of families with incomes below the poverty line for their family size.

Figure 2 shows the poverty rate since 1959, when the official data begin. You can see that the poverty rate fell from 22.4 percent in 1959 to a low of 11.1 percent in 1973. This decline is not surprising, as average income in the economy (adjusted for inflation) rose more than 50 percent during this period. Because the pov- erty line is an absolute rather than a relative standard, more families are pushed above the poverty line as economic growth pushes the entire income distribution upward. As John F. Kennedy once put it, a rising tide lifts all boats.

Since the early 1970s, however, the economy’s rising tide has left some boats behind. Despite continued growth in average income, the poverty rate has not declined below the level reached in 1973. This lack of progress in reducing pov- erty in recent decades is closely related to the increasing inequality we saw in Table 2. Although economic growth has raised the income of the typical family, the increase in inequality has prevented the poorest families from sharing in this greater economic prosperity.

Poverty is an economic malady that affects all groups within the population, but it does not affect all groups with equal frequency. Table 3 shows the poverty rates for several groups, and it reveals three striking facts:

• Poverty is correlated with race. Blacks and Hispanics are more than twice as likely to live in poverty as whites.

poverty rate

the percentage of the

population whose family

income falls below an

absolute level called the

poverty line

an absolute level of

income set by the fed-

eral government for each

family size below which a

family is deemed to be in

poverty

Percent of the Population

below Poverty Line

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 0

Poverty rate

FIGURE 2

The Poverty Rate

The poverty rate measures

the percentage of the

population with incomes

below an absolute level

called the poverty line.

Source: U.S. Bureau of the Census.

407CHAPTER 20 INCOME INEQUALITY AND POVERTY

• Poverty is correlated with age. Children are more likely than average to be members of poor families, and the elderly are less likely than average to be poor.

• Poverty is correlated with family composition. Families headed by a single mother are about five times as likely to live in poverty as families headed by a married couple.

These three facts have described American society for many years, and they show which people are most likely to be poor. These effects also work together: Almost half the children in black and Hispanic female-headed households live in poverty.

20-1d Problems in Measuring Inequality Although data on the income distribution and the poverty rate give us some idea about the degree of inequality in our society, interpreting these data is not always straightforward. The data are based on households’ annual incomes. What people care about, however, is not their incomes but their ability to main- tain a good standard of living. For at least three reasons, data on the income dis- tribution and the poverty rate give an incomplete picture of inequality in living standards.

In-Kind Transfers Measurements of the distribution of income and the poverty rate are based on families’ monetary income. Through various government pro- grams, however, the poor receive many nonmonetary items, including free food, housing vouchers, and medical services. Transfers given to the poor in the form of goods and services rather than cash are called in-kind transfers. Standard mea- surements of the degree of inequality do not include these in-kind transfers.

Because in-kind transfers are received mostly by the poorest members of society, the failure to include in-kind transfers as part of income greatly affects the measured poverty rate. According to a study by the Census Bureau, if in-kind transfers were included in income at their market value, the number of families in poverty would be about 10 percent lower than the standard data indicate.

The Economic Life Cycle Incomes vary predictably over people’s lives. A young worker, especially one in school, has a low income. Income rises as the worker gains maturity and experience, peaks at around age 50, and then falls sharply when the worker retires at around age 65. This regular pattern of income variation is called the life cycle.

in-kind transfers

transfers to the poor

given in the form of

goods and services rather

than cash

life cycle

the regular pattern of

income variation over a

person’s life

TABLE 3

Who Is Poor?

This table shows that the pov-

erty rate varies greatly among

different groups within the

population.

Source: U.S. Bureau of the Census. Data are for 2014.

Group Poverty Rate

All persons 14.8%

White, not Hispanic 10.1

Black 26.2

Hispanic 23.6

Asian 12.0

Children (under age 18) 21.1

Elderly (over age 64) 10.0

Married-couple families 6.2

Female household, no spouse present 33.1

408 PART VI THE ECONOMICS OF LABOR MARKETS

Because people can borrow and save to smooth out life cycle changes in income, their standard of living in any year depends more on lifetime income than on that year ’s income. The young often borrow, perhaps to go to school or to buy a house, and then repay these loans later when their incomes rise. People have their highest saving rates when they are middle-aged. Because people can save in anticipation of retirement, the large declines in incomes at retirement need not lead to similar declines in the standard of living. This normal life cycle pattern causes inequality in the distribution of annual income, but it does not necessarily represent true inequality in living standards.

Transitory versus Permanent Income Incomes vary over people’s lives not only because of predictable life cycle variation but also because of random and transi- tory forces. One year a frost kills off the Florida orange crop, and Florida orange growers see their incomes fall temporarily. At the same time, the Florida frost drives up the price of oranges, and California orange growers see their incomes temporarily rise. The next year the reverse might happen.

Just as people can borrow and save to smooth out life cycle variation in income, they can also borrow and save to smooth out transitory variation in income. To the extent that a family saves in good years and borrows (or depletes its savings) in bad years, transitory changes in income need not affect its standard of living. A family’s ability to buy goods and services depends largely on its permanent income, which is its normal, or average, income.

To gauge inequality of living standards, the distribution of permanent income is more relevant than the distribution of annual income. Many economists believe that people base their consumption on their permanent income; as a result, inequality in consumption is one gauge of inequality of permanent income. Because permanent income and consumption are less affected by transitory changes in income, they are more equally distributed than is current income.

permanent income

a person’s normal income

CASE STUDY

ALTERNATIVE MEASURES OF INEQUALITY A 2008 study by Michael Cox and Richard Alm of the Federal Reserve Bank of Dallas shows how different measures of inequality lead to dramatically different results. Cox and Alm compared American households in the top fifth of the income distribution to those in the

bottom fifth to see how far apart they are. According to Cox and Alm, the richest fifth of U.S. households in 2006 had an

average income of $149,963, while the poorest fifth had an average income of $9,974. Thus, the top group had about 15 times as much income as the bottom group.

The gap between rich and poor shrinks a bit if taxes are taken into account. Because the tax system is progressive, the top group paid a higher percentage of its income in taxes than did the bottom group. Cox and Alm found that the richest fifth had 14 times as much after-tax income as the poorest fifth.

The gap shrinks more if one looks at consumption rather than income. House- holds having an unusually good year are more likely to be in the top group and are likely to save a high fraction of their incomes. Households having an unusually bad year are more likely to be in the bottom group and are more likely to consume out of their savings. According to Cox and Alm, the consumption of the richest fifth was only 3.9 times as much as the consumption of the poorest fifth.

The consumption gap becomes smaller still if one corrects for differences in the number of people in the household. Because larger families are more likely to have

409CHAPTER 20 INCOME INEQUALITY AND POVERTY

two earners, they are more likely to find themselves near the top of the income distribution. But they also have more mouths to feed. Cox and Alm reported that households in the top fifth had an average of 3.1 people, while those in the bottom fifth had an average of 1.7 people. As a result, consumption per person in the rich- est fifth of households was only 2.1 times consumption per person in the poorest fifth.

These data show that inequality in material standards of living is much smaller than inequality in annual income. ●

20-1e Economic Mobility People sometimes speak of “the rich” and “the poor” as if these groups con- sisted of the same families year after year. But this is not at all the case. Economic mobility, the movement of people between income classes, is significant in the U.S. economy. Movements up the income ladder can be due to good luck or hard work, and movements down the ladder can be due to bad luck or laziness. Some of this mobility reflects transitory variation in income, while some reflects more persistent changes in income.

Because family income changes over time, temporary poverty is more common than the poverty rate suggests, but persistent poverty is less common. In a typical 10-year period, about one in four families falls below the poverty line in at least one year. Yet fewer than 3 percent of families are poor for 8 or more years. Because it is likely that the temporarily poor and the persistently poor face different problems, policies that aim to combat poverty need to distinguish between these groups.

Another way to gauge economic mobility is the persistence of economic success from generation to generation. Economists who have studied this topic find that having an above-average income carries over from parents to children, but the per- sistence is far from perfect, indicating substantial mobility among income classes. If a father earns 20 percent above his generation’s average income, his son will most likely earn 8 percent above his generation’s average income. There is only a small correlation between the income of a grandfather and the income of his grandson.

One result of this intergenerational economic mobility is that the U.S. economy is filled with self-made millionaires (as well as with heirs who have squandered the fortunes they inherited). According to one study, about four out of five mil- lionaires made their money on their own, often by starting and building a busi- ness or by climbing the corporate ladder. Only one in five millionaires inherited his fortune.

QuickQuiz What does the poverty rate measure? • Describe three potential problems

in interpreting the measured poverty rate.

20-2 The Political Philosophy of Redistributing Income We have just seen how the economy’s income is distributed and have considered some of the problems in interpreting measured inequality. This discussion was positive in the sense that it merely described the world as it is. We now turn to the normative question facing policymakers: What should the government do about economic inequality?

This question is not just about economics. Economic analysis alone cannot tell us whether policymakers should try to make our society more egalitarian. Our views on this question are, to a large extent, a matter of political philosophy. Yet

410 PART VI THE ECONOMICS OF LABOR MARKETS

because the government’s role in redistributing income is central to so many debates over economic policy, let’s digress from economic science to consider a bit of political philosophy.

20-2a Utilitarianism A prominent school of thought in political philosophy is utilitarianism. The founders of utilitarianism are the English philosophers Jeremy Bentham (1748– 1832) and John Stuart Mill (1806–1873). To a large extent, the goal of utilitarians is to apply the logic of individual decision making to questions concerning morality and public policy.

The starting point of utilitarianism is the notion of utility—the level of hap- piness or satisfaction that a person receives from his circumstances. Utility is a measure of well-being and, according to utilitarians, is the ultimate objective of all public and private actions. The proper goal of the government, they claim, is to maximize the sum of utility achieved by everyone in society.

The utilitarian case for redistributing income is based on the assumption of diminishing marginal utility. It seems reasonable that an extra dollar of income provides a poor person with more additional utility than an extra dollar would provide to a rich person. In other words, as a person’s income rises, the extra well-being derived from an additional dollar of income falls. This plausible assumption, together with the utilitarian goal of maximizing total utility, implies that the government should try to achieve a more equal distribution of income.

The argument is simple. Imagine that Peter and Paul are the same, except that Peter earns $80,000 and Paul earns $20,000. In this case, taking a dollar from Peter to pay Paul will reduce Peter’s utility and raise Paul’s utility. But because of diminishing marginal utility, Peter ’s utility falls by less than Paul’s utility rises. Thus, this redistribution of income raises total utility, which is the utilitarian’s objective.

At first, this utilitarian argument might seem to imply that the govern- ment should continue to redistribute income until everyone in society has exactly the same income. Indeed, that would be the case if the total amount of income—$100,000 in our example—were fixed. But in fact, it is not. Utilitari- ans reject complete equalization of incomes because they accept one of the Ten Principles of Economics presented in Chapter 1: People respond to incentives.

To take from Peter to pay Paul, the government must pursue policies that redistribute income. The U.S. federal income tax and welfare system are examples. Under these policies, people with high incomes pay high taxes, and people with low incomes receive income transfers. These income transfers are phased out: As a person earns more, he receives less from the government. Yet when Peter faces a higher income tax rate and Paul faces a system of phased-out transfers, both have less incentive to work hard, because each gets to keep only a fraction of any additional earnings. As they both work less, society’s income falls, and so does total utility. The utilitarian government has to balance the gains from greater equality against the losses from distorted incentives. To maximize total utility, therefore, the government stops short of making society fully egalitarian.

A famous parable sheds light on the utilitarian’s logic. Imagine that Peter and Paul are thirsty travelers trapped at different places in the desert. Peter’s oasis has a lot of water; Paul’s has only a little. If the government could transfer water from one oasis to the other without cost, it would maximize total utility from water by equalizing the amount in the two places. But suppose that the government has only a leaky bucket. As it tries to move water from one place to the other, some of

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

411CHAPTER 20 INCOME INEQUALITY AND POVERTY

the water is lost in transit. In this case, a utilitarian government might still try to move some water from Peter to Paul, depending on the size of Paul’s thirst and the size of the bucket’s leak. But with only a leaky bucket at its disposal, a utilitar- ian government will stop short of trying to reach complete equality.

20-2b Liberalism A second way of thinking about inequality might be called liberalism. Philoso- pher John Rawls develops this view in his book A Theory of Justice. This book was first published in 1971, and it quickly became a classic in political philosophy.

Rawls begins with the premise that a society’s institutions, laws, and policies should be just. He then takes up the natural question: How can we, the members of society, ever agree on what justice means? It might seem that every person’s point of view is inevitably based on his particular circumstances—whether he is talented or less talented, diligent or lazy, educated or less educated, born to a wealthy family or a poor one. Could we ever objectively determine what a just society would look like?

To answer this question, Rawls proposes the following thought experiment. Imagine that before any of us is born, we all get together in the beforelife (the pre-birth version of the afterlife) for a meeting to design the rules that will govern society. At this point, we are all ignorant about the station in life each of us will end up filling. In Rawls’s words, we are sitting in an “original position” behind a “veil of ignorance.” In this original position, Rawls argues, we can choose a just set of rules for society because we must consider how those rules will affect every person. As Rawls puts it, “Since all are similarly situated and no one is able to design principles to favor his particular conditions, the principles of justice are the result of fair agreement or bargain.” Designing public policies and institutions in this way allows us to be objective about what policies are just.

Rawls then considers what public policy designed behind this veil of igno- rance would try to achieve. In particular, he considers what income distribution a person would consider fair if that person did not know whether he would end up at the top, bottom, or middle of the distribution. Rawls argues that a person in the original position would be chiefly concerned about the possibility of being at the bottom of the income distribution. In designing public policies, therefore, we should aim to raise the welfare of the worst-off person in society. That is, rather than maximizing the sum of everyone’s utility, as a utilitarian would do, Rawls would strive to maximize the minimum utility. Rawls’s rule is called the maximin criterion.

Because the maximin criterion emphasizes the least fortunate person in soci- ety, it justifies public policies aimed at equalizing the distribution of income. By transferring income from the rich to the poor, society raises the well-being of the least fortunate. The maximin criterion would not, however, lead to a completely egalitarian society. If the government promised to equalize incomes completely, people would have no incentive to work hard, society’s total income would fall substantially, and the least fortunate person would be worse off. Thus, the maximin criterion still allows disparities in income because such disparities can improve incentives and thereby raise society’s ability to help the poor. Nonethe- less, because Rawls’s philosophy puts weight on only the least fortunate members of society, it calls for more income redistribution than does utilitarianism.

Rawls’s views are controversial, but the thought experiment he proposes has much appeal. In particular, this thought experiment allows us to consider the redistribution of income as a form of social insurance. That is, from the

liberalism

the political philosophy

according to which the

government should choose

policies deemed just, as

evaluated by an impartial

observer behind a “veil of

ignorance”

maximin criterion

the claim that the

government should aim to

maximize the well-being

of the worst-off person in

society

social insurance

government policy

aimed at protecting

people against the risk

of adverse events

412 PART VI THE ECONOMICS OF LABOR MARKETS

perspective of the original position behind the veil of ignorance, income redis- tribution is like an insurance policy. Homeowners buy fire insurance to protect themselves from the risk of their house burning down. Similarly, when we as a society choose policies that tax the rich to supplement the incomes of the poor, we are all insuring ourselves against the possibility that we might have been mem- bers of poor families. Because people generally dislike risk, we should be happy to have been born into a society that provides us this insurance.

It is not at all clear, however, that rational people behind the veil of igno- rance would truly be so risk averse that they would follow the maximin crite- rion. Indeed, because a person in the original position might end up anywhere in the distribution of outcomes, he might treat all possible outcomes equally when designing public policies. In this case, the best policy behind the veil of ignorance would be to maximize the average utility of members of society, and the resulting notion of justice would be more utilitarian than Rawlsian.

20-2c Libertarianism A third view of inequality is called libertarianism. The two views we have consid- ered so far—utilitarianism and liberalism—both view the total income of society as a shared resource that a social planner can freely redistribute to achieve some social goal. By contrast, libertarians argue that society itself earns no income— only individual members of society earn income. According to libertarians, the government should not take from some individuals and give to others to achieve any particular distribution of income.

For instance, philosopher Robert Nozick writes the following in his famous 1974 book Anarchy, State, and Utopia:

We are not in the position of children who have been given portions of pie by someone who now makes last minute adjustments to rectify careless cutting. There is no central distribution, no person or group entitled to control all the resources, jointly deciding how they are to be doled out. What each person gets, he gets from others who give to him in exchange for something, or as a gift. In a free society, diverse persons control different resources, and new holdings arise out of the voluntary exchanges and actions of persons.

Whereas utilitarians and liberals try to judge what amount of inequality is desirable in a society, Nozick denies the validity of this very question.

The libertarian alternative to evaluating economic outcomes is to evaluate the process by which these outcomes arise. When the distribution of income is achieved unfairly—for instance, when one person steals from another—the gov- ernment has the right and duty to remedy the problem. But as long as the process determining the distribution of income is just, the resulting distribution is fair, no matter how unequal.

Nozick criticizes Rawls’s liberalism by drawing an analogy between the dis- tribution of income in society and the distribution of grades in a course. Suppose you were asked to judge the fairness of the grades in the economics course you are now taking. Would you imagine yourself behind a veil of ignorance and choose a grade distribution without knowing the talents and efforts of each student? Or would you ensure that the process of assigning grades to students is fair without regard for whether the resulting distribution is equal or unequal? For the case of grades at least, the libertarian emphasis on process over outcomes is compelling.

Libertarians conclude that equality of opportunities is more important than equality of incomes. They believe that the government should enforce individual

libertarianism

the political philosophy

according to which the

government should punish

crimes and enforce

voluntary agreements but

not redistribute income

413CHAPTER 20 INCOME INEQUALITY AND POVERTY

rights to ensure that everyone has the same opportunity to use his talents and achieve success. Once these rules of the game are established, the government has no reason to alter the resulting distribution of income.

QuickQuiz Petra earns more than Paula. Someone proposes taxing Petra to supple-

ment Paula’s income. How would a utilitarian, a liberal, and a libertarian

each evaluate this proposal?

20-3 Policies to Reduce Poverty As we have just seen, political philosophers hold various views about what role the government should take in altering the distribution of income. Political debate among the larger population of voters reflects a similar disagreement. Despite these continuing debates, most people believe that, at the very least, the government should try to help those most in need. According to a popular metaphor, the govern- ment should provide a “safety net” to prevent any citizen from falling too far.

Poverty is one of the most difficult problems that policymakers face. Poor fam- ilies are more likely than the overall population to experience homelessness, drug dependence, health problems, teenage pregnancy, illiteracy, unemployment, and low educational attainment. Members of poor families are more likely both to commit crimes and to be victims of crimes. Although it is hard to separate the causes of poverty from the effects, there is no doubt that poverty is associated with various economic and social ills.

Suppose that you were a policymaker in the government and your goal was to reduce the number of people living in poverty. How would you achieve this goal? Here we examine some of the policy options that you might consider. Each of these options helps some people escape poverty, but none of them is perfect, and deciding upon the best combination to use is not easy.

20-3a Minimum-Wage Laws Laws setting a minimum wage that employers can pay workers are a perennial source of debate. Advocates view the minimum wage as a way of helping the working poor without any cost to the government. Critics view it as hurting those it is intended to help.

The minimum wage is easily understood using the tools of supply and demand, as we first saw in Chapter 6. For workers with low levels of skill and experience, a high minimum wage forces the wage above the level that balances supply and demand. It therefore raises the cost of labor to firms and reduces the quantity of labor that those firms demand. The result is higher unemployment among those groups of workers affected by the minimum wage. Those workers who remain employed benefit from a higher wage, but those who might have been employed at a lower wage are worse off.

The magnitude of these effects depends crucially on the elasticity of labor demand. Advocates of a high minimum wage argue that the demand for unskilled labor is relatively inelastic so that a high minimum wage depresses employment only slightly. Critics of the minimum wage argue that labor demand is more elas- tic, especially in the long run when firms can adjust employment and production more fully. They also note that many minimum-wage workers are teenagers from middle-class families so that a high minimum wage is imperfectly targeted as a policy for helping the poor.

414 PART VI THE ECONOMICS OF LABOR MARKETS

20-3b Welfare One way for the government to raise the living standards of the poor is to supplement their incomes. The primary way the government does this is through the welfare system. Welfare is a broad term that encompasses various government programs. Temporary Assistance for Needy Families (TANF) is a program that assists families with children and no adult able to support the family. In a typical family receiving such assistance, the father is absent and the mother is at home raising small children. Another welfare program is Supplemental Security Income (SSI), which provides as- sistance to the poor who are sick or disabled. Note that for both of these welfare pro- grams, a poor person cannot qualify for assistance simply by having a low income. He must also establish some additional “need,” such as small children or a disability.

A common criticism of welfare programs is that they create incentives for peo- ple to become “needy.” For example, these programs may encourage families to break up, for many families qualify for financial assistance only if the father is absent. The programs may also encourage illegitimate births, for many poor, sin- gle women qualify for assistance only if they have children. Because poor, single mothers are such a large part of the poverty problem and because welfare pro- grams seem to raise the number of poor, single mothers, critics of the welfare sys- tem assert that these policies exacerbate the very problems they are supposed to cure. As a result of these arguments, the welfare system was revised in a 1996 law that limited the amount of time recipients could stay on welfare.

How severe are these potential problems with the welfare system? No one knows for sure. Proponents of the welfare system point out that being a poor, single mother on welfare is a difficult existence at best, and they do not believe that many people would choose such a life if it were not thrust upon them. More- over, trends over time do not support the view that the decline of the two-parent family is largely a symptom of the welfare system, as the system’s critics some- times claim. Since the early 1970s, welfare benefits (adjusted for inflation) have declined, yet the percentage of children living with only one parent has risen.

20-3c Negative Income Tax Whenever the government chooses a system to collect taxes, it affects the dis- tribution of income. This is clearly true in the case of a progressive income tax, whereby high-income families pay a larger percentage of their income in taxes than do low-income families. As we discussed in Chapter 12, equity across income groups is an important goal in the design of a tax system.

Many economists have advocated supplementing the income of the poor using a negative income tax. According to this policy, every family would report its income to the government. High-income families would pay a tax based on their incomes. Low-income families would receive a subsidy. In other words, they would “pay” a “negative tax.”

For example, suppose the government used the following formula to compute a family’s tax liability:

Taxes owed = (1/3 of income) – $10,000.

In this case, a family that earned $60,000 would pay $10,000 in taxes, and a fam- ily that earned $90,000 would pay $20,000 in taxes. A family that earned $30,000 would owe nothing. And a family that earned $15,000 would “owe” −$5,000. In other words, the government would send this family a check for $5,000.

Under a negative income tax, poor families would receive financial assistance without having to demonstrate need. The only qualification required to receive

welfare

government programs

that supplement the

incomes of the needy

negative income tax

a tax system that

collects revenue from

high- income households

and gives subsidies to

low- income households

415CHAPTER 20 INCOME INEQUALITY AND POVERTY

assistance would be a low income. Depending on one’s point of view, this feature can be either an advantage or a disadvantage. On the one hand, a negative income tax does not encourage illegitimate births and the breakup of families, as critics of the welfare system believe current policy does. On the other hand, a negative income tax would subsidize not only the unfortunate but also those who are sim- ply lazy and, in some people’s eyes, undeserving of government support.

One actual tax provision that works much like a negative income tax is the Earned Income Tax Credit (EITC). This credit allows poor working families to receive income tax refunds greater than the taxes they paid during the year. Because the EITC applies only to the working poor, it does not discourage recipients from work- ing, as other antipoverty programs may. For the same reason, however, it also does not help alleviate poverty due to unemployment, sickness, or other inability to work.

20-3d In-Kind Transfers Another way to help the poor is to provide them directly with some of the goods and services they need to raise their living standards. For example, charities provide the needy with food, clothing, shelter, and toys at Christmas. The gov- ernment gives poor families food through the Supplemental Nutrition Assis- tance Program, or SNAP. This program, which replaced a similar one called food stamps, gives low-income families a plastic card, like a debit card, that can be used to buy food at stores. The government also gives many poor people health- care through a program called Medicaid.

Is it better to help the poor with these in-kind transfers or with direct cash payments? There is no clear answer.

Advocates of in-kind transfers argue that such transfers ensure that the poor get what they need most. Among the poorest members of society, alcohol and drug addiction is more common than it is in society as a whole. By providing the poor with food and shelter, society can be more confident that it is not helping to support such addictions. This is one reason in-kind transfers are more politically popular than cash payments to the poor.

Advocates of cash payments, on the other hand, argue that in-kind transfers are inefficient and disrespectful. The government does not know what goods and services the poor need most. Many of the poor are ordinary people down on their luck. Despite their misfortune, they are in the best position to decide how to raise their own living standards. Rather than giving the poor in-kind transfers of goods and services that they may not want, it may be better to give them cash and allow them to buy what they think they need most.

20-3e Antipoverty Programs and Work Incentives Many policies aimed at helping the poor can have the unintended effect of dis- couraging the poor from escaping poverty on their own. To see why, consider the following example. Suppose that a family needs an income of $20,000 to maintain a reasonable standard of living. And suppose that, out of concern for the poor, the government promises to guarantee every family that income. Whatever a family earns, the government makes up the difference between that income and $20,000. What effect would you expect this policy to have?

The incentive effects of this policy are obvious: Any person who would make under $20,000 by working has little incentive to find and keep a job. For every dollar that the person would earn, the government would reduce the income supplement by a dollar. In effect, the government taxes 100 percent of additional earnings. An effective marginal tax rate of 100 percent is surely a policy with a large deadweight loss.

416 PART VI THE ECONOMICS OF LABOR MARKETS

Many nations have more generous

social safety nets than the United

States, but they also have very different

tax systems.

Combating Inequality May

Require Broader Tax

By Eduardo Porter

R arely have we experienced such a con-

fluence of arguments in favor of raising

taxes on the rich. After a hard-won re- election

fought mainly over taxes and spending,

President Obama arguably has a mandate

from voters to tap the wealthy to address our

budget woes.

[Author’s note: Shortly after this article

was written, President Obama did indeed sign

into law an increase in taxes on high incomes.

These higher tax rates went into effect in

2013.]…

Yet while raising more taxes from the win-

ners in the globalized economy is a start, and

may help us dig out of our immediate fiscal

hole, it is unlikely to be enough to address

our long-term needs. The experience of many

other developed countries suggests that pay-

ing for a government that could help the poor

and the middle class cope in our brave new

globalized world will require more money from

the middle class itself.

Many Americans may find this hard to

believe, but the United States already has one

of the most progressive tax systems in the

developed world, according to several stud-

ies, raising proportionately more revenue from

the wealthy than other advanced countries

do. Taxes on American households do more to

redistribute resources and reduce inequality

than the tax codes of most other rich nations.

But taxation provides only half the picture

of public finance. Despite the progressivity of

our taxes, according to a study of public fi-

nances across the industrial countries in the

Organization for Economic Cooperation and

Development, we also have one of the least

effective governments at combating income

inequality. There is one main reason: our tax

code does not raise enough money.

This paradox underscores two crucial les-

sons we could learn from the experience of our

peers around the globe. The first is that the

government’s success at combating income

inequality is determined less by the progres-

sivity of either the tax code or the benefits

than by the amount of tax revenue that the

government can spend on programs that ben-

efit the middle class and the poor.

The second is that very progressive tax

codes are not very effective at raising money.

The corollary—suggested by Peter Lindert

of the University of California, Davis in his

2004 book Growing Public—is that insisting

on highly progressive taxes that draw most

revenue from the rich may result in more

inequality than if we relied on a flatter, more

“regressive” tax schedule to raise money from

everybody and pay for a government that

could help every American family attain a

decent standard of living.

Consider government aid for families.

According to the O.E.C.D. study, our Tem-

porary Assistance for Needy Families is the

most progressive program of cash benefits for

families among 22 advanced countries, accu-

rately targeted to serve the poor.

But American family cash benefits are

the least effective at reducing inequality. The

reason is that they are so meager. The entire

budget for cash assistance for families in

the United States amounts to one-tenth of

1 percent of the nation’s economic output.

The average across the O.E.C.D. nations is

11 times bigger. Even including tax breaks

and direct government services, we spend a

much smaller share of our economic output

on family assistance than almost any other

advanced nation.

International Differences in Income Redistribution

IN THE NEWS

The adverse effects of this high effective tax rate can persist over time. A person discouraged from working loses the on-the-job training that a job might offer. In addition, his children miss the lessons learned by observing a parent with a full- time job, and this may adversely affect their own ability to find and hold a job.

The antipoverty program we have been discussing is hypothetical, but it is not as unrealistic as it might first appear. Welfare, Medicaid, SNAP, and the EITC are all programs aimed at helping the poor, and they are all tied to family income. As a family’s income rises, the family becomes ineligible for these programs. When all these programs are taken together, it is common for families to face effective marginal tax rates that are very high. Sometimes the effective marginal tax rates even exceed 100 percent so that poor families are worse off when they earn more. By trying to help the poor, the government discourages those families from

417CHAPTER 20 INCOME INEQUALITY AND POVERTY

Source: New York Times, November 28, 2012.

The same pattern can be found across a

range of government programs. The reason is

always the same: their relatively small size.

Over all, government cash benefits in the

United States—including pensions, disability,

unemployment insurance and the like—con-

tribute about 10 percent to household income,

on average, according to the study. The aver-

age across industrial nations is twice that.

Our budget reveals a core philosophical

difference with other advanced countries.

In the big-government social democracies

like those of Western Europe, government is

expected to guarantee a set of universal pub-

lic services—from health care to child care to

pensions—that are considered basic rights

of citizenry. To pay for this minimum welfare

package, everybody is expected to contribute

proportionately into the pot.

Government in the United States has a

different goal. Benefits are narrower. Social

Security and Medicare follow a universal service

template, but only for older Americans. Other

social spending is aimed carefully to benefit the

poor. Financed through a more progressive tax

code, it looks more like charity than a universal

right. On top of that, our philosophical stance

virtually ensures a small government.

Progressive taxes make it hard to raise

money because they distort people’s behav-

ior. They encourage taxpayers to reduce their

tax liability rather than to increase their pre-

tax income. High corporate taxes encourage

companies to avoid them. High taxes on cap-

ital income also encourage avoidance and

capital flight. High income tax rates on top

earners can discourage work and investment,

too. So trying to raise a lot of money with

our progressive tax code would probably not

achieve the goal and could damage economic

growth.

Big-government social democracies,

by contrast, rely on flatter taxes to finance

their public spending, like gas taxes and

value-added taxes on consumption. The

Nordic countries, for instance, have very

low tax rates on capital income relative to

income from work. And they have relatively

high taxes on consumption. In Denmark,

consumption tax revenue amounts to about

11 percent of the nation’s economy. In the

United States, sales taxes and excise taxes

on cigarettes and other items amount to

roughly 4 percent.

Liberal Democrats have long opposed

them because they fall much more heavily

on the poor, who spend a larger share of their

incomes than the rich. But these taxes have

one big positive feature: they are difficult to

avoid and produce fewer disincentives to work

or invest. That means they can be used to

raise much more revenue.

Public finances are under strain today

on both sides of the Atlantic, as govern-

ments struggle to cope with our long global

recession and the aging of the baby boom

generation. In Southern Europe, the pressure

to pare back universal welfare systems is

intense. In the United States, political lead-

ers on both sides of the partisan divide have

realized that even our relatively meager pack-

age of social goods cannot be sustained with

our slim tax take.

But the United States has one option that

most of Europe’s flailing economies do not. Its

tax revenue is so low, comparatively, that it

has more space to raise it. A more efficient,

flatter tax schedule would allow us to do so

without hindering economic activity.

Bruce Bartlett, a tax expert who served in

the administrations of Ronald Reagan and

George H. W. Bush, told me last week that he

thought federal tax revenue could increase to

22 percent of the nation’s economic output, well

above its historical average of 18.5 percent,

without causing economic harm. If President

Obama tries to go down this road, however, he

may have to build a flatter tax code.

“We should reform the tax system, no

question,” William Gale, a tax policy expert

at the Brookings Institution and co-director of

the nonpartisan Tax Policy Center, wrote in an

e-mail. “We are going to need to move beyond

the current set of tax instruments to raise the

needed revenues—a VAT and/or a carbon

tax seem like the obvious ways to go.” And

Mr. Bartlett also pointed out: “We can’t get all

the revenue we need from the rich. Eventually,

everyone will have to pay more.” ■

working. According to critics of antipoverty programs, these programs alter work attitudes and create a “culture of poverty.”

It might seem that there is an easy solution to this problem: Reduce benefits to poor families more gradually as their incomes rise. For example, if a poor family loses 30 cents of benefits for every dollar it earns, then it faces an effective mar- ginal tax rate of 30 percent. This effective tax reduces work effort to some extent, but it does not eliminate the incentive to work completely.

The problem with this solution is that it greatly increases the cost of programs to combat poverty. If benefits are phased out gradually as a poor family’s income rises, then families just above the poverty level will also be eligible for substantial benefits. The more gradual the phase-out, the more families are eligible, and the more the program costs. Thus, policymakers face a trade-off between burdening

418 PART VI THE ECONOMICS OF LABOR MARKETS

20-4 Conclusion

the poor with high effective marginal tax rates and burdening taxpayers with costly programs to reduce poverty.

There are various other ways to reduce the work disincentive of antipoverty programs. One is to require any person collecting benefits to accept a govern- ment-provided job—a system sometimes called workfare. Another possibility is to provide benefits for only a limited period of time. This route was taken in the 1996 welfare reform bill, which imposed a 5-year lifetime limit on welfare recipients. When President Clinton signed the bill, he explained his policy as follows: “Wel- fare should be a second chance, not a way of life.”

QuickQuiz List three policies aimed at helping the poor, and discuss the pros and

cons of each.

People have long reflected on the distribution of income in society. Plato, the ancient Greek philosopher, concluded that in an ideal society the income of the richest person would be no more than four times the income of the poorest per- son. Although the measurement of inequality is difficult, it is clear that our society has much more inequality than Plato recommended.

One of the Ten Principles of Economics discussed in Chapter 1 is that govern- ments can sometimes improve market outcomes. There is little consensus, how- ever, about how this principle should be applied to the distribution of income. Philosophers and policymakers today do not agree on how much income inequal- ity is desirable, or even whether public policy should aim to alter the distribution of income. Much of public debate reflects this disagreement. Whenever taxes are raised, for instance, lawmakers argue over how much of the tax hike should fall on the rich, the middle class, and the poor.

Another of the Ten Principles of Economics is that people face trade-offs. This principle is important to keep in mind when thinking about economic inequal- ity. Policies that penalize the successful and reward the unsuccessful reduce the incentive to succeed. Thus, policymakers face a trade-off between equality and efficiency. The more equally the pie is divided, the smaller the pie becomes. This is the one lesson concerning the distribution of income about which almost every- one agrees.

419CHAPTER 20 INCOME INEQUALITY AND POVERTY

• Data on the distribution of income show a wide dispar-

ity in U.S. society. The richest fifth of families earns more

than twelve times as much income as the poorest fifth.

• Because in-kind transfers, the economic life cycle, transi-

tory income, and economic mobility are so important for

understanding variation in income, it is difficult to gauge

the degree of inequality in our society using data on the

distribution of income in a single year. When these other

factors are taken into account, they tend to suggest that

economic well-being is more equally distributed than is

annual income.

• Political philosophers differ in their views about the role

of government in altering the distribution of income.

Utilitarians (such as John Stuart Mill) would choose

the distribution of income that maximizes the sum of

utility of everyone in society. Liberals (such as John

Rawls) would determine the distribution of income as if

we were behind a “veil of ignorance” that prevented us

from knowing our stations in life. Libertarians (such as

Robert Nozick) would have the government enforce indi-

vidual rights to ensure a fair process but then would not

be concerned about inequality in the resulting distribu-

tion of income.

• Various policies aim to help the poor—minimum-wage

laws, welfare, negative income taxes, and in-kind trans-

fers. While these policies help alleviate poverty, they also

have unintended side effects. Because financial assistance

declines as income rises, the poor often face very high

effective marginal tax rates, which discourage poor fami-

lies from escaping poverty on their own.

CHAPTER QuickQuiz

1. In the United States today, the poorest fifth of the popu-

lation earns about _____ percent of all income, while the

richest fifth earns about _____ percent.

a. 2, 70

b. 4, 50

c. 6, 35

d. 8, 25

2. When income inequality is compared across nations, one

finds that the United States is

a. the most equal nation in the world.

b. more equal than most nations but not the most equal.

c. less equal than most nations but not the least equal.

d. the least equal nation in the world.

3. A utilitarian believes that the redistribution of income

from the rich to the poor is worthwhile as long as

a. the worst-off members of society benefit from it.

b. those contributing to the system are in favor of it.

c. each person’s income, after taxes and transfers, re-

flects his marginal product.

d. the distortionary effect on work incentives is not too

large.

4. Rawls’s thought experiment of the “original position”

behind the “veil of ignorance” is meant to draw attention

to the fact that

a. most of the poor do not know how to find better jobs

and escape poverty.

b. the station of life each of us was born into is largely a

matter of luck.

c. the rich have so much money that they don’t know

how to spend it all.

d. outcomes are efficient only if everyone begins with

equal opportunity.

5. A negative income tax is a policy under which

a. individuals with low income get transfers from the

government.

b. the government raises tax revenue without distorting

incentives.

c. everyone pays less than under a conventional income

tax.

d. some taxpayers are on the wrong side of the Laffer

curve.

6. If the benefits from an antipoverty program are phased

out as an individual’s income increases, then the pro-

gram will

a. encourage greater work effort from the poor.

b. lead to an excess supply of labor among unskilled

workers.

c. increase the effective marginal tax rate that the poor

face.

d. cost the government more than a program that bene-

fits everyone.

SUMMARY

420 PART VI THE ECONOMICS OF LABOR MARKETS

QUESTIONS FOR REVIEW

1. Does the richest fifth of the U.S. population earn closer

to three, six, or twelve times the income of the poorest

fifth?

2. What has happened to the income share of the richest

fifth of the U.S. population over the past 40 years?

3. What groups in the U.S. population are most likely to

live in poverty?

4. When gauging the amount of inequality, why do

transitory and life cycle variations in income cause

difficulties?

5. How would a utilitarian, a liberal, and a libertar-

ian each determine how much income inequality is

permissible?

6. What are the pros and cons of in-kind (rather than

cash) transfers to the poor?

7. Describe how antipoverty programs can discourage

the poor from working. How might you reduce this

disincentive? What are the disadvantages of your

proposed policy?

PROBLEMS AND APPLICATIONS

1. Table 2 shows that income inequality in the United

States has increased since 1970. Some factors contrib-

uting to this increase were discussed in Chapter 19.

What are they?

2. Table 3 shows that the percentage of children in fam-

ilies with income below the poverty line far exceeds

the percentage of the elderly in such families. How

might the allocation of government money across

different social programs have contributed to this

phenomenon?

3. This chapter discusses the importance of economic

mobility.

a. What policies might the government pursue to

increase economic mobility within a generation? b. What policies might the government pursue to

increase economic mobility across generations? c. Do you think we should reduce spending on

current welfare programs to increase spending on

programs that enhance economic mobility? What

are some of the advantages and disadvantages of

doing so?

4. Consider two communities. In one community,

ten families have incomes of $100,000 each and ten

families have incomes of $20,000 each. In the other

community, ten families have incomes of $200,000

each and ten families have incomes of $22,000 each.

a. In which community is the distribution of

income more unequal? In which community is

the problem of poverty likely to be worse?

b. Which distribution of income would Rawls

prefer? Explain.

c. Which distribution of income do you prefer?

Explain.

d. Why might someone have the opposite

preference?

5. This chapter uses the analogy of a “leaky bucket” to

explain one constraint on the redistribution of income.

a. What elements of the U.S. system for redistribut-

ing income create the leaks in the bucket?

Be specific.

b. Do you think that Republicans or Democrats gen-

erally believe that the bucket used for redistribut-

ing income is leakier? How does that belief affect

their views about the amount of income redistri-

bution that the government should undertake?

KEY CONCEPTS

poverty rate, p. 406

poverty line, p. 406

in-kind transfers, p. 407

life cycle, p. 407

permanent income, p. 408

utilitarianism, p. 410

utility, p. 410

liberalism, p. 411

maximin criterion, p. 411

social insurance, p. 411

libertarianism, p. 412

welfare, p. 414

negative income tax, p. 414

421CHAPTER 20 INCOME INEQUALITY AND POVERTY

6. Suppose there are two possible income distributions

in a society of ten people. In the first distribution, nine

people have incomes of $30,000 and one person has an

income of $10,000. In the second distribution, all ten

people have incomes of $25,000.

a. If the society had the first income distribution,

what would be the utilitarian argument for redis-

tributing income?

b. Which income distribution would Rawls consider

more equitable? Explain.

c. Which income distribution would Nozick

consider more equitable? Explain.

7. The poverty rate would be substantially lower if the

market value of in-kind transfers were added to fam-

ily income. The largest in-kind transfer is Medicaid,

the government health program for the poor. Let’s say

the program costs $10,000 per recipient family.

a. If the government gave each recipient family a

$10,000 check instead of enrolling them in the

Medicaid program, do you think that most of

these families would spend that money to pur-

chase health insurance? Why? (Recall that the

poverty level for a family of four is about $23,000.)

b. How does your answer to part (a) affect your view

about whether we should determine the poverty

rate by valuing in-kind transfers at the price the

government pays for them? Explain.

c. How does your answer to part (a) affect your

view about whether we should provide assistance

to the poor in the form of cash transfers or in-kind

transfers? Explain.

8. Consider two of the income security programs in the

United States: Temporary Assistance for Needy Fam-

ilies (TANF) and the Earned Income Tax Credit (EITC).

a. When a woman with children and very low

income earns an extra dollar, she receives less in

TANF benefits. What do you think is the effect

of this feature of TANF on the labor supply of

low-income women? Explain.

b. The EITC provides greater benefits as low-

income workers earn more income (up to a

point). What do you think is the effect of this

program on the labor supply of low-income indi-

viduals? Explain.

c. What are the disadvantages of eliminating TANF

and allocating the savings to the EITC?

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

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PART VII

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425

The Theory of Consumer Choice

CHAPTER

21 W

hen you walk into a store, you are confronted with thousands of goods that you might buy. Because your financial resources are limited, however, you cannot buy everything that you want. You therefore consider the prices of

the various goods offered for sale and buy a bundle of goods that, given your resources, best suits your needs and desires.

In this chapter, we develop a theory that describes how consumers make deci- sions about what to buy. Thus far in this book, we have summarized consumers’ decisions with the demand curve. As we have seen, the demand curve for a good

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426 PART VII TOPICS FOR FURTHER STUDY

reflects consumers’ willingness to pay for that good. When the price rises, con- sumers are willing to pay for fewer units, so the quantity demanded falls. We now look more deeply at the decisions that lie behind the demand curve. The theory of consumer choice presented in this chapter provides a more complete understand- ing of demand, just as the theory of the competitive firm in Chapter 14 provides a more complete understanding of supply.

One of the Ten Principles of Economics discussed in Chapter 1 is that people face trade-offs. The theory of consumer choice examines the trade-offs that people face as consumers. When a consumer buys more of one good, she can afford less of other goods. When she spends more time enjoying leisure and less time work- ing, she has lower income and therefore lower consumption. When she spends more of her income in the present and saves less of it, she reduces the amount she will be able to consume in the future. The theory of consumer choice examines how consumers facing these trade-offs make decisions and how they respond to changes in their environment.

After developing the basic theory of consumer choice, we apply it to three questions about household decisions. In particular, we ask:

• Do all demand curves slope downward? • How do wages affect labor supply? • How do interest rates affect household saving?

At first, these questions might seem unrelated. But as we will see, we can use the theory of consumer choice to address each of them.

21-1 The Budget Constraint: What the Consumer Can Afford Most people would like to increase the quantity or quality of the goods they con- sume—to take longer vacations, drive fancier cars, or eat at better restaurants. People consume less than they desire because their spending is constrained, or lim- ited, by their income. We begin our study of consumer choice by examining this link between income and spending.

To keep things simple, we examine the decision facing a consumer who buys only two goods: pizza and Pepsi. Of course, real people buy thousands of dif- ferent kinds of goods. Assuming there are only two goods greatly simplifies the problem without altering the basic insights about consumer choice.

We first consider how the consumer ’s income constrains the amount she spends on pizza and Pepsi. Suppose the consumer has an income of $1,000 per month and spends her entire income on pizza and Pepsi. The price of a pizza is $10, and the price of a liter of Pepsi is $2.

The table in Figure 1 shows some of the many combinations of pizza and Pepsi that the consumer can buy. The first row in the table shows that if the consumer spends all her income on pizza, she can eat 100 pizzas during the month, but she would not be able to buy any Pepsi at all. The second row shows another possible consumption bundle: 90 pizzas and 50 liters of Pepsi. And so on. Each consump- tion bundle in the table costs exactly $1,000.

The graph in Figure 1 illustrates the consumption bundles that the consumer can choose. The vertical axis measures the number of liters of Pepsi, and the horizontal axis measures the number of pizzas. Three points are marked on this

427CHAPTER 21 THE THEORY OF CONSUMER CHOICE

figure. At point A, the consumer buys no Pepsi and consumes 100 pizzas. At point B, the consumer buys no pizza and consumes 500 liters of Pepsi. At point C, the consumer buys 50 pizzas and 250 liters of Pepsi. Point C, which is exactly at the middle of the line from A to B, is the point at which the consumer spends an equal amount ($500) on pizza and Pepsi. These are only three of the many combinations of pizza and Pepsi that the consumer can choose. All the points on the line from A to B are possible. This line, called the budget constraint, shows the consumption bundles that the consumer can afford. In this case, it shows the trade-off between pizza and Pepsi that the consumer faces.

The slope of the budget constraint measures the rate at which the consumer can trade one good for the other. Recall that the slope between two points is calculated as the change in the vertical distance divided by the change in the horizontal dis- tance (“rise over run”). From point A to point B, the vertical distance is 500 liters, and the horizontal distance is 100 pizzas. Thus, the slope is 5 liters per pizza. (Actually, because the budget constraint slopes downward, the slope is a negative number. But for our purposes we can ignore the minus sign.)

Notice that the slope of the budget constraint equals the relative price of the two goods—the price of one good compared to the price of the other. A pizza costs five times as much as a liter of Pepsi, so the opportunity cost of a pizza is 5 liters of Pepsi. The budget constraint’s slope of 5 reflects the trade-off the market is offer- ing the consumer: 1 pizza for 5 liters of Pepsi.

QuickQuiz Draw the budget constraint for a person with income of $1,000 if the

price of Pepsi is $5 and the price of pizza is $10. What is the slope of

this budget constraint?

budget constraint

the limit on the

consumption bundles

that a consumer can

afford

FIGURE 1

The Consumer’s Budget Constraint

100 Quantity of Pizza

Quantity of Pepsi

250

500 B

Consumer’s budget constraint

The budget constraint shows the various bundles of goods that the consumer

can buy for a given income. Here the consumer buys bundles of pizza and

Pepsi. The table and graph show what the consumer can afford if her income

is $1,000, the price of pizza is $10, and the price of Pepsi is $2.

Number

of Pizzas

Liters

of Pepsi

Spending

on Pizza

Spending

on Pepsi

Total

Spending

100 0 $1,000 $ 0 $1,000

90 50 900 100 1,000

80 100 800 200 1,000

70 150 700 300 1,000

60 200 600 400 1,000

50 250 500 500 1,000

40 300 400 600 1,000

30 350 300 700 1,000

20 400 200 800 1,000

10 450 100 900 1,000

0 500 0 1,000 1,000

428 PART VII TOPICS FOR FURTHER STUDY

Our goal in this chapter is to understand how consumers make choices. The bud- get constraint is one piece of the analysis: It shows the combinations of goods the consumer can afford given her income and the prices of the goods. The consum- er ’s choices, however, depend not only on her budget constraint but also on her preferences regarding the two goods. Therefore, the consumer ’s preferences are the next piece of our analysis.

21-2a Representing Preferences with Indifference Curves The consumer’s preferences allow her to choose among different bundles of pizza and Pepsi. If you offer the consumer two different bundles, she chooses the bun- dle that best suits her tastes. If the two bundles suit her tastes equally well, we say that the consumer is indifferent between the two bundles.

Just as we have represented the consumer ’s budget constraint graphically, we can also represent her preferences graphically. We do this with indifference curves. An indifference curve shows the various bundles of consumption that make the consumer equally happy. In this case, the indifference curves show the combinations of pizza and Pepsi with which the consumer is equally satisfied.

Figure 2 shows two of the consumer’s many indifference curves. The consumer is indifferent among combinations A, B, and C because they are all on the same curve. Not surprisingly, if the consumer ’s consumption of pizza is reduced, say, from point A to point B, consumption of Pepsi must increase to keep her equally happy. If consumption of pizza is reduced again, from point B to point C, the amount of Pepsi consumed must increase yet again.

The slope at any point on an indifference curve equals the rate at which the consumer is willing to substitute one good for the other. This rate is called the marginal rate of substitution (MRS). In this case, the marginal rate of substitution measures how much Pepsi the consumer requires to be compensated for a one- unit reduction in pizza consumption. Notice that because the indifference curves are not straight lines, the marginal rate of substitution is not the same at all points on a given indifference curve. The rate at which a consumer is willing to trade one good for the other depends on the amounts of the goods she is already consuming. In other words, the rate at which a consumer is willing to trade pizza

indifference curve

a curve that shows

consumption bundles

that give the consumer

the same level of

satisfaction

21-2 Preferences: What the Consumer Wants

FIGURE 2

The Consumer’s Preferences

The consumer’s preferences are repre-

sented with indifference curves, which

show the combinations of pizza and Pepsi

that make the consumer equally satisfied.

Because the consumer prefers more of

a good, points on a higher indifference

curve (I 2 ) are preferred to points on a

lower indifference curve (I 1 ). The mar-

ginal rate of substitution (MRS) shows

the rate at which the consumer is willing

to trade Pepsi for pizza. It measures the

quantity of Pepsi the consumer must be

given in exchange for 1 pizza.

Quantity of Pizza

Quantity of Pepsi

Indifference curve, I 1

I 2MRS

marginal rate of

substitution

the rate at which a con-

sumer is willing to trade

one good for another

Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203CCopy i hright 20t 2018 C18 Cenga Lge Learniing AllAll RiRighthts RRese drved MMay not bt be copi died sca dnned or dduplilicat dted iin h lwhole or iin tpart WWCN 0CN 02 202 200 200 2033

429CHAPTER 21 THE THEORY OF CONSUMER CHOICE

for Pepsi depends on whether she is hungrier or thirstier, which in turn depends on her current consumption of pizza and Pepsi.

The consumer is equally happy at all points on any given indifference curve, but she prefers some indifference curves to others. Because she prefers more consumption to less, higher indifference curves are preferred to lower ones. In Figure 2, any point on curve I

2 is preferred to any point on curve I

1 .

A consumer’s set of indifference curves gives a complete ranking of the consum- er’s preferences. That is, we can use the indifference curves to rank any two bundles of goods. For example, the indifference curves tell us that point D is preferred to point A because point D is on a higher indifference curve than point A. (That con- clusion may be obvious, however, because point D offers the consumer both more pizza and more Pepsi.) The indifference curves also tell us that point D is preferred to point C because point D is on a higher indifference curve. Even though point D has less Pepsi than point C, it has more than enough extra pizza to make the con- sumer prefer it. By seeing which point is on the higher indifference curve, we can use the set of indifference curves to rank any combination of pizza and Pepsi.

21-2b Four Properties of Indifference Curves Because indifference curves represent a consumer’s preferences, they have certain properties that reflect those preferences. Here we consider four properties that describe most indifference curves:

• Property 1: Higher indifference curves are preferred to lower ones. People usually prefer to consume more rather than less. This preference for greater quanti- ties is reflected in the indifference curves. As Figure 2 shows, higher indif- ference curves represent larger quantities of goods than lower indifference curves. Thus, the consumer prefers being on higher indifference curves.

• Property 2: Indifference curves are downward-sloping. The slope of an indiffer- ence curve reflects the rate at which the consumer is willing to substitute one good for the other. In most cases, the consumer likes both goods. Therefore, if the quantity of one good is reduced, the quantity of the other good must increase for the consumer to be equally happy. For this reason, most indiffer- ence curves slope downward.

• Property 3: Indifference curves do not cross. To see why this is true, suppose that two indifference curves did cross, as in Figure 3. Then, because point A

FIGURE 3

The Impossibility of Intersecting

Indifference Curves

A situation like this can never happen.

According to these indifference curves,

the consumer would be equally satisfied

at points A, B, and C, even though

point C has more of both goods than

point A.

Quantity of Pizza

Quantity of Pepsi

Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203CopyCopyrighright 20t 2018 C18 Cengaengage Lge Learnearninging AllAll RigRightshts ReseReservedrved MaMay noy not bet be copcopiedied scascannednned oror dupduplicalicatedted inin wholwhole ore or inin partpart WWCN 0CN 02 202 200 200 2033

430 PART VII TOPICS FOR FURTHER STUDY

is on the same indifference curve as point B, the two points would make the consumer equally happy. In addition, because point B is on the same indif- ference curve as point C, these two points would make the consumer equally happy. But these conclusions imply that points A and C would also make the consumer equally happy, even though point C has more of both goods. This contradicts our assumption that the consumer always prefers more of both goods to less. Thus, indifference curves cannot cross.

• Property 4: Indifference curves are bowed inward. The slope of an indifference curve is the marginal rate of substitution—the rate at which the consumer is willing to trade off one good for the other. The marginal rate of substitu- tion (MRS) usually depends on the amount of each good the consumer is currently consuming. In particular, because people are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little, the indifference curves are bowed inward toward the graph’s origin. As an example, consider Figure 4. At point A, because the consumer has a lot of Pepsi and only a little pizza, she is very hungry but not very thirsty. To induce the consumer to give up 1 pizza, she has to be given 6 liters of Pepsi: The MRS is 6 liters per pizza. By contrast, at point B, the consumer has little Pepsi and a lot of pizza, so she is very thirsty but not very hungry. At this point, she would be willing to give up 1 pizza to get 1 liter of Pepsi: The MRS is 1 liter per pizza. Thus, the bowed shape of the indifference curve reflects the consumer’s greater willingness to give up a good that she already has a lot of.

21-2c Two Extreme Examples of Indifference Curves The shape of an indifference curve reveals the consumer ’s willingness to trade one good for the other. When the goods are easy to substitute for each other, the indifference curves are less bowed; when the goods are hard to substitute, the

FIGURE 4

Bowed Indifference Curves

Indifference curves are usually bowed

inward. This shape implies that the

marginal rate of substitution (MRS)

depends on the quantity of the two goods

the consumer is currently consuming. At

point A, the consumer has little pizza and

much Pepsi, so she requires a lot of extra

Pepsi to induce her to give up one of the

pizzas: The MRS is 6 liters of Pepsi per

pizza. At point B, the consumer has much

pizza and little Pepsi, so she requires

only a little extra Pepsi to induce her to

give up one of the pizzas: The MRS is

1 liter of Pepsi per pizza.

Quantity of Pizza

Quantity of Pepsi

0 2 3 6 7

Indifference curve

MRS = 6

MRS = 1

431CHAPTER 21 THE THEORY OF CONSUMER CHOICE

indifference curves are very bowed. To see why this is true, let’s consider the extreme cases.

Perfect Substitutes Suppose that someone offered you bundles of nickels and dimes. How would you rank the different bundles?

Most likely, you would care only about the total monetary value of each bun- dle. If so, you would always be willing to trade 2 nickels for 1 dime. Your mar- ginal rate of substitution between nickels and dimes would be a fixed number: MRS = 2, regardless of the number of nickels and dimes in the bundle.

We can represent your preferences for nickels and dimes with the indifference curves in panel (a) of Figure 5. Because the marginal rate of substitution is con- stant, the indifference curves are straight lines. In this extreme case of straight indifference curves, we say that the two goods are perfect substitutes.

Perfect Complements Suppose now that someone offered you bundles of shoes. Some of the shoes fit your left foot, others your right foot. How would you rank these different bundles?

In this case, you might care only about the number of pairs of shoes. In other words, you would judge a bundle based on the number of pairs you could assemble from it. A bundle of 5 left shoes and 7 right shoes yields only 5 pairs. Getting 1 more right shoe has no value if there is no left shoe to go with it.

We can represent your preferences for right and left shoes with the indifference curves in panel (b) of Figure 5. In this case, a bundle with 5 left shoes and 5 right shoes is just as good as a bundle with 5 left shoes and 7 right shoes. It is also just as good as a bundle with 7 left shoes and 5 right shoes. The indifference curves, therefore, are right angles. In this extreme case of right-angle indifference curves, we say that the two goods are perfect complements.

perfect substitutes

two goods with straight-

line indifference curves

When two goods are easily substitutable, such as nickels and dimes, the indifference curves

are straight lines, as shown in panel (a). When two goods are strongly complementary, such

as left shoes and right shoes, the indifference curves are right angles, as shown in panel (b).

FIGURE 5

Perfect Substitutes and Perfect

Complements

Dimes1 2 3 750

Nickels

(a) Perfect Substitutes

Right Shoes0

Left Shoes

(b) Perfect Complements

I 1 I 2 I 3

I 1

I 2

perfect complements

two goods with right-

angle indifference curves

432 PART VII TOPICS FOR FURTHER STUDY

In the real world, of course, most goods are neither perfect substitutes (like nickels and dimes) nor perfect complements (like right shoes and left shoes). More typically, the indifference curves are bowed inward, but not so bowed that they become right angles.

QuickQuiz Draw some indifference curves for pizza and Pepsi. Explain the four prop-

erties of these indifference curves.

21-3 Optimization: What the Consumer Chooses The goal of this chapter is to understand how a consumer makes choices. We have the two pieces necessary for this analysis: the consumer’s budget constraint (how much she can afford to spend) and the consumer’s preferences (what she wants to spend it on). Now we put these two pieces together and consider the consumer ’s decision about what to buy.

21-3a The Consumer’s Optimal Choices Once again, consider our pizza and Pepsi example. The consumer would like to end up with the best possible combination of pizza and Pepsi for her—that is, the combination on her highest possible indifference curve. But the consumer must also end up on or below her budget constraint, which measures the total resources available to her.

Figure 6 shows the consumer ’s budget constraint and three of her many indifference curves. The highest indifference curve that the consumer can reach (I

2 in the figure) is the one that just barely touches her budget constraint. The

point at which this indifference curve and the budget constraint touch is called the optimum. The consumer would prefer point A, but she cannot afford that point because it lies above her budget constraint. The consumer can afford point B, but that point is on a lower indifference curve and, therefore, provides the consumer less satisfaction. The optimum represents the best combination of pizza and Pepsi available to the consumer.

FIGURE 6

The Consumer’s Optimum

The consumer chooses the point on her budget

constraint that lies on the highest indifference

curve. At this point, called the optimum, the

marginal rate of substitution equals the relative

price of the two goods. Here the highest indif-

ference curve the consumer can reach is I 2 .

The consumer prefers point A, which lies on

indifference curve I 3 , but she cannot afford this

bundle of pizza and Pepsi. By contrast, point B

is affordable, but because it lies on a lower indif-

ference curve, the consumer does not prefer it. Quantity of Pizza

Quantity of Pepsi

Optimum

A B

Budget constraint

I 1 I 2

I 3

433CHAPTER 21 THE THEORY OF CONSUMER CHOICE

Notice that, at the optimum, the slope of the indifference curve equals the slope of the budget constraint. We say that the indifference curve is tangent to the bud- get constraint. The slope of the indifference curve is the marginal rate of substitu- tion between pizza and Pepsi, and the slope of the budget constraint is the relative price of pizza and Pepsi. Thus, the consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price.

In Chapter 7, we saw how market prices reflect the marginal value that con- sumers place on goods. This analysis of consumer choice shows the same result in another way. In making her consumption choices, the consumer takes the relative price of the two goods as given and then chooses an optimum at which her mar- ginal rate of substitution equals this relative price. The relative price is the rate at which the market is willing to trade one good for the other, whereas the mar- ginal rate of substitution is the rate at which the consumer is willing to trade one good for the other. At the consumer ’s optimum, the consumer ’s valuation of the

Utility: An Alternative Way to Describe Preferences and Optimization

W e have used indifference curves to represent the consumer’s pref-

erences. Another common way to represent preferences is with the

concept of utility. Utility is an abstract measure of the satisfaction or

happiness that a consumer receives from a bundle of goods. Economists

say that a consumer prefers one bundle of goods to another if one pro-

vides more utility than the other.

Indifference curves and utility are closely related. Because the con-

sumer prefers points on higher indifference curves, bundles of goods on

higher indifference curves provide higher utility. Because the consumer

is equally happy with all points on the same indifference curve, all these

bundles provide the same utility. You can think of an indifference curve

as an “equal-utility” curve.

The marginal utility of any good is the increase in utility that the

consumer gets from an additional unit of that good. Most goods are

assumed to exhibit diminishing marginal utility : The more of the good

the consumer already has, the lower the marginal utility provided by an

extra unit of that good.

The marginal rate of substitution between two goods depends on

their marginal utilities. For example, if the marginal utility of good

X is twice the marginal utility of good Y, then a person would need

2 units of good Y to compensate for losing 1 unit of good X, and the

MRS equals 2. More generally, the marginal rate of substitution (and

thus the slope of the indifference curve) equals the marginal utility

of one good divided by the marginal utility of the other good.

Utility analysis provides another way to describe consumer optimi-

zation. Recall that, at the consumer’s optimum, the marginal rate of

substitution equals the ratio of prices. That is,

MRS = P X /P

Y .

Because the marginal rate

of substitution equals the

ratio of marginal utilities,

we can write this condition

for optimization as

MU X /MU

Y = P

X /P

Y .

Now rearrange this expression to become

MU X /P

X = MU

Y /P

Y .

This equation has a simple interpretation: At the optimum, the marginal

utility per dollar spent on good X equals the marginal utility per dol-

lar spent on good Y. If this equality did not hold, the consumer could

increase utility by spending less on the good that provided lower mar-

ginal utility per dollar and more on the good that provided higher mar-

ginal utility per dollar.

When economists discuss the theory of consumer choice, they

sometimes express the theory using different words. One economist

might say that the goal of the consumer is to maximize utility. Another

economist might say that the goal of the consumer is to end up on the

highest possible indifference curve. The first economist would conclude

that at the consumer’s optimum, the marginal utility per dollar is

the same for all goods, whereas the second would conclude that the

indifference curve is tangent to the budget constraint. In essence, these

are two ways of saying the same thing. ■

F Y I

434 PART VII TOPICS FOR FURTHER STUDY

two goods (as measured by the marginal rate of substitution) equals the market’s valuation (as measured by the relative price). As a result of this consumer optimi- zation, market prices of different goods reflect the value that consumers place on those goods.

21-3b How Changes in Income Affect the Consumer’s Choices Now that we have seen how the consumer makes a consumption decision, let’s examine how this decision responds to changes in the consumer ’s income. To be specific, suppose that income increases. With higher income, the consumer can afford more of both goods. The increase in income, therefore, shifts the budget constraint outward, as in Figure 7. Because the relative price of the two goods has not changed, the slope of the new budget constraint is the same as the slope of the initial budget constraint. That is, an increase in income leads to a parallel shift in the budget constraint.

The expanded budget constraint allows the consumer to choose a better combination of pizza and Pepsi, one that is on a higher indifference curve. Given the shift in the budget constraint and the consumer ’s preferences as represented by her indifference curves, the consumer’s optimum moves from the point labeled “initial optimum” to the point labeled “new optimum.”

Notice that, in Figure 7, the consumer chooses to consume more Pepsi and more pizza. The logic of the model does not require increased consumption of both goods in response to increased income, but this situation is the most common. As you may recall from Chapter 4, if a consumer wants more of a good when her income rises, economists call it a normal good. The indifference curves in Figure 7 are drawn under the assumption that both pizza and Pepsi are normal goods.

normal good

a good for which an

increase in income raises

the quantity demanded

FIGURE 7

An Increase in Income

When the consumer’s income

rises, the budget constraint

shifts outward. If both goods

are normal goods, the consumer

responds to the increase in

income by buying more of both

of them. Here the consumer

buys more pizza and more

Pepsi.

Quantity of Pizza

Quantity of Pepsi

New optimum

New budget constraint

I 1

I 2

2. . . . raising pizza consumption . . .

3. . . . and raising Pepsi consumption.

Initial budget constraint

Initial optimum

1. An increase in income shifts the budget constraint outward . . .

435CHAPTER 21 THE THEORY OF CONSUMER CHOICE

Figure 8 shows an example in which an increase in income induces the consumer to buy more pizza but less Pepsi. If a consumer buys less of a good when her income rises, economists call it an inferior good. Figure 8 is drawn under the assumption that pizza is a normal good and Pepsi is an inferior good.

Although most goods in the world are normal goods, there are some inferior goods as well. An example is bus rides. As income increases, consumers are more likely to own cars or take taxis and less likely to ride the bus. Bus rides, therefore, are an inferior good.

21-3c How Changes in Prices Affect the Consumer’s Choices Let’s now use this model of consumer choice to consider how a change in the price of one of the goods alters the consumer ’s choices. Suppose, in particular, that the price of Pepsi falls from $2 to $1 per liter. It is no surprise that the lower price expands the consumer’s set of buying opportunities. In other words, a fall in the price of any good shifts the budget constraint outward.

Figure 9 considers more specifically how the fall in price affects the budget constraint. If the consumer spends her entire $1,000 income on pizza, then the price of Pepsi is irrelevant. Thus, point A in the figure stays the same. Yet if the consumer spends her entire income of $1,000 on Pepsi, she can now buy 1,000 liters rather than only 500. Thus, the endpoint of the budget constraint moves from point B to point D.

Notice that in this case the outward shift in the budget constraint changes its slope. (This differs from what happened previously when prices stayed the same but the consumer’s income changed.) As we have discussed, the slope of the budget constraint reflects the relative price of pizza and Pepsi. Because the price of Pepsi has fallen to $1 from $2, while the price of pizza has remained $10, the consumer can now trade a pizza for 10 rather than 5 liters of Pepsi. As a result, the new budget constraint has a steeper slope.

inferior good

a good for which an

increase in income

reduces the quantity

demanded

FIGURE 8

An Inferior Good

A good is inferior if the consumer

buys less of it when her income

rises. Here Pepsi is an inferior

good: When the consumer’s

income increases and the budget

constraint shifts outward, the

consumer buys more pizza but

less Pepsi.

Quantity of Pizza

Quantity of Pepsi

Initial optimum

New optimum

Initial budget constraint

New budget constraint

I 1 I 2

1. When an increase in income shifts the budget constraint outward . . .3. . . . but

Pepsi consumption falls, making Pepsi an inferior good.

2. . . . pizza consumption rises, making pizza a normal good . . .

436 PART VII TOPICS FOR FURTHER STUDY

How such a change in the budget constraint alters the consumption of both goods depends on the consumer’s preferences. For the indifference curves drawn in this figure, the consumer buys more Pepsi and less pizza.

21-3d Income and Substitution Effects The impact of a change in the price of a good on consumption can be decomposed into two effects: an income effect and a substitution effect. To see what these two effects are, consider how our consumer might respond when she learns that the price of Pepsi has fallen. She might reason in the following ways:

• “Great news! Now that Pepsi is cheaper, my income has greater purchasing power. I am, in effect, richer than I was. Because I am richer, I can buy both more pizza and more Pepsi.” (This is the income effect.)

• “Now that the price of Pepsi has fallen, I get more liters of Pepsi for every pizza that I give up. Because pizza is now relatively more expensive, I should buy less pizza and more Pepsi.” (This is the substitution effect.)

Which statement do you find more compelling? In fact, both of these statements make sense. The decrease in the price of Pepsi

makes the consumer better off. If pizza and Pepsi are both normal goods, the consumer will want to spread this improvement in her purchasing power over both goods. This income effect tends to make the consumer buy more pizza and more Pepsi. Yet at the same time, consumption of Pepsi has become less expensive relative to consumption of pizza. This substitution effect tends to make the consumer choose less pizza and more Pepsi.

Now consider the result of these two effects working at the same time. The consumer certainly buys more Pepsi because the income and substitution effects both act to increase purchases of Pepsi. But for pizza, the income and substitution effects work in opposite directions. As a result, whether the consumer buys more

income effect

the change in

consumption that results

when a price change

moves the consumer

to a higher or lower

indifference curve

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

FIGURE 9

A Change in Price

When the price of Pepsi falls,

the consumer’s budget con-

straint shifts outward and

changes slope. The consumer

moves from the initial optimum

to the new optimum, which

changes her purchases of both

pizza and Pepsi. In this case,

the quantity of Pepsi consumed

rises, and the quantity of pizza

consumed falls.

Quantity of Pizza

100

Quantity of Pepsi

1,000

500

New optimum

I 1 I 2

Initial optimum

New budget constraint

Initial budget constraint

1. A fall in the price of Pepsi rotates the budget constraint outward . . .

3. . . . and raising Pepsi consumption.

2. . . . reducing pizza consumption . . .

437CHAPTER 21 THE THEORY OF CONSUMER CHOICE

or less pizza is not clear. The outcome could go either way, depending on the sizes of the income and substitution effects. Table 1 summarizes these conclusions.

We can interpret the income and substitution effects using indifference curves. The income effect is the change in consumption that results from the movement to a new indifference curve. The substitution effect is the change in consumption that results from moving to a new point on the same indifference curve with a different marginal rate of substitution.

Figure 10 shows graphically how to decompose the change in the consumer ’s decision into the income effect and the substitution effect. When the price of Pepsi falls, the consumer moves from the initial optimum, point A, to the new optimum, point C. We can view this change as occurring in two steps. First, the consumer moves along the initial indifference curve, I

1 , from point A to point B. The consumer

FIGURE 10

Income and Substitution Effects

The effect of a change in price can be broken

down into an income effect and a substi-

tution effect. The substitution effect—the

movement along an indifference curve to

a point with a different marginal rate of

substitution—is shown here as the change

from point A to point B along indifference

curve I 1 . The income effect—the shift to a

higher indifference curve—is shown here

as the change from point B on indifference

curve I 1 to point C on indifference curve I

2 .

Quantity of Pizza

Quantity of Pepsi

Income effect

Substitution effect

C New optimum

I 1

I 2

Initial optimum

New budget constraint

Initial budget constraint

Substitution effect

Income effect

TABLE 1

Income and Substitution

Effects When the Price of

Pepsi Falls

Good Income Effect Substitution Effect Total Effect

Pepsi Consumer is richer, Pepsi is relatively Income and substitution

so she buys more Pepsi. cheaper, so consumer effects act in the

buys more Pepsi. same direction,

so consumer buys

more Pepsi.

Pizza Consumer is richer, Pizza is relatively Income and substitution

so she buys more pizza. more expensive, effects act in

so consumer buys opposite directions,

less pizza. so the total effect

on pizza consumption

is ambiguous.

438 PART VII TOPICS FOR FURTHER STUDY

is equally happy at these two points, but at point B, the marginal rate of substitution reflects the new relative price. (The dashed line through point B is parallel to the new budget constraint and thus reflects the new relative price.) Next, the consumer shifts to the higher indifference curve, I

2 , by moving from point B to point C. Even

though point B and point C are on different indifference curves, they have the same marginal rate of substitution. That is, the slope of the indifference curve I

1 at point B

equals the slope of the indifference curve I 2 at point C.

The consumer never actually chooses point B, but this hypothetical point is useful to clarify the two effects that determine the consumer’s decision. Notice that the change from point A to point B represents a pure change in the marginal rate of substitution without any change in the consumer ’s welfare. Similarly, the change from point B to point C represents a pure change in welfare without any change in the marginal rate of substitution. Thus, the movement from A to B shows the substitution effect, and the movement from B to C shows the income effect.

21-3e Deriving the Demand Curve We have just seen how changes in the price of a good alter the consumer’s budget constraint and, therefore, the quantities of the two goods that she chooses to buy. The demand curve for any good reflects these consumption decisions. Recall that a demand curve shows the quantity demanded of a good for any given price. We can view a consumer’s demand curve as a summary of the optimal decisions that arise from her budget constraint and indifference curves.

For example, Figure 11 considers the demand for Pepsi. Panel (a) shows that when the price of a liter falls from $2 to $1, the consumer’s budget constraint shifts outward. Because of both income and substitution effects, the consumer increases her purchases of Pepsi from 250 to 750 liters. Panel (b) shows the demand curve

FIGURE 11

Deriving the Demand Curve

Quantity of Pizza

250 7500

250 Demand

(a) The Consumer’s Optimum

Quantity of Pepsi

Price of Pepsi

(b) The Demand Curve for Pepsi

Quantity of Pepsi

750 B A

I 1

I 2

New budget constraint

Initial budget constraint

Panel (a) shows that when the price of Pepsi falls from $2 to $1, the consumer’s

optimum moves from point A to point B, and the quantity of Pepsi consumed rises

from 250 to 750 liters. The demand curve in panel (b) reflects this relationship

between the price and the quantity demanded.

439CHAPTER 21 THE THEORY OF CONSUMER CHOICE

that results from this consumer ’s decisions. In this way, the theory of consumer choice provides the theoretical foundation for the consumer ’s demand curve.

It may be comforting to know that the demand curve arises naturally from the theory of consumer choice, but this exercise by itself does not justify developing the theory. There is no need for a rigorous, analytic framework just to establish that people respond to changes in prices. The theory of consumer choice is, however, useful in studying various decisions that people make as they go about their lives, as we see in the next section.

QuickQuiz Draw a budget constraint and indifference curves for pizza and Pepsi.

Show what happens to the budget constraint and the consumer’s optimum

when the price of pizza rises. In your diagram, decompose the change into an income effect

and a substitution effect.

21-4 Three Applications Now that we have developed the basic theory of consumer choice, let’s use it to shed light on three questions about how the economy works. These three questions might at first seem unrelated. But because each question involves household decision making, we can address it with the model of consumer behavior we have just developed.

21-4a Do All Demand Curves Slope Downward? Normally, when the price of a good rises, people buy less of it. This typical behavior, called the law of demand, is reflected in the downward slope of the demand curve.

As a matter of economic theory, however, demand curves can sometimes slope upward. In other words, consumers can sometimes violate the law of demand and buy more of a good when the price rises. To see how this can happen, consider Figure 12. In this example, the consumer buys two goods—meat and potatoes.

FIGURE 12

A Giffen Good

In this example, when the price of potatoes

rises, the consumer’s optimum shifts from

point C to point E. In this case, the con-

sumer responds to a higher price of potatoes

by buying less meat and more potatoes.

Quantity of Meat

Quantity of Potatoes

I 2 I 1

Initial budget constraint

New budget constraint

2. . . . which increases potato consumption if potatoes are a Giffen good.

Optimum with low price of potatoes

Optimum with high price of potatoes

1. An increase in the price of potatoes rotates the budget constraint inward . . .

440 PART VII TOPICS FOR FURTHER STUDY

Initially, the consumer’s budget constraint is the line from point A to point B. The optimum is point C. When the price of potatoes rises, the budget constraint shifts inward and is now the line from point A to point D. The optimum is now point E. Notice that a rise in the price of potatoes has led the consumer to buy a larger quantity of potatoes.

Why is the consumer responding in this strange way? In this example, potatoes are a strongly inferior good; that is, potatoes are a good that a person buys a lot less of when her income rises and a lot more of when her income falls. In Figure 12, the increase in the price of potatoes makes the consumer poorer; that is, the higher price puts her on a lower indifference curve. Because she is poorer and potatoes are an inferior good, the income effect makes her want to buy less meat and more potatoes. At the same time, because the potatoes have become more expensive relative to meat, the substitution effect makes the consumer want to buy more meat and fewer potatoes. If the income effect is much larger than the substitution effect, as it is in this example, the consumer responds to the higher price of potatoes by buying less meat and more potatoes.

Economists use the term Giffen good to describe a good that violates the law of demand. (The term is named for economist Robert Giffen, who first noted this possibility.) In this example, potatoes are a Giffen good. Giffen goods are inferior goods for which the income effect dominates the substitution effect. Therefore, they have demand curves that slope upward.

CASE STUDY

THE SEARCH FOR GIFFEN GOODS Have any actual Giffen goods ever been observed? Some historians suggest that potatoes were a Giffen good during the Irish potato famine of the 19th century. Potatoes were such a large part of people’s

diet that when the price of potatoes rose, the change had a large income effect. People responded to their reduced living standard by cutting back on the luxury of meat and buying more of the staple food of potatoes. Thus, it is argued that a higher price of potatoes actually raised the quantity of potatoes demanded.

A study by Robert Jensen and Nolan Miller, published in the American Economic Review in 2008, produced similar but more concrete evidence for the existence of Giffen goods. These two economists conducted a field experiment for five months in the Chinese province of Hunan. They gave randomly selected households vouchers that subsidized the purchase of rice, a staple in local diets, and used surveys to measure how consumption of rice responded to changes in the price. They found strong evidence that poor households exhibited Giffen behavior. Lowering the price of rice with the subsidy voucher caused households to reduce their consumption of rice, and removing the subsidy had the opposite effect. Jensen and Miller wrote, “To the best of our knowledge, this is the first rigorous empirical evidence of Giffen behavior.”

Thus, the theory of consumer choice allows demand curves to slope upward, and sometimes that strange phenomenon actually occurs. As a result, the law of demand we first saw in Chapter 4 is not completely reliable. It is safe to say, however, that Giffen goods are very rare. ●

21-4b How Do Wages Affect Labor Supply? So far, we have used the theory of consumer choice to analyze how a person allocates income between two goods. We can apply the same theory to analyze how a person allocates time. People spend some of their time enjoying leisure and

Giffen good

a good for which an

increase in the price

raises the quantity

demanded

441CHAPTER 21 THE THEORY OF CONSUMER CHOICE

some of it working so they can afford to buy consumption goods. The essence of the time-allocation problem is the trade-off between leisure and consumption.

Consider the decision facing Kayla, a freelance software designer. Kayla is awake for 100 hours per week. She spends some of this time enjoying leisure— playing Minecraft, watching The Bachelor on television, and reading this textbook. She spends the rest of this time at her computer developing software. For every hour she works developing software, she earns $50, which she spends on consumption goods—food, clothing, and music downloads. Her hourly wage of $50 reflects the trade-off Kayla faces between leisure and consumption. For every hour of leisure she gives up, she works one more hour and gets $50 of consumption.

Figure 13 shows Kayla’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 40-hour week, she enjoys 60 hours of leisure and has weekly consumption of $2,000.

Figure 13 uses indifference curves to represent Kayla’s preferences for consumption and leisure. Here consumption and leisure are the two “goods” between which Kayla is choosing. Because Kayla 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, Kayla 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, I

2 .

Now consider what happens when Kayla’s wage increases from $50 to $60 per hour. Figure 14 illustrates two possible outcomes. In each case, the budget constraint, shown in the left graphs, shifts outward from BC

1 to BC

2 . In the process,

the budget constraint becomes steeper, reflecting the change in relative price: At the higher wage, Kayla earns more consumption for every hour of leisure that she gives up.

Kayla’s preferences, as represented by her indifference curves, determine how her choice regarding consumption and leisure responds to the higher wage. In both panels, consumption rises. Yet the response of leisure to the change in the

FIGURE 13

The Work-Leisure Decision

This figure shows Kayla’s budget constraint

for deciding how much to work, her indiffer-

ence curves for consumption and leisure, and

her optimum.

Hours of Leisure0

2,000

$5,000

Consumption

100

Optimum

442 PART VII TOPICS FOR FURTHER STUDY

wage is different in the two cases. In panel (a), Kayla responds to the higher wage by enjoying less leisure. In panel (b), Kayla responds by enjoying more leisure.

Kayla’s decision between leisure and consumption determines her supply of labor because the more leisure she enjoys, the less time she has left to work. In each panel of Figure 14, the right graph shows the labor-supply curve implied by Kayla’s decision. In panel (a), a higher wage induces Kayla to enjoy less leisure

FIGURE 14

An Increase in the Wage

Hours of Leisure

Consumption

(a) For a person with these preferences . . .

Hours of Labor Supplied

Wage

. . . the labor supply curve slopes upward.

Hours of Leisure

Consumption

(b) For a person with these preferences . . .

Hours of Labor Supplied

Wage

. . . the labor supply curve slopes backward.

I 1

I 2BC2

BC1

I 1

I 2

BC2

BC1

1. When the wage rises . . .

2. . . . hours of leisure increase . . . 3. . . . and hours of labor decrease.

2. . . . hours of leisure decrease . . . 3. . . . and hours of labor increase.

1. When the wage rises . . .

Labor supply

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, BC 1 , and new budget

constraint, BC 2 , 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.

443CHAPTER 21 THE THEORY OF CONSUMER CHOICE

and work more, so the labor-supply curve slopes upward. In panel (b), a higher wage induces Kayla 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 Kayla’s wage rises, leisure becomes more expensive relative to consumption, and this encourages Kayla to substitute away from leisure and toward consumption. In other words, the substitution effect induces Kayla to work more in response to higher wages, which tends to make the labor-supply curve slope upward.

Now consider the income effect. When Kayla’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 Kayla to work more or less. If the substitution effect is greater than the income effect, 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

IN COME 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, does indeed 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. This 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 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 9 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. “No more 9 to 5 for me.”

G ET

TY IM

A G

ES N

EW S/

G ET

TY IM

A G

444 PART VII TOPICS FOR FURTHER STUDY

Similar results were found in a 1993 study, published in 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 19th-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. ●

21-4c How Do Interest Rates Affect Household Saving? 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 Saul, a worker planning for retirement. To keep things simple, let’s divide Saul’s life into two periods. In the first period, Saul is young and working. In the second period, he is old and retired. When young, Saul earns $100,000. He divides this income between current consumption and saving. When he is old, Saul will consume what he has saved, including the interest that his savings have earned.

Suppose the interest rate is 10 percent. Then for every dollar that Saul 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 Saul must choose between. The interest rate determines the relative price of these two goods.

Figure 15 shows Saul’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 15

The Consumption-Saving Decision

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 Young

55,000

$110,000

$50,000

Consumption When Old

100,000

Optimum

I 3

I 2

I 1

Budget constraint

445CHAPTER 21 THE THEORY OF CONSUMER CHOICE

Figure 15 uses indifference curves to represent Saul’s preferences for consumption in the two periods. Because Saul prefers more consumption in both periods, he prefers points on higher indifference curves to points on lower ones. Given his preferences, Saul 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, Saul consumes $50,000 when young and $55,000 when old.

Now consider what happens when the interest rate increases from 10 to 20 percent. Figure 16 shows two possible outcomes. In both cases, the budget constraint shifts outward and becomes steeper. At the new, higher interest rate, Saul gets more consumption when old for every dollar of consumption that he gives up when young.

The two panels show the results given different preferences by Saul. 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), Saul responds to the higher interest rate by consuming less when young. In panel (b), Saul responds by consuming more when young.

Saul’s saving is his income when young minus the amount he consumes when young. In panel (a), an increase in the interest rate reduces consumption when young, so saving must rise. In panel (b), an increase in the interest rate induces Saul to consume more when young, so saving must fall.

The case shown in panel (b) might at first seem odd: Saul responds to an increase in the return to saving by saving less. But 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.

(a) Higher Interest Rate Raises Saving (b) Higher Interest Rate Lowers Saving

Consumption When Old

I 1

I 2

BC1

BC2

I 1 I 2

BC1

BC2

Consumption When Old

Consumption When Young

1. A higher interest rate rotates the budget constraint outward . . .

2. . . . resulting in lower consumption when young and, thus, higher saving.

2. . . . resulting in higher consumption when young and, thus, lower saving.

Consumption When Young

FIGURE 16

An Increase in the Interest Rate

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.

446 PART VII TOPICS FOR FURTHER STUDY

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 Saul to consume more when old and less when young. In other words, the substitution effect induces Saul to save more.

Now consider the income effect. When the interest rate rises, Saul 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.

The result depends on both the income and substitution effects. If the substitution effect of a higher interest rate is greater than the income effect, Saul saves more. If the income effect is greater than the substitution effect, Saul saves less. Thus, the theory of consumer choice says that an increase in the interest rate could either encourage or discourage saving.

This ambiguous result is interesting from the standpoint of economic theory, but 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 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.

QuickQuiz Explain how an increase in the wage can potentially decrease the amount

that a person wants to work.

21-5 Conclusion: Do People Really Think This 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 pizza and Pepsi, work and leisure, consumption and saving, and so on.

At this point, however, you might be tempted to look upon 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 do not decide by writing down budget constraints and indifference curves. Doesn’t this knowledge about your own decision making 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 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 do 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.

447CHAPTER 21 THE THEORY OF CONSUMER CHOICE

Just as the proof of the pudding is in the eating, the test of a theory is in its applications. In the last section of this chapter, we applied the theory of consumer choice to three 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.

1. Emilio buys pizza for $10 and soda for $2. He

has income of $100. His budget constraint will

experience a parallel outward shift if which of the

following events occur?

a. The price of pizza falls to $5, the price of soda

falls to $1, and his income falls to $50.

b. The price of pizza rises to $20, the price of soda

rises to $4, and his income remains the same.

c. The price of pizza falls to $8, the price of soda

falls to $1, and his income rises to $120.

d. The price of pizza rises to $20, the price of soda

rises to $4, and his income rises to $400.

2. At any point on an indifference curve, the slope of the

curve measures the consumer’s

a. income.

b. willingness to trade one good for the other.

c. perception of the two goods as substitutes or

complements.

d. elasticity of demand.

3. Matthew and Susan are both optimizing consumers in

the markets for shirts and hats, where they pay $100

for a shirt and $50 for a hat. Matthew buys 4 shirts

and 16 hats, while Susan buys 6 shirts and 12 hats.

From this information, we can infer that Matthew’s

marginal rate of substitution is _____ hats per shirt,

while Susan’s is _____.

a. 2, 1

b. 2, 2

c. 4, 1

d. 4, 2

4. Darius buys only lobster and chicken. Lobster is a

normal good, while chicken is an inferior good. When

the price of lobster rises, Darius buys

a. less of both goods.

b. more lobster and less chicken.

c. less lobster and more chicken.

d. less lobster, but the impact on chicken is

ambiguous.

5. If the price of pasta increases and a consumer buys

more pasta, we can infer that

a. pasta is a normal good and the income effect is

greater than the substitution effect.

b. pasta is a normal good and the substitution effect

is greater than the income effect.

c. pasta is an inferior good and the income effect is

greater than the substitution effect.

d. pasta is an inferior good and the substitution

effect is greater than the income effect.

6. The labor-supply curve slopes upward if

a. leisure is a normal good.

b. consumption is a normal good.

c. the income effect on leisure is greater than the

substitution effect.

d. the substitution effect on leisure is greater than

the income effect.

CHAPTER QuickQuiz

SUMMARY

• A consumer ’s budget constraint shows the possible

combinations of different goods she can buy given

her 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 her

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 her

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), and the consumer ’s valuation

of the two goods (measured by the marginal rate of

substitution) equals the market’s valuation (measured

by the relative price).

448 PART VII TOPICS FOR FURTHER STUDY

• 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 explains why demand curves can

potentially slope upward, why higher wages could

either increase or decrease the quantity of labor

supplied, and why higher interest rates could either

increase or decrease saving.

KEY CONCEPTS

budget constraint, p. 427

indifference curve, p. 428

marginal rate of substitution, p. 428

perfect substitutes, p. 431

perfect complements, p. 431

normal good, p. 434

inferior good, p. 435

income effect, p. 436

substitution effect, p. 436

Giffen good, p. 440

QUESTIONS FOR REVIEW

1. A consumer has income of $3,000. Wine costs

$3 per glass, and cheese costs $6 per pound. Draw the

consumer’s budget constraint with wine on the vertical

axis. What is the slope of this budget constraint?

2. Draw a consumer’s indifference curves for wine and

cheese. Describe and explain four properties of these

indifference curves.

3. 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?

4. 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 per glass

and the price of cheese is $6 per pound, what is the

marginal rate of substitution at this optimum?

5. A person who consumes wine and cheese gets a raise,

so her income increases from $3,000 to $4,000. Show

what happens if both wine and cheese are normal

goods. Next, show what happens if cheese is an

inferior good.

6. The price of cheese rises from $6 to $10 per pound,

while the price of wine remains $3 per 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.

7. Can an increase in the price of cheese possibly induce

a consumer to buy more cheese? Explain.

PROBLEMS AND APPLICATIONS

1. Maya 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 Maya’s budget

constraint.

b. Show the effect of the frost on Maya’s optimal

consumption bundle assuming that the substitution

effect outweighs the income effect for croissants.

c. Show the effect of the frost on Maya’s optimal

consumption bundle assuming that the income

effect outweighs the substitution effect for

croissants.

2. Compare the following two pairs of goods:

• Coke and Pepsi

• Skis and ski bindings

a. In which case are the two goods complements? In

which case are they substitutes?

b. In which case do you expect the indifference

curves to be fairly straight? In which case do you

expect the indifference curves to be very bowed?

c. In which case will the consumer respond more to

a change in the relative price of the two goods?

449CHAPTER 21 THE THEORY OF CONSUMER CHOICE

3. You consume only soda and pizza. One day, the price

of soda goes up, the price of pizza goes down, and

you are just as happy as you were before the price

changes.

a. Illustrate this situation on a graph.

b. How does your consumption of the two goods

change? How does your response depend on

income and substitution effects?

c. Can you afford the bundle of soda and pizza you

consumed before the price changes?

4. Carlos consumes only cheese and crackers.

a. Could cheese and crackers both be inferior goods

for Carlos? Explain.

b. Suppose that cheese is a normal good for Carlos

while crackers are an inferior good. If the

price of cheese falls, what happens to Carlos’s

consumption of crackers? What happens to his

consumption of cheese? Explain.

5. Jacob buys only milk and cookies.

a. In year 1, Jacob earns $100, milk costs $2 per

quart, and cookies cost $4 per dozen. Draw

Jacob’s budget constraint.

b. Now suppose that all prices increase by

10 percent in year 2 and that Jacob’s salary

increases by 10 percent as well. Draw Jacob’s

new budget constraint. How would Jacob’s

optimal combination of milk and cookies in year 2

compare to his optimal combination in year 1?

6. State whether each of the following statements is true

or false. Explain your answers.

a. “All Giffen goods are inferior goods.”

b. “All inferior goods are Giffen goods.”

7. A college student has two options for meals: eating at

the dining hall for $6 per meal, or eating a Cup O’ Soup

for $1.50 per meal. Her weekly food budget is $60.

a. Draw the budget constraint showing the

trade-off between dining hall meals and Cups

O’ Soup. Assuming that she spends equal

amounts on both goods, draw an indifference

curve showing the optimum choice. Label the

optimum as point A.

b. Suppose the price of a Cup O’ Soup now rises to

$2. Using your diagram from part (a), show the

consequences of this change in price. Assume

that our student now spends only 30 percent of

her income on dining hall meals. Label the new

optimum as point B.

c. What happened to the quantity of Cups O’

Soup consumed as a result of this price change?

What does this result say about the income and

substitution effects? Explain.

d. Use points A and B to draw a demand curve for

Cup O’ Soup. What is this type of good called?

8. 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 income tax.

b. Show how the tax might lead to more hours of

work, fewer hours, or the same number of hours.

Explain.

9. Anya is awake for 100 hours per week. Using one

diagram, show Anya’s budget constraints if she

earns $12 per hour, $16 per hour, and $20 per hour.

Now draw indifference curves such that Anya’s

labor-supply curve is upward-sloping when

the wage is between $12 and $16 per hour and

backward-sloping when the wage is between $16

and $20 per hour.

10. Draw the indifference curve for someone deciding

how to allocate time between work and leisure.

Suppose the wage increases. Is it possible that the

person’s consumption would fall? Is this plausible?

Discuss. (Hint: Think about income and substitution effects.)

11. Economist George Stigler once wrote that, according

to consumer theory, “if consumers do not buy less of a

commodity when their incomes rise, they will surely

buy less when the price of the commodity rises.”

Explain this statement using the concepts of income

and substitution effects.

12. Five consumers have the following marginal utility of

apples and pears:

Marginal Utility Marginal Utility

of Apples of Pears

Claire 6 12

Phil 6 6

Haley 6 3

Alex 3 6

Luke 3 12

The price of an apple is $1, and the price of a pear is

$2. Which, if any, of these consumers are optimizing

over their choice of fruit? For those who are not, how

should they change their spending?

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

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451

E conomics is a study of the choices that people make and the resulting interac- tions they have with one another. As the preceding chapters demonstrate, the field has many facets. Yet it would be a mistake to think that all the facets we

have seen make up a finished jewel, perfect and unchanging. Like all scientists, economists are always looking for new areas to study and new phenomena to explain. This final chapter on microeconomics offers an assortment of three top- ics at the discipline’s frontier to show how economists are trying to expand their understanding of human behavior and society.

The first topic is the economics of asymmetric information. In many different situations, some people are better informed than others, and the imbalance in information affects the choices they make and how they deal with one another.

CHAPTER

22Frontiers of Microeconomics

452 PART VII TOPICS FOR FURTHER STUDY

Thinking about this asymmetry can shed light on many aspects of the world, from the market for used cars to the custom of gift giving.

The second topic we examine in this chapter is political economy. Throughout this book, we have seen many examples in which markets fail and government policy can potentially improve matters. But “potentially” is a necessary qualifier: Whether this potential is realized depends on how well our political institutions work. The field of political economy uses the tools of economics to understand the functioning of government.

The third topic in this chapter is behavioral economics. This field brings some insights from psychology into the study of economic issues. It offers a view of human behavior that is more subtle and complex than the one found in conven- tional economic theory, a view that may be more realistic.

This chapter covers a lot of ground. To do so, it offers not full helpings of these three topics but, instead, a taste of each. One goal of this chapter is to show a few of the directions economists are heading in their effort to expand knowledge of how the economy works. Another is to whet your appetite for more courses in economics.

22-1 Asymmetric Information “I know something you don’t know.” This statement is a common taunt among children, but it also conveys a deep truth about how people sometimes interact with one another. Many times in life, one person knows more about what is going on than another. A difference in access to knowledge that is relevant to an interac- tion is called an information asymmetry.

Examples abound. A worker knows more than his employer about how much effort he puts into his job. A seller of a used car knows more than the buyer about the car ’s condition. The first is an example of a hidden action, whereas the second is an example of a hidden characteristic. In each case, the uninformed party (the employer, the car buyer) would like to know the relevant information, but the informed party (the worker, the car seller) may have an incentive to conceal it.

Because asymmetric information is so prevalent, economists have devoted much effort in recent decades to studying its effects. Let’s discuss some of the insights that this study has revealed.

22-1a Hidden Actions: Principals, Agents, and Moral Hazard Moral hazard is a problem that arises when one person, called the agent, is per- forming some task on behalf of another person, called the principal. If the prin- cipal cannot perfectly monitor the agent’s behavior, the agent tends to undertake less effort than the principal considers desirable. The phrase moral hazard refers to the risk, or “hazard,” of inappropriate or otherwise “immoral” behavior by the agent. In such a situation, the principal tries various ways to encourage the agent to act more responsibly.

The employment relationship is the classic example. The employer is the prin- cipal, and the worker is the agent. The moral-hazard problem is the temptation of imperfectly monitored workers to shirk their responsibilities. Employers can respond to this problem in various ways:

• Better monitoring. Employers may plant hidden video cameras to record workers’ behavior. The aim is to catch irresponsible actions that might occur when supervisors are absent.

moral hazard

the tendency of a person

who is imperfectly

monitored to engage in

dishonest or otherwise

undesirable behavior

agent

a person who is

performing an act for

another person, called

the principal

principal

a person for whom another

person, called the agent, is

performing some act

453CHAPTER 22 FRONTIERS OF MICROECONOMICS

• High wages. According to efficiency-wage theories (discussed in Chapter 19), some employers may choose to pay their workers a wage above the level that balances supply and demand in the labor market. A worker who earns an above-equilibrium wage is less likely to shirk because if he is caught and fired, he might not be able to find another high-paying job.

• Delayed payment. Firms can delay part of a worker ’s compensation, so if the worker is caught shirking and is fired, he suffers a larger penalty. One example of delayed compensation is the year-end bonus. Similarly, a firm may choose to pay its workers more later in their lives. Thus, the wage increases that workers get as they age may reflect not just the benefits of experience but also a response to moral hazard.

Employers can use any combination of these various mechanisms to reduce the problem of moral hazard.

Corporate Management

M uch production in the modern economy takes place within corpo-

rations. Like other firms, corporations buy inputs in markets for

the factors of production and sell their output in markets for goods and

services. Also like other firms, they are guided in their decisions by the

objective of profit maximization. But a large corporation has to deal with

some issues that do not arise in, say, a small family-owned business.

What is distinctive about a corporation? From a legal standpoint, a

corporation is an organization that is granted a charter recognizing it as

a separate legal entity, with its own rights and responsibilities distinct

from those of its owners and employees. From an economic standpoint,

the most important feature of the corporate form of organization is the

separation of ownership and control. One group of people, called the

shareholders, own the corporation and share in its profits. Another group

of people, called the managers, are employed by the corporation to make

decisions about how to deploy the corporation’s resources.

The separation of ownership and control creates a principal-agent

problem. In this case, the shareholders are the principals and the

managers are the agents. The chief executive officer and other man-

agers, who are in the best position to know the available business

opportunities, are charged with the task of maximizing profits for

the shareholders. But ensuring that they carry out this task is not

always easy. The managers may have goals of their own, such as taking

life easy, having a plush office and a private jet, throwing lavish parties,

or presiding over a large business empire. The managers’ goals may not

always coincide with the shareholders’ goal of profit maximization.

The corporation’s board of directors is responsible for hiring

and firing the top management. The board monitors the managers’

performance, and it de-

signs their compensation

packages. These packages

often include incentives

aimed at aligning the inter-

ests of shareholders with the

interests of management. Managers

might be given bonuses based on performance or options to buy the

company’s stock, which are more valuable if the company performs well.

Note, however, that the directors are themselves agents of the share-

holders. The existence of a board overseeing management only shifts the

principal-agent problem. The issue then becomes how to ensure that the

board of directors fulfills its own legal obligation of acting in the best

interest of the shareholders. If the directors become too friendly with

management, they may not provide the required oversight.

The corporation’s principal-agent problem became big news around

2005. The top managers of several prominent companies, including

Enron, Tyco, and WorldCom, were found to be engaging in activities

that enriched themselves at the expense of their shareholders. In these

cases, the actions were so extreme as to be criminal, and the corporate

managers were not just fired but also sent to prison. Some shareholders

sued the directors for failing to monitor management sufficiently.

Fortunately, criminal activity by corporate managers is rare. But in

some ways, it is only the tip of the iceberg. Whenever ownership and

control are separated, as they are in most large corporations, there is an

inevitable tension between the interests of shareholders and the inter-

ests of management. ■

F Y I

454 PART VII TOPICS FOR FURTHER STUDY

There are also many examples of moral hazard beyond the workplace. A home- owner with fire insurance will likely buy too few fire extinguishers because the home- owner bears the cost of the extinguisher while the insurance company receives much of the benefit. A family may live near a river with a high risk of flooding because the family enjoys the scenic views, while the government bears the cost of disaster relief after a flood. Many regulations are aimed at addressing the problem: An insurance company may require homeowners to buy fire extinguishers, and the government may prohibit building homes on land with high risk of flooding. But the insurance company does not have perfect information about how cautious homeowners are, and the government does not have perfect information about the risk that families under- take when choosing where to live. As a result, the problem of moral hazard persists.

22-1b Hidden Characteristics: Adverse Selection and the Lemons Problem

Adverse selection is a problem that arises in markets in which the seller knows more about the attributes of the good being sold than the buyer does. In such a situation, the buyer runs the risk of being sold a good of low quality. That is, the “selection” of goods sold may be “adverse” from the standpoint of the unin- formed buyer.

The classic example of adverse selection is the market for used cars. Sellers of used cars know their vehicles’ defects while buyers often do not. Because owners of the worst cars are more likely to sell them than are the owners of the best cars, buyers are worried about getting a “lemon.” As a result, many people avoid buying vehicles in the used car market. This lemons problem can explain why a used car only a few weeks old sells for thousands of dollars less than a new car of the same type. A buyer of the used car might surmise that the seller is getting rid of the car quickly because the seller knows something about it that the buyer does not.

A second example of adverse selection occurs in the labor market. According to another efficiency-wage theory, workers vary in their abilities, and they know their own abilities better than do the firms that hire them. When a firm cuts the wage it pays, the more talented workers are more likely to quit, knowing they will be able to find employment elsewhere. Conversely, a firm may choose to pay an above-equilibrium wage to attract a better mix of workers.

A third example of adverse selection occurs in markets for insurance. For exam- ple, buyers of health insurance know more about their own health problems than do insurance companies. Because people with greater hidden health problems are more likely to buy health insurance than are other people, the price of health insurance reflects the costs of a sicker-than-average person. As a result, people with average health may observe the high price of insurance and decide not to buy it.

When markets suffer from adverse selection, the invisible hand does not neces- sarily work its magic. In the used car market, owners of good cars may choose to keep them rather than sell them at the low price that skeptical buyers are willing to pay. In the labor market, wages may be stuck above the level that balances supply and demand, resulting in unemployment. In insurance markets, buyers with low risk may choose to remain uninsured because the policies they are offered fail to reflect their true characteristics. Advocates of government-provided health insur- ance sometimes point to the problem of adverse selection as one reason not to trust the private market to provide the right amount of health insurance on its own.

adverse selection

the tendency for the mix

of unobserved attributes

to become undesirable

from the standpoint of an

uninformed party

455CHAPTER 22 FRONTIERS OF MICROECONOMICS

22-1c Signaling to Convey Private Information Although asymmetric information is sometimes a motivation for public policy, it also motivates some individual behavior that otherwise might be hard to explain. Markets respond to problems of asymmetric information in many ways. One of them is signaling, which refers to actions taken by an informed party for the sole purpose of credibly revealing his private information.

We have seen examples of signaling in previous chapters. As we saw in Chapter 16, firms may spend money on advertising to signal to potential cus- tomers that they have high-quality products. As we saw in Chapter 19, students may earn college degrees merely to signal to potential employers that they are high-ability individuals, rather than to increase their productivity. These two examples of signaling (advertising, education) may seem very different, but below the surface, they are much the same: In both cases, the informed party (the firm, the student) uses the signal to convince the uninformed party (the customer, the employer) that the informed party is offering something of high quality.

What does it take for an action to be an effective signal? Obviously, it must be costly. If a signal were free, everyone would use it and it would convey no infor- mation. For the same reason, there is another requirement: The signal must be less costly, or more beneficial, to the person with the higher-quality product. Other- wise, everyone would have the same incentive to use the signal, and the signal would reveal nothing.

Consider again our two examples. In the advertising case, a firm with a good product reaps a larger benefit from advertising because customers who try the product once are more likely to become repeat customers. Thus, it is rational for the firm with a good product to pay for the cost of the signal (advertising), and it is rational for the customer to use the signal as a piece of information about the product’s quality. In the education case, a talented person can get through school more easily than a less talented one. Thus, it is rational for the talented person to pay for the cost of the signal (education), and it is rational for the employer to use the signal as a piece of information about the person’s talent.

The world is replete with instances of signaling. Magazine ads sometimes include the phrase “as seen on TV.” Why does a firm selling a product in a mag- azine choose to stress this fact? One possibility is that the firm is trying to convey its willingness to pay for an expensive signal (a spot on television) in the hope that you will infer that its product is of high quality. For the same reason, gradu- ates of elite schools are always sure to put that fact on their résumés.

signaling

an action taken by an

informed party to reveal

private information to an

uninformed party

CASE STUDY

GIFTS AS SIGNALS A man is debating what to give his girlfriend for her birthday. “I know,” he says to himself, “I’ll give her cash. After all, I don’t know her tastes as well as she does, and with cash, she can buy any-

thing she wants.” But when he hands her the money, she is offended. Convinced he doesn’t really love her, she breaks off the relationship.

What’s the economics behind this story? In some ways, gift giving is a strange custom. As the man in our story suggests,

people typically know their own preferences better than others do, so we might expect everyone to prefer cash to in-kind transfers. If your employer substituted merchandise of his choosing for your paycheck, you would likely object to this means of payment. But your reaction is very different when someone who (you hope) loves you does the same thing.

456 PART VII TOPICS FOR FURTHER STUDY

One interpretation of gift giving is that it reflects asymmetric information and signaling. The man in our story has private information that the girlfriend would like to know: Does he really love her? Choosing a good gift for her is a signal of his love. Certainly, the act of picking out a gift, rather than giving cash, has the right characteristics to be a signal. It is costly (it takes time), and its cost depends on private information (how much he loves her). If he really loves her, choosing a good gift is easy because he is thinking about her all the time. If he doesn’t love her, finding the right gift is more difficult. Thus, giving a gift that suits his girlfriend is one way for him to convey the private information of his love for her. Giving cash shows that he isn’t even bothering to try.

The signaling theory of gift giving is consistent with another observation: Peo- ple care most about the custom when the strength of affection is most in question. Thus, giving cash to a girlfriend or boyfriend is usually a bad move. But when col- lege students receive a check from their parents, they are less often offended. The parents’ love is less likely to be in doubt, so the recipient probably won’t interpret the cash gift as a signal of insufficient affection. ●

22-1d Screening to Uncover Private Information When an informed party takes actions to reveal private information, the phenom- enon is called signaling. When an uninformed party takes actions to induce the informed party to reveal private information, the phenomenon is called screening.

Some screening is common sense. A person buying a used car may ask that it be checked by an auto mechanic before the sale. A seller who refuses this request reveals his private information that the car is a lemon. The buyer may decide to offer a lower price or to look for another car.

Other examples of screening are more subtle. For example, consider a firm that sells car insurance. The firm would like to charge a low premium to safe driv- ers and a high premium to risky drivers. But how can it tell them apart? Drivers know whether they are safe or risky, but the risky ones won’t admit it. A driver ’s history is one piece of information (which insurance companies in fact use), but because of the intrinsic randomness of car accidents, history is an imperfect indi- cator of future risk.

The insurance company might be able to sort out the two kinds of drivers by offering different insurance policies that would induce the drivers to separate themselves. One policy would have a high premium and cover the full cost of any accidents that occur. Another policy would have low premiums but would have, say, a $1,000 deductible. (That is, the driver would be responsible for the first $1,000 of damage, and the insurance company would cover the remaining risk.) Notice that the deductible is more of a burden for risky drivers because they are more likely to have an accident. Thus, with a large enough deductible, the low-premium policy with a deductible would attract the safe drivers, while the high-premium policy without a deductible would attract the risky drivers. Faced with these two policies, the two kinds of drivers would reveal their private infor- mation by choosing different insurance policies.

22-1e Asymmetric Information and Public Policy We have examined two kinds of asymmetric information: moral hazard and adverse selection. And we have seen how individuals may respond to the prob- lem with signaling or screening. Now let’s consider what the study of asymmetric information suggests about the proper scope of public policy.

screening

an action taken by an

uninformed party to

induce an informed party

to reveal information

M O

N KE

Y BU

SI N

ES S

IM A

G ES

/S H

U TT

ER ST

O CK

.C O

“Now we’ll see how much he loves me.”

457CHAPTER 22 FRONTIERS OF MICROECONOMICS

The tension between market success and market failure is central in microeco- nomics. We learned in Chapter 7 that the equilibrium of supply and demand is efficient in the sense that it maximizes the total surplus that society can obtain in a market. Adam Smith’s invisible hand seemed to reign supreme. This con- clusion was then tempered with the study of externalities (Chapter 10), public goods (Chapter 11), imperfect competition (Chapters 15 through 17), and poverty (Chapter 20). In those chapters, we saw that government can sometimes improve market outcomes.

The study of asymmetric information gives us a new reason to be wary of markets. When some people know more than others, the market may fail to put resources to their best use. People with high-quality used cars may have trou- ble selling them because buyers will be afraid of getting a lemon. People with few health problems may have trouble getting low-cost health insurance because insurance companies lump them together with those who have significant (but hidden) health problems.

Asymmetric information may call for government action in some cases, but three facts complicate the issue. First, as we have seen, the private market can sometimes deal with information asymmetries on its own using a combination of signaling and screening. Second, the government rarely has more information than the private parties. Even if the market’s allocation of resources is not ideal, it may be the best that can be achieved. That is, when there are information asym- metries, policymakers may find it hard to improve upon the market’s admittedly imperfect outcome. Third, the government is itself an imperfect institution—a topic we take up in the next section.

QuickQuiz A person who buys a life insurance policy pays a certain amount per year

and receives for his family a much larger payment in the event of his

death. Would you expect buyers of life insurance to have higher or lower death rates than the

average person? How might this be an example of moral hazard? Of adverse selection? How

might a life insurance company deal with these problems?

22-2 Political Economy As we have seen, markets left on their own do not always reach a desirable allo- cation of resources. When we judge the market’s outcome to be either inefficient or inequitable, there may be a role for the government to step in and improve the situation. Yet before we embrace an activist government, we need to consider one more fact: The government is also an imperfect institution. The field of political economy (sometimes called the field of public choice) uses the methods of eco- nomics to study how government works.

22-2a The Condorcet Voting Paradox Most advanced societies rely on democratic principles to set government policy. When a city is deciding between two locations to build a new park, for example, we have a simple way to choose: The majority gets its way. Yet for most policy issues, the number of possible outcomes far exceeds two. A new park could be placed in many possible locations. In this case, as the 18th-century French polit- ical theorist Marquis de Condorcet famously noted, democracy might run into some problems trying to choose the best outcome.

political economy

the study of government

using the analytic

methods of economics

458 PART VII TOPICS FOR FURTHER STUDY

For example, suppose there are three possible outcomes, labeled A, B, and C, and there are three voter types with the preferences shown in Table 1. The mayor of our town wants to aggregate these individual preferences into preferences for society as a whole. How should he do it?

At first, he might try some pairwise votes. If he asks voters to choose first between B and C, voter types 1 and 2 will vote for B, giving B the majority. If he then asks voters to choose between A and B, voter types 1 and 3 will vote for A, giving A the majority. Observing that A beats B, and B beats C, the mayor might conclude that A is the voters’ clear choice.

But wait: Suppose the mayor then asks voters to choose between A and C. In this case, voter types 2 and 3 vote for C, giving C the majority. That is, under pair- wise majority voting, A beats B, B beats C, and C beats A. Normally, we expect preferences to exhibit a property called transitivity: If A is preferred to B, and B is preferred to C, then we would expect A to be preferred to C. The Condorcet paradox is that democratic outcomes do not always obey this property. Pairwise voting might produce transitive preferences for society in some cases, but as our example in the table shows, it cannot be counted on to do so.

One implication of the Condorcet paradox is that the order in which things are voted on can affect the result. If the mayor suggests choosing first between A and B and then comparing the winner to C, the town ends up choosing C. But if the voters choose first between B and C and then compare the winner to A, the town ends up with A. And if the voters choose first between A and C and then compare the winner to B, the town ends up with B.

The Condorcet paradox teaches two lessons. The narrow lesson is that when there are more than two options, setting the agenda (that is, deciding the order in which items are voted on) can have a powerful influence over the outcome of a democratic election. The broad lesson is that majority voting by itself does not tell us what outcome a society really wants.

22-2b Arrow’s Impossibility Theorem Since political theorists first noticed Condorcet’s paradox, they have spent much energy studying existing voting systems and proposing new ones. For example, as an alternative to pairwise majority voting, the mayor of our town could ask each voter to rank the possible outcomes. For each voter, we could give 1 point for last place, 2 points for second to last, 3 points for third to last, and so on. The outcome that receives the most total points wins. With the preferences in Table 1, outcome B is the winner. (You can do the arithmetic yourself.) This voting method is called a Borda count for the 18th-century French mathematician and political

Condorcet paradox

the failure of majority

rule to produce transitive

preferences for society

TABLE 1

The Condorcet Paradox

If voters have these

preferences over outcomes

A, B, and C, then in pairwise

majority voting, A beats B, B

beats C, and C beats A.

Voter Type

Type 1 Type 2 Type 3

Percent of electorate 35 45 20

First choice A B C

Second choice B C A

Third choice C A B

459CHAPTER 22 FRONTIERS OF MICROECONOMICS

theorist, Jean-Charles de Borda, who devised it. It is often used in polls that rank sports teams.

Is there a perfect voting system? Economist Kenneth Arrow took up this ques- tion in his 1951 book Social Choice and Individual Values. Arrow started by defining what a perfect voting system would be. He assumes that individuals in society have preferences over the various possible outcomes: A, B, C, and so on. He then assumes that society wants a voting system to choose among these outcomes that satisfies several properties:

• Unanimity: If everyone prefers A to B, then A should beat B. • Transitivity: If A beats B, and B beats C, then A should beat C. • Independence of irrelevant alternatives: The ranking between any two out-

comes A and B should not depend on whether some third outcome C is also available.

• No dictators: There is no person who always gets his way, regardless of every- one else’s preferences.

These all seem like desirable properties of a voting system. Yet Arrow proved, mathematically and incontrovertibly, that no voting system can satisfy all these prop- erties. This amazing result is called Arrow’s impossibility theorem.

The mathematics needed to prove Arrow’s theorem is beyond the scope of this book, but we can get some sense of why the theorem is true from a couple of examples. We have already seen the problem with the method of majority rule. The Condorcet paradox shows that majority rule fails to produce a ranking of out- comes that always satisfies transitivity.

As another example, the Borda count fails to satisfy the independence of irrel- evant alternatives. Recall that, using the preferences in Table 1, outcome B wins with a Borda count. But suppose that suddenly C disappears as an alternative. If the Borda count method is applied only to outcomes A and B, then A wins. (Once again, you can do the arithmetic on your own.) Thus, eliminating alter- native C changes the ranking between A and B. This change occurs because the result of the Borda count depends on the number of points that A and B receive, and the number of points depends on whether the irrelevant alternative, C, is also available.

Arrow’s impossibility theorem is a deep and disturbing result. It doesn’t say that we should abandon democracy as a form of government. But it does say that no matter what voting system society adopts for aggregating the preferences of its members, it will in some way be flawed as a mechanism for social choice.

22-2c The Median Voter Is King Despite Arrow’s theorem, voting is how most societies choose their leaders and public policies, often by majority rule. The next step in studying government is to examine how governments run by majority rule work. That is, in a democratic society, who determines what policy is chosen? In some cases, the theory of dem- ocratic government yields a surprisingly simple answer.

Let’s consider an example. Imagine that society is deciding how much money to spend on some public good, such as the army or the national parks. Each voter has his own most preferred budget, and he always prefers outcomes closer to his most preferred value to outcomes farther away. Thus, we can line up voters from those who prefer the smallest budget to those who prefer the largest. Figure 1 is an example. Here there are 100 voters, and the budget size varies from zero to $20

Arrow’s impossibility

theorem

a mathematical result

showing that, under

certain assumed

conditions, there is no

scheme for aggregating

individual preferences

into a valid set of social

preferences

460 PART VII TOPICS FOR FURTHER STUDY

billion. Given these preferences, what outcome would you expect democracy to produce?

According to a famous result called the median voter theorem, majority rule will produce the outcome most preferred by the median voter. The median voter is the voter exactly in the middle of the distribution. In this example, if you take the line of voters ordered by their preferred budgets and count 50 voters from either end of the line, you will find that the median voter wants a budget of $10 billion. By contrast, the average preferred outcome (calculated by adding the preferred outcomes and dividing by the number of voters) is $9 billion, and the modal out- come (the one preferred by the greatest number of voters) is $15 billion.

The median voter rules the day because his preferred outcome beats any other proposal in a two-way race. In our example, more than half the voters want $10 billion or more, and more than half want $10 billion or less. If someone proposes, say, $8 billion instead of $10 billion, everyone who prefers $10 billion or more will vote with the median voter. Similarly, if someone proposes $12 billion instead of $10 billion, everyone who wants $10 billion or less will vote with the median voter. In either case, the median voter has more than half the voters on his side.

What about the Condorcet voting paradox? It turns out that when the voters are picking a point along a line and each voter aims for his own most preferred point, the Condorcet paradox cannot arise. The median voter ’s most preferred outcome beats all challengers.

One implication of the median voter theorem is that if two political parties are each trying to maximize their chance of election, they will both move their posi- tions toward the median voter. Suppose, for example, that the Democratic Party advocates a budget of $15 billion, while the Republican Party advocates a budget of $10 billion. The Democratic position is more popular in the sense that $15 bil- lion has more proponents than any other single choice. Nonetheless, the Republi- cans get more than 50 percent of the vote: They will attract the 20 voters who want $10 billion, the 15 voters who want $5 billion, and the 25 voters who want zero.

median voter theorem

a mathematical result

showing that if voters are

choosing a point along a

line and each voter wants

the point closest to his

most preferred point,

then majority rule will

pick the most preferred

point of the median voter

FIGURE 1

The Median Voter Theorem:

An Example

This bar chart shows how

100 voters’ most preferred

budgets are distributed

over five options, ranging

from zero to $20 billion. If

society makes its choice by

majority rule, the median

voter, who here prefers

$10 billion, determines the

outcome.

Number of People

0 $0

$10

$15

$20

Preferred Size of Budget (in billions)

461CHAPTER 22 FRONTIERS OF MICROECONOMICS

If the Democrats want to win, they will move their platform toward the median voter. Thus, this theory can explain why the parties in a two-party system are sim- ilar to each other: They are both moving toward the median voter.

Another implication of the median voter theorem is that minority views are not given much weight. Imagine that 40 percent of the population want a lot of money spent on the national parks and 60 percent want nothing spent. In this case, the median voter ’s preference is zero, regardless of the intensity of the mi- nority’s view. Rather than reaching a compromise that takes everyone’s prefer- ences into account, majority rule looks only to the person in the exact middle of the distribution. Such is the logic of democracy.

22-2d Politicians Are People Too When economists study consumer behavior, they assume that consumers buy the bundle of goods and services that gives them the greatest level of satisfaction. When economists study firm behavior, they assume that firms produce the quan- tity of goods and services that yields the greatest level of profits. What should they assume when they study people involved in the practice of politics?

Politicians also have objectives. It would be nice to assume that political lead- ers are always looking out for the well-being of society as a whole, that they are aiming for an optimal combination of efficiency and equality. Nice, perhaps, but not realistic. Self-interest is as powerful a motive for political actors as it is for consumers and firm owners. Some politicians, motivated by a desire for reelec- tion, are willing to sacrifice the national interest to solidify their base of voters. Others are motivated by simple greed. If you have any doubt, you should look at the world’s poor nations, where corruption among government officials is a common impediment to economic development.

This book is not the place to develop a theory of political behavior. But when thinking about economic policy, remember that this policy is made not by a benevolent king (or even by benevolent economists) but by real people with their own all-too-human desires. Sometimes they are motivated to further the national interest, but sometimes they are motivated by their own political and financial ambitions. We shouldn’t be surprised when economic policy fails to resemble the ideals derived in economics textbooks.

QuickQuiz A public school district is deciding on the school budget and the resulting

student–teacher ratio. A poll finds that 20 percent of the voters want

a ratio of 9:1, 25 percent want a ratio of 10:1, 15 percent want a ratio of 11:1, and

40 percent want a ratio of 12:1. If the district uses majority-rule voting, what outcome

would you expect the district to end up with? Explain.

22-3 Behavioral Economics Economics is a study of human behavior, but it is not the only field that can make that claim. The social science of psychology also sheds light on the choices that people make in their lives. The fields of economics and psychology usually pro- ceed independently, in part because they address a different range of questions. But recently, a field called behavioral economics has emerged in which econo- mists are making use of basic psychological insights. Let’s consider some of these insights here.

behavioral economics

the subfield of economics

that integrates the

insights of psychology

“Isn’t that the real genius of democracy? . . . The VOTERS are ultimately to blame.”

W W

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O O

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.C O

M /C

H RI

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IL D

462 PART VII TOPICS FOR FURTHER STUDY

22-3a People Aren’t Always Rational Economic theory is populated by a particular species of organism, sometimes called Homo economicus. Members of this species are always rational. As firm owners, they maximize profits. As consumers, they maximize utility (or equivalently, pick the point on the highest indifference curve). Given the constraints they face, they rationally weigh all the costs and benefits and always choose the best possible course of action.

Real people, however, are Homo sapiens. Although in many ways they resemble the rational, calculating people assumed in economic theory, they are far more complex. They can be forgetful, impulsive, confused, emotional, and shortsighted. These imperfections of human reasoning are the bread and butter of psycholo- gists, but until recently, economists have neglected them.

Herbert Simon, one of the first social scientists to work at the boundary of eco- nomics and psychology, suggested that humans should be viewed not as ratio- nal maximizers but as satisficers. Instead of always choosing the best course of action, they make decisions that are merely good enough. Similarly, other econ- omists have suggested that humans are only “near rational” or that they exhibit “bounded rationality.”

Studies of human decision making have tried to detect systematic mistakes that people make. Here are a few of the findings:

• People are overconfident. Imagine that you were asked some numerical ques- tions, such as the number of African countries in the United Nations, the height of the tallest mountain in North America, and so on. Instead of being asked for a single estimate, however, you were asked to give a 90 percent confidence interval—a range such that you were 90 percent confident the true number falls within it. When psychologists run experiments like this, they find that most people give ranges that are too small: The true number falls within their intervals far less than 90 percent of the time. That is, most people are too sure of their own abilities.

• People give too much weight to a small number of vivid observations. Imagine that you are thinking about buying a car of brand X. To learn about its reliability, you read Consumer Reports, which has surveyed 1,000 owners of car X. Then you run into a friend who owns car X, and he tells you that his car is a lemon. How do you treat your friend’s observation? If you think rationally, you will realize that he has only increased your sample size from 1,000 to 1,001, which does not provide much new information. But because your friend’s story is so vivid, you may be tempted to give it more weight in your decision making than you should.

• People are reluctant to change their minds. People tend to interpret evidence to confirm beliefs they already hold. In one study, subjects were asked to read and evaluate a research report on whether capital punishment deters crime. After reading the report, those who initially favored the death penalty said they were more certain of their view, and those who initially opposed the death penalty also said they were more certain of their view. The two groups interpreted the same evidence in exactly opposite ways. This behavior is sometimes called confirmation bias.

Think about decisions you have made in your own life. Do you exhibit some of these traits?

A hotly debated issue is whether deviations from rationality are important for understanding economic phenomena. An intriguing example arises in the study of 401(k) plans, the tax-advantaged retirement savings accounts that some firms

463CHAPTER 22 FRONTIERS OF MICROECONOMICS

offer their workers. In some firms, workers can choose to participate in the plan by filling out a simple form. In other firms, workers are automatically enrolled and can opt out of the plan by filling out a simple form. It turns out many more workers participate in the second case than in the first. If workers were perfectly rational maximizers, they would choose the optimal amount of retirement sav- ing, regardless of the default offered by their employer. In fact, workers’ behavior appears to exhibit substantial inertia. Understanding their behavior seems easier once we abandon the model of rational man.

Why, you might ask, is economics built on the rationality assumption when psychology and common sense cast doubt on it? One answer is that the assump- tion, even if not exactly true, may be true enough that it yields reasonably accu- rate models of behavior. For example, when we studied the differences between competitive and monopoly firms, the assumption that firms rationally maximize profit yielded many important and valid insights. Incorporating complex psycho- logical deviations from rationality into the story might have added realism, but it also would have muddied the waters and made those insights harder to find. Recall from Chapter 2 that economic models are not meant to replicate reality but are supposed to show the essence of the problem at hand.

Another reason economists often assume rationality may be that economists are themselves not rational maximizers. Like most people, they are overconfident and reluctant to change their minds. Their choice among alternative theories of human behavior may exhibit excessive inertia. Moreover, economists may be con- tent with a theory that is not perfect but is good enough. The model of rational man may be the theory of choice for a satisficing social scientist.

22-3b People Care about Fairness Another insight about human behavior is best illustrated with an experiment called the ultimatum game. The game works like this: Two volunteers (who are otherwise strangers to each other) are told that they are going to play a game and could win a total of $100. Before they play, they learn the rules. The game begins with a coin toss, which is used to assign the volunteers to the roles of player A and player B. Player A’s job is to propose a division of the $100 prize between himself and the other player. After player A makes his proposal, player B decides whether to accept or reject it. If he accepts it, both players are paid according to the pro- posal. If player B rejects the proposal, both players walk away with nothing. In either case, the game then ends.

Before proceeding, stop and think about what you would do in this situation. If you were player A, what division of the $100 would you propose? If you were player B, what proposals would you accept?

Conventional economic theory assumes in this situation that people are ratio- nal wealth maximizers. This assumption leads to a simple prediction: Player A should propose that he gets $99 and player B gets $1, and player B should accept the proposal. After all, once the proposal is made, player B is better off accepting it as long as he gets something out of it. Moreover, because player A knows that accepting the proposal is in player B’s interest, player A has no reason to offer him more than $1. In the language of game theory (discussed in Chapter 17), the 99–1 split is the Nash equilibrium.

Yet when experimental economists ask real people to play the ultimatum game, the results differ from this prediction. People in player B’s role usually reject proposals that give them only $1 or a similarly small amount. Anticipating this, people in the role of player A usually propose giving player B much more than $1. Some people will offer a 50–50 split, but it is more common for player A

464 PART VII TOPICS FOR FURTHER STUDY

to propose giving player B an amount such as $30 or $40, keeping the larger share for himself. In this case, player B usually accepts the proposal.

What’s going on here? The natural interpretation is that people are driven in part by some innate sense of fairness. A 99–1 split seems so wildly unfair to many people that they reject it, even to their own detriment. By contrast, a 70–30 split is still unfair, but it is not so unfair that it induces people to abandon their normal self-interest.

Throughout our study of household and firm behavior, the innate sense of fair- ness has not played any role. But the results of the ultimatum game suggest that

A leading behavioral economist makes

the case for his field.

The Importance of Irrelevance

By Richard H. Thaler

E arly in my teaching career I managed to get

most of the students in my class mad at me.

A midterm exam caused the problem.

I wanted the exam to sort out the stars,

the average Joes and the duds, so it had to be

hard and have a wide dispersion of scores. I

succeeded in writing such an exam, but when

the students got their results they were in an

uproar. Their principal complaint was that the

average score was only 72 points out of 100.

What was odd about this reaction was that I

had already explained that the average numer-

ical score on the exam had absolutely no effect

on the distribution of letter grades. We employed

a curve in which the average grade was a B+,

and only a tiny number of students received

grades below a C. I told the class this, but it

had no effect on the students’ mood. They still

hated my exam, and they were none too happy

with me either. As a young professor worried

about keeping my job, I wasn’t sure what to do.

Finally, an idea occurred to me. On the next

exam, I raised the points available for a perfect

score to 137. This exam turned out to be harder

than the first. Students got only 70 percent of the

answers right but the average numerical score was

96 points. The students were delighted!

I chose 137 as a maximum score for two

reasons. First, it produced an average well into

the 90s, and some students scored above 100,

generating a reaction approaching ecstasy.

Second, because dividing by 137 is not easy to

do in your head, I figured that most students

wouldn’t convert their scores into percentages.

Striving for full disclosure, in subsequent

years I included this statement in my course

syllabus: “Exams will have a total of 137 points

rather than the usual 100. This scoring system

has no effect on the grade you get in the course,

but it seems to make you happier.” And, indeed,

after I made that change, I never got a com-

plaint that my exams were too hard.

In the eyes of an economist, my students

were “misbehaving.” By that I mean that their

behavior was inconsistent with the idealized

model at the heart of much of economics.

Rationally, no one should be happier about a

score of 96 out of 137 (70 percent) than 72 out

of 100, but my students were. And by realizing

this, I was able to set the kind of exam I wanted

but still keep the students from grumbling.

This illustrates an important problem with

traditional economic theory. Economists dis-

count any factors that would not influence the

thinking of a rational person. These things are

supposedly irrelevant. But unfortunately for the

theory, many supposedly irrelevant factors do

matter.

Economists create this problem with their

insistence on studying mythical creatures of-

ten known as Homo economicus. I prefer to call

them “Econs”—highly intelligent beings that

are capable of making the most complex of

calculations but are totally lacking in emotions.

Think of Mr. Spock in “Star Trek.” In a world of

Econs, many things would in fact be irrelevant.

No Econ would buy a larger portion of what-

ever will be served for dinner on Tuesday because

he happens to be hungry when shopping on Sun-

day. Your hunger on Sunday should be irrelevant in

choosing the size of your meal for Tuesday. An Econ

would not finish that huge meal on Tuesday, even

though he is no longer hungry, just because he had

paid for it. To an Econ, the price paid for an item

in the past is not relevant in making the decision

about how much of it to eat now.

An Econ would not expect a gift on the day of

the year in which she happened to get married, or

be born. What difference do these arbitrary dates

make? In fact, Econs would be perplexed by the

idea of gifts. An Econ would know that cash is

the best possible gift; it allows the recipient to

buy whatever is optimal. But unless you are mar-

ried to an economist, I don’t advise giving cash

on your next anniversary. Come to think of it,

even if your spouse is an economist, this is not

a great idea.

Of course, most economists know that the

people with whom they interact do not resemble

Econs. In fact, in private moments, economists are

often happy to admit that most of the people they

know are clueless about economic matters. But for

decades, this realization did not affect the way most

economists did their work. They had a justification:

Using Deviations from Rationality

IN THE NEWS

465CHAPTER 22 FRONTIERS OF MICROECONOMICS

perhaps it should. For example, in Chapters 18 and 19, we discussed how wages were determined by labor supply and labor demand. Some economists have sug- gested that the perceived fairness of what a firm pays its workers should also enter the picture. Thus, when a firm has an especially profitable year, workers (like player B) may expect to be paid a fair share of the prize, even if the standard equilibrium does not dictate it. The firm (like player A) might well decide to give workers more than the equilibrium wage for fear that the workers might other- wise try to punish the firm with reduced effort, strikes, or even vandalism.

markets. To defenders of economics orthodoxy, mar-

kets are thought to have magic powers.

There is a version of this magic market argu-

ment that I call the invisible hand wave. It goes

something like this. “Yes, it is true that my spouse

and my students and members of Congress don’t

understand anything about economics, but when

they have to interact with markets . . . .” It is at

this point that the hand waving comes in. Words

and phrases such as high stakes, learning and

arbitrage are thrown around to suggest some of

the ways that markets can do their magic, but it

is my claim that no one has ever finished making

the argument with both hands remaining still.

Hand waving is required because there is

nothing in the workings of markets that turns

otherwise normal human beings into Econs. For

example, if you choose the wrong career, select

the wrong mortgage or fail to save for retire-

ment, markets do not correct those failings.

In fact, quite the opposite often happens. It is

much easier to make money by catering to con-

sumers’ biases than by trying to correct them.

Perhaps because of undue acceptance of invis-

ible-hand-wave arguments, economists have been

ignoring supposedly irrelevant factors, comforted

by the knowledge that in markets these factors just

wouldn’t matter. Alas, both the field of econom-

ics and society are much worse for it. Supposedly

irrelevant factors, or SIFs, matter a lot, and if we

economists recognize their importance, we can do

our jobs better. Behavioral economics is, to a large

extent, standard economics that has been modified

to incorporate SIFs.

SIFs matter in more important domains than

keeping students happy with test scores. Consider

defined-contribution retirement plans like 401(k)’s.

Econs would have no trouble figuring out how much

to save for retirement and how to invest the money,

but mere humans can find it quite tough. So knowl-

edgeable employers have incorporated three SIFs in

their plan design: they automatically enroll employ-

ees (who can opt out), they automatically increase

the saving rate every year, and they offer a sensible

default investment choice like a target date fund.

These features significantly improve the outcomes

of plan participants, but to economists they are

SIFs because Econs would just figure out the right

thing to do without them.

These retirement plans also have a suppos-

edly relevant factor: Contributions and capital

appreciation are tax-sheltered until retirement.

This tax break was created to induce people to

save more. But guess what: A recent study using

Danish data has compared the relative effec-

tiveness of the SIFs and a similar tax subsidy

offered in Denmark. The authors attribute only

1 percent of the saving done in the Danish plans

to the tax breaks. The other 99 percent comes from

the automatic features.

They conclude: “In sum, the findings of our

study call into question whether tax subsidies

are the most effective policy to increase retire-

ment savings. Automatic enrollment or default

policies that nudge individuals to save more

could have larger impacts on national saving at

lower social cost.” Irrelevant indeed!

Notice that the irrelevant design features

that do all the work are essentially free, whereas

a tax break is quite expensive. The Joint Eco-

nomic Committee estimates that the United

States tax break will cost the government $62

billion in 2015, a number that is predicted to

grow rapidly. Furthermore, most of these tax

benefits accrue to affluent taxpayers.

Here is another example. In the early years

of the Obama administration, Congress passed

a law giving taxpayers a temporary tax cut and

the administration had to decide how to carry

it out. Should taxpayers be given a lump sum

check, or should the extra money be spread out

over the year via regular paychecks?

In a world of Econs this choice would be

irrelevant. A $1,200 lump sum would have the

same effect on consumption as monthly pay-

checks that are $100 larger. But while most

middle-class taxpayers spend almost their

entire paycheck every month, if given a lump

sum they are more likely to save some of it or

pay off debts. Since the tax cut was intended to

stimulate spending, I believe the administration

made a wise choice in choosing to spread it out.

The field of behavioral economics has been

around for more than three decades, but the

application of its findings to societal problems

has only recently been catching on. Fortunately,

economists open to new ways of thinking are

finding novel ways to use supposedly irrelevant

factors to make the world a better place. ■

Richard Thaler is a professor of economics at

the University of Chicago.

Source: New York Times, May 10, 2015.

Richard Thaler

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466 PART VII TOPICS FOR FURTHER STUDY

22-3c People Are Inconsistent over Time Imagine some dreary task, such as doing your laundry, shoveling snow off your driveway, or filling out your income tax forms. Now consider the following questions:

1. Would you prefer (A) to spend 50 minutes doing the task right now or (B) to spend 60 minutes doing the task tomorrow?

2. Would you prefer (A) to spend 50 minutes doing the task in 90 days or (B) to spend 60 minutes doing the task in 91 days?

When asked questions like these, many people choose B for question 1 and A for question 2. When looking ahead to the future (as in question 2), they minimize the amount of time spent on the dreary task. But faced with the prospect of doing the task immediately (as in question 1), they choose to put it off.

In some ways, this behavior is not surprising: Everyone procrastinates from time to time. But from the standpoint of the theory of rational man, it is puzzling. Suppose that in response to question 2, a person chooses to spend 50 minutes in 90 days. Then, when the 90th day arrives, we allow him to change his mind. In effect, he then faces question 1, so he opts for doing the task the next day. But why should the mere passage of time affect the choices he makes?

Many times in life, people make plans for themselves, but then they fail to follow through. A smoker promises himself that he will quit, but within a few hours of smoking his last cigarette, he craves another and breaks his promise. A person trying to lose weight promises that he will stop eating dessert, but when the waiter brings the dessert cart, the diet goes out the window. In both cases, the desire for instant gratification induces the decision maker to abandon his past plans.

Some economists believe that the consumption–saving decision is an import- ant instance in which people exhibit this inconsistency over time. For many peo- ple, spending provides a type of instant gratification. Saving, like passing up the cigarette or the dessert, requires a sacrifice in the present for a reward in the dis- tant future. And just as many smokers wish they could quit and many overweight individuals wish they ate less, many consumers wish they saved more of their in- come. According to one survey, 76 percent of Americans said they were not saving enough for retirement.

An implication of this inconsistency over time is that people should try to find ways to commit their future selves to following through on their plans. A smoker trying to quit may throw away his cigarettes, and a person on a diet may put a lock on the refrigerator. What can a person who saves too little do? He should find some way to lock up his money before he spends it. Some retirement accounts, such as 401(k) plans, do exactly that. A worker can agree to have some money taken out of his paycheck before he ever sees it. The money is deposited in an account that can be used before retirement only with a penalty. Perhaps that is one reason these retirement accounts are so popular: They protect people from their own desires for instant gratification.

QuickQuiz Describe at least three ways in which human decision making differs from

that of the rational individual of conventional economic theory.

467CHAPTER 22 FRONTIERS OF MICROECONOMICS

1. Because Elaine has a family history of significant

medical problems, she buys health insurance,

whereas her friend Jerry, who has a healthier family,

goes without. This is an example of

a. moral hazard.

b. adverse selection.

c. signaling.

d. screening.

2. George has a life insurance policy that pays his family

$1 million if he dies. As a result, he does not hesitate

to enjoy his favorite hobby of bungee jumping. This is

an example of

a. moral hazard.

b. adverse selection.

c. signaling.

d. screening.

3. Before selling anyone a health insurance policy, the

Kramer Insurance Company requires that applicants

undergo a medical examination. Those with signifi-

cant preexisting medical problems are charged more.

This is an example of

a. moral hazard.

b. adverse selection.

c. signaling.

d. screening.

4. The Condorcet paradox illustrates Arrow’s impossibil-

ity theorem by showing that pairwise majority voting

a. is inconsistent with the principle of unanimity.

b. leads to social preferences that are not transitive.

c. violates the independence of irrelevant

alternatives.

d. makes one person in effect a dictator.

5. Two political candidates are vying for town mayor, and

the key issue is how much to spend on the annual

Fourth of July fireworks. Among the 100 voters, 40

want to spend $30,000, 30 want to spend $10,000,

and 30 want to spend nothing at all. What is the win-

ning position on this issue?

a. $10,000

b. $15,000

c. $20,000

d. $30,000

6. The experiment called the ultimatum game illustrates

that people

a. are overconfident in their own abilities.

b. play the Nash equilibrium in strategic situations.

c. care about fairness, even to their own detriment.

d. make inconsistent decisions over time.

CHAPTER QuickQuiz

22-4 Conclusion This chapter examined the frontier of microeconomics. You may have noticed that we sketched out ideas rather than fully developing them. This is no accident. One reason is that you might study these topics in more detail in advanced courses. Another reason is that these topics remain active areas of research and, therefore, are still being fleshed out.

To see how these topics fit into the broader picture, recall the Ten Principles of Economics from Chapter 1. One principle states that markets are usually a good way to organize economic activity. Another principle states that governments can sometimes improve market outcomes. As you study economics, you can more fully appreciate the truth of these principles as well as the caveats that go with them. The study of asymmetric information should make you more wary of mar- ket outcomes. The study of political economy should make you more wary of government solutions. And the study of behavioral economics should make you wary of any institution that relies on human decision making, including both the market and the government.

If there is a unifying theme to these topics, it is that life is messy. Information is imperfect, government is imperfect, and people are imperfect. Of course, you knew this long before you started studying economics, but economists need to understand these imperfections as precisely as they can if they are to explain, and perhaps even improve, the world around them.

468 PART VII TOPICS FOR FURTHER STUDY

• In many economic transactions, information is asym-

metric. When there are hidden actions, principals may

be concerned that agents suffer from the problem of

moral hazard. When there are hidden characteris-

tics, buyers may be concerned about the problem of

adverse selection among the sellers. Private markets

sometimes deal with asymmetric information with sig-

naling and screening.

• Although government policy can sometimes improve

market outcomes, governments are themselves imper-

fect institutions. The Condorcet paradox shows that

majority rule fails to produce transitive preferences for

society, and Arrow’s impossibility theorem shows that

no voting system will be perfect. In many situations,

democratic institutions will produce the outcome

desired by the median voter, regardless of the prefer-

ences of the rest of the electorate. Moreover, the indi-

viduals who set government policy may be motivated

by self-interest rather than the national interest.

• The study of psychology and economics reveals that

human decision making is more complex than is

assumed in conventional economic theory. People are

not always rational, they care about the fairness of eco-

nomic outcomes (even to their own detriment), and

they can be inconsistent over time.

moral hazard, p. 452

agent, p. 452

principal, p. 452

adverse selection, p. 454

signaling, p. 455

screening, p. 456

political economy, p. 457

Condorcet paradox, p. 458

Arrow’s impossibility theorem, p. 459

median voter theorem, p. 460

behavioral economics, p. 461

1. What is moral hazard? List three things an employer

might do to reduce the severity of this problem.

2. What is adverse selection? Give an example of a mar-

ket in which adverse selection might be a problem.

3. Define signaling and screening and give an example of each.

4. What unusual property of voting did Condorcet

notice?

5. Explain why majority rule respects the preferences of

the median voter rather than the average voter.

6. Describe the ultimatum game. What outcome from

this game would conventional economic theory pre-

dict? Do experiments confirm this prediction? Explain.

1. Each of the following situations involves moral

hazard. In each case, identify the principal and

the agent and explain why there is asymmetric

information. How does the action described reduce

the problem of moral hazard?

a. Landlords require tenants to pay security

deposits.

b. Firms compensate top executives with options to

buy company stock at a given price in the future.

c. Car insurance companies offer discounts to

customers who install antitheft devices in their cars.

2. Suppose that the Live-Long-and-Prosper Health

Insurance Company charges $5,000 annually for a

family insurance policy. The company’s president

suggests that the company raise the annual price to

$6,000 to increase its profits. If the firm followed this

suggestion, what economic problem might arise?

Would the firm’s pool of customers tend to become

more or less healthy on average? Would the compa-

ny’s profits necessarily increase?

3. A case study in this chapter describes how a boyfriend

can signal his love to a girlfriend by giving an appro-

priate gift. Do you think saying “I love you” can also

serve as a signal? Why or why not?

SUMMARY

l b l h

KEY CONCEPTS

h l h d h h l l h l h f f

QUESTIONS FOR REVIEW

h f h f ll l l f l l h d

PROBLEMS AND APPLICATIONS

469CHAPTER 22 FRONTIERS OF MICROECONOMICS

4. The health insurance reform signed into law by President

Obama in 2010 included the following two provisions:

i. Insurance companies must offer health insur-

ance to everyone who applies and charge them

the same price regardless of a person’s preex-

isting health condition.

ii. Everyone must buy health insurance or pay a

penalty for not doing so.

a. Which of these policies taken on its own makes

the problem of adverse selection worse? Explain.

b. Why do you think the policy you identified in

part (a) was included in the law?

c. Why do you think the other policy was included

in the law?

5. Ken walks into an ice-cream parlor.

Waiter: “We have vanilla and chocolate today.”

Ken: “I’ll take vanilla.”

Waiter: “I almost forgot. We also have strawberry.”

Ken: “In that case, I’ll take chocolate.”

What standard property of decision making is Ken

violating? (Hint: Reread the section on Arrow’s impossibility theorem.)

6. Three friends are choosing a restaurant for dinner.

Here are their preferences:

Rachel Ross Joey

First choice Italian Italian Chinese

Second choice Chinese Chinese Mexican

Third choice Mexican Mexican French

Fourth choice French French Italian

a. If the three friends use a Borda count to make

their decision, where do they go to eat?

b. On their way to their chosen restaurant, they

see that the Mexican and French restaurants are

closed, so they use a Borda count again to decide

between the remaining two restaurants. Where do

they decide to go now?

c. How do your answers to parts (a) and (b) relate to

Arrow’s impossibility theorem?

7. Three friends are choosing a TV show to watch. Here

are their preferences:

Chandler Phoebe Monica

First choice Empire Supergirl Homeland

Second choice Supergirl Homeland Empire

Third choice Homeland Empire Supergirl

a. If the three friends try using a Borda count to

make their choice, what would happen?

b. Monica suggests a vote by majority rule. She pro-

poses that first they choose between Empire and Supergirl, and then they choose between the winner of the first vote and Homeland. If they all vote their preferences honestly, what outcome would occur?

c. Should Chandler agree to Monica’s suggestion?

What voting system would he prefer?

d. Phoebe and Monica convince Chandler to go

along with Monica’s proposal. In round one,

Chandler dishonestly says he prefers Supergirl over Empire. Why might he do this?

8. Five roommates are planning to spend the weekend

in their dorm room watching movies, and they are

debating how many movies to watch. Here is their

willingness to pay:

Quentin Spike Ridley Martin Steven

First film $14 $10 $8 $4 $2

Second film 12 8 4 2 0

Third film 10 6 2 0 0

Fourth film 6 2 0 0 0

Fifth film 2 0 0 0 0

Buying a DVD costs $15, which the roommates split

equally, so each pays $3 per movie.

a. What is the efficient number of movies to watch

(that is, the number that maximizes total surplus)?

b. From the standpoint of each roommate, what is

the preferred number of movies?

c. What is the preference of the median roommate?

d. If the roommates held a vote on the efficient out-

come versus the median voter’s preference, how

would each person vote? Which outcome would

get a majority?

e. If one of the roommates proposed a different

number of movies, could his proposal beat the

winner from part (d) in a vote?

f. Can majority rule be counted on to reach efficient

outcomes in the provision of public goods?

9. Two ice-cream stands are deciding where to set

up along a 1-mile beach. The people are uniformly

located along the beach, and each person sitting on the

beach buys exactly 1 ice-cream cone per day from the

nearest stand. Each ice-cream seller wants the maxi-

mum number of customers. Where along the beach

will the two stands locate? Of which result in this

chapter does this outcome remind you?

10. The government is considering two ways to help the

needy: giving them cash or giving them free meals at

soup kitchens.

a. Give an argument, based on the standard theory

of the rational consumer, for giving cash.

b. Give an argument, based on asymmetric informa-

tion, for why the soup kitchen may be better than

the cash handout.

c. Give an argument, based on behavioral econom-

ics, for why the soup kitchen may be better than

the cash handout.

To find additional study resources, visit cengagebrain.com,

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The Data of Macroeconomics

PART VIII

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473

W hen you finish school and start looking for a full-time job, your experience will, to a large extent, be shaped by prevailing economic conditions. In some years, firms throughout the economy are expanding their production

of goods and services, employment is rising, and jobs are easy to find. In other years, firms are cutting back production, employment is declining, and finding a good job takes a long time. Not surprisingly, any college graduate would rather enter the labor force in a year of economic expansion than in a year of economic contraction.

Because the health of the overall economy profoundly affects all of us, changes in economic conditions are widely reported by the

Measuring a Nation’s Income

CHAPTER

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474 PART VIII THE DATA OF MACROECONOMICS

media. Indeed, it is hard to pick up a newspaper, check an online news service, or turn on the TV without seeing some newly reported statistic about the econ- omy. The statistic might measure the total income of everyone in the economy (gross domestic product, or GDP), the rate at which average prices are rising or falling (inflation/deflation), the percentage of the labor force that is out of work (unemployment), total spending at stores (retail sales), or the imbalance of trade between the United States and the rest of the world (the trade deficit). All these statistics are macroeconomic. Rather than telling us about a particular household, firm, or market, they tell us something about the entire economy.

As you may recall from Chapter 2, economics is divided into two branches: microeconomics and macroeconomics. Microeconomics is the study of how individual households and firms make decisions and how they interact with one another in markets. Macroeconomics is the study of the economy as a whole. The goal of macroeconomics is to explain the economic changes that affect many households, firms, and markets simultaneously. Macroeconomists address a broad variety of questions: Why is average income high in some countries and low in others? Why do prices sometimes rise rapidly while at other times they are more stable? Why do production and employment expand in some years and contract in others? What, if anything, can the government do to promote rapid growth in incomes, low inflation, and stable employment? These questions are all macroeco- nomic in nature because they concern the workings of the entire economy.

Because the economy as a whole is a collection of many households and many firms interacting in many markets, microeconomics and macroeconomics are closely linked. The basic tools of supply and demand, for instance, are as central to macroeconomic analysis as they are to microeconomic analysis. Yet studying the economy in its entirety raises some new and intriguing challenges.

In this and the next chapter, we discuss some of the data that economists and policymakers use to monitor the performance of the overall economy. These data reflect the economic changes that macroeconomists try to explain. This chapter considers gross domestic product, which measures the total income of a nation. GDP is the most closely watched economic statistic because it is thought to be the sin- gle best measure of a society’s economic well-being.

microeconomics

the study of how house-

holds and firms make

decisions and how they

interact in markets

macroeconomics

the study of

economy-wide

phenomena, including

inflation, unemployment,

and economic growth

23-1 The Economy’s Income and Expenditure If you were to judge how a person is doing economically, you might first look at her income. A person with a high income can more easily afford life’s necessi- ties and luxuries. It is no surprise that people with higher incomes enjoy higher standards of living—better housing, better healthcare, fancier cars, more opulent vacations, and so on.

The same logic applies to a nation’s overall economy. When judging whether the economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning. That is the task of gross domestic product.

GDP measures two things at once: the total income of everyone in the economy and the total expenditure on the economy’s output of goods and services. GDP can per- form the trick of measuring both total income and total expenditure because these two things are the same. For an economy as a whole, income must equal expenditure.

Why is this true? An economy’s income is the same as its expenditure because every transaction has two parties: a buyer and a seller. Every dollar of spending by some buyer is a dollar of income for some seller. Suppose, for instance, that Karen pays Doug $100 to mow her lawn. In this case, Doug is a seller of a ser- vice and Karen is a buyer. Doug earns $100 and Karen spends $100. Thus, the

475CHAPTER 23 MEASURING A NATION’S INCOME

transaction contributes equally to the economy’s income and to its expenditure. GDP, whether measured as total income or total expenditure, rises by $100.

Another way to see the equality of income and expenditure is with the circu- lar-flow diagram in Figure 1. As you may recall from Chapter 2, this diagram describes all the transactions between households and firms in a simple econ- omy. It simplifies matters by assuming that all goods and services are bought by households and that households spend all of their income. In this economy, when households buy goods and services from firms, these expenditures flow through the markets for goods and services. When the firms use the money they receive from sales to pay workers’ wages, landowners’ rent, and firm owners’ profit, this income flows through the markets for the factors of production. Money continu- ously flows from households to firms and then back to households.

GDP measures this flow of money. We can compute it for this economy in one of two ways: by adding up the total expenditure by households or by adding up the total income (wages, rent, and profit) paid by firms. Because all expenditure in the economy ends up as someone’s income, GDP is the same regardless of how we compute it.

The actual economy is, of course, more complicated than the one illustrated in Figure 1. Households do not spend all of their income; they pay some of it to the government in taxes, and they save some for use in the future. In addition, households do not buy all goods and services produced in the economy; some goods and services are bought by governments, and some are bought by firms that plan to use them in the future to produce their own output. Yet the basic les- son remains the same: Regardless of whether a household, government, or firm buys a good or service, the transaction always has a buyer and a seller. Thus, for the economy as a whole, expenditure and income are the same.

QuickQuiz What two things does GDP measure? How can it measure two things at once?

FIGURE 1

The Circular-Flow Diagram

Households buy goods and services

from firms, and firms use their

revenue from sales to pay wages to

workers, rent to landowners, and profit

to firm owners. GDP equals the total

amount spent by households in the

market for goods and services. It also

equals the total wages, rent, and profit

paid by firms in the markets for the

factors of production.

Spending (= GDP)

Goods and services bought

Revenue (= GDP)

Goods and services sold

Labor, land, and capital

Income (= GDP)

5 Flow of inputs and outputs

5 Flow of dollars

Factors of production

Wages, rent, and profit (= GDP)

FIRMS HOUSEHOLDS

MARKETS FOR FACTORS OF PRODUCTION

MARKETS FOR GOODS AND

SERVICES

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476 PART VIII THE DATA OF MACROECONOMICS

Having discussed the meaning of gross domestic product in general terms, let’s be more precise about how this statistic is measured. Here is a definition of GDP that focuses on GDP as a measure of total expenditure:

is the market value of all final goods and ser- vices produced within a country in a given period of time.

This definition might seem simple enough. But in fact, many subtle issues arise when computing an economy’s GDP. Let’s therefore consider each phrase in this definition with some care.

23-2a “GDP Is the Market Value . . .” You have probably heard the adage “You can’t compare apples and oranges.” Yet GDP does exactly that. GDP adds together many different kinds of products into a single measure of the value of economic activity. To do this, it uses market prices. Because market prices measure the amount people are willing to pay for different goods, they reflect the value of those goods. If the price of an apple is twice the price of an orange, then an apple contributes twice as much to GDP as does an orange.

23-2b “. . . of All . . .” GDP tries to be comprehensive. It includes all items produced in the economy and sold legally in markets. GDP measures the market value of not just apples and oranges but also pears and grapefruit, books and movies, haircuts and healthcare, and so on.

GDP also includes the market value of the housing services provided by the economy’s stock of housing. For rental housing, this value is easy to calculate— the rent equals both the tenant’s expenditure and the landlord’s income. Yet many people own their homes and, therefore, do not pay rent. The government includes this owner-occupied housing in GDP by estimating its rental value. In effect, GDP is based on the assumption that the owner is renting the house to herself. The imputed rent is included both in the homeowner ’s expenditure and in her income, so it adds to GDP.

There are some products, however, that GDP excludes because measuring them is difficult. GDP excludes most items produced and sold illicitly, such as illegal drugs. It also excludes most items that are produced and consumed at home and, therefore, never enter the marketplace. Vegetables you buy at the grocery store are part of GDP; vegetables you grow in your garden are not.

These exclusions from GDP can at times lead to paradoxical results. For exam- ple, when Karen pays Doug to mow her lawn, that transaction is part of GDP. But suppose Doug and Karen marry. Even though Doug may continue to mow Kar- en’s lawn, the value of the mowing is now left out of GDP because Doug’s service is no longer sold in a market. Thus, their marriage reduces GDP.

23-2c “. . . Final . . .” When International Paper makes paper, which Hallmark then uses to make a greeting card, the paper is called an intermediate good and the card is called a final good. GDP includes only the value of final goods. This is done because the value

gross domestic product

(GDP)

the market value of all

final goods and services

produced within a coun-

try in a given period of

time

23-2 The Measurement of GDP

477CHAPTER 23 MEASURING A NATION’S INCOME

of intermediate goods is already included in the prices of the final goods. Adding the market value of the paper to the market value of the card would be double counting. That is, it would (incorrectly) count the paper twice.

An important exception to this principle arises when an intermediate good is produced and, rather than being used, is added to a firm’s inventory of goods for use or sale at a later date. In this case, the intermediate good is taken to be “final” for the moment, and its value as inventory investment is included as part of GDP. Thus, additions to inventory add to GDP, and when the goods in inventory are later used or sold, the reductions in inventory subtract from GDP.

23-2d “. . . Goods and Services . . .” GDP includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits). When you buy a CD by your favorite band, you are buying a good, and the purchase price is part of GDP. When you pay to hear a concert by the same band, you are buying a service, and the ticket price is also part of GDP.

23-2e “. . . Produced . . .” GDP includes goods and services currently produced. It does not include transac- tions involving items produced in the past. When Ford produces and sells a new car, the value of the car is included in GDP. But when one person sells a used car to another person, the value of the used car is not included in GDP.

23-2f “. . . Within a Country . . .” GDP measures the value of production within the geographic confines of a coun- try. When a Canadian citizen works temporarily in the United States, her produc- tion is part of U.S. GDP. When an American citizen owns a factory in Haiti, the production at her factory is not part of U.S. GDP. (It is part of Haiti’s GDP.) Thus, items are included in a nation’s GDP if they are produced domestically, regardless of the nationality of the producer.

23-2g “. . . In a Given Period of Time.” GDP measures the value of production that takes place within a specific interval of time. Usually, that interval is a year or a quarter (3 months). GDP measures the economy’s flow of income, as well as its flow of expenditure, during that interval.

When the government reports the GDP for a quarter, it usually presents GDP “at an annual rate.” This means that the figure reported for quarterly GDP is the amount of income and expenditure during the quarter multiplied by 4. The gov- ernment uses this convention so that quarterly and annual figures on GDP can be compared more easily.

In addition, when the government reports quarterly GDP, it presents the data after they have been modified by a statistical procedure called seasonal adjustment. The unadjusted data show clearly that the economy produces more goods and services during some times of the year than during others. (As you might guess, December ’s holiday shopping season is a high point.) When monitoring the con- dition of the economy, economists and policymakers often want to look beyond these regular seasonal changes. Therefore, government statisticians adjust the quarterly data to take out the seasonal cycle. The GDP data reported in the news are always seasonally adjusted.

478 PART VIII THE DATA OF MACROECONOMICS

Other Measures of Income

W hen the U.S. Department of Commerce computes the nation’s GDP,

it also computes various other measures of income to get a more

complete picture of what’s happening in the economy. These other mea-

sures differ from GDP by excluding or including certain categories of

income. What follows is a brief description of five of these income mea-

sures, ordered from largest to smallest.

Gross national product (GNP) is the total income earned by a

nation’s permanent residents (called nationals). It differs from

GDP in that it includes income that our citizens earn abroad and

excludes income that foreigners earn here. For example, when a

Canadian citizen works temporarily in the United States, her pro-

duction is part of U.S. GDP, but it is not part of U.S. GNP. (It is part

of Canada’s GNP.) For most countries, including the United States,

domestic residents are responsible for most domestic production,

so GDP and GNP are quite close.

Net national product (NNP) is the total income of a nation’s residents

(GNP) minus losses from depreciation. Depreciation is the wear and

tear on the economy’s stock of equipment and structures, such as

trucks rusting and old computer models becoming obsolete. In the

national income accounts prepared by the Department of Commerce,

depreciation is called the “consumption of fixed capital.”

National income is the total income earned by a nation’s resi-

dents in the production of goods and services. It is almost iden-

tical to net national product. These two measures differ because

of the statistical discrepancy that arises from problems in data

collection.

P e r s o n a l i n c o m e

i s t h e i n c o m e

t h a t h o u s e h o l d s

a n d n o n c o r p o r a t e

businesses receive.

Unlike national income,

it excludes retained earnings,

which is income that corporations have earned but have not paid

out to their owners. It also subtracts indirect business taxes (such

as sales taxes), corporate income taxes, and contributions for

social insurance (mostly Social Security taxes). In addition, per-

sonal income includes the interest income that households receive

from their holdings of government debt and the income that house-

holds receive from government transfer programs, such as welfare

and Social Security.

Disposable personal income is the income that households and

noncorporate businesses have left after satisfying all their obli-

gations to the government. It equals personal income minus per-

sonal taxes and certain nontax payments (such as traffic tickets).

Although the various measures of income differ in detail, they

almost always tell the same story about economic conditions. When GDP

grows rapidly, these other measures of income usually grow rapidly. And

when GDP falls, these other measures usually fall as well. For monitoring

fluctuations in the overall economy, it does not matter much which mea-

sure of income we use. ■

F Y I

Now let’s repeat the definition of GDP:

Gross domestic product (GDP) is the market value of all final goods and ser- vices produced within a country in a given period of time.

This definition focuses on GDP as total expenditure in the economy. But don’t forget that every dollar spent by a buyer of a good or service becomes a dollar of income to the seller of that good or service. Therefore, in addition to applying this definition, the government adds up total income in the economy. The two ways of calculating GDP give almost exactly the same answer. (Why “almost”? The two measures should be precisely the same, but data sources are not perfect. The dif- ference between the two calculations of GDP is called the statistical discrepancy.)

It should be apparent that GDP is a sophisticated measure of the value of eco- nomic activity. In advanced courses in macroeconomics, you will learn more about the subtleties that arise in its calculation. But even now you can see that each phrase in this definition is packed with meaning.

QuickQuiz Which contributes more to GDP—the production of a pound of hamburger

or the production of a pound of caviar? Why?

479CHAPTER 23 MEASURING A NATION’S INCOME

23-3 The Components of GDP Spending in an economy takes many forms. At any moment, the Smith family may be having lunch at Burger King; Ford may be building a car factory; the U.S. Navy may be procuring a submarine; and British Airways may be buying an airplane from Boeing. GDP includes all of these various forms of spending on domestically produced goods and services.

To understand how the economy is using its scarce resources, economists study the composition of GDP among various types of spending. To do this, GDP (which we denote as Y) is divided into four components: consumption (C), invest- ment (I), government purchases (G), and net exports (NX):

Y 5 C 1 I 1 G 1 NX.

This equation is an identity—an equation that must be true because of how the variables in the equation are defined. In this case, because each dollar of expendi- ture included in GDP is placed into one of the four components of GDP, the total of the four components must be equal to GDP. Let’s look at each of these four components more closely.

23-3a Consumption is spending by households on goods and services, with the excep-

tion of purchases of new housing. Goods include durable goods, such as automo- biles and appliances, and nondurable goods, such as food and clothing. Services include such intangible items as haircuts and medical care. Household spending on education is also included in consumption of services (although one might argue that it would fit better in the next component).

23-3b Investment is the purchase of goods (called capital goods) that will be used in the

future to produce more goods and services. Investment is the sum of purchases of business capital, residential capital, and inventories. Business capital includes business structures (such as a factory or office building), equipment (such as a worker’s computer), and intellectual property products (such as the software that runs the computer). Residential capital includes the landlord’s apartment build- ing and a homeowner’s personal residence. By convention, the purchase of a new house is the one type of household spending categorized as investment rather than consumption.

As mentioned earlier, the treatment of inventory accumulation is noteworthy. When Apple produces a computer and adds it to its inventory instead of selling it, Apple is assumed to have “purchased” the computer for itself. That is, the national income accountants treat the computer as part of Apple’s investment spending. (If Apple later sells the computer out of inventory, Apple’s inventory investment will then be negative, offsetting the positive expenditure of the buyer.) Inventories are treated this way because one aim of GDP is to measure the value of the economy’s production, and goods added to inventory are part of that period’s production.

Notice that GDP accounting uses the word investment differently from how you might hear the term in everyday conversation. When you hear the word investment, you might think of financial investments, such as stocks, bonds, and mutual funds—topics that we study later in this book. By contrast, because GDP measures expenditure on goods and services, here the word investment means

consumption

spending by households

on goods and services,

with the exception of

purchases of new housing

investment

spending on business

capital, residential

capital, and inventories

480 PART VIII THE DATA OF MACROECONOMICS

Some nations are debating what

to include in their national income

accounts.

No Sex, Please, We’re French

By Zachary Karabell

T he government of France has just made

what on the face of it appears to be a

nonannouncement announcement: It will

not include illegal drugs and prostitution in

its official calculation of the country’s gross

domestic product.

What made the announcement odd was

that it never has included such activities, nor

have most countries. Nor do most governments

announce what they do not plan to do. (“The

U.S. government has no intention of sending

a man to Venus.”) Yet the French decision

comes in the wake of significant pressure from

neighboring countries and from the European

Union to integrate these activities into national

accounts and economic output. That raises a

host of questions: Should these activities be

included, and if those are, why not others? And

what exactly are we measuring—and why?

Few numbers shape our world today more

than GDP. It has become the alpha and omega

of national success, used by politicians and

pundits as the primary gauge of national

strength and treated as a numerical proxy for

greatness or the lack thereof.

Yet GDP is only a statistic, replete with

the limitations of all statistics. Created as

an outgrowth of national accounts that were

themselves only devised in the 1930s, GDP

was never an all-inclusive measure, even as it

is treated as such. Multiple areas of economic

life were left out, including volunteer work and

domestic work.

Now Eurostat, the official statistical

agency of the European Union, is leading the

drive to include a host of illegal activities in

national calculations of GDP, most notably

prostitution and illicit drugs. The argument,

as a United Nations commission laid out in

2008, is fairly simple: Prostitution and illicit

drugs are significant economic activities, and

if they’re not factored into economic statistics,

then we’re looking at an incomplete picture—

which in turn will make it that much harder

to craft smart policy. Additionally, different

Sex, Drugs, and GDP

IN THE NEWS

government purchases

spending on goods and

services by local, state,

and federal governments

purchases of goods (such as business capital, residential structures, and invento- ries) that will be used to produce other goods and services in the future.

23-3c Government Purchases include spending on goods and services by local, state,

and federal governments. It includes the salaries of government workers as well as expenditures on public works. Recently, the U.S. national income accounts have switched to the longer label government consumption expenditure and gross investment, but in this book, we will use the traditional and shorter term government purchases.

The meaning of government purchases requires a bit of clarification. When the government pays the salary of an Army general or a schoolteacher, that salary is part of government purchases. But when the government pays a Social Secu- rity benefit to a person who is elderly or an unemployment insurance benefit to a worker who was recently laid off, the story is very different: These are called transfer payments because they are not made in exchange for a currently produced good or service. Transfer payments alter household income, but they do not reflect the economy’s production. (From a macroeconomic standpoint, transfer payments are like negative taxes.) Because GDP is intended to measure income from, and expenditure on, the production of goods and services, transfer pay- ments are not counted as part of government purchases.

23-3d Net Exports equal the foreign purchases of domestically produced goods (exports)

minus the domestic purchases of foreign goods (imports). A domestic firm’s sale

net exports

spending on domestically

produced goods by

foreigners (exports) minus

spending on foreign

goods by domestic

residents (imports)

481CHAPTER 23 MEASURING A NATION’S INCOME

countries have different laws: In the Nether-

lands, for instance, prostitution is legal, as

is marijuana. Those commercial transactions

(or at least those that are recorded and taxed)

are already part of Dutch GDP. Not including

them in Italy’s or Spain’s GDPs can thus make

it challenging to compare national numbers.

That is why Spain, Italy, Belgium, and the

U.K. have in recent months moved to include

illegal drugs and nonlicensed sex trade in their

national accounts. The U.K. Office for National

Statistics in particular approached its mandate

with wonkish seriousness, publishing a 20-

page précis of its methodology that explained

how it would, say, calculate the dollar amount

of prostitution (police records help) or deal with

domestically produced drugs versus imported

drugs. The result, which will be formally an-

nounced in September, will be an additional 10

billion pounds added to Great Britain’s GDP.

France, however, has demurred. A nation

with a clichéd reputation for a certain savoir

faire when it comes to sex and other nocturnal

activities has decided (or at least its bureau-

crats have) that in spite of an EU directive,

it will not calculate the effects of illegal

activities that are often nonconsensual or

nonvoluntary. That is clearly the case for some

prostitution—one French minister stated that

“street prostitution” is largely controlled by

the Mafia—and the same could be reason-

ably said of the use of some hard drugs, given

their addictive nature.

There is undeniably a strong moralistic

component in the French decision. By aver-

ring that because they are not voluntary or

consensual these exchanges should not be

included in GDP, the French government is

placing a moral vision of what society should

be ahead of an economic vision of what soci-

ety is. That in turn makes an already messy

statistic far messier, and that serves no one’s

national interests. . . .

With all of GDP’s limitations, adding a

new moral dimension would only make the

number that much less useful. After all, why

stop at not including prostitution because it

degrades women? Why not refuse to measure

coal production because it degrades the envi-

ronment? Why not leave out cigarette usage

because it causes cancer? The list of possible

exclusions on this basis is endless.

If GDP is our current best metric for national

output, then at the very least it should attempt

to include all measurable output. The usually

moralistic United States has actually been

including legal prostitution in Nevada and now

marijuana sales and consumption in Colorado,

California, and Washington without any strong

objections based solely on the argument that

these are commercial exchanges that constitute

this fuzzy entity we call “the economy.”…

Not measuring drugs and sex won’t make

them go away, but it will hobble efforts to

understand the messy latticework of our eco-

nomic lives, all in a futile attempt to excise

what we do not like. ■

Source: Slate, June 20, 2014.

CASE STUDY

THE COMPONENTS OF U.S. GDP Table 1 shows the composition of U.S. GDP in 2015. In this year, the GDP of the United States was almost $18 trillion. Dividing this num- ber by the 2015 U.S. population of 321 million yields GDP per person

(sometimes called GDP per capita). In 2015 the income and expendi- ture of the average American was $55,882.

Consumption made up 68 percent of GDP, or $38,218 per person. Investment was $9,402 per person. Government purchases were $9,919 per person. Net exports were −$1,657 per person. This number is negative because Americans spent more on foreign goods than foreigners spent on American goods.

to a buyer in another country, such as Boeing’s sale of an airplane to British Air- ways, increases net exports.

The net in net exports refers to the fact that imports are subtracted from exports. This subtraction is made because other components of GDP include imports of goods and services. For example, suppose that a household buys a $40,000 car from Volvo, the Swedish carmaker. This transaction increases consumption by $40,000 because car purchases are part of consumer spending. It also reduces net exports by $40,000 because the car is an import. In other words, net exports include goods and services produced abroad (with a minus sign) because these goods and ser- vices are included in consumption, investment, and government purchases (with a plus sign). Thus, when a domestic household, firm, or government buys a good or service from abroad, the purchase reduces net exports, but because it also raises consumption, investment, or government purchases, it does not affect GDP.

482 PART VIII THE DATA OF MACROECONOMICS

23-4 Real versus Nominal GDP As we have seen, GDP measures the total spending on goods and services in all markets in the economy. If total spending rises from one year to the next, at least one of two things must be true: (1) the economy is producing a larger output of goods and services, or (2) goods and services are being sold at higher prices. When studying changes in the economy over time, economists want to separate these two effects. In particular, they want a measure of the total quantity of goods and services the economy is producing that is not affected by changes in the prices of those goods and services.

To do this, economists use a measure called real GDP. Real GDP answers a hypothetical question: What would be the value of the goods and services pro- duced this year if we valued these goods and services at the prices that prevailed in some specific year in the past? By evaluating current production using prices that are fixed at past levels, real GDP shows how the economy’s overall produc- tion of goods and services changes over time.

To see more precisely how real GDP is constructed, let’s consider an example.

23-4a A Numerical Example Table 2 shows some data for an economy that produces only two goods: hot dogs and hamburgers. The table shows the prices and quantities produced of the two goods in the years 2016, 2017, and 2018.

To compute total spending in this economy, we would multiply the quantities of hot dogs and hamburgers by their prices. In the year 2016, 100 hot dogs are sold at a price of $1 per hot dog, so expenditure on hot dogs equals $100. In the same year, 50 hamburgers are sold for $2 per hamburger, so expenditure on hamburg- ers also equals $100. Total expenditure in the economy—the sum of expenditure on hot dogs and expenditure on hamburgers—is $200. This amount, the produc- tion of goods and services valued at current prices, is called .

nominal GDP

the production of goods

and services valued at

current prices

TABLE 1

GDP and Its Components

This table shows

total GDP for the

U.S. economy in 2015

and the breakdown of

GDP among its four

components. When

reading this table,

recall the identity

Y 5 C 1 I 1 G 1 NX.

Total

(in billions of dollars)

Per Person

(in dollars)

Percent

of Total

Gross domestic product, Y $17,938 $55,882 100%

Consumption, C 12,268 38,218 68

Investment, I 3,018 9,402 17

Government purchases, G 3,184 9,919 18

Net exports, NX 2532 21,657 23

Source: U.S. Department of Commerce. Parts may not sum to totals due to rounding.

These data come from the Bureau of Economic Analysis, the part of the U.S. De- partment of Commerce that produces the national income accounts. You can find more recent data on GDP on its website, http://www.bea.gov. ●

QuickQuiz List the four components of expenditure. Which is the largest?

483CHAPTER 23 MEASURING A NATION’S INCOME

The table shows the calculation of nominal GDP for these 3 years. Total spend- ing rises from $200 in 2016 to $600 in 2017 and then to $1,200 in 2018. Part of this rise is attributable to the increase in the quantities of hot dogs and hamburgers, and part is attributable to the increase in the prices of hot dogs and hamburgers.

To obtain a measure of the amount produced that is not affected by changes in prices, we use , which is the production of goods and services valued at constant prices. We calculate real GDP by first designating 1 year as a base year. We then use the prices of hot dogs and hamburgers in the base year to compute the value of goods and services in all the years. In other words, the prices in the base year provide the basis for comparing quantities in different years.

Suppose that we choose 2016 to be the base year in our example. We can then use the prices of hot dogs and hamburgers in 2016 to compute the value of goods and services produced in 2016, 2017, and 2018. Table 2 shows these calculations. To compute real GDP for 2016, we use the prices of hot dogs and hamburgers in 2016 (the base year) and the quantities of hot dogs and hamburgers produced in 2016. (Thus, for the base year, real GDP always equals nominal GDP.) To com- pute real GDP for 2017, we use the prices of hot dogs and hamburgers in 2016 (the base year) and the quantities of hot dogs and hamburgers produced in 2017. Similarly, to compute real GDP for 2018, we use the prices in 2016 and the quan- tities in 2018. When we find that real GDP has risen from $200 in 2016 to $350 in 2017 and then to $500 in 2018, we know that the increase is attributable to an increase in the quantities produced because the prices are being held fixed at base-year levels.

TABLE 2

Real and Nominal

GDP

This table shows

how to calculate

real GDP, nomi-

nal GDP, and the

GDP deflator for a

hypothetical econ-

omy that produces

only hot dogs and

hamburgers.

Prices and Quantities

Year

Price of

Hot Dogs

Quantity of

Hot Dogs

Price of

Hamburgers

Quantity of

Hamburgers

2016 $1 100 $2 50

2017 $2 150 $3 100

2018 $3 200 $4 150

Calculating Nominal GDP

2016 ($1 per hot dog 3 100 hot dogs) 1 ($2 per hamburger 3 50 hamburgers) 5 $200

2017 ($2 per hot dog 3 150 hot dogs) 1 ($3 per hamburger 3 100 hamburgers) 5 $600

2018 ($3 per hot dog 3 200 hot dogs) 1 ($4 per hamburger 3 150 hamburgers) 5 $1,200

Calculating Real GDP (base year 2016)

2016 ($1 per hot dog 3 100 hot dogs) 1 ($2 per hamburger 3 50 hamburgers) 5 $200

2017 ($1 per hot dog 3 150 hot dogs) 1 ($2 per hamburger 3 100 hamburgers) 5 $350

2018 ($1 per hot dog 3 200 hot dogs) 1 ($2 per hamburger 3 150 hamburgers) 5 $500

Calculating the GDP Deflator

2016 ($200/$200) 3 100 5 100

2017 ($600/$350) 3 100 5 171

2018 ($1,200/$500) 3 100 5 240

real GDP

the production of goods

and services valued at

constant prices

484 PART VIII THE DATA OF MACROECONOMICS

To sum up: Nominal GDP uses current prices to place a value on the economy’s produc- tion of goods and services. Real GDP uses constant base-year prices to place a value on the economy’s production of goods and services. Because real GDP is not affected by changes in prices, changes in real GDP reflect only changes in the amounts being produced. Thus, real GDP is a measure of the economy’s production of goods and services.

Our goal in computing GDP is to gauge how well the overall economy is per- forming. Because real GDP measures the economy’s production of goods and ser- vices, it reflects the economy’s ability to satisfy people’s needs and desires. Thus, real GDP is a better gauge of economic well-being than is nominal GDP. When economists talk about the economy’s GDP, they usually mean real GDP rather than nominal GDP. And when they talk about growth in the economy, they mea- sure that growth as the percentage change in real GDP from one period to another.

23-4b The GDP Deflator As we have just seen, nominal GDP reflects both the quantities of goods and ser- vices the economy is producing and the prices of those goods and services. By contrast, by holding prices constant at base-year levels, real GDP reflects only the quantities produced. From these two statistics, we can compute a third, called the GDP deflator, which reflects only the prices of goods and services.

The is calculated as follows:

GDP de flator 5 Nominal GDP

Re al GDP 3 1 0 0 .

Because nominal GDP and real GDP must be the same in the base year, the GDP deflator for the base year always equals 100. The GDP deflator for subsequent years measures the change in nominal GDP from the base year that cannot be attributable to a change in real GDP.

The GDP deflator measures the current level of prices relative to the level of prices in the base year. To see why this is true, consider a couple of simple exam- ples. First, imagine that the quantities produced in the economy rise over time but prices remain the same. In this case, both nominal and real GDP rise at the same rate, so the GDP deflator is constant. Now suppose, instead, that prices rise over time but the quantities produced stay the same. In this second case, nominal GDP rises but real GDP remains the same, so the GDP deflator rises. Notice that, in both cases, the GDP deflator reflects what’s happening to prices, not quantities.

Let’s now return to our numerical example in Table 2. The GDP deflator is com- puted at the bottom of the table. For the year 2016, nominal GDP is $200 and real GDP is $200, so the GDP deflator is 100. (The deflator is always 100 in the base year.) For the year 2017, nominal GDP is $600 and real GDP is $350, so the GDP deflator is 171.

Economists use the term inflation to describe a situation in which the economy’s overall price level is rising. The inflation rate is the percentage change in some measure of the price level from one period to the next. Using the GDP deflator, the inflation rate between two consecutive years is computed as follows:

Inflation rate in year 2 5 GDP deflator in year 2 2 GDP deflator in year 1

GDP deflator in year 1 3 100.

Because the GDP deflator rose in year 2017 from 100 to 171, the inflation rate is 100 3 (171 2 100)/100, or 71 percent. In 2018, the GDP deflator rose to 240 from 171 the previous year, so the inflation rate is 100 3 (240 2 171)/171, or 40 percent.

The GDP deflator is one measure that economists use to monitor the average level of prices in the economy and thus the rate of inflation. The GDP deflator gets its name

GDP deflator

a measure of the price

level calculated as the

ratio of nominal GDP to

real GDP times 100

485CHAPTER 23 MEASURING A NATION’S INCOME

CASE STUDY

A HALF CENTURY OF REAL GDP Now that we know how real GDP is defined and measured, let’s look at what this macroeconomic variable tells us about the recent history of the United States. Figure 2 shows quarterly data on real GDP for

the U.S. economy since 1965. The most obvious feature of these data is that real GDP grows over time. The real

GDP of the U.S. economy in 2015 was more than four times its 1965 level. Put differently, the output of goods and services produced in the United States has grown on average about 3 percent per year. This continued growth in real GDP enables most Americans to enjoy greater economic prosperity than their parents and grandparents did.

A second feature of the GDP data is that growth is not steady. The upward climb of real GDP is occasionally interrupted by periods during which GDP declines, called recessions. Figure 2 marks recessions with shaded vertical bars. (There is no ironclad rule for when the official business cycle dating committee will declare that a recession has occurred, but an old rule of thumb is two consecutive quar- ters of falling real GDP.) Recessions are associated not only with lower incomes but also with other forms of economic distress: rising unemployment, falling profits, increased bankruptcies, and so on.

Much of macroeconomics is aimed at explaining the long-run growth and short- run fluctuations in real GDP. As we will see in the coming chapters, we need dif- ferent models for these two purposes. Because the short-run fluctuations represent deviations from the long-run trend, we first examine the behavior of key macro- economic variables, including real GDP, in the long run. Then in later chapters, we build on this analysis to explain short-run fluctuations. ●

because it can be used to take inflation out of nominal GDP—that is, to “deflate” nom- inal GDP for the rise that is due to increases in prices. We examine another measure of the economy’s price level, called the consumer price index, in the next chapter, where we also describe the differences between the two measures.

FIGURE 2

Real GDP in the United

States

This figure shows quar-

terly data on real GDP for

the U.S. economy since

1965. Recessions—

periods of falling real

GDP—are marked with

the shaded vertical bars.

Source: U.S. Department of Commerce.

16,000

14,000

12,000

10,000

8,000

6,000

4,000

2,000

0 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Year

Billions of 2009 Dollars

Real GDP

486 PART VIII THE DATA OF MACROECONOMICS

GDP measures the economy’s total

output. Labor productivity measures

output per unit of labor input. If

GDP is incorrectly measured, so is

productivity.

Silicon Valley Doesn’t Believe

U.S. Productivity Is Down

By Timothy Aeppel

M OUNTAIN VIEW, Calif.—Google Inc. chief

economist Hal Varian is an evangelist for

Silicon Valley’s contrarian take on America’s

productivity slump.

Swiveling to a large screen on the desk

behind him, Mr. Varian types in a search

for the most commonly asked question

on the subject economists elsewhere are

wringing their hands over. Up pops, “What is

productivity?”

See, he says, vindicated: “Most people

don’t know what it even means.”

To Mr. Varian and other wealthy brains

in the world’s most innovative neighborhood,

productivity means giving people and com-

panies tools to do things better and faster.

By that measure, there is an explosion under

way, thanks to the shiny gadgets, apps and

digital geegaws spewing out of Silicon Valley.

Official U.S. figures tell a different story.

For a decade, economic output per hour

worked—the federal government’s formula

for productivity—has barely budged…. Pro-

ductivity matters, economists point out, be-

cause at a 2% annual growth rate, it takes 35

years to double the standard of living; at 1%,

it takes 70. Low productivity growth slows the

economy and holds down wages.

The 68-year-old Mr. Varian, dressed in a

purple hoodie and khaki pants, says the U.S.

doesn’t have a productivity problem, it has a

measurement problem, a sound bite shaping

up as the gospel according to Silicon Valley.

“There is a lack of appreciation for what’s

happening in Silicon Valley,” he says, “because

we don’t have a good way to measure it.”

One measurement problem is that a lot

of what originates here is free or nearly free.

Take, for example, a recent walk Mr. Varian

Gauging the High-Tech Economy

IN THE NEWS

QuickQuiz Define real GDP and nominal GDP. Which is a better measure of eco-

nomic well-being? Why?

23-5 Is GDP a Good Measure of Economic Well-Being?

Earlier in this chapter, GDP was called the single best measure of the economic well-being of a society. Now that we know what GDP is, we can evaluate this claim.

As we have seen, GDP measures both the economy’s total income and the economy’s total expenditure on goods and services. Thus, GDP per person tells us the income and expenditure of the average person in the economy. Because most people would prefer to receive higher income and enjoy higher expenditure, GDP per person seems a natural measure of the economic well-being of the average individual.

Yet some people dispute the validity of GDP as a measure of well-being. When Senator Robert Kennedy was running for president in 1968, he gave a moving critique of such economic measures:

[Gross domestic product] does not allow for the health of our children, the quality of their education, or the joy of their play. It does not include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our courage,

487CHAPTER 23 MEASURING A NATION’S INCOME

arranged with friends. To find each other in

the sprawling park nearby, he and his pals

used an app that tracked their location,

allowing them to meet up quickly. The same

tool can track the movement of workers in a

warehouse, office or shopping mall.

“Obviously that’s a productivity enhance-

ment,” Mr. Varian says. “But I doubt that gets

measured anywhere.”

Consider the efficiency of hailing a taxi

with an app on your mobile phone, or finding

someone who will meet you at the airport and

rent your car while you’re away, a new service

in San Francisco. Add in online tools that

instantly translate conversations or help

locate organ donors—the list goes on and on.

Surely, Mr. Varian says, they also make the

U.S. more productive….

One problem with the government’s pro-

ductivity measure, Mr. Varian says, is that it

is based on gross domestic product, the tally

of goods and services produced by the U.S.

economy. GDP was conceived in the 1930s,

when economists worried mostly about how

much, for example, steel and grain were pro-

duced—output easy to measure compared

with digital goods and services.

Technological improvements and time-

saving apps are trickier. For one thing, it is

tough to capture the full impact of quality

improvements. For example, if a newer model

car breaks down less often than older models

but costs the same, the consumers’ gain can

get lost in the ether….

The U.S. Labor Department has sought

to update its GDP measure over the years to

include more intangibles, such as adjusting

for higher quality. Productivity measures of

computer chips, for example, are periodically

updated to account for faster speeds. But

critics say the process lags behind badly….

Silicon Valley’s complaints echo earlier

eras. The introduction in the last century of

indoor plumbing and household appliances

drastically increased the efficiency of per-

forming domestic chores. But since domestic

labor isn’t counted in GDP either, the time

saved hauling water or washing clothes by

hand didn’t show up in productivity numbers.

However, these timesaving technolo-

gies—among other factors—eventually led

to the flood of women into the workforce start-

ing in the 1960s, which, in turn, sent U.S.

output soaring.

Mr. Varian is convinced something similar

will happen again. At the heart of his argument

is the Internet search, cutting short the time to,

say, learn how to grow geraniums or find the

best Mexican restaurant—a free tool that pro-

vides uncounted value at home and at work….

“To be fair,” he says, “as we adopt technologies

that save time in these nonmarket activities,

that frees up time for market-based activities

which will show up in GDP.” ■

Source: The Wall Street Journal, July 17, 2015.

nor our wisdom, nor our devotion to our country. It measures everything, in short, except that which makes life worthwhile, and it can tell us everything about America except why we are proud that we are Americans.

Much of what Robert Kennedy said is correct. Why, then, do we care about GDP? The answer is that a large GDP does in fact help us to lead good lives. GDP

does not measure the health of our children, but nations with larger GDP can afford better healthcare for their children. GDP does not measure the quality of their education, but nations with larger GDP can afford better educational sys- tems. GDP does not measure the beauty of our poetry, but nations with larger GDP can afford to teach more of their citizens to read and enjoy poetry. GDP does not take account of our intelligence, integrity, courage, wisdom, or devotion to country, but all of these laudable attributes are easier to foster when people are less concerned about being able to afford the material necessities of life. In short, GDP does not directly measure those things that make life worthwhile, but it does measure our ability to obtain many of the inputs for a worthwhile life.

GDP is not, however, a perfect measure of well-being. Some things that con- tribute to a good life are left out of GDP. One is leisure. Suppose, for instance, that everyone in the economy suddenly started working every day of the week, rather than enjoying leisure on weekends. More goods and services would be produced, and GDP would rise. But despite the increase in GDP, we should not conclude that everyone would be better off. The loss from reduced leisure would offset the gain from producing and consuming a greater quantity of goods and services.

Because GDP uses market prices to value goods and services, it excludes the value of almost all activity that takes place outside markets. In particular, GDP

488 PART VIII THE DATA OF MACROECONOMICS

omits the value of goods and services produced at home. When a chef prepares a delicious meal and sells it at her restaurant, the value of that meal is part of GDP. But if the chef prepares the same meal for her family, the value she has added to the raw ingredients is left out of GDP. Similarly, child care provided in day-care centers is part of GDP, whereas child care by parents at home is not. Volunteer work also contributes to the well-being of those in society, but GDP does not re- flect these contributions.

Another thing that GDP excludes is the quality of the environment. Imag- ine that the government eliminated all environmental regulations. Firms could then produce goods and services without considering the pollution they create,

Can we do better than using gross

domestic product?

Nations Seek Success Beyond

GDP

By Mark Whitehouse

M oney isn’t everything. But in measuring

the success of nations, it isn’t easy to

find a substitute.

Political leaders are increasingly expressing

dissatisfaction with gross domestic product—a

monetary measure of all the goods and services

a country produces—as a gauge of a nation’s

success in raising living standards.

In November, British Prime Minister David

Cameron announced plans to build measures

of national well-being that would take into

account factors such as peoples’ life satis-

faction, following a similar effort by French

President Nicolas Sarkozy.

Their efforts cut to the core of what eco-

nomics is supposed to be about: What makes

us better off? How can we all have more of it?

Anyone hoping for a clear-cut answer, though,

is likely to be disappointed.

“There is more to life than GDP, but it will

be hard to come up with a single measure

to replace it and we are not sure that a sin-

gle measure is the answer,” said Paul Allin,

director of the Measuring National Well-Being

Project at the U.K.’s Office of National Statis-

tics. “Maybe we live in a multidimensional

world and we have to get used to handling a

reasonable number of bits of information.”

After a session on creating a national suc-

cess indicator at the annual meeting of the

American Economic Association on Friday, Carol

Graham, fellow at the Brookings Institution,

summed up the situation thus: “It’s like a new

science. There’s still a lot of work to be done.”

For much of the past four decades, econ-

omists have puzzled over a paradox that cast

doubt on GDP as the world’s main indicator

of success.

People in richer countries didn’t appear to

be any happier than people in poor countries.

In research beginning in the 1970s, University

of Pennsylvania economist Richard Easterlin

found no evidence of a link between countries’

income—as measured by GDP per person—

and peoples’ reported levels of happiness.

More recent research suggests GDP isn’t

quite so bad. Using more data and different

statistical techniques, three economists at

the University of Pennsylvania’s Wharton

School—Daniel Sacks, Betsey Stevenson

and Justin Wolfers—found that a given per-

centage increase in GDP per person tends to

coincide with a similar increase in reported

well-being. The correlation held across differ-

ent countries and over time.

Still, for measuring the success of pol-

icy, GDP is far from ideal. Making everybody

work 120 hours a week could radically boost

a country’s GDP per capita, but it wouldn’t

make people happier. Removing pollution

limits could boost GDP per hour worked, but

wouldn’t necessarily lead to a world we’d

want to live in.

One approach is to enhance GDP with

other objective factors such as inequality, lei-

sure and life expectancy. In a paper presented

Saturday at the American Economic Associa-

tion meeting, Stanford economists Peter Kle-

now and Charles Jones found that doing so

can make a big difference.

By their calculation, accounting for longer

life expectancy, additional leisure time and

lower levels of inequality makes living stan-

dards in France and Germany look almost the

same as those in the U.S., which otherwise

leads the pack by a large margin.

Mr. Klenow points out that the calculation

is fraught with difficulties. For one, many

countries have poor data on crucial factors

such as life expectancy.

Measuring Macroeconomic Well-Being

IN THE NEWS

489CHAPTER 23 MEASURING A NATION’S INCOME

and GDP might rise. Yet well-being would most likely fall. The deterioration in the quality of air and water would more than offset the gains from greater production.

GDP also says nothing about the distribution of income. A society in which 100 people have annual incomes of $50,000 has GDP of $5 million and, not sur- prisingly, GDP per person of $50,000. So does a society in which 10 people earn $500,000 and 90 suffer with nothing at all. Few people would look at those two situations and call them equivalent. GDP per person tells us what happens to the average person, but behind the average lies a large variety of personal experiences.

Source: Peter Klenow and Charles Jones, Stanford University. Data are for 2000.

For the purpose of comparing well-being

across countries, asking people how they feel

might be better than monetary measures.

Angus Deaton, an economist at Princeton

University, notes that placing values on the

extremely different goods and services con-

sumed in the U.S. and, say, Tajikistan, can

be impossible to do in a comparable way. Just

asking people about their situation could be

much easier and no less accurate.

Surveys already play a meaningful role in

the way many countries assess their perfor-

mance, from consumer confidence in the U.S.

to the Netherlands’s Life Situation Index, which

accounts for factors such as relationships

and community involvement.

As part of its effort to gauge well-being,

the U.K. plans to add more subjective ques-

tions to its household surveys.

But surveys can also send misleading policy

signals. Mr. Wolfers, for example, has found that

surveys of women’s subjective well-being in the

U.S. suggest that they are less happy than they

were four decades ago, despite improvements in

wages, education and other objective measures.

That, he says, doesn’t mean the feminist move-

ment should be reversed. Rather, it could be re-

lated to rising expectations or greater frankness

among the women interviewed.

Peoples’ true preferences are often re-

vealed more by what they do than by what

they say. Surveys suggest people with chil-

dren tend to be less happy than those with-

out, yet people keep having children—and

nobody would advocate mass sterilization to

improve overall well-being.

“What we care about in the world is not just

happiness,” says Mr. Wolfers. “If you measure

just one part of what makes for a full life you’re

going to end up harming the other parts.”

For the time being, that leaves policy

makers to choose the measures of success

that seem most appropriate for the task at

hand. That’s not ideal, but it’s the best eco-

nomics has to offer. ■

Source: The Wall Street Journal, January 10, 2011.

Happily ever after

More wealth doesn’t always translate into greater quality of life, when factors such as leisure and length of life are included.

U.S.

Germany

France

Japan

Hong Kong

Italy

U.K.

Singapore

South Korea

Mexico

Brazil

Russia

Thailand

Indonesia

China

South Africa

India

Botswana

Malawi

Well-being index

100.0100.0

74.098.0

70.197.4

72.491.5

82.190.0

69.589.7

69.889.0

82.943.6

47.129.7

25.917.4

21.812.2

20.98.6

18.47.1

10.86.6

11.35.3

21.64.4

6.63.5

17.91.8

2.90.4

Per capita GDP index

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D W

O RL

D W

ID E.

490 PART VIII THE DATA OF MACROECONOMICS

Average Overall Life

Real GDP per Life Years of Satisfaction

Country Person Expectancy Schooling (0 to 10 scale)

United States $52,947 79 years 13 years 7.2

Germany 43,919 81 13 7.0

Japan 36,927 83 12 5.9

Russia 22,352 70 12 6.0

Mexico 16,056 77 9 6.7

Brazil 15,175 74 8 7.0

China 12,547 76 8 5.2

Indonesia 9,788 69 8 5.6

India 5,497 68 5 4.4

Nigeria 5,341 53 6 4.8

Pakistan 4,866 66 5 5.4

Bangladesh 3,191 72 5 4.6

TABLE 3

GDP and the Quality of

Life

The table shows GDP per

person and three other

measures of the quality

of life for twelve major

countries.

Source: Human Development Report 2015,

United Nations. Real GDP is for 2014,

expressed in 2011 dollars. Average years

of schooling is among adults 25 years

and older.

In the end, we can conclude that GDP is a good measure of economic well- being for most—but not all—purposes. It is important to keep in mind what GDP includes and what it leaves out.

CASE STUDY

INTERNATIONAL DIFFERENCES IN GDP AND THE QUALITY OF LIFE One way to gauge the usefulness of GDP as a measure of economic well-being is to examine international data. Rich and poor countries have vastly different levels of GDP per person. If a large GDP leads

to a higher standard of living, then we should observe GDP to be strongly cor- related with various measures of the quality of life. And, in fact, we do.

Table 3 shows twelve large nations ranked in order of GDP per person. The table also shows life expectancy at birth, the average years of schooling among adults, and an index of life satisfaction based on asking people to gauge how they feel about their lives on a scale of 0 to 10 (with 10 being the best). These data show a clear pattern. In rich countries, such as the United States and Germany, people can expect to live to about 80, have about 13 years of schooling, and rate their life satisfaction at about 7. In poor countries, such as Bangladesh and Pakistan, people typically die about 10 years earlier, have less than half as much schooling, and rate their life satisfaction about 2 points lower on the 10-point scale.

Data on other aspects of the quality of life tell a similar story. Countries with low GDP per person tend to have more infants with low birth weight, higher rates of infant mortality, higher rates of maternal mortality, and higher rates of child mal- nutrition. They also have lower rates of access to electricity, paved roads, and clean drinking water. In these countries, fewer school-age children are actually in school, those who are in school must learn with fewer teachers per student, and illiteracy among adults is more common. The citizens of these nations tend to have fewer televisions, fewer telephones, and fewer opportunities to access the Internet. Inter- national data leave no doubt that a nation’s GDP per person is closely associated with its citizens’ standard of living. ●

QuickQuiz Why should policymakers care about GDP?

491CHAPTER 23 MEASURING A NATION’S INCOME

23-6 Conclusion In this chapter we learned how economists measure the total income of a nation. Measurement is, of course, only a starting point. Much of macroeconomics is aimed at revealing the long-run and short-run determinants of a nation’s gross domestic product. Why, for example, is GDP higher in the United States and Japan than in India and Nigeria? What can the governments of the poorest coun- tries do to promote more rapid GDP growth? Why does GDP in the United States rise rapidly in some years and fall in others? What can U.S. policymakers do to reduce the severity of these fluctuations in GDP? These are the questions we will take up shortly.

At this point, it is important to acknowledge the significance of just measur- ing GDP. We all get some sense of how the economy is doing as we go about our lives. But the economists who study changes in the economy and the policymak- ers who formulate economic policies need more than this vague sense—they need concrete data on which to base their judgments. Quantifying the behavior of the economy with statistics such as GDP is, therefore, the first step to developing a science of macroeconomics.

1. If the price of a hot dog is $2 and the price of a ham-

burger is $4, then 30 hot dogs contribute as much to

GDP as _____ hamburgers.

a. 5

b. 15

c. 30

d. 60

2. Angus the sheep farmer sells wool to Barnaby the

knitter for $20. Barnaby makes two sweaters, each of

which has a market price of $40. Collette buys one of

them, while the other remains on the shelf of Barna-

by’s store to be sold later. What is GDP here?

a. $40

b. $60

c. $80

d. $100

3. Which of the following does NOT add to U.S. GDP?

a. Air France buys a plane from Boeing, the U.S. air-

craft manufacturer.

b. General Motors builds a new auto factory in North

Carolina.

c. The city of New York pays a salary to a policeman.

d. The federal government sends a Social Security

check to your grandmother.

4. An American buys a pair of shoes made in Italy.

How do the U.S. national income accounts treat the

transaction?

a. Net exports and GDP both rise.

b. Net exports and GDP both fall.

c. Net exports fall, while GDP is unchanged.

d. Net exports are unchanged, while GDP rises.

5. Which is the largest component of GDP?

a. consumption

b. investment

c. government purchases

d. net exports

6. If all quantities produced rise by 10 percent and

all prices fall by 10 percent, which of the following

occurs?

a. Real GDP rises by 10 percent, while nominal GDP

falls by 10 percent.

b. Real GDP rises by 10 percent, while nominal GDP

is unchanged.

c. Real GDP is unchanged, while nominal GDP rises

by 10 percent.

d. Real GDP is unchanged, while nominal GDP falls

by 10 percent.

CHAPTER QuickQuiz

492 PART VIII THE DATA OF MACROECONOMICS

1. Explain why an economy’s income must equal its

expenditure.

2. Which contributes more to GDP—the production of

an economy car or the production of a luxury car?

Why?

3. A farmer sells wheat to a baker for $2. The baker uses

the wheat to make bread, which is sold for $3. What is

the total contribution of these transactions to GDP?

4. Many years ago, Peggy paid $500 to put together a re-

cord collection. Today, she sold her albums at a garage

sale for $100. How does this sale affect current GDP?

5. List the four components of GDP. Give an example of

each.

6. Why do economists use real GDP rather than nominal

GDP to gauge economic well-being?

7. In the year 2017, the economy produces 100 loaves of

bread that sell for $2 each. In the year 2018, the econ-

omy produces 200 loaves of bread that sell for $3 each.

Calculate nominal GDP, real GDP, and the GDP defla-

tor for each year. (Use 2017 as the base year.) By what

percentage does each of these three statistics rise from

one year to the next?

8. Why is it desirable for a country to have a large GDP?

Give an example of something that would raise GDP

and yet be undesirable.

Because every transaction has a buyer and a seller, the

total expenditure in the economy must equal the total

income in the economy.

Gross domestic product (GDP) measures an econo-

my’s total expenditure on newly produced goods and

services and the total income earned from the produc-

tion of these goods and services. More precisely, GDP

is the market value of all final goods and services pro-

duced within a country in a given period of time.

GDP is divided among four components of expendi-

ture: consumption, investment, government purchases,

and net exports. Consumption includes spending on

goods and services by households, with the exception

of purchases of new housing. Investment includes

spending on business capital, residential capital, and

inventories. Government purchases include spending

on goods and services by local, state, and federal gov-

ernments. Net exports equal the value of goods and

services produced domestically and sold abroad (ex-

ports) minus the value of goods and services produced

abroad and sold domestically (imports).

Nominal GDP uses current prices to value the econ-

omy’s production of goods and services. Real GDP

uses constant base-year prices to value the economy’s

production of goods and services. The GDP deflator—

calculated from the ratio of nominal to real GDP—

measures the level of prices in the economy.

GDP is a good measure of economic well-being be-

cause people prefer higher to lower incomes. But it is

not a perfect measure of well-being. For example, GDP

excludes the value of leisure and the value of a clean

environment.

microeconomics, p. 474

macroeconomics, p. 474

gross domestic product (GDP), p. 476

consumption, p. 479

investment, p. 479

government purchases, p. 480

net exports, p. 480

nominal GDP, p. 482

real GDP, p. 483

GDP deflator, p. 484

QUESTIONS FOR REVIEW

SUMMARY

KEY CONCEPTS

493CHAPTER 23 MEASURING A NATION’S INCOME

1. What components of GDP (if any) would each of the

following transactions affect? Explain.

a. Uncle Henry buys a new refrigerator from a

domestic manufacturer.

b. Aunt Jane buys a new house from a local builder.

c. The Jackson family buys an old Victorian house

from the Walker family.

d. You pay a hairdresser for a haircut.

e. Ford sells a Mustang from its inventory to the

Martinez family.

f. Ford manufactures a Focus and sells it to Avis, the

car rental company.

g. California hires workers to repave Highway 101.

h. The federal government sends your grandmother

a Social Security check.

i. Your parents buy a bottle of French wine.

j. Honda expands its factory in Ohio.

2. Fill in the blanks:

Year

Real GDP

(in 2000

dollars)

Nominal GDP

(in current

dollars)

GDP Deflator

(base year

2000)

1970 3,000 1,200 _________

1980 5,000 _________ 60

1990 _________ 6,000 100

2000 _________ 8,000 _________

2010 _________ 15,000 200

2020 10,000 _________ 300

2030 20,000 50,000 _________

3. The government purchases component of GDP does

not include spending on transfer payments such as

Social Security. Thinking about the definition of GDP,

explain why transfer payments are excluded.

4. As the chapter states, GDP does not include the value

of used goods that are resold. Why would including

such transactions make GDP a less informative mea-

sure of economic well-being?

5. Below are some data from the land of milk and honey.

Year

Price

of Milk

Quantity

of Milk

Price

of Honey

Quantity

of Honey

2016 $1 100 quarts $2 50 quarts

2017 1 200 2 100

2018 2 200 4 100

a. Compute nominal GDP, real GDP, and the GDP

deflator for each year, using 2016 as the base year.

b. Compute the percentage change in nominal GDP,

real GDP, and the GDP deflator in 2017 and 2018

from the preceding year. For each year, identify

the variable that does not change. Explain why

your answer makes sense.

c. Did economic well-being increase more in 2017 or

2018? Explain.

6. Consider an economy that produces only chocolate

bars. In year 1, the quantity produced is 3 bars and the

price is $4. In year 2, the quantity produced is 4 bars

and the price is $5. In year 3, the quantity produced is

5 bars and the price is $6. Year 1 is the base year.

a. What is nominal GDP for each of these three

years?

b. What is real GDP for each of these years?

c. What is the GDP deflator for each of these years?

d. What is the percentage growth rate of real GDP

from year 2 to year 3?

e. What is the inflation rate as measured by the GDP

deflator from year 2 to year 3?

f. In this one-good economy, how might you have

answered parts (d) and (e) without first answering

parts (b) and (c)?

7. Consider the following data on U.S. GDP:

Year

Nominal GDP

(in billions of dollars)

GDP Deflator

(base year 2009)

2014 17,419 108.3

1994 7,309 73.8

a. What was the growth rate of nominal GDP

between 1994 and 2014? (Hint: The growth rate of a variable X over an N-year period is calculated as 100 3 [(X

final /X

initial )1/N 2 1].)

b. What was the growth rate of the GDP deflator

between 1994 and 2014?

c. What was real GDP in 1994 measured in 2009

prices?

d. What was real GDP in 2014 measured in 2009

prices?

e. What was the growth rate of real GDP between

1994 and 2014?

f. Was the growth rate of nominal GDP higher or

lower than the growth rate of real GDP? Explain.

8. Revised estimates of U.S. GDP are usually released

by the government near the end of each month. Find

a newspaper article that reports on the most recent

release, or read the news release yourself at http://

www.bea.gov, the website of the U.S. Bureau of Eco-

nomic Analysis. Discuss the recent changes in real and

nominal GDP and in the components of GDP.

9. A farmer grows wheat, which she sells to a miller for

$100. The miller turns the wheat into flour, which she

sells to a baker for $150. The baker turns the wheat

PROBLEMS AND APPLICATIONS

494 PART VIII THE DATA OF MACROECONOMICS

into bread, which she sells to consumers for $180. Con-

sumers eat the bread.

a. What is GDP in this economy? Explain.

b. Value added is defined as the value of a producer’s output minus the value of the intermediate goods

that the producer buys to make the output. Assum-

ing there are no intermediate goods beyond those

described above, calculate the value added of each of

the three producers.

c. What is total value added of the three producers in

this economy? How does it compare to the econo-

my’s GDP? Does this example suggest another way

of calculating GDP?

10. Goods and services that are not sold in markets, such

as food produced and consumed at home, are generally

not included in GDP. Can you think of how this might

cause the numbers in the second column of Table 3 to be

misleading in a comparison of the economic well-being of

the United States and India? Explain.

11. The participation of women in the U.S. labor force has

risen dramatically since 1970.

a. How do you think this rise affected GDP?

b. Now imagine a measure of well-being that includes

time spent working in the home and taking leisure.

How would the change in this measure of well-being

compare to the change in GDP?

c. Can you think of other aspects of well-being

that are associated with the rise in women’s

labor-force participation? Would it be practical to

construct a measure of well-being that includes

these aspects?

12. One day, Barry the Barber, Inc., collects $400 for hair-

cuts. Over this day, his equipment depreciates in value

by $50. Of the remaining $350, Barry sends $30 to the

government in sales taxes, takes home $220 in wages,

and retains $100 in his business to add new equipment

in the future. From the $220 that Barry takes home, he

pays $70 in income taxes. Based on this information,

compute Barry’s contribution to the following measures

of income.

a. gross domestic product

b. net national product

c. national income

d. personal income

e. disposable personal income

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

495

I n 1931, as the U.S. economy was suffering through the Great Depression, the New York Yankees paid famed baseball player Babe Ruth a salary of $80,000. At the time, this pay was extraordinary, even among the stars of baseball.

According to one story, a reporter asked Ruth whether he thought it was right that he made more than President Herbert Hoover, who had a salary of $75,000. Ruth replied, “I had a better year.”

In 2015, the average salary earned by major league baseball players was about $4 million, and Los Angeles Dodgers pitcher Clayton Kershaw was paid $31 million. At first, this fact might lead you to think that baseball has become vastly more lucrative over the past eight decades. But as everyone knows, the prices of goods and services have also risen.

Measuring the Cost of Living CHAPTER

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496 PART VIII THE DATA OF MACROECONOMICS

In 1931, a nickel would buy an ice-cream cone and a quarter would buy a ticket at the local movie theater. Because prices were so much lower in Babe Ruth’s day than they are today, it is not clear whether Ruth enjoyed a higher or lower stan- dard of living than today’s players.

In the preceding chapter, we looked at how economists use gross domestic product (GDP) to measure the quantity of goods and services that the economy is producing. This chapter examines how economists measure the overall cost of liv- ing. To compare Babe Ruth’s salary of $80,000 to salaries from today, we need to find some way of turning dollar figures into meaningful measures of purchasing power. That is exactly the job of a statistic called the consumer price index, or sim- ply the CPI. After seeing how the CPI is constructed, we discuss how we can use such a price index to compare dollar figures from different points in time.

The CPI is used to monitor changes in the cost of living over time. When the CPI rises, the typical family has to spend more money to maintain the same stan- dard of living. Economists use the term inflation to describe a situation in which the economy’s overall price level is rising. The inflation rate is the percentage change in the price level from the previous period. The preceding chapter showed how economists can measure inflation using the GDP deflator. The inflation rate you are likely to hear on the nightly news, however, is calculated from the CPI, which better reflects the goods and services bought by consumers.

As we will see in the coming chapters, inflation is a closely watched aspect of macroeconomic performance and is a key variable guiding macroeconomic pol- icy. This chapter provides the background for that analysis by showing how econ- omists measure the inflation rate using the CPI and how this statistic can be used to compare dollar figures from different times.

24-1 The Consumer Price Index The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer. Every month, the Bureau of Labor Statistics (BLS), which is part of the Department of Labor, computes and reports the CPI. In this section, we discuss how the CPI is calculated and what problems arise in its measurement. We also consider how this index compares to the GDP deflator, another measure of the overall level of prices, which we examined in the preceding chapter.

24-1a How the CPI Is Calculated When the BLS calculates the CPI and the inflation rate, it uses data on the prices of thousands of goods and services. To see exactly how these statistics are constructed, let’s consider a simple economy in which consumers buy only two goods: hot dogs and hamburgers. Table 1 shows the five steps that the BLS follows.

1. Fix the basket. Determine which prices are most important to the typical consumer. If the typical consumer buys more hot dogs than hamburgers, then the price of hot dogs is more important than the price of hamburgers and, therefore, should be given greater weight in measuring the cost of living. The BLS sets these weights by surveying consumers to find the basket of goods and services bought by the typical consumer. In the example in the table, the typical consumer buys a basket of 4 hot dogs and 2 hamburgers.

2. Find the prices. Find the prices of each of the goods and services in the basket at each point in time. The table shows the prices of hot dogs and hamburgers for three different years.

consumer price index (CPI)

a measure of the overall

cost of the goods and

services bought by a

typical consumer

497CHAPTER 24 MEASURING THE COST OF LIVING

3. Compute the basket’s cost. Use the data on prices to calculate the cost of the basket of goods and services at different times. The table shows this calculation for each of the three years. Notice that only the prices in this calculation change. By keeping the basket of goods the same (4 hot dogs and 2 hamburgers), we are isolating the effects of price changes from the effects of any quantity changes that might be occurring at the same time.

4. Choose a base year and compute the index. Designate one year as the base year, the benchmark against which other years are to be compared. (The choice of base year is arbitrary. The index is used to measure percentage changes in the cost of living, and these changes are the same regardless of the choice of base year.) Once the base year is chosen, the index is calculated as follows:

Consumer price index 5 Price of basket of goods and services in current year

Price of basket in base year 3 100.

That is, the price of the basket of goods and services in each year is divided by the price of the basket in the base year, and this ratio is then multiplied by 100. The resulting number is the CPI.

In the example in Table 1, 2016 is the base year. In this year, the basket of hot dogs and hamburgers costs $8. Therefore, to calculate the CPI, the price of the basket in each year is divided by $8 and multiplied by 100. The CPI is 100 in 2016. (The index is always 100 in the base year.) The CPI is 175 in 2017. This means that the price of the basket in 2017 is 175 percent of its price in the base year. Put differently, a basket of goods that costs $100 in the base year costs

TABLE 1

Calculating the

Consumer Price

Index and the

Inflation Rate:

An Example

This table shows

how to calculate

the CPI and the

inflation rate for

a hypothetical

economy in which

consumers buy

only hot dogs and

hamburgers.

Step 1: Survey Consumers to Determine a Fixed Basket of Goods

Basket 5 4 hot dogs, 2 hamburgers

Step 2: Find the Price of Each Good in Each Year

Year Price of Hot Dogs Price of Hamburgers

2016 $1 $2

2017 2 3

2018 3 4

Step 3: Compute the Cost of the Basket of Goods in Each Year

2016 ($1 per hot dog 3 4 hot dogs) 1 ($2 per hamburger 3 2 hamburgers) 5 $8 per basket 2017 ($2 per hot dog 3 4 hot dogs) 1 ($3 per hamburger 3 2 hamburgers) 5 $14 per basket 2018 ($3 per hot dog 3 4 hot dogs) 1 ($4 per hamburger 3 2 hamburgers) 5 $20 per basket

Step 4: Choose One Year as a Base Year (2016) and Compute the CPI in Each Year

2016 ($8/$8) 3 100 5 100 2017 ($14/$8) 3 100 5 175 2018 ($20/$8) 3 100 5 250

Step 5: Use the CPI to Compute the Inflation Rate from Previous Year

2017 (175 − 100)/100 3 100 5 75% 2018 (250 – 175)/175 3 100 5 43%

498 PART VIII THE DATA OF MACROECONOMICS

$175 in 2017. Similarly, the CPI is 250 in 2018, indicating that the price level in 2018 is 250 percent of the price level in the base year.

5. Compute the inflation rate. Use the CPI to calculate the inflation rate, which is the percentage change in the price index from the preceding period. That is, the inflation rate between two consecutive years is computed as follows:

Inflation rate in year 2 5 CPI in year 2 2 CPI in year 1

CPI in year 1 3 100.

As shown at the bottom of Table 1, the inflation rate in our example is 75 per- cent in 2017 and 43 percent in 2018.

Although this example simplifies the real world by including only two goods, it shows how the BLS computes the CPI and the inflation rate. The BLS collects and processes data on the prices of thousands of goods and services every month and, by following the five foregoing steps, determines how quickly the cost of living for the typical consumer is rising. When the BLS makes its monthly announcement of the CPI, you can usually hear the number on the evening television news or see it in the next day’s newspaper.

In addition to the CPI for the overall economy, the BLS calculates several other price indexes. It reports the index for some narrow categories of goods and services, such as food, clothing, and energy. It also calculates the CPI for all goods

inflation rate

the percentage change in

the price index from the

preceding period

What’s in the CPI’s Basket?

W hen constructing the consumer price index, the Bureau of Labor

Statistics tries to include all the goods and services that the typi-

cal consumer buys. Moreover, it tries to weight these goods and services

according to how much consumers buy of each item.

Figure 1 shows the breakdown of consumer spending into the major

categories of goods and services. By far the largest category is housing,

which makes up 42 percent of the typical consumer’s budget. This category

includes the cost of shelter (33 percent), fuel and utilities (5 percent), and

household furnishings and operation (4 percent). The next largest category,

at 16 percent, is transportation, which includes spending on cars, gaso-

line, buses, subways, and so on. The next category, at 15 percent, is food

and beverages; this includes food at home (8 percent), food away from

home (6 percent), and alcoholic beverages (1 percent). Next are medical

care at 8 percent, education and communication at 7 percent, and recre-

ation at 6 percent. Apparel, which includes clothing, footwear, and jewelry,

makes up 3 percent of the typical consumer’s budget.

Also included in the figure, at 3 percent of spending, is a category

for other goods and services. This is a catchall for consumer purchases

(such as cigarettes, haircuts, and funeral expenses) that do not naturally

fit into the other categories. ■

F Y I

FIGURE 1

The Typical Basket of

Goods and Services

This figure shows how the typical consumer divides spending

among various categories of goods and services. The Bureau of

Labor Statistics calls each percentage the “relative importance”

of the category.

Source: Bureau of Labor Statistics.

15% Food and beverages

16% Transportation

Other goods and services

Education and communication

ApparelRecreation

7% 6% 3% 3%

42% Housing

Medical care

499CHAPTER 24 MEASURING THE COST OF LIVING

and services excluding food and energy, a statistic called the core CPI. Because food and energy prices show substantial short-run volatility, the core CPI better reflects ongoing inflation trends. Finally, the BLS also calculates the producer price index (PPI), which measures the cost of a basket of goods and services bought by firms rather than consumers. Because firms eventually pass on their costs to consumers in the form of higher consumer prices, changes in the PPI are often thought to be useful in predicting changes in the CPI.

24-1b Problems in Measuring the Cost of Living The goal of the consumer price index is to measure changes in the cost of living. In other words, the CPI tries to gauge how much incomes must rise to maintain a constant standard of living. The CPI, however, is not a perfect measure of the cost of living. Three problems with the index are widely acknowledged but difficult to solve.

The first problem is called substitution bias. When prices change from one year to the next, they do not all change proportionately: Some prices rise more than others. Consumers respond to these differing price changes by buying less of the goods whose prices have risen by relatively large amounts and by buying more of the goods whose prices have risen less or perhaps even have fallen. That is, consumers substitute toward goods that have become relatively less expensive. If a price index is computed assuming a fixed basket of goods, it ignores the possibility of consumer substitution and, therefore, overstates the increase in the cost of living from one year to the next.

Let’s consider a simple example. Imagine that in the base year, apples are cheaper than pears, so consumers buy more apples than pears. When the BLS constructs the basket of goods, it will include more apples than pears. Suppose that next year pears are cheaper than apples. Consumers will naturally respond to the price changes by buying more pears and fewer apples. Yet when computing the CPI, the BLS uses a fixed basket, which in essence assumes that consumers continue buying the now expensive apples in the same quantities as before. For this reason, the index will measure a much larger increase in the cost of living than consumers actually experience.

The second problem with the CPI is the introduction of new goods. When a new good is introduced, consumers have more variety from which to choose, and this in turn reduces the cost of maintaining the same level of economic well-being. To see why, consider a hypothetical situation: Suppose you could choose between a $100 gift certificate at a large store that offered a wide array of goods and a $100 gift certificate at a small store with the same prices but a more limited selection. Which would you prefer? Most people would pick the store with greater variety. In essence, the increased set of possible choices makes each dollar more valuable. The same is true with the evolution of the economy over time: As new goods are introduced, consumers have more choices, and each dollar is worth more. But because the CPI is based on a fixed basket of goods and services, it does not reflect the increase in the value of the dollar that arises from the introduction of new goods.

Again, let’s consider an example. When the iPod was introduced in 2001, consumers found it more convenient to listen to their favorite music. Devices to play music were available previously, but they were not nearly as portable and versatile. The iPod was a new option that increased consumers’ set of opportunities. For any given number of dollars, the introduction of the iPod made people better off; conversely, achieving the same level of economic well-being required a smaller number of dollars. A perfect cost-of-living index would have reflected the introduction of the iPod with a decrease in the cost of living. The CPI,

core CPI

a measure of the overall

cost of consumer goods

and services excluding

food and energy

producer price index

a measure of the cost of

a basket of goods and

services bought by firms

500 PART VIII THE DATA OF MACROECONOMICS

however, did not decrease in response to the introduction of the iPod. Eventually, the BLS revised the basket of goods to include the iPod, and subsequently, the index reflected changes in iPod prices. But the reduction in the cost of living associated with the initial introduction of the iPod never showed up in the index.

The third problem with the CPI is unmeasured quality change. If the quality of a good deteriorates from one year to the next while its price remains the same, the value of a dollar falls, because you are getting a lesser good for the same amount of money. Similarly, if the quality rises from one year to the next, the value of a dollar rises. The BLS does its best to account for quality change. When the quality of a good in the basket changes—for example, when a car model has more horsepower or gets better gas mileage from one year to the next—the Bureau adjusts the price of the good to account for the quality change. It is, in essence,

The web is providing alternative ways

to collect data on the overall level of

prices.

Do We Need Google to Measure

Inflation?

By Annie Lowrey

A t some 23,000 retailers and businesses

in 90 U.S. cities, hundreds of government

workers find and mark down prices on very pre-

cise products. And I’m not kidding when I say

“very precise.”

Say the relevant worker is finding the

price for a motel room. She might write a

report like this: Occupancy—two adults;

Type of accommodation—deluxe room; Room

classification/location—ocean view, room 306;

Time of stay—weekend; Length of stay—one

night; Bathroom facilities—one full bathroom;

Kitchen facilities—none; Television—one,

includes free movie channel; Telephone—one

telephone, free local calls; Air-conditioned—

yes; Meals included—breakfast; Parking—free

self parking; Transportation—Transportation

to airport, no charge; Recreation facilities—an

indoor and an outdoor pool, a private beach,

three tennis courts, and an exercise room.

This mind-numbingly tedious process

goes on for a dizzying panoply of items:

wine, takeaway meals, bedroom furniture,

surgical procedures, pet dogs, college tuition,

cigarettes, haircuts, funerals. When all of the

prices are marked down, the workers submit

forms that are collated, checked, and input into

massive spreadsheets. Then the government

boils all those numbers down to one. It weights

certain prices, taking into account that

consumers spend more on rent than cereal, for

instance. It considers product improvements

and changes in spending habits. Then it comes

up with a master number showing how much

a customer’s spending needed to increase

to buy the same goods, month-on-month.

That number is the Consumer Price Index, the

government’s main gauge of inflation.

Each month, the Bureau of Labor Statistics

goes through all that hassle because knowing

the rate of inflation is such an important measure

of economic health—and it’s important to

the government’s own budget. High inflation?

Savers panic, watching the spending power of

their accounts erode. Deflation? Everyone saves,

awaiting cheaper prices in a few months. And

wildly changing inflation makes it difficult for

businesses and consumers to make economic

decisions. Moreover, the government needs

to know the rate of inflation to index certain

payments, like Social Security benefits or interest

payments on TIPS bonds.

But just because the government expends

so much energy determining the rate of inflation

does not mean it is tallying it in the smartest or

most accurate way. The reigning methodology

is, well, clunky. It costs Washington around

$234 million a year to get all those people to

go and bear witness to a $1.57 price increase

in a packet of tube socks and then to massage

those individual data points down to one number.

Moreover, there is a weekslong lag between

the checkers tallying up the numbers and the

government announcing the changes: The

inflation measure comes out only 12 times a year,

though prices change, sometimes dramatically,

all the time. Plus, the methodology is archaic,

given that we live in the Internet age. Prices

are easily available online and a lot of shopping

happens on the Web rather than in stores.

But there might be a better way. In the

last few months, economists have come up

with new methods for calculating inflation

at Internet speed—nimbler, cheaper, faster,

a n d p e r h a p s e v e n m o r e a c c u r a t e t h a n

Washington’s. The first comes from the

Massachusetts Institute of Technology. In

Monitoring Inflation in the Internet Age

IN THE NEWS

501CHAPTER 24 MEASURING THE COST OF LIVING

trying to compute the price of a basket of goods of constant quality. Despite these efforts, changes in quality remain a problem because quality is hard to measure.

There is still much debate among economists about how severe these measurement problems are and what should be done about them. Several studies written during the 1990s concluded that the CPI overstated inflation by about 1 percentage point per year. In response to this criticism, the BLS adopted several technical changes to improve the CPI, and many economists believe that the bias is now only about half as large as it once was. The issue is important because many government programs use the CPI to adjust for changes in the overall level of prices. Recipients of Social Security, for instance, get annual increases in benefits that are tied to the CPI. Some economists have suggested modifying these programs to correct for the measurement problems by, for instance, reducing the magnitude of the automatic benefit increases.

2007, economists Roberto Rigobon and

Alberto Cavallo started tracking prices online

and inputting them into a massive database.

Then, last month, they unveiled the Billion

Prices Project, an inflation measure based on

5 million items sold by 300 online retailers in

70 countries. (For the United States, the BPP

collects about 500,000 prices.)

The BPP’s inflation measure is markedly

different from the government’s. The economists

just average all the prices culled online,

meaning the basket of goods is whatever you

can buy on the Web. (Some things, like books,

are most often bought online. Some items, like

cats, are not.) Plus, the researchers do not

weight certain items’ prices, even if they tend

to make up a bigger proportion of household

spending.

Still, thus far, the BPP has tracked the CPI

closely. And the online-based measure has

additional advantages. It comes out daily, giving

a better sense of inflation’s direction. It also lets

researchers examine minute, day-to-day price

changes. For instance, this month Rigobon and

Cavallo noted that Black Friday discounts “had a

smaller effect on average prices in 2010 than in

2009,” contrary to reports of deeper discounting

this year. And it has already produced some

academic insights. For instance, Cavallo found

that retailers change prices less often, but more,

percentage-wise, than economists previously

thought.

A second inflation measure comes from

Web behemoth Google and is a pet project of

the company’s chief economist, Hal Varian.

As reported by the Financial Times, earlier

this year, Varian decided to use Google’s

vast database of Web prices to construct the

“Google Price Index,” a constantly updated

measure of price changes and inflation. (The

idea came to him when he was searching for

a pepper grinder online.) Google has not yet

decided whether it will publish the price index,

and has not released its methodology. But

Varian said that his preliminary index tracked

CPI closely, though it did show periods of

deflation—the worrisome incidence of prices

actually falling—where the CPI did not.

The new indices lead to the big question of

whether the government needs to update its

methods to account for changes in the economy—

taking new pricing trends into consideration,

rejiggering its formula, updating more frequently.

The answer might be yes. (Economists have

reformed the CPI before.) But the CPI and its

Stone Age method of calculation boasts one huge

benefit: It’s a stable, tested measure, consistent

over time, since its methodology doesn’t change

much. Moreover, and somewhat remarkably, the

Google and Billion Prices Project indices actually

seem to confirm the accuracy of the old-fashioned

CPI, tracking it closely rather than showing it to

be off-base.

Ultimately, there is a good argument for

more inflation measures, not just better or

newer ones. The government already calculates

a number of rates of inflation to give a fuller

picture of price changes, the value of money, and

the economy. Most notably, the BLS publishes a

“core inflation” number, a measure of inflation

outside volatile food and energy prices. There are

dozens of other measures, as well. The new Web-

based yardsticks provide even more alternatives

and opportunities to examine the accuracy of the

CPI—and to make new findings. That means,

for now, those detective-like government rubes

painstakingly checking prices on clipboards get

to stay in work. ■

Source: Slate, December 20, 2010.“I wonder how much this costs online.”

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502 PART VIII THE DATA OF MACROECONOMICS

24-1c The GDP Deflator versus the Consumer Price Index In the preceding chapter, we examined another measure of the overall level of prices in the economy—the GDP deflator. The GDP deflator is the ratio of nominal GDP to real GDP. Because nominal GDP is current output valued at current prices and real GDP is current output valued at base-year prices, the GDP deflator reflects the current level of prices relative to the level of prices in the base year.

Economists and policymakers monitor both the GDP deflator and the CPI to gauge how quickly prices are rising. Usually, these two statistics tell a similar story. Yet two important differences can cause them to diverge.

The first difference is that the GDP deflator reflects the prices of all goods and services produced domestically, whereas the CPI reflects the prices of all goods and services bought by consumers. For example, suppose that the price of an airplane produced by Boeing and sold to the Air Force rises. Even though the plane is part of GDP, it is not part of the basket of goods and services bought by a typical consumer. Thus, the price increase shows up in the GDP deflator but not in the CPI.

As another example, suppose that Volvo raises the price of its cars. Because Volvos are made in Sweden, the car is not part of U.S. GDP. But U.S. consumers buy Volvos, so the car is part of the typical consumer ’s basket of goods. Hence, a price increase in an imported consumption good, such as a Volvo, shows up in the CPI but not in the GDP deflator.

This first difference between the CPI and the GDP deflator is particularly important when the price of oil changes. The United States produces some oil, but much of the oil we use is imported. As a result, oil and oil products such as gasoline and heating oil make up a much larger share of consumer spending than of GDP. When the price of oil rises, the CPI rises by much more than does the GDP deflator.

The second and subtler difference between the GDP deflator and the CPI concerns how various prices are weighted to yield a single number for the overall level of prices. The CPI compares the price of a fixed basket of goods and services to the price of the basket in the base year. Only occasionally does the BLS change the basket of goods. By contrast, the GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year. Thus, the group of goods and services used to compute the GDP deflator changes automatically over time. This difference is not important when all prices are changing proportionately. But if the prices of different goods and services are changing by varying amounts, the way we weight the various prices matters for the overall inflation rate.

Figure 2 shows the inflation rate as measured by both the GDP deflator and the CPI for each year since 1965. You can see that sometimes the two measures diverge. When they do diverge, it is possible to go behind these numbers and explain the divergence with the two differences we have discussed. For example, in 1979 and 1980, CPI inflation spiked up more than the GDP deflator largely because oil prices more than doubled during these two years. Yet divergence between these two measures is the exception rather than the rule. In the 1970s, both the GDP deflator and the CPI show high rates of inflation. In the late 1980s, 1990s, and the first decade of the 2000s, both measures show low rates of inflation.

QuickQuiz Explain briefly what the CPI measures and how it is constructed. Identify one reason why the CPI is an imperfect measure of the

cost of living.

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“The price may seem a little high, but you have to remember that’s in today’s dollars.”

503CHAPTER 24 MEASURING THE COST OF LIVING

24-2 Correcting Economic Variables for the Effects of Inflation

The purpose of measuring the overall level of prices in the economy is to allow us to compare dollar figures from different times. Now that we know how price indexes are calculated, let’s see how we might use such an index to compare a dollar figure from the past to a dollar figure in the present.

24-2a Dollar Figures from Different Times We first return to the issue of Babe Ruth’s salary. Was his salary of $80,000 in 1931 high or low compared to the salaries of today’s players?

To answer this question, we need to know the level of prices in 1931 and the level of prices today. Part of the increase in baseball salaries compensates players for higher prices today. To compare Ruth’s salary to those of today’s players, we need to inflate Ruth’s salary to turn 1931 dollars into today’s dollars.

The formula for turning dollar figures from year T into today’s dollars is the following:

Amount in todayrs dollars 5 Amount in year T dollars 3 Price level today

Price level in year T .

A price index such as the CPI measures the price level and thus determines the size of the inflation correction.

Let’s apply this formula to Ruth’s salary. Government statistics show a CPI of 15.2 for 1931 and 237 for 2015. Thus, the overall level of prices has risen by a factor

FIGURE 2

Two Measures of

Inflation

This figure shows the

inflation rate—the

percentage change in

the level of prices—as

measured by the GDP

deflator and the CPI

using annual data since

1965. Notice that the

two measures of inflation

generally move together.

Source: U.S. Department of Labor;

U.S. Department of Commerce.

Inflation Rate (percent per year)

1965 1970 1975 1980 1985 1990 1995 2000 2005 20152010

CPI

GDP deflator

504 PART VIII THE DATA OF MACROECONOMICS

of 15.6 (calculated from 237/15.2). We can use these numbers to measure Ruth’s salary in 2015 dollars, as follows:

Salary in 2015 dollars 5 Salary in 1931 dollars 3 Price level in 2015

Price level in 1931

5 $80,000 3 237

15.2

5 $1,247,368.

We find that Babe Ruth’s 1931 salary is equivalent to a salary today of over $1.2 million. That is a good income, but it is only a third of the average player ’s salary today and only 4 percent of what the Dodgers pay Clayton Kershaw. Various forces, including overall economic growth and the increasing income shares earned by superstars, have substantially raised the living standards of the best athletes.

Let’s also examine President Hoover ’s 1931 salary of $75,000. To translate that figure into 2015 dollars, we again multiply the ratio of the price levels in the two years. We find that Hoover ’s salary is equivalent to $75,000 3 (237/15.2), or $1,169,408 in 2015 dollars. This is well above President Barack Obama’s salary of $400,000. It seems that President Hoover did have a pretty good year after all.

Mr. Index Goes to Hollywood

W hat is the most popular movie of all time? The answer might

surprise you.

Movie popularity is usually gauged by box office receipts. By

that measure, Star Wars: The Force Awakens is the number-one

movie of all time with domestic receipts of $923 million, followed

by Avatar ($761 million)

a n d T i t a n i c ( $ 6 5 9

million). But this ranking

ignores an obvious but

important fact: Prices,

including those of movie

tickets, have been rising

over time. Inflation gives an advantage to newer films.

When we correct box office receipts for the effects of inflation, the

story is very different. The number-one movie is now Gone with the Wind

($1,758 million), followed by the original Star Wars ($1,550 million) and

The Sound of Music ($1,239 million). Star Wars: The Force Awakens falls

to number 11.

Gone with the Wind was released in 1939, before everyone had

televisions in their homes. In the 1930s, about 90 million Americans

went to the cinema each week, compared to about 25 million today.

But the movies from that era don’t show up in conventional popularity

rankings because ticket prices were only a quarter. And indeed, in the

ranking based on nominal box office receipts, Gone with the Wind does

not make the top 100 films. Scarlett and Rhett fare a lot better once we

correct for the effects of inflation. ■

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“May the force of inflation be with you.”

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505CHAPTER 24 MEASURING THE COST OF LIVING

FIGURE 3

Regional Variation in the

Cost of Living

This figure shows how

the cost of living in the

fifty U.S. states and

the District of Columbia

compares to the U.S.

average.

Source: U.S. Department of Commerce.

Data are for 2013.

District of Columbia

2013 Regional Price Parities by State (US = 100)

Hawaii New York

New Jersey California Maryland

Connecticut Massachusetts

Alaska New Hampshire

Washington Virginia

Colorado Delaware

Illinois Vermont

Florida Oregon

Pennsylvania Nevada

Rhode Island Maine

Minnesota Utah

Arizona Texas

Wyoming New Mexico

Montana Michigan

Wisconsin Idaho

Georgia North Carolina

Indiana North Dakota

Louisiana Kansas

Tennessee Nebraska

South Carolina Iowa

Oklahoma Ohio

Missouri Kentucky

West Virginia Alabama

South Dakota Arkansas

Mississippi

117.7 116.2

115.3 114.5

112.3 110.9

108.5 107.3

106.0 105.9

103.2 103.0

102.2 101.4

101.0 100.2

98.8 98.7 98.6

98.2 98.1

97.7 97.6

97.2 97.1

96.7 95.8

95.0 94.4

94.2 92.9 92.8

91.9 91.7

91.4 91.4 91.2

90.8 90.6 90.5 90.5 90.3

89.9 89.6

89.2 89.1

88.4 87.7 87.6 87.5

86.8

80 85 90 95 100 105 110 115 120

Cost of Living Relative to U.S. Average

U.S. average

CASE STUDY

REGIONAL DIFFERENCES IN THE COST OF LIVING When you graduate from college, you may well have several job offers from which to choose. Not surprisingly, some jobs pay more than others. If the jobs are located in different places, however, be careful

when comparing them. The cost of living varies not only over time but also over geography. What seems like a larger paycheck might not turn out to be so once you take into account regional differences in the prices of goods and services.

The Bureau of Economic Analysis has used the data collected for the CPI to compare prices around the United States. The resulting statistic is called regional price parities. Just as the CPI measures variation in the cost of living from year to year, regional price parities measure variation in the cost of living from state to state.

Figure 3 shows the regional price parities for 2013. For example, living in the state of New York costs 115.3 percent of what it costs to live in the typical place in the United States (that is, New York is 15.3 percent more expensive than average).

506 PART VIII THE DATA OF MACROECONOMICS

Living in Mississippi costs 86.8 percent of what it costs to live in the typical place (that is, Mississippi is 13.2 percent less expensive than average).

What accounts for these differences? It turns out that the prices of goods, such as food and clothing, explain only a small part of these regional differences. Most goods are tradable: They can be easily transported from one state to another. As a consequence of regional trade, large price disparities are unlikely to persist for long.

Services explain a larger part of these regional differences. A haircut, for example, can cost more in one state than another. If barbers were willing to move to where the price of a haircut is high, or if customers were willing to fly across the country in search of cheap haircuts, then the prices of haircuts across regions might well converge. But because transporting haircuts is so costly, large price disparities can persist.

Housing services are particularly important for understanding regional differences in the cost of living. Such services represent a large share of a typical consumer ’s budget. Moreover, once built, a house or apartment building can’t easily be moved, and the land on which it sits is completely immobile. As a result, differences in housing costs can be persistently large. For example, rents in New York are almost twice what they are in Mississippi.

Keep these facts in mind when it comes time to compare job offers. Look not only at the dollar salaries but also at the local prices of goods and services, especially housing. ●

24-2b Indexation As we have just seen, price indexes are used to correct for the effects of inflation when comparing dollar figures from different times. This type of correction shows up in many places in the economy. When some dollar amount is automatically corrected for changes in the price level by law or contract, the amount is said to be indexed for inflation.

For example, many long-term contracts between firms and unions include partial or complete indexation of the wage to the CPI. Such a provision, called a cost-of- living allowance (or COLA), automatically raises the wage when the CPI rises.

Indexation is also a feature of many laws. Social Security benefits, for instance, are adjusted every year to compensate the elderly for increases in prices. The brackets of the federal income tax—the income levels at which the tax rates change—are also indexed for inflation. There are, however, many ways in which the tax system is not indexed for inflation, even when perhaps it should be. We discuss these issues more fully when we discuss the costs of inflation later in this book.

24-2c Real and Nominal Interest Rates Correcting economic variables for the effects of inflation is particularly important, and somewhat tricky, when we look at data on interest rates. The very concept of an interest rate necessarily involves comparing amounts of money at different points in time. When you deposit your savings in a bank account, you give the bank some money now, and the bank returns your deposit with interest in the future. Similarly, when you borrow from a bank, you get some money now, but you will have to repay the loan with interest in the future. In both cases, to fully understand the deal between you and the bank, it is crucial to acknowledge that future dollars could have a different value than today’s dollars. That is, you have to correct for the effects of inflation.

Let’s consider an example. Suppose Sally Saver deposits $1,000 in a bank account that pays an annual interest rate of 10 percent. A year later, after Sally has

indexation

the automatic correction

by law or contract of a

dollar amount for the

effects of inflation

507CHAPTER 24 MEASURING THE COST OF LIVING

accumulated $100 in interest, she withdraws her $1,100. Is Sally $100 richer than she was when she made the deposit a year earlier?

The answer depends on what we mean by “richer.” Sally does have $100 more than she had before. In other words, the number of dollars in her possession has risen by 10 percent. But Sally does not care about the amount of money itself: She cares about what she can buy with it. If prices have risen while her money was in the bank, each dollar now buys less than it did a year ago. In this case, her purchasing power—the amount of goods and services she can buy—has not risen by 10 percent.

To keep things simple, let’s suppose that Sally is a movie fan and buys only DVDs. When Sally made her deposit, a DVD cost $10. Her deposit of $1,000 was equivalent to 100 DVDs. A year later, after getting her 10 percent interest, she has $1,100. How many DVDs can she buy now? It depends on what has happened to the price of a DVD. Here are some examples:

Zero inflation: If the price of a DVD remains at $10, the amount she can buy has risen from 100 to 110 DVDs. The 10 percent increase in the number of dollars means a 10 percent increase in her purchasing power. Six percent inflation: If the price of a DVD rises from $10 to $10.60, then the number of DVDs she can buy has risen from 100 to approximately 104. Her purchasing power has increased by about 4 percent. Ten percent inflation: If the price of a DVD rises from $10 to $11, she can still buy only 100 DVDs. Even though Sally’s dollar wealth has risen, her purchasing power is the same as it was a year earlier. Twelve percent inflation: If the price of a DVD increases from $10 to $11.20, the number of DVDs she can buy has fallen from 100 to approximately 98. Even with her greater number of dollars, her purchasing power has decreased by about 2 percent.

And if Sally were living in an economy with deflation—falling prices—another possibility could arise:

Two percent deflation: If the price of a DVD falls from $10 to $9.80, then the number of DVDs she can buy rises from 100 to approximately 112. Her pur- chasing power increases by about 12 percent.

These examples show that the higher the rate of inflation, the smaller the increase in Sally’s purchasing power. If the rate of inflation exceeds the rate of interest, her purchasing power actually falls. And if there is deflation (that is, a negative rate of inflation), her purchasing power rises by more than the rate of interest.

To understand how much a person earns in a savings account, we need to consider both the interest rate and the change in prices. The interest rate that measures the change in dollar amounts is called the nominal interest rate, and the interest rate corrected for inflation is called the real interest rate. The nominal interest rate, the real interest rate, and inflation are related approximately as follows:

Real interest rate 5 Nominal interest rate 2 Inflation rate.

The real interest rate is the difference between the nominal interest rate and the rate of inflation. The nominal interest rate tells you how fast the number of dollars in your bank account rises over time, while the real interest rate tells you how fast the purchasing power of your bank account rises over time.

nominal interest rate

the interest rate as

usually reported without a

correction for the effects

of inflation

real interest rate

the interest rate corrected

for the effects of inflation

508 PART VIII THE DATA OF MACROECONOMICS

FIGURE 4

Real and Nominal

Interest Rates

This figure shows

nominal and real interest

rates using annual

data since 1965. The

nominal interest rate is

the rate on a three-

month Treasury bill. The

real interest rate is the

nominal interest rate

minus the inflation rate

as measured by the CPI.

Notice that nominal and

real interest rates often

do not move together.

Source: U.S. Department of Labor;

U.S. Department of Treasury. 1965

Interest Rates (percent

per year) 15

Real interest rate

25 1970 1975 1980 1985 1990 1995 2000 2005 20152010

Nominal interest rate

CASE STUDY

INTEREST RATES IN THE U.S. ECONOMY Figure 4 shows real and nominal interest rates in the U.S. economy since 1965. The nominal interest rate in this figure is the rate on three- month Treasury bills (although data on other interest rates would be

similar). The real interest rate is computed by subtracting the rate of inflation from this nominal interest rate. Here the inflation rate is measured as the percentage change in the CPI.

One feature of this figure is that the nominal interest rate almost always exceeds the real interest rate. This reflects the fact that the U.S. economy has experienced rising consumer prices in almost every year during this period. By contrast, if you look at data for the U.S. economy during the late 19th century or for the Japanese economy in some recent years, you will find periods of deflation. During deflation, the real interest rate exceeds the nominal interest rate.

The figure also shows that because inflation is variable, real and nominal interest rates do not always move together. For example, in the late 1970s, nominal interest rates were high. But because inflation was very high, real interest rates were low. Indeed, during much of the 1970s, real interest rates were negative, for inflation eroded people’s savings more quickly than nominal interest payments increased them. By contrast, in the late 1990s, nominal interest rates were lower than they had been two decades earlier. But because inflation was much lower, real interest rates were higher. In the coming chapters, we will examine the economic forces that determine both real and nominal interest rates. ●

QuickQuiz Henry Ford paid his workers $5 a day in 1914. If the CPI was 10 in 1914

and 237 in 2015, how much is the Ford paycheck worth in 2015 dollars?

24-3 Conclusion “A nickel ain’t worth a dime anymore,” the late, great baseball player Yogi Berra once observed. Indeed, throughout recent history, the real values behind the nickel, the dime, and the dollar have not been stable. Persistent increases in the

509CHAPTER 24 MEASURING THE COST OF LIVING

overall level of prices have been the norm. Such inflation reduces the purchasing power of each unit of money over time. When comparing dollar figures from different times, it is important to keep in mind that a dollar today is not the same as a dollar 20 years ago or, most likely, 20 years from now.

This chapter has discussed how economists measure the overall level of prices in the economy and how they use price indexes to correct economic variables for the effects of inflation. Price indexes allow us to compare dollar figures from different points in time and, therefore, get a better sense of how the economy is changing.

The discussion of price indexes in this chapter, together with the preceding chapter’s discussion of GDP, is only the first step in the study of macroeconomics. We have not yet examined what determines a nation’s GDP or the causes and effects of inflation. To do that, we need to go beyond issues of measurement. Indeed, that is our next task. Having explained how economists measure macroeconomic quantities and prices in the past two chapters, we are now ready to develop the models that explain movements in these variables.

Here is our strategy in the upcoming chapters. First, we look at the long-run determinants of real GDP and related variables, such as saving, investment, real interest rates, and unemployment. Second, we look at the long-run determinants of the price level and related variables, such as the money supply, inflation, and nominal interest rates. Last of all, having seen how these variables are determined in the long run, we examine the more complex question of what causes short-run fluctuations in real GDP and the price level. In all of these chapters, the measurement issues we have just discussed will provide the foundation for the analysis.

1. The CPI measures approximately the same economic

phenomenon as

a. nominal GDP.

b. real GDP.

c. the GDP deflator.

d. the unemployment rate.

2. The largest component in the basket of goods and

services used to compute the CPI is

a. food and beverages.

b. housing.

c. medical care.

d. apparel.

3. If a Pennsylvania gun manufacturer raises the price

of rifles it sells to the U.S. Army, its price hikes will

increase

a. both the CPI and the GDP deflator.

b. neither the CPI nor the GDP deflator.

c. the CPI but not the GDP deflator.

d. the GDP deflator but not the CPI.

4. Because consumers can sometimes substitute

cheaper goods for those that have risen in price,

a. the CPI overstates inflation.

b. the CPI understates inflation.

c. the GDP deflator overstates inflation.

d. the GDP deflator understates inflation.

5. If the CPI is 200 in year 1980 and 300 today, then

$600 in 1980 has the same purchasing power as

________ today.

a. $400

b. $500

c. $700

d. $900

6. You deposit $2,000 in a savings account, and a year

later you have $2,100. Meanwhile, the CPI rises from

200 to 204. In this case, the nominal interest rate

is _____ percent, and the real interest rate is _____

percent.

a. 1, 5

b. 3, 5

c. 5, 1

d. 5, 3

CHAPTER QuickQuiz

510 PART VIII THE DATA OF MACROECONOMICS

The consumer price index (CPI) shows the cost of

a basket of goods and services relative to the cost of

the same basket in the base year. The index is used

to measure the overall level of prices in the economy.

The percentage change in the CPI measures the

inflation rate.

The CPI is an imperfect measure of the cost of living

for three reasons. First, it does not take into account

consumers’ ability to substitute toward goods that

become relatively cheaper over time. Second, it does

not take into account increases in the purchasing

power of the dollar due to the introduction of new

goods. Third, it is distorted by unmeasured changes

in the quality of goods and services. Because of these

measurement problems, the CPI overstates true

inflation.

Like the CPI, the GDP deflator measures the overall

level of prices in the economy. The two price indexes

usually move together, but there are important

differences. The GDP deflator differs from the CPI

because it includes goods and services produced

rather than goods and services consumed. As a result,

imported goods affect the CPI but not the GDP deflator.

In addition, while the CPI uses a fixed basket of goods,

the GDP deflator automatically changes the group of

goods and services over time as the composition of

GDP changes.

Dollar figures from different times do not represent a

valid comparison of purchasing power. To compare a

dollar figure from the past to a dollar figure today, the

older figure should be inflated using a price index.

Various laws and private contracts use price indexes

to correct for the effects of inflation. The tax laws,

however, are only partially indexed for inflation.

A correction for inflation is especially important when

looking at data on interest rates. The nominal interest

rate is the interest rate usually reported; it is the rate

at which the number of dollars in a savings account

increases over time. By contrast, the real interest rate

takes into account changes in the value of the dollar

over time. The real interest rate equals the nominal

interest rate minus the rate of inflation.

SUMMARY

consumer price index (CPI), p. 496

inflation rate, p. 498

core CPI, p. 499

producer price index, p. 499

indexation, p. 506

nominal interest rate, p. 507

real interest rate, p. 507

KEY CONCEPTS

1. Which do you think has a greater effect on the CPI:

a 10 percent increase in the price of chicken or a 10

percent increase in the price of caviar? Why?

2. Describe the three problems that make the CPI an

imperfect measure of the cost of living.

3. If the price of imported French wine rises, is the CPI or

the GDP deflator affected more? Why?

4. Over a long period of time, the price of a candy bar

rose from $0.20 to $1.20. Over the same period, the CPI

rose from 150 to 300. Adjusted for overall inflation,

how much did the price of the candy bar change?

5. Explain the meaning of nominal interest rate and real interest rate. How are they related?

QUESTIONS FOR REVIEW

511CHAPTER 24 MEASURING THE COST OF LIVING

1. Suppose that the year you were born someone bought

$100 of goods and services for your baby shower. How

much would you guess it would cost today to buy a

similar amount of goods and services? Now find data

on the CPI and compute the answer based on it. (You

can find the BLS’s inflation calculator here: http://

www.bls.gov/data/inflation_calculator.htm).

2. The residents of Vegopia spend all of their income on

cauliflower, broccoli, and carrots. In 2016, they spend

a total of $200 for 100 heads of cauliflower, $75 for 50

bunches of broccoli, and $50 for 500 carrots. In 2017,

they spend a total of $225 for 75 heads of cauliflower,

$120 for 80 bunches of broccoli, and $100 for

500 carrots.

a. Calculate the price of one unit of each vegetable in

each year.

b. Using 2016 as the base year, calculate the CPI for

each year.

c. What is the inflation rate in 2017?

3. Suppose that people consume only three goods, as

shown in this table:

Bottles of

Tennis Balls Golf Balls Gatorade

2017 price $2 $4 $1

2017 quantity 100 100 200

2018 price $2 $6 $2

2018 quantity 100 100 200

a. What is the percentage change in the price of each

of the three goods?

b. Using a method similar to the CPI, compute the

percentage change in the overall price level.

c. If you were to learn that a bottle of Gatorade

increased in size from 2017 to 2018, should that

information affect your calculation of the inflation

rate? If so, how?

d. If you were to learn that Gatorade introduced new

flavors in 2018, should that information affect

your calculation of the inflation rate? If so, how?

4. Go to the website of the Bureau of Labor Statistics

(http://www.bls.gov) and find data on the CPI. By

how much has the index including all items risen over

the past year? For which categories of spending have

prices risen the most? The least? Have any categories

experienced price declines? Can you explain any of

these facts?

5. A small nation of ten people idolizes the TV show

The Voice. All they produce and consume are karaoke machines and CDs, in the following amounts:

Karaoke Machines CDs

Quantity Price Quantity Price

2017 10 $40 30 $10

2018 12 60 50 12

a. Using a method similar to the CPI, compute

the percentage change in the overall price level.

Use 2017 as the base year and fix the basket at 1

karaoke machine and 3 CDs.

b. Using a method similar to the GDP deflator,

compute the percentage change in the overall

price level. Also use 2017 as the base year.

c. Is the inflation rate in 2018 the same using the two

methods? Explain why or why not.

6. Which of the problems in the construction of the

CPI might be illustrated by each of the following

situations? Explain.

a. the invention of cell phones

b. the introduction of air bags in cars

c. increased personal computer purchases in

response to a decline in their price

d. more scoops of raisins in each package of Raisin

Bran

e. greater use of fuel-efficient cars after gasoline

prices increase

7. A dozen eggs cost $0.88 in January 1980 and $2.11

in January 2015. The average wage for production

workers was $7.58 per hour in January 1980 and

$19.64 in January 2015.

a. By what percentage did the price of eggs rise?

b. By what percentage did the wage rise?

c. In each year, how many minutes did a worker

have to work to earn enough to buy a

dozen eggs?

d. Did workers’ purchasing power in terms of eggs

rise or fall?

8. The chapter explains that Social Security benefits are

increased each year in proportion to the increase in

the CPI, even though most economists believe that the

CPI overstates actual inflation.

a. If the elderly consume the same market basket

as other people, does Social Security provide the

elderly with an improvement in their standard of

living each year? Explain.

b. In fact, the elderly consume more healthcare com-

pared to younger people, and healthcare costs

have risen faster than overall inflation. What

would you do to determine whether the elderly

are actually better off from year to year?

i C

PROBLEMS AND APPLICATIONS

9. Suppose that a borrower and a lender agree on the

nominal interest rate to be paid on a loan. Then infla-

tion turns out to be higher than they both expected.

a. Is the real interest rate on this loan higher or lower

than expected?

b. Does the lender gain or lose from this

unexpectedly high inflation? Does the borrower

gain or lose?

c. Inflation during the 1970s was much higher

than most people had expected when the decade

began. How did this affect homeowners who

obtained fixed-rate mortgages during the 1960s?

How did it affect the banks that lent the money?

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

512 PART VIII THE DATA OF MACROECONOMICS

The Real Economy in the Long Run

PART IX

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515

W hen you travel around the world, you see tremendous variation in the standard of living. The average income in a rich country, such as the United States, Japan, or Germany, is about ten times the average income in a poor

country, such as India, Nigeria, or Nicaragua. These large differences in income are reflected in large differences in the quality of life. People in richer countries have better nutrition, safer housing, better healthcare, and longer life expectancy as well as more automobiles, more telephones, and more computers.

Even within a country, there are large changes in the standard of living over time. In the United States over the past century, average income as measured by real gross domestic product (GDP) per person has grown by about 2 percent per year. Although 2 percent might

CHAPTER

25Production and Growth

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516 PART IX THE REAL ECONOMY IN THE LONG RUN

seem small, this rate of growth implies that average income doubles every 35 years. Because of this growth, most Americans enjoy much greater economic prosperity than did their parents, grandparents, and great-grandparents.

Growth rates vary substantially from country to country. From 2000 to 2014, GDP per person in China grew at a rate of 11 percent per year, accumulating to a 357 percent increase in average income. A country experiencing such rapid growth can, in one generation, go from being among the poorest in the world to being among the richest. By contrast, in the same time span, income per person in Zimbabwe fell by a total of 13 percent, leaving the typical citizen mired in poverty.

What explains these diverse experiences? How can rich countries maintain their high standard of living? What policies can poor countries pursue to promote more rapid growth and join the developed world? These are among the most important questions in macroeconomics. As the Nobel-Prize-winning economist Robert Lucas put it, “The consequences for human welfare in questions like these are simply staggering: Once one starts to think about them, it is hard to think about anything else.”

In the previous two chapters, we discussed how economists measure mac- roeconomic quantities and prices. We can now begin to study the forces that determine these variables. As we have seen, an economy’s GDP measures both the total income earned in the economy and the total expenditure on the econ- omy’s output of goods and services. The level of real GDP is a good gauge of economic prosperity, and the growth of real GDP is a good gauge of economic progress. In this chapter we focus on the long-run determinants of the level and growth of real GDP. Later, we study the short-run fluctuations of real GDP around its long-run trend.

We proceed here in three steps. First, we examine international data on real GDP per person. These data will give you some sense of how much the level and growth of living standards vary around the world. Second, we examine the role of productivity—the amount of goods and services produced for each hour of a worker ’s time. In particular, we see that a nation’s standard of living is deter- mined by the productivity of its workers, and we consider the factors that deter- mine a nation’s productivity. Third, we consider the link between productivity and the economic policies that a nation pursues.

25-1 Economic Growth around the World As a starting point for our study of long-run growth, let’s look at the experiences of some of the world’s economies. Table 1 shows data on real GDP per person for thirteen countries. For each country, the data span over a century of history. The first and second columns of the table present the countries and time periods. (The time periods differ somewhat from country to country because of differences in data availability.) The third and fourth columns show estimates of real GDP per person more than a century ago and for a recent year.

The data on real GDP per person show that living standards vary widely from country to country. Income per person in the United States, for instance, is now about four times that in China and about ten times that in India. The poorest countries have average levels of income not seen in the developed world for many decades. The typical resident of Pakistan in 2014 had about the same real income as the typical resident of the United Kingdom in 1870. The typical Bangladeshi in 2014 had considerably less real income than a typical American in 1870.

517CHAPTER 25 PRODUCTION AND GROWTH

The last column of the table shows each country’s growth rate. The growth rate measures how rapidly real income per person grew in the typical year. In the United States, for example, where real income per person was $4,264 in 1870 and $55,860 in 2014, the growth rate was 1.80 percent per year. This means that if real income per person, beginning at $4,264, were to increase by 1.80 percent for each of 144 years, it would end up at $55,860. Of course, income did not rise exactly 1.80 percent every year: Some years it rose by more, other years it rose by less, and in still other years it fell. The growth rate of 1.80 percent per year ignores short-run fluctuations around the long-run trend and represents an average rate of growth for real income per person over many years.

The countries in Table 1 are ordered by their growth rate from the most to the least rapid. Here you can see the large variety in growth experiences. High on the list are Brazil and China, which went from being among the poorest nations in the world to being among middle-income nations. Also high on the list is Japan, which went from being a middle-income nation to being among the richest nations.

Near the bottom of the list you can find Pakistan and Bangladesh, which were among the poorest nations at the end of the nineteenth century and remain so today. At the bottom of the list is the United Kingdom. In 1870, the United Kingdom was the richest country in the world, with average income about 20 percent higher than that of the United States and more than twice Canada’s. Today, average income in the United Kingdom is 30 percent below that of the United States and 10 percent below Canada’s.

TABLE 1

The Variety of Growth

Experiences

Real GDP per Person

Country Period

At Beginning

of Perioda At End

of Perioda Growth Rate

(per year)

Brazil 1900–2014 $ 828 $15,590 2.61%

Japan 1890–2014 1,600 37,920 2.59

China 1900–2014 762 13,170 2.53

Mexico 1900–2014 1,233 16,640 2.31

Germany 1870–2014 2,324 46,850 2.11

Indonesia 1900–2014 948 10,190 2.10

Canada 1870–2014 2,527 43,360 1.99

India 1900–2014 718 5,630 1.82

United States 1870–2014 4,264 55,860 1.80

Pakistan 1900–2014 785 5,090 1.65

Argentina 1900–2014 2,440 12,510 1.44

Bangladesh 1900–2014 663 3,330 1.43

United Kingdom 1870–2014 5,117 39,040 1.42 aReal GDP is measured in 2014 dollars.

Source: Robert J. Barro and Xavier Sala-i-Martin, Economic Growth (New York: McGraw-Hill, 1995), Tables 10.2 and 10.3; World Bank online data; and author’s

calculations. To account for international price differences, data are PPP-adjusted when available.

518 PART IX THE REAL ECONOMY IN THE LONG RUN

These data show that the world’s richest countries have no guarantee they will stay the richest and that the world’s poorest countries are not doomed to remain forever in poverty. But what explains these changes over time? Why do some countries zoom ahead while others lag behind? These are precisely the questions that we take up next.

QuickQuiz What has been the approximate long-run growth rate of real GDP per person

in the United States? Name a country that has had faster growth and a

country that has had slower growth.

Are You Richer Than the Richest American?

A merican Heritage magazine once published a list of the richest

Americans of all time. The number 1 spot went to John D.

Rockefeller, the oil entrepreneur who lived from 1839 to 1937. According

to the magazine’s calculations, his wealth would today be the equivalent

of about $200 billion, almost three times that of Bill Gates, the software

entrepreneur who is today’s richest American.

Despite his great wealth, Rockefeller did not enjoy many of the

conveniences that we now take for granted. He couldn’t watch television,

play video games, surf the Internet, or send e-mail. During the heat of

summer, he couldn’t cool his home

with air-conditioning. For much of his

life, he couldn’t travel by car or plane,

and he couldn’t use a telephone to

call friends or family. If he became ill,

he couldn’t take advantage of many

medicines, such as antibiotics, that

doctors today routinely use to prolong

and enhance life.

N o w c o n s i d e r : H o w

m u c h m o n e y w o u l d

someone have to pay you

to give up for the rest of

y o u r l i f e a l l t h e m o d e r n

conveniences that Rockefeller

lived without? Would you do it for $200

billion? Perhaps not. And if you wouldn’t, is it fair to say that you are

better off than John D. Rockefeller, allegedly the richest American ever?

The preceding chapter discussed how standard price indexes, which

are used to compare sums of money from different points in time, fail to

fully reflect the introduction of new goods in the economy. As a result,

the rate of inflation is overestimated. The flip side of this observation

is that the rate of real economic growth is underestimated. Pondering

Rockefeller’s life shows how significant this problem might be. Because

of tremendous technological advances, the average American today is

arguably “richer” than the richest American a century ago, even if that

fact is lost in standard economic statistics. ■

F Y I

John D. Rockefeller

BE TT

M A

N N

/G ET

TY IM

A G

25-2 Productivity: Its Role and Determinants Explaining why living standards vary so much around the world is, in one sense, very easy. The answer can be summarized in a single word—productivity. But in another sense, the international variation in living standards is deeply puzzling. To explain why incomes are so much higher in some countries than in others, we must look at the many factors that determine a nation’s productivity.

25-2a Why Productivity Is So Important Let’s begin our study of productivity and economic growth by developing a simple model based loosely on Daniel Defoe’s famous novel Robinson Crusoe about a sailor stranded on a desert island. Because Crusoe lives alone, he

519CHAPTER 25 PRODUCTION AND GROWTH

catches his own fish, grows his own vegetables, and makes his own clothes. We can think of Crusoe’s activities—his production and consumption of fish, vegetables, and clothing—as a simple economy. By examining Crusoe’s economy, we can learn some lessons that also apply to more complex and realistic economies.

What determines Crusoe’s standard of living? In a word, productivity, the quantity of goods and services produced from each unit of labor input. If Crusoe is good at catching fish, growing vegetables, and making clothes, he lives well. If he is bad at doing these things, he lives poorly. Because Crusoe gets to consume only what he produces, his living standard is tied to his productivity.

In the case of Crusoe’s economy, it is easy to see that productivity is the key determinant of living standards and that growth in productivity is the key determinant of growth in living standards. The more fish Crusoe can catch per hour, the more he eats at dinner. If Crusoe finds a better place to catch fish, his productivity rises. This increase in productivity makes Crusoe better off: He can eat the extra fish, or he can spend less time fishing and devote more time to making other goods he enjoys.

Productivity’s key role in determining living standards is as true for nations as it is for stranded sailors. Recall that an economy’s GDP measures two things at once: the total income earned by everyone in the economy and the total expenditure on the economy’s output of goods and services. GDP can measure these two things simultaneously because, for the economy as a whole, they must be equal. Put simply, an economy’s income is the economy’s output.

Like Crusoe, a nation can enjoy a high standard of living only if it can produce a large quantity of goods and services. Americans live better than Nigerians because American workers are more productive than Nigerian workers. The Japanese have enjoyed more rapid growth in living standards than Argentineans because Japanese workers have experienced more rapid growth in productivity. Indeed, one of the Ten Principles of Economics in Chapter 1 is that a country’s standard of living depends on its ability to produce goods and services.

Hence, to understand the large differences in living standards we observe across countries or over time, we must focus on the production of goods and services. But seeing the link between living standards and productivity is only the first step. It leads naturally to the next question: Why are some economies so much better at producing goods and services than others?

25-2b How Productivity Is Determined Although productivity is uniquely important in determining Robinson Crusoe’s standard of living, many factors determine Crusoe’s productivity. Crusoe will be better at catching fish, for instance, if he has more fishing poles, if he has been trained in the best fishing techniques, if his island has a plentiful fish supply, or if he invents a better fishing lure. Each of these determinants of Crusoe’s productivity—which we can call physical capital, human capital, natural resources, and technological knowledge—has a counterpart in more complex and realistic economies. Let’s consider each factor in turn.

Physical Capital per Worker Workers are more productive if they have tools with which to work. The stock of equipment and structures used to produce goods and services is called physical capital, or just capital. For example,

productivity

the quantity of goods and

services produced from

each unit of labor input

physical capital

the stock of equipment

and structures that are

used to produce goods

and services

520 PART IX THE REAL ECONOMY IN THE LONG RUN

A Picture Is Worth a Thousand Statistics

G eorge Bernard Shaw once said, “It is the mark of a truly intelligent

person to be moved by statistics.” Most of us, however, have trouble

being moved by data on GDP—until we see with our own eyes what

these statistics represent.

The three photos on these pages show a typical family from each of

three countries—the United Kingdom, Mexico, and Mali. Each family was

photographed outside their home, together with all their material possessions.

These nations have very different standards of living, as judged by

these photos, GDP, or other statistics.

• The United Kingdom is an advanced economy. In 2014, its income per

person was $39,040. A baby born in the United Kingdom can expect

a relatively healthy childhood: Only 4 out of 1,000 children die before

reaching age 5. Almost the entire population has access to modern

sanitation facilities, such as a bathroom and sewer system, to safely

remove human waste. Educational attainment is high: Among indi-

viduals of college age, 60 percent are enrolled in higher education.

• Mexico is a mid-

dle-income country.

In 2014, its income

per person was

$16,640. About 13 out

of 1,000 children die

before age 5. About 85 percent

have access to modern sanitation. Among those of college age, 30

percent are enrolled.

• Mali is a poor country. In 2014, its income per person was only

$1,510. Life is often cut short: 115 out of 1,000 children die before

age 5. Only 25 percent of the population has access to modern san-

itation. And educational attainment in Mali is low: Among those of

college age, only 7 percent are enrolled.

Economists who study economic growth try to understand what causes

such large differences in the standard of living. ■

F Y I

A Typical Family in the United Kingdom

D AV

ID R

EE D

- FR

O M

M AT

ER IA

L W

O RL

521CHAPTER 25 PRODUCTION AND GROWTH

A Typical Family in Mali

A Typical Family in Mexico

PE TE

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EN ZE

L/ M

EN ZE

LP H

O TO

.C O

M PE

TE R

M EN

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M EN

ZE LP

H O

TO .C

O M

522 PART IX THE REAL ECONOMY IN THE LONG RUN

when woodworkers make furniture, they use saws, lathes, and drill presses. More tools allow the woodworkers to produce their output more quickly and more accurately: A worker with only basic hand tools can make less furniture each week than a worker with sophisticated and specialized woodworking equipment.

As you may recall, the inputs used to produce goods and services—labor, capital, and so on—are called the factors of production. An important feature of capital is that it is a produced factor of production. That is, capital is an input into the production process that in the past was an output from the production process. The woodworker uses a lathe to make the leg of a table. Earlier, the lathe itself was the output of a firm that manufactures lathes. The lathe manufacturer in turn used other equipment to make its product. Thus, capital is a factor of production used to produce all kinds of goods and services, including more capital.

Human Capital per Worker A second determinant of productivity is human capital. Human capital is the economist’s term for the knowledge and skills that workers acquire through education, training, and experience. Human capital includes the skills accumulated in early childhood programs, grade school, high school, college, and on-the-job training for adults in the labor force.

Education, training, and experience are less tangible than lathes, bulldozers, and buildings, but human capital is similar to physical capital in many ways. Like physical capital, human capital raises a nation’s ability to produce goods and services. Also like physical capital, human capital is a produced factor of production. Producing human capital requires inputs in the form of teachers, libraries, and student time. Indeed, students can be viewed as “workers” who have the important job of producing the human capital that will be used in future production.

Natural Resources per Worker A third determinant of productivity is natural resources. Natural resources are inputs into production that are provided by nature, such as land, rivers, and mineral deposits. Natural resources take two forms: renewable and nonrenewable. A forest is an example of a renewable resource. When one tree is cut down, a seedling can be planted in its place to be harvested in the future. Oil is an example of a nonrenewable resource. Because oil is produced by nature over many millions of years, there is only a limited supply. Once the supply of oil is depleted, it is impossible to create more.

Differences in natural resources are responsible for some of the differences in standards of living around the world. The historical success of the United States was driven in part by the large supply of land well suited for agriculture. Today, some countries in the Middle East, such as Kuwait and Saudi Arabia, are rich simply because they happen to be on top of some of the largest pools of oil in the world.

Although natural resources can be important, they are not necessary for an economy to be highly productive in producing goods and services. Japan, for instance, is one of the richest countries in the world, despite having few natural resources. International trade makes Japan’s success possible. Japan imports many of the natural resources it needs, such as oil, and exports its manufactured goods to economies rich in natural resources.

human capital

the knowledge and skills

that workers acquire

through education,

training, and experience

natural resources

the inputs into the

production of goods and

services that are provided

by nature, such as land,

rivers, and mineral

deposits

523CHAPTER 25 PRODUCTION AND GROWTH

Technological Knowledge A fourth determinant of productivity is technological knowledge—the understanding of the best ways to produce goods and services. A hundred years ago, most Americans worked on farms because farm technology required a high input of labor to feed the entire population. Today, thanks to advances in farming technology, a small fraction of the population can produce enough food to feed the entire country. This technological change made labor available to produce other goods and services.

Technological knowledge takes many forms. Some technology is common knowledge—after one person uses it, everyone becomes aware of it. For example, once Henry Ford successfully introduced assembly-line production, other carmakers quickly followed suit. Other technology is proprietary—it is known only by the company that discovers it. Only the Coca-Cola Company, for instance, knows the secret recipe for making its famous soft drink. Still other technology is proprietary for a short time. When a pharmaceutical company discovers a new drug, the patent system gives that company a temporary right to be its exclusive manufacturer. When the patent expires, however, other companies are allowed to make the drug. All these forms of technological knowledge are important for the economy’s production of goods and services.

It is worthwhile to distinguish between technological knowledge and human capital. Although they are closely related, there is an important difference.

technological knowledge

society’s understanding of

the best ways to produce

goods and services

The Production Function

E conomists often use a production function to describe the relationship

between the quantity of inputs used in production and the quantity of

output from production. For example, suppose Y denotes the quantity of

output, L the quantity of labor, K the quantity of physical capital, H the

quantity of human capital, and N the quantity of natural resources. Then

we might write

Y 5 AF (L, K, H, N ),

where F( ) is a function that shows how the inputs are combined to

produce output. A is a variable that reflects the available production

technology. As technology improves, A rises, so the economy produces

more output from any given combination of inputs.

Many production functions have a property called constant returns

to scale. If a production function has constant returns to scale, then

doubling all inputs causes the amount of output to double as well.

Mathematically, we write that a production function has constant

returns to scale if, for any positive number x,

xY 5 AF (xL, xK, xH, xN ).

A doubling of all inputs

would be represented in

this equation by x 5 2. The

right side shows the inputs

doubling, and the left side

shows output doubling.

Production functions with constant

returns to scale have an interesting and useful implication. To see this

implication, set x 5 1/L so that the preceding equation becomes

Y/L 5 AF (1, K/L, H/L, N/L).

Notice that Y/L is output per worker, which is a measure of productivity.

This equation says that labor productivity depends on physical capital

per worker (K/L), human capital per worker (H/L), and natural resources

per worker (N/L). Productivity also depends on the state of technology, as

reflected by the variable A. Thus, this equation provides a mathematical

summary of the four determinants of productivity we have just

discussed. ■

F Y I

524 PART IX THE REAL ECONOMY IN THE LONG RUN

Technological knowledge refers to society’s understanding about how the world works. Human capital refers to the resources expended transmitting this understanding to the labor force. To use a relevant metaphor, technological knowledge is the quality of society’s textbooks, whereas human capital is the amount of time that the population has devoted to reading them. Workers’ productivity depends on both.

CASE STUDY

ARE NATURAL RESOURCES A LIMIT TO GROWTH? Today, the world’s population is over 7 billion, more than four times what it was a century ago. At the same time, many people are enjoying a much higher standard of living than did their great-

grandparents. A perennial debate concerns whether this growth in population and living standards can continue in the future.

Many commentators have argued that natural resources will eventually limit how much the world’s economies can grow. At first, this argument might seem hard to ignore. If the world has only a fixed supply of nonrenewable natural resources, how can population, production, and living standards continue to grow over time? Eventually, won’t supplies of oil and minerals start to run out? When these shortages start to occur, won’t they stop economic growth and, perhaps, even force living standards to fall?

Despite the apparent appeal of such arguments, most economists are less concerned about such limits to growth than one might guess. They argue that technological progress often yields ways to avoid these limits. If we compare the economy today to the economy of the past, we see various ways in which the use of natural resources has improved. Modern cars have better gas mileage. New houses have better insulation and require less energy to heat and cool. More efficient oil rigs waste less oil in the process of extraction. Recycling allows some nonrenewable resources to be reused. The development of alternative fuels, such as ethanol instead of gasoline, allows us to substitute renewable for nonrenewable resources.

Seventy years ago, some conservationists were concerned about the excessive use of tin and copper. At the time, these were crucial commodities: Tin was used to make many food containers, and copper was used to make telephone wire. Some people advocated mandatory recycling and rationing of tin and copper so that supplies would be available for future generations. Today, however, plastic has replaced tin as a material for making many food containers, and phone calls often travel over fiber-optic cables, which are made from sand. Technological progress has made once crucial natural resources less necessary.

But are all these efforts enough to permit continued economic growth? One way to answer this question is to look at the prices of natural resources. In a market economy, scarcity is reflected in market prices. If the world were running out of natural resources, then the prices of those resources would be rising over time. But in fact, the opposite is more often true. Natural resource prices exhibit substantial short-run fluctuations, but over long spans of time, the prices of most natural resources (adjusted for overall inflation) are stable or falling. It appears that our ability to conserve these resources is growing more rapidly than their supplies are dwindling. Market prices give no reason to believe that natural resources are a limit to economic growth. ●

QuickQuiz List and describe four determinants of a country’s productivity.

525CHAPTER 25 PRODUCTION AND GROWTH

25-3 Economic Growth and Public Policy So far, we have determined that a society’s standard of living depends on its ability to produce goods and services and that its productivity in turn depends on physical capital per worker, human capital per worker, natural resources per worker, and technological knowledge. Let’s now turn to the question faced by policymakers around the world: What can government policy do to raise productivity and living standards?

25-3a Saving and Investment Because capital is a produced factor of production, a society can change the amount of capital it has. If today the economy produces a large quantity of new capital goods, then tomorrow it will have a larger stock of capital and be able to produce more goods and services. Thus, one way to raise future productivity is to invest more current resources in the production of capital.

One of the Ten Principles of Economics presented in Chapter 1 is that people face trade-offs. This principle is especially important when considering the accumulation of capital. Because resources are scarce, devoting more resources to producing capital requires devoting fewer resources to producing goods and services for current consumption. That is, for society to invest more in capital, it must consume less and save more of its current income. The growth that arises from capital accumulation is not a free lunch: It requires that society sacrifice consumption of goods and services in the present to enjoy higher consumption in the future.

The next chapter examines in more detail how an economy’s financial markets coordinate saving and investment. It also examines how government policies influence the amount of saving and investment that take place. At this point, it is important to note that encouraging saving and investment is one way that a government can encourage growth and, in the long run, raise an economy’s standard of living.

25-3b Diminishing Returns and the Catch-Up Effect Suppose that a government pursues policies that raise the nation’s saving rate—the percentage of GDP devoted to saving rather than consumption. What happens? With the nation saving more, fewer resources are needed to make consumption goods and more resources are available to make capital goods. As a result, the capital stock increases, leading to rising productivity and more rapid growth in GDP. But how long does this higher rate of growth last? Assuming that the saving rate remains at its new, higher level, does the growth rate of GDP stay high indefinitely or only for a period of time?

The traditional view of the production process is that capital is subject to diminishing returns: As the stock of capital rises, the extra output produced from an additional unit of capital falls. In other words, when workers already have a large quantity of capital to use in producing goods and services, giving them an additional unit of capital increases their productivity only slightly. This is illustrated in Figure 1, which shows how the amount of capital per worker determines the amount of output per worker, holding constant all the other determinants of output (such as natural resources and technological knowledge).

Because of diminishing returns, an increase in the saving rate leads to higher growth only for a while. As the higher saving rate allows more capital to be accumulated, the benefits from additional capital become smaller over time, and

diminishing returns

the property whereby the

benefit from an extra unit

of an input declines as

the quantity of the input

increases

526 PART IX THE REAL ECONOMY IN THE LONG RUN

so growth slows down. In the long run, the higher saving rate leads to a higher level of productivity and income but not to higher growth in these variables. Reaching this long run, however, can take quite a while. According to studies of international data on economic growth, increasing the saving rate can lead to substantially higher growth for a period of several decades.

The property of diminishing returns to capital has another important implication: Other things being equal, it is easier for a country to grow fast if it starts out relatively poor. This effect of initial conditions on subsequent growth is sometimes called the catch-up effect. In poor countries, workers lack even the most rudimentary tools and, as a result, have low productivity. Thus, small amounts of capital investment can substantially raise these workers’ productivity. By contrast, workers in rich countries have large amounts of capital with which to work, and this partly explains their high productivity. Yet with the amount of capital per worker already so high, additional capital investment has a relatively small effect on productivity. Studies of international data on economic growth confirm this catch-up effect: Controlling for other variables, such as the percentage of GDP devoted to investment, poor countries tend to grow at faster rates than rich countries.

This catch-up effect can help explain some otherwise puzzling facts. Here’s an example: From 1960 to 1990, the United States and South Korea devoted a similar share of GDP to investment. Yet over this time, the United States experienced only mediocre growth of about 2 percent, while South Korea experienced spectacular growth of more than 6 percent. The explanation is the catch-up effect. In 1960, South Korea had GDP per person less than one-tenth the U.S. level, in part because previous investment had been so low. With a small initial capital stock, the benefits to capital accumulation were much greater in South Korea, and this gave South Korea a higher subsequent growth rate.

catch-up effect

the property whereby

countries that start off

poor tend to grow more

rapidly than countries

that start off rich

FIGURE 1

Illustrating the Production Function

This figure shows how the amount of

capital per worker influences the amount

of output per worker. Other determinants

of output, including human capital,

natural resources, and technology, are

held constant. The curve becomes flatter

as the amount of capital increases

because of diminishing returns to capital.

Output per Worker

Capital per Worker

1. When the economy has a low level of capital, an extra unit of capital leads to a large increase in output.

2. When the economy has a high level of capital, an extra unit of capital leads to a small increase in output.

527CHAPTER 25 PRODUCTION AND GROWTH

This catch-up effect shows up in other aspects of life. When a school gives an end-of-year award to the “Most Improved” student, that student is usually one who began the year with relatively poor performance. Students who began the year not studying find improvement easier than students who always worked hard. Note that it is good to be “Most Improved,” given the starting point, but it is even better to be “Best Student.” Similarly, economic growth over the last several decades has been much more rapid in South Korea than in the United States, but GDP per person is still higher in the United States.

25-3c Investment from Abroad So far, we have discussed how policies aimed at increasing a country’s saving rate can increase investment and, thereby, long-term economic growth. Yet saving by domestic residents is not the only way for a country to invest in new capital. The other way is investment by foreigners.

Investment from abroad takes several forms. Ford Motor Company might build a car factory in Mexico. A capital investment that is owned and operated by a foreign entity is called foreign direct investment. Alternatively, an American might buy stock in a Mexican corporation (that is, buy a share in the ownership of the corporation), and the corporation can use the proceeds from the stock sale to build a new factory. An investment that is financed with foreign money but operated by domestic residents is called foreign portfolio investment. In both cases, Americans provide the resources necessary to increase the stock of capital in Mexico. That is, American saving is being used to finance Mexican investment.

When foreigners invest in a country, they do so because they expect to earn a return on their investment. Ford’s car factory increases the Mexican capital stock and, therefore, increases Mexican productivity and Mexican GDP. Yet Ford takes some of this additional income back to the United States in the form of profit. Similarly, when an American investor buys Mexican stock, the investor has a right to a portion of the profit that the Mexican corporation earns.

Investment from abroad, therefore, does not have the same effect on all measures of economic prosperity. Recall that gross domestic product (GDP) is the income earned within a country by both residents and nonresidents, whereas gross national product (GNP) is the income earned by residents of a country both at home and abroad. When Ford opens its car factory in Mexico, some of the income the factory generates accrues to people who do not live in Mexico. As a result, foreign investment in Mexico raises the income of Mexicans (measured by GNP) by less than it raises the production in Mexico (measured by GDP).

Nonetheless, investment from abroad is one way for a country to grow. Even though some of the benefits from this investment flow back to the foreign owners, this investment does increase the economy’s stock of capital, leading to higher productivity and higher wages. Moreover, investment from abroad is one way for poor countries to learn the state-of-the-art technologies developed and used in richer countries. For these reasons, many economists who advise governments in less developed economies advocate policies that encourage investment from abroad. Often, this means removing restrictions that governments have imposed on foreign ownership of domestic capital.

An organization that tries to encourage the flow of capital to poor countries is the World Bank. This international organization obtains funds from the world’s advanced countries, such as the United States, and uses these resources to make loans to less developed countries so that they can invest in roads, sewer systems, schools, and other types of capital. It also offers the countries advice about how

528 PART IX THE REAL ECONOMY IN THE LONG RUN

the funds might best be used. The World Bank and its sister organization, the International Monetary Fund, were set up after World War II. One lesson from the war was that economic distress often leads to political turmoil, international tensions, and military conflict. Thus, every country has an interest in promoting economic prosperity around the world. The World Bank and the International Monetary Fund were established to achieve that common goal.

25-3d Education Education—investment in human capital—is at least as important as investment in physical capital for a country’s long-run economic success. In the United States, each year of schooling has historically raised a person’s wage by an average of about 10 percent. In less developed countries, where human capital is especially scarce, the gap between the wages of educated and uneducated workers is even larger. Thus, one way government policy can enhance the standard of living is to provide good schools and to encourage the population to take advantage of them.

Investment in human capital, like investment in physical capital, has an opportunity cost. When students are in school, they forgo the wages they could have earned as members of the labor force. In less developed countries, children often drop out of school at an early age, even though the benefit of additional schooling is very high, simply because their labor is needed to help support the family.

Some economists have argued that human capital is particularly important for economic growth because human capital conveys positive externalities. An externality is the effect of one person’s actions on the well-being of a bystander. An educated person, for instance, might generate new ideas about how best to produce goods and services. If these ideas enter society’s pool of knowledge so that everyone can use them, then the ideas are an external benefit of education. In this case, the return from schooling for society is even greater than the return for the individual. This argument would justify the large subsidies to human-capital investment that we observe in the form of public education.

One problem facing some poor countries is the brain drain—the emigration of many of the most highly educated workers to rich countries, where these workers can enjoy a higher standard of living. If human capital does have positive externalities, then this brain drain makes those people left behind even poorer. This problem offers policymakers a dilemma. On the one hand, the United States and other rich countries have the best systems of higher education, and it would seem natural for poor countries to send their best students abroad to earn higher degrees. On the other hand, those students who have spent time abroad may choose not to return home, and this brain drain will reduce the poor nation’s stock of human capital even further.

25-3e Health and Nutrition The term human capital usually refers to education, but it can also be used to describe another type of investment in people: expenditures that lead to a healthier population. Other things being equal, healthier workers are more productive. The right investments in the health of the population provide one way for a nation to increase productivity and raise living standards.

According to the late economic historian Robert Fogel, improved health from better nutrition has been a significant factor in long-run economic growth. Fogel estimated that in Great Britain in 1780, about one in five people were so malnourished that they were incapable of manual labor. Among those who could

529CHAPTER 25 PRODUCTION AND GROWTH

work, insufficient caloric intake substantially reduced the work effort they could put forth. As nutrition improved, so did workers’ productivity.

Fogel studied these historical trends in part by looking at the height of the population. Short stature can be an indicator of malnutrition, especially during gestation and the early years of life. Fogel found that as nations develop economically, people eat more and the population gets taller. From 1775 to 1975, the average caloric intake in Great Britain rose by 26 percent and the height of the average man rose by 3.6 inches. Similarly, during the spectacular economic growth in South Korea from 1962 to 1995, caloric consumption rose by 44 percent and average male height rose by 2 inches. Of course, a person’s height is determined by a combination of genetics and environment. But because the genetic makeup of a population is slow to change, such increases in average height are most likely due to changes in the environment—nutrition being the obvious explanation.

Moreover, studies have found that height is an indicator of productivity. Looking at data on a large number of workers at a point in time, researchers have found that taller workers tend to earn more. Because wages reflect a worker ’s productivity, this finding suggests that taller workers tend to be more productive. The effect of height on wages is especially pronounced in poorer countries, where malnutrition is a bigger risk.

Fogel won the Nobel Prize in Economics in 1993 for his work in economic history, which includes not only his studies of nutrition but also his studies of American slavery and the role of railroads in the development of the American economy. In the lecture he gave when he was awarded the prize, he surveyed the evidence on health and economic growth. He concluded that “improved gross nutrition accounts for roughly 30 percent of the growth of per capita income in Britain between 1790 and 1980.”

Today, malnutrition is fortunately rare in developed nations such as Great Britain and the United States. (Obesity is a more widespread problem.) But for people in developing nations, poor health and inadequate nutrition remain obstacles to higher productivity and improved living standards. The United Nations estimates that almost a third of the population in sub-Saharan Africa is undernourished.

The causal link between health and wealth runs in both directions. Poor countries are poor in part because their populations are not healthy, and their populations are not healthy in part because they are poor and cannot afford adequate healthcare and nutrition. It is a vicious circle. But this fact opens the possibility of a virtuous circle: Policies that lead to more rapid economic growth would naturally improve health outcomes, which in turn would further promote economic growth.

25-3f Property Rights and Political Stability Another way policymakers can foster economic growth is by protecting property rights and promoting political stability. This issue goes to the very heart of how market economies work.

Production in market economies arises from the interactions of millions of individuals and firms. When you buy a car, for instance, you are buying the output of a car dealer, a car manufacturer, a steel company, an iron ore mining company, and so on. This division of production among many firms allows the economy’s factors of production to be used as effectively as possible. To achieve this outcome, the economy has to coordinate transactions among these firms, as well as between firms and consumers. Market economies achieve this coordination

530 PART IX THE REAL ECONOMY IN THE LONG RUN

through market prices. That is, market prices are the instrument with which the invisible hand of the marketplace brings supply and demand into balance in each of the many thousands of markets that make up the economy.

An important prerequisite for the price system to work is an economy-wide respect for property rights. Property rights refer to the ability of people to exercise authority over the resources they own. A mining company will not make the effort to mine iron ore if it expects the ore to be stolen. The company mines the ore only if it is confident that it will benefit from the ore’s subsequent sale. For this reason, courts serve an important role in a market economy: They enforce property rights. Through the criminal justice system, the courts discourage theft. In addition, through the civil justice system, the courts ensure that buyers and sellers live up to their contracts.

Those of us in developed countries tend to take property rights for granted, but those living in less developed countries understand that a lack of property rights can be a major problem. In many countries, the system of justice does not work well. Contracts are hard to enforce, and fraud often goes unpunished. In more extreme cases, the government not only fails to enforce property rights but actually infringes upon them. To do business in some countries, firms are expected to bribe government officials. Such corruption impedes the coordinating power of markets. It also discourages domestic saving and investment from abroad.

One threat to property rights is political instability. When revolutions and coups are common, there is doubt about whether property rights will be respected in the future. If a revolutionary government might confiscate the capital of some businesses, as was often true after communist revolutions, domestic residents have less incentive to save, invest, and start new businesses. At the same time, foreigners have less incentive to invest in the country. Even the threat of revolution can act to depress a nation’s standard of living.

Thus, economic prosperity depends in part on political prosperity. A country with an efficient court system, honest government officials, and a stable constitution will enjoy a higher economic standard of living than a country with a poor court system, corrupt officials, and frequent revolutions and coups.

25-3g Free Trade Some of the world’s poorest countries have tried to achieve more rapid economic growth by pursuing inward-oriented policies. These policies attempt to increase productivity and living standards within the country by avoiding interaction with the rest of the world. Domestic firms often advance the infant-industry argument, claiming they need protection from foreign competition to thrive and grow. Together with a general distrust of foreigners, this argument has at times led policymakers in less developed countries to impose tariffs and other trade restrictions.

Most economists today believe that poor countries are better off pursuing outward-oriented policies that integrate these countries into the world economy. International trade in goods and services can improve the economic well-being of a country’s citizens. Trade is, in some ways, a type of technology. When a country exports wheat and imports textiles, the country benefits as if it had invented a technology for turning wheat into textiles. A country that eliminates trade restrictions will, therefore, experience the same kind of economic growth that would occur after a major technological advance.

The adverse impact of inward orientation becomes clear when one considers the small size of many less developed economies. The total GDP of Argentina,

531CHAPTER 25 PRODUCTION AND GROWTH

for instance, is about that of Houston, Texas. Imagine what would happen if the Houston city council were to prohibit city residents from trading with people living outside the city limits. Without being able to take advantage of the gains from trade, Houston would need to produce all the goods it consumes. It would also have to produce all its own capital goods, rather than importing state-of- the-art equipment from other cities. Living standards in Houston would fall immediately, and the problem would likely only get worse over time. This is precisely what happened when Argentina pursued inward-oriented policies throughout much of the 20th century. In contrast, countries that pursued outward- oriented policies, such as South Korea, Singapore, and Taiwan, enjoyed high rates of economic growth.

The amount that a nation trades with others is determined not only by government policy but also by geography. Countries with natural seaports find trade easier than countries without this resource. It is not a coincidence that many of the world’s major cities, such as New York, San Francisco, and Hong Kong, are located next to oceans. Similarly, because landlocked countries find international trade more difficult, they tend to have lower levels of income than countries with easy access to the world’s waterways. For example, countries with more than 80 percent of their population living within 100 kilometers of a coast have an average GDP per person about four times as large as countries with less than 20 percent of their population living near a coast. The critical importance of access to the sea helps explain why the African continent, which contains many landlocked countries, is so poor.

25-3h Research and Development The primary reason that living standards are higher today than they were a century ago is that technological knowledge has advanced. The telephone, the transistor, the computer, and the internal combustion engine are among the thousands of innovations that have improved the ability to produce goods and services.

Most technological advances come from private research by firms and individual inventors, but there is also a public interest in promoting these efforts. To a large extent, knowledge is a public good: That is, once one person discovers an idea, the idea enters society’s pool of knowledge and other people can freely use it. Just as government has a role in providing a public good such as national defense, it also has a role in encouraging the research and development of new technologies.

The U.S. government has long played a role in the creation and dissemination of technological knowledge. A century ago, the government sponsored research about farming methods and advised farmers how best to use their land. More recently, the U.S. government, through the Air Force and NASA, has supported aerospace research; as a result, the United States is a leading maker of rockets and planes. The government continues to encourage advances in knowledge with research grants from the National Science Foundation and the National Institutes of Health and with tax breaks for firms engaging in research and development.

Yet another way in which government policy encourages research is through the patent system. When a person or firm creates an innovative product, such as a new drug, the inventor can apply for a patent. If the product is deemed truly original,

“Future innovations worldwide will not be transformational

enough to promote sustained per-capita economic growth rates

in the United States and western Europe over the next century

as high as those over the past 150 years.”

What do economists say?

59% uncertain

7% agree

34% disagree

Source: IGM Economic Experts Panel, February 11, 2014.

Innovation and Growth

ASK THE EXPERTS

532 PART IX THE REAL ECONOMY IN THE LONG RUN

When economists look ahead to future tech-

nological progress, their crystal ball is often

foggy.

Has All the Important Stuff

Already Been Invented?

By Timothy Aeppel

R obert Gordon, a curmudgeonly 73-year-old

economist, believes our best days are over.

After a century of life-changing innovations

that spurred growth, he says, human progress

is slowing to a crawl.

J o e l M o k y r, a c h e e r f u l 6 7 - y e a r- o l d

economist, imagines a coming age of new

inventions, including gene therapies to prolong

our life span and miracle seeds that can feed

the world without fertilizers.

T h e s e b i g - n a m e c o l l e a g u e s a t

Northwestern University represent opposite

poles in the debate over the future of the 21st

century economy: rapid innovation driven

by robotic manufacturing, 3-D printing and

cloud computing, versus years of job losses,

stagnant wages and rising income inequality.

T h e d i v e r g e n t v i e w s a r e m o r e t h a n

academic. For many Americans, the recession

left behind the scars of lost jobs, lower wages

and depressed home prices. The question is

whether tough times are here for good. The

answer depends on who you ask.

“I think the rate of innovation is just

getting faster and faster,” Mr. Mokyr said over

noodles and spicy chicken at a Thai restaurant

near the campus where he and Mr. Gordon have

taught for four decades.

“What’s the evidence of that?” snapped

Mr. Gordon. “There isn’t any.”

The men get along fine when talk is limited

to, say, faculty gossip. About the future,

though, they bicker constantly. When Mr. Mokyr

described life-prolonging medical advances,

Mr. Gordon cut in: “Extending life without

curing Alzheimer’s means people who can walk

but can’t think.”

Mr. Gordon landed at Northwestern from

the University of Chicago in the fall of 1973,

a year before Mr. Mokyr arrived there from

Yale after finishing his Ph.D. Their tit-for-tat

repartee makes them popular speakers—for

economists, at least….

The professors headlined a Bank of Korea

event in Seoul earlier this month. “We always

go mano-a-mano,” Mr. Mokyr said. “But we

often end up talking about different things.

Bob’s a macroeconomist, I’m an economic

historian.”

Mr. Mokyr has long studied how new tools

have led to economic breakthroughs. For

example, how the development of telescopes

allowed for rapid advances in astronomy.

History makes him certain his colleague is

wrong.

Mr. Gordon’s ideas, in fact, fly in the

face of modern economic orthodoxy. Since

Nobel economist Robert Solow first argued

in the 1950s that growth was driven by new

technology, most economists have embraced

the idea. Progress may be uneven, according to

this view, but there is no reason to expect the

world to run out of ideas.

“Bob says the low-hanging fruit has been

picked, because we won’t invent indoor plumbing

again,” Mr. Mokyr said. In speeches, Mr. Gordon

often displays images of a flush toilet and iPhone

and asks: Which would you give up?

Mr. Mokyr said many economists before

M r. G o r d o n h a v e p r o c l a i m e d t h e e n d o f

progress, but these pessimists have always

been proven wrong. It was a popular theme

during the Depression, he said, but modern

economists now recognize the 1930s as a

period of rapid technological progress with

such advances as the development of jet

engines and radar.

Today, Mr. Mokyr said, fast computing

is a new tool that will open the way to new

inventions in the future.

The darkness of Mr. Mokyr’s family history

contrasts with his optimism for the future.

His parents were Dutch Jews who survived the

Holocaust. His father, a civil servant, died of

cancer when Mr. Mokyr was a year old. He was

raised by his mother in a small apartment in

the port city of Haifa in Israel. “My mother was

not an optimist,” he said. “She had lived a very

tough life.”

Mr. Gordon, the more famous of the two

men, has the credentials to buck conventional

Curmudgeon versus Optimist

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wisdom. His parents and a brother were Ph.D.

economists. His father, an expert on business

cycles, taught at the University of California,

Berkeley, for decades….

If anything, his family should have made

him an optimist. Mr. Gordon’s father grew

up grindingly poor, at one point supporting

three younger brothers after his own father

died; his eventual success mirrored the larger

transformation of the U.S. into the world’s

richest country.

“His generation saw the move from

crowded tenements in the 1920s to suburbia

in the 1950s—with everyone having a yard

and a car,” Mr. Gordon said, a leap showing

how much progress has since slowed.

Mr. Gordon sees a hobbled U.S. economy

ahead. Americans are getting older, leaving

t o o f e w w o r k e r s t o s u p p o r t t h e a g i n g

population. The problem is even worse in

other Western economies.

An aging citizenry is among a list of

troubles, including the declining share of

working-age men with jobs; stagnant rates

of Americans earning college degrees; jobs

lost abroad and high government debt. The

biggest obstacle, he said, is growing income

inequality.

To c o m p e n s a t e , M r. G o r d o n s a i d ,

economies need technological advances. The

problem is that the biggest breakthroughs—

l i k e e l e c t r i f i c a t i o n o r t h e d i s c o v e r y o f

antibiotics—are behind us. Electricity

changed how people lived and worked, and

it spawned hundreds of new industries.

The technology that allowed people to

communicate instantly or travel quickly over

long distances were 19th- and 20th-century

innovations.

More recent inventions—including the

Internet—won’t pack the same punch, he

said: “The rapid progress made over the past

250 years could well turn out to be a unique

episode in human history.”

Cellphones, he said, are just a refinement

of the telephone. “Look at what an ideal

kitchen looked like in 1955—it’s not that

different than today,” Mr. Gordon said. “It’s

nothing like moving from clothes lines to

clothes dryers.”…

Mr. Gordon said his ideas began taking

shape between semesters at graduate school.

He worked during the summer of 1965 for a

team of economists analyzing the dazzling

productivity growth that began around 1920

and ran through World War II and the postwar

boom.

Except for an upturn in the 1990s, growth

has been tepid ever since.

“ E v e r y o n e h a s l o o k e d f o r a b i g

overarching factor to explain this,” he said.

“But it occurred to me, it could be as simple

as that we’d run out of the great inventions.”

Mr. Gordon said his ideas evolved from

there. In 2000, he published a paper saying

that computer technology, hailed as the driver

of the “new economy,” was far less impressive

than earlier big inventions. He generated

more controversy with a 2012 academic paper

titled “Is U.S. Economic Growth Over?”

The paper included a dire prediction:

The economy will grow less than half as fast

as the remarkable 2% average it notched

between 1870 and 2007. “Americans got used

to their standard of living doubling from that

of their parents. No more,” he told investment

managers in Germany this year.

If he is right, the standard of living for the

average American—measured in per capita

income—will in the future take 78 years to

double, compared with the 35 years it took

between 1972 and 2007….

Much of Mr. Gordon’s work focuses on

an economy’s output. Mr. Mokyr, meanwhile,

is more interested in how new inventions

improve the quality of life in ways that

don’t show up in traditional measures: new

medicines that treat chronic pain or allow

older people to stay active years longer. A hip

replacement, he said, let him keep riding his

bike to and from work.

“For Bob, it’s all about the measure of

input and output—especially output,” said

Mr. Mokyr. That is why the aging population

is such a big problem for Mr. Gordon, since

retired people stop producing.

Mr. Gordon countered that many of the

innovations Mr. Mokyr anticipates—such

as new technology to clean air and water

pollution—will solve problems created by

past economic growth. Those shouldn’t be

counted the same way as breakthroughs that

add to output, he said.

“Maybe the problem is that we didn’t

measure growth in the past correctly,”

Mr. Mokyr retorted, “because we didn’t

account for the costs.”

The two men agree on one point. “One of

the main missions I have in life is to point

out to my students how lucky they are to be

born in the 20th century,” Mr. Mokyr said.

“Compared to what life was like 100 or 200

years ago, we’re incredibly fortunate.” ■

Source: The Wall Street Journal, June 16, 2014.

Optimist

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534 PART IX THE REAL ECONOMY IN THE LONG RUN

the government awards the patent, which gives the inventor the exclusive right to make the product for a specified number of years. In essence, the patent gives the inventor a property right over her invention, turning her new idea from a public good into a private good. By allowing inventors to profit from their inventions—even if only temporarily—the patent system enhances the incentive for individuals and firms to engage in research.

25-3i Population Growth Economists and other social scientists have long debated how population affects a society. The most direct effect is on the size of the labor force: A large population means more workers to produce goods and services. The tremendous size of the Chinese population is one reason China is such an important player in the world economy.

At the same time, however, a large population means more people to consume those goods and services. So while a large population means a larger total output of goods and services, it need not mean a higher standard of living for the typical citizen. Indeed, both large and small nations are found at all levels of economic development.

Beyond these obvious effects of population size, population growth interacts with the other factors of production in ways that are more subtle and open to debate.

Stretching Natural Resources Thomas Robert Malthus (1766–1834), an English minister and early economic thinker, is famous for his book called An Essay on the Principle of Population as It Affects the Future Improvement of Society. In it, he offered what may be history’s most chilling forecast. Malthus argued that an ever- increasing population would continually strain society’s ability to provide for itself. As a result, mankind was doomed to forever live in poverty.

Malthus’s logic was simple. He began by noting that “food is necessary to the existence of man” and that “the passion between the sexes is necessary and will remain nearly in its present state.” He concluded that “the power of population is infinitely greater than the power in the earth to produce subsistence for man.” According to Malthus, the only check on population growth was “misery and vice.” Attempts by charities or governments to alleviate poverty were counterproductive, he argued, because they merely allowed the poor to have more children, placing even greater strains on society’s productive capabilities.

Malthus may have correctly described the world at the time when he lived, but fortunately, his dire forecast was far off the mark. The world population has increased about sixfold over the past two centuries, but living standards around the world are on average much higher. As a result of economic growth, chronic hunger and malnutrition are less common now than they were in Malthus’s day. Modern famines occur from time to time but are more often the result of an unequal income distribution or political instability than inadequate food production.

Where did Malthus go wrong? As we discussed in a case study earlier in this chapter, growth in human ingenuity has offset the effects of a larger population. Pesticides, fertilizers, mechanized farm equipment, new crop varieties, and other technological advances that Malthus never imagined have allowed each farmer to feed ever greater numbers of people. Even with more mouths to feed, fewer farmers are necessary because each farmer is much more productive.

Diluting the Capital Stock Whereas Malthus worried about the effects of population on the use of natural resources, some modern theories of economic Thomas Robert Malthus

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535CHAPTER 25 PRODUCTION AND GROWTH

growth emphasize its effects on capital accumulation. According to these theories, high population growth reduces GDP per worker because rapid growth in the number of workers forces the capital stock to be spread more thinly. In other words, when population growth is rapid, each worker is equipped with less capital. A smaller quantity of capital per worker leads to lower productivity and lower GDP per worker.

This problem is most apparent in the case of human capital. Countries with high population growth have large numbers of school-age children. This places a larger burden on the educational system. It is not surprising, therefore, that educational attainment tends to be low in countries with high population growth.

The differences in population growth around the world are large. In developed countries, such as the United States and those in Western Europe, the population has risen only about 1 percent per year in recent decades and is expected to rise even more slowly in the future. By contrast, in many poor African countries, population grows at about 3 percent per year. At this rate, the population doubles every 23 years. This rapid population growth makes it harder to provide workers with the tools and skills they need to achieve high levels of productivity.

Rapid population growth is not the main reason that less developed countries are poor, but some analysts believe that reducing the rate of population growth would help these countries raise their standards of living. In some countries, this goal is accomplished directly with laws that regulate the number of children families may have. For example, from 1980 to 2015, China allowed only one child per family; couples who violated this rule were subject to substantial fines. In countries with greater freedom, the goal of reduced population growth is accomplished less directly by increasing awareness of birth control techniques.

Another way in which a country can influence population growth is to apply one of the Ten Principles of Economics: People respond to incentives. Bearing a child, like any decision, has an opportunity cost. When the opportunity cost rises, people will choose to have smaller families. In particular, women with the opportunity to receive a good education and desirable employment tend to want fewer children than those with fewer opportunities outside the home. Hence, policies that foster equal treatment of women may be one way for less developed economies to reduce the rate of population growth and, perhaps, raise their standards of living.

Promoting Technological Progress Rapid population growth may depress economic prosperity by reducing the amount of capital each worker has, but it may also have some benefits. Some economists have suggested that world population growth has been an engine of technological progress and economic prosperity. The mechanism is simple: If there are more people, then there are more scientists, inventors, and engineers to contribute to technological advance, which benefits everyone.

Economist Michael Kremer provided some support for this hypothesis in an article titled “Population Growth and Technological Change: One Million b.c. to 1990,” which was published in the Quarterly Journal of Economics in 1993. Kremer began by noting that over the broad span of human history, world growth rates have increased with world population. For example, world growth was more rapid when the world population was 1 billion (which occurred around the year 1800) than when the population was only 100 million (around 500 b.c.). This fact is consistent with the hypothesis that a larger population induces more technological progress.

536 PART IX THE REAL ECONOMY IN THE LONG RUN

Kremer ’s second piece of evidence comes from comparing regions of the world. The melting of the polar icecaps at the end of the Ice Age around 10,000 b.c. flooded the land bridges and separated the world into several distinct regions that could not communicate with one another for thousands of years. If technological progress is more rapid when there are more people to discover things, then larger regions should have experienced more rapid growth.

According to Kremer, that is exactly what happened. The most successful region of the world in 1500 (when Columbus reestablished contact) comprised the “Old World” civilizations of the large Eurasia-Africa region. Next in technological development were the Aztec and Mayan civilizations in the Americas, followed by the hunter-gatherers of Australia, and then the primitive people of Tasmania, who lacked even fire-making and most stone and bone tools.

To figure out what policies work in

developing nations, economists are

increasingly turning to randomized

controlled experiments.

What It Takes to Lift Families

Out of Poverty

By Michaeleen Doucleff

E ighteen years ago, Dean Karlan was a fresh,

bright-eyed graduate student in economics

at the Massachusetts Institute of Technology.

He wanted to answer what seemed like a sim-

ple question:

“Does global aid work?” Karlan says.

He was reading a bunch of studies on the

topic. But none of them actually answered the

question. “We were tearing our hair out reading

these papers because it was frustrating,” he

says. “[We] never really felt like the papers

were really satisfactory.”

One problem was that no one was actually

testing global aid programs—methodically—

to see if they really changed people’s lives

permanently. “They haven’t been taking the

scientific method to problems of poverty,” he

says.

Take, for instance, a charity that gives a

family a cow. The charity might check on the

family a year later and say, “Wow! The family is

doing so much better with this cow. Cows must

be the reason.”

But maybe it wasn’t the cow that improved

the family’s life. Maybe it had a bumper crop

that year or property values went up in the

neighborhood. Researchers really weren’t doing

those experiments, Karlan says.

So he and a bunch of his colleagues had

a radical idea: Test aid with the same method

doctors use to test drugs (that is, randomized

control trials).

The idea is quite simple. Give some

families aid but others nothing. Then follow

both groups, and see if the aid actually made a

difference in the long run.

Karlan, who’s now a professor at Yale

University, says many people were skeptical.

“I have many conversations with people who

say, ‘You want to do what? Why would you want

to do that?’ ”

One issue is that some families go home

empty-handed, with no aid. So the idea seems

unethical. But Karlan disagrees. “The whole

point of this is to help more people,” he says.

“If we find out what works and what doesn’t,

in five years we can have a much bigger

impact.”

So Karlan and collaborators around the world,

including those at the Abdul Latif Jameel Poverty

Action Lab at MIT and the nonprofit Innovations

for Poverty Action, decided to try out the idea with

one of the toughest problems out there: helping

families get out of extreme poverty.

An anti-poverty program in Bangladesh,

called BRAC, looked like it was successful.

It seemed to help nearly 400,000 families

who were living off less than $1.25 each day.

So Karlan and his colleagues wanted to test

the program and see if it could work in other

countries.

Using Experiments to Evaluate Aid

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537CHAPTER 25 PRODUCTION AND GROWTH

The smallest isolated region was Flinders Island, a tiny island between Tasmania and Australia. With the smallest population, Flinders Island had the fewest opportunities for technological advance and, indeed, seemed to regress. Around 3000 b.c., human society on Flinders Island died out completely. A large population, Kremer concluded, is a prerequisite for technological advance.

QuickQuiz Describe three ways a government policymaker can try to raise the growth

in living standards in a society. Are there any drawbacks to these policies?

T h e y t e a m e d u p w i t h a n e t w o r k o f

researchers and nonprofits in six developing

c o u n t r i e s . T h e y w e n t t o t h o u s a n d s o f

communities and found the poorest families.

Then they divided the families into two

groups. They gave half the families nothing.

And the other half a whole smorgasbord of aid

for one to two years. They gave them:

1. Some livestock for making money,

such as goats for milk, bees for honey,

or guinea pigs for selling. “Depending

on the site, there were different things

specifically appropriate for that con-

text,” Karlan says.

2. Tr a i n i n g a b o u t h o w t o r a i s e t h e

livestock

3. Food or cash so they wouldn’t eat the

livestock

4. A savings account

5. Help with their health—both physical

and mental

Karlan and his colleagues reported the

results of the massive experiment in the

journal Science this week.

So what did they find? Well, the strategy

worked pretty well in five of the six countries

they tried it in. Families who got the aid

started making a little more money, and they

had more food to eat.

“We see mental health go up. Happiness

go up. We even saw things like female power

increase,” Karlan says.

But here’s what sets this study apart from

the rest: Families continued to make a bit

more money even a year after the aid stopped.

“People were stuck. They give them

this big push, and they seem to be on a

sustained increased income level,” says

Justin Sandefur, an economist at the Center

for Global Development in Washington, who

wasn’t involved in the study.

“What I found exciting and unique about

this study is that the impact of the aid was

durable and sustainable,” he added.

The results suggest that the right kind of

aid does help people in multiple places. It lifted

the families up just a little bit so they could

finally start inching out of extreme poverty.

But we shouldn’t get too excited yet. These

people are still very poor, says Sarah Baird, an

economist at George Washington University.

The effect of the aid was actually quite

small, she says. Families’ incomes and food

consumption together went up by only a small

amount — about 5 percent, on average,

when compared with the control group.

And it’s still unknown how long this

bump will last. The researchers looked at the

change only a year after the aid stopped.

“Moving poverty is hard,” Baird says.

“The fact that they [Karlan and colleagues]

were able to move it, and it was sustainable

after a year, I think is important.”

The findings are a leap forward, she says,

because it shows charities and governments

a basic strategy that often works.

And even a little bit of extra money can

make a huge difference in these peoples’

lives, she says. It can help them send their

kids to school. Or even just give them a little

more hope. ■

report titled “What It Takes To Lift Families Out Of Poverty”

by Michaeleen Doucleff was originally published on NPR.

org on May 15, 2015, and is used with the permission of

NPR. Any unauthorized duplication is strictly prohibited.PE R-

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538 PART IX THE REAL ECONOMY IN THE LONG RUN

25-4 Conclusion: The Importance of Long-Run Growth

1. Over the past century, real GDP per person in the

United States has grown about _____ percent per

year, which means it doubles about every _____ years.

a. 2, 14

b. 2, 35

c. 5, 14

d. 5, 35

2. The world’s rich countries, such as the United States

and Germany, have income per person that is about

_____ times the income per person in the world’s poor

countries, such as Pakistan and India.

a. 2

b. 4

c. 10

d. 30

3. Most economists are ________ that natural resources

will eventually limit economic growth. As evidence,

they note that the prices of most natural resources,

adjusted for overall inflation, have tended to ________

over time.

a. concerned, rise

b. concerned, fall

c. not concerned, rise

d. not concerned, fall

4. Because capital is subject to diminishing returns,

higher saving and investment do not lead to higher

a. income in the long run.

b. income in the short run.

c. growth in the long run.

d. growth in the short run.

5. When the Japanese car maker Toyota expands one

of its car factories in the United States, what is the

likely impact of this event on the gross domestic prod-

uct and gross national product of the United States?

a. GDP rises and GNP falls.

b. GNP rises and GDP falls.

c. GDP shows a larger increase than GNP.

d. GNP shows a larger increase than GDP.

6. Thomas Robert Malthus believed that population

growth would

a. put stress on the economy’s ability to produce

food, dooming humans to remain in poverty.

b. spread the capital stock too thinly across the labor

force, lowering each worker’s productivity.

c. promote technological progress, because there

would be more scientists and inventors.

d. eventually decline to sustainable levels, as birth

control improved and people had smaller families.

CHAPTER QuickQuiz

In this chapter, we have discussed what determines the standard of living in a nation and how policymakers can endeavor to raise it through policies that promote economic growth. Most of this chapter is summarized in one of the Ten Principles of Economics: A country’s standard of living depends on its ability to produce goods and services. Policymakers who want to encourage growth in living standards must aim to increase their nation’s productive ability by encouraging rapid accumulation of the factors of production and ensuring that these factors are employed as effectively as possible.

Economists differ in their views on the role of government in promoting economic growth. At the very least, government can lend support to the invisible hand by maintaining property rights and political stability. More controversial is whether government should target and subsidize specific industries that might be especially important for technological progress. There is no doubt that these issues are among the most important in economics. The success of one generation’s policymakers in learning and heeding the fundamental lessons about economic growth determines what kind of world the next generation will inherit.

539CHAPTER 25 PRODUCTION AND GROWTH

• Economic prosperity, as measured by GDP per person,

varies substantially around the world. The average

income in the world’s richest countries is more than

ten times that in the world’s poorest countries. Because

growth rates of real GDP also vary substantially, the

relative positions of countries can change dramatically

over time.

• The standard of living in an economy depends on

the economy’s ability to produce goods and services.

Productivity, in turn, depends on the physical capital,

human capital, natural resources, and technological

knowledge available to workers.

• Government policies can try to influence t he

economy’s growth rate in many ways: by encouraging

saving and investment, encouraging investment from

abroad, fostering education, promoting good health,

maintaining property rights and political stability,

allowing free trade, and promoting the research and

development of new technologies.

• The accumulation of capital is subject to diminishing

returns: The more capital an economy has, the less

additional output the economy gets from an extra unit

of capital. As a result, although higher saving leads to

higher growth for a period of time, growth eventually

slows down as capital, productivity, and income rise.

Also because of diminishing returns, the return to

capital is especially high in poor countries. Other

things being equal, these countries can grow faster

because of the catch-up effect.

• Population growth has a variety of effects on economic

growth. On the one hand, more rapid population

growth may lower productivity by stretching the

supply of natural resources and by reducing the

amount of capital available for each worker. On the

other hand, a larger population may enhance the

rate of technological progress because there are more

scientists and engineers.

SUMMARY

productivity, p. 519

physical capital, p. 519

human capital, p. 522

natural resources, p. 522

technological knowledge, p. 523

diminishing returns, p. 525

catch-up effect, p. 526

KEY CONCEPTS

1. What does the level of a nation’s GDP measure? What

does the growth rate of GDP measure? Would you

rather live in a nation with a high level of GDP and a

low growth rate or in a nation with a low level of GDP

and a high growth rate?

2. List and describe four determinants of productivity.

3. In what way is a college degree a form of capital?

4. Explain how higher saving leads to a higher standard

of living. What might deter a policymaker from trying

to raise the rate of saving?

5. Does a higher rate of saving lead to higher growth

temporarily or indefinitely?

6. Why would removing a trade restriction, such as a

tariff, lead to more rapid economic growth?

7. How does the rate of population growth influence the

level of GDP per person?

8. Describe two ways the U.S. government tries to

encourage advances in technological knowledge.

QUESTIONS FOR REVIEW

540 PART IX THE REAL ECONOMY IN THE LONG RUN

1. Most countries, including the United States, import

substantial amounts of goods and services from other

countries. Yet the chapter says that a nation can enjoy

a high standard of living only if it can produce a

large quantity of goods and services itself. Can you

reconcile these two facts?

2. Suppose that society decided to reduce consumption

and increase investment.

a. How would this change affect economic growth?

b. What groups in society would benefit from this

change? What groups might be hurt?

3. Societies choose what share of their resources to

devote to consumption and what share to devote to

investment. Some of these decisions involve private

spending; others involve government spending.

a. Describe some forms of private spending that

represent consumption and some forms that

represent investment. The national income

accounts include tuition as a part of consumer

spending. In your opinion, are the resources you

devote to your education a form of consumption

or a form of investment?

b. Describe some forms of government spending

that represent consumption and some forms that

represent investment. In your opinion, should we

view government spending on health programs

as a form of consumption or investment? Would

you distinguish between health programs for the

young and health programs for the elderly?

4. What is the opportunity cost of investing in capital?

Do you think a country can overinvest in capital?

What is the opportunity cost of investing in human

capital? Do you think a country can overinvest in

human capital? Explain.

5. In the 1990s and the first decade of the 2000s, investors

from the Asian economies of Japan and China made

significant direct and portfolio investments in the

United States. At the time, many Americans were

unhappy that this investment was occurring.

a. In what way was it better for the United States

to receive this foreign investment than not to

receive it?

b. In what way would it have been better still for

Americans to have made this investment?

6. In many developing nations, young women have

lower enrollment rates in secondary school than do

young men. Describe several ways in which greater

educational opportunities for young women could

lead to faster economic growth in these countries.

7. The International Property Right Index scores

countries based on the legal and political environment

and how well property rights are protected. Go online

and find a recent ranking. Choose three countries with

high scores and three countries with low scores. Then

find estimates of GDP per person in each of these

six countries. What pattern do you find? Give two

possible interpretations of the pattern.

8. International data show a positive correlation between

income per person and the health of the population.

a. Explain how higher income might cause better

health outcomes.

b. Explain how better health outcomes might cause

higher income.

c. How might the relative importance of your two

hypotheses be relevant for public policy?

9. The great 18th-century economist Adam Smith wrote,

“Little else is requisite to carry a state to the highest

degree of opulence from the lowest barbarism but

peace, easy taxes, and a tolerable administration of

justice: all the rest being brought about by the natu-

ral course of things.” Explain how each of the three

conditions Smith describes would promote economic

growth.

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

PROBLEMS AND APPLICATIONS

541

Saving, Investment, and the Financial System

CHAPTER

26 I

magine that you have just graduated from college (with a degree in economics, of course) and you decide to start your own business—an economic forecasting firm. Before you make any money selling your forecasts, you have to incur

substantial costs to set up your business. You have to buy computers with which to make your forecasts, as well as desks, chairs, and filing cabinets to furnish your new office. Each of these items is a type of capital that your firm will use to produce and sell its services.

How do you obtain the funds to invest in these capital goods? Perhaps you are able to pay for them out of your past savings. More likely, however, like most entrepreneurs, you do not have enough money of your own

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542 PART IX THE REAL ECONOMY IN THE LONG RUN

to finance the start of your business. As a result, you have to get the money you need from other sources.

There are various ways to finance these capital investments. You could borrow the money, perhaps from a bank or from a friend or relative. In this case, you would promise not only to return the money to the lender at a later date but also to pay the lender interest for the use of the money. Alternatively, you could con- vince someone to provide the money you need for your business in exchange for a share of your future profits, whatever they might happen to be. In either case, your investment in computers and office equipment is being financed by some- one else’s saving.

The financial system consists of the institutions that help to match one per- son’s saving with another person’s investment. As we discussed in the previous chapter, saving and investment are key ingredients to long-run economic growth: When a country saves a large portion of its GDP, more resources are available for investment in capital, and higher capital raises a country’s productivity and liv- ing standard. The previous chapter, however, did not explain how the economy coordinates saving and investment. At any time, some people want to save some of their income for the future and others want to borrow to finance investments in new and growing businesses. What brings these two groups of people together? What ensures that the supply of funds from those who want to save balances the demand for funds from those who want to invest?

This chapter examines how the financial system works. First, we discuss the large variety of institutions that make up the financial system in our economy. Second, we examine the relationship between the financial system and some key macroeconomic variables—notably saving and investment. Third, we develop a model of the supply and demand for funds in financial markets. In the model, the interest rate is the price that adjusts to balance supply and demand. The model shows how various government policies affect the interest rate and, thereby, soci- ety’s allocation of scarce resources.

financial system

the group of institutions

in the economy that help

to match one person’s

saving with another

person’s investment

26-1 Financial Institutions in the U.S. Economy At the broadest level, the financial system moves the economy’s scarce resources from savers (people who spend less than they earn) to borrowers (people who spend more than they earn). Savers save for various reasons—to put a child through college in several years or to retire comfortably in several decades. Similarly, borrowers borrow for various reasons—to buy a house in which to live or to start a business with which to make a living. Savers supply their money to the financial system with the expectation that they will get it back with interest at a later date. Borrowers demand money from the financial system with the knowledge that they will be required to pay it back with interest at a later date.

The financial system is made up of various financial institutions that help coordinate the actions of savers and borrowers. As a prelude to analyzing the economic forces that drive the financial system, let’s discuss the most important of these institutions. Financial institutions can be grouped into two categories: financial markets and financial intermediaries. We consider each category in turn.

26-1a Financial Markets Financial markets are the institutions through which a person who wants to save can directly supply funds to a person who wants to borrow. The two most important financial markets in our economy are the bond market and the stock market.

financial markets

financial institutions

through which savers can

directly provide funds to

borrowers

543CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

The Bond Market When Intel, the giant maker of computer chips, wants to borrow to finance construction of a new factory, it can borrow directly from the public. It does this by selling bonds. A bond is a certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond. Put simply, a bond is an IOU. It identifies the time at which the loan will be repaid, called the date of maturity, and the rate of interest that will be paid periodically until the loan matures. The buyer of a bond gives his money to Intel in exchange for this promise of interest and eventual repayment of the amount borrowed (called the principal). The buyer can hold the bond until maturity, or he can sell the bond at an earlier date to someone else.

There are millions of different bonds in the U.S. economy. When large corporations, the federal government, or state and local governments need to borrow to finance the purchase of a new factory, a new jet fighter, or a new school, they usually do so by issuing bonds. If you look at The Wall Street Journal or the business section of your local newspaper, you will find a listing of the prices and interest rates on some of the most important bond issues. These bonds differ according to three significant characteristics.

The first characteristic is a bond’s term—the length of time until the bond matures. Some bonds have short terms, such as a few months, while others have terms as long as 30 years. (The British government has even issued a bond that never matures, called a perpetuity. This bond pays interest forever, but the principal is never repaid.) The interest rate on a bond depends, in part, on its term. Long-term bonds are riskier than short-term bonds because holders of long-term bonds have to wait longer for repayment of principal. If a holder of a long-term bond needs his money earlier than the distant date of maturity, he has no choice but to sell the bond to someone else, perhaps at a reduced price. To compensate for this risk, long-term bonds usually pay higher interest rates than short-term bonds.

The second important characteristic of a bond is its credit risk—the probability that the borrower will fail to pay some of the interest or principal. Such a failure to pay is called a default. Borrowers can (and sometimes do) default on their loans by declaring bankruptcy. When bond buyers perceive that the probability of default is high, they demand a higher interest rate as compensation for this risk. Because the U.S. government is considered a safe credit risk, government bonds tend to pay low interest rates. By contrast, financially shaky corporations raise money by issuing junk bonds, which pay very high interest rates. Buyers of bonds can judge credit risk by checking with various private agencies that evaluate the credit risk of different bonds. For example, Standard & Poor ’s rates bonds from AAA (the safest) to D (those already in default).

The third important characteristic of a bond is its tax treatment—the way the tax laws treat the interest earned on the bond. The interest on most bonds is taxable income; that is, the bond owner has to pay a portion of the interest he earns in income taxes. By contrast, when state and local governments issue bonds, called municipal bonds, the bond owners are not required to pay federal income tax on the interest income. Because of this tax advantage, bonds issued by state and local governments typically pay a lower interest rate than bonds issued by corporations or the federal government.

The Stock Market Another way for Intel to raise funds to build a new semiconductor factory is to sell stock in the company. Stock represents ownership in a firm and is, therefore, a claim to the profits that the firm makes. For example, if Intel sells a total of 1,000,000 shares of stock, then each share represents ownership of 1/1,000,000 of the business.

bond

a certificate of

indebtedness

stock

a claim to partial

ownership in a firm

544 PART IX THE REAL ECONOMY IN THE LONG RUN

The sale of stock to raise money is called equity finance, whereas the sale of bonds is called debt finance. Although corporations use both equity and debt finance to raise money for new investments, stocks and bonds are very different. The owner of shares of Intel stock is a part owner of Intel, while the owner of an Intel bond is a creditor of the corporation. If Intel is very profitable, the stockholders enjoy the benefits of these profits, whereas the bondholders get only the interest on their bonds. And if Intel runs into financial difficulty, the bondholders are paid what they are due before stockholders receive anything at all. Compared to bonds, stocks offer the holder both higher risk and potentially higher return.

After a corporation issues stock by selling shares to the public, these shares trade among stockholders on organized stock exchanges. In these transactions, the corporation itself receives no money when its stock changes hands. The most important stock exchanges in the U.S. economy are the New York Stock Exchange and the NASDAQ (National Association of Securities Dealers Automated Quotations). Most of the world’s countries have their own stock exchanges on which the shares of local companies trade.

The prices at which shares trade on stock exchanges are determined by the supply of and demand for the stock in these companies. Because stock represents ownership in a corporation, the demand for a stock (and thus its price) reflects people’s perception of the corporation’s future profitability. When people become optimistic about a company’s future, they raise their demand for its stock and thereby bid up the price of a share of stock. Conversely, when people’s expectations of a company’s prospects decline, the price of a share falls.

Various stock indexes are available to monitor the overall level of stock prices. A stock index is computed as an average of a group of stock prices. The most famous stock index is the Dow Jones Industrial Average, which has been computed regularly since 1896. It is now based on the prices of the stocks of thirty major U.S. companies, such as General Electric, Microsoft, Coca-Cola, Boeing, Apple, and Wal-Mart. Another well-known stock index is the Standard & Poor ’s 500 Index, which is based on the prices of the stocks of 500 major companies. Because stock prices reflect expected profitability, these stock indexes are watched closely as possible indicators of future economic conditions.

26-1b Financial Intermediaries Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. The term intermediary reflects the role of these institutions in standing between savers and borrowers. Here we consider two of the most important financial intermediaries: banks and mutual funds.

Banks If the owner of a small grocery store wants to finance an expansion of his business, he probably takes a strategy quite different from that of Intel. Unlike Intel, a small grocer would find it difficult to raise funds in the bond and stock markets. Most buyers of stocks and bonds prefer to buy those issued by larger, more familiar companies. The small grocer, therefore, most likely finances his business expansion with a loan from a local bank.

Banks are the financial intermediaries with which people are most familiar. A primary job of banks is to take in deposits from people who want to save and use these deposits to make loans to people who want to borrow. Banks pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans. The difference between these rates of interest covers the banks’ costs and returns some profit to the owners of the banks.

financial intermediaries

financial institutions

through which savers can

indirectly provide funds

to borrowers

545CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

Besides being financial intermediaries, banks play another important role in the economy: They facilitate purchases of goods and services by allowing people to write checks against their deposits and to access those deposits with debit cards. In other words, banks help create a special asset that people can use as a medium of exchange. A medium of exchange is an item that people can easily use to engage in transactions. A bank’s role in providing a medium of exchange distinguishes it from many other financial institutions. Stocks and bonds, like bank deposits, are a possible store of value for the wealth that people have accumulated in past saving, but access to this wealth is not as easy, cheap, and immediate as just writing a check or swiping a debit card. For now, we ignore this second role of banks, but we will return to it when we discuss the monetary system later in the book.

Mutual Funds A financial intermediary of increasing importance in the U.S. economy is the mutual fund. A mutual fund is an institution that sells shares to the public and uses the proceeds to buy a selection, or portfolio, of various types of stocks, bonds, or both stocks and bonds. The shareholder of the mutual fund accepts all the risk and return associated with the portfolio. If the value of the portfolio rises, the shareholder benefits; if the value of the portfolio falls, the shareholder suffers the loss.

The primary advantage of mutual funds is that they allow people with small amounts of money to diversify their holdings. Buyers of stocks and bonds are well advised to heed the adage: Don’t put all your eggs in one basket. Because the

mutual fund

an institution that sells

shares to the public and

uses the proceeds to buy

a portfolio of stocks and

bonds

Key Numbers for Stock Watchers

W hen following the stock of any company, you should keep an eye

on three key numbers. These numbers are reported on the financial

pages of some newspapers, and you can easily obtain them online as

well (such as at Yahoo! Finance):

• Price. The single most important piece of information about a stock

is the price of a share. News services usually present several prices.

The “last” price is the price at which the stock more recently traded.

The “previous close” is the price of the last transaction that occurred

before the stock exchange closed on its previous day of trading. A

news service may also give the “high” and “low” prices over the past

day of trading and, sometimes, over the past year as well. It may also

report the change from the previous day’s closing price.

• Dividend. Corporations pay out some of their profits to their stock-

holders; this amount is called the dividend. (Profits not paid out

are called retained earnings and are used by the corporation for

additional investment.) News services often report the dividend

paid over the previous year for each share of stock. They some-

times report the dividend yield, which is the dividend expressed as

a percentage of the stock’s price.

• Price-earnings ratio. A corporation’s earnings, or account-

ing profit, is the amount of revenue it receives for the sale

of its products minus its costs of production as measured by

its accountants.

Earnings per share is

the company’s total

earnings divided by

the number of shares

of stock outstanding.

The price-earnings ratio,

often called the P/E, is the price of a corporation’s stock divided

by the amount the corporation earned per share over the past

year. Historically, the typical price-earnings ratio is about 15.

A higher P/E indicates that a corporation’s stock is expensive

relative to its recent earnings; this might indicate either that

people expect earnings to rise in the future or that the stock is

overvalued. Conversely, a lower P/E indicates that a corporation’s

stock is cheap relative to its recent earnings; this might indicate

either that people expect earnings to fall or that the stock is

undervalued.

Why do news services report all these data? Many people who invest

their savings in stock follow these numbers closely when deciding which

stocks to buy and sell. By contrast, other stockholders follow a buy-and-

hold strategy: They buy the stock of well-run companies, hold it for long

periods of time, and do not respond to the daily fluctuations. ■

F Y I

546 PART IX THE REAL ECONOMY IN THE LONG RUN

value of any single stock or bond is tied to the fortunes of one company, holding a single kind of stock or bond is very risky. By contrast, people who hold a diverse portfolio of stocks and bonds face less risk because they have only a small stake in each company. Mutual funds make this diversification easy. With only a few hundred dollars, a person can buy shares in a mutual fund and, indirectly, become the part owner or creditor of hundreds of major companies. For this service, the company operating the mutual fund charges shareholders a fee, usually between 0.25 and 2.0 percent of assets each year.

A second advantage claimed by mutual fund companies is that mutual funds give ordinary people access to the skills of professional money managers. The managers of most mutual funds pay close attention to the developments and prospects of the companies in which they buy stock. These managers buy the stock of companies they view as having a profitable future and sell the stock of companies with less promising prospects. This professional management, it is argued, should increase the return that mutual fund depositors earn on their savings.

Financial economists, however, are often skeptical of this argument. With thousands of money managers paying close attention to each company’s prospects, the price of a company’s stock is usually a good reflection of the company’s true value. As a result, it is hard to “beat the market” by buying good stocks and selling bad ones. In fact, mutual funds called index funds, which buy all the stocks in a given stock index, perform somewhat better on average than mutual funds that take advantage of active trading by professional money managers. The explanation for the superior performance of index funds is that they keep costs low by buying and selling very rarely and by not having to pay the salaries of professional money managers.

26-1c Summing Up The U.S. economy contains a large variety of financial institutions. In addition to the bond market, the stock market, banks, and mutual funds, there are also pension funds, credit unions, insurance companies, and even the local loan shark. These institutions differ in many ways. When analyzing the macroeconomic role of the financial system, however, it is more important to keep in mind that, despite their differences, these financial institutions all serve the same goal: directing the resources of savers into the hands of borrowers.

QuickQuiz What is a share of stock? What is a bond? Explain their differences and

similarities.

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547CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

26-2 Saving and Investment in the National Income Accounts

Events that occur within the financial system are central to understanding developments in the overall economy. As we have just seen, the institutions that make up this system—the bond market, the stock market, banks, and mutual funds—have the role of coordinating the economy’s saving and investment. And as we saw in the previous chapter, saving and investment are important determinants of long-run growth in GDP and living standards. As a result, macroeconomists need to understand how financial markets work and how various events and policies affect them.

As a starting point for analyzing financial markets, we discuss the key macroeconomic variables that measure activity in these markets. Our emphasis here is not on behavior but on accounting. Accounting refers to how various numbers are defined and added up. A personal accountant might help an individual add up his income and expenses. A national income accountant does the same thing for the economy as a whole. The national income accounts include, in particular, GDP and the many related statistics.

The rules of national income accounting include several important identities. Recall that an identity is an equation that must be true because of the way the variables in the equation are defined. Identities are useful to keep in mind, for they clarify how different variables are related to one another. Here we consider some accounting identities that shed light on the macroeconomic role of financial markets.

26-2a Some Important Identities Recall that gross domestic product (GDP) is both total income in an economy and the total expenditure on the economy’s output of goods and services. GDP (denoted as Y) is divided into four components of expenditure: consumption (C), investment (I), government purchases (G), and net exports (NX). We write

Y 5 C 1 I 1 G 1 NX.

This equation is an identity because every dollar of expenditure that shows up on the left side also shows up in one of the four components on the right side. Because of the way each of the variables is defined and measured, this equation must always hold.

In this chapter, we simplify our analysis by assuming that the economy we are examining is closed. A closed economy is one that does not interact with other economies. In particular, a closed economy does not engage in international trade in goods and services, nor does it engage in international borrowing and lending. Actual economies are open economies—that is, they interact with other economies around the world. Nonetheless, assuming a closed economy is a useful simplification with which we can learn some lessons that apply to all economies. Moreover, this assumption applies perfectly to the world economy (for interplanetary trade is not yet common).

Because a closed economy does not engage in international trade, imports and exports are exactly zero. Therefore, net exports (NX) are also zero. We can now simplify the identity as

Y 5 C 1 I 1 G.

548 PART IX THE REAL ECONOMY IN THE LONG RUN

This equation states that GDP is the sum of consumption, investment, and government purchases. Each unit of output sold in a closed economy is consumed, invested, or bought by the government.

To see what this identity can tell us about financial markets, subtract C and G from both sides of this equation. We then obtain

Y 2 C 2 G 5 I.

The left side of this equation (Y 2 C 2 G) is the total income in the economy that remains after paying for consumption and government purchases: This amount is called national saving, or just saving, and is denoted S. Substituting S for Y − C − G, we can write the last equation as

S 5 I.

This equation states that saving equals investment. To understand the meaning of national saving, it is helpful to manipulate the

definition a bit more. Let T denote the amount that the government collects from households in taxes minus the amount it pays back to households in the form of transfer payments (such as Social Security and welfare). We can then write national saving in either of two ways:

S 5 Y 2 C 2 G

S 5 (Y 2 T 2 C) 1 (T 2 G).

These equations are the same because the two T’s in the second equation cancel each other, but each reveals a different way of thinking about national saving. In particular, the second equation separates national saving into two pieces: private saving (Y 2 T 2 C) and public saving (T 2 G).

Consider each of these two pieces. Private saving is the amount of income that households have left after paying their taxes and paying for their consumption. In particular, because households receive income of Y, pay taxes of T, and spend C on consumption, private saving is Y 2 T 2 C. Public saving is the amount of tax revenue that the government has left after paying for its spending. The government receives T in tax revenue and spends G on goods and services. If T exceeds G, the government runs a budget surplus because it receives more money than it spends. This surplus of T 2 G represents public saving. If the government spends more than it receives in tax revenue, then G is larger than T. In this case, the government runs a budget deficit, and public saving (T 2 G) is a negative number.

Now consider how these accounting identities are related to financial markets. The equation S = I reveals an important fact: For the economy as a whole, saving must be equal to investment. Yet this fact raises some important questions: What mechanisms lie behind this identity? What coordinates those people who are deciding how much to save and those people who are deciding how much to invest? The answer is the financial system. The bond market, the stock market, banks, mutual funds, and other financial markets and intermediaries stand between the two sides of the S = I equation. They take in the nation’s saving and direct it to the nation’s investment.

national saving (saving)

the total income in

the economy that

remains after paying

for consumption and

government purchases

private saving

the income that

households have left

after paying for taxes and

consumption

public saving

the tax revenue that the

government has left after

paying for its spending

budget surplus

an excess of tax revenue

over government

spending

budget deficit

a shortfall of tax revenue

from government

spending

549CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

26-2b The Meaning of Saving and Investment The terms saving and investment can sometimes be confusing. Most people use these terms casually and sometimes interchangeably. By contrast, the macroeconomists who put together the national income accounts use these terms carefully and distinctly.

Consider an example. Suppose that Larry earns more than he spends and deposits his unspent income in a bank or uses it to buy some stock or a bond from a corporation. Because Larry’s income exceeds his consumption, he adds to the nation’s saving. Larry might think of himself as “investing” his money, but a macroeconomist would call Larry’s act saving rather than investment.

In the language of macroeconomics, investment refers to the purchase of new capital, such as equipment or buildings. When Moe borrows from the bank to build himself a new house, he adds to the nation’s investment. (Remember, the purchase of a new house is the one form of household spending that is investment rather than consumption.) Similarly, when the Curly Corporation sells some stock and uses the proceeds to build a new factory, it also adds to the nation’s investment.

Although the accounting identity S = I shows that saving and investment are equal for the economy as a whole, this does not have to be true for every individual household or firm. Larry’s saving can be greater than his investment, and he can deposit the excess in a bank. Moe’s saving can be less than his investment, and he can borrow the shortfall from a bank. Banks and other financial institutions make these individual differences between saving and investment possible by allowing one person’s saving to finance another person’s investment.

QuickQuiz Define private saving, public saving, national saving, and investment.

How are they related?

26-3 The Market for Loanable Funds Having discussed some of the important financial institutions in our economy and the macroeconomic role of these institutions, we are ready to build a model of financial markets. Our purpose in building this model is to explain how financial markets coordinate the economy’s saving and investment. The model also gives us a tool with which we can analyze various government policies that influence saving and investment.

To keep things simple, we assume that the economy has only one financial market, called the market for loanable funds. All savers go to this market to deposit their saving, and all borrowers go to this market to take out their loans. Thus, the term loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption, and to the amount that investors have chosen to borrow to fund new investment projects. In the market for loanable funds, there is one interest rate, which is both the return to saving and the cost of borrowing.

The assumption of a single financial market, of course, is not realistic. As we have seen, the economy has many types of financial institutions. But as we discussed in Chapter 2, the art in building an economic model is simplifying the world in order to explain it. For our purposes here, we can ignore the diversity of financial institutions and assume that the economy has a single financial market.

market for loanable funds

the market in which those

who want to save supply

funds and those who

want to borrow to invest

demand funds

550 PART IX THE REAL ECONOMY IN THE LONG RUN

26-3a Supply and Demand for Loanable Funds The economy’s market for loanable funds, like other markets in the economy, is governed by supply and demand. To understand how the market for loanable funds operates, therefore, we first look at the sources of supply and demand in that market.

The supply of loanable funds comes from people who have some extra income they want to save and lend out. This lending can occur directly, such as when a household buys a bond from a firm, or it can occur indirectly, such as when a household makes a deposit in a bank, which then uses the funds to make loans. In both cases, saving is the source of the supply of loanable funds.

The demand for loanable funds comes from households and firms who wish to borrow to make investments. This demand includes families taking out mortgages to buy new homes. It also includes firms borrowing to buy new equipment or build factories. In both cases, investment is the source of the demand for loanable funds.

The interest rate is the price of a loan. It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving. Because a high interest rate makes borrowing more expensive, the quantity of loanable funds demanded falls as the interest rate rises. Similarly, because a high interest rate makes saving more attractive, the quantity of loanable funds supplied rises as the interest rate rises. In other words, the demand curve for loanable funds slopes downward, and the supply curve for loanable funds slopes upward.

Figure 1 shows the interest rate that balances the supply and demand for loanable funds. In the equilibrium shown, the interest rate is 5 percent, and the quantity of loanable funds demanded and the quantity of loanable funds supplied both equal $1,200 billion.

The adjustment of the interest rate to the equilibrium level occurs for the usual reasons. If the interest rate were lower than the equilibrium level, the quantity of loanable funds supplied would be less than the quantity of loanable funds demanded. The resulting shortage of loanable funds would encourage lenders to

FIGURE 1

The Market for Loanable Funds

The interest rate in the economy adjusts

to balance the supply and demand for

loanable funds. The supply of loanable

funds comes from national saving,

including both private saving and public

saving. The demand for loanable funds

comes from firms and households

that want to borrow for purposes of

investment. Here the equilibrium interest

rate is 5 percent, and $1,200 billion

of loanable funds are supplied and

demanded. Loanable Funds

(in billions of dollars) 0

Interest Rate

Supply

Demand

$1,200

551CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

raise the interest rate they charge. A higher interest rate would encourage saving (thereby increasing the quantity of loanable funds supplied) and discourage borrowing for investment (thereby decreasing the quantity of loanable funds demanded). Conversely, if the interest rate were higher than the equilibrium level, the quantity of loanable funds supplied would exceed the quantity of loanable funds demanded. As lenders compete for the scarce borrowers, interest rates would be driven down. In this way, the interest rate approaches the equilibrium level at which the supply and demand for loanable funds exactly balance.

Recall that economists distinguish between the real interest rate and the nominal interest rate. The nominal interest rate is the monetary return to saving and the monetary cost of borrowing. It is the interest rate as usually reported. The real interest rate is the nominal interest rate corrected for inflation; it equals the nominal interest rate minus the inflation rate. Because inflation erodes the value of money over time, the real interest rate more accurately reflects the real return to saving and the real cost of borrowing. Therefore, the supply and demand for loanable funds depend on the real (rather than nominal) interest rate, and the equilibrium in Figure 1 should be interpreted as determining the real interest rate in the economy. For the rest of this chapter, when you see the term interest rate, you should remember that we are talking about the real interest rate.

This model of the supply and demand for loanable funds shows that financial markets work much like other markets in the economy. In the market for milk, for instance, the price of milk adjusts so that the quantity of milk supplied balances the quantity of milk demanded. In this way, the invisible hand coordinates the behavior of dairy farmers and the behavior of milk drinkers. Once we realize that saving represents the supply of loanable funds and investment represents the demand, we can see how the invisible hand coordinates saving and investment. When the interest rate adjusts to balance supply and demand in the market for loanable funds, it coordinates the behavior of people who want to save (the suppliers of loanable funds) and the behavior of people who want to invest (the demanders of loanable funds).

We can now use this analysis of the market for loanable funds to examine various government policies that affect the economy’s saving and investment. Because this model is just supply and demand in a particular market, we analyze any policy using the three steps discussed in Chapter 4. First, we decide whether the policy shifts the supply curve or the demand curve. Second, we determine the direction of the shift. Third, we use the supply-and-demand diagram to see how the equilibrium changes.

26-3b Policy 1: Saving Incentives Many economists and policymakers have advocated increases in how much people save. Their argument is simple. One of the Ten Principles of Economics in Chapter 1 is that a country’s standard of living depends on its ability to produce goods and services. And as we discussed in the preceding chapter, saving is an important long-run determinant of a nation’s productivity. If the United States could somehow raise its saving rate, more resources would be available for capital accumulation, GDP would grow more rapidly, and over time, U.S. citizens would enjoy a higher standard of living.

Another of the Ten Principles of Economics is that people respond to incentives. Many economists have used this principle to suggest that the low rate of saving is at least partly attributable to tax laws that discourage saving. The U.S. federal government, as well as many state governments, collects revenue by taxing

552 PART IX THE REAL ECONOMY IN THE LONG RUN

income, including interest and dividend income. To see the effects of this policy, consider a 25-year-old who saves $1,000 and buys a 30-year bond that pays an interest rate of 9 percent. In the absence of taxes, the $1,000 grows to $13,268 when the individual reaches age 55. Yet if that interest is taxed at a rate of, say, 33 percent, the after-tax interest rate is only 6 percent. In this case, the $1,000 grows to only $5,743 over the 30 years. The tax on interest income substantially reduces the future payoff from current saving and, as a result, reduces the incentive for people to save.

In response to this problem, some economists and lawmakers have proposed reforming the tax code to encourage greater saving. For example, one proposal is to expand eligibility for special accounts, such as Individual Retirement Accounts, that allow people to shelter some of their saving from taxation. Let’s consider the effect of such a saving incentive on the market for loanable funds, as illustrated in Figure 2. We analyze this policy following our three steps.

First, which curve would this policy affect? Because the tax change would alter the incentive for households to save at any given interest rate, it would affect the quantity of loanable funds supplied at each interest rate. Thus, the supply of loanable funds would shift. The demand for loanable funds would remain the same because the tax change would not directly affect the amount that borrowers want to borrow at any given interest rate.

Second, which way would the supply curve shift? Because saving would be taxed less heavily than under current law, households would increase their saving by consuming a smaller fraction of their income. Households would use this additional saving to increase their deposits in banks or to buy more bonds. The supply of loanable funds would increase, and the supply curve would shift to the right from S1 to S2, as shown in Figure 2.

Finally, we can compare the old and new equilibria. In the figure, the increased supply of loanable funds reduces the interest rate from 5 percent to 4 percent. The lower interest rate raises the quantity of loanable funds demanded from $1,200 billion to $1,600 billion. That is, the shift in the supply curve moves the market

FIGURE 2

Saving Incentives Increase the Supply of

Loanable Funds

A change in the tax laws to encourage

Americans to save more would shift the

supply of loanable funds to the right from

S1 to S2. As a result, the equilibrium

interest rate would fall, and the lower

interest rate would stimulate investment.

Here the equilibrium interest rate falls

from 5 percent to 4 percent, and the

equilibrium quantity of loanable funds

saved and invested rises from $1,200

billion to $1,600 billion. Loanable Funds

(in billions of dollars) 0

Interest Rate

Supply, S1 S2

$1,200 $1,600

2. . . . which reduces the equilibrium interest rate . . .

3. . . . and raises the equilibrium quantity of loanable funds.

Demand

1. Tax incentives for saving increase the supply of loanable funds . . .

553CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

equilibrium along the demand curve. With a lower cost of borrowing, households and firms are motivated to borrow more to finance greater investment. Thus, if a reform of the tax laws encouraged greater saving, the result would be lower interest rates and greater investment.

This analysis of the effects of increased saving is widely accepted among economists, but there is less consensus about what kinds of tax changes should be enacted. Many economists endorse tax reform aimed at increasing saving to stimulate investment and growth. Yet others are skeptical that these tax changes would have much effect on national saving. These skeptics also doubt the equity of the proposed reforms. They argue that, in many cases, the benefits of the tax changes would accrue primarily to the wealthy, who are least in need of tax relief.

26-3c Policy 2: Investment Incentives Suppose that Congress passed a tax reform aimed at making investment more attractive. In essence, this is what Congress does when it institutes an investment tax credit, which it does from time to time. An investment tax credit gives a tax advantage to any firm building a new factory or buying a new piece of equipment. Let’s consider the effect of such a tax reform on the market for loanable funds, as illustrated in Figure 3.

First, would the law affect supply or demand? Because the tax credit would reward firms that borrow and invest in new capital, it would alter investment at any given interest rate and, thereby, change the demand for loanable funds. By contrast, because the tax credit would not affect the amount that households save at any given interest rate, it would not affect the supply of loanable funds.

Second, which way would the demand curve shift? Because firms would have an incentive to increase investment at any interest rate, the quantity of loanable funds demanded would be higher at any given interest rate. Thus, the demand curve for loanable funds would move to the right, as shown by the shift from D1 to D2 in the figure.

FIGURE 3

Investment Incentives Increase the

Demand for Loanable Funds

If the passage of an investment tax

credit encouraged firms to invest more,

the demand for loanable funds would

increase. As a result, the equilibrium

interest rate would rise, and the higher

interest rate would stimulate saving.

Here, when the demand curve shifts

from D1 to D2, the equilibrium interest

rate rises from 5 percent to 6 percent,

and the equilibrium quantity of loanable

funds saved and invested rises from

$1,200 billion to $1,400 billion.Loanable Funds (in billions of dollars)

Interest Rate

$1,200 $1,400

1. An investment tax credit increases the demand for loanable funds . . .

2. . . . which raises the equilibrium interest rate . . .

3. . . . and raises the equilibrium quantity of loanable funds.

Supply

Demand, D1

554 PART IX THE REAL ECONOMY IN THE LONG RUN

Third, consider how the equilibrium would change. In Figure 3, the increased demand for loanable funds raises the interest rate from 5 percent to 6 percent, and the higher interest rate in turn increases the quantity of loanable funds supplied from $1,200 billion to $1,400 billion, as households respond by increasing the amount they save. This change in household behavior is represented here as a movement along the supply curve. Thus, if a reform of the tax laws encouraged greater investment, the result would be higher interest rates and greater saving.

26-3d Policy 3: Government Budget Deficits and Surpluses A perpetual topic of political debate is the status of the government budget. Recall that a budget deficit is an excess of government spending over tax revenue. Governments finance budget deficits by borrowing in the bond market, and the accumulation of past government borrowing is called the government debt. A budget surplus, an excess of tax revenue over government spending, can be used to repay some of the government debt. If government spending exactly equals tax revenue, the government is said to have a balanced budget.

Imagine that the government starts with a balanced budget and then, because of an increase in government spending, starts running a budget deficit. We can analyze the effects of the budget deficit by following our three steps in the market for loanable funds, as illustrated in Figure 4.

First, which curve shifts when the government starts running a budget deficit? Recall that national saving—the source of the supply of loanable funds— is composed of private saving and public saving. A change in the government budget balance represents a change in public saving and, therefore, in the supply of loanable funds. Because the budget deficit does not influence the amount that households and firms want to borrow to finance investment at any given interest rate, it does not alter the demand for loanable funds.

Second, which way does the supply curve shift? When the government runs a budget deficit, public saving is negative, and this reduces national saving. In other words, when the government borrows to finance its budget deficit, it reduces

FIGURE 4

The Effect of a Government Budget Deficit

When the government spends more than

it receives in tax revenue, the resulting

budget deficit lowers national saving.

The supply of loanable funds decreases,

and the equilibrium interest rate rises.

Thus, when the government borrows to

finance its budget deficit, it crowds out

households and firms that otherwise

would borrow to finance investment.

Here, when the supply curve shifts from

S1 to S2, the equilibrium interest rate

rises from 5 percent to 6 percent, and the

equilibrium quantity of loanable funds

saved and invested falls from $1,200

billion to $800 billion.

Loanable Funds (in billions of dollars)

Interest Rate

$800 $1,200

3. . . . and reduces the equilibrium quantity of loanable funds.

2. . . . which raises the equilibrium interest rate . . .

Supply, S1

Demand

6% 1. A budget deficit decreases the supply of loanable funds . . .

555CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

the supply of loanable funds available to finance investment by households and firms. Thus, a budget deficit shifts the supply curve for loanable funds to the left from S1 to S2, as shown in Figure 4.

Third, we can compare the old and new equilibria. In the figure, when the budget deficit reduces the supply of loanable funds, the interest rate rises from 5 percent to 6 percent. This higher interest rate then alters the behavior of the households and firms that participate in the loan market. In particular, many demanders of loanable funds are discouraged by the higher interest rate. Fewer families buy new homes, and fewer firms choose to build new factories. The fall in investment because of government borrowing is called crowding out and is represented in Figure 4 by the movement along the demand curve from a quantity of $1,200 billion in loanable funds to a quantity of $800 billion. That is, when the government borrows to finance its budget deficit, it crowds out private borrowers who are trying to finance investment.

Thus, the most basic lesson about budget deficits follows directly from their effects on the supply and demand for loanable funds: When the government reduces national saving by running a budget deficit, the interest rate rises and investment falls. Because investment is important for long-run economic growth, government budget deficits reduce the economy’s growth rate.

Why, you might ask, does a budget deficit affect the supply of loanable funds, rather than the demand for them? After all, the government finances a budget deficit by selling bonds, thereby borrowing from the private sector. Why does increased borrowing by the government shift the supply curve, whereas increased borrowing by private investors shifts the demand curve? To answer this question, we need to examine more precisely the meaning of “loanable funds.” The model as presented here takes this term to mean the flow of resources available to fund private investment; thus, a government budget deficit reduces the supply of loanable funds. If, instead, we had defined the term “loanable funds” to mean the flow of resources available from private saving, then the government budget deficit would increase demand rather than reduce supply. Changing the interpretation of the term would cause a semantic change in how we described the model, but the bottom line from the analysis would be the same: In either case, a budget deficit increases the interest rate, thereby crowding out private borrowers who are relying on financial markets to fund private investment projects.

So far, we have examined a budget deficit that results from an increase in government spending, but a budget deficit that results from a tax cut has similar effects. A tax cut reduces public saving, T 2 G. Private saving, Y 2 T 2 C, might increase because of lower T, but as long as households respond to the lower taxes by consuming more, C increases, so private saving rises by less than public saving declines. Thus, national saving (S 5 Y 2 C 2 G), the sum of public and private saving, declines. Once again, the budget deficit reduces the supply of loanable funds, drives up the interest rate, and crowds out borrowers trying to finance capital investments.

Now that we understand the impact of budget deficits, we can turn the analysis around and see that government budget surpluses have the opposite effects. When the government collects more in tax revenue than it spends, it saves the difference by retiring some of the outstanding government

crowding out

a decrease in investment

that results from

government borrowing

“Sustained tax and spending policies that boost consumption

in ways that reduce the saving rate are likely to lower long-run

living standards.”

79% agree

21% uncertain

What do economists say?

0% disagree

Fiscal Policy and Saving

ASK THE EXPERTS

Source: IGM Economic Experts Panel, July 8, 2013.

556 PART IX THE REAL ECONOMY IN THE LONG RUN

debt. This budget surplus, or public saving, contributes to national saving. Thus, a budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment. Higher investment, in turn, means greater capital accumulation and more rapid economic growth.

CASE STUDY

THE HISTORY OF U.S. GOVERNMENT DEBT How indebted is the U.S. government? The answer to this question varies substantially over time. Figure 5 shows the debt of the U.S. federal government expressed as a percentage of U.S. GDP. It shows

that the government debt has fluctuated from zero in 1836 to 107 percent of GDP in 1945.

The behavior of the debt-to-GDP ratio is one gauge of what’s happening with the government’s finances. Because GDP is a rough measure of the government’s tax base, a declining debt-to-GDP ratio indicates that the government indebtedness is shrinking relative to its ability to raise tax revenue. This suggests that the government is, in some sense, living within its means. By contrast, a rising debt-to-GDP ratio means that the government indebtedness is increasing relative to its ability to raise tax revenue. It is often interpreted as meaning that fiscal policy—government spending and taxes—cannot be sustained forever at current levels.

FIGURE 5

The U.S. Government Debt

Percent of GDP

201119911791 1811 1831 1851 1871 1891 1911 1931

Revolutionary War Civil

War

World War II

Financial Crisis

100

120

1951 1971

World War I

The debt of the U.S. federal government, expressed here as a percentage of GDP, has

varied throughout history. Wartime spending is typically associated with substantial

increases in government debt. Source: U.S. Department of Treasury; U.S. Department of Commerce; and T. S. Berry, “Production and Population since 1789,” Bostwick Paper No. 6,

Richmond, 1988.

557CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

Throughout history, the primary cause of fluctuations in government debt has been war. When wars occur, government spending on national defense rises substantially to pay for soldiers and military equipment. Taxes sometimes rise as well but typically by much less than the increase in spending. The result is a budget deficit and increasing government debt. When the war is over, government spending declines and the debt-to-GDP ratio starts declining as well.

There are two reasons to believe that debt financing of war is an appropriate policy. First, it allows the government to keep tax rates smooth over time. Without debt financing, tax rates would have to rise sharply during wars, and this would cause a substantial decline in economic efficiency. Second, debt financing of wars shifts part of the cost of wars to future generations, who will have to pay off the government debt. This is arguably a fair distribution of the burden, for future generations get some of the benefit when one generation fights a war to defend the nation against foreign aggressors.

One large increase in government debt that cannot be explained by war is the increase that occurred beginning around 1980. When President Ronald Reagan took office in 1981, he was committed to smaller government and lower taxes. Yet he found cutting government spending to be more difficult politically than cutting taxes. The result was the beginning of a period of large budget deficits that continued not only through Reagan’s time in office but also for many years thereafter. As a result, government debt rose from 26 percent of GDP in 1980 to 48 percent of GDP in 1993.

Because government budget deficits reduce national saving, investment, and long-run economic growth, the rise in government debt during the 1980s troubled many economists and policymakers. When Bill Clinton moved into the Oval Office in 1993, deficit reduction was his first major goal. Similarly, when the Republicans took control of Congress in 1995, deficit reduction was high on their legislative agenda. Both of these efforts substantially reduced the size of the government budget deficit. In addition, a booming economy in the late 1990s brought in even more tax revenue. Eventually, the federal budget turned from deficit to surplus, and the debt-to-GDP ratio declined significantly for several years.

This fall in the debt-to-GDP ratio, however, stopped during the presidency of George W. Bush, as the budget surplus turned back into a budget deficit. There were three main reasons for this change. First, President Bush signed into law several major tax cuts, which he had promised during the 2000 presidential campaign. Second, in 2001, the economy experienced a recession (a reduction in economic activity), which automatically decreased tax revenue and increased government spending. Third, there were increases in government spending on homeland security following the September 11, 2001 attacks and on the subsequent wars in Iraq and Afghanistan.

Truly dramatic increases in the debt-to-GDP ratio started occurring in 2008, as the economy experienced a financial crisis and a deep recession. (The accompanying FYI box addresses this topic briefly, but we will study it more fully in coming chapters.) The recession automatically increased the budget deficit, and several policy measures enacted during the Bush and Obama administrations aimed at combating the recession reduced tax revenue and increased government spending even more. From 2009 to 2012, the federal government’s budget deficit averaged about 9 percent of GDP, levels not seen since World War II. The borrowing to finance these deficits led to an increase in the debt-to-GDP ratio from 39 percent in 2008 to 70 percent in 2012. After 2012, as the economy recovered, the budget deficits shrank, and the increases in the debt-to-GDP ratio became smaller. ●

QuickQuiz If more Americans adopted a “live for today” approach to life, how would

this affect saving, investment, and the interest rate?

558 PART IX THE REAL ECONOMY IN THE LONG RUN

26-4 Conclusion

Financial Crises

I n 2008 and 2009, the U.S. economy and many other major economies

around the world experienced a financial crisis, which in turn led to

a deep downturn in economic activity. We will examine these events

in detail later in this book. But because this chapter introduces the

financial system, let’s discuss briefly the key elements of financial

crises.

The first element of a financial crisis is a large decline in some

asset prices. In 2008 and 2009, that asset was real estate. The price of

housing, after experiencing a boom earlier in the decade, fell by about 30

percent over just a few years. Such a large decline in real estate prices

had not been seen in the United States since the 1930s.

The second element of a financial crisis is widespread insolvencies

at financial institutions. (A company is insolvent when its debts exceed

the value of its assets.) In 2008 and 2009, many banks and other

financial firms had in effect placed bets on real estate prices by holding

mortgages backed by that real estate. When house prices fell, large

numbers of homeowners stopped repaying their loans. These defaults

pushed several major financial institutions toward bankruptcy.

The third element of a financial crisis is a decline in confidence

in financial institutions. Although some deposits in banks are

insured by government policies, not all are. As insolvencies mounted,

every financial institution became a possible candidate for the next

bankruptcy. Individuals and firms with uninsured deposits in those

institutions pulled out their money. Facing a rash of withdrawals, banks

started selling off assets (sometimes at reduced “fire-sale” prices) and

cut back on new lending.

T h e f o u r t h e l e m e n t

of a financial crisis is a

credit crunch. With many

financial institutions facing

d i f f i c u l t i e s , p r o s p e c t i v e

borrowers had trouble getting

loans, even if they had profitable

investment projects. In essence, the financial system had trouble

performing its normal function of directing the resources of savers into

the hands of borrowers with the best investment opportunities.

The fifth element of a financial crisis is an economic downturn.

With people unable to obtain financing for new investment projects,

the overall demand for goods and services declined. As a result, for

reasons we discuss more fully later in the book, national income fell and

unemployment rose.

The sixth and final element of a financial crisis is a vicious circle.

The economic downturn reduced the profitability of many companies

and the value of many assets. Thus, we started over again at step one,

and the problems in the financial system and the economic downturn

reinforced each other.

Financial crises, such as the one of 2008 and 2009, can have severe

consequences. Fortunately, they do end. Financial institutions eventually

get back on their feet, perhaps with some help from government policy,

and they return to their normal function of financial intermediation. ■

F Y I

“Neither a borrower nor a lender be,” Polonius advises his son in Shakespeare’s Hamlet. If everyone followed this advice, this chapter would have been unnecessary.

Few economists would agree with Polonius. In our economy, people borrow and lend often, and usually for good reason. You may borrow one day to start your own business or to buy a home. And people may lend to you in the hope that the interest you pay will allow them to enjoy a more prosperous retirement. The financial system’s job is to coordinate all this borrowing and lending activity.

In many ways, financial markets are like other markets in the economy. The price of loanable funds—the interest rate—is governed by the forces of supply and demand, just as other prices in the economy are. And we can analyze shifts in supply or demand in financial markets as we do in other markets. One of the Ten Principles of Economics introduced in Chapter 1 is that markets are usually a good way to organize economic activity. This principle applies to financial markets as well. When financial markets bring the supply and demand for loanable funds

559CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

into balance, they help allocate the economy’s scarce resources to their most efficient uses.

In one way, however, financial markets are special. Financial markets, unlike most other markets, serve the important role of linking the present and the future. Those who supply loanable funds—savers—do so because they want to convert some of their current income into future purchasing power. Those who demand loanable funds—borrowers—do so because they want to invest today in order to have additional capital in the future to produce goods and services. Thus, well- functioning financial markets are important not only for current generations but also for future generations who will inherit many of the resulting benefits.

• The U.S. financial system is made up of many types

of financial institutions, such as the bond market,

the stock market, banks, and mutual funds. All these

institutions act to direct the resources of households

that want to save some of their income into the hands

of households and firms that want to borrow.

• National income accounting identities reveal some

important relationships among macroeconomic

variables. In particular, for a closed economy, national

saving must equal investment. Financial institutions

are the mechanism through which the economy

matches one person’s saving with another person’s

investment.

• The interest rate is determined by the supply and

demand for loanable funds. The supply of loanable

funds comes from households that want to save

1. Elaine wants to buy and operate an ice-cream truck

but doesn’t have the financial resources to start the

business. She borrows $10,000 from her friend

George, to whom she promises an interest rate of

7 percent, and gets another $20,000 from her friend

Jerry, to whom she promises a third of her profits.

What best describes this situation?

a. George is a stockholder, and Elaine is a bondholder.

b. George is a stockholder, and Jerry is a bondholder.

c. Jerry is a stockholder, and Elaine is a bondholder.

d. Jerry is a stockholder, and George is a bondholder.

2. If the government collects more in tax revenue than it

spends, and households consume more than they get

in after-tax income, then

a. private and public saving are both positive.

b. private and public saving are both negative.

c. private saving is positive, but public saving is negative.

d. private saving is negative, but public saving is

positive.

3. A closed economy has income of $1,000, government

spending of $200, taxes of $150, and investment of

$250. What is private saving?

a. $100

b. $200

c. $300

d. $400

4. If a popular TV show on personal finance convinces

Americans to save more for retirement, the ________

curve for loanable funds would shift, driving the equi-

librium interest rate ________.

a. supply, up

b. supply, down

c. demand, up

d. demand, down

5. If the business community becomes more optimistic

about the profitability of capital, the ________ curve

for loanable funds would shift, driving the equilibrium

interest rate ________.

a. supply, up

b. supply, down

c. demand, up

d. demand, down

6. From 2008 to 2012, the ratio of government debt to

GDP in the United States

a. increased markedly.

b. decreased markedly.

c. was stable at a historically high level.

d. was stable at a historically low level.

CHAPTER QuickQuiz

SUMMARY

560 PART IX THE REAL ECONOMY IN THE LONG RUN

financial system, p. 542

financial markets, p. 542

bond, p. 543

stock, p. 543

financial intermediaries, p. 544

mutual fund, p. 545

national saving (saving), p. 548

private saving, p. 548

public saving, p. 548

budget surplus, p. 548

budget deficit, p. 548

market for loanable funds, p. 549

crowding out, p. 555

KEY CONCEPTS

1. What is the role of the financial system? Name and

describe two markets that are part of the financial

system in the U.S. economy. Name and describe two

financial intermediaries.

2. Why is it important for people who own stocks and

bonds to diversify their holdings? What type of

financial institution makes diversification easier?

3. What is national saving? What is private saving?

What is public saving? How are these three variables

related?

4. What is investment? How is it related to national

saving in a closed economy?

5. Describe a change in the tax code that might increase

private saving. If this policy were implemented, how

would it affect the market for loanable funds?

6. What is a government budget deficit? How does it

affect interest rates, investment, and economic

growth?

QUESTIONS FOR REVIEW

some of their income and lend it out. The demand

for loanable funds comes from households and firms

that want to borrow for investment. To analyze how

any policy or event affects the interest rate, one must

consider how it affects the supply and demand for

loanable funds.

• National saving equals private saving plus public

saving. A government budget deficit represents

negative public saving and, therefore, reduces national

saving and the supply of loanable funds available

to finance investment. When a government budget

deficit crowds out investment, it reduces the growth of

productivity and GDP.

1. For each of the following pairs, which bond would

you expect to pay a higher interest rate? Explain.

a. a bond of the U.S. government or a bond of an

Eastern European government

b. a bond that repays the principal in year 2020 or a

bond that repays the principal in year 2040

c. a bond from Coca-Cola or a bond from a software

company you run in your garage

d. a bond issued by the federal government or a

bond issued by New York State

2. Many workers hold large amounts of stock issued by

the firms at which they work. Why do you suppose

companies encourage this behavior? Why might a

person not want to hold stock in the company where he works?

3. Explain the difference between saving and investment

as defined by a macroeconomist. Which of the

following situations represent investment and which

represent saving? Explain.

a. Your family takes out a mortgage and buys a new

house.

b. You use your $200 paycheck to buy stock in AT&T.

c. Your roommate earns $100 and deposits it in his

account at a bank.

d. You borrow $1,000 from a bank to buy a car to use

in your pizza delivery business.

PROBLEMS AND APPLICATIONS

561CHAPTER 26 SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

4. Suppose GDP is $8 trillion, taxes are $1.5 trillion,

private saving is $0.5 trillion, and public saving is

$0.2 trillion. Assuming this economy is closed,

calculate consumption, government purchases,

national saving, and investment.

5. Economists in Funlandia, a closed economy, have

collected the following information about the

economy for a particular year:

Y 5 10,000

C 5 6,000

T 5 1,500

G 5 1,700

The economists also estimate that the investment

function is:

I 5 3,300 2 100r,

where r is the country’s real interest rate, expressed as a percentage. Calculate private saving, public saving,

national saving, investment, and the equilibrium real

interest rate.

6. Suppose that Intel is considering building a new chip-

making factory.

a. Assuming that Intel needs to borrow money in the

bond market, why would an increase in interest

rates affect Intel’s decision about whether to build

the factory?

b. If Intel has enough of its own funds to finance

the new factory without borrowing, would an

increase in interest rates still affect Intel’s decision

about whether to build the factory? Explain.

7. Three students have each saved $1,000. Each has

an investment opportunity in which he or she can

invest up to $2,000. Here are the rates of return on the

students’ investment projects:

Harry 5 percent

Ron 8 percent

Hermione 20 percent

a. If borrowing and lending are prohibited, so each

student uses only personal saving to finance his or

her own investment project, how much will each

student have a year later when the project pays its

return?

b. Now suppose their school opens up a market for

loanable funds in which students can borrow and

lend among themselves at an interest rate r. What

would determine whether a student would choose

to be a borrower or lender in this market?

c. Among these three students, what would be the

quantity of loanable funds supplied and quantity

demanded at an interest rate of 7 percent? At

10 percent?

d. At what interest rate would the loanable funds

market among these three students be in

equilibrium? At this interest rate, which student(s)

would borrow and which student(s) would lend?

e. At the equilibrium interest rate, how much does

each student have a year later after the investment

projects pay their return and loans have been

repaid? Compare your answers to those you gave

in part (a). Who benefits from the existence of

the loanable funds market—the borrowers or the

lenders? Is anyone worse off?

8. Suppose the government borrows $20 billion more

next year than this year.

a. Use a supply-and-demand diagram to analyze

this policy. Does the interest rate rise or fall?

b. What happens to investment? To private saving?

To public saving? To national saving? Compare

the size of the changes to the $20 billion of extra

government borrowing.

c. How does the elasticity of supply of loanable

funds affect the size of these changes?

d. How does the elasticity of demand for loanable

funds affect the size of these changes?

e. Suppose households believe that greater govern-

ment borrowing today implies higher taxes to pay

off the government debt in the future. What does

this belief do to private saving and the supply of

loanable funds today? Does it increase or decrease

the effects you discussed in parts (a) and (b)?

9. This chapter explains that investment can be increased

both by reducing taxes on private saving and by

reducing the government budget deficit.

a. Why is it difficult to implement both of these

policies at the same time?

b. What would you need to know about private sav-

ing to judge which of these two policies would be

a more effective way to raise investment?

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

563

The Basic Tools of Finance CHAPTER

27 S

ometime in your life, you will deal with the economy’s financial system. You will deposit your savings in a bank account, or you will take out a loan to cover tuition or to buy a house. After you have a job, your employer will start

a retirement account for you, and you will decide whether to invest the funds in stocks, bonds, or other financial instruments. If you try to put together your own portfolio, you will have to decide between investing in established companies such as General Electric or newer ones such as Twitter. And in the media, you will hear reports about whether the stock market is up or down, together with the often feeble attempts to explain why the market behaves as it does.

If you reflect for a moment on the many financial decisions you will make during your life, you will see two related elements in almost all of them: time and risk.

564 PART IX THE REAL ECONOMY IN THE LONG RUN

As we saw in the preceding two chapters, the financial system coordinates the economy’s saving and investment, which in turn are crucial determinants of eco- nomic growth. Most fundamentally, the financial system concerns decisions and actions we undertake today that will affect our lives in the future. But the future is unknown. When a person decides to allocate some saving, or a firm decides to undertake an investment, the decision is based on a guess about the likely result. The actual result, however, could end up being very different from what was expected.

This chapter introduces some tools that help us understand the decisions that people make as they participate in financial markets. The field of finance devel- ops these tools in great detail, and you may choose to take courses that focus on this topic. But because the financial system is so important to the functioning of the economy, many of the basic insights of finance are central to understanding how the economy works. The tools of finance can also help you think through some of the decisions that you will make in your own life.

This chapter takes up three topics. First, we discuss how to compare sums of money at different points in time. Second, we discuss how to manage risk. Third, we build on our analysis of time and risk to examine what determines the value of an asset, such as a share of stock.

finance

the field that studies how

people make decisions

regarding the allocation

of resources over time

and the handling of risk

27-1 Present Value: Measuring the Time Value of Money Imagine that someone offers to give you $100 today or $100 in 10 years. Which would you choose? This is an easy question. Getting $100 today is better because you can always deposit the money in a bank, still have it in 10 years, and earn interest on the $100 along the way. The lesson: Money today is more valuable than the same amount of money in the future.

Now consider a harder question: Imagine that someone offers you $100 today or $200 in 10 years. Which would you choose? To answer this question, you need some way to compare sums of money from different points in time. Economists do this with a concept called present value. The present value of any future sum of money is the amount today that would be needed, at current interest rates, to produce that future sum.

To learn how to use the concept of present value, let’s work through a couple of simple examples:

Question: If you put $100 in a bank account today, how much will it be worth in N years? That is, what will be the future value of this $100?

Answer: Let’s use r to denote the interest rate expressed in decimal form (so an interest rate of 5 percent means r = 0.05). Suppose that interest is paid annually and that it remains in the bank account to earn more interest—a process called compounding. Then the $100 will become

(1 1 r) 3 $100 after 1 year,

(1 1 r) 3 (1 1 r) 3 $100 5 (1 1 r)2 3 $100 after 2 years,

(1 1 r) 3 (1 1 r) 3 (1 1 r) 3 $100 5 (1 1 r)3 3 $100 after 3 years, . . .

(1 1 r)N 3 $100 after N years.

For example, if we are investing at an interest rate of 5 percent for 10 years, then the future value of the $100 will be (1.05)10 3 $100, or $163.

present value

the amount of money

today that would be

needed, using prevailing

interest rates, to produce

a given future amount of

money

future value

the amount of money in

the future that an amount

of money today will yield,

given prevailing interest

rates

compounding

the accumulation of a

sum of money in, say, a

bank account, where the

interest earned remains

in the account to earn

additional interest in the

future

565CHAPTER 27 THE BASIC TOOLS OF FINANCE

Question: Now suppose you are going to be paid $200 in N years. What is the present value of this future payment? That is, how much would you have to deposit in a bank right now to yield $200 in N years?

Answer: To answer this question, just turn the previous answer on its head. In the last question, we computed a future value from a present value by multiplying by the factor (1 1 r)N. To compute a present value from a future value, we divide by the factor (1 1 r)N. Thus, the present value of $200 in N years is $200/(1 1 r)N. If that amount is deposited in a bank today, after N years it will become (1 1 r)N 3 [$200/ (1 1 r)N], which equals $200. For instance, if the interest rate is 5 percent, the present value of $200 to be paid in 10 years is $200/(1.05)10, or $123. This means that $123 deposited today in a bank account that earned 5 percent would produce $200 after 10 years.

This illustrates the general formula:

• If r is the interest rate, then an amount X to be received in N years has a present value of X/(1 1 r)N.

Because the possibility of earning interest reduces the present value below the amount X, the process of finding a present value of a future sum of money is called discounting. This formula shows precisely how much future sums should be discounted.

Let’s now return to our earlier question: Should you choose $100 today or $200 in 10 years? Based on our calculation of present value using an interest rate of 5 percent, you should prefer the $200 in 10 years. The future $200 has a present value of $123, which is greater than $100. You are better off waiting for the future sum.

Notice that the answer to our question depends on the interest rate. If the interest rate were 8 percent, then the $200 in 10 years would have a present value of $200/(1.08)10, which is only $93. In this case, you should take the $100 today. Why should the interest rate matter for your choice? The answer is that the higher the interest rate, the more you can earn by depositing your money in a bank, so the more attractive getting $100 today becomes.

The concept of present value is useful in many applications, including the decisions that companies face when evaluating investment projects. For instance, imagine that General Motors is thinking about building a new factory. Suppose that the factory will cost $100 million today and will yield the company $200 million in 10 years. Should General Motors undertake the project? You can see that this decision is exactly like the one we have been studying. To make its decision, the company should compare the present value of the $200 million return to the $100 million cost.

The company’s decision, therefore, will depend on the interest rate. If the interest rate is 5 percent, then the present value of the $200 million return from the factory is $123 million, and the company will choose to pay the $100 million cost. By contrast, if the interest rate is 8 percent, then the present value of the return is only $93 million, and the company will decide to forgo the project. Thus, the concept of present value helps explain why investment—and thus the quantity of loanable funds demanded—declines when the interest rate rises.

Here is another application of present value: Suppose you win a million- dollar lottery and are given a choice between $20,000 a year for 50 years (totaling $1,000,000) or an immediate payment of $400,000. Which would you choose?

566 PART IX THE REAL ECONOMY IN THE LONG RUN

To make the right choice, you need to calculate the present value of the stream of payments. Let’s suppose the interest rate is 7 percent. After performing 50 calculations similar to those above (one calculation for each payment) and adding up the results, you would learn that the present value of this million-dollar prize at a 7 percent interest rate is only $276,000. You are better off picking the immediate payment of $400,000. The million dollars may seem like more money, but the future cash flows, once discounted to the present, are worth far less.

QuickQuiz The interest rate is 7 percent. What is the present value of $150 to be

received in 10 years?

The Magic of Compounding and the Rule of 70

S uppose you observe that one country has an average growth rate

of 1 percent per year, while another has an average growth rate of

3 percent per year. At first, this might not seem like a big deal. What

difference can 2 percent make?

The answer is: a big difference. Growth rates that seem small when

written in percentage terms are large after they are compounded for

many years.

Consider an example. Suppose that two college graduates—Elliot

and Darlene—both take their first jobs at the age of 22 earning $30,000

a year. Elliot lives in an economy where all incomes grow at 1 percent

per year, while Darlene lives in one where incomes grow at 3 percent per

year. Straightforward calculations show what happens. Forty years later,

when both are 62 years old, Elliot earns $45,000 a year, while Darlene

earns $98,000. Because of that difference of 2 percentage points in the

growth rate, Darlene’s salary is more than twice Elliot’s.

An old rule of thumb, called the rule of 70, is helpful in understanding

growth rates and the effects of compounding. According to the rule of 70,

if some variable grows at a rate of x percent per year, then that variable

doubles in approximately 70/x years. In Elliot’s economy, incomes grow

at 1 percent per year, so it takes about 70 years for incomes to double. In

Darlene’s economy, incomes

grow at 3 percent per year,

so it takes about 70/3, or

23, years for incomes to

double.

The rule of 70 applies not

only to a growing economy but also to

a growing savings account. Here is an example: In 1791, Ben Franklin died

and left $5,000 to be invested for a period of 200 years to benefit medical

students and scientific research. If this money had earned 7 percent per

year (which would, in fact, have been possible), the investment would have

doubled in value every 10 years. Over 200 years, it would have doubled 20

times. At the end of 200 years of compounding, the investment would have

been worth 220 × $5,000, which is about $5 billion. (In fact, Franklin’s

$5,000 grew to only $2 million over 200 years because some of the money

was spent along the way.)

As these examples show, growth rates and interest rates

compounded over many years can lead to some spectacular results. That

is probably why Albert Einstein once called compounding “the greatest

mathematical discovery of all time.” ■

F Y I

27-2 Managing Risk Life is full of gambles. When you go skiing, you risk breaking your leg in a fall. When you drive to work, you risk a car accident. When you put some of your savings in the stock market, you risk a fall in stock prices. The rational response to this risk is not necessarily to avoid it at any cost but to take it into account in your decision making. Let’s consider how a person might do that.

27-2a Risk Aversion Most people are risk averse. This means more than that people dislike bad things happening to them. It means that they dislike bad things more than they like comparable good things.

risk aversion

a dislike of uncertainty

567CHAPTER 27 THE BASIC TOOLS OF FINANCE

For example, suppose a friend offers you the following opportunity. She will toss a coin. If it comes up heads, she will pay you $1,000. But if it comes up tails, you will have to pay her $1,000. Would you accept the bargain? You wouldn’t if you were risk averse. For a risk-averse person, the pain of losing the $1,000 would exceed the pleasure from winning $1,000.

Economists have developed models of risk aversion using the concept of utility, which is a person’s subjective measure of well-being or satisfaction. Every level of wealth provides a certain amount of utility, as shown by the utility function in Figure 1. But the function exhibits the property of diminishing marginal utility: The more wealth a person has, the less utility she gets from an additional dollar. Thus, in the figure, the utility function gets flatter as wealth increases. Because of diminishing marginal utility, the utility lost from losing the $1,000 bet is more than the utility gained from winning it. As a result, people are risk averse.

Risk aversion provides the starting point for explaining various things we observe in the economy. Let’s consider three of them: insurance, diversification, and the risk-return trade-off.

27-2b The Markets for Insurance One way to deal with risk is to buy insurance. The general feature of insurance contracts is that a person facing a risk pays a fee to an insurance company, which in return agrees to accept all or part of the risk. There are many types of insurance. Car insurance covers the risk of your being in an auto accident, fire insurance covers the risk that your house will burn down, health insurance covers the risk that you might need expensive medical treatment, and life insurance covers the risk that you will die and leave your family without your income. There is also insurance against the risk of living too long: For a fee paid today, an insurance company will pay you an annuity—a regular income every year until you die.

In a sense, every insurance contract is a gamble. It is possible that you will not be in an auto accident, that your house will not burn down, and that you will not need expensive medical treatment. In most years, you will pay the insurance company the premium and get nothing in return except peace of mind. Indeed,

FIGURE 1

The Utility Function

This utility function shows how utility,

a subjective measure of satisfaction,

depends on wealth. As wealth rises, the

utility function becomes flatter, reflecting

the property of diminishing marginal

utility. Because of diminishing marginal

utility, a $1,000 loss decreases utility by

more than a $1,000 gain increases it.

Wealth0

Utility

Current wealth $1,000

gain

Utility gain from winning $1,000

Utility loss from losing $1,000

$1,000 loss

568 PART IX THE REAL ECONOMY IN THE LONG RUN

the insurance company is counting on the fact that most people will not make claims on their policies; otherwise, it couldn’t pay out large claims to the unlucky few and still stay in business.

From the standpoint of the economy as a whole, the role of insurance is not to eliminate the risks inherent in life but to spread them around more efficiently. Consider fire insurance, for instance. Owning fire insurance does not reduce the risk of losing your home in a fire. But if that unlucky event occurs, the insurance company compensates you. The risk, rather than being borne by you alone, is shared among the thousands of insurance-company shareholders. Because people are risk averse, it is easier for 10,000 people to bear 1/10,000 of the risk than for one person to bear the entire risk herself.

The markets for insurance suffer from two types of problems that impede their ability to spread risk. One problem is adverse selection: A high-risk person is more likely to apply for insurance than a low-risk person because a high-risk person would benefit more from insurance protection. A second problem is moral hazard: After people buy insurance, they have less incentive to be careful about their risky behavior because the insurance company will cover much of the resulting losses. Insurance companies are aware of these problems, but they cannot fully guard against them. An insurance company cannot perfectly distinguish between high-risk and low-risk customers, and it cannot monitor all of its customers’ risky behavior. The price of insurance reflects the actual risks that the insurance company will face after the insurance is bought. The high price of insurance is why some people, especially those who know themselves to be low-risk, decide against buying it and, instead, endure some of life’s uncertainty on their own.

27-2c Diversification of Firm-Specific Risk In 2002, Enron, a large and once widely respected company, went bankrupt amid accusations of fraud and accounting irregularities. Several of the company’s top executives were prosecuted and ended up going to prison. The saddest part of the story, however, involved thousands of lower-level employees. Not only did they lose their jobs but many lost their life savings as well. The employees had put about two-thirds of their retirement funds in Enron stock, which became worthless.

If there is one piece of practical advice that finance offers to risk-averse people, it is this: “Don’t put all your eggs in one basket.” You may have heard this before, but finance has turned this folk wisdom into a science. It goes by the name diversification.

The market for insurance is one example of diversification. Imagine a town with 10,000 homeowners, each facing the risk of a house fire. If someone starts an insurance company and each person in town becomes both a shareholder and a policyholder of the company, they all reduce their risk through diversification. Each person now faces 1/10,000 of the risk of 10,000 possible fires, rather than the entire risk of a single fire in her own home. Unless the entire town catches fire at the same time, the downside that each person faces is much smaller.

When people use their savings to buy financial assets, they can also reduce risk through diversification. A person who buys stock in a company is placing a bet on the future profitability of that company. That bet is often quite risky because companies’ fortunes are hard to predict. Microsoft evolved from a start-up by some geeky teenagers into one of the world’s most valuable companies in only a few years; Enron went from one of the world’s most respected companies to an almost worthless one in only a few months. Fortunately, a shareholder need not

diversification

the reduction of risk

achieved by replacing a

single risk with a large

number of smaller,

unrelated risks

569CHAPTER 27 THE BASIC TOOLS OF FINANCE

tie her own fortune to that of any single company. Risk can be reduced by placing a large number of small bets, rather than a small number of large ones.

Figure 2 shows how the risk of a portfolio of stocks depends on the number of stocks in the portfolio. Risk is measured here with a statistic called the standard deviation, which you may have learned about in a math or statistics class. The standard deviation measures the volatility of a variable—that is, how much the variable is likely to fluctuate. The higher the standard deviation of a portfolio’s return, the more volatile its return is likely to be, and the riskier it is that someone holding the portfolio will fail to get the return that she expected.

The figure shows that the risk of a stock portfolio falls substantially as the number of stocks increases. For a portfolio with a single stock, the standard deviation is 49 percent. Going from 1 stock to 10 stocks eliminates about half the risk. Going from 10 to 20 stocks reduces the risk by another 10 percent. As the number of stocks continues to increase, risk continues to fall, although the reductions in risk after 20 or 30 stocks are small.

Notice that it is impossible to eliminate all risk by increasing the number of stocks in the portfolio. Diversification can eliminate firm-specific risk—the uncertainty associated with the specific companies. But diversification cannot eliminate market risk—the uncertainty associated with the entire economy, which affects all companies traded on the stock market. For example, when the economy goes into a recession, most companies experience falling sales, reduced profit, and low stock returns. Diversification reduces the risk of holding stocks, but it does not eliminate it.

27-2d The Trade-off between Risk and Return One of the Ten Principles of Economics in Chapter 1 is that people face trade-offs. The trade-off that is most relevant for understanding financial decisions is the trade-off between risk and return.

As we have seen, there are risks inherent in holding stocks, even in a diversified portfolio. But risk-averse people are willing to accept this uncertainty because they are compensated for doing so. Historically, stocks have offered much higher

firm-specific risk

risk that affects only a

single company

market risk

risk that affects all

companies in the stock

market

FIGURE 2

Diversification Reduces Risk

This figure shows how the risk of a

portfolio, measured here with a statistic

called the standard deviation, depends

on the number of stocks in the portfolio.

The investor is assumed to put an equal

percentage of her portfolio in each of the

stocks. Increasing the number of stocks

reduces, but does not eliminate, the

amount of risk in a stock portfolio. Source: Adapted from Meir Statman, “How Many Stocks Make a

Diversified Portfolio?” Journal of Financial and Quantitative Analysis 22

(September 1987): 353–364. Number of

Stocks in Portfolio

(More risk)

(Less risk)

0 1 42 6 8 10 20 40

Risk (standard deviation of

portfolio return)

1. Increasing the number of stocks in a portfolio reduces firm-specific risk through diversification . . .

2. . . . but market risk remains.

570 PART IX THE REAL ECONOMY IN THE LONG RUN

rates of return than alternative financial assets, such as bonds and bank savings accounts. Over the past two centuries, stocks offered an average real return of about 8 percent per year, while short-term government bonds paid a real return of only 3 percent per year.

When deciding how to allocate their savings, people have to decide how much risk they are willing to undertake to earn a higher return. For example, consider a person choosing how to allocate her portfolio between two asset classes:

• The first asset class is a diversified group of risky stocks, with an average return of 8 percent and a standard deviation of 20 percent. (You may recall from a math or statistics class that a normal random variable stays within 2 standard deviations of its average about 95 percent of the time. Thus, while actual returns are centered around 8 percent, they typically vary from a gain of 48 percent to a loss of 32 percent.)

• The second asset class is a safe alternative, with a return of 3 percent and a standard deviation of zero. The safe alternative can be either a bank savings account or a government bond.

Figure 3 illustrates the trade-off between risk and return. Each point in this figure represents a particular allocation of a portfolio between risky stocks and the safe asset. The figure shows that the more the individual puts into stocks, the greater both the risk and the return are.

Acknowledging the risk-return trade-off does not, by itself, tell us what a person should do. The choice of a particular combination of risk and return depends on a person’s risk aversion, which reflects her own preferences. But it is important for stockholders to recognize that the higher average return that they enjoy comes at the price of higher risk.

QuickQuiz Describe three ways that a risk-averse person might reduce the risk she faces.

FIGURE 3

The Trade-off between Risk and Return

When people increase the percentage of

their savings that they have invested in

stocks, they increase the average return

they can expect to earn, but they also

increase the risks they face.

Risk (standard deviation)

0 5 10 15 20

Return (percent

per year) 75% stocks

50% stocks

25% stocks

No stocks

100% stocks

571CHAPTER 27 THE BASIC TOOLS OF FINANCE

27-3 Asset Valuation Now that we have developed a basic understanding of the two building blocks of finance—time and risk—let’s apply this knowledge. This section considers a simple question: What determines the price of a share of stock? As with most prices, the answer is supply and demand. But that is not the end of the story. To understand stock prices, we need to think more deeply about what determines a person’s willingness to pay for a share of stock.

27-3a Fundamental Analysis Let’s imagine that you have decided to put 60 percent of your savings into stock, and to achieve diversification, you have decided to buy twenty different stocks. If you open up the newspaper, you will find thousands of stocks listed. How should you pick the twenty for your portfolio?

When you buy stock, you are buying shares in a business. To decide which businesses you want to own, it is natural to consider two things: the value of that share of the business and the price at which the shares are being sold. If the price is less than the value, the stock is said to be undervalued. If the price is more than the value, the stock is said to be overvalued. If the price and the value are equal, the stock is said to be fairly valued. When choosing twenty stocks for your portfolio, you should prefer undervalued stocks. In these cases, you are getting a bargain by paying less than the business is worth.

This is easier said than done. Learning the price is easy: You can just look it up. Determining the value of the business is the hard part. The term fundamental analysis refers to the detailed analysis of a company to estimate its value. Many Wall Street firms hire stock analysts to conduct such fundamental analysis and offer advice about which stocks to buy.

The value of a stock to a stockholder is what she gets out of owning it, which includes the present value of the stream of dividend payments and the final sale price. Recall that dividends are the cash payments that a company makes to its shareholders. A company’s ability to pay dividends, as well as the value of the stock when the stockholder sells her shares, depends on the company’s ability to earn profits. Its profitability, in turn, depends on a large number of factors: the demand for its product, how much competition it faces, how much capital it has in place, whether its workers are unionized, how loyal its customers are, what kinds of government regulations and taxes it faces, and so on. The goal of fundamental analysis is to take all these factors into account to determine how much a share of stock in the company is worth.

If you want to rely on fundamental analysis to pick a stock portfolio, there are three ways to do it. One way is to do all the necessary research yourself, such as by reading through companies’ annual reports. A second way is to rely on the advice of Wall Street analysts. A third way is to buy shares in a mutual fund, which has a manager who conducts fundamental analysis and makes the decision for you.

27-3b The Efficient Markets Hypothesis There is another way to choose twenty stocks for your portfolio: Pick them randomly by, for instance, putting the stock pages on your bulletin board and throwing darts at them. This may sound crazy, but there is reason to believe that it won’t lead you too far astray. That reason is called the efficient markets hypothesis.

fundamental analysis

the study of a company’s

accounting statements

and future prospects to

determine its value

efficient markets

hypothesis

the theory that asset

prices reflect all publicly

available information

about the value of an

asset

572 PART IX THE REAL ECONOMY IN THE LONG RUN

To understand this theory, the starting point is to acknowledge that each company listed on a major stock exchange is followed closely by many money managers, such as the individuals who run mutual funds. Every day, these managers monitor news stories and conduct fundamental analysis to try to determine the stock’s value. Their job is to buy a stock when its price falls below its fundamental value and to sell it when its price rises above its fundamental value.

The second piece to the efficient markets hypothesis is that the equilibrium of supply and demand sets the market price. This means that, at the market price, the number of shares being offered for sale exactly equals the number of shares that people want to buy. In other words, at the market price, the number of people who think the stock is overvalued exactly balances the number of people who think it’s undervalued. As judged by the typical person in the market, all stocks are fairly valued all the time.

According to this theory, the stock market exhibits informational efficiency: It reflects all available information about the value of the asset. Stock prices change when information changes. When good news about the company’s prospects becomes public, the value and the stock price both rise. When the company’s prospects deteriorate, the value and price both fall. But at any moment in time, the market price is the best guess of the company’s value based on available information.

One implication of the efficient markets hypothesis is that stock prices should follow a random walk. This means that changes in stock prices are impossible to predict from available information. If, based on publicly available information, a person could predict that a stock price would rise by 10 percent tomorrow, then the stock market must be failing to incorporate that information today. According to this theory, the only thing that can move stock prices is news that changes the market’s perception of the company’s value. But news must be unpredictable— otherwise, it wouldn’t really be news. For the same reason, changes in stock prices should be unpredictable.

If the efficient markets hypothesis is correct, then there is little point in spending many hours studying the business page to decide which twenty stocks to add to your portfolio. If prices reflect all available information, no stock is a better buy than any other. The best you can do is to buy a diversified portfolio.

informational efficiency

the description of asset

prices that rationally

reflect all available

information

random walk

the path of a variable

whose changes are

impossible to predict

CASE STUDY

RANDOM WALKS AND INDEX FUNDS The efficient markets hypothesis is a theory about how financial markets work. The theory may not be completely true: As we discuss in the next section, there is reason to doubt that stockholders are

always rational and that stock prices are informationally efficient at every moment. Nonetheless, the efficient markets hypothesis does much better as a description of the world than you might expect.

19 97

S CO

TT A

D A

M S

/ D

IS T.

B Y

U N

IT ED

F EA

TU RE

N D

IC AT

E, IN

573CHAPTER 27 THE BASIC TOOLS OF FINANCE

There is much evidence that stock prices, even if not exactly a random walk, are very close to it. For example, you might be tempted to buy stocks that have recently risen and avoid stocks that have recently fallen (or perhaps just the opposite). But statistical studies have shown that following such trends (or bucking them) fails to outperform the market. The correlation between how well a stock does one year and how well it does the following year is about zero.

Some of the best evidence in favor of the efficient markets hypothesis comes from the performance of index funds. An index fund is a mutual fund that buys all the stocks in a given stock index. The performance of these funds can be compared with that of actively managed mutual funds, where a professional portfolio manager picks stocks based on extensive research and alleged expertise. In essence, an index fund buys all stocks, whereas active funds are supposed to buy only the best stocks.

In practice, active managers usually fail to beat index funds. For example, in the 15-year period ending February 2016, 81 percent of stock mutual funds performed worse than a broadly based index fund holding all stocks traded on U.S. stock exchanges. Over this period, the average annual return on stock funds fell short of the return on the index fund by 0.89 percentage points. Most active portfolio managers failed to beat the market because they trade more frequently, incurring more trading costs, and because they charge greater fees as compensation for their alleged expertise.

What about the 19 percent of managers who did beat the market? Perhaps they are smarter than average, or perhaps they were luckier. If you have 5,000 people flipping coins ten times, on average about 5 will flip ten heads; these 5 might claim an exceptional coin-flipping skill, but they would have trouble replicating the feat. Similarly, studies have shown that mutual fund managers with a history of superior performance usually fail to maintain it in subsequent periods.

The efficient markets hypothesis says that it is impossible to beat the market. The accumulation of many studies of financial markets confirms that beating the market is, at best, extremely difficult. Even if the efficient markets hypothesis is not an exact description of the world, it contains a large element of truth. ●

27-3c Market Irrationality The efficient markets hypothesis assumes that people buying and selling stock rationally process the information they have about the stock’s underlying value. But is the stock market really that rational? Or do stock prices sometimes deviate from reasonable expectations of their true value?

There is a long tradition suggesting that fluctuations in stock prices are partly psychological. In the 1930s, economist John Maynard Keynes suggested that asset markets are driven by the “animal spirits” of investors—irrational waves of optimism and pessimism. In the 1990s, as the stock market soared to new heights, Fed Chairman Alan Greenspan questioned whether the boom reflected “irrational exuberance.” Stock prices did subsequently fall, but whether the exuberance of the 1990s was irrational given the information available at the time remains debatable. Whenever the price of an asset rises above what appears to be its fundamental value, the market is said to be experiencing a speculative bubble.

“In general, absent any inside information, an equity investor

can expect to do better by choosing a well-diversified, low-cost

index fund than by picking a few stocks.”

95% agree

What do economists say? 3% uncertain2% disagree

Diversification

ASK THE EXPERTS

Source: IGM Economic Experts Panel, November 20, 2013.

574 PART IX THE REAL ECONOMY IN THE LONG RUN

The possibility of speculative bubbles in the stock market arises in part because the value of the stock to a stockholder depends not only on the stream of dividend payments but also on the final sale price. Thus, a person might be willing to pay more than a stock is worth today if she expects another person to pay even more for it tomorrow. When evaluating a stock, you have to estimate not only the value of the business but also what other people will think the business is worth in the future.

There is much debate among economists about the frequency and importance of departures from rational pricing. Believers in market irrationality point out (correctly) that the stock market often moves in ways that are hard to explain on the basis of news that might alter a rational valuation. Believers in the efficient markets hypothesis point out (correctly) that it is impossible to know the correct, rational valuation of a company, so one should not quickly jump to the conclusion that any particular valuation is irrational. Moreover, if the market were irrational, a rational person should be able to take advantage of this fact; yet as the previous case study discussed, beating the market is nearly impossible.

QuickQuiz Fortune magazine regularly publishes a list of the “most respected”

companies. According to the efficient markets hypothesis, if you restrict

your stock portfolio to these companies, will you earn a better-than-average return? Explain.

1. If the interest rate is zero, then $100 to be paid in

10 years has a present value that is

a. less than $100.

b. exactly $100.

c. more than $100.

d. indeterminate.

2. If the interest rate is 10 percent, then the future

value in 2 years of $100 today is

a. $80.

b. $83.

c. $120.

d. $121.

3. If the interest rate is 10 percent, then the present

value of $100 to be paid in 2 years is

a. $80

b. $83.

c. $120.

d. $121.

4. The ability of insurance to spread risk is limited by

a. risk aversion and moral hazard.

b. risk aversion and adverse selection.

c. moral hazard and adverse selection.

d. risk aversion only.

CHAPTER QuickQuiz

27-4 Conclusion This chapter has developed some of the basic tools that people should (and often do) use as they make financial decisions. The concept of present value reminds us that a dollar in the future is less valuable than a dollar today, and it gives us a way to compare sums of money at different points in time. The theory of risk management reminds us that the future is uncertain and that risk-averse people can take precautions to guard against this uncertainty. The study of asset valuation tells us that the stock price of any company should reflect its expected future profitability.

Although most of the tools of finance are well established, there is more controversy about the validity of the efficient markets hypothesis and whether stock prices are, in practice, rational estimates of a company’s true worth. Rational or not, the large movements in stock prices that we observe have important macroeconomic implications. Stock market fluctuations often go hand in hand with fluctuations in the economy more broadly. We revisit the stock market when we study economic fluctuations later in the book.

575CHAPTER 27 THE BASIC TOOLS OF FINANCE

5. The benefit of diversification when constructing a

portfolio is that it can eliminate

a. speculative bubbles.

b. risk aversion.

c. firm-specific risk.

d. market risk.

6. According to the efficient markets hypothesis,

a. changes in stock prices are impossible to predict

from public information.

b. excessive diversification can reduce an investor’s

expected portfolio returns.

c. the stock market moves based on the changing

animal spirits of investors.

d. actively managed mutual funds should give higher

returns than index funds.

• Because savings can earn interest, a sum of money

today is more valuable than the same sum of money in

the future. A person can compare sums from different

times using the concept of present value. The present

value of any future sum is the amount that would

be needed today, given prevailing interest rates, to

produce that future sum.

• Because of diminishing marginal utility, most people

are risk averse. Risk-averse people can reduce risk by

buying insurance, diversifying their holdings, and

choosing a portfolio with lower risk and lower return.

• The value of an asset equals the present value of

the cash flows the owner will receive. For a share

of stock, these cash flows include the stream of

dividends and the final sale price. According to the

efficient markets hypothesis, financial markets process

available information rationally, so a stock price

always equals the best estimate of the value of the

underlying business. Some economists question the

efficient markets hypothesis, however, and believe that

irrational psychological factors also influence asset

prices.

finance, p. 564

present value, p. 564

future value, p. 564

compounding, p. 564

risk aversion, p. 566

diversification, p. 568

firm-specific risk, p. 569

market risk, p. 569

fundamental analysis, p. 571

efficient markets hypothesis, p. 571

informational efficiency, p. 572

random walk, p. 572

1. The interest rate is 7 percent. Use the concept of

present value to compare $200 to be received in 10

years and $300 to be received in 20 years.

2. What benefit do people get from the market for

insurance? What two problems impede the insurance

market from working perfectly?

3. What is diversification? Does a stockholder get a

greater benefit from diversification when going from

1 to 10 stocks or when going from 100 to 120 stocks?

4. Comparing stocks and government bonds, which type

of asset has more risk? Which pays a higher average

return?

5. What factors should a stock analyst think about in

determining the value of a share of stock?

6. Describe the efficient markets hypothesis, and give a

piece of evidence consistent with this hypothesis.

7. Explain the view of those economists who are

skeptical of the efficient markets hypothesis.

f f

SUMMARY

f k f d l l

KEY CONCEPTS

h h f k d b d h h

QUESTIONS FOR REVIEW

576 PART IX THE REAL ECONOMY IN THE LONG RUN

1. According to an old myth, Native Americans sold the

island of Manhattan about 400 years ago for $24. If

they had invested this amount at an interest rate of

7 percent per year, how much, approximately, would

they have today?

2. A company has an investment project that would cost

$10 million today and yield a payoff of $15 million in

4 years.

a. Should the firm undertake the project if the

interest rate is 11 percent? 10 percent? 9 percent?

8 percent?

b. Can you figure out the exact cutoff for the interest

rate between profitability and nonprofitability?

3. Bond A pays $8,000 in 20 years. Bond B pays $8,000

in 40 years. (To keep things simple, assume these are

zero-coupon bonds, which means the $8,000 is the

only payment the bondholder receives.)

a. If the interest rate is 3.5 percent, what is the value

of each bond today? Which bond is worth more?

Why? (Hint: You can use a calculator, but the rule of 70 should make the calculation easy.)

b. If the interest rate increases to 7 percent, what is

the value of each bond? Which bond has a larger

percentage change in value? c. Based on the example above, complete the two

blanks in this sentence: “The value of a bond

[rises/falls] when the interest rate increases, and

bonds with a longer time to maturity are

[more/less] sensitive to changes in the interest rate.”

4. Your bank account pays an interest rate of 8 percent.

You are considering buying a share of stock in XYZ

Corporation for $110. After 1, 2, and 3 years, it will

pay a dividend of $5. You expect to sell the stock after

3 years for $120. Is XYZ a good investment? Support

your answer with calculations.

5. For each of the following kinds of insurance, give an

example of behavior that can be called moral hazard and another example of behavior that can be called

adverse selection. a. health insurance

b. car insurance

c. life insurance

6. Which kind of stock would you expect to pay the

higher average return: stock in an industry that is

very sensitive to economic conditions (such as an

automaker) or stock in an industry that is relatively

insensitive to economic conditions (such as a water

company)? Why?

7. A company faces two kinds of risk. A firm-specific

risk is that a competitor might enter its market and

take some of its customers. A market risk is that the

economy might enter a recession, reducing sales.

Which of these two risks would more likely cause the

company’s shareholders to demand a higher return?

Why?

8. When company executives buy and sell stock based

on private information they obtain as part of their

jobs, they are engaged in insider trading. a. Give an example of inside information that might

be useful for buying or selling stock.

b. Those who trade stocks based on inside

information usually earn very high rates of

return. Does this fact violate the efficient markets

hypothesis?

c. Insider trading is illegal. Why do you suppose

that is?

9. Jamal has a utility function U 5 W1/2, where W is his wealth in millions of dollars and U is the utility he obtains from that wealth. In the final stage of a game

show, the host offers Jamal a choice between (A) $4

million for sure, or (B) a gamble that pays $1 million

with probability 0.6 and $9 million with probability 0.4.

a. Graph Jamal’s utility function. Is he risk averse?

Explain.

b. Does A or B offer Jamal a higher expected

prize? Explain your reasoning with appropriate

calculations. (Hint: The expected value of a random variable is the weighted average of the

possible outcomes, where the probabilities are the

weights.)

c. Does A or B offer Jamal a higher expected utility?

Again, show your calculations.

d. Should Jamal pick A or B? Why?

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

d ( h

PROBLEMS AND APPLICATIONS

Unemployment CHAPTER

28 L

osing a job can be the most distressing economic event in a person’s life. Most people rely on their labor earnings to maintain their standard of living, and many people also get a sense of personal accomplishment from working. A job

loss means a lower living standard in the present, anxiety about the future, and reduced self-esteem. It is not surprising, therefore, that politicians campaigning for office often speak about how their proposed policies will help create jobs.

In previous chapters, we have seen some of the forces that determine the level and growth of a country’s standard of living. A country that saves and invests a high fraction of its income, for instance, enjoys more rapid growth in its cap- ital stock and GDP than a similar country that saves and invests less. An even more obvious determinant of a country’s

578 PART IX THE REAL ECONOMY IN THE LONG RUN

standard of living is the amount of unemployment it typically experiences. People who would like to work but cannot find a job are not contributing to the econo- my’s production of goods and services. Although some degree of unemployment is inevitable in a complex economy with thousands of firms and millions of work- ers, the amount of unemployment varies substantially over time and across coun- tries. When a country keeps its workers as fully employed as possible, it achieves a higher level of GDP than it would if it left many of its workers idle.

This chapter begins our study of unemployment. The problem of unemploy- ment can be divided into two categories: the long-run problem and the short- run problem. The economy’s natural rate of unemployment refers to the amount of unemployment that the economy normally experiences. Cyclical unemployment refers to the year-to-year fluctuations in unemployment around its natural rate, and it is closely associated with the short-run ups and downs of economic activity. Cyclical unemployment has its own explanation, which we defer until we study short-run economic fluctuations later in this book. In this chapter, we discuss the determinants of an economy’s natural rate of unemployment. As we will see, the designation natural does not imply that this rate of unemployment is desirable. Nor does it imply that it is constant over time or impervious to economic policy. It just means that this unemployment does not go away on its own even in the long run.

We begin the chapter by looking at some of the relevant facts that describe unemployment. In particular, we examine three questions: How does the gov- ernment measure the economy’s rate of unemployment? What problems arise in interpreting the unemployment data? How long are the unemployed typically without work?

We then turn to the reasons economies always experience some unemploy- ment and the ways in which policymakers can help the unemployed. We discuss four explanations for the economy’s natural rate of unemployment: job search, minimum-wage laws, unions, and efficiency wages. As we will see, long-run unemployment does not arise from a single problem that has a single solution. Instead, it reflects a variety of related problems. As a result, there is no easy way for policymakers to reduce the economy’s natural rate of unemployment and, at the same time, to alleviate the hardships experienced by the unemployed.

28-1 Identifying Unemployment Let’s start by examining more precisely what the term unemployment means.

28-1a How Is Unemployment Measured? Measuring unemployment is the job of the Bureau of Labor Statistics (BLS), which is part of the Department of Labor. Every month, the BLS produces data on unemployment and on other aspects of the labor market, including types of em- ployment, length of the average workweek, and the duration of unemployment. These data come from a regular survey of about 60,000 households, called the Current Population Survey.

Based on the answers to survey questions, the BLS places each adult (age 16 and older) in each surveyed household into one of three categories:

Employed: This category includes those who worked as paid employees, worked in their own business, or worked as unpaid workers in a family

579CHAPTER 28 UNEMPLOYMENT

member’s business. Both full-time and part-time workers are counted. This category also includes those who were not working but who had jobs from which they were temporarily absent because of, for example, vacation, illness, or bad weather. Unemployed: This category includes those who were not employed, were available for work, and had tried to find employment during the previous four weeks. It also includes those waiting to be recalled to a job from which they had been laid off. Not in the labor force: This category includes those who fit neither of the first two categories, such as full-time students, homemakers, and retirees.

Figure 1 shows the breakdown into these categories for January 2016. Once the BLS has placed all the individuals covered by the survey in a cate-

gory, it computes various statistics to summarize the state of the labor market. The BLS defines the labor force as the sum of the employed and the unemployed:

Labor force 5 Number of employed 1 Number of unemployed.

The BLS defines the unemployment rate as the percentage of the labor force that is unemployed:

Unemployment rate 5 Number of unemployed

Labor force 3 100.

The BLS computes unemployment rates for the entire adult population and for specific groups defined by race, gender, and so on.

labor force

the total number of

workers, including both

the employed and the

unemployed

unemployment rate

the percentage of the

labor force that is

unemployed

FIGURE 1

The Breakdown of the Population in

January 2016

The Bureau of Labor Statistics divides the

adult population into three categories:

employed, unemployed, and not in the

labor force.

Source: Bureau of Labor Statistics.

Adult Population

(252.4 million)

Labor Force (158.3 million)

Employed (150.5 million)

Not in labor force (94.1 million)

Unemployed (7.8 million)

580 PART IX THE REAL ECONOMY IN THE LONG RUN

The BLS uses the same survey to produce data on labor-force participation. The labor-force participation rate measures the percentage of the total adult popula- tion of the United States that is in the labor force:

Labor-force participation rate 5 Labor force

Adult population 3 100.

This statistic tells us the fraction of the population that has chosen to participate in the labor market. The labor-force participation rate, like the unemployment rate, is computed for both the entire adult population and more specific groups.

To see how these data are computed, consider the figures for January 2016. At that time, 150.5 million people were employed, and 7.8 million people were un- employed. The labor force was

Labor force 5 150.5 1 7.8 5 158.3 million.

The unemployment rate was

Unemployment rate 5 (7.8/158.3) 3 100 5 4.9 percent.

Because the adult population was 252.4 million, the labor-force participation rate was

Labor-force participation rate 5 (158.3/252.4) 3 100 5 62.7 percent.

Hence, in January 2016, almost two-thirds of the U.S. adult population were par- ticipating in the labor market, and 4.9 percent of those labor-market participants were without work.

Table 1 shows the statistics on unemployment and labor-force participation for various groups within the U.S. population. Three comparisons are most appar- ent. First, women of prime working age (25 to 54 years old) have lower rates of labor-force participation than men, but once in the labor force, men and women have similar rates of unemployment. Second, prime-age blacks have similar rates of labor-force participation as prime-age whites, but they have much higher rates

labor-force participation

rate

the percentage of the

adult population that is in

the labor force

TABLE 1

The Labor-Market

Experiences of Various

Demographic Groups

This table shows the

unemployment rate and

the labor-force partic-

ipation rate of various

groups in the U.S.

population for 2014.

Source: Bureau of Labor Statistics.

Demographic Group

Unemployment

Rate

Labor-Force

Participation Rate

Adults of Prime Working Age (ages 25–54)

White, male 4.4% 89.4%

White, female 4.6 74.3

Black, male 10.1 80.7

Black, female 9.1 75.8

Teenagers (ages 16–19)

White, male 19.2 35.6

White, female 15.5 36.8

Black, male 36.5 25.9

Black, female 29.7 28.4

581CHAPTER 28 UNEMPLOYMENT

of unemployment. Third, teenagers have much lower rates of labor-force partic- ipation and much higher rates of unemployment than older workers. More gen- erally, these data show that labor-market experiences vary widely among groups within the economy.

The BLS data on the labor market also allow economists and policymakers to monitor changes in the economy over time. Figure 2 shows the unemployment rate in the United States since 1960. The figure shows that the economy always has some unemployment and that the amount changes from year to year. The normal rate of unemployment around which the unemployment rate fluctuates is called the natural rate of unemployment, and the deviation of unemployment from its natu- ral rate is called cyclical unemployment. The natural rate of unemployment shown in the figure is a series estimated by economists at the Congressional Budget Office. For 2015, they estimated a natural rate of 4.9 percent, close to the actual unemploy- ment rate of 5.3 percent. Later in this book, we discuss short-run economic fluctua- tions, including the year-to-year fluctuations in unemployment around its natural rate. In the rest of this chapter, however, we ignore the short-run fluctuations and examine why there is always some unemployment in market economies.

natural rate of

unemployment

the normal rate of

unemployment around

which the unemployment

rate fluctuates

cyclical unemployment

the deviation of

unemployment from its

natural rate CASE

STUDY

LABOR-FORCE PARTICIPATION OF MEN AND WOMEN IN THE U.S. ECONOMY Women’s role in American society has changed dramatically over the past century. Social commentators have pointed to many causes for

this change. In part, it is attributable to new technologies, such as the washing machine, clothes dryer, refrigerator, freezer, and dishwasher, which have reduced the amount of time required to complete routine household tasks. In part, it

FIGURE 2

Unemployment Rate since

1960

This graph uses annual data on the U.S. unemployment rate to show the percentage of

the labor force without a job. The natural rate of unemployment is the normal level of

unemployment around which the unemployment rate fluctuates.

Source: U.S. Department of Labor, Congressional Budget Office.

Unemployment rate 10

0 1970 19751960 1965 1980 1985 1990 2005 20152010

Percent of Labor Force

1995 2000

Natural rate of unemployment

582 PART IX THE REAL ECONOMY IN THE LONG RUN

is attributable to improved birth control, which has reduced the number of children born to the typical family. This change in women’s role is also partly attributable to changing political and social attitudes, which in turn may have been facilitated by the advances in technology and birth control. Together these developments have had a profound impact on society in general and on the economy in particular.

Nowhere is that impact more obvious than in data on labor-force participation. Figure 3 shows the labor-force participation rates of men and women in the United States since 1950. Just after World War II, men and women had very different roles in society. Only 33 percent of women were working or looking for work, in contrast to 87 percent of men. Since then, this difference in participation rates has gradually diminished, as growing numbers of women have entered the labor force and some men have left it. Data for 2015 show that 57 percent of women were in the labor force, in contrast to 69 percent of men. As measured by labor-force participation, men and women are now playing a more equal role in the economy.

The increase in women’s labor-force participation is easy to understand, but the fall in men’s may seem puzzling. There are several reasons for this decline. First, young men now stay in school longer than their fathers and grandfathers did. Second, older men now retire earlier and live longer. Third, with more women employed, more fathers now stay at home to raise their children. Full-time students, retirees, and stay-at-home dads are all counted as being out of the labor force. ●

28-1b Does the Unemployment Rate Measure What We Want It To? Measuring the amount of unemployment in the economy might seem a straight- forward task, but it is not. While it is easy to distinguish between a person with a full-time job and a person who is not working at all, it is much harder to distinguish between a person who is unemployed and a person who is not in the labor force.

FIGURE 3

Labor-Force Participation Rates

for Men and Women since 1950

This figure shows the percentage of adult men and women who are members of the labor

force. It shows that, over the past 60 years, women have entered the labor force and men

have left it.

Source: U.S. Department of Labor.

100

0 1950 1955 1960 1965 1970 1975 1980 1985 1990 2000 2005 20152010

Labor-Force Participation

Rate (in percent)

Women

Men

1995

583CHAPTER 28 UNEMPLOYMENT

TABLE 2

Measures of Labor

Underutilization

The table shows various

measures of joblessness

for the U.S. economy.

The data are for January

2016.

Source: U.S. Department of Labor.

Measure and Description Rate

U-1 Persons unemployed 15 weeks or longer, as a percent of the civilian

labor force (includes only very long-term unemployed)

2.0%

U-2 Job losers and persons who have completed temporary jobs, as a

percent of the civilian labor force (excludes job leavers)

2.3

U-3 Total unemployed, as a percent of the civilian labor force (official

unemployment rate)

4.9

U-4 Total unemployed, plus discouraged workers, as a percent of the

civilian labor force plus discouraged workers

5.3

U-5 Total unemployed plus all marginally attached workers, as a percent of

the civilian labor force plus all marginally attached workers

6.2

U-6 Total unemployed, plus all marginally attached workers, plus total

employed part-time for economic reasons, as a percent of the civilian

labor force plus all marginally attached workers

9.9

Note: The Bureau of Labor Statistics defines terms as follows:

Marginally attached workers are persons who currently are neither working nor looking

for work but indicate that they want and are available for a job and have looked for work

sometime in the recent past.

Discouraged workers are marginally attached workers who have given a job-market-

related reason for not currently looking for a job.

Persons employed part-time for economic reasons are those who want and are available

for full-time work but have had to settle for a part-time schedule.

Movements into and out of the labor force are, in fact, common. More than one-third of the unemployed are recent entrants into the labor force. These entrants include young workers looking for their first jobs. They also include, in greater numbers, older workers who had previously left the labor force but have now returned to look for work. Moreover, not all unemployment ends with the job seeker finding a job. Almost half of all spells of unemployment end when the unemployed person leaves the labor force.

Because people move into and out of the labor force so often, statistics on unemployment are difficult to interpret. On the one hand, some of those who report being unemployed may not, in fact, be trying hard to find a job. They may be calling themselves unemployed because they want to qualify for a government program that gives financial assistance to the unemployed or because they are working but paid “under the table” to avoid taxes on their earnings. It may be more accurate to view these individuals as out of the labor force or, in some cases, employed. On the other hand, some of those who report being out of the labor force may want to work. These individuals may have tried to find a job and may have given up after an unsuccessful search. Such individuals, called discouraged workers, do not show up in unemployment statistics, even though they are truly workers without jobs.

Because of these and other problems, the BLS calculates several other measures of labor underutilization, in addition to the official unemployment rate. These alternative measures are presented in Table 2. In the end, it is best to view the offi- cial unemployment rate as a useful but imperfect measure of joblessness.

discouraged workers

individuals who would

like to work but have

given up looking for a job

584 PART IX THE REAL ECONOMY IN THE LONG RUN

28-1c How Long Are the Unemployed without Work? In judging how serious the problem of unemployment is, one question to con- sider is whether unemployment is typically a short-term or long-term condition. If unemployment is short-term, one might conclude that it is not a big problem. Workers may require a few weeks between jobs to find the openings that best suit their tastes and skills. Yet if unemployment is long-term, one might conclude that it is a serious problem. Workers unemployed for many months are more likely to suffer economic and psychological hardship.

Because the duration of unemployment can affect our view about how big a problem unemployment is, economists have devoted much energy to studying data on the duration of unemployment spells. In this work, they have uncov- ered a result that is important, subtle, and seemingly contradictory: Most spells of unemployment are short, but most unemployment observed at any given time is long-term.

To see how this statement can be true, consider an example. Suppose that you visited the government’s unemployment office every week for a year to survey the unemployed. Each week you find that there are four unemployed workers. Three of these workers are the same individuals for the whole year, while the fourth person changes every week. Based on this experience, would you say that unemployment is typically short-term or long-term?

Some simple calculations help answer this question. In this example, you meet a total of 55 unemployed people over the course of a year; 52 of them are unem- ployed for one week, and 3 are unemployed for the full year. This means that 52/55, or 95 percent, of unemployment spells end in one week. Yet whenever you walk into the unemployment office, three of the four people you meet will be unemployed for the entire year. So, even though 95 percent of unemployment spells end in one week, 75 percent of the unemployment observed at any moment is attributable to those individuals who are unemployed for a full year. In this example, as in the world, most spells of unemployment are short, but most unem- ployment observed at any given time is long-term.

This subtle conclusion implies that economists and policymakers must be care- ful when interpreting data on unemployment and when designing policies to help the unemployed. Most people who become unemployed will soon find jobs. Yet most of the economy’s unemployment problem is attributable to the relatively few workers who are jobless for long periods of time.

28-1d Why Are There Always Some People Unemployed? We have discussed how the government measures the amount of unemployment, the problems that arise in interpreting unemployment statistics, and the findings of labor economists on the duration of unemployment. You should now have a good idea about what unemployment is.

This discussion, however, has not explained why economies experience unem- ployment. In most markets in the economy, prices adjust to bring quantity supplied and quantity demanded into balance. In an ideal labor market, wages would adjust to balance the quantity of labor supplied and the quantity of labor demanded. This adjustment of wages would ensure that all workers are always fully employed.

Of course, reality does not resemble this ideal. There are always some workers without jobs, even when the overall economy is doing well. In other words, the unemployment rate never falls to zero; instead, it fluctuates around the natural

585CHAPTER 28 UNEMPLOYMENT

The Jobs Number

W hen the Bureau of Labor Statistics announces the unemployment

rate at the beginning of every month, it also announces the num-

ber of jobs the economy has gained or lost. As an indicator of short-run

economic trends, the jobs number gets as much attention as the unem-

ployment rate.

Where does the jobs number come from? You might guess that

it comes from the same survey of 60,000 households that yields the

unemployment rate. And indeed the household survey does produce data

on total employment. The jobs number that gets the most attention, how-

ever, comes from a separate survey of 160,000 business establishments,

which have over 40 million workers on their payrolls. The results from

the establishment survey are announced at the same time as the results

from the household survey.

Both surveys yield information about total employment, but the

results are not always the same. One reason is that the establishment

survey has a larger sample, which makes it more reliable. Another

reason is that the surveys

are not measuring exactly

the same thing. For exam-

ple, a person who has two

part-time jobs at different

companies would be counted

as one employed person in the house-

hold survey but as two jobs in the establishment survey. As another

example, a person running his own small business would be counted

as employed in the household survey but would not show up at all in

the establishment survey, because the establishment survey counts only

employees on business payrolls.

The establishment survey is closely watched for its data on jobs, but

it says nothing about unemployment. To measure the number of unem-

ployed, we need to know how many people without jobs are trying to find

them. The household survey is the only source of that information. ■

F Y I

rate of unemployment. To understand this natural rate, the remaining sections of this chapter examine the reasons actual labor markets depart from the ideal of full employment.

To preview our conclusions, we will find that there are four ways to explain unemployment in the long run. The first explanation is that it takes time for workers to search for the jobs that are best suited for them. The unemployment that results from the process of matching workers and jobs is sometimes called frictional unemployment, and it is often thought to explain relatively short spells of unemployment.

The next three explanations for unemployment suggest that the number of jobs available in some labor markets may be insufficient to give a job to every- one who wants one. This occurs when the quantity of labor supplied exceeds the quantity demanded. Unemployment of this sort is sometimes called structural unemployment, and it is often thought to explain longer spells of unemployment. As we will see, this kind of unemployment results when wages are set above the level that brings supply and demand into equilibrium. We will examine three pos- sible reasons for an above-equilibrium wage: minimum-wage laws, unions, and efficiency wages.

QuickQuiz How is the unemployment rate measured? How might the unemployment

rate overstate the amount of joblessness? How might it understate the

amount of joblessness?

frictional unemployment

unemployment that

results because it takes

time for workers to search

for the jobs that best suit

their tastes and skills

structural unemployment

unemployment that

results because the

number of jobs available

in some labor markets

is insufficient to provide

a job for everyone who

wants one

586 PART IX THE REAL ECONOMY IN THE LONG RUN

28-2 Job Search One reason economies always experience some unemployment is job search. Job search is the process of matching workers with appropriate jobs. If all workers and all jobs were the same, so that all workers were equally well suited for all jobs, job search would not be a problem. Laid-off workers would quickly find new jobs that were well suited for them. But in fact, workers differ in their tastes and skills, jobs differ in their attributes, and information about job candidates and job vacancies is disseminated slowly among the many firms and households in the economy.

28-2a Why Some Frictional Unemployment Is Inevitable Frictional unemployment is often the result of changes in the demand for labor among different firms. When consumers decide that they prefer Ford to General Motors cars, Ford increases employment and General Motors lays off workers. The former General Motors workers must now search for new jobs, and Ford must decide which new workers to hire for the various jobs that have opened up. The result of this transition is a period of unemployment.

Similarly, because different regions of the country produce different goods, employment can rise in one region while it falls in another. Consider, for instance, what happens when the world price of oil falls. Oil-producing firms in Texas and North Dakota respond to the lower price by cutting back on produc- tion and employment. At the same time, cheaper gasoline stimulates car sales, so auto-producing firms in Michigan and Ohio raise production and employment. The opposite happens when the world price of oil rises. Changes in the compo- sition of demand among industries or regions are called sectoral shifts. Because it takes time for workers to search for jobs in the new sectors, sectoral shifts tempo- rarily cause unemployment.

Changing patterns of international trade are also a source of frictional unem- ployment. In Chapter 3, we learned that nations export goods for which they have a comparative advantage and import goods for which other nations have a com- parative advantage. Comparative advantage, however, need not be stable over time. As the world economy evolves, nations may find themselves importing and exporting different goods than they have in the past. Workers will therefore need to move among industries. As they make this transition, they may find them- selves unemployed for a period of time.

Frictional unemployment is inevitable simply because the economy is always changing. For example, in the U.S. economy from 2004 to 2014, employment fell by 838,000 in construction and 2.1 million in manufacturing. During the same period, employment rose by 321,000 in mining, 629,000 in computer systems design, 1.9 million in food services, and 2.6 million in healthcare. This churning of the labor force is normal in a well-functioning and dynamic economy. Because workers tend to move toward those industries in which they are most valuable, the long-run result of the process is higher productivity and higher living standards. But along the way, workers in declining industries find themselves out of work and search- ing for new jobs. The result is some amount of frictional unemployment.

28-2b Public Policy and Job Search Even if some frictional unemployment is inevitable, the precise amount is not. The faster information spreads about job openings and worker availability, the more rapidly the economy can match workers and firms. The Internet, for instance, may

job search

the process by which

workers find appropriate

jobs given their tastes

and skills

587CHAPTER 28 UNEMPLOYMENT

help facilitate job search and reduce frictional unemployment. In addition, public policy may play a role. If policy can reduce the time it takes unemployed workers to find new jobs, it can reduce the economy’s natural rate of unemployment.

Government programs try to facilitate job search in various ways. One way is through government-run employment agencies, which give out information about job vacancies. Another way is through public training programs, which aim to ease workers’ transition from declining to growing industries and to help disadvantaged groups escape poverty. Advocates of these programs believe that they make the economy operate more efficiently by keeping the labor force more fully employed and that they reduce the inequities inherent in a constantly chang- ing market economy.

Critics of these programs question whether the government should get involved with the process of job search. They argue that it is better to let the pri- vate market match workers and jobs. In fact, most job search in our economy takes place without intervention by the government. Newspaper ads, online job sites, college career offices, headhunters, and word of mouth all help spread informa- tion about job openings and job candidates. Similarly, much worker education is done privately, either through schools or through on-the-job training. These critics contend that the government is no better—and most likely worse—at disseminat- ing the right information to the right workers and deciding what kinds of worker training would be most valuable. They claim that these decisions are best made privately by workers and employers.

28-2c Unemployment Insurance One government program that increases the amount of frictional unemploy- ment, without intending to do so, is unemployment insurance. This program is designed to offer workers partial protection against job loss. The unemployed who quit their jobs, were fired for cause, or just entered the labor force are not eligible. Benefits are paid only to the unemployed who were laid off because their previous employers no longer needed their skills. The terms of the program vary over time and across states, but a typical worker covered by unemployment in- surance in the United States receives 50 percent of his former wages for 26 weeks.

While unemployment insurance reduces the hardship of unemployment, it also increases the amount of unemployment. The explanation is based on one of the Ten Principles of Economics in Chapter 1: People respond to incentives. Because unemployment benefits stop when a worker takes a new job, the unemployed devote less effort to job search and are more likely to turn down unattractive job offers. In addition, because unemployment insurance makes unemployment less onerous, workers are less likely to seek guarantees of job security when they negotiate with employers over the terms of employment.

Many studies by labor economists have analyzed the incentive effects of unem- ployment insurance. One study examined an experiment run by the state of Illinois in 1985. When unemployed workers applied to collect unemployment insurance benefits, the state randomly selected some of them and offered each a $500 bonus if they found new jobs within 11 weeks. This group was then compared to a control group not offered the incentive. The average spell of unemployment for the group offered the bonus was 7 percent shorter than the average spell for the control group. This experiment shows that the design of the unemployment insurance system influences the effort that the unemployed devote to job search.

Several other studies examined search effort by following a group of workers over time. Unemployment insurance benefits, rather than lasting forever, usually

unemployment insurance

a government program

that partially protects

workers’ incomes when

they become unemployed

588 PART IX THE REAL ECONOMY IN THE LONG RUN

run out after 6 months or 1 year. These studies found that when the unemployed become ineligible for benefits, the probability of their finding a new job rises markedly. Thus, receiving unemployment insurance benefits does reduce the search effort of the unemployed.

Even though unemployment insurance reduces search effort and raises unem- ployment, we should not necessarily conclude that the policy is bad. The program does achieve its primary goal of reducing the income uncertainty that workers face. In addition, when workers turn down unattractive job offers, they have the opportunity to look for jobs that better suit their tastes and skills. Some econo- mists argue that unemployment insurance improves the ability of the economy to match each worker with the most appropriate job.

The study of unemployment insurance shows that the unemployment rate is an imperfect measure of a nation’s overall level of economic well-being. Most economists agree that eliminating unemployment insurance would reduce the amount of unemployment in the economy. Yet economists disagree on whether economic well-being would be enhanced or diminished by this change in policy.

QuickQuiz How would an increase in the world price of oil affect the amount of

frictional unemployment? Is this unemployment undesirable? What public

policies might affect the amount of unemployment caused by this price change?

28-3 Minimum-Wage Laws Having seen how frictional unemployment results from the process of matching workers and jobs, let’s now examine how structural unemployment results when the number of jobs is insufficient for the number of workers.

To understand structural unemployment, we begin by reviewing how minimum-wage laws can cause unemployment. Minimum wages are not the pre- dominant reason for unemployment in our economy, but they have an important effect on certain groups with particularly high unemployment rates. Moreover, the analysis of minimum wages is a natural place to start because, as we will see, it can be used to understand some of the other reasons for structural unemployment.

Figure 4 reviews the basic economics of a minimum wage. When a mini- mum-wage law forces the wage to remain above the level that balances supply and demand, it raises the quantity of labor supplied and reduces the quantity of labor demanded compared to the equilibrium level. There is a surplus of labor. Because there are more workers willing to work than there are jobs, some workers are unemployed.

While minimum-wage laws are one reason unemployment exists in the U.S. economy, they do not affect everyone. The vast majority of workers have wages well above the legal minimum, so the law does not prevent most wages from adjusting to balance supply and demand. Minimum-wage laws matter most for the least skilled and least experienced members of the labor force, such as teenag- ers. Their equilibrium wages tend to be low and, therefore, are more likely to fall below the legal minimum. It is only among these workers that minimum-wage laws explain the existence of unemployment.

Figure 4 is drawn to show the effects of a minimum-wage law, but it also illustrates a more general lesson: If the wage is kept above the equilibrium level for any reason, the result is unemployment. Minimum-wage laws are just one reason wages

589CHAPTER 28 UNEMPLOYMENT

may be “too high.” In the remaining two sections of this chapter, we consider two other reasons wages may be kept above the equilibrium level: unions and effi- ciency wages. The basic economics of unemployment in these cases is the same as that shown in Figure 4, but these explanations of unemployment can apply to many more of the economy’s workers.

At this point, however, we should stop and notice that the structural unem- ployment that arises from an above-equilibrium wage is, in an important sense, different from the frictional unemployment that arises from the process of job search. The need for job search is not due to the failure of wages to balance labor supply and labor demand. When job search is the explanation for unemployment, workers are searching for the jobs that best suit their tastes and skills. By contrast, when the wage is above the equilibrium level, the quantity of labor supplied exceeds the quantity of labor demanded, and workers are unemployed because they are waiting for jobs to open up.

QuickQuiz Draw the supply curve and the demand curve for a labor market in which

the wage is fixed above the equilibrium level. Show the quantity of labor

supplied, the quantity demanded, and the amount of unemployment.

FIGURE 4

Unemployment from a Wage above the

Equilibrium Level

In this labor market, supply and demand

are balanced at the wage W E . At this

equilibrium wage, the quantity of labor

supplied and the quantity of labor

demanded both equal L E . By contrast, if

the wage is forced to remain above the

equilibrium level, perhaps because of a

minimum-wage law, the quantity of labor

supplied rises to L S and the quantity of

labor demanded falls to L D . The result-

ing surplus of labor, L S – L

D , represents

unemployment.

Quantity of Labor

LE0

Surplus of labor � Unemployment

Labor supply

Labor demand

Wage

Minimum wage

LD LS

WHO EARNS THE MINIMUM WAGE? In 2015, the Department of Labor released a study of which work- ers reported earnings at or below the minimum wage in 2014, when the minimum wage was $7.25 per hour. (A reported wage below the

minimum is possible because some workers are exempt from the stat- ute, because enforcement is imperfect, and because some workers round down when reporting their wages on surveys.) Here is a summary of the findings:

In 2014, 77 million workers were paid at hourly rates (as opposed to being on salary or self-employed), representing about half of the labor force. Among

CASE STUDY

590 PART IX THE REAL ECONOMY IN THE LONG RUN

hourly paid workers, about 4 percent reported wages at or below the prevail- ing federal minimum. Thus, the minimum wage directly affects about 2 percent of all workers. Minimum-wage workers are more likely to be female. Among hourly paid workers, 5 percent of women had wages at or below the minimum wage, compared with 3 percent of men. Minimum-wage workers tend to be young. Among employed teenagers (ages 16 to 19) paid by the hour, about 15 percent earned the minimum wage or less, compared with 3 percent of hourly paid workers age 25 and older. Minimum-wage workers tend to be less educated. Among hourly paid work- ers age 16 and older, about 7 percent of those without a high school diploma earned the minimum wage or less, compared with about 4 percent of those who completed a high school diploma (but did not attend college) and about 2 percent for those who had obtained a college degree.

An economist who studies the minimum

wage says there are better ways to help

the working poor.

Why Market Forces Will Over-

whelm a Higher Minimum Wage

By David Neumark

T he slogans are everywhere: Fight for 15;

People Not Profits; One Job Should Be

Enough. Worsening income inequality and the

persistence of poverty have spurred a movement

to raise the minimum wage, at both the national

and state levels. Some West Coast cities have

already voted to boost their minimum wage to

$15, or more than double the federal standard.

And Los Angeles is now considering a similarly

aggressive move.

The labor market problems that these higher

minimum wages are intended to fix are very

real. But would a higher wage floor address the

underlying problems? A large body of research

shows that the answer is almost certainly no,

and that there are better solutions, although

they are harder for policymakers to embrace.

There are several reasons why workers’ wages

are currently too low to provide what many view

as an acceptable standard of living. One big fac-

tor is that technological changes have increased

the value of higher-skilled work and reduced the

value of lower-skilled work. Globalization, mean-

while, has brought many lower-skilled American

workers into greater competition with their coun-

terparts in other countries.

Simply requiring employers to pay $15 won’t

provide much ballast against these market

forces. In fact, data indicate that minimum

wages are ineffective at delivering benefits to

poor or low-income families, and that many of

the benefits flow to higher-income families.

That’s because minimum wages target low

wages rather than low family incomes. And

many minimum-wage workers are not poor or

even in low-income families; nearly a quarter

are teenagers who will eventually find bet-

ter-paid jobs. Moreover, most poor families have

no workers at all.

As a result, for every $5 in higher wages

that a higher minimum imposes on employers,

only about $1 goes to poor families, whereas

roughly twice as much goes to families with

incomes above the median.

Higher minimum wages also reduce employ-

ment for the least-skilled workers. Certainly not

every one of the hundreds of studies on the topic

confirms this conclusion. But there are also

studies claiming that humans have not contrib-

uted to climate change, and that supply-side

economics did not contribute to massive bud-

get deficits. The most comprehensive survey of

minimum wage studies, which I conducted with

William Wascher of the Federal Reserve System,

found that two-thirds of studies point to nega-

tive employment effects, as do over 80% of the

more credible studies.

Yet another reason to be wary of raising the

minimum wage is that modest job loss over-

all may mask much steeper job loss among

the least skilled. Economists use the phrase

“labor-labor substitution” to describe employ-

ers responding to a higher minimum wage by

replacing their lowest-skilled workers with high-

er-skilled workers, whom they are more willing

to hire at the higher minimum.

Based on my research, I think it is likely that

a $15 minimum wage in Los Angeles will lead

Should the minimum wage be raised to $15 an hour?

IN THE NEWS

591CHAPTER 28 UNEMPLOYMENT

Minimum-wage workers are more likely to be working part-time. Among part-time workers (those who usually work less than 35 hours per week), 10 percent were paid the minimum wage or less, compared to 2 percent of full-time workers. The industry with the highest proportion of workers with reported hourly wages at or below the minimum wage was leisure and hospitality (18 percent). Over half of all workers paid at or below the minimum wage were employed in this industry, primarily in food services and drinking establishments. For many of these workers, tips supplement the hourly wages received. The proportion of hourly paid workers earning the prevailing federal minimum wage or less has changed substantially over time. It trended downward from 13 percent in 1979, when data collection first began on a regular basis, to 2 percent in 2006. It then increased to 4 percent in 2014. This recent increase is in part attributable to a legislated increase in the minimum wage from $5.15 per hour in 2006 to $7.25 per hour in 2014. ●

some teenagers currently focused on their edu-

cation to take part-time jobs at the new, higher

minimum, and displace low-skilled workers

from the jobs they now hold. That seems like a

bad outcome.

If we really want to help low-skilled workers,

we need to recognize that the solutions that

actually work are expensive, difficult to achieve

or both.

Guaranteeing a minimally acceptable

standard of living for those who work entails

redistribution of some kind. Minimum wage is

one form of redistribution — although we don’t

always think of it as such — but it’s a blunt

instrument. Using the tax system is clearly better.

T h e E a r n e d I n c o m e Ta x C r e d i t , f o r

instance, targets low-income families very

well. Research establishes that it provides

generous government subsidies to these fam-

ilies’ labor market earnings and that it leads

more people to work, which probably explains

its bipartisan support.

Some decry the EITC as “corporate welfare,”

because the labor market entry it encourages

pushes down market wages. But that is pre-

cisely why it increases employment. If it did

not lower wages, employers would not hire

additional workers, and those not hired would

be more dependent on public programs.

Of course we could still do more. We could

make the EITC more generous, including

increasing it for those without children who

a r e e l i g i b l e

o n l y f o r m i n u s -

c u l e p a y m e n t s .

M o r e r a d i c a l l y,

w e m i g h t c o n -

sider whether all

low-income fam-

ilies, irrespective

o f e m p l o y m e n t ,

s h o u l d r e c e i v e

m o r e g e n e r a l

income support in

the form of direct

c a s h p a y m e n t s .

One might think

of these payments

as a “public dividend” from the extraordinary

productivity of the U.S. economy, which has

permitted those at the top to earn dramatically

increasing salaries while incomes at the bottom

have stagnated.

These alternative policies would have

to be financed by higher taxes, but that’s a

good thing. Redistribution through taxes is

paid for by those with the highest incomes.

In contrast, higher minimum wages are paid

for by those who happen to own businesses

in low-wage industries, and the consumers of

the products of those industries, who are more

likely to be poor.

Progressives who want to help low-income

families by pushing for higher minimum wages

would do better to channel their energy toward

methods of redistribution that do less to harm

the least-skilled, and more to help them.

And assuming that something is going to

change in response to stagnating incomes, con-

servatives may be happier with the consequences

of well-designed redistribution policies than the

kind of high minimum wage floor Los Angeles is

contemplating. For now, redistribution is a dead

letter that provokes anguished cries of “social-

ism.” But it doesn’t have to be. ■

David Neumark is Chancellor’s Professor of

Economics at University of California at Irvine.

Source: Los Angeles Times, May 15, 2015.

LY N

N E

SL A

D KY

/A P

IM A

G ES

592 PART IX THE REAL ECONOMY IN THE LONG RUN

28-4 Unions and Collective Bargaining A union is a worker association that bargains with employers over wages, ben- efits, and working conditions. Only 11 percent of U.S. workers now belong to unions, but unions played a much larger role in the U.S. labor market in the past. In the 1940s and 1950s, when union membership was at its peak, about a third of the U.S. labor force was unionized.

Moreover, for a variety of historical reasons, unions continue to play a large role in many European countries. In Belgium, Norway, and Sweden, for instance, more than half of workers belong to unions. In France and Germany, a majority of work- ers have wages set by collective bargaining by law, even though only some of these workers are themselves union members. In these cases, wages are not determined by the equilibrium of supply and demand in competitive labor markets.

28-4a The Economics of Unions A union is a type of cartel. Like any cartel, a union is a group of sellers acting together in the hope of exerting their joint market power. Most workers in the U.S. economy discuss their wages, benefits, and working conditions with their employers as individuals. By contrast, workers in a union do so as a group. The process by which unions and firms agree on the terms of employment is called collective bargaining.

When a union bargains with a firm, it asks for higher wages, better benefits, and better working conditions than the firm would offer in the absence of a union. If the union and the firm do not reach agreement, the union can organize a with- drawal of labor from the firm, called a strike. Because a strike reduces production, sales, and profit, a firm facing a strike threat is likely to agree to pay higher wages than it otherwise would. Economists who study the effects of unions typically find that union workers earn about 10 to 20 percent more than similar workers who do not belong to unions.

When a union raises the wage above the equilibrium level, it raises the quan- tity of labor supplied and reduces the quantity of labor demanded, resulting in unemployment. Workers who remain employed at the higher wage are better off, but those who were previously employed and are now unemployed are worse off. Indeed, unions are often thought to cause conflict between different groups of workers—between the insiders who benefit from high union wages and the outsiders who do not get the union jobs.

The outsiders can respond to their status in one of two ways. Some of them remain unemployed and wait for the chance to become insiders and earn the high union wage. Others take jobs in firms that are not unionized. Thus, when unions raise wages in one part of the economy, the supply of labor increases in other parts of the economy. This increase in labor supply, in turn, reduces wages in industries that are not unionized. In other words, workers in unions reap the benefit of collective bargaining, while workers not in unions bear some of the cost.

The role of unions in the economy depends in part on the laws that govern union organization and collective bargaining. Normally, explicit agreements among members of a cartel are illegal. When firms selling similar products agree to set high prices, the agreement is considered a “conspiracy in restraint of trade,” and the government prosecutes the firms in civil and criminal court for violating the antitrust laws. By contrast, unions are exempt from these laws. The policy- makers who wrote the antitrust laws believed that workers needed greater market power as they bargained with employers. Indeed, various laws are designed to

union

a worker association that

bargains with employers

over wages, benefits, and

working conditions

collective bargaining

the process by which

unions and firms agree on

the terms of employment

strike

the organized withdrawal

of labor from a firm by a

union

593CHAPTER 28 UNEMPLOYMENT

encourage the formation of unions. In particular, the Wagner Act of 1935 prevents employers from interfering when workers try to organize unions and requires employers to bargain with unions in good faith. The National Labor Relations Board (NLRB) is the government agency that enforces workers’ right to unionize.

Legislation affecting the market power of unions is a perennial topic of political debate. State lawmakers sometimes debate right-to-work laws, which give workers in a unionized firm the right to choose whether to join the union. In the absence of such laws, unions can insist during collective bargaining that firms make union membership a requirement for employment. At times, lawmakers in Washington have debated a proposed law that would prevent firms from hiring permanent replacements for workers who are on strike. This law would make strikes more costly for firms, thereby increasing the market power of unions. These and similar policy decisions will help determine the future of the union movement.

28-4b Are Unions Good or Bad for the Economy? Economists disagree about whether unions are good or bad for the economy as a whole. Let’s consider both sides of the debate.

Critics argue that unions are merely a type of cartel. When unions raise wages above the level that would prevail in competitive markets, they reduce the quan- tity of labor demanded, cause some workers to be unemployed, and reduce the wages in the rest of the economy. The resulting allocation of labor is, critics argue, both inefficient and inequitable. It is inefficient because high union wages reduce employment in unionized firms below the efficient, competitive level. It is inequi- table because some workers benefit at the expense of other workers.

Advocates contend that unions are a necessary antidote to the market power of the firms that hire workers. The extreme case of this market power is the “com- pany town,” where a single firm does most of the hiring in a geographical region. In a company town, if workers do not accept the wages and working conditions that the firm offers, they have little choice but to move or stop working. In the absence of a union, therefore, the firm could use its market power to pay lower wages and offer worse working conditions than would prevail if it had to com- pete with other firms for the same workers. In this case, a union may balance the firm’s market power and protect the workers from being at the mercy of the firm’s owners.

Advocates of unions also claim that unions are important for helping firms respond efficiently to workers’ concerns. Whenever a worker takes a job, the worker and the firm must agree on many attributes of the job in addition to the wage: hours of work, overtime, vacations, sick leave, health benefits, promotion schedules, job security, and so on. By representing workers’ views on these issues, unions allow firms to provide the right mix of job attributes. Even if unions have the adverse effect of pushing wages above the equilibrium level and causing unemployment, they have the benefit of helping firms keep a happy and produc- tive workforce.

In the end, there is no consensus among economists about whether unions are good or bad for the economy. Like many institutions, their influence is probably beneficial in some circumstances and adverse in others.

QuickQuiz How does a union in the auto industry affect wages and employment at

General Motors and Ford? How does it affect wages and employment in

other industries?

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“Gentlemen, nothing stands in the way of a final accord except that management wants profit maximization and the union wants more moola.”

594 PART IX THE REAL ECONOMY IN THE LONG RUN

28-5 The Theory of Efficiency Wages A fourth reason economies always experience some unemployment—in addition to job search, minimum-wage laws, and unions—is suggested by the theory of efficiency wages. According to this theory, firms operate more efficiently if wages are above the equilibrium level. Therefore, it may be profitable for firms to keep wages high even in the presence of a surplus of labor.

In some ways, the unemployment that arises from efficiency wages is similar to the unemployment that arises from minimum-wage laws and unions. In all three cases, unemployment is the result of wages above the level that balances the quantity of labor supplied and the quantity of labor demanded. Yet there is also an important difference. Minimum-wage laws and unions prevent firms from lowering wages in the presence of a surplus of workers. Efficiency-wage theory states that such a constraint on firms is unnecessary in many cases because firms may be better off keeping wages above the equilibrium level.

Why should firms want to keep wages high? This decision may seem odd at first, for wages are a large part of firms’ costs. Normally, we expect profit-maxi- mizing firms to want to keep costs—and therefore wages—as low as possible. The novel insight of efficiency-wage theory is that paying high wages might be profit- able because they might raise the efficiency of a firm’s workers.

There are several types of efficiency-wage theory. Each type suggests a differ- ent explanation for why firms may want to pay high wages. Let’s now consider four of these types.

28-5a Worker Health The first and simplest type of efficiency-wage theory emphasizes the link between wages and worker health. Better-paid workers eat a more nutritious diet, and workers who eat a better diet are healthier and more productive. A firm may find it more profitable to pay high wages and have healthy, productive workers than to pay lower wages and have less healthy, less productive workers.

This type of efficiency-wage theory can be relevant for explaining unemploy- ment in less developed countries where inadequate nutrition can be a problem. In these countries, firms may fear that cutting wages would, in fact, adversely influence their workers’ health and productivity. In other words, nutrition concerns may explain why firms maintain above-equilibrium wages despite a surplus of labor. Worker health concerns are far less relevant for firms in rich countries such as the United States, where the equilibrium wages for most work- ers are well above the level needed for an adequate diet.

28-5b Worker Turnover A second type of efficiency-wage theory emphasizes the link between wages and worker turnover. Workers quit jobs for many reasons: to take jobs at other firms, to move to other parts of the country, to leave the labor force, and so on. The frequency with which they quit depends on the entire set of incentives they face, including the benefits of leaving and the benefits of staying. The more a firm pays its workers, the less often its workers will choose to leave. Thus, a firm can reduce turnover among its workers by paying them a high wage.

Why do firms care about turnover? The reason is that it is costly for firms to hire and train new workers. Moreover, even after they are trained, newly hired workers are not as productive as experienced ones. Firms with higher turnover,

efficiency wages

above-equilibrium wages

paid by firms to increase

worker productivity

595CHAPTER 28 UNEMPLOYMENT

therefore, will tend to have higher production costs. Firms may find it profitable to pay wages above the equilibrium level to reduce worker turnover.

28-5c Worker Quality A third type of efficiency-wage theory emphasizes the link between wages and worker quality. All firms want workers who are talented, and they strive to pick the best applicants to fill job openings. But because firms cannot perfectly gauge the quality of applicants, hiring has a degree of randomness to it. When a firm pays a high wage, it attracts a better pool of workers to apply for its jobs and thereby increases the quality of its workforce. If the firm responded to a surplus of labor by reducing the wage, the most competent applicants—who are more likely to have better alternative opportunities than less competent applicants— may choose not to apply. If this influence of the wage on worker quality is strong enough, it may be profitable for the firm to pay a wage above the level that bal- ances supply and demand.

28-5d Worker Effort A fourth and final type of efficiency-wage theory emphasizes the link between wages and worker effort. In many jobs, workers have some discretion over how hard to work. As a result, firms monitor the efforts of their workers, and workers caught shirking their responsibilities are fired. But because monitoring is costly and imperfect, not all shirkers are caught immediately. A firm in such a circum- stance is always looking for ways to deter shirking.

One solution is paying wages above the equilibrium level. High wages make workers more eager to keep their jobs and thus motivate them to put forward their best effort. If the wage were at the level that balanced supply and demand, workers would have less reason to work hard because if they were fired, they could quickly find new jobs at the same wage. Therefore, firms may raise wages above the equi- librium level to provide an incentive for workers not to shirk their responsibilities.

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CASE STUDY

HENRY FORD AND THE VERY GENEROUS $5-A-DAY WAGE Henry Ford was an industrial visionary. As founder of the Ford Motor Company, he was responsible for introducing modern tech- niques of production. Rather than building cars with small teams of

skilled craftsmen, Ford built cars on assembly lines in which unskilled workers were taught to perform the same simple tasks over and over again. The output of this assembly process was the Model T Ford, one of the most famous early automobiles.

596 PART IX THE REAL ECONOMY IN THE LONG RUN

In 1914, Ford introduced another innovation: the $5 workday. This might not seem like much today, but back then $5 was about twice the going wage. It was also far above the wage that balanced supply and demand. When the new $5-a-day wage was announced, long lines of job seekers formed outside the Ford factories. The number of workers willing to work at this wage far exceeded the number of workers Ford needed.

Ford’s high-wage policy had many of the effects predicted by efficiency-wage theory. Turnover fell, absenteeism fell, and productivity rose. Workers were so much more efficient that Ford’s production costs were lower despite higher wages. Thus, paying a wage above the equilibrium level was profitable for the firm. An historian of the early Ford Motor Company wrote, “Ford and his associates freely declared on many occasions that the high-wage policy turned out to be good busi- ness. By this they meant that it had improved the discipline of the workers, given them a more loyal interest in the institution, and raised their personal efficiency.” Henry Ford himself called the $5-a-day wage “one of the finest cost-cutting moves we ever made.”

Why did it take a Henry Ford to introduce this efficiency wage? Why were other firms not already taking advantage of this seemingly profitable business strategy? According to some analysts, Ford’s decision was closely linked to his use of the assembly line. Workers organized in an assembly line are highly interdependent. If one worker is absent or works slowly, other workers are less able to complete their own tasks. Thus, while assembly lines made production more efficient, they also raised the importance of low worker turnover, high worker effort, and high worker quality. As a result, paying efficiency wages may have been a better strategy for the Ford Motor Company than for other businesses at the time. ●

QuickQuiz Give four explanations for why firms might find it profitable to pay wages

above the level that balances quantity of labor supplied and quantity of

labor demanded.

28-6 Conclusion In this chapter, we discussed the measurement of unemployment and the rea- sons economies always experience some degree of unemployment. We have seen how job search, minimum-wage laws, unions, and efficiency wages can all help explain why some workers do not have jobs. Which of these four explanations for the natural rate of unemployment are the most important for the U.S. economy and other economies around the world? Unfortunately, there is no easy way to tell. Economists differ in which of these explanations of unemployment they con- sider most important.

The analysis in this chapter yields an important lesson: Although the economy will always have some unemployment, its natural rate does change over time. Many events and policies can alter the amount of unemployment the economy typically experiences. As the information revolution changes the process of job search, as Congress and state legislatures adjust the minimum wage, as workers form or quit unions, and as firms change their reliance on efficiency wages, the natural rate of unemployment evolves. Unemployment is not a simple problem with a simple solution. But how we choose to organize our society can profoundly influence how prevalent a problem it is.

597CHAPTER 28 UNEMPLOYMENT

1. The population of Ectenia is 100 people: 40 work

full-time, 20 work half-time but would prefer to work

full-time, 10 are looking for a job, 10 would like to

work but are so discouraged they have given up look-

ing, 10 are not interested in working because they

are full-time students, and 10 are retired. What is the

number of unemployed?

a. 10

b. 20

c. 30

d. 40

2. Using the numbers in the preceding question, what is

the size of Ectenia’s labor force?

a. 50

b. 60

c. 70

d. 80

3. The main policy goal of the unemployment insurance

system is to reduce the

a. search effort of the unemployed.

b. income uncertainty that workers face.

c. role of unions in wage setting.

d. amount of frictional unemployment.

4. In a competitive labor market, when the government

increases the minimum wage, the result is a(n)

__________ in the quantity of labor supplied and a(n)

__________ in the quantity of labor demanded.

a. increase, increase

b. increase, decrease

c. decrease, increase

d. decrease, decrease

5. Unionized workers are paid about _____ percent more

than similar nonunion workers.

a. 2

b. 5

c. 15

d. 40

6. According to the theory of efficiency wages,

a. firms may find it profitable to pay above-

equilibrium wages.

b. an excess supply of labor puts downward pressure

on wages.

c. sectoral shifts are the main source of frictional

unemployment.

d. right-to-work laws reduce the bargaining power of

unions.

CHAPTER QuickQuiz

The unemployment rate is the percentage of those who

would like to work who do not have jobs. The Bureau

of Labor Statistics calculates this statistic monthly

based on a survey of thousands of households.

The unemployment rate is an imperfect measure of

joblessness. Some people who call themselves unem-

ployed may actually not want to work, and some peo-

ple who would like to work have left the labor force

after an unsuccessful search and therefore are not

counted as unemployed.

In the U.S. economy, most people who become unem-

ployed find work within a short period of time. None-

theless, most unemployment observed at any given

time is attributable to the few people who are unem-

ployed for long periods of time.

One reason for unemployment is the time it takes

workers to search for jobs that best suit their tastes and

skills. This frictional unemployment is increased as a

result of unemployment insurance, a government pol-

icy designed to protect workers’ incomes.

A second reason our economy always has some

unemployment is minimum-wage laws. By raising the

wage of unskilled and inexperienced workers above

the equilibrium level, minimum-wage laws raise the

quantity of labor supplied and reduce the quantity

demanded. The resulting surplus of labor represents

unemployment.

A third reason for unemployment is the market power

of unions. When unions push the wages in unionized

industries above the equilibrium level, they create a

surplus of labor.

A fourth reason for unemployment is suggested by the

theory of efficiency wages. According to this theory,

firms find it profitable to pay wages above the equi-

librium level. High wages can improve worker health,

lower worker turnover, raise worker quality, and

increase worker effort.

SUMMARY

598 PART IX THE REAL ECONOMY IN THE LONG RUN

labor force, p. 579

unemployment rate, p. 579

labor-force participation rate, p. 580

natural rate of unemployment, p. 581

cyclical unemployment, p. 581

discouraged workers, p. 583

frictional unemployment, p. 585

structural unemployment, p. 585

job search, p. 586

unemployment insurance, p. 587

union, p. 592

collective bargaining, p. 592

strike, p. 592

efficiency wages, p. 594

1. What are the three categories into which the Bureau of

Labor Statistics divides everyone? How does the BLS

compute the labor force, the unemployment rate, and

the labor-force participation rate?

2. Is unemployment typically short-term or long-term?

Explain.

3. Why is frictional unemployment inevitable? How

might the government reduce the amount of frictional

unemployment?

4. Are minimum-wage laws a better explanation for

structural unemployment among teenagers or among

college graduates? Why?

5. How do unions affect the natural rate of

unemployment?

6. What claims do advocates of unions make to argue

that unions are good for the economy?

7. Explain four ways in which a firm might increase its

profits by raising the wages it pays.

1. In June 2009, at the trough of the Great Recession, the

Bureau of Labor Statistics announced that of all adult

Americans, 140,196,000 were employed, 14,729,000

were unemployed, and 80,729,000 were not in the

labor force. Use this information to calculate:

a. the adult population

b. the labor force

c. the labor-force participation rate

d. the unemployment rate

2. Explain whether each of the following events

increases, decreases, or has no effect on the unemploy-

ment rate and the labor-force participation rate.

a. After a long search, Jon finds a job.

b. Tyrion, a full-time college student, graduates and

is immediately employed.

c. After an unsuccessful job search, Arya gives up

looking and retires.

d. Daenerys quits her job to become a stay-at-home

mom.

e. Sansa has a birthday, becomes an adult, but has no

interest in working.

f. Jaime has a birthday, becomes an adult, and starts

looking for a job.

g. Cersei dies while enjoying retirement.

h. Jorah dies working long hours at the office.

3. Go to the website of the Bureau of Labor Statistics

(http://www.bls.gov). What is the national unem-

ployment rate right now? Find the unemployment

rate for the demographic group that best fits a descrip-

tion of you (for example, based on age, sex, and race).

Is it higher or lower than the national average? Why

do you think this is so?

4. Between January 2010 and January 2016, U.S.

employment increased by 12.1 million workers, but

the number of unemployed workers declined by only

7.3 million. How are these numbers consistent with

each other? Why might one expect a reduction in the

number of people counted as unemployed to be smaller

than the increase in the number of people employed?

5. Economists use labor-market data to evaluate how

well an economy is using its most valuable resource—

its people. Two closely watched statistics are the

unemployment rate and the employment–population

ratio (calculated as the percentage of the adult popula-

tion that is employed). Explain what happens to each

of these in the following scenarios. In your opinion,

KEY CONCEPTS

QUESTIONS FOR REVIEW

d h l

PROBLEMS AND APPLICATIONS

599CHAPTER 28 UNEMPLOYMENT

which statistic is the more meaningful gauge of how

well the economy is doing?

a. An auto company goes bankrupt and lays off its

workers, who immediately start looking for new

jobs.

b. After an unsuccessful search, some of the laid-off

workers quit looking for new jobs.

c. Numerous students graduate from college but

cannot find work.

d. Numerous students graduate from college and

immediately begin new jobs.

e. A stock market boom induces newly enriched

60-year-old workers to take early retirement.

f. Advances in healthcare prolong the life of many

retirees.

6. Are the following workers more likely to experience

short-term or long-term unemployment? Explain.

a. a construction worker who is laid off because of

bad weather

b. a manufacturing worker who loses his job at a

plant in an isolated area

c. a stagecoach-industry worker who is laid off

because of competition from railroads

d. a short-order cook who loses his job when a new

restaurant opens across the street

e. an expert welder with little formal education who

loses his job when the company installs automatic

welding machinery

7. Using a diagram of the labor market, show the effect

of an increase in the minimum wage on the wage

paid to workers, the number of workers supplied, the

number of workers demanded, and the amount of

unemployment.

8. Consider an economy with two labor markets—one

for manufacturing workers and one for service work-

ers. Suppose initially that neither is unionized.

a. If manufacturing workers formed a union, what

impact would you predict on the wages and em-

ployment in manufacturing?

b. How would these changes in the manufacturing

labor market affect the supply of labor in the

market for service workers? What would happen

to the equilibrium wage and employment in this

labor market?

9. Structural unemployment is sometimes said to result

from a mismatch between the job skills that employers

want and the job skills that workers have. To explore

this idea, consider an economy with two industries:

auto manufacturing and aircraft manufacturing.

a. If workers in these two industries require similar

amounts of training, and if workers at the begin-

ning of their careers can choose which industry to

train for, what would you expect to happen to the

wages in these two industries? How long would

this process take? Explain.

b. Suppose that one day the economy opens itself to

international trade and, as a result, starts

importing autos and exporting aircraft. What

would happen to the demand for labor in these

two industries?

c. Suppose that workers in one industry cannot be

quickly retrained for the other. How would these

shifts in demand affect equilibrium wages both in

the short run and in the long run?

d. If for some reason wages fail to adjust to the new

equilibrium levels, what would occur?

10. Suppose that Congress passes a law requiring

employers to provide employees some benefit (such as

healthcare) that raises the cost of an employee by

$4 per hour.

a. What effect does this employer mandate have

on the demand for labor? (In answering this and

the following questions, be quantitative when

you can.)

b. If employees place a value on this benefit exactly

equal to its cost, what effect does this employer

mandate have on the supply of labor?

c. If the wage can freely adjust to balance supply

and demand, how does this law affect the wage

and the level of employment? Are employers

better or worse off? Are employees better or

worse off?

d. Suppose that, before the mandate, the wage in this

market was $3 above the minimum wage. In this

case, how does the employer mandate affect the

wage, the level of employment, and the level of

unemployment?

e. Now suppose that workers do not value the

mandated benefit at all. How does this alternative

assumption change your answers to parts (b)

and (c)?

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

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Money and Prices in the Long Run

PART X

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CHAPTER

29The Monetary System

W hen you walk into a restaurant to buy a meal, you get something of value—a full stomach. To pay for this service, you might hand the restaurateur several worn-out pieces of greenish paper decorated with strange symbols,

government buildings, and the portraits of famous dead Americans. Or you might hand her a single piece of paper with the name of a bank and your signature. Or you might show her a plastic card and sign a paper slip. Whether you pay by cash, check, or debit card, the restaurateur is happy to work hard to satisfy your gastronomical desires in exchange for these pieces of paper, which, in and of themselves, are worthless.

Anyone who has lived in a modern economy is familiar with this social custom. Even though paper money has no intrinsic value, the restaurateur is confident

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604 PART X MONEY AND PRICES IN THE LONG RUN

that, in the future, some third person will accept it in exchange for something that the restaurateur does value. And that third person is confident that some fourth person will accept the money, with the knowledge that yet a fifth person will accept the money . . . and so on. To the restaurateur and to other people in our society, your cash, check, or debit card receipt represents a claim to goods and services in the future.

The social custom of using money for transactions is extraordinarily useful in a large, complex society. Imagine, for a moment, that there was no item in the econ- omy widely accepted in exchange for goods and services. People would have to rely on barter—the exchange of one good or service for another—to obtain the things they need. To get your restaurant meal, for instance, you would have to offer the restaurateur something of immediate value. You could offer to wash some dishes, mow her lawn, or give her your family’s secret recipe for meat loaf. An economy that relies on barter will have trouble allocating its scarce resources efficiently. In such an economy, trade is said to require the double coincidence of wants—the unlikely occurrence that two people each have a good or service that the other wants.

The existence of money makes trade easier. The restaurateur does not care whether you can produce a valuable good or service for her. She is happy to accept your money, knowing that other people will do the same for her. Such a convention allows trade to be roundabout. The restaurateur accepts your money and uses it to pay her chef; the chef uses her paycheck to send her child to day care; the day care center uses this tuition to pay a teacher; and the teacher hires you to mow her lawn. As money flows from person to person in the economy, it facilitates production and trade, thereby allowing each person to specialize in what she does best and raising everyone’s standard of living.

In this chapter, we begin to examine the role of money in the economy. We discuss what money is, the various forms that money takes, how the banking sys- tem helps create money, and how the government controls the quantity of money in circulation. Because money is so important in the economy, we devote much effort in the rest of this book to learning how changes in the quantity of money affect various economic variables, including inflation, interest rates, produc- tion, and employment. Consistent with our long-run focus in the previous four chapters, in the next chapter we examine the long-run effects of changes in the quantity of money. The short-run effects of monetary changes are a more complex topic, which we take up later in the book. This chapter provides the background for all of this further analysis.

29-1 The Meaning of Money What is money? This might seem like an odd question. When you read that billionaire Mark Zuckerberg has a lot of money, you know what that means: He is so rich that he can buy almost anything he wants. In this sense, the term money is used to mean wealth.

Economists, however, use the word in a more specific sense: Money is the set of assets in the economy that people regularly use to buy goods and services from each other. The cash in your wallet is money because you can use it to buy a meal at a restaurant or a shirt at a store. By contrast, if you happened to own a large share of Facebook, as Mark Zuckerberg does, you would be wealthy, but this asset is not considered a form of money. You could not buy a meal or a shirt with this wealth without first obtaining some cash. According to the economist’s definition, money includes only those few types of wealth that are regularly accepted by sellers in exchange for goods and services.

money

the set of assets in an

economy that people

regularly use to buy goods

and services from other

people

605CHAPTER 29 THE MONETARY SYSTEM

29-1a The Functions of Money Money has three functions in the economy: It is a medium of exchange, a unit of account, and a store of value. These three functions together distinguish money from other assets in the economy, such as stocks, bonds, real estate, art, and even baseball cards. Let’s examine each of these functions of money.

A medium of exchange is an item that buyers give to sellers when they purchase goods and services. When you go to a store to buy a shirt, the store gives you the shirt and you give the store your money. This transfer of money from buyer to seller allows the transaction to take place. When you walk into a store, you are confident that the store will accept your money for the items it is selling because money is the commonly accepted medium of exchange.

A unit of account is the yardstick people use to post prices and record debts. When you go shopping, you might observe that a shirt costs $50 and a hamburger costs $5. Even though it would be accurate to say that the price of a shirt is 10 hamburgers and the price of a hamburger is 1/10 of a shirt, prices are never quoted in this way. Similarly, if you take out a loan from a bank, the size of your future loan repayments will be measured in dollars, not in a quantity of goods and services. When we want to measure and record economic value, we use money as the unit of account.

A store of value is an item that people can use to transfer purchasing power from the present to the future. When a seller accepts money today in exchange for a good or service, that seller can hold the money and become a buyer of another good or service at another time. Money is not the only store of value in the economy: A person can also transfer purchasing power from the present to the future by holding nonmonetary assets such as stocks and bonds. The term wealth is used to refer to the total of all stores of value, including both money and nonmonetary assets.

Economists use the term liquidity to describe the ease with which an asset can be converted into the economy’s medium of exchange. Because money is the economy’s medium of exchange, it is the most liquid asset available. Other assets vary widely in their liquidity. Most stocks and bonds can be sold easily with small cost, so they are relatively liquid assets. By contrast, selling a house, a Rembrandt painting, or a 1948 Joe DiMaggio baseball card requires more time and effort, so these assets are less liquid.

When people decide how to allocate their wealth, they have to balance the liquidity of each possible asset against the asset’s usefulness as a store of value. Money is the most liquid asset, but it is far from perfect as a store of value. When prices rise, the value of money falls. In other words, when goods and services become more expensive, each dollar in your wallet can buy less. This link between the price level and the value of money is key to understanding how money affects the economy, a topic we start to explore in the next chapter.

29-1b The Kinds of Money When money takes the form of a commodity with intrinsic value, it is called commodity money. The term intrinsic value means that the item would have value even if it were not used as money. One example of commodity money is gold. Gold has intrinsic value because it is used in industry and in the making of jewelry. Although today we no longer use gold as money, historically gold was a common form of money because it is relatively easy to carry, measure, and verify for impurities. When an economy uses gold as money (or uses paper money that is convertible into gold on demand), it is said to be operating under a gold standard.

medium of exchange

an item that buyers give

to sellers when they want

to purchase goods and

services

unit of account

the yardstick people use

to post prices and record

debts

store of value

an item that people can

use to transfer purchasing

power from the present to

the future

liquidity

the ease with which an

asset can be converted

into the economy’s

medium of exchange

commodity money

money that takes the

form of a commodity with

intrinsic value

606 PART X MONEY AND PRICES IN THE LONG RUN

Another example of commodity money is cigarettes. In prisoner-of-war camps during World War II, prisoners traded goods and services with one another using cigarettes as the store of value, unit of account, and medium of exchange. Similarly, as the Soviet Union was breaking up in the late 1980s, cigarettes started replacing the ruble as the preferred currency in Moscow. In both cases, even nonsmokers were happy to accept cigarettes in an exchange, knowing that they could use the cigarettes to buy other goods and services.

Money without intrinsic value is called fiat money. A fiat is an order or decree, and fiat money is established as money by government decree. For example, compare the paper dollars in your wallet (printed by the U.S. government) and the paper dollars from a game of Monopoly (printed by the Parker Brothers game company). Why can you use the first to pay your bill at a restaurant but not the second? The answer is that the U.S. government has decreed its dollars to be valid money. Each paper dollar in your wallet reads: “This note is legal tender for all debts, public and private.”

Although the government is central to establishing and regulating a system of fiat money (by prosecuting counterfeiters, for example), other factors are also required for the success of such a monetary system. To a large extent, the acceptance of fiat money depends as much on expectations and social convention as on government decree. The Soviet government in the 1980s never abandoned the ruble as the official currency. Yet the people of Moscow preferred to accept cigarettes (or even American dollars) in exchange for goods and services because they were more confident that these alternative monies would be accepted by others in the future.

fiat money

money without intrinsic

value that is used as

money by government

decree

For many centuries, when societies have

used a form of commodity money, the

most common choice has been the gold

standard. This outcome may have a

sound scientific basis.

A Chemist Explains Why

Gold Beat Out Lithium,

Osmium, Einsteinium...

By Jacob Goldstein and David Kestenbaum

T he periodic table lists 118 different chemical

elements. And yet, for thousands of years,

humans have really, really liked one of them in

particular: gold. Gold has been used as money

for millennia, and its price has been going

through the roof.

Why gold? Why not osmium, lithium, or

ruthenium?

We went to an expert to find out: Sanat

Kumar, a chemical engineer at Columbia

University. We asked him to take the periodic

table, and start eliminating anything that

wouldn’t work as money.

The periodic table looks kind of like a bingo

card. Each square has a different element in

it—one for carbon, another for gold, and so on.

Sanat starts with the far-right column of the

table. The elements there have a really appeal-

ing characteristic: They’re not going to change.

They’re chemically stable.

But there’s also a big drawback: They’re

gases. You could put all your gaseous money in

a jar, but if you opened the jar, you’d be broke.

So Sanat crosses out the right-hand column.

Then he swings over to the far left-hand col-

umn, and points to one of the elements there:

Lithium

“If you expose lithium to air, it will cause a

huge fire that can burn through concrete walls,”

he says.

Money that spontaneously bursts into flames

is clearly a bad idea. In fact, you don’t want your

money undergoing any kind of spontaneous chem-

ical reactions. And it turns out that a lot of the ele-

ments in the periodic table are pretty reactive.

Not all of them burst into flames. But some-

times they corrode, start to fall apart.

So Sanat crosses out another 38 elements,

because they’re too reactive.

Then we ask him about those two weird

rows at the bottom of the table. They’re always

Why Gold?

IN THE NEWS

607CHAPTER 29 THE MONETARY SYSTEM

29-1c Money in the U.S. Economy As we will see, the quantity of money circulating in the economy, called the money stock, has a powerful influence on many economic variables. But before we consider why that is true, we need to ask a preliminary question: What is the quantity of money? In particular, suppose you were given the task of measuring how much money there is in the U.S. economy. What would you include in your measure?

The most obvious asset to include is currency—the paper bills and coins in the hands of the public. Currency is clearly the most widely accepted medium of exchange in our economy. There is no doubt that it is part of the money stock.

Yet currency is not the only asset that you can use to buy goods and services. Many stores also accept personal checks. Wealth held in your checking account is almost as convenient for buying things as wealth held in your wallet. To measure the money stock, therefore, you might want to include demand deposits—balances in bank accounts that depositors can access on demand simply by writing a check or swiping a debit card at a store.

Once you start to consider balances in checking accounts as part of the money stock, you are led to consider the large variety of other accounts that people hold at banks and other financial institutions. Bank depositors usually cannot write checks against the balances in their savings accounts, but they can easily transfer funds from savings into checking accounts. In addition, depositors in money market mutual funds can often write checks against their balances. Thus, these other accounts should plausibly be part of the U.S. money stock.

currency

the paper bills and coins

in the hands of the public

demand deposits

balances in bank

accounts that depositors

can access on demand by

writing a check

broken out separately from the main table, and

they have some great names—promethium,

einsteinium.

But it turns out they’re radioactive—put some

einsteinium in your pocket, and a year later, you’ll

be dead.

So we’re down from 118 elements to 30,

and we’ve come up with a list of three key

requirements:

1. Not a gas.

2. Doesn’t corrode or burst into flames.

3. Doesn’t kill you.

Now Sanat adds a new requirement: You

want the thing you pick to be rare. This lets him

cross off a lot of the boxes near the top of the

table, because the elements clustered there

tend to be more abundant.

At the same time, you don’t want to pick an

element that’s too rare. So osmium—which appar-

ently comes to earth via meteorites—gets the axe.

That leaves us with just five elements: rho-

dium, palladium, silver, platinum and gold. And

all of them, as it happens, are considered pre-

cious metals.

But even here we can cross things out. Sil-

ver has been widely used as money, of course.

But it’s reactive—it tarnishes. So Sanat says

it’s not the best choice.

Early civilizations couldn’t have used rho-

dium or palladium, because they weren’t dis-

covered until the early 1800s.

That leaves platinum and gold, both of

which can be found in rivers and streams.

But if you were in the ancient world and

wanted to make platinum coins, you would have

needed some sort of magic furnace from the

future. The melting point for platinum is over

3,000 degrees Fahrenheit.

Gold happens to melt at a much lower tem-

perature, which made it much easier for pre-

industrial people to work with.

So we ask Sanat: If we could run the clock

back and start history again, could things go

a different way, or would gold emerge again as

the element of choice?

“For the earth, with every parameter we

have, gold is the sweet spot,” he says. “It would

come out no other way.” ■

report titled “A Chemist Explains Why Gold Beat Out Lithium,

Osmium, Einsteinium ...” by Jacob Goldstein and David Kes-

tenbaum was originally published on NPR.org on November

19, 2010, and is used with the permission of NPR. Any unau-

thorized duplication is strictly prohibited.

In Gold We Trust

FI KM

IK /S

H U

TT ER

ST O

608 PART X MONEY AND PRICES IN THE LONG RUN

In a complex economy such as ours, it is not easy to draw a line between assets that can be called “money” and assets that cannot. The coins in your pocket clearly are part of the money stock, and the Empire State Building clearly is not, but there are many assets in between these extremes for which the choice is less clear. Because different analysts can reasonably disagree about where to draw the dividing line between monetary and nonmonetary assets, various measures of the money stock are available for the U.S. economy. Figure 1 shows the two most commonly used, designated M1 and M2. M2 includes more assets in its measure of money than does M1.

For our purposes in this book, we need not dwell on the differences between the various measures of money. None of our discussion will hinge on the distinction between M1 and M2. The important point is that the money stock for the U.S. economy includes not only currency but also deposits in banks and other financial institutions that can be readily accessed and used to buy goods and services.

FIGURE 1

Two Measures of the Money Stock

for the U.S. Economy

The two most widely followed measures

of the money stock are M1 and M2.

This figure shows the size of each

measure in January 2016.

Source: Federal Reserve.

Billions of Dollars

$3,202

$12,467

CASE STUDY

WHERE IS ALL THE CURRENCY? One puzzle about the money stock of the U.S. economy concerns the amount of currency. In January 2016, there was $1.4 trillion of currency outstanding. To put this number in perspective, we can

divide it by 252 million, the number of adults (age 16 and older) in the United States. This calculation implies that the average adult holds over $5,500 of currency. Most people are surprised to learn that our economy has so much currency because they carry far less than this in their wallets.

Who is holding all this currency? No one knows for sure, but there are two plausible explanations.

The first explanation is that much of the currency is held abroad. In foreign countries without a stable monetary system, people often prefer U.S. dollars to domestic assets. Estimates suggest that over half of U.S. dollars circulate outside the United States.

The second explanation is that much of the currency is held by drug dealers, tax evaders, and other criminals. For most people in the U.S. economy, currency is not a particularly good way to hold wealth. Not only can currency be lost or stolen

609CHAPTER 29 THE MONETARY SYSTEM

Why Credit Cards Aren’t Money

I t might seem natural to include credit cards as part of the economy’s

stock of money. After all, people use credit cards to make many of their

purchases. Aren’t credit cards, therefore, a medium of exchange?

At first this argument may seem persuasive, but credit cards are

excluded from all measures of the quantity of money. The reason is that

credit cards are not really a method of payment but rather a method of

deferring payment. When you buy a meal with a credit card, the bank

that issued the card pays the restaurant what it is due. At a later date,

you will have to repay the bank (perhaps with interest). When the time

comes to pay your credit card bill, you will probably do so by writing

a check against your checking account. The balance in this checking

account is part of the economy’s stock of money.

Notice that credit cards are different from debit cards, which

automatically withdraw funds from a bank account to pay for items

bought. Rather than allowing the user to postpone payment for a

purchase, a debit card gives the user immediate access to deposits in

a bank account. In this

sense, a debit card is more

similar to a check than to

a credit card. The account

balances that lie behind

debit cards are included in

measures of the quantity of money.

Even though credit cards are not considered a form of money, they

are nonetheless important for analyzing the monetary system. People

who have credit cards can pay many of their bills together at the end of

the month, rather than sporadically as they make purchases. As a result,

people who have credit cards probably hold less money on average

than people who do not have credit cards. Thus, the introduction and

increased popularity of credit cards may reduce the amount of money

that people choose to hold. ■

F Y I

but it also does not earn interest, whereas a bank deposit does. Thus, most people hold only small amounts of currency. By contrast, criminals may avoid putting their wealth in banks because a bank deposit gives police a paper trail that they can use to trace illegal activities. For criminals, currency may be the best store of value available. ●

QuickQuiz List and describe the three functions of money.

29-2 The Federal Reserve System Whenever an economy uses a system of fiat money, as the U.S. economy does, some agency must be responsible for regulating the system. In the United States, that agency is the Federal Reserve, often simply called the Fed. If you look at the top of a dollar bill, you will see that it is called a “Federal Reserve Note.” The Fed is an example of a central bank—an institution designed to oversee the banking system and regulate the quantity of money in the economy. Other major central banks around the world include the Bank of England, the Bank of Japan, and the European Central Bank.

29-2a The Fed’s Organization The Federal Reserve was created in 1913 after a series of bank failures in 1907 convinced Congress that the United States needed a central bank to ensure the health of the nation’s banking system. Today, the Fed is run by its board of governors, which has seven members appointed by the president and confirmed by the Senate. The governors have 14-year terms. Just as federal judges are given

Federal Reserve (Fed)

the central bank of the

United States

central bank

an institution designed

to oversee the banking

system and regulate the

quantity of money in the

economy

610 PART X MONEY AND PRICES IN THE LONG RUN

lifetime appointments to insulate them from politics, Fed governors are given long terms to give them independence from short-term political pressures when they formulate monetary policy.

Among the seven members of the board of governors, the most important is the chair. The chair directs the Fed staff, presides over board meetings, and testifies regularly about Fed policy in front of congressional committees. The president appoints the chair to a 4-year term. As this book was going to press, the chair of the Fed was Janet Yellen, a former economics professor who was appointed to the Fed job by President Barack Obama in 2014.

The Federal Reserve System is made up of the Federal Reserve Board in Washington, D.C., and twelve regional Federal Reserve Banks located in major cities around the country. The presidents of the regional banks are chosen by each bank’s board of directors, whose members are typically drawn from the region’s banking and business community.

The Fed has two related jobs. The first is to regulate banks and ensure the health of the banking system. This task is largely the responsibility of the regional Federal Reserve Banks. In particular, the Fed monitors each bank’s financial condition and facilitates bank transactions by clearing checks. It also acts as a bank’s bank. That is, the Fed makes loans to banks when banks themselves want to borrow. When financially troubled banks find themselves short of cash, the Fed acts as a lender of last resort—a lender to those who cannot borrow anywhere else—to maintain stability in the overall banking system.

The Fed’s second and more important job is to control the quantity of money that is made available in the economy, called the money supply. Decisions by policymakers concerning the money supply constitute monetary policy. At the Federal Reserve, monetary policy is made by the Federal Open Market Committee (FOMC). The FOMC meets about every six weeks in Washington, D.C., to discuss the condition of the economy and consider changes in monetary policy.

29-2b The Federal Open Market Committee The Federal Open Market Committee is made up of the seven members of the board of governors and five of the twelve regional bank presidents. All twelve regional presidents attend each FOMC meeting, but only five get to vote. Voting rights rotate among the twelve regional presidents over time. The president of the New York Fed always gets a vote, however, because New York is the traditional financial center of the U.S. economy and because all Fed purchases and sales of government bonds are conducted at the New York Fed’s trading desk.

Through the decisions of the FOMC, the Fed has the power to increase or decrease the number of dollars in the economy. In simple metaphorical terms, you can imagine the Fed printing dollar bills and dropping them around the country by helicopter. Similarly, you can imagine the Fed using a giant vacuum cleaner to suck dollar bills out of people’s wallets. Although in practice the Fed’s methods for changing the money supply are more complex and subtle than this, the helicopter-vacuum metaphor is a good first step to understanding the meaning of monetary policy.

Later in this chapter, we discuss how the Fed actually changes the money supply, but it is worth noting here that the Fed’s primary tool is the open-market operation—the purchase and sale of U.S. government bonds. (Recall that a U.S.

money supply

the quantity of money

available in the economy

monetary policy

the setting of the money

supply by policymakers in

the central bank

611CHAPTER 29 THE MONETARY SYSTEM

government bond is a certificate of indebtedness of the federal government.) If the FOMC decides to increase the money supply, the Fed creates dollars and uses them to buy government bonds from the public in the nation’s bond markets. After the purchase, these dollars are in the hands of the public. Thus, an open- market purchase of bonds by the Fed increases the money supply. Conversely, if the FOMC decides to decrease the money supply, the Fed sells government bonds from its portfolio to the public in the nation’s bond markets. After the sale, the dollars the Fed receives for the bonds are out of the hands of the public. Thus, an open-market sale of bonds by the Fed decreases the money supply.

Central banks are important institutions because changes in the money supply can profoundly affect the economy. One of the Ten Principles of Economics introduced in Chapter 1 is that prices rise when the government prints too much money. Another of the Ten Principles of Economics is that society faces a short-run trade-off between inflation and unemployment. The power of the Fed rests on these principles. For reasons we discuss more fully in the coming chapters, the Fed’s policy decisions are key determinants of the economy’s rate of inflation in the long run and the economy’s employment and production in the short run. Indeed, the Fed’s chair has been called the second most powerful person in the United States.

QuickQuiz What are the primary responsibilities of the Federal Reserve? If the Fed

wants to increase the supply of money, how does it usually do so?

29-3 Banks and the Money Supply So far, we have introduced the concept of “money” and discussed how the Federal Reserve controls the supply of money by buying and selling government bonds in open-market operations. This explanation of the money supply is correct, but it is not complete. In particular, it omits the key role that banks play in the monetary system.

Recall that the amount of money you hold includes both currency (the bills in your wallet and coins in your pocket) and demand deposits (the balance in your checking account). Because demand deposits are held in banks, the behavior of banks can influence the quantity of demand deposits in the economy and, therefore, the money supply. This section examines how banks affect the money supply and, in doing so, how they complicate the Fed’s job of controlling the money supply.

29-3a The Simple Case of 100-Percent-Reserve Banking To see how banks influence the money supply, let’s first imagine a world without any banks at all. In this simple world, currency is the only form of money. To be concrete, let’s suppose that the total quantity of currency is $100. The supply of money is, therefore, $100.

Now suppose that someone opens a bank, appropriately called First National Bank. First National Bank is only a depository institution—that is, it accepts deposits but does not make loans. The purpose of the bank is to give depositors a safe place to keep their money. Whenever a person deposits some money,

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“I’ve heard a lot about money, and now I’d like to try some.”

612 PART X MONEY AND PRICES IN THE LONG RUN

the bank keeps the money in its vault until the depositor withdraws it, writes a check, or uses a debit card to access her balance. Deposits that banks have received but have not loaned out are called reserves. In this imaginary economy, all deposits are held as reserves, so this system is called 100-percent-reserve banking.

We can express the financial position of First National Bank with a T-account, which is a simplified accounting statement that shows changes in a bank’s assets and liabilities. Here is the T-account for First National Bank if the economy’s entire $100 of money is deposited in the bank:

First National Bank

Assets Liabilities

Reserves $100.00 Deposits $100.00

On the left side of the T-account are the bank’s assets of $100 (the reserves it holds in its vaults). On the right side are the bank’s liabilities of $100 (the amount it owes to its depositors). Because the assets and liabilities exactly balance, this accounting statement is called a balance sheet.

Now consider the money supply in this imaginary economy. Before First National Bank opens, the money supply is the $100 of currency that people are holding. After the bank opens and people deposit their currency, the money supply is the $100 of demand deposits. (There is no longer any currency outstanding, since it is all in the bank vault.) Each deposit in the bank reduces currency and raises demand deposits by exactly the same amount, leaving the money supply unchanged. Thus, if banks hold all deposits in reserve, banks do not influence the supply of money.

29-3b Money Creation with Fractional-Reserve Banking Eventually, the bankers at First National Bank may start to reconsider their policy of 100-percent-reserve banking. Leaving all that money idle in their vaults seems unnecessary. Why not lend some of it out and earn a profit by charging interest on the loans? Families buying houses, firms building new factories, and students paying for college would all be happy to pay interest to borrow some of that money for a while. First National Bank has to keep some reserves so that currency is available if depositors want to make withdrawals. But if the flow of new deposits is roughly the same as the flow of withdrawals, First National needs to keep only a fraction of its deposits in reserve. Thus, First National adopts a system called fractional-reserve banking.

The fraction of total deposits that a bank holds as reserves is called the reserve ratio. This ratio is influenced by both government regulation and bank policy. As we discuss more fully later in the chapter, the Fed sets a minimum amount of reserves that banks must hold, called a reserve requirement. In addition, banks may hold reserves above the legal minimum, called excess reserves, so they can be more confident that they will not run short of cash. For our purpose here, we take the reserve ratio as given to examine how fractional-reserve banking influences the money supply.

reserves

deposits that banks have

received but have not

loaned out

fractional-reserve banking

a banking system in

which banks hold only

a fraction of deposits as

reserves

reserve ratio

the fraction of deposits

that banks hold as

reserves

613CHAPTER 29 THE MONETARY SYSTEM

Let’s suppose that First National has a reserve ratio of 1/10, or 10 percent. This means that it keeps 10 percent of its deposits in reserve and loans out the rest. Now let’s look again at the bank’s T-account:

First National Bank

Assets Liabilities

Reserves $10.00 Deposits $100.00

Loans 90.00

First National still has $100 in liabilities because making the loans did not alter the bank’s obligation to its depositors. But now the bank has two kinds of assets: It has $10 of reserves in its vault, and it has loans of $90. (These loans are liabilities of the people borrowing from First National, but they are assets of the bank because the borrowers will later repay the loans.) In total, First National’s assets still equal its liabilities.

Once again consider the supply of money in the economy. Before First National makes any loans, the money supply is the $100 of deposits. Yet when First National lends out some of these deposits, the money supply increases. The depositors still have demand deposits totaling $100, but now the borrowers hold $90 in currency. The money supply (which equals currency plus demand deposits) equals $190. Thus, when banks hold only a fraction of deposits in reserve, the banking system creates money.

At first, this creation of money by fractional-reserve banking may seem too good to be true: It appears that the bank has created money out of thin air. To make this feat seem less miraculous, note that when First National Bank loans out some of its reserves and creates money, it does not create any wealth. Loans from First National give the borrowers some currency and thus the ability to buy goods and services. Yet the borrowers are also taking on debts, so the loans do not make them any richer. In other words, as a bank creates the asset of money, it also creates a corresponding liability for those who borrowed the created money. At the end of this process of money creation, the economy is more liquid in the sense that there is more of the medium of exchange, but the economy is no wealthier than before.

29-3c The Money Multiplier The creation of money does not stop with First National Bank. Suppose the borrower from First National uses the $90 to buy something from someone who then deposits the currency in Second National Bank. Here is the T-account for Second National Bank:

Second National Bank

Assets Liabilities

Reserves $ 9.00 Deposits $90.00

Loans 81.00

After the deposit, this bank has liabilities of $90. If Second National also has a reserve ratio of 10 percent, it keeps assets of $9 in reserve and makes $81 in loans. In this way, Second National Bank creates an additional $81 of money. If this $81 is eventually deposited in Third National Bank, which also has a reserve ratio of

614 PART X MONEY AND PRICES IN THE LONG RUN

10 percent, this bank keeps $8.10 in reserve and makes $72.90 in loans. Here is the T-account for Third National Bank:

Third National Bank

Assets Liabilities

Reserves $ 8.10 Deposits $81.00

Loans 72.90

The process goes on and on. Each time that money is deposited and a bank loan is made, more money is created.

How much money is eventually created in this economy? Let’s add it up:

Original deposit 5 $100.00 First National lending 5 $ 90.00 (5 .9 3 $100.00) Second National lending 5 $ 81.00 (5 .9 × $90.00) Third National lending 5 $ 72.90 (5 .9 3 $81.00)

___________________________ Total money supply 5 $1,000.00

It turns out that even though this process of money creation can continue forever, it does not create an infinite amount of money. If you laboriously add the infinite sequence of numbers in the preceding example, you find that the $100 of reserves generates $1,000 of money. The amount of money the banking system generates with each dollar of reserves is called the money multiplier. In this imaginary economy, where the $100 of reserves generates $1,000 of money, the money multiplier is 10.

What determines the size of the money multiplier? It turns out that the answer is simple: The money multiplier is the reciprocal of the reserve ratio. If R is the reserve ratio for all banks in the economy, then each dollar of reserves generates 1/R dollars of money. In our example, R = 1/10, so the money multiplier is 10.

This reciprocal formula for the money multiplier makes sense. If a bank holds $1,000 in deposits, then a reserve ratio of 1/10 (10 percent) means that the bank must hold $100 in reserves. The money multiplier just turns this idea around: If the banking system as a whole holds a total of $100 in reserves, it can have only $1,000 in deposits. In other words, if R is the ratio of reserves to deposits at each bank (that is, the reserve ratio), then the ratio of deposits to reserves in the banking system (that is, the money multiplier) must be 1/R.

This formula shows how the amount of money banks create depends on the reserve ratio. If the reserve ratio were only 1/20 (5 percent), then the banking system would have 20 times as much in deposits as in reserves, implying a money multiplier of 20. Each dollar of reserves would generate $20 of money. Similarly, if the reserve ratio were 1/4 (25 percent), deposits would be 4 times reserves, the money multiplier would be 4, and each dollar of reserves would generate $4 of money. Thus, the higher the reserve ratio, the less of each deposit banks loan out, and the smaller the money multiplier. In the special case of 100-percent-reserve banking, the reserve ratio is 1, the money multiplier is 1, and banks do not make loans or create money.

money multiplier

the amount of money the

banking system generates

with each dollar of

reserves

615CHAPTER 29 THE MONETARY SYSTEM

29-3d Bank Capital, Leverage, and the Financial Crisis of 2008–2009

In the previous sections, we have seen a simplified explanation of how banks work. But the reality of modern banking is a bit more complicated, and these complications played a key role in the financial crisis of 2008 and 2009. Before looking at that crisis, we need to learn a bit more about how banks actually function.

In the bank balance sheets you have seen so far, a bank accepts deposits and either uses those deposits to make loans or holds them as reserves. More realistically, a bank gets financial resources not only from accepting deposits but also, like other companies, from issuing equity and debt. The resources that a bank obtains from issuing equity to its owners are called bank capital. A bank uses these financial resources in various ways to generate profit for its owners. It not only makes loans and holds reserves but also buys financial securities, such as stocks and bonds.

Here is a more realistic example of a bank’s balance sheet:

More Realistic National Bank

Assets Liabilities and Owners’ Equity

Reserves $200 Deposits $800

Loans 700 Debt 150

Securities 100 Capital (owners’ equity) 50

On the right side of this balance sheet are the bank’s liabilities and capital (also called owners’ equity). This bank obtained $50 of resources from its owners. It also took in $800 of deposits and issued $150 of debt. The total of $1,000 was put to use in three ways; these are listed on the left side of the balance sheet, which shows the bank’s assets. This bank held $200 in reserves, made $700 in bank loans, and used $100 to buy financial securities, such as government or corporate bonds. The bank decides how to allocate its resources among asset classes based on their risk and return, as well as on any regulations (such as reserve requirements) that restrict the bank’s choices.

By the rules of accounting, the reserves, loans, and securities on the left side of the balance sheet must always equal, in total, the deposits, debt, and capital on the right side of the balance sheet. There is no magic in this equality. It occurs because the value of the owners’ equity is, by definition, the value of the bank’s assets (reserves, loans, and securities) minus the value of its liabilities (deposits and debt). Therefore, the left and right sides of the balance sheet always sum to the same total.

Many businesses in the economy rely on leverage, the use of borrowed money to supplement existing funds for investment purposes. Indeed, whenever anyone uses debt to finance an investment project, she is applying leverage. Leverage is particularly important for banks, however, because borrowing and lending are at the heart of what they do. To fully understand banking, therefore, it is crucial to understand how leverage works.

The leverage ratio is the ratio of the bank’s total assets to bank capital. In this example, the leverage ratio is $1,000/$50, or 20. A leverage ratio of 20 means that for every dollar of capital that the bank owners have contributed, the bank has

bank capital

the resources a bank’s

owners have put into the

institution

leverage

the use of borrowed

money to supplement

existing funds for

purposes of investment

leverage ratio

the ratio of assets to bank

capital

616 PART X MONEY AND PRICES IN THE LONG RUN

$20 of assets. Of the $20 of assets, $19 are financed with borrowed money—either by taking in deposits or issuing debt.

You may have learned in a science class that a lever can amplify a force: A boulder that you cannot move with your arms alone will move more easily if you use a lever. A similar result occurs with bank leverage. To see how this amplification works, let’s continue with this numerical example. Suppose that the bank’s assets were to rise in value by 5 percent because, say, some of the securities the bank was holding rose in price. Then the $1,000 of assets would now be worth $1,050. Because the depositors and debt holders are still owed $950, the bank capital rises from $50 to $100. Thus, when the leverage rate is 20, a 5-percent increase in the value of assets increases the owners’ equity by 100 percent.

The same principle works on the downside, but with troubling consequences. Suppose that some people who borrowed from the bank default on their loans, reducing the value of the bank’s assets by 5 percent, to $950. Because the depositors and debt holders have the legal right to be paid before the bank owners, the value of the owners’ equity falls to zero. Thus, when the leverage ratio is 20, a 5-percent fall in the value of the bank’s assets leads to a 100-percent fall in bank capital. If the value of assets were to fall by more than 5 percent, the bank’s assets would fall below its liabilities. In this case, the bank would be insolvent, and it would be unable to pay off its debt holders and depositors in full.

Bank regulators require banks to hold a certain amount of capital. The goal of such a capital requirement is to ensure that banks will be able to pay off their depositors (without having to resort to government-provided deposit insurance funds). The amount of capital required depends on the kind of assets a bank holds. If the bank holds safe assets such as government bonds, regulators require less capital than if the bank holds risky assets such as loans to borrowers whose credit is of dubious quality.

Economic turmoil can result when banks find themselves with too little capital to satisfy capital requirements. An example of this phenomenon occurred in 2008 and 2009, when many banks realized they had incurred sizable losses on some of their assets—specifically, mortgage loans and securities backed by mortgage loans. The shortage of capital induced the banks to reduce lending, a phenomenon called a credit crunch, which in turn contributed to a severe downturn in economic activity. (This event is discussed more fully in Chapter 33.) To address this problem, the U.S. Treasury, working together with the Federal Reserve, put many billions of dollars of public funds into the banking system to increase the amount of bank capital. As a result, it temporarily made the U.S. taxpayer a part owner of many banks. The goal of this unusual policy was to recapitalize the banking system so that bank lending could return to a more normal level, which in fact occurred by late 2009.

QuickQuiz Describe how banks create money.

capital requirement

a government regulation

specifying a minimum

amount of bank capital

29-4 The Fed’s Tools of Monetary Control As we have already discussed, the Federal Reserve is responsible for controlling the supply of money in the economy. Now that we understand how banking works, we are in a better position to understand how the Fed carries out this job. Because banks create money in a system of fractional-reserve banking, the Fed’s control of the money supply is indirect. When the Fed decides to change the money supply, it must consider how its actions will work through the banking system.

617CHAPTER 29 THE MONETARY SYSTEM

The Fed has various tools in its monetary toolbox. We can group the tools into two groups: those that influence the quantity of reserves and those that influence the reserve ratio and thereby the money multiplier.

29-4a How the Fed Influences the Quantity of Reserves The first way the Fed can change the money supply is by changing the quantity of reserves. The Fed alters the quantity of reserves in the economy either by buying or selling bonds in open-market operations or by making loans to banks (or by some combination of the two). Let’s consider each of these in turn.

Open-Market Operations As we noted earlier, the Fed conducts open-market operations when it buys or sells government bonds. To increase the money sup- ply, the Fed instructs its bond traders at the New York Fed to buy bonds from the public in the nation’s bond markets. The dollars the Fed pays for the bonds increase the number of dollars in the economy. Some of these new dollars are held as currency, and some are deposited in banks. Each new dollar held as currency increases the money supply by exactly $1. Each new dollar deposited in a bank in- creases the money supply by more than a dollar because it increases reserves and, thereby, the amount of money that the banking system can create.

To reduce the money supply, the Fed does just the opposite: It sells government bonds to the public in the nation’s bond markets. The public pays for these bonds with its holdings of currency and bank deposits, directly reducing the amount of money in circulation. In addition, as people make withdrawals from banks to buy these bonds from the Fed, banks find themselves with a smaller quantity of reserves. In response, banks reduce the amount of lending, and the process of money creation reverses itself.

Open-market operations are easy to conduct. In fact, the Fed’s purchases and sales of government bonds in the nation’s bond markets are similar to the transactions that any individual might undertake for her own portfolio. (Of course, when two individuals engage in a purchase or sale with each other, money changes hands, but the amount of money in circulation remains the same.) In addition, the Fed can use open-market operations to change the money supply by a small or large amount on any day without major changes in laws or bank regulations. Therefore, open-market operations are the tool of monetary policy that the Fed uses most often.

Fed Lending to Banks The Fed can also increase the quantity of reserves in the economy by lending reserves to banks. Banks borrow from the Fed when they feel they do not have enough reserves on hand, either to satisfy bank regulators, meet depositor withdrawals, make new loans, or for some other business reason.

There are various ways banks can borrow from the Fed. Traditionally, banks borrow from the Fed’s discount window and pay an interest rate on that loan called the discount rate. When the Fed makes such a loan to a bank, the banking system has more reserves than it otherwise would, and these additional reserves allow the banking system to create more money.

The Fed can alter the money supply by changing the discount rate. A higher discount rate discourages banks from borrowing reserves from the Fed. Thus, an increase in the discount rate reduces the quantity of reserves in the banking system, which in turn reduces the money supply. Conversely, a lower discount rate encourages banks to borrow from the Fed, increasing the quantity of reserves and the money supply.

open-market operations

the purchase and sale of

U.S. government bonds

by the Fed

discount rate

the interest rate on the

loans that the Fed makes

to banks

618 PART X MONEY AND PRICES IN THE LONG RUN

At times, the Fed has set up other mechanisms for banks to borrow from it. For example, from 2007 to 2010, under the Term Auction Facility, the Fed set a quantity of funds it wanted to lend to banks, and eligible banks then bid to borrow those funds. The loans went to the highest eligible bidders—that is, to the banks that had acceptable collateral and offered to pay the highest interest rate. Unlike at the discount window, where the Fed sets the price of a loan and the banks determine the quantity of borrowing, at the Term Auction Facility the Fed set the quantity of borrowing and competitive bidding among banks determined the price. The more funds the Fed made available, the greater the quantity of reserves and the larger the money supply.

The Fed lends to banks not only to control the money supply but also to help financial institutions when they are in trouble. For example, when the stock market crashed by 22 percent on October 19, 1987, many Wall Street brokerage firms found themselves temporarily in need of funds to finance the high volume of stock trading. The next morning, before the stock market opened, Fed Chair Alan Greenspan announced the Fed’s “readiness to serve as a source of liquidity to support the economic and financial system.” Many economists believe that Greenspan’s reaction to the stock crash was an important reason it had few repercussions.

Similarly, in 2008 and 2009, a fall in housing prices throughout the United States led to a sharp rise in the number of homeowners defaulting on their mortgage loans, and many financial institutions holding those mortgages ran into trouble. In an attempt to prevent these events from having broader economic ramifications, the Fed provided many billions of dollars in loans to financial institutions in distress.

29-4b How the Fed Influences the Reserve Ratio In addition to influencing the quantity of reserves, the Fed changes the money supply by influencing the reserve ratio and thereby the money multiplier. The Fed can influence the reserve ratio either through regulating the quantity of reserves banks must hold or through the interest rate that the Fed pays banks on their reserves. Again, let’s consider each of these policy tools in turn.

Reserve Requirements One way the Fed can influence the reserve ratio is by altering reserve requirements, the regulations that set the minimum amount of reserves that banks must hold against their deposits. Reserve requirements influence how much money the banking system can create with each dollar of reserves. An increase in reserve requirements means that banks must hold more reserves and, therefore, can loan out less of each dollar that is deposited. As a re- sult, an increase in reserve requirements raises the reserve ratio, lowers the money multiplier, and decreases the money supply. Conversely, a decrease in reserve re- quirements lowers the reserve ratio, raises the money multiplier, and increases the money supply.

The Fed changes reserve requirements only rarely because such changes disrupt the business of banking. When the Fed increases reserve requirements, for instance, some banks find themselves short of reserves, even though they have seen no change in deposits. As a result, they have to curtail lending until they build their level of reserves to the new required level. Moreover, in recent years, this particular tool has become less effective because many banks hold excess reserves (that is, more reserves than are required).

reserve requirements

regulations on the

minimum amount of

reserves that banks must

hold against deposits

619CHAPTER 29 THE MONETARY SYSTEM

Paying Interest on Reserves Traditionally, banks did not earn any interest on the reserves they held. In October 2008, however, the Fed began paying interest on reserves. That is, when a bank holds reserves on deposit at the Fed, the Fed now pays the bank interest on those deposits. This change gives the Fed another tool with which to influence the economy. The higher the interest rate on reserves, the more reserves banks will choose to hold. Thus, an increase in the interest rate on reserves will tend to increase the reserve ratio, lower the money multiplier, and lower the money supply.

29-4c Problems in Controlling the Money Supply The Fed’s various tools—open-market operations, bank lending, reserve requirements, and interest on reserves—have powerful effects on the money supply. Yet the Fed’s control of the money supply is not precise. The Fed must wrestle with two problems, each of which arises because much of the money supply is created by our system of fractional-reserve banking.

The first problem is that the Fed does not control the amount of money that households choose to hold as deposits in banks. The more money households deposit, the more reserves banks have, and the more money the banking system can create. The less money households deposit, the less reserves banks have, and the less money the banking system can create. To see why this is a problem, suppose that one day people lose confidence in the banking system and withdraw some of their deposits to hold more currency. When this happens, the banking system loses reserves and creates less money. The money supply falls, even without any Fed action.

The second problem of monetary control is that the Fed does not control the amount that bankers choose to lend. When money is deposited in a bank, it creates more money only when the bank loans it out. Because banks can choose to hold excess reserves instead, the Fed cannot be sure how much money the banking system will create. For instance, suppose that one day bankers become more cautious about economic conditions and decide to make fewer loans and hold greater reserves. In this case, the banking system creates less money than it otherwise would. Because of the bankers’ decision, the money supply falls.

Hence, in a system of fractional-reserve banking, the amount of money in the economy depends in part on the behavior of depositors and bankers. Because the Fed cannot control or perfectly predict this behavior, it cannot perfectly control the money supply. Yet if the Fed is vigilant, these problems need not be large. The Fed collects data on deposits and reserves from banks every week, so it quickly becomes aware of any changes in depositor or banker behavior. It can, therefore, respond to these changes and keep the money supply close to whatever level it chooses.

CASE STUDY

BANK RUNS AND THE MONEY SUPPLY Most likely you have never witnessed a bank run in real life, but you may have seen one depicted in movies such as Mary Poppins or It’s a Wonderful Life. A bank run occurs when depositors fear that a bank

may be having financial troubles and “run” to the bank to withdraw their deposits. The United States has not seen a major bank run in recent history, but in the United Kingdom, a bank called Northern Rock experienced a run in 2007 and, as a result, was eventually taken over by the government.

Bank runs are a problem for banks under fractional-reserve banking. Because a bank holds only a fraction of its deposits in reserve, it cannot satisfy withdrawal

A not-so-wonderful bank run

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620 PART X MONEY AND PRICES IN THE LONG RUN

requests from all depositors. Even if the bank is solvent (meaning that its assets exceed its liabilities), it will not have enough cash on hand to allow all depositors immediate access to all of their money. When a run occurs, the bank is forced to close its doors until some bank loans are repaid or until some lender of last resort (such as the Fed) provides it with the currency it needs to satisfy depositors.

Bank runs complicate the control of the money supply. An important example of this problem occurred during the Great Depression in the early 1930s. After a wave of bank runs and bank closings, households and bankers became more cautious. Households withdrew their deposits from banks, preferring to hold their money in the form of currency. This decision reversed the process of money creation, as bankers responded to falling reserves by reducing bank loans. At the same time, bankers increased their reserve ratios so that they would have enough cash on hand to meet their depositors’ demands in any future bank runs. The higher reserve ratio reduced the money multiplier, which further reduced the money supply. From 1929 to 1933, the money supply fell by 28 percent, without the Federal Reserve taking any deliberate contractionary action. Many economists point to this massive fall in the money supply to explain the high unemployment and falling prices that prevailed during this period. (In future chapters, we examine the mechanisms by which changes in the money supply affect unemployment and prices.)

Here’s the story of how the Federal

Reserve came into being.

The Stranger-Than-Fiction Story

of How the Fed Was Created

By Roger Lowenstein

A ccording to opinion surveys, no institu-

tion save the Internal Revenue Service is

held in lower regard than the Federal Reserve.

It’s also a font of conspiracy theories stoked

by radical libertarians, who insist the Fed is

debauching the currency and will ultimately

bankrupt the country.

The Fed’s unpopularity would make sense

if it had, say, failed to intervene and save the

system during the 2008 financial crisis. But,

in fact, the Fed did rescue the economy….

Nonetheless, dissatisfaction is alive in

Congress, where various bills would strip the

Fed’s autonomy and subject sensitive mone-

tary decisions to the scrutiny of elected poli-

ticians. Some bills would go even further and

explore a return to the gold standard.

For central bank watchers, this dynamic —

effective policy rewarded with populist scorn —

is nothing new. In America, it has always been

thus.

At Alexander Hamilton’s urging, Congress first

chartered a national bank — the ur-Fed — in

1791. However, Thomas Jefferson, who famously

mistrusted banks (he thought agriculture more

virtuous), and who was fearful of a strong cen-

tral government, opposed this development. After

20 years, the Jeffersonians won and Congress let

the charter expire.

This decision led to disaster: ruinous

inflation. So Congress chartered a Second

Bank of the United States, which began in

1817, providing the growing country with a

better, more uniform currency and improved

its public finances. But success couldn’t save

it. Andrew Jackson despised the Second Bank

as a tool of East Coast elites, and it too was

abolished.

For most of the 19th century, the U.S.,

unlike most nations in Europe, did not have

a lender of last resort. Frequent panics and

credit shortages were the result. Yet some

of the very people who could have benefited

most from a central bank, such as farmers

who were starved for credit, preferred the

status quo. Like Jackson and Jefferson before

them, they were fearful that a government

bank would tyrannize the people, perhaps in

cahoots with Wall Street.

After a financial panic in 1907 virtually

shut down the banking system, reformers

began to press once more for a central bank.

But popular mistrust remained so pronounced

that they were afraid to go public.

This is the point — 105 years ago —

when the story seems to have been hijacked

by a future Hollywood scriptwriter.

On a November evening in 1910, a power-

ful senator, Rhode Island Republican Nelson

W. Aldrich, boarded his private rail car near

A Trip to Jekyll Island

IN THE NEWS

621CHAPTER 29 THE MONETARY SYSTEM

Today, bank runs are not a major problem for the U.S. banking system or the Fed. The federal government now guarantees the safety of deposits at most banks, primarily through the Federal Deposit Insurance Corporation (FDIC). Depositors do not make runs on their banks because they are confident that, even if their bank goes bankrupt, the FDIC will make good on the deposits. The policy of government deposit insurance has costs: Bankers whose deposits are guaranteed may have too little incentive to avoid bad risks when making loans. But one benefit of deposit insurance is a more stable banking system. As a result, most people see bank runs only in the movies. ●

29-4d The Federal Funds Rate If you read about U.S. monetary policy in the newspaper, you will find much discussion of the federal funds rate. This raises several questions:

Q: What is the federal funds rate? A: The federal funds rate is the short-term interest rate that banks charge one

another for loans. If one bank finds itself short of reserves while another bank has excess reserves, the second bank can lend some reserves to the first. The loans are temporary—typically overnight. The price of the loan is the federal funds rate.

federal funds rate

the interest rate at which

banks make overnight

loans to one another

New York. A light snow was falling, muting the

hushed, conspiratorial tones of his guests,

which is exactly how Aldrich wanted it.

The reform-minded banker Paul Warburg,

one of his guests, was toting a hunting rifle,

but he had no interest in hunting. The party

also included a member of the powerful

Morgan bank, as well as an assistant U.S.

Treasury secretary, and Frank Vanderlip, head

of the country’s largest bank, National City.

“On what sort of errand are we going?”

Vanderlip inquired.

“It may be a wild-goose chase; it may the

biggest thing you and I ever did,” Warburg

replied.

Masquerading as duck hunters, they dis-

embarked in Brunswick, Ga., and traveled by

launch to Jekyll Island, home of an exclusive

club surrounded by pine and palmetto groves.

Over the course of a week, Aldrich and his

bankers mapped out a draft of what was to

become the Federal Reserve Act, changing the

U.S. economy forever.

Congress was never told that Aldrich’s

bill had been drafted by Wall Street moguls.

His bill did not pass, but it was the basis

of a successor bill, the Federal Reserve Act,

which Woodrow Wilson signed in 1913. Years

later, when the Jekyll trip was revealed to

the public, extremists seized on this strang-

er-than-fiction episode to bolster their claim

that the Fed was a bankers’ plot against the

American people. For conspiracy theorists,

the bankers’ conclave on Jekyll became a

metaphor for the Fed itself. The obvious irony

is that, fearing Americans’ irrational suspi-

cion of central banking, Aldrich and his crew

resorted to a plot that, ultimately, deepened

the country’s paranoia.

Despite their clandestine tactics, the

financiers’ motives were actually patriotic.

Aldrich had visited Europe and studied

its central banks. He wanted expert help

to draft an American equivalent. And in

between sumptuous meals featuring wild

turkey and freshly scalloped oysters, his

group of wealthy bankers earnestly wrestled

with issues that still provoke us today: How

should power over the economy be appor-

tioned between Washington and localities?

How should the central bank set interest

rates and the money supply?

The Federal Reserve today is not per-

fect. But it is more transparent than ever,

thanks to reforms instituted by the previous

chairman, Ben S. Bernanke, and it is no less

necessary than was a central bank in 1791.

Americans’ paranoia is unjustified, just as it

has always been. ■

Roger Lowenstein is the author of “America’s

Bank: The Epic Struggle to Create the Federal

Reserve.”

Source: Los Angeles Times, November 2, 2015.Senator Nelson Aldrich

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622 PART X MONEY AND PRICES IN THE LONG RUN

Q: How is the federal funds rate different from the discount rate? A: The discount rate is the interest rate banks pay to borrow directly from

the Federal Reserve through the discount window. Borrowing reserves from another bank in the federal funds market is an alternative to borrow- ing reserves from the Fed, and a bank short of reserves will typically do whichever is cheaper. In practice, the discount rate and the federal funds rate move closely together.

Q: Does the federal funds rate matter only for banks? A: Not at all. Although only banks borrow directly in the federal funds market,

the economic impact of this market is much broader. Because different parts of the financial system are highly interconnected, interest rates on different kinds of loans are strongly correlated with one another. So when the federal funds rate rises or falls, other interest rates often move in the same direction.

Q: What does the Federal Reserve have to do with the federal funds rate? A: In recent years, the Federal Reserve has set a target goal for the federal funds

rate. When the Federal Open Market Committee meets approximately every 6 weeks, it decides whether to raise or lower that target.

Q: How can the Fed make the federal funds rate hit the target it sets? A: Although the actual federal funds rate is set by supply and demand in the

market for loans among banks, the Fed can use open-market operations to influence that market. For example, when the Fed buys bonds in open- market operations, it injects reserves into the banking system. With more reserves in the system, fewer banks find themselves in need of borrowing reserves to meet reserve requirements. The fall in demand for borrowing reserves decreases the price of such borrowing, which is the federal funds rate. Conversely, when the Fed sells bonds and withdraws reserves from the banking system, more banks find themselves short of reserves, and they bid up the price of borrowing reserves. Thus, open-market purchases lower the federal funds rate, and open-market sales raise the federal funds rate.

Q: But don’t these open-market operations affect the money supply? A: Yes, absolutely. When the Fed announces a change in the federal funds rate, it is

committing itself to the open-market operations necessary to make that change happen, and these open-market operations will alter the supply of money. Decisions by the FOMC to change the target for the federal funds rate are also decisions to change the money supply. They are two sides of the same coin. Other things being equal, a decrease in the target for the federal funds rate means an expansion in the money supply, and an increase in the target for the federal funds rate means a contraction in the money supply.

QuickQuiz If the Fed wanted to use all of its policy tools to decrease the money

supply, what would it do?

29-5 Conclusion Some years ago, a book made the best-seller list with the title Secrets of the Temple: How the Federal Reserve Runs the Country. Though no doubt an exaggeration, this title did highlight the important role of the monetary system in our daily lives. Whenever we buy or sell anything, we are relying on the extraordinarily useful social convention called “money.” Now that we know what money is and what determines its supply, we can discuss how changes in the quantity of money affect the economy. We begin to address that topic in the next chapter.

623CHAPTER 29 THE MONETARY SYSTEM

1. The money supply includes all of the following

EXCEPT

a. metal coins.

b. paper currency.

c. lines of credit accessible with credit cards.

d. bank balances accessible with debit cards.

2. Chloe takes $100 of currency from her wallet and

deposits it into her checking account. If the bank

adds the entire $100 to reserves, the money sup-

ply ________, but if the bank lends out some of the

$100, the money supply ________.

a. increases, increases even more

b. increases, increases by less

c. is unchanged, increases

d. decreases, decreases by less

3. If the reserve ratio is ¼ and the central bank

increases the quantity of reserves in the banking

system by $120, the money supply increases by

a. $90.

b. $150.

c. $160.

d. $480.

4. A bank has capital of $200 and a leverage ratio of 5.

If the value of the bank’s assets declines by 10 per-

cent, then its capital will be reduced to

a. $100.

b. $150.

c. $180.

d. $185.

5. Which of the following actions by the Fed would

reduce the money supply?

a. an open-market purchase of government bonds

b. a reduction in banks’ reserve requirements

c. an increase in the interest rate paid on reserves

d. a decrease in the discount rate on Fed lending

6. In a system of fractional-reserve banking, even with-

out any action by the central bank, the money sup-

ply declines if households choose to hold ________

currency or if banks choose to hold ________ excess

reserves.

a. more, more

b. more, less

c. less, more

d. less, less

CHAPTER QuickQuiz

The term money refers to assets that people regularly use to buy goods and services.

Money serves three functions. As a medium of exchange,

it is the item used to make transactions. As a unit of

account, it provides the way to record prices and other

economic values. As a store of value, it offers a way to

transfer purchasing power from the present to the future.

Commodity money, such as gold, is money that has

intrinsic value: It would be valued even if it were not

used as money. Fiat money, such as paper dollars, is

money without intrinsic value: It would be worthless if

it were not used as money.

In the U.S. economy, money takes the form of currency

and various types of bank deposits, such as checking

accounts.

The Federal Reserve, the central bank of the United

States, is responsible for regulating the U.S. monetary

system. The Fed chair is appointed by the president

and confirmed by Congress every 4 years. The chair

is the head of the Federal Open Market Committee,

which meets about every 6 weeks to consider changes

in monetary policy.

Bank depositors provide resources to banks by

depositing their funds into bank accounts. These deposits

are part of a bank’s liabilities. Bank owners also provide

resources (called bank capital) for the bank. Because of

leverage (the use of borrowed funds for investment),

a small change in the value of a bank’s assets can lead

to a large change in the value of the bank’s capital. To

protect depositors, bank regulators require banks to hold

a certain minimum amount of capital.

The Fed controls the money supply primarily through

open-market operations: The purchase of government

bonds increases the money supply, and the sale of

government bonds decreases the money supply. The

Fed also uses other tools to control the money supply.

It can expand the money supply by decreasing the

discount rate, increasing its lending to banks, lowering

reserve requirements, or decreasing the interest rate

on reserves. It can contract the money supply by

increasing the discount rate, decreasing its lending to

banks, raising reserve requirements, or increasing the

interest rate on reserves.

When individuals deposit money in banks and banks

loan out some of these deposits, the quantity of money

in the economy increases. Because the banking system

influences the money supply in this way, the Fed’s

control of the money supply is imperfect.

SUMMARY

624 PART X MONEY AND PRICES IN THE LONG RUN

money, p. 604

medium of exchange, p. 605

unit of account, p. 605

store of value, p. 605

liquidity, p. 605

commodity money, p. 605

fiat money, p. 606

currency, p. 607

demand deposits, p. 607

Federal Reserve (Fed), p. 609

central bank, p. 609

money supply, p. 610

monetary policy, p. 610

reserves, p. 612

fractional-reserve banking, p. 612

reserve ratio, p. 612

money multiplier, p. 614

bank capital, p. 615

leverage, p. 615

leverage ratio, p. 615

capital requirement, p. 616

open-market operations, p. 617

discount rate, p. 617

reserve requirements, p. 618

federal funds rate, p. 621

1. What distinguishes money from other assets in the

economy?

2. What is commodity money? What is fiat money?

Which kind do we use?

3. What are demand deposits and why should they be

included in the stock of money?

4. Who is responsible for setting monetary policy in the

United States? How is this group chosen?

5. If the Fed wants to increase the money supply with

open-market operations, what does it do?

6. Why don’t banks hold 100-percent reserves? How

is the amount of reserves banks hold related to the

amount of money the banking system creates?

7. Bank A has a leverage ratio of 10, while Bank B has

a leverage ratio of 20. Similar losses on bank loans at

the two banks cause the value of their assets to fall by

7 percent. Which bank shows a larger change in bank

capital? Does either bank remain solvent? Explain.

8. What is the discount rate? What happens to the

money supply when the Fed raises the discount rate?

9. What are reserve requirements? What happens

to the money supply when the Fed raises reserve

requirements?

10. Why can’t the Fed control the money supply

perfectly?

1. Which of the following are considered money in the

U.S. economy? Which are not? Explain your answers

by discussing each of the three functions of money.

a. a U.S. penny

b. a Mexican peso

c. a Picasso painting

d. a plastic credit card

2. Explain whether each of the following events increases

or decreases the money supply.

a. The Fed buys bonds in open-market operations.

b. The Fed reduces the reserve requirement.

c. The Fed increases the interest rate it pays on

reserves.

d. Citibank repays a loan it had previously taken

from the Fed.

e. After a rash of pickpocketing, people decide to

hold less currency.

f. Fearful of bank runs, bankers decide to hold more

excess reserves.

g. The FOMC increases its target for the federal

funds rate.

The Federal Reserve has in recent years set monetary

policy by choosing a target for the federal funds rate,

a short-term interest rate at which banks make loans

to one another. As the Fed achieves its target, it adjusts

the money supply.

KEY CONCEPTS

f f

QUESTIONS FOR REVIEW

f f h d h

PROBLEMS AND APPLICATIONS

625CHAPTER 29 THE MONETARY SYSTEM

3. Your uncle repays a $100 loan from Tenth National

Bank (TNB) by writing a $100 check from his TNB

checking account. Use T-accounts to show the effect of

this transaction on your uncle and on TNB. Has your

uncle’s wealth changed? Explain.

4. Beleaguered State Bank (BSB) holds $250 million in

deposits and maintains a reserve ratio of 10 percent.

a. Show a T-account for BSB.

b. Now suppose that BSB’s largest depositor

withdraws $10 million in cash from her account. If

BSB decides to restore its reserve ratio by reducing

the amount of loans outstanding, show its new

T-account.

c. Explain what effect BSB’s action will have on

other banks.

d. Why might it be difficult for BSB to take the action

described in part (b)? Discuss another way for BSB

to return to its original reserve ratio.

5. You take $100 you had kept under your mattress and

deposit it in your bank account. If this $100 stays in

the banking system as reserves and if banks hold

reserves equal to 10 percent of deposits, by how much

does the total amount of deposits in the banking

system increase? By how much does the money

supply increase?

6. Happy Bank starts with $200 in bank capital. It then

accepts $800 in deposits. It keeps 12.5 percent (1/8th)

of deposits in reserve. It uses the rest of its assets to

make bank loans.

a. Show the balance sheet of Happy Bank.

b. What is Happy Bank’s leverage ratio?

c. Suppose that 10 percent of the borrowers from

Happy Bank default and these bank loans become

worthless. Show the bank’s new balance sheet.

d. By what percentage do the bank’s total assets

decline? By what percentage does the bank’s

capital decline? Which change is larger? Why?

7. The Fed conducts a $10 million open-market purchase

of government bonds. If the required reserve ratio is

10 percent, what are the largest and smallest possible

increases in the money supply that could result?

Explain.

8. Assume that the reserve requirement is 5 percent.

All other things being equal, will the money supply

expand more if the Fed buys $2,000 worth of bonds

or if someone deposits in a bank $2,000 that she had

been hiding in her cookie jar? If one creates more, how

much more does it create? Support your thinking.

9. Suppose that the reserve requirement for checking

deposits is 10 percent and that banks do not hold any

excess reserves.

a. If the Fed sells $1 million of government bonds,

what is the effect on the economy’s reserves and

money supply?

b. Now suppose the Fed lowers the reserve

requirement to 5 percent, but banks choose to

hold another 5 percent of deposits as excess

reserves. Why might banks do so? What is the

overall change in the money multiplier and the

money supply as a result of these actions?

10. Assume that the banking system has total reserves of

$100 billion. Assume also that required reserves are

10 percent of checking deposits and that banks hold

no excess reserves and households hold no currency.

a. What is the money multiplier? What is the money

supply?

b. If the Fed now raises required reserves to

20 percent of deposits, what are the change in

reserves and the change in the money supply?

11. Assume that the reserve requirement is 20 percent.

Also assume that banks do not hold excess reserves

and there is no cash held by the public. The Fed

decides that it wants to expand the money supply by

$40 million.

a. If the Fed is using open-market operations, will it

buy or sell bonds?

b. What quantity of bonds does the Fed need to

buy or sell to accomplish the goal? Explain your

reasoning.

12. The economy of Elmendyn contains 2,000 $1 bills.

a. If people hold all money as currency, what is the

quantity of money?

b. If people hold all money as demand deposits and

banks maintain 100 percent reserves, what is the

quantity of money?

c. If people hold equal amounts of currency and

demand deposits and banks maintain 100 percent

reserves, what is the quantity of money?

d. If people hold all money as demand deposits and

banks maintain a reserve ratio of 10 percent, what

is the quantity of money?

e. If people hold equal amounts of currency and

demand deposits and banks maintain a reserve

ratio of 10 percent, what is the quantity of money?

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

627

Money Growth and Inflation CHAPTER

30 T

oday, if you want to buy an ice-cream cone, you need at least a couple of dollars, but that has not always been the case. In the 1930s, my grandmother ran a sweet shop in Trenton, New Jersey, where she sold ice-cream cones in

two sizes. A cone with a small scoop of ice cream cost 3 cents. Hungry customers could buy a large scoop for a nickel.

You may not be surprised at the increase in the price of ice cream. In most modern economies, most prices tend to rise over time. This increase in the overall level of prices is called inflation. Earlier in the book, we examined how economists

628 PART X MONEY AND PRICES IN THE LONG RUN

measure the inflation rate as the percentage change in the consumer price index (CPI), the GDP deflator, or some other index of the overall price level. These price indexes show that, in the United States over the past 80 years, prices have risen on average 3.6 percent per year. Accumulated over so many years, a 3.6 percent annual inflation rate leads to a seventeenfold increase in the price level.

Inflation may seem natural and inevitable to a person who grew up in the United States during recent decades, but in fact, it is not inevitable at all. There were long periods in the 19th century during which most prices fell—a phenomenon called deflation. The average level of prices in the U.S. economy was 23 percent lower in 1896 than in 1880, and this deflation was a major issue in the presidential election of 1896. Farmers, who had accumulated large debts, suf- fered when declines in crop prices reduced their incomes and thus their ability to pay off their debts. They advocated government policies to reverse the deflation.

Although inflation has been the norm in more recent history, there has been substantial variation in the rate at which prices rise. From 2005 to 2015, prices rose at an average rate of 1.2 percent per year. By contrast, in the 1970s, prices rose by 7.8 percent per year, which meant the price level more than doubled over the decade. The public often views such high rates of inflation as a major economic problem. In fact, when President Jimmy Carter ran for reelection in 1980, chal- lenger Ronald Reagan pointed to high inflation as one of the failures of Carter ’s economic policy.

International data show an even broader range of inflation experiences. In 2015, while the inflation rate in the United States was a mere 0.1 percent, it was 1.5 percent in China, 4.9 percent in India, 15 percent in Russia, and 84 percent in Venezuela. And even the high inflation rates in Russia and Venezuela are mod- erate by some standards. In February 2008, the central bank of Zimbabwe announced the inflation rate in its economy had reached 24,000 percent; some in- dependent estimates put the figure even higher. An extraordinarily high rate of inflation such as this is called hyperinflation.

What determines whether an economy experiences inflation and, if so, how much? This chapter answers this question by developing the quantity theory of money. Chapter 1 summarized this theory as one of the Ten Principles of Economics: Prices rise when the government prints too much money. This insight has a long and venerable tradition among economists. The quantity theory was discussed by the famous 18th-century philosopher and economist David Hume and was advocated more recently by the prominent economist Milton Friedman. This the- ory can explain moderate inflations, such as those we have experienced in the United States, as well as hyperinflations.

After developing a theory of inflation, we turn to a related question: Why is inflation a problem? At first glance, the answer to this question may seem obvious: Inflation is a problem because people don’t like it. In the 1970s, when the United States experienced a relatively high rate of inflation, opinion polls placed inflation as the most important issue facing the nation. President Ford echoed this sentiment in 1974 when he called inflation “public enemy number one.” Ford wore a “WIN” button on his lapel—for Whip Inflation Now.

But what, exactly, are the costs that inflation imposes on a society? The answer may surprise you. Identifying the various costs of inflation is not as straightfor- ward as it first appears. As a result, although all economists decry hyperinflation, some economists argue that the costs of moderate inflation are not nearly as large as the public believes.

629CHAPTER 30 MONEY GROWTH AND INFLATION

30-1 The Classical Theory of Inflation We begin our study of inflation by developing the quantity theory of money. This theory is often called “classical” because it was developed by some of the earliest economic thinkers. Most economists today rely on this theory to explain the long- run determinants of the price level and the inflation rate.

30-1a The Level of Prices and the Value of Money Suppose we observe that over some period of time the price of an ice-cream cone rises from a nickel to a dollar. What conclusion should we draw from the fact that people are willing to give up so much more money in exchange for a cone? It is possible that people have come to enjoy ice cream more (perhaps because some chemist has developed a miraculous new flavor). But that is probably not the case. It is more likely that people’s enjoyment of ice cream has stayed roughly the same and that, over time, the money used to buy ice cream has become less valuable. Indeed, the first insight about inflation is that it is more about the value of money than about the value of goods.

This insight helps point the way toward a theory of inflation. When the consumer price index and other measures of the price level rise, commentators are often tempted to look at the many individual prices that make up these price indexes: “The CPI rose by 3 percent last month, led by a 20 percent rise in the price of coffee and a 30 percent rise in the price of heating oil.” Although this approach does contain some interesting information about what’s happening in the economy, it also misses a key point: Inflation is an economy-wide phenomenon that concerns, first and foremost, the value of the economy’s medium of exchange.

The economy’s overall price level can be viewed in two ways. So far, we have viewed the price level as the price of a basket of goods and services. When the price level rises, people have to pay more for the goods and services they buy. Alternatively, we can view the price level as a measure of the value of money. A rise in the price level means a lower value of money because each dollar in your wallet now buys a smaller quantity of goods and services.

It may help to express these ideas mathematically. Suppose P is the price level as measured by the consumer price index or the GDP deflator. Then P measures the number of dollars needed to buy a basket of goods and services. Now turn this idea around: The quantity of goods and services that can be bought with $1 equals 1/P. In other words, if P is the price of goods and services measured in terms of money, 1/P is the value of money measured in terms of goods and services.

This mathematics is simplest to understand in an economy that produces only a single good, say, ice-cream cones. In that case, P would be the price of a cone. When the price of a cone (P) is $2, then the value of a dollar (1/P) is half a cone. When the price (P) rises to $3, the value of a dollar (1/P) falls to a third of a cone. The actual economy produces thousands of goods and services, so we use a price index rather than the price of a single good. But the logic remains the same: When the overall price level rises, the value of money falls.

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“So what’s it going to be? The same size as last year or the same price as last year?”

630 PART X MONEY AND PRICES IN THE LONG RUN

30-1b Money Supply, Money Demand, and Monetary Equilibrium What determines the value of money? The answer to this question, like many in economics, is supply and demand. Just as the supply and demand for bananas determines the price of bananas, the supply and demand for money determines the value of money. Thus, our next step in developing the quantity theory of money is to consider the determinants of money supply and money demand.

First consider money supply. In the preceding chapter, we discussed how the Federal Reserve, together with the banking system, determines the supply of money. When the Fed sells bonds in open-market operations, it receives dollars in exchange and contracts the money supply. When the Fed buys government bonds, it pays out dollars and expands the money supply. In addition, if any of these dollars are deposited in banks, which hold some as reserves and loan out the rest, the money multiplier swings into action, and these open-market operations can have an even greater effect on the money supply. For our purposes in this chapter, we ignore the complications introduced by the banking system and simply take the quantity of money supplied as a policy variable that the Fed controls.

Now consider money demand. Most fundamentally, the demand for money reflects how much wealth people want to hold in liquid form. Many factors influence the quantity of money demanded. The amount of currency that people hold in their wallets, for instance, depends on how much they rely on credit cards and on whether an automatic teller machine is easy to find. And as we will emphasize in Chapter 34, the quantity of money demanded depends on the interest rate that a person could earn by using the money to buy an interest- bearing bond rather than leaving it in his wallet or low-interest checking account.

Although many variables affect the demand for money, one variable stands out in importance: the average level of prices in the economy. People hold money because it is the medium of exchange. Unlike other assets, such as bonds or stocks, people can use money to buy the goods and services on their shopping lists. How much money they choose to hold for this purpose depends on the prices of those goods and services. The higher prices are, the more money the typical transaction requires, and the more money people will choose to hold in their wallets and checking accounts. That is, a higher price level (a lower value of money) increases the quantity of money demanded.

What ensures that the quantity of money the Fed supplies balances the quantity of money people demand? The answer depends on the time horizon being considered. Later in this book, we examine the short-run answer and learn that interest rates play a key role. The long- run answer, however, is much simpler. In the long run, money supply and money demand are brought into equilibrium by the overall level of prices. If the price level is above the equilibrium level, people will want to hold more money than the Fed has created, so the price level must fall to balance supply and demand. If the price level is below the equilibrium level, people will want to hold less money than the Fed has created, and the price level must rise to balance supply and demand. At the equilibrium price level, the quantity of money that people want to hold exactly balances the quantity of money supplied by the Fed.

Figure 1 illustrates these ideas. The horizontal axis of this graph shows the quantity of money. The left vertical axis shows the value of money 1/P, and the right vertical axis shows the price level P. Notice that the price-level axis on the right is inverted: A low price level is shown near the top of this axis, and a high price level is shown near the bottom. This inverted axis illustrates that when the value of money is high (as shown near the top of the left axis), the price level is low (as shown near the top of the right axis).

631CHAPTER 30 MONEY GROWTH AND INFLATION

The two curves in this figure are the supply and demand curves for money. The supply curve is vertical because the Fed has fixed the quantity of money available. The demand curve for money slopes downward, indicating that when the value of money is low (and the price level is high), people demand a larger quantity of it to buy goods and services. At the equilibrium, shown in the figure as point A, the quantity of money demanded balances the quantity of money supplied. This equilibrium of money supply and money demand determines the value of money and the price level.

30-1c The Effects of a Monetary Injection Let’s now consider the effects of a change in monetary policy. To do so, imagine that the economy is in equilibrium and then, suddenly, the Fed doubles the supply of money by printing some dollar bills and dropping them around the country from helicopters. (Or, less dramatically and more realistically, the Fed could inject money into the economy by buying some government bonds from the public in open-market operations.) What happens after such a monetary injection? How does the new equilibrium compare to the old one?

Figure 2 shows what happens. The monetary injection shifts the supply curve to the right from MS

1 to MS

2 , and the equilibrium moves from point A to point B.

As a result, the value of money (shown on the left axis) decreases from 1/2 to 1/4 , and the equilibrium price level (shown on the right axis) increases from 2 to 4. In other words, when an increase in the money supply makes dollars more plentiful, the result is an increase in the price level that makes each dollar less valuable.

This explanation of how the price level is determined and why it might change over time is called the quantity theory of money. According to the quantity theory, the quantity of money available in an economy determines the value of money, and growth in the quantity of money is the primary cause of inflation. As economist Milton Friedman once put it, “Inflation is always and everywhere a monetary phenomenon.”

FIGURE 1

How the Supply and Demand for Money

Determine the Equilibrium Price Level

The horizontal axis shows the quantity of

money. The left vertical axis shows the

value of money, and the right vertical

axis shows the price level. The supply

curve for money is vertical because the

quantity of money supplied is fixed by

the Fed. The demand curve for money

slopes downward because people want

to hold a larger quantity of money when

each dollar buys less. At the equilibrium,

point A, the value of money (on the left

axis) and the price level (on the right

axis) have adjusted to bring the quantity

of money supplied and the quantity of

money demanded into balance.

Quantity fixed by the Fed

Quantity of Money

Value of Money, 1/P

Price Level, P

Money supply

(Low)

(High)

(Low)

1/2

1/4

3/4

1.33

Equilibrium value of money

Equilibrium price level

Money demand

quantity theory of money

a theory asserting that

the quantity of money

available determines

the price level and

that the growth rate in

the quantity of money

available determines the

inflation rate

632 PART X MONEY AND PRICES IN THE LONG RUN

30-1d A Brief Look at the Adjustment Process So far, we have compared the old equilibrium and the new equilibrium after an injection of money. How does the economy move from the old to the new equilibrium? A complete answer to this question requires an understanding of short-run fluctuations in the economy, which we examine later in this book. Here, we briefly consider the adjustment process that occurs after a change in the money supply.

The immediate effect of a monetary injection is to create an excess supply of money. Before the injection, the economy was in equilibrium (point A in Figure 2). At the prevailing price level, people had exactly as much money as they wanted. But after the helicopters drop the new money and people pick it up off the streets, people have more dollars in their wallets than they want. At the prevailing price level, the quantity of money supplied now exceeds the quantity demanded.

People try to get rid of this excess supply of money in various ways. They might use it to buy goods and services. Or they might use this excess money to make loans to others by buying bonds or by depositing the money in a bank savings account. These loans allow other people to buy goods and services. In either case, the injection of money increases the demand for goods and services.

The economy’s ability to supply goods and services, however, has not changed. As we saw in the chapter on production and growth, the economy’s output of goods and services is determined by the available labor, physical capital, human capital, natural resources, and technological knowledge. None of these is altered by the injection of money.

Thus, the greater demand for goods and services causes the prices of goods and services to increase. The increase in the price level, in turn, increases the quantity of money demanded because people are using more dollars for every transaction. Eventually, the economy reaches a new equilibrium (point B in Figure 2) at which the quantity of money demanded again equals the quantity of money supplied.

FIGURE 2

An Increase in the Money

Supply

When the Fed increases the

supply of money, the money

supply curve shifts from MS1

to MS2. The value of money (on

the left axis) and the price level

(on the right axis) adjust

to bring supply and demand

back into balance. The

equilibrium moves from point

A to point B. Thus, when an

increase in the money supply

makes dollars more plentiful,

the price level increases, making

each dollar less valuable.

Quantity of Money

Value of Money, 1/

Price Level,

Money demand

(Low)

(High)

(Low)

1/2

1/4

3/4

1.33

MS1

MS2

2. . . . decreases the value of money . . . 3. . . . and

increases the price level.

1. An increase in the money supply . . .

633CHAPTER 30 MONEY GROWTH AND INFLATION

In this way, the overall price level for goods and services adjusts to bring money supply and money demand into balance.

30-1e The Classical Dichotomy and Monetary Neutrality We have seen how changes in the money supply lead to changes in the average level of prices of goods and services. How do monetary changes affect other economic variables, such as production, employment, real wages, and real interest rates? This question has long intrigued economists, including David Hume in the 18th century.

Hume and his contemporaries suggested that economic variables should be divided into two groups. The first group consists of nominal variables—variables measured in monetary units. The second group consists of real variables— variables measured in physical units. For example, the income of corn farmers is a nominal variable because it is measured in dollars, whereas the quantity of corn they produce is a real variable because it is measured in bushels. Nominal GDP is a nominal variable because it measures the dollar value of the economy’s output of goods and services; real GDP is a real variable because it measures the total quantity of goods and services produced and is not influenced by the current prices of those goods and services. The separation of real and nominal variables is now called the classical dichotomy. (A dichotomy is a division into two groups, and classical refers to the earlier economic thinkers.)

Applying the classical dichotomy is tricky when we turn to prices. Most prices are quoted in units of money and, therefore, are nominal variables. When we say that the price of corn is $2 a bushel or that the price of wheat is $1 a bushel, both prices are nominal variables. But what about a relative price—the price of one thing compared to another? In our example, we could say that the price of a bushel of corn is 2 bushels of wheat. This relative price is not measured in terms of money. When comparing the prices of any two goods, the dollar signs cancel, and the resulting number is measured in physical units. Thus, while dollar prices are nominal variables, relative prices are real variables.

This lesson has many applications. For instance, the real wage (the dollar wage adjusted for inflation) is a real variable because it measures the rate at which people exchange goods and services for a unit of labor. Similarly, the real interest rate (the nominal interest rate adjusted for inflation) is a real variable because it measures the rate at which people exchange goods and services today for goods and services in the future.

Why separate variables into these groups? The classical dichotomy is useful because different forces influence real and nominal variables. According to classical analysis, nominal variables are influenced by developments in the economy’s monetary system, whereas money is largely irrelevant for explaining real variables.

This idea was implicit in our discussion of the real economy in the long run. In previous chapters, we examined how real GDP, saving, investment, real interest rates, and unemployment are determined without mentioning the existence of money. In that analysis, the economy’s production of goods and services depends on technology and factor supplies, the real interest rate balances the supply and demand for loanable funds, the real wage balances the supply and demand for labor, and unemployment results when the real wage is kept above the equilibrium level. These conclusions have nothing to do with the quantity of money supplied.

Changes in the supply of money, according to classical analysis, affect nominal variables but not real ones. When the central bank doubles the money supply, the

nominal variables

variables measured in

monetary units

real variables

variables measured in

physical units

classical dichotomy

the theoretical separation

of nominal and real

variables

634 PART X MONEY AND PRICES IN THE LONG RUN

price level doubles, the dollar wage doubles, and all other dollar values double. Real variables, such as production, employment, real wages, and real interest rates, are unchanged. The irrelevance of monetary changes for real variables is called monetary neutrality.

An analogy helps explain monetary neutrality. As the unit of account, money is the yardstick we use to measure economic transactions. When a central bank doubles the money supply, all prices double, and the value of the unit of account falls by half. A similar change would occur if the government were to reduce the length of the yard from 36 to 18 inches: With the new, shorter yardstick, all measured distances (nominal variables) would double, but the actual distances (real variables) would remain the same. The dollar, like the yard, is merely a unit of measurement, so a change in its value should not have real effects.

Is monetary neutrality realistic? Not completely. A change in the length of the yard from 36 to 18 inches would not matter in the long run, but in the short run, it would lead to confusion and mistakes. Similarly, most economists today believe that over short periods of time—within the span of a year or two—monetary changes affect real variables. Hume himself also doubted that monetary neutrality would apply in the short run. (We will study short-run non-neutrality later in the book, and this topic will help explain why the Fed changes the money supply over time.)

Yet classical analysis is right about the economy in the long run. Over the course of a decade, monetary changes have significant effects on nominal variables (such as the price level) but only negligible effects on real variables (such as real GDP). When studying long-run changes in the economy, the neutrality of money offers a good description of how the world works.

30-1f Velocity and the Quantity Equation We can obtain another perspective on the quantity theory of money by considering the following question: How many times per year is the typical dollar bill used to pay for a newly produced good or service? The answer to this question is given by a variable called the velocity of money. In physics, the term velocity refers to the speed at which an object travels. In economics, the velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.

To calculate the velocity of money, we divide the nominal value of output (nominal GDP) by the quantity of money. If P is the price level (the GDP deflator), Y the quantity of output (real GDP), and M the quantity of money, then velocity is

V 5 (P 3 Y)/M.

To see why this makes sense, imagine a simple economy that produces only pizza. Suppose that the economy produces 100 pizzas in a year, that a pizza sells for $10, and that the quantity of money in the economy is $50. Then the velocity of money is

V 5 ($10 3 100)/$50

5 20.

In this economy, people spend a total of $1,000 per year on pizza. For this $1,000 of spending to take place with only $50 of money, each dollar bill must change hands on average 20 times per year.

monetary neutrality

the proposition that

changes in the money

supply do not affect real

variables

velocity of money

the rate at which money

changes hands

635CHAPTER 30 MONEY GROWTH AND INFLATION

With slight algebraic rearrangement, this equation can be rewritten as

M 3 V 5 P 3 Y.

This equation states that the quantity of money (M) times the velocity of money (V) equals the price of output (P) times the amount of output (Y). It is called the quantity equation because it relates the quantity of money (M) to the nominal value of output (P 3 Y). The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of the other three variables: The price level must rise, the quantity of output must rise, or the velocity of money must fall.

In many cases, it turns out that the velocity of money is relatively stable. For example, Figure 3 shows nominal GDP, the quantity of money (as measured by M2), and the velocity of money for the U.S. economy since 1960. During this period, the money supply and nominal GDP both increased more than thirtyfold. By contrast, the velocity of money, although not exactly constant, has not changed

quantity equation

the equation M 3 V 5

P 3 Y, which relates

the quantity of money,

the velocity of money,

and the dollar value of

the economy’s output of

goods and services

FIGURE 3

Nominal GDP, the Quantity

of Money, and the Velocity

of Money

This figure shows the nominal value of output as measured by nominal GDP, the quantity

of money as measured by M2, and the velocity of money as measured by their ratio. For

comparability, all three series have been scaled to equal 100 in 1960. Notice that nominal

GDP and the quantity of money have grown dramatically over this period, while velocity has

been relatively stable.

Source: U.S. Department of Commerce; Federal Reserve Board.

1960 1965 1970 1975 1960 1980 1985 1990 1995 2000 2005 2010 2015

Velocity

Nominal GDP

500

1000

1500

2000

2500

3000

3500

4000

Indexes (1960 = 100)

636 PART X MONEY AND PRICES IN THE LONG RUN

dramatically. Thus, for some purposes, the assumption of constant velocity is a good approximation.

We now have all the elements necessary to explain the equilibrium price level and inflation rate. They are as follows:

1. The velocity of money is relatively stable over time. 2. Because velocity is stable, when the central bank changes the quantity of

money (M), it causes proportionate changes in the nominal value of output (P 3 Y).

3. The economy’s output of goods and services (Y) is primarily determined by factor supplies (labor, physical capital, human capital, and natural resources) and the available production technology. In particular, because money is neutral, money does not affect output.

4. With output (Y) determined by factor supplies and technology, when the central bank alters the money supply (M) and induces proportional changes in the nominal value of output (P 3 Y), these changes are reflected in changes in the price level (P).

5. Therefore, when the central bank increases the money supply rapidly, the result is a high rate of inflation.

These five steps are the essence of the quantity theory of money.

CASE STUDY

MONEY AND PRICES DURING FOUR HYPERINFLATIONS Although earthquakes can wreak havoc on a society, they have the beneficial by-product of providing much useful data for

seismologists. These data can shed light on alternative theories and, thereby, help society predict and deal with future threats. Similarly, hyperinflations offer monetary economists a natural experiment they can use to study the effects of money on the economy.

Hyperinflations are interesting in part because the changes in the money supply and price level are so large. Indeed, hyperinflation is generally defined as inflation that exceeds 50 percent per month. This means that the price level increases more than 100-fold over the course of a year.

The data on hyperinflation show a clear link between the quantity of money and the price level. Figure 4 graphs data from four classic hyperinflations that occurred during the 1920s in Austria, Hungary, Germany, and Poland. Each graph shows the quantity of money in the economy and an index of the price level. The slope of the money line represents the rate at which the quantity of money was growing, and the slope of the price line represents the inflation rate. The steeper the lines, the higher the rates of money growth or inflation.

Notice that in each graph the quantity of money and the price level are almost parallel. In each instance, growth in the quantity of money is moderate at first and so is inflation. But over time, the quantity of money in the economy starts growing faster and faster. At about the same time, inflation also takes off. Then when the quantity of money stabilizes, the price level stabilizes as well. These episodes illustrate well one of the Ten Principles of Economics: Prices rise when the government prints too much money. ●

637CHAPTER 30 MONEY GROWTH AND INFLATION

30-1g The Inflation Tax If inflation is so easy to explain, why do countries experience hyperinflation? That is, why do the central banks of these countries choose to print so much money that its value is certain to fall rapidly over time?

The answer is that the governments of these countries are using money creation as a way to pay for their spending. When the government wants to build roads, pay salaries to its soldiers, or give transfer payments to the poor or elderly, it first has to raise the necessary funds. Normally, the government does this by levying taxes, such as income and sales taxes, and by borrowing from the public by selling government bonds. Yet the government can also pay for spending simply by printing the money it needs.

When the government raises revenue by printing money, it is said to levy an inflation tax. The inflation tax is not exactly like other taxes, however, because no one receives a bill from the government for this tax. Instead, the inflation tax is

inflation tax

the revenue the

government raises by

creating money

FIGURE 4

Money and Prices during

Four Hyperinflations

This figure shows the quantity of money and the price level during four hyperinflations.

(Note that these variables are graphed on logarithmic scales. This means that equal vertical

distances on the graph represent equal percentage changes in the variable.) In each case, the

quantity of money and the price level move closely together. The strong association between

these two variables is consistent with the quantity theory of money, which states that growth

in the money supply is the primary cause of inflation.

Source: Adapted from Thomas J. Sargent, “The End of Four Big Inflations,” in Robert Hall, ed., Inflation (Chicago: University of Chicago Press, 1983), pp. 41–93.

(a) Austria (b) Hungary

Money supply

Price level

Index (Jan. 1921 = 100)

Index (July 1921 = 100)

Price level

Index (Jan. 1921 = 100)

(d) Poland

100,000,000,000,000

1,000,000

10,000,000,000 1,000,000,000,000

100,000,000

10,000 100

100,000

10,000

1,000

100 19251924192319221921

Money supply

Price level

100,000

10,000

1,000

100 19251924192319221921

19251924192319221921

Price level Money supply

Index (Jan. 1921 = 100)

100

10,000,000

100,000

1,000,000

10,000

1,000

19251924192319221921

638 PART X MONEY AND PRICES IN THE LONG RUN

subtler. When the government prints money, the price level rises, and the dollars in your wallet become less valuable. Thus, the inflation tax is like a tax on everyone who holds money.

The importance of the inflation tax varies from country to country and over time. In the United States in recent years, the inflation tax has been a trivial source of revenue: It has accounted for less than 3 percent of government revenue. During the 1770s, however, the Continental Congress of the fledgling United States relied heavily on the inflation tax to pay for military spending. Because the new government had a limited ability to raise funds through regular taxes or borrowing, printing dollars was the easiest way to pay the American soldiers. As the quantity theory predicts, the result was a high rate of inflation: Prices measured in terms of the continental dollar rose more than a 100-fold over a few years.

Almost all hyperinflations follow the same pattern as the hyperinflation during the American Revolution. The government has high spending, inadequate tax revenue, and limited ability to borrow. As a result, it turns to the printing press to pay for its spending. The massive increases in the quantity of money lead to massive inflation. The inflation ends when the government institutes fiscal reforms—such as cuts in government spending—that eliminate the need for the inflation tax.

Hyperinflation in Zimbabwe

D uring the first decade of the 2000s, the nation of Zimbabwe

experienced one of history’s most extreme examples of hyperinflation.

In many ways, the story is common: Large government budget deficits led

to the creation of large quantities of money and high rates of inflation.

The hyperinflation ended in April 2009 when the Zimbabwe central bank

stopped printing the Zimbabwe dollar and the nation started using

foreign currencies such as the U.S. dollar and the South African rand as

the medium of exchange.

Estimates vary about how high inflation in Zimbabwe got, but the

magnitude of the problem is well documented by the denomination of

the notes being issued by the central bank. Before the hyperinflation

started, the Zimbabwe dollar was worth a bit more than one U.S. dollar,

so the denominations of the paper currency were similar to those one

would find in the United States. A person might carry, for example, a

10-dollar note in his wallet. In January 2008, however, after years of high

inflation, the Reserve Bank of Zimbabwe issued notes worth 10 million

Zimbabwe dollars, which was then equivalent to about 4 U.S. dollars.

But even that did not prove to be large enough. A year later, the central

bank announced it would issue notes worth 10 trillion Zimbabwe dollars,

then worth about 3 U.S. dollars.

A s p r i c e s r o s e a n d t h e c e n t r a l b a n k p r i n t e d e v e r- l a r g e r

denominations of money, the older, smaller-denomination currency lost

value and became almost

worthless. One indication

of this phenomenon can

b e f o u n d o n t h i s s i g n

from a public restroom in

Zimbabwe, shown below. ■

F Y I

IS TO

CK /G

ET TY

IM A

G ES

639CHAPTER 30 MONEY GROWTH AND INFLATION

30-1h The Fisher Effect According to the principle of monetary neutrality, an increase in the rate of money growth raises the rate of inflation but does not affect any real variable. An important application of this principle concerns the effect of money on interest rates. Interest rates are important variables for macroeconomists to understand because they link the economy of the present and the economy of the future through their effects on saving and investment.

To understand the relationship between money, inflation, and interest rates, recall the distinction between the nominal interest rate and the real interest rate. The nominal interest rate is the interest rate you hear about at your bank. If you have a savings account, for instance, the nominal interest rate tells you how fast the number of dollars in your account will rise over time. The real interest rate corrects the nominal interest rate for the effect of inflation to tell you how fast the purchasing power of your savings account will rise over time. The real interest rate is the nominal interest rate minus the inflation rate:

Real interest rate 5 Nominal interest rate 2 Inflation rate.

For example, if the bank posts a nominal interest rate of 7 percent per year and the inflation rate is 3 percent per year, then the real value of the deposits grows by 4 percent per year.

We can rewrite this equation to show that the nominal interest rate is the sum of the real interest rate and the inflation rate:

Nominal interest rate 5 Real interest rate 1 Inflation rate.

This way of looking at the nominal interest rate is useful because different economic forces determine each of the two terms on the right side of this equation. As we discussed earlier in the book, the supply and demand for loanable funds determine the real interest rate. And according to the quantity theory of money, growth in the money supply determines the inflation rate.

Let’s now consider how growth in the money supply affects interest rates. In the long run over which money is neutral, a change in money growth should not affect the real interest rate. The real interest rate is, after all, a real variable. For the real interest rate not to be affected, the nominal interest rate must adjust one-for- one to changes in the inflation rate. Thus, when the Fed increases the rate of money growth, the long-run result is both a higher inflation rate and a higher nominal interest rate. This adjustment of the nominal interest rate to the inflation rate is called the Fisher effect, after Irving Fisher (1867–1947), the economist who first studied it.

Keep in mind that our analysis of the Fisher effect has maintained a long-run perspective. The Fisher effect need not hold in the short run because inflation may be unanticipated. A nominal interest rate is a payment on a loan, and it is typically set when the loan is first made. If a jump in inflation catches the borrower and lender by surprise, the nominal interest rate they agreed on will fail to reflect the higher inflation. But if inflation remains high, people will eventually come to expect it, and loan agreements will reflect this expectation. To be precise, therefore, the Fisher effect states that the nominal interest rate adjusts to expected inflation. Expected inflation moves with actual inflation in the long run, but that is not necessarily true in the short run.

The Fisher effect is crucial for understanding changes over time in the nominal interest rate. Figure 5 shows the nominal interest rate and the inflation rate in

Fisher effect

the one-for-one

adjustment of the

nominal interest rate to

the inflation rate

640 PART X MONEY AND PRICES IN THE LONG RUN

the U.S. economy since 1960. The close association between these two variables is clear. The nominal interest rate rose from the early 1960s through the 1970s because inflation was also rising during this time. Similarly, the nominal interest rate fell from the early 1980s through the 1990s because the Fed got inflation under control. In recent years, both the nominal interest rate and the inflation rate have been low by historical standards.

QuickQuiz The government of a country increases the growth rate of the money

supply from 5 percent per year to 50 percent per year. What happens to

prices? What happens to nominal interest rates? Why might the government be doing this?

FIGURE 5

The Nominal Interest Rate

and the Inflation Rate

This figure uses annual data since 1960 to show the nominal interest rate on three-month

Treasury bills and the inflation rate as measured by the consumer price index. The close

association between these two variables is evidence for the Fisher effect: When the inflation

rate rises, so does the nominal interest rate.

Source: U.S. Department of Treasury; U.S. Department of Labor.

Percent (per year)

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

Nominal interest rate

Inflation

–3

30-2 The Costs of Inflation In the late 1970s, when the U.S. inflation rate reached about 10 percent per year, inflation dominated debates over economic policy. And even though inflation has been low over the past 20 years, it remains a closely watched macroeconomic variable. One study found that inflation is the economic term mentioned most often in U.S. newspapers (ahead of second-place finisher unemployment and third- place finisher productivity).

Inflation is closely watched and widely discussed because it is thought to be a serious economic problem. But is that true? And if so, why?

641CHAPTER 30 MONEY GROWTH AND INFLATION

30-2a A Fall in Purchasing Power? The Inflation Fallacy If you ask the typical person why inflation is bad, he will tell you that the answer is obvious: Inflation robs him of the purchasing power of his hard-earned dollars. When prices rise, each dollar of income buys fewer goods and services. Thus, it might seem that inflation directly lowers living standards.

Yet further thought reveals a fallacy in this answer. When prices rise, buyers of goods and services pay more for what they buy. At the same time, however, sellers of goods and services get more for what they sell. Because most people earn their incomes by selling their services, such as their labor, inflation in incomes goes hand in hand with inflation in prices. Thus, inflation does not in itself reduce people’s real purchasing power.

People believe the inflation fallacy because they do not appreciate the principle of monetary neutrality. A worker who receives an annual raise of 10 percent tends to view that raise as a reward for his own talent and effort. When an inflation rate of 6 percent reduces the real value of that raise to only 4 percent, the worker might feel that he has been cheated of what is rightfully his due. In fact, as we discussed in the chapter on production and growth, real incomes are determined by real variables, such as physical capital, human capital, natural resources, and the available production technology. Nominal incomes are determined by those factors and the overall price level. If the Fed were to lower the inflation rate from 6 percent to zero, our worker ’s annual raise would fall from 10 percent to 4 percent. He might feel less robbed by inflation, but his real income would not rise more quickly.

If nominal incomes tend to keep pace with rising prices, why then is inflation a problem? It turns out that there is no single answer to this question. Instead, economists have identified several costs of inflation. Each of these costs shows some way in which persistent growth in the money supply does, in fact, have some adverse effect on real variables.

30-2b Shoeleather Costs As we have discussed, inflation is like a tax on the holders of money. The tax itself is not a cost to society: It is only a transfer of resources from households to the government. Yet most taxes give people an incentive to alter their behavior to avoid paying the tax, and this distortion of incentives causes deadweight losses for society as a whole. Like other taxes, the inflation tax also causes deadweight losses because people waste scarce resources trying to avoid it.

How can a person avoid paying the inflation tax? Because inflation erodes the real value of the money in your wallet, you can avoid the inflation tax by holding less money. One way to do this is to go to the bank more often. For example, rather than withdrawing $200 every four weeks, you might withdraw $50 once a week. By making more frequent trips to the bank, you can keep more of your wealth in your interest-bearing savings account and less in your wallet, where inflation erodes its value.

The cost of reducing your money holdings is called the shoeleather cost of inflation because making more frequent trips to the bank causes your shoes to wear out more quickly. Of course, this term is not to be taken literally: The actual cost of reducing your money holdings is not the wear and tear on your shoes but the time and convenience you must sacrifice to keep less money on hand than you would if there were no inflation.

The shoeleather costs of inflation may seem trivial. Indeed, they are in the U.S. economy, which has had only moderate inflation in recent years. But this cost is magnified in countries experiencing hyperinflation. Here is a description of one

shoeleather costs

the resources wasted

when inflation encourages

people to reduce their

money holdings

642 PART X MONEY AND PRICES IN THE LONG RUN

person’s experience in Bolivia during its hyperinflation (as reported in the August 13, 1985, issue of The Wall Street Journal):

When Edgar Miranda gets his monthly teacher’s pay of 25 million pesos, he hasn’t a moment to lose. Every hour, pesos drop in value. So, while his wife rushes to market to lay in a month’s supply of rice and noodles, he is off with the rest of the pesos to change them into black-market dollars.

Mr. Miranda is practicing the First Rule of Survival amid the most out-of-control inflation in the world today. Bolivia is a case study of how runaway inflation undermines a society. Price increases are so huge that the figures build up almost beyond comprehension. In one six-month period, for example, prices soared at an annual rate of 38,000 percent. By official count, however, last year ’s inflation reached 2,000 percent, and this year ’s is expected to hit 8,000 percent—though other estimates range many times higher. In any event, Bolivia’s rate dwarfs Israel’s 370 percent and Argentina’s 1,100 percent—two other cases of severe inflation.

It is easier to comprehend what happens to the thirty-eight-year-old Mr. Miranda’s pay if he doesn’t quickly change it into dollars. The day he was paid 25 million pesos, a dollar cost 500,000 pesos. So he received $50. Just days later, with the rate at 900,000 pesos, he would have received $27.

As this story shows, the shoeleather costs of inflation can be substantial. With the high inflation rate, Mr. Miranda does not have the luxury of holding the local money as a store of value. Instead, he is forced to convert his pesos quickly into goods or into U.S. dollars, which offer a more stable store of value. The time and effort that Mr. Miranda expends to reduce his money holdings are a waste of resources. If the monetary authority pursued a low-inflation policy, Mr. Miranda would be happy to hold pesos, and he could put his time and effort to more productive use. In fact, shortly after this article was written, the Bolivian inflation rate was reduced substantially with a more restrictive monetary policy.

30-2c Menu Costs Most firms do not change the prices of their products every day. Instead, firms often announce prices and leave them unchanged for weeks, months, or even years. One survey found that the typical U.S. firm changes its prices about once a year.

Firms change prices infrequently because there are costs to changing prices. Costs of price adjustment are called menu costs, a term derived from a restaurant’s cost of printing a new menu. Menu costs include the costs of deciding on new prices, printing new price lists and catalogs, sending these new price lists and catalogs to dealers and customers, advertising the new prices, and even dealing with customer annoyance over price changes.

Inflation increases the menu costs that firms must bear. In the current U.S. economy, with its low inflation rate, annual price adjustment is an appropriate business strategy for many firms. But when high inflation makes firms’ costs rise rapidly, annual price adjustment is impractical. During hyperinflations, for example, firms must change their prices daily or even more often just to keep up with all the other prices in the economy.

30-2d Relative-Price Variability and the Misallocation of Resources Suppose that the Eatabit Eatery prints a new menu with new prices every January and then leaves its prices unchanged for the rest of the year. If there is no inflation, Eatabit’s relative prices—the prices of its meals compared to other prices in the

menu costs

the costs of changing

prices

643CHAPTER 30 MONEY GROWTH AND INFLATION

economy—would be constant over the course of the year. By contrast, if the inflation rate is 12 percent per year, Eatabit’s relative prices will automatically fall by 1 percent each month. The restaurant’s relative prices will be high in the early months of the year, just after it has printed a new menu, and low in the later months. And the higher the inflation rate, the greater is this automatic variability. Thus, because prices change only once in a while, inflation causes relative prices to vary more than they otherwise would.

Why does this matter? The reason is that market economies rely on relative prices to allocate scarce resources. Consumers decide what to buy by comparing the quality and prices of various goods and services. Through these decisions, they determine how the scarce factors of production are allocated among industries and firms. When inflation distorts relative prices, consumer decisions are distorted and markets are less able to allocate resources to their best use.

30-2e Inflation-Induced Tax Distortions Almost all taxes distort incentives, cause people to alter their behavior, and lead to a less efficient allocation of the economy’s resources. Many taxes, however, become even more problematic in the presence of inflation. The reason is that lawmakers often fail to take inflation into account when writing the tax laws. Economists who have studied the tax code conclude that inflation tends to raise the tax burden on income earned from savings.

One example of how inflation discourages saving is the tax treatment of capital gains—the profits made by selling an asset for more than its purchase price. Suppose that in 1988 you used some of your savings to buy stock in IBM for $30 and that in 2016 you sold the stock for $130. According to the tax law, you have earned a capital gain of $100, which you must include in your income when computing how much income tax you owe. But because the overall price level doubled from 1988 to 2016, the $30 you invested in 1988 is equivalent (in terms of purchasing power) to $60 in 2016. When you sell your stock for $130, you have a real gain (an increase in purchasing power) of only $70. The tax code, however, does not take account of inflation and assesses you a tax on a gain of $100. Thus, inflation exaggerates the size of capital gains and inadvertently increases the tax burden on this type of income.

Another example is the tax treatment of interest income. The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation. To see the effects of this policy, consider the numerical example in Table 1. The table compares two economies, both of which tax interest income at a rate of 25 percent. In Economy A, inflation is zero and the nominal and real interest rates are both 4 percent. In this case, the 25 percent tax on interest income reduces the real interest rate from 4 percent to 3 percent. In Economy B, the real interest rate is again 4 percent but the inflation rate is 8 percent. As a result of the Fisher effect, the nominal interest rate is 12 percent. Because the income tax treats this entire 12 percent interest as income, the government takes 25 percent of it, leaving an after-tax nominal interest rate of only 9 percent and an after-tax real interest rate of only 1 percent. In this case, the 25 percent tax on interest income reduces the real interest rate from 4 percent to 1 percent. Because the after-tax real interest rate provides the incentive to save, saving is much less attractive in the economy with inflation (Economy B) than in the economy with stable prices (Economy A).

The taxes on nominal capital gains and on nominal interest income are two examples of how the tax code interacts with inflation. There are many others. Because of these inflation-induced tax changes, higher inflation tends to

644 PART X MONEY AND PRICES IN THE LONG RUN

discourage people from saving. Recall that the economy’s saving provides the resources for investment, which in turn is a key ingredient to long-run economic growth. Thus, when inflation raises the tax burden on saving, it tends to depress the economy’s long-run growth rate. There is, however, no consensus among economists about the size of this effect.

One solution to this problem, other than eliminating inflation, is to index the tax system. That is, the tax laws could be rewritten to take account of the effects of inflation. In the case of capital gains, for example, the tax code could adjust the purchase price using a price index and assess the tax only on the real gain. In the case of interest income, the government could tax only real interest income by excluding that portion of the interest income that merely compensates for inflation. To some extent, the tax laws have moved in the direction of indexation. For example, the income levels at which income tax rates change are adjusted automatically each year based on changes in the consumer price index. Yet many other aspects of the tax laws—such as the tax treatment of capital gains and interest income—are not indexed.

In an ideal world, the tax laws would be written so that inflation would not alter anyone’s real tax liability. In the real world, however, tax laws are far from perfect. More complete indexation would probably be desirable, but it would further complicate a tax code that many people already consider too complex.

30-2f Confusion and Inconvenience Imagine that we took a poll and asked people the following question: “This year the yard is 36 inches. How long do you think it should be next year?” Assuming we could get people to take us seriously, they would tell us that the yard should stay the same length—36 inches. Anything else would just complicate life needlessly.

What does this finding have to do with inflation? Recall that money, as the economy’s unit of account, is what we use to quote prices and record debts. In other words, money is the yardstick with which we measure economic transactions. The job of the Federal Reserve is a bit like the job of the Bureau of

TABLE 1

How Inflation Raises the

Tax Burden on Saving

In the presence of zero

inflation, a 25 percent

tax on interest income

reduces the real interest

rate from 4 percent to

3 percent. In the

presence of 8 percent

inflation, the same tax

reduces the real interest

rate from 4 percent to

1 percent.

Economy A Economy B

(price stability) (inflation)

Real interest rate 4% 4%

Inflation rate 0 8

Nominal interest rate 4 12

(real interest rate 1 inflation rate) Reduced interest due to 25 percent tax 1 3

(0.25 3 nominal interest rate) After-tax nominal interest rate 3 9

(0.75 3 nominal interest rate) After-tax real interest rate 3 1

(after-tax nominal interest rate 2 inflation rate)

645CHAPTER 30 MONEY GROWTH AND INFLATION

Standards—to ensure the reliability of a commonly used unit of measurement. When the Fed increases the money supply and creates inflation, it erodes the real value of the unit of account.

It is difficult to judge the costs of the confusion and inconvenience that arise from inflation. Earlier, we discussed how the tax code incorrectly measures real incomes in the presence of inflation. Similarly, accountants incorrectly measure firms’ earnings when prices are rising over time. Because inflation causes dollars at different times to have different real values, computing a firm’s profit—the difference between its revenue and costs—is more complicated in an economy with inflation. Therefore, to some extent, inflation makes investors less able to sort successful from unsuccessful firms, which in turn impedes financial markets in their role of allocating the economy’s saving to alternative types of investment.

30-2g A Special Cost of Unexpected Inflation: Arbitrary Redistributions of Wealth

So far, the costs of inflation we have discussed occur even if inflation is steady and predictable. Inflation has an additional cost, however, when it comes as a surprise. Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need. These redistributions occur because many loans in the economy are specified in terms of the unit of account—money.

Consider an example. Suppose that Sam Student takes out a $20,000 loan at a 7 percent interest rate from Bigbank to attend college. In 10 years, the loan will come due. After his debt has compounded for 10 years at 7 percent, Sam will owe Bigbank $40,000. The real value of this debt will depend on inflation over the decade. If Sam is lucky, the economy will have a hyperinflation. In this case, wages and prices will rise so high that Sam will be able to pay the $40,000 debt out of pocket change. By contrast, if the economy goes through a major deflation, then wages and prices will fall, and Sam will find the $40,000 debt a greater burden than he anticipated.

This example shows that unexpected changes in prices redistribute wealth among debtors and creditors. A hyperinflation enriches Sam at the expense of Bigbank because it diminishes the real value of the debt; Sam can repay the loan in dollars that are less valuable than he anticipated. Deflation enriches Bigbank at Sam’s expense because it increases the real value of the debt; in this case, Sam has to repay the loan in dollars that are more valuable than he anticipated. If inflation were predictable, then Bigbank and Sam could take inflation into account when setting the nominal interest rate. (Recall the Fisher effect.) But if inflation is hard to predict, it imposes risk on Sam and Bigbank that both would prefer to avoid.

This cost of unexpected inflation is important to consider together with another fact: Inflation is especially volatile and uncertain when the average rate of inflation is high. This is seen most simply by examining the experience of different countries. Countries with low average inflation, such as Germany in the late 20th century, tend to have stable inflation. Countries with high average inflation, such as many countries in Latin America, tend to have unstable inflation. There are no known examples of economies with high, stable inflation. This relationship between the level and volatility of inflation points to another cost of inflation. If a country pursues a high-inflation monetary policy, it will have to bear not only the costs of high expected inflation but also the arbitrary redistributions of wealth associated with unexpected inflation.

646 PART X MONEY AND PRICES IN THE LONG RUN

30-2h Inflation Is Bad, but Deflation May Be Worse In recent U.S. history, inflation has been the norm. But the level of prices has fallen at times, such as during the late 19th century and early 1930s. From 1998 to 2012, Japan experienced a 4-percent decline in its overall price level. So as we conclude our discussion of the costs of inflation, we should briefly consider the costs of deflation as well.

Some economists have suggested that a small and predictable amount of deflation may be desirable. Milton Friedman pointed out that deflation would lower the nominal interest rate (via the Fisher effect) and that a lower nominal interest rate would reduce the cost of holding money. The shoeleather costs of holding money would, he argued, be minimized by a nominal interest rate close to zero, which in turn would require deflation equal to the real interest rate. This prescription for moderate deflation is called the Friedman rule.

Yet there are also costs of deflation. Some of these mirror the costs of inflation. For example, just as a rising price level induces menu costs and relative-price variability, so does a falling price level. Moreover, in practice, deflation is rarely as steady and predictable as Friedman recommended. More often, it comes as a surprise, resulting in the redistribution of wealth toward creditors and away from debtors. Because debtors are often poorer, these redistributions in wealth are particularly painful.

Perhaps most important, deflation often arises because of broader macroeconomic difficulties. As we will see in future chapters, falling prices result when some event, such as a monetary contraction, reduces the overall demand for goods and services in the economy. This fall in aggregate demand can lead to falling incomes and rising unemployment. In other words, deflation is often a symptom of deeper economic problems.

CASE STUDY

THE WIZARD OF OZ AND THE FREE-SILVER DEBATE As a child, you probably saw the movie The Wizard of Oz, based on a children’s book written in 1900. The movie and book tell the story of

a young girl, Dorothy, who finds herself lost in a strange land far from home. You probably did not know, however, that some scholars believe that the story is actually an allegory about U.S. monetary policy in the late 19th century.

From 1880 to 1896, the price level in the U.S. economy fell by 23 percent. Because this event was unanticipated, it led to a major redistribution of wealth. Most farmers in the western part of the country were debtors. Their creditors were the bankers in the east. When the price level fell, it caused the real value of these debts to rise, which enriched the banks at the expense of the farmers.

According to Populist politicians of the time, the solution to the farmers’ problem was the free coinage of silver. During this period, the United States was operating with a gold standard. The quantity of gold determined the money supply and, thereby, the price level. The free-silver advocates wanted silver, as well as gold, to be used as money. If adopted, this proposal would have increased the money supply, pushed up the price level, and reduced the real burden of the farmers’ debts.

The debate over silver was heated, and it was central to the politics of the 1890s. A common election slogan of the Populists was “We Are Mortgaged. All but Our Votes.” One prominent advocate of free silver was William Jennings Bryan,

647CHAPTER 30 MONEY GROWTH AND INFLATION

the Democratic nominee for president in 1896. He is remembered in part for a speech at the Democratic Party’s nominating convention in which he said, “You shall not press down upon the brow of labor this crown of thorns. You shall not crucify mankind upon a cross of gold.” Rarely since then have politicians waxed so poetic about alternative approaches to monetary policy. Nonetheless, Bryan lost the election to Republican William McKinley, and the United States remained on the gold standard.

L. Frank Baum, author of the book The Wonderful Wizard of Oz, was a midwestern journalist. When he sat down to write a story for children, he made the characters represent protagonists in the major political battle of his time. Here is how economic historian Hugh Rockoff, writing in the Journal of Political Economy in 1990, interprets the story:

Dorothy: Traditional American values Toto: Prohibitionist party, also called the Teetotalers Scarecrow: Farmers

Tin Woodsman: Industrial workers Cowardly Lion: William Jennings Bryan

Munchkins: Citizens of the East Wicked Witch of the East: Grover Cleveland Wicked Witch of the West: William McKinley

Wizard: Marcus Alonzo Hanna, chairman of the Republican Party

Oz: Abbreviation for ounce of gold Yellow Brick Road: Gold standard

At the end of Baum’s story, Dorothy does find her way home, but it is not by just following the yellow brick road. After a long and perilous journey, she learns that the wizard is incapable of helping her or her friends. Instead, Dorothy finally discovers the magical power of her silver slippers. (When the book was made into a movie in 1939, Dorothy’s slippers were changed from silver to ruby. The Hollywood filmmakers were more interested in showing off the new technology of Technicolor than in telling a story about 19th-century monetary policy.)

The Populists lost the debate over the free coinage of silver, but they eventually got the monetary expansion and inflation that they wanted. In 1898, prospectors discovered gold near the Klondike River in the Canadian Yukon. Increased supplies of gold also arrived from the mines of South Africa. As a result, the money supply and the price level started to rise in the United States and in other countries operating on the gold standard. Within 15 years, prices in the United States were back to the levels that had prevailed in the 1880s, and farmers were better able to handle their debts. ●

QuickQuiz List and describe six costs of inflation.

30-3 Conclusion This chapter discussed the causes and costs of inflation. The primary cause of inflation is growth in the quantity of money. When the central bank creates money in large quantities, the value of money falls quickly. To maintain stable prices, the central bank must maintain strict control over the money supply.

An early debate over monetary policy

M G

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648 PART X MONEY AND PRICES IN THE LONG RUN

The costs of inflation are more subtle. They include shoeleather costs, menu costs, increased variability of relative prices, unintended changes in tax liabilities, confusion and inconvenience, and arbitrary redistributions of wealth. Are these costs, in total, large or small? All economists agree that they become huge during hyperinflation. But during periods of moderate inflation—when prices rise by less than 10 percent per year—the size of these costs is more open to debate.

This chapter presented many of the most important lessons about inflation, but the analysis is incomplete. When the central bank reduces the rate of money growth, prices rise less rapidly, as the quantity theory suggests. Yet as the economy makes the transition to the lower inflation rate, the change in monetary policy will likely disrupt production and employment. That is, even though monetary policy is neutral in the long run, it has profound effects on real variables in the short run. Later in this book we will examine the reasons for short-run monetary non- neutrality to enhance our understanding of the causes and effects of inflation.

1. The classical principle of monetary neutrality states

that changes in the money supply do not influence

________ variables and is thought most applicable in

the ________ run.

a. nominal, short

b. nominal, long

c. real, short

d. real, long

2. If nominal GDP is $400, real GDP is $200, and the

money supply is $100, then

a. the price level is ½, and velocity is 2.

b. the price level is ½, and velocity is 4.

c. the price level is 2, and velocity is 2.

d. the price level is 2, and velocity is 4.

3. According to the quantity theory of money, which vari-

able in the quantity equation is most stable over long

periods of time?

a. money

b. velocity

c. price level

d. output

4. Hyperinflations occur when the government runs a

large budget ________, which the central bank

finances with a substantial monetary ________.

a. deficit, contraction

b. deficit, expansion

c. surplus, contraction

d. surplus, expansion

5. According to the quantity theory of money and the

Fisher effect, if the central bank increases the rate of

money growth,

a. inflation and the nominal interest rate both

increase.

b. inflation and the real interest rate both increase.

c. the nominal interest rate and the real interest rate

both increase.

d. inflation, the real interest rate, and the nominal

interest rate all increase.

6. If an economy always has inflation of 10 percent per

year, which of the following costs of inflation will it

NOT suffer?

a. shoeleather costs from reduced holdings of money

b. menu costs from more frequent price adjustment

c. distortions from the taxation of nominal capital

gains

d. arbitrary redistributions between debtors and

creditors

CHAPTER QuickQuiz

649CHAPTER 30 MONEY GROWTH AND INFLATION

The overall level of prices in an economy adjusts to

bring money supply and money demand into balance.

When the central bank increases the supply of money,

it causes the price level to rise. Persistent growth in

the quantity of money supplied leads to continuing

inflation.

The principle of monetary neutrality asserts that

changes in the quantity of money influence nominal

variables but not real variables. Most economists

believe that monetary neutrality approximately

describes the behavior of the economy in the long run.

A government can pay for some of its spending simply

by printing money. When countries rely heavily on this

“inflation tax,” the result is hyperinflation.

One application of the principle of monetary neutrality

is the Fisher effect. According to the Fisher effect, when

the inflation rate rises, the nominal interest rate rises by

the same amount so that the real interest rate remains

the same.

Many people think that inflation makes them poorer

because it raises the cost of what they buy. This view

is a fallacy, however, because inflation also raises

nominal incomes.

Economists have identified six costs of inflation:

shoeleather costs associated with reduced money

holdings, menu costs associated with more frequent

adjustment of prices, increased variability of relative

prices, unintended changes in tax liabilities due

to nonindexation of the tax code, confusion and

inconvenience resulting from a changing unit of

account, and arbitrary redistributions of wealth

between debtors and creditors. Many of these costs are

large during hyperinflation, but the size of these costs

for moderate inflation is less clear.

quantity theory of money, p. 631

nominal variables, p. 633

real variables, p. 633

classical dichotomy, p. 633

monetary neutrality, p. 634

velocity of money, p. 634

quantity equation, p. 635

inflation tax, p. 637

Fisher effect, p. 639

shoeleather costs, p. 641

menu costs, p. 642

1. Explain how an increase in the price level affects the

real value of money.

2. According to the quantity theory of money, what is the

effect of an increase in the quantity of money?

3. Explain the difference between nominal and real

variables and give two examples of each. According

to the principle of monetary neutrality, which

variables are affected by changes in the quantity of

money?

4. In what sense is inflation like a tax? How does thinking

about inflation as a tax help explain hyperinflation?

5. According to the Fisher effect, how does an increase

in the inflation rate affect the real interest rate and the

nominal interest rate?

6. What are the costs of inflation? Which of these costs do

you think are most important for the U.S. economy?

7. If inflation is less than expected, who benefits—

debtors or creditors? Explain.

SUMMARY

h f l h ff

KEY CONCEPTS

l h h l l ff h h fl l k d h k

QUESTIONS FOR REVIEW

1. Suppose that this year’s money supply is $500 billion,

nominal GDP is $10 trillion, and real GDP is $5 trillion.

a. What is the price level? What is the velocity of

money?

b. Suppose that velocity is constant and the

economy’s output of goods and services rises by

5 percent each year. What will happen to nominal

GDP and the price level next year if the Fed keeps

the money supply constant?

c. What money supply should the Fed set next year

if it wants to keep the price level stable?

d. What money supply should the Fed set next year

if it wants inflation of 10 percent?

PROBLEMS AND APPLICATIONS

650 PART X MONEY AND PRICES IN THE LONG RUN

2. Suppose that changes in bank regulations expand the

availability of credit cards so that people need to hold

less cash.

a. How does this event affect the demand for

money?

b. If the Fed does not respond to this event, what

will happen to the price level?

c. If the Fed wants to keep the price level stable,

what should it do?

3. It is sometimes suggested that the Federal Reserve

should try to achieve zero inflation. If we assume

that velocity is constant, does this zero-inflation goal

require that the rate of money growth equal zero? If

yes, explain why. If no, explain what the rate of money

growth should equal.

4. Suppose that a country’s inflation rate increases

sharply. What happens to the inflation tax on the

holders of money? Why is wealth that is held in

savings accounts not subject to a change in the inflation tax? Can you think of any way holders

of savings accounts are hurt by the increase in the

inflation rate?

5. Let’s consider the effects of inflation in an economy

composed of only two people: Bob, a bean farmer, and

Rita, a rice farmer. Bob and Rita both always consume

equal amounts of rice and beans. In 2016, the price of

beans was $1 and the price of rice was $3.

a. Suppose that in 2017 the price of beans was $2

and the price of rice was $6. What was inflation?

Was Bob better off, worse off, or unaffected by the

changes in prices? What about Rita?

b. Now suppose that in 2017 the price of beans

was $2 and the price of rice was $4. What was

inflation? Was Bob better off, worse off, or

unaffected by the changes in prices? What about

Rita?

c. Finally, suppose that in 2017 the price of beans

was $2 and the price of rice was $1.50. What

was inflation? Was Bob better off, worse off, or

unaffected by the changes in prices? What about

Rita?

d. What matters more to Bob and Rita—the over-

all inflation rate or the relative price of rice and

beans?

6. If the tax rate is 40 percent, compute the before-tax real

interest rate and the after-tax real interest rate in each

of the following cases.

a. The nominal interest rate is 10 percent, and the

inflation rate is 5 percent.

b. The nominal interest rate is 6 percent, and the

inflation rate is 2 percent.

c. The nominal interest rate is 4 percent, and the

inflation rate is 1 percent.

7. Recall that money serves three functions in the

economy. What are those functions? How does

inflation affect the ability of money to serve each of

these functions?

8. Suppose that people expect inflation to equal 3

percent, but in fact, prices rise by 5 percent. Describe

how this unexpectedly high inflation rate would help

or hurt the following:

a. the government

b. a homeowner with a fixed-rate mortgage

c. a union worker in the second year of a labor

contract

d. a college that has invested some of its endowment

in government bonds

9. Explain whether the following statements are true,

false, or uncertain.

a. “Inflation hurts borrowers and helps lenders,

because borrowers must pay a higher rate of

interest.”

b. “If prices change in a way that leaves the overall

price level unchanged, then no one is made better

or worse off.”

c. “Inflation does not reduce the purchasing power

of most workers.”

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

The Macroeconomics of Open Economies

PART XI

Open-Economy Macroeconomics: Basic Concepts

CHAPTER

31 W

hen you decide to buy a car, you may compare the latest models offered by Ford and Toyota. When you take your next vacation, you may consider spending it on a beach in Florida or in Mexico. When you start saving for

your retirement, you may choose between a mutual fund that buys stock in U.S. companies and one that buys stock in foreign companies. In all these cases, you are participating not just in the U.S. economy but also in economies around the world.

International trade yields clear benefits: Trade allows people to produce what they produce best and to consume the great variety of goods and services produced around the world. Indeed, one of the Ten Principles of Economics

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654 PART XI THE MACROECONOMICS OF OPEN ECONOMIES

highlighted in Chapter 1 is that trade can make everyone better off. International trade can raise living standards in all countries by allowing each country to specialize in producing those goods and services in which it has a comparative advantage.

So far, our development of macroeconomics has largely ignored the economy’s interaction with other economies around the world. For most questions in macro- economics, international issues are peripheral. For instance, when we discuss the natural rate of unemployment and the causes of inflation, the effects of interna- tional trade can safely be ignored. Indeed, to keep their models simple, macroeco- nomists often assume a closed economy—an economy that does not interact with other economies.

Yet when macroeconomists study an open economy—an economy that inter- acts freely with other economies around the world—they encounter a whole set of new issues. This chapter and the next provide an introduction to open-economy macroeconomics. We begin in this chapter by discussing the key macroeconomic variables that describe an open economy’s interactions in world markets. You may have noticed mention of these variables—exports, imports, the trade balance, and exchange rates—in the news. Our first job is to understand what these data mean. In the next chapter, we develop a model to explain how these variables are determined and how they are affected by various government policies.

31-1 The International Flows of Goods and Capital An open economy interacts with other economies in two ways: It buys and sells goods and services in world product markets, and it buys and sells capital assets such as stocks and bonds in world financial markets. Here we discuss these two activities and the close relationship between them.

31-1a The Flow of Goods: Exports, Imports, and Net Exports Exports are domestically produced goods and services that are sold abroad, and imports are foreign-produced goods and services that are sold domestically. When Boeing, the U.S. aircraft manufacturer, builds a plane and sells it to Air France, the sale is an export for the United States and an import for France. When Volvo, the Swedish car manufacturer, makes a car and sells it to a U.S. resident, the sale is an import for the United States and an export for Sweden.

The net exports of any country are the difference between the value of its exports and the value of its imports:

Net exports 5 Value of country’s exports 2 Value of country’s imports.

The Boeing sale raises U.S. net exports, and the Volvo sale reduces U.S. net exports. Because net exports tell us whether a country is, in total, a seller or a buyer in world markets for goods and services, net exports are also called the trade balance. If net exports are positive, exports are greater than imports, indicating that the country sells more goods and services abroad than it buys from other countries. In this case, the country is said to run a trade surplus. If net exports are negative, exports are less than imports, indicating that the country sells fewer goods and services abroad than it buys from other countries. In this case, the country is said to run a trade deficit. If net exports are zero,

exports

goods and services

that are produced

domestically and sold

abroad

imports

goods and services that

are produced abroad and

sold domestically

net exports

the value of a nation’s

exports minus the value

of its imports; also called

the trade balance

closed economy

an economy that does

not interact with other

economies in the world

open economy

an economy that

interacts freely with other

economies around the

world

trade balance

the value of a nation’s

exports minus the value

of its imports; also called

net exports

trade surplus

an excess of exports over

imports

trade deficit

an excess of imports over

exports

655CHAPTER 31 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS

its exports and imports are exactly equal, and the country is said to have balanced trade.

In the next chapter, we develop a theory that explains an economy’s trade balance, but even at this early stage, it is easy to think of many factors that might influence a country’s exports, imports, and net exports. Those factors include the following:

• The tastes of consumers for domestic and foreign goods • The prices of goods at home and abroad • The exchange rates at which people can use domestic currency to

buy foreign currencies • The incomes of consumers at home and abroad • The cost of transporting goods from country to country • Government policies toward international trade

As these variables change, so does the amount of international trade.

balanced trade

a situation in which

exports equal imports

CASE STUDY

THE INCREASING OPENNESS OF THE U.S. ECONOMY One dramatic change in the U.S. economy over the past six decades has been the increasing importance of international trade and

finance. This change is illustrated in Figure 1, which shows the total value of goods and services exported to other countries and imported from other countries expressed as a percentage of gross domestic product. In the 1950s, imports and exports of goods and services were typically between 4 and 5 percent of GDP. In recent years, they have been about three times that level. The trading partners of the United States include a diverse group of countries. As of 2015, the largest trading partner, as measured by imports and exports combined, was China, followed by Canada, Mexico, Japan, Germany, South Korea, and the United Kingdom.

O RT

G ER

BE RG

/ TH

E N

EW Y

O RK

CO LL

EC TI

O N

/ W

W W

.C A

RT O

O N

BA N

K. CO

FIGURE 1

The Internationalization of

the U.S. Economy

This figure shows exports

and imports of the U.S.

economy as a percentage

of U.S. GDP since 1950.

The substantial increases

over time show the

increasing importance of

international trade and

finance.

Source: U.S. Department of Commerce.

Percent of GDP

Exports

Imports

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

“But we’re not just talking about buying a car—we’re talking about confronting this country’s trade deficit with Japan.”

656 PART XI THE MACROECONOMICS OF OPEN ECONOMIES

The political maneuvering over the

Trans-Pacific Partnership in 2015

is a good example of how difficult

ratifying a trade deal can be.

The Great Trans-Pacific

Partnership Debate

By Doyle McManus

T he White House released the text of its new

trade deal, the Trans-Pacific Partnership,

last week, and like any good citizen, I tried my

best to read it. But the 12-country agreement

is more than 2,700 pages long, plus annexes,

and a lot of it sounds like this: “The parties

shall at all times endeavor to agree on the

interpretation and application of this agree-

ment, and shall make every attempt through

cooperation and consultations to arrive at a

mutually satisfactory resolution.”

And that’s one of the lucid bits. Those

members of Congress who say they’ve read

the whole thing? They’re fibbing.

There are three ways a befuddled citizen

can figure out what to think about a complex

deal like the TPP.

The first is tribal: Listen for signals from

the politicians you support and assume

they’ve made the right decisions. But that’s

not so easy when it comes to the TPP because

the agreement divides both parties.

It’s no surprise that President Obama is

strongly in favor of a deal he and his aides

just finished negotiating. “It’s an agreement

that puts American workers first and will help

middle-class families get ahead,” he said. “It

includes the strongest commitments on labor

and the environment of any trade agreement

in history.” The Democratic presidential can-

didates don’t agree. Bernie Sanders says the

TPP is “even worse” than he expected. Hillary

Rodham Clinton opposes it too, and hopes

you’ll forget that she once called it “the gold

standard” of trade deals.

Among Republicans, “establishment”

candidates Jeb Bush and John Kasich support

the agreement, as do Ben Carson and Marco

Rubio. But Donald Trump and Ted Cruz have

said they are opposed.

A second approach is to listen to what in-

terested parties say and choose sides based

on where your sympathies lie.

Manufacturing workers and their unions

think another free-trade deal will inevitably

hurt them. The last half-century of global-

ization has coincided with a massive loss of

blue-collar jobs; not all of the erosion was

due to trade, but to labor, the TPP looks like

more of the same. “A bad deal for American

workers,” AFL-CIO President Richard Trumka

said.

Environmentalists are condemning the

deal too, mostly because it doesn’t crack

The Complicated Politics of Trade Agreements

IN THE NEWS

The increase in international trade over the past several decades is partly due to improvements in transportation. In 1950, the average merchant ship carried less than 10,000 tons of cargo; today, many ships carry more than 100,000 tons. The long-distance jet was introduced in 1958 and the wide-body jet in 1967, making air transport far cheaper than it had been previously. These developments allow goods that once had to be produced locally to be traded around the world. Cut flowers grown in Israel are flown to the United States to be sold. Fresh fruits and vegetables that can grow only in summer in the United States can now be consumed in winter as well because they can be shipped from countries in the Southern Hemisphere.

The increase in international trade has also been influenced by advances in telecommunications, which have allowed businesses to reach overseas customers more easily. For example, the first transatlantic telephone cable was not laid until 1956. As recently as 1966, the technology allowed only 138 simultaneous conversations between North America and Europe. Today, because e-mail is such a common form of business communication, it is almost as easy to communicate with a customer across the world as it is to communicate with one across town.

Technological progress has also fostered international trade by changing the kinds of goods that economies produce. When bulky raw materials (such as steel) and perishable goods (such as foodstuffs) were a large part of the world’s output,

657CHAPTER 31 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS

transporting goods was often costly and sometimes impossible. By contrast, goods produced with modern technology are often light and easy to transport. Consumer electronics, for instance, have low weight for every dollar of value, which makes them easy to produce in one country and sell in another. An even more extreme example is the film industry. Once a studio in Hollywood makes a movie, it can send copies of the film around the world at almost zero cost. And indeed, movies are a major export of the United States.

Governments’ trade policies have also been a factor in increasing international trade. As we discussed earlier in this book, economists have long believed that free trade between countries is mutually beneficial. Over time, most policymakers around the world have come to accept these conclusions. International agreements, such as the North American Free Trade Agreement (NAFTA) and the General Agreement on Tariffs and Trade (GATT), have gradually lowered tariffs, import quotas, and other trade barriers. As this book was going to press, the United States was debating whether to ratify a new trade agreement—the Trans- Pacific Partnership—which President Obama’s representatives had negotiated with eleven other Pacific Rim nations. (See the accompanying In the News box.) Thus, the pattern of increasing trade illustrated in Figure 1 is a phenomenon that most economists and policymakers endorse and encourage. ●

down on climate change. But this is, after

all, a trade deal; talks on global warming are

already underway.

Big business is mostly in favor of the deal,

although not universally so. Tobacco compa-

nies are unhappy that it deprives them of the

right to sue countries that restrict trade by lim-

iting cigarette sales. Pharmaceutical compa-

nies complain that they aren’t getting enough

protection for their patents. (Doctors Without

Borders thinks they are getting too much.)

Hollywood, Silicon Valley and agribusi-

ness mostly like the deal, which protects

entertainment copyrights, eases the flow of

data across borders and opens doors for U.S.

exports of meat and rice to Asia. California

would reap benefits that the Rust Belt

won’t see.

N o w f o r t h e f i n a l , l a b o r- i n t e n s i v e

approach: Listen to smart people who don’t

have a vested interest but are trying to ana-

lyze the deal in a comprehensive way.

For a start, I consulted with Joseph A.

Massey, a former U.S. trade negotiator with

China and Japan who has served as an advi-

sor to Republicans and Democrats.

Massey made three points.

First, he said, the TPP’s impact has

probably been oversold. “It has benefits for

U.S. export industries, but I think they’re

modest,” he said. “It’s clearly good for the

entertainment and tech sectors. But it’s not

revolutionary.”

Second, he said, the biggest threat to jobs

in the United States isn’t free-trade agree-

ments; it’s domestic policy. “We’ve neglected

our own manufacturing sector,” he said.

“Germany is a party to trade agreements too,

but they’ve done a much better job at main-

taining a skilled blue-collar workforce. We

need more incentives for companies to invest

here, employ American workers and invest in

their training.”

Third, he noted, the TPP isn’t only about

trade. It’s also about economic reform,

higher labor standards and environmental

protection in developing countries such

as Vietnam and Malaysia. And it’s a way

to knit countries on the Pacific Rim into

a trading system that the United States

helped design instead of one run by Asia’s

growing power, China.

Obama hasn’t been subtle about pushing

that geopolitical argument. “If we don’t pass

this agreement—if America doesn’t write

those rules—then countries like China will,”

he said last week.

To foreign policy strategists, that’s a com-

pelling pitch. To American workers, it’s not.

So are we better off with or without the

TPP? If Congress ratifies it, that won’t turbo-

charge the U.S. economy. If Congress blocks

the deal, that won’t stop globalization. And

like any trade agreement, it creates winners

and losers.

One political lesson is clear: The biparti-

san consensus that enabled Bill Clinton and

George W. Bush to pass trade agreements has

broken down, mostly because, to many Ameri-

cans, their costs have been clearer than their

benefits.

To win Congress’ approval of the deal—

an important part of Obama’s second-term

agenda and his legacy—the president still

has a lot of persuading to do. ■

Source: Los Angeles Times, November 8, 2015.

658 PART XI THE MACROECONOMICS OF OPEN ECONOMIES

31-1b The Flow of Financial Resources: Net Capital Outflow So far, we discussed how residents of an open economy participate in world markets for goods and services. In addition, residents of an open economy participate in world financial markets. A U.S. resident with $25,000 could use that money to buy a car from Toyota or, instead, to buy stock in the Toyota Corporation. The first transaction would represent a flow of goods, whereas the second would represent a flow of capital.

The term net capital outflow refers to the difference between the purchase of foreign assets by domestic residents and the purchase of domestic assets by foreigners:

Net capital outflow 5 Purchase of foreign assets by domestic residents 2 Purchase of domestic assets by foreigners.

When a U.S. resident buys stock in Petrobras, the Brazilian energy company, the purchase increases the first term on the right side of this equation and, therefore, increases U.S. net capital outflow. When a Japanese resident buys a bond issued by the U.S. government, the purchase increases the second term on the right side of this equation and, therefore, decreases U.S. net capital outflow.

The flow of capital between the U.S. economy and the rest of the world takes two forms. If McDonald’s opens up a fast-food outlet in Russia, that is an example of foreign direct investment. Alternatively, if an American buys stock in a Russian corporation, that is an example of foreign portfolio investment. In the first case, the American owner (McDonald’s Corporation) actively manages the investment, whereas in the second case, the American owner (the stockholder) has a more passive role. In both cases, U.S. residents are buying assets located in another country, so both purchases increase U.S. net capital outflow.

The net capital outflow (sometimes called net foreign investment) can be either positive or negative. When it is positive, domestic residents are buying more foreign assets than foreigners are buying domestic assets. Capital is said to be flowing out of the country. When the net capital outflow is negative, domestic residents are buying less foreign assets than foreigners are buying domestic assets. Capital is said to be flowing into the country. That is, when net capital outflow is negative, a country is experiencing a capital inflow.

We develop a theory to explain net capital outflow in the next chapter. Here let’s consider briefly some of the more important variables that influence net capital outflow:

• The real interest rates paid on foreign assets • The real interest rates paid on domestic assets • The perceived economic and political risks of holding assets abroad • The government policies that affect foreign ownership of domestic assets

For example, consider U.S. investors deciding whether to buy Mexican government bonds or U.S. government bonds. (Recall that a bond is, in effect, an IOU of the issuer.) To make this decision, U.S. investors compare the real interest rates offered on the two bonds. The higher a bond’s real interest rate, the more attractive it is. While making this comparison, however, U.S. investors must also take into account the risk that one of these governments might default on its debt (that is, not pay interest or principal when it is due), as well as any restrictions

net capital outflow

the purchase of foreign

assets by domestic

residents minus the

purchase of domestic

assets by foreigners

659CHAPTER 31 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS

that the Mexican government has imposed, or might impose in the future, on foreign investors in Mexico.

31-1c The Equality of Net Exports and Net Capital Outflow We have seen that an open economy interacts with the rest of the world in two ways—in world markets for goods and services and in world financial markets. Net exports and net capital outflow each measure a type of imbalance in these markets. Net exports measure an imbalance between a country’s exports and its imports. Net capital outflow measures an imbalance between the amount of foreign assets bought by domestic residents and the amount of domestic assets bought by foreigners.

An important but subtle fact of accounting states that, for an economy as a whole, net capital outflow (NCO) must always equal net exports (NX):

NCO 5 NX.

This equation holds because every transaction that affects one side of this equation affects the other side by exactly the same amount. This equation is an identity—an equation that must hold because of how the variables in the equation are defined and measured.

To see why this accounting identity is true, let’s consider an example. Imagine that you are a computer programmer residing in the United States. One day, you write some software and sell it to a Japanese consumer for 10,000 yen. The sale of software is an export of the United States, so it increases U.S. net exports. What else happens to ensure that this identity holds? The answer depends on what you do with the 10,000 yen you are paid.

First, let’s suppose that you simply stuff the yen in your mattress. (We might say you have a yen for yen.) In this case, you are using some of your income to invest in the Japanese economy. That is, a domestic resident (you) has acquired a foreign asset (the Japanese currency). The increase in U.S. net exports is matched by an increase in the U.S. net capital outflow.

More realistically, however, if you want to invest in the Japanese economy, you won’t do so by holding on to Japanese currency. More likely, you would use the 10,000 yen to buy stock in a Japanese corporation, or you might buy a Japanese government bond. Yet the result of your decision is much the same: A domestic resident ends up acquiring a foreign asset. The increase in U.S. net capital outflow (the purchase of the Japanese stock or bond) exactly equals the increase in U.S. net exports (the sale of software).

Let’s now change the example. Suppose that instead of using the 10,000 yen to buy a Japanese asset, you use them to buy a good made in Japan, such as a Sony TV. As a result of the TV purchase, U.S. imports increase. Together, the software export and the TV import represent balanced trade. Because exports and imports increase by the same amount, net exports are unchanged. In this case, no American ends up acquiring a foreign asset and no foreigner ends up acquiring a U.S. asset, so there is also no impact on U.S. net capital outflow.

A final possibility is that you go to a local bank to exchange your 10,000 yen for U.S. dollars. But this doesn’t change the situation because the bank now has to do something with the 10,000 yen. It can buy Japanese assets (a U.S. net capital outflow); it can buy a Japanese good (a U.S. import); or it can sell the yen to another American who wants to make such a transaction. In the end, U.S. net exports must equal U.S. net capital outflow.

660 PART XI THE MACROECONOMICS OF OPEN ECONOMIES

This example all started when a U.S. programmer sold some software abroad, but the story is much the same when Americans buy goods and services from other countries. For example, if Walmart buys $50 million of clothing from China and sells it to American consumers, something must happen to that $50 million. One possibility is that China could use the $50 million to invest in the U.S. economy. This capital inflow from China might take the form of Chinese purchases of U.S. government bonds. In this case, the purchase of the clothing reduces U.S. net exports, and the sale of bonds reduces U.S. net capital outflow. Alternatively, China could use the $50 million to buy a plane from Boeing, the U.S. aircraft manufacturer. In this case, the U.S. import of clothing balances the U.S. export of aircraft, so net exports and net capital outflow are both unchanged. In all cases, the transactions have the same effect on net exports and net capital outflow.

We can summarize these conclusions for the economy as a whole.

• When a nation is running a trade surplus (NX . 0), it is selling more goods and services to foreigners than it is buying from them. What is it doing with the foreign currency it receives from the net sale of goods and services abroad? It must be using it to buy foreign assets. Capital is flowing out of the country (NCO . 0).

• When a nation is running a trade deficit (NX , 0), it is buying more goods and services from foreigners than it is selling to them. How is it financing the net purchase of these goods and services in world markets? It must be selling assets abroad. Capital is flowing into the country (NCO , 0).

The international flow of goods and services and the international flow of capital are two sides of the same coin.

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

A nation’s saving and investment are crucial to its long-run economic growth. As we saw in an earlier chapter, saving and investment are equal in a closed economy. But matters are not as simple in an open economy. Let’s now consider how saving and investment are related to the international flows of goods and capital as measured by net exports and net capital outflow.

As you may recall, the term net exports appeared earlier in the book when we discussed the components of gross domestic product. The economy’s GDP (denoted Y) is divided among four components: consumption (C), investment (I), government purchases (G), and net exports (NX). We write this as

Y 5 C 1 I 1 G 1 NX.

Total expenditure on the economy’s output of goods and services is the sum of expenditure on consumption, investment, government purchases, and net exports. Because each dollar of expenditure is placed into one of these four components, this equation is an accounting identity: It must be true because of the way the variables are defined and measured.

Recall that national saving is the income of the nation that is left after paying for current consumption and government purchases. National saving (S) equals Y 2 C 2 G. If we rearrange the equation to reflect this fact, we obtain

Y 2 C 2 G 5 I 1 NX

S 5 I 1 NX.

661CHAPTER 31 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS

Because net exports (NX) also equal net capital outflow (NCO), we can write this equation as

S 5 I 1 NCO

Domestic Net capital Saving 5 1 .

investment outflow

This equation shows that a nation’s saving must equal its domestic investment plus its net capital outflow. In other words, when a U.S. citizen saves a dollar of her income for the future, that dollar can be used to finance the accumulation of domestic capital or it can be used to finance the purchase of foreign capital.

This equation should look somewhat familiar. Earlier in the book, when we analyzed the role of the financial system, we considered this identity for the special case of a closed economy. In a closed economy, net capital outflow is zero (NCO 5 0), so saving equals investment (S 5 I). By contrast, an open economy has two uses for its saving: domestic investment and net capital outflow.

As before, we can view the financial system as standing between the two sides of this identity. For example, suppose the Garcia family decides to save some of its income for retirement. This decision contributes to national saving, the left side of our equation. If the Garcias deposit their saving in a mutual fund, the mutual fund may use some of the deposit to buy stock issued by General Motors, which uses the proceeds to build a factory in Ohio. In addition, the mutual fund may use some of the Garcias’ deposit to buy stock issued by Toyota, which uses the proceeds to build a factory in Osaka. These transactions show up on the right side of the equation. From the standpoint of U.S. accounting, the General Motors expenditure on a new factory is domestic investment, and the purchase of Toyota stock by a U.S. resident is net capital outflow. Thus, all saving in the U.S. economy shows up as investment in the U.S. economy or as U.S. net capital outflow.

The bottom line is that saving, investment, and international capital flows are inextricably linked. When a nation’s saving exceeds its domestic investment, its net capital outflow is positive, indicating that the nation is using some of its saving to buy assets abroad. When a nation’s domestic investment exceeds its saving, its net capital outflow is negative, indicating that foreigners are financing some of this investment by purchasing domestic assets.

31-1e Summing Up Table 1 summarizes many of the ideas presented so far in this chapter. It describes the three possibilities for an open economy: a country with a trade deficit, a country with balanced trade, and a country with a trade surplus.

Consider first a country with a trade surplus. By definition, a trade surplus means that the value of exports exceeds the value of imports. Because net exports are exports minus imports, net exports, NX, are positive. As a result, income, Y 5 C 1 I 1 G 1 NX, must be greater than domestic spending, C 1 I 1 G. But if income, Y, is more than spending, C 1 I 1 G, then saving, S 5 Y 2 C 2 G, must be more than investment, I. Because the country is saving more than it is investing, it must be sending some of its saving abroad. That is, the net capital outflow must be positive.

Similar logic applies to a country with a trade deficit (such as the U.S. economy in recent years). By definition, a trade deficit means that the value of exports is less than the value of imports. Because net exports are exports minus imports, net exports, NX, are negative. Thus, income, Y 5 C 1 I 1 G 1 NX, must be less than

662 PART XI THE MACROECONOMICS OF OPEN ECONOMIES

domestic spending, C 1 I 1 G. But if income, Y, is less than spending, C 1 I 1 G, then saving, S 5 Y 2 C 2 G, must be less than investment, I. Because the country is investing more than it is saving, it must be financing some domestic investment by selling assets abroad. That is, the net capital outflow must be negative.

A country with balanced trade falls between these cases. Exports equal imports, so net exports are zero. Income equals domestic spending, and saving equals investment. The net capital outflow equals zero.

TABLE 1

International Flows

of Goods and Capital:

Summary

This table shows the

three possible outcomes

for an open economy.

Trade Deficit Balanced Trade Trade Surplus

Exports , Imports Exports 5 Imports Exports . Imports

Net Exports , 0 Net Exports 5 0 Net Exports . 0

Y , C 1 I 1 G Y 5 C 1 I 1 G Y . C 1 I 1 G

Saving , Investment Saving 5 Investment Saving . Investment

Net Capital Outflow , 0 Net Capital Outflow 5 0 Net Capital Outflow . 0

CASE STUDY

IS THE U.S. TRADE DEFICIT A NATIONAL PROBLEM? You may have heard the press call the United States “the world’s largest debtor.” The nation earned that description by borrowing

heavily in world financial markets during the past three decades to finance large trade deficits. Why did the United States do this, and should this practice give Americans reason to worry?

To answer these questions, let’s see what the macroeconomic accounting identities tell us about the U.S. economy. Panel (a) of Figure 2 shows national saving and domestic investment as a percentage of GDP since 1960. Panel (b) shows net capital outflow (that is, the trade balance) as a percentage of GDP. Notice that, as the identities require, net capital outflow always equals national saving minus domestic investment. The figure shows that both national saving and domestic investment, as a percentage of GDP, fluctuate substantially over time. Before 1980, they tended to fluctuate together, so the net capital outflow was typically small— between −1 and 1 percent of GDP. Since 1980, national saving has often fallen well below domestic investment, leading to sizable trade deficits and substantial inflows of capital. That is, the net capital outflow is often a large negative number.

To understand the fluctuations in Figure 2, we need to go beyond these data and discuss the policies and events that influence national saving and domestic investment. History shows that there is no single cause of trade deficits. Rather, they can arise under a variety of circumstances. Here are three prominent historical episodes.

Unbalanced fiscal policy: From 1980 to 1987, the flow of capital into the United States went from 0.5 to 3.0 percent of GDP. This 2.5 percentage point change is largely attributable to a fall in national saving of 2.7 percentage points. This decline in national saving, in turn, is often explained by the decline in public saving— that is, the increase in the government budget deficit. These budget deficits arose because President Ronald Reagan cut taxes and increased defense spending, while he found his proposed cuts in nondefense spending harder to enact.

663CHAPTER 31 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS

An investment boom: A different story explains the trade deficits that arose during the following decade. From 1991 to 2000, the capital flow into the United States went from 0.5 to 3.7 percent of GDP. None of this 3.2 percentage point change is attributable to a decline in saving; in fact, saving increased over this time, as the government’s budget switched from deficit to surplus. But investment went from 15.3 to 19.8 percent of GDP, as the economy enjoyed a boom in information technology and many firms were eager to make these high-tech investments.

FIGURE 2

National Saving, Domestic

Investment, and Net Capital

Outflow

Panel (a) shows national

saving and domestic

investment as a percentage

of GDP. Panel (b) shows

net capital outflow as a

percentage of GDP. You can

see from the figure that

national saving has been

lower since 1980 than

it was before 1980. This

fall in national saving has

been reflected primarily in

reduced net capital outflow

rather than in reduced

domestic investment.

Source: U.S. Department of Commerce.

Percent of GDP

(b) Net Capital Outflow (as a percentage of GDP)

–6

–5

–4

–3

–2

–1

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

Net capital outflow

Percent of GDP

(a) National Saving and Domestic Investment (as a percentage of GDP)

(b) Net Capital Outflow (as a percentage of GDP)

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

Domestic investment

National saving

664 PART XI THE MACROECONOMICS OF OPEN ECONOMIES

An economic downturn and recovery: During the period from 2000 to 2015, the capital flow into the United States remained large. The consistency of this variable, however, stands in stark contrast to the remarkable changes in saving and investment. From 2000 to 2009, both fell by about 6 percentage points. Investment fell because tough economic times made capital accumulation less profitable, while national saving fell because the government began running extraordinarily large budget deficits in response to the downturn. From 2009 to 2015, as the economy recovered, these forces reversed themselves, and both saving and investment increased by about 3 percentage points.

Are these trade deficits and international capital flows a problem for the U.S. economy? There is no easy answer to this question. One has to evaluate the circumstances and the possible alternatives.

Consider first a trade deficit induced by a fall in saving, as occurred during the 1980s. Lower saving means that the nation is putting away less of its income to provide for its future. Once national saving has fallen, however, there is no reason to deplore the resulting trade deficits. If national saving fell without inducing a trade deficit, investment in the United States would have to fall. This fall in investment, in turn, would adversely affect the growth in the capital stock, labor productivity, and real wages. In other words, given that U.S. saving has declined, it is better to have foreigners invest in the U.S. economy than no one at all.

Now consider a trade deficit induced by an investment boom, like the trade deficits of the 1990s. In this case, the economy is borrowing from abroad to finance the purchase of new capital goods. If this additional capital provides a good return in the form of higher production of goods and services, then the economy should be able to handle the debt that is being accumulated. On the other hand, if the investment projects fail to yield the expected returns, the debts will look less desirable, at least with the benefit of hindsight.

Just as an individual can go into debt in either a prudent or a profligate manner, so can a nation. A trade deficit is not a

problem in itself, but it can sometimes be a symptom of a problem. ●

QuickQuiz Define net exports and net capital outflow. Explain how they are related.

“A typical country can increase its citizens’ welfare by enacting

policies that would increase its trade surplus (or decrease its

trade deficit).”

What do economists say?

28% uncertain

6% agree

66% disagree

“An important reason why many workers in Michigan and

Ohio have lost jobs in recent years is because US presidential

administrations over the past 30 years have not been tough

enough in trade negotiations.”

10% uncertain

3% agree

87% disagree

What do economists say?

Source: IGM Economic Experts Panel, December 9, 2014 and March 22, 2016.

Trade Balances and Trade Negotiations

ASK THE EXPERTS

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

So far, we have discussed measures of the flow of goods and services and the flow of capital across a nation’s border. In addition to these quantity variables, macroeconomists also study variables that measure the prices at which these international transactions take place. Just as the price in any market serves the important role of coordinating buyers and sellers in that market, international prices help coordinate the decisions of consumers and producers as they interact

665CHAPTER 31 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS

in world markets. Here we discuss the two most important international prices: the nominal and real exchange rates.

31-2a Nominal Exchange Rates The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another. For example, when you go to a bank, you might see a posted exchange rate of 80 yen per dollar. If you give the bank 1 U.S. dollar, you will receive 80 Japanese yen in return; and if you give the bank 80 Japanese yen, you will receive 1 U.S. dollar. (In actuality, the bank will post slightly different prices for buying and selling yen. The difference gives the bank some profit for offering this service. For our purposes here, we can ignore these differences.)

An exchange rate can always be expressed in two ways. If the exchange rate is 80 yen per dollar, it is also 1/80 (5 0.0125) dollar per yen. Throughout this book, we always express the nominal exchange rate as units of foreign currency per U.S. dollar, such as 80 yen per dollar.

If the exchange rate changes so that a dollar buys more foreign currency, that change is called an appreciation of the dollar. If the exchange rate changes so that a dollar buys less foreign currency, that change is called a depreciation of the dollar. For example, when the exchange rate rises from 80 to 90 yen per dollar, the dollar is said to appreciate. At the same time, because a Japanese yen now buys less of the U.S. currency, the yen is said to depreciate. When the exchange rate falls from 80 to 70 yen per dollar, the dollar is said to depreciate, and the yen is said to appreciate.

At times, you may have heard the media report that the dollar is either “strong” or “weak.” These descriptions usually refer to recent changes in the nominal exchange rate. When a currency appreciates, it is said to strengthen because it can then buy more foreign currency. Similarly, when a currency depreciates, it is said to weaken.

For any country, there are many nominal exchange rates. The U.S. dollar can be used to buy Japanese yen, British pounds, Mexican pesos, and so on. When economists study changes in the exchange rate, they often use indexes that average these many exchange rates. Just as the consumer price index turns the many prices in the economy into a single measure of the price level, an exchange-rate index turns these many exchange rates into a single measure of the international value of a currency. So when economists talk about the dollar appreciating or depreciating, they often are referring to an exchange-rate index that takes into account many individual exchange rates.

31-2b Real Exchange Rates The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another. For example, if you go shopping and find that a pound of Swiss cheese is twice as expensive as a pound of American cheese, the real exchange rate is 1/2 pound of Swiss cheese per pound of American cheese. Notice that, like the nominal exchange rate, we express the real exchange rate as units of the foreign item per unit of the domestic item. But in this instance, the item is a good rather than a currency.

Real and nominal exchange rates are closely related. For example, suppose that a bushel of American rice sells for $100 and a bushel of Japanese rice sells for 16,000 yen. What is the real exchange rate between American and Japanese rice? To answer this question, we must first use the nominal exchange rate to convert

nominal exchange rate

the rate at which a person

can trade the currency

of one country for the

currency of another

appreciation

an increase in the

value of a currency as

measured by the amount

of foreign currency it can

buy

depreciation

a decrease in the value of

a currency as measured

by the amount of foreign

currency it can buy

real exchange rate

the rate at which a person

can trade the goods and

services of one country

for the goods and services

of another

666 PART XI THE MACROECONOMICS OF OPEN ECONOMIES

the prices into a common currency. If the nominal exchange rate is 80 yen per dollar, then a price for American rice of $100 per bushel is equivalent to 8,000 yen per bushel. American rice is half as expensive as Japanese rice. The real exchange rate is 1/2 bushel of Japanese rice per bushel of American rice.

We can summarize this calculation for the real exchange rate with the following formula:

Real exchange rate 5 Nominal exchange rate 3 Domestic price

Foreign price .

The Euro

Y ou may have once heard of, or perhaps even

seen, currencies such as the French franc, the

German mark, or the Italian lira. These types of

money no longer exist. During the 1990s, many

European nations decided to give up their national

currencies and instead use a common currency

called the euro. The euro started circulating on

January 1, 2002, when twelve nations began

using it as their official money. As of 2016, there

were nineteen nations using the euro. Several

European nations, such as the United Kingdom,

Sweden, and Denmark, have declined joining and

have kept their own currencies.

Monetary policy for the euro area is set

by the European Central Bank (ECB), with

representatives from all of the participating countries. The ECB issues

the euro and controls the supply of this money, much as the Federal

Reserve controls the supply of dollars in the U.S. economy.

Why did these countries adopt a common currency? One benefit of

a common currency is that it makes trade easier. Imagine if each of

the fifty U.S. states had a different currency. Every time you crossed

a state border, you would need to change your money and perform the

kind of exchange-rate calculations discussed in the text. This would be

inconvenient, and it might deter you from buying goods and services

outside your own state. The countries of Europe decided that as their

economies became more integrated, it would be better to avoid this

inconvenience.

To some extent, the adoption of a common currency in Europe was

a political decision based on concerns beyond the scope of standard

economics.

Some

advocates

of the euro

wanted to

reduce

nationalistic feelings

and to make Europeans appreciate more fully their

shared history and destiny. A single money for most

of the continent, they argued, would help achieve this

goal.

There are, however, costs of choosing a common

currency. If the nations of Europe have only one money,

they can have only one monetary policy. If they disagree

about what monetary policy is best, they will have to

reach some kind of agreement, rather than each country going its own

way. Because adopting a single money has both benefits and costs,

there is debate among economists about whether Europe’s adoption of

the euro was a good decision.

From 2010 to 2015, the euro question heated up as several

European nations dealt with a variety of economic difficulties. Greece,

in particular, had run up a large government debt and found itself

facing possible default. As a result, it had to raise taxes and cut back

government spending substantially. Some observers suggested that

dealing with these problems would have been easier if the government

had had an additional tool—a national monetary policy. The possibility

of Greece’s leaving the euro area and reintroducing its own currency was

even discussed. In the end, that outcome did not occur, but it remained

a possibility for the future. ■

F Y I

PE TE

R ST

O N

E /

A LA

M Y

667CHAPTER 31 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS

Using the numbers in our example, the formula applies as follows:

Real exchange rate 5 180 yen/dollar2 3 1$100/bushel of American rice2

16,000 yen/bushel of Japanese rice

5 8,000 yen/bushel of American rice

16,000 yen/bushel of Japanese rice

5 1/2 bushel of Japanese rice/bushel of American rice.

Thus, the real exchange rate depends on the nominal exchange rate and on the prices of goods in the two countries measured in the local currencies.

Why does the real exchange rate matter? As you might guess, the real exchange rate is a key determinant of how much a country exports and imports. When Uncle Ben’s, Inc., is deciding whether to buy U.S. rice or Japanese rice to put into its boxes, it will ask which rice is cheaper. The real exchange rate gives the answer. As another example, imagine that you are deciding whether to take a seaside vacation in Miami, Florida, or in Cancún, Mexico. You might ask your travel agent the price of a hotel room in Miami (measured in dollars), the price of a hotel room in Cancún (measured in pesos), and the exchange rate between pesos and dollars. If you decide where to vacation by comparing costs, you are basing your decision on the real exchange rate.

When studying an economy as a whole, macroeconomists focus on overall prices rather than the prices of individual items. That is, to measure the real exchange rate, they use price indexes, such as the consumer price index, which measure the price of a basket of goods and services. By using a price index for a U.S. basket (P), a price index for a foreign basket (P*), and the nominal exchange rate between the U.S. dollar and foreign currencies (e), we can compute the overall real exchange rate between the United States and other countries as follows:

Real exchange rate 5 (e 3 P)/P*.

This real exchange rate measures the price of a basket of goods and services available domestically relative to a basket of goods and services available abroad.

As we examine more fully in the next chapter, a country’s real exchange rate is a key determinant of its net exports of goods and services. A depreciation (fall) in the U.S. real exchange rate means that U.S. goods have become cheaper relative to foreign goods. This change encourages consumers both at home and abroad to buy more U.S. goods and fewer goods from other countries. As a result, U.S. exports rise and U.S. imports fall; both of these changes raise U.S. net exports. Conversely, an appreciation (rise) in the U.S. real exchange rate means that U.S. goods have become more expensive compared to foreign goods, so U.S. net exports fall.

QuickQuiz Define nominal exchange rate and real exchange rate, and explain how

they are related. • If the nominal exchange rate goes from 100 to 120

yen per dollar, has the dollar appreciated or depreciated?

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

Exchange rates vary substantially over time. In 1970, a U.S. dollar could be used to buy 3.65 German marks or 627 Italian lira. In 1998, as both Germany and Italy were getting ready to adopt the euro as their common currency, a U.S. dollar

668 PART XI THE MACROECONOMICS OF OPEN ECONOMIES

bought 1.76 German marks or 1,737 Italian lira. In other words, over this period, the value of the dollar fell by more than half compared to the mark, while it more than doubled compared to the lira.

What explains these large and opposite changes? Economists have developed many models to explain how exchange rates are determined, each emphasizing just some of the many forces at work. Here we develop the simplest theory of exchange rates, called purchasing-power parity. This theory states that a unit of any given currency should be able to buy the same quantity of goods in all countries. Many economists believe that purchasing-power parity describes the forces that determine exchange rates in the long run. We now consider the logic on which this long-run theory of exchange rates is based, as well as the theory’s implications and limitations.

31-3a The Basic Logic of Purchasing-Power Parity The theory of purchasing-power parity is based on a principle called the law of one price. This law asserts that a good must sell for the same price in all locations. Otherwise, there would be opportunities for profit left unexploited. For example, suppose that coffee beans sold for less in Seattle than in Dallas. A person could buy coffee in Seattle for, say, $4 a pound and then sell it in Dallas for $5 a pound, making a profit of $1 per pound from the difference in price. The process of taking advantage of price differences for the same item in different markets is called arbitrage. In our example, as people took advantage of this arbitrage opportunity, they would increase the demand for coffee in Seattle and increase the supply in Dallas. The price of coffee would rise in Seattle (in response to greater demand) and fall in Dallas (in response to greater supply). This process would continue until, eventually, the prices were the same in the two markets.

Now consider how the law of one price applies to the international marketplace. If a dollar (or any other currency) could buy more coffee in the United States than in Japan, international traders could profit by buying coffee in the United States and selling it in Japan. This export of coffee from the United States to Japan would drive up the U.S. price of coffee and drive down the Japanese price. Conversely, if a dollar could buy more coffee in Japan than in the United States, traders could buy coffee in Japan and sell it in the United States. This import of coffee into the United States from Japan would drive down the U.S. price of coffee and drive up the Japanese price. In the end, the law of one price tells us that a dollar must buy the same amount of coffee in all countries.

This logic leads us to the theory of purchasing-power parity. According to this theory, a currency must have the same purchasing power in all countries. That is, a U.S. dollar must buy the same quantity of goods in the United States and Japan, and a Japanese yen must buy the same quantity of goods in Japan and the United States. Indeed, the name of this theory describes it well. Parity means equality, and purchasing power refers to the value of money in terms of the quantity of goods it can buy. Purchasing-power parity states that a unit of a currency must have the same real value in every country.

31-3b Implications of Purchasing-Power Parity What does the theory of purchasing-power parity say about exchange rates? It tells us that the nominal exchange rate between the currencies of two countries depends on the price levels in those countries. If a dollar buys the same quantity of goods in the United States (where prices are measured in dollars) as in Japan (where prices are measured in yen), then the number of yen per dollar must reflect the prices of

purchasing-power parity

a theory of exchange

rates whereby a unit of

any given currency should

be able to buy the same

quantity of goods in all

countries

669CHAPTER 31 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS

goods in the United States and Japan. For example, if a pound of coffee costs 500 yen in Japan and $5 in the United States, then the nominal exchange rate must be 100 yen per dollar (500 yen/$5 5 100 yen per dollar). Otherwise, the purchasing power of the dollar would not be the same in the two countries.

To see more fully how this works, it is helpful to use just a bit of mathematics. Suppose that P is the price of a basket of goods in the United States (measured in dollars), P* is the price of a basket of goods in Japan (measured in yen), and e is the nominal exchange rate (the number of yen a dollar can buy). Now consider the quantity of goods a dollar can buy at home and abroad. At home, the price level is P, so the purchasing power of $1 at home is 1/P. That is, a dollar can buy 1/P quantity of goods. Abroad, a dollar can be exchanged into e units of foreign currency, which in turn have purchasing power e/P*. For the purchasing power of a dollar to be the same in the two countries, it must be the case that

1/P 5 e/P*.

With rearrangement, this equation becomes

1 5 eP/P*.

Notice that the left side of this equation is a constant and the right side is the real exchange rate. Thus, if the purchasing power of the dollar is always the same at home and abroad, then the real exchange rate—the relative price of domestic and foreign goods—cannot change.

To see the implication of this analysis for the nominal exchange rate, we can rearrange the last equation to solve for the nominal exchange rate:

e 5 P*/P.

That is, the nominal exchange rate equals the ratio of the foreign price level (measured in units of the foreign currency) to the domestic price level (measured in units of the domestic currency). According to the theory of purchasing-power parity, the nominal exchange rate between the currencies of two countries must reflect the price levels in those countries.

A key implication of this theory is that nominal exchange rates change when price levels change. As we saw in the preceding chapter, the price level in any country adjusts to bring the quantity of money supplied and the quantity of money demanded into balance. Because the nominal exchange rate depends on the price levels, it also depends on the money supply and demand in each country. When a central bank in any country increases the money supply and causes the price level to rise, it also causes that country’s currency to depreciate relative to other currencies in the world. In other words, when the central bank prints large quantities of money, that money loses value both in terms of the goods and services it can buy and in terms of the amount of other currencies it can buy.

We can now answer the question that began this section: Why did the U.S. dollar lose value compared to the German mark and gain value compared to the Italian lira? The answer is that Germany pursued a less inflationary monetary policy than the United States, and Italy pursued a more inflationary monetary policy. From 1970 to 1998, inflation in the United States was 5.3 percent per year. By contrast, inflation was 3.5 percent in Germany and 9.6 percent in Italy. As U.S. prices rose relative to German prices, the value of the dollar fell relative to the mark. Similarly, as U.S. prices fell relative to Italian prices, the value of the dollar rose relative to the lira.

670 PART XI THE MACROECONOMICS OF OPEN ECONOMIES

Germany and Italy now have a common currency—the euro. This means that the two countries share a single monetary policy and that the inflation rates in the two countries will be closely linked. But the historical lessons of the lira and the mark will apply to the euro as well. Whether the U.S. dollar buys more or fewer euros 20 years from now than it does today depends on whether the European Central Bank produces more or less inflation in Europe than the Federal Reserve does in the United States.

CASE STUDY

THE NOMINAL EXCHANGE RATE DURING A HYPERINFLATION Macroeconomists can only rarely conduct controlled experiments. Most often, they must glean what they can from the natural experiments that history gives them. One natural experiment is hyperinflation—the

high inflation that arises when a government turns to the printing press to pay for large amounts of government spending. Because hyperinflations are so extreme, they illustrate some basic economic principles with clarity.

Consider the German hyperinflation of the early 1920s. Figure 3 shows the German money supply, the German price level, and the nominal exchange rate (measured as U.S. cents per German mark) for that period. Notice that these series move closely together. When the supply of money starts growing quickly, the price level also takes off, and the German mark depreciates. When the money supply stabilizes, so do the price level and the exchange rate.

The pattern shown in this figure appears during every hyperinflation. It leaves no doubt that there is a fundamental link among money, prices, and the nominal exchange rate. The quantity theory of money discussed in the previous chapter explains how the money supply affects the price level. The theory of purchasing- power parity discussed here explains how the price level affects the nominal exchange rate. ●

FIGURE 3

Money, Prices, and the Nominal

Exchange Rate during the German

Hyperinflation

This figure shows the money

supply, the price level, and the

nominal exchange rate (measured

as U.S. cents per mark) for the

German hyperinflation from

January 1921 to December 1924.

Notice how similarly these three

variables move. When the quantity

of money started growing quickly,

the price level followed and the

mark depreciated relative to the

dollar. When the German central

bank stabilized the money supply,

the price level and exchange rate

stabilized as well.

Source: Adapted from Thomas J. Sargent, “The End of Four Big

Inflations,” in Robert Hall, ed., Inflation (Chicago: University of

Chicago Press, 1983), pp. 41–93.

10,000,000,000

1,000,000,000,000,000

100,000

.00001

.0000000001 1921 1922 1923 1924

Exchange rate

Money supply

Price level

1925

Indexes (Jan. 1921 = 100)

671CHAPTER 31 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS

31-3c Limitations of Purchasing-Power Parity Purchasing-power parity provides a simple model of how exchange rates are determined. For understanding many economic phenomena, the theory works well. In particular, it can explain many long-term trends, such as the depreciation of the U.S. dollar against the German mark and the appreciation of the U.S. dollar against the Italian lira. It can also explain the major changes in exchange rates that occur during hyperinflations.

Yet the theory of purchasing-power parity is not completely accurate. That is, exchange rates do not always move to ensure that a dollar has the same real value in all countries all the time. There are two reasons the theory of purchasing-power parity does not always hold in practice.

The first reason is that many goods are not easily traded. Imagine, for instance, that haircuts are more expensive in Paris than in New York. International travelers might avoid getting their haircuts in Paris, and some haircutters might move from New York to Paris. Yet such arbitrage would be too limited to eliminate the differences in prices. Thus, the deviation from purchasing-power parity might persist, and a dollar (or euro) would continue to buy less of a haircut in Paris than in New York.

The second reason that purchasing-power parity does not always hold is that even tradable goods are not always perfect substitutes when they are produced in different countries. For example, some consumers prefer German cars, and others prefer American cars. Moreover, consumer tastes can change over time. If German cars suddenly become more popular, the increase in demand will drive up the price of German cars compared to American cars. Despite this difference in prices in the two markets, there might be no opportunity for profitable arbitrage because consumers do not view the two cars as equivalent.

Thus, both because some goods are not tradable and because some tradable goods are not perfect substitutes for their foreign counterparts, purchasing-power parity is not a perfect theory of exchange-rate determination. For these reasons, real exchange rates fluctuate over time. Nonetheless, the theory of purchasing-power parity does provide a useful first step in understanding exchange rates. The basic logic is persuasive: As the real exchange rate drifts from the level predicted by purchasing-power parity, people have greater incentive to move goods across national borders. Even if the forces of purchasing-power parity do not completely fix the real exchange rate, they provide a reason to expect that changes in the real exchange rate are most often small or temporary. As a result, large and persistent movements in nominal exchange rates typically reflect changes in price levels at home and abroad.

CASE STUDY

THE HAMBURGER STANDARD When economists apply the theory of purchasing-power parity to explain exchange rates, they need data on the prices of a basket

of goods available in different countries. One analysis of this sort is conducted by The Economist, an international newsmagazine. The magazine occasionally collects data on a basket of goods consisting of “two all-beef patties, special sauce, lettuce, cheese, pickles, onions, on a sesame seed bun.” It’s called the “Big Mac” and is sold by McDonald’s around the world.

Once we have the prices of Big Macs in two countries denominated in the local currencies, we can compute the exchange rate predicted by the theory of purchasing-power parity. The predicted exchange rate is the one that makes the cost of a Big Mac the same in the two countries. For instance, if the price of a Big

You can find a Big Mac almost anywhere you look.

ST IN

G /S

H U

TT ER

ST O

CK .C

O M

672 PART XI THE MACROECONOMICS OF OPEN ECONOMIES

Mac is $5 in the United States and 500 yen in Japan, purchasing-power parity would predict an exchange rate of 100 yen per dollar.

How well does purchasing-power parity work when applied using Big Mac prices? Here are some examples from January 2016, when the price of a Big Mac was $4.93 in the United States:

Country Price of a Big Mac Predicted Exchange Rate Actual Exchange Rate

Indonesia 30,500 rupiah 6,187 rupiah/$ 13,947 rupiah/$

South Korea 4,300 won 872 won/$ 1,198 won/$

Japan 370 yen 75 yen/$ 119 yen/$

Mexico 49 pesos 9.9 pesos/$ 17.4 pesos/$

Sweden 45 krona 9.1 krona/$ 8.6 krona/$

Euro area 3.72 euros 0.75 euros/$ 0.93 euros/$

Britain 2.89 pounds 0.59 pound/$ 0.68 pound/$

You can see that the predicted and actual exchange rates are not exactly the same. After all, international arbitrage in Big Macs is not easy. Yet the two exchange rates are usually in the same ballpark. Purchasing-power parity is not a precise theory of exchange rates, but it often provides a reasonable first approximation. ●

QuickQuiz Over the past 20 years, Mexico has had high inflation and Japan has had

low inflation. What do you predict has happened to the number of

Mexican pesos a person can buy with a Japanese yen?

31-4 Conclusion The purpose of this chapter has been to develop some basic concepts that macroeconomists use to study open economies. You should now understand how a nation’s trade balance is related to the international flow of capital and how national saving can differ from domestic investment in an open economy. You should understand that when a nation is running a trade surplus, it must be sending capital abroad, and that when it is running a trade deficit, it must be experiencing a capital inflow. You should also understand the meaning of the nominal and real exchange rates, as well as the implications and limitations of purchasing-power parity as a theory of how exchange rates are determined.

The macroeconomic variables defined here offer a starting point for analyzing an open economy’s interactions with the rest of the world. In the next chapter, we develop a model that can explain what determines these variables. We can then discuss how various events and policies affect a country’s trade balance and the rate at which nations make exchanges in world markets.

1. Comparing the U.S. economy today to that of 1950,

one finds that today, as a percentage of GDP,

a. exports and imports are both higher.

b. exports and imports are both lower.

c. exports are higher, and imports are lower.

d. exports are lower, and imports are higher.

2. In an open economy, national saving equals domestic

investment

a. plus the net outflow of capital abroad.

b. minus the net exports of goods and services.

c. plus the government’s budget deficit.

d. minus foreign portfolio investment.

CHAPTER QuickQuiz

673CHAPTER 31 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS

3. If the value of a nation’s imports exceeds the value of

its exports, which of the following is NOT true?

a. Net exports are negative.

b. GDP is less than the sum of consumption,

investment, and government purchases.

c. Domestic investment is greater than national

saving.

d. The nation is experiencing a net outflow of capital.

4. If a nation’s currency doubles in value on foreign

exchange markets, the currency is said to ________,

reflecting a change in the ________ exchange rate.

a. appreciate, nominal

b. appreciate, real

c. depreciate, nominal

d. depreciate, real

5. If a cup of coffee costs 2 euros in Paris and $6 in

New York and purchasing-power parity holds, what is

the exchange rate?

a. 1/4 euro per dollar

b. 1/3 euro per dollar

c. 3 euros per dollar

d. 4 euros per dollar

6. The theory of purchasing-power parity says that higher

inflation in a nation causes the nation’s currency

to ________, leaving the ________ exchange rate

unchanged.

a. appreciate, nominal

b. appreciate, real

c. depreciate, nominal

d. depreciate, real

• Net exports are the value of domestic goods and

services sold abroad (exports) minus the value of

foreign goods and services sold domestically (imports).

Net capital outflow is the acquisition of foreign assets

by domestic residents (capital outflow) minus the

acquisition of domestic assets by foreigners (capital

inflow). Because every international transaction

involves an exchange of an asset for a good or service,

an economy’s net capital outflow always equals its net

exports.

• An economy’s saving can be used either to finance

investment at home or to buy assets abroad. Thus,

national saving equals domestic investment plus net

capital outflow.

• The nominal exchange rate is the relative price of the

currency of two countries, and the real exchange rate

is the relative price of the goods and services of two

countries. When the nominal exchange rate changes so

that each dollar buys more foreign currency, the dollar

is said to appreciate or strengthen. When the nominal exchange rate changes so that each dollar buys less

foreign currency, the dollar is said to depreciate or weaken.

• According to the theory of purchasing-power parity, a

dollar (or a unit of any other currency) should be able

to buy the same quantity of goods in all countries.

This theory implies that the nominal exchange rate

between the currencies of two countries should reflect

the price levels in those countries. As a result, countries

with relatively high inflation should have depreciating

currencies, and countries with relatively low inflation

should have appreciating currencies.

closed economy, p. 654

open economy, p. 654

exports, p. 654

imports, p. 654

net exports, p. 654

trade balance, p. 654

trade surplus, p. 654

trade deficit, p. 654

balanced trade, p. 655

net capital outflow, p. 658

nominal exchange rate, p. 665

appreciation, p. 665

depreciation, p. 665

real exchange rate, p. 665

purchasing-power parity, p. 668

f h l f h d d f

SUMMARY

l d d b l l h

KEY CONCEPTS

674 PART XI THE MACROECONOMICS OF OPEN ECONOMIES

1. Define net exports and net capital outflow. Explain how and why they are related.

2. Explain the relationship among saving, investment,

and net capital outflow.

3. If a Japanese car costs 1,500,000 yen, a similar

American car costs $30,000, and a dollar can buy

100 yen, what are the nominal and real exchange

rates?

4. Describe the economic logic behind the theory of

purchasing-power parity.

5. If the Fed started printing large quantities of U.S.

dollars, what would happen to the number of

Japanese yen a dollar could buy? Why?

1. How would the following transactions affect U.S.

exports, imports, and net exports?

a. An American art professor spends the summer

touring museums in Europe.

b. Students in Paris flock to see the latest movie from

Hollywood.

c. Your uncle buys a new Volvo.

d. The student bookstore at Oxford University in

England sells a copy of this textbook.

e. A Canadian citizen shops at a store in northern

Vermont to avoid Canadian sales taxes.

2. Would each of the following transactions be included

in net exports or net capital outflow? Be sure to say

whether it would represent an increase or a decrease

in that variable.

a. An American buys a Sony TV.

b. An American buys a share of Sony stock.

c. The Sony pension fund buys a bond from the U.S.

Treasury.

d. A worker at a Sony plant in Japan buys some

Georgia peaches from an American farmer.

3. Describe the difference between foreign direct

investment and foreign portfolio investment. Who is

more likely to engage in foreign direct investment—a

corporation or an individual investor? Who is more

likely to engage in foreign portfolio investment?

4. How would the following transactions affect U.S. net

capital outflow? Also, state whether each involves

direct investment or portfolio investment.

a. An American cellular phone company establishes

an office in the Czech Republic.

b. Harrods of London sells stock to the General

Electric pension fund.

c. Honda expands its factory in Marysville, Ohio.

d. A Fidelity mutual fund sells its Volkswagen stock

to a French investor.

5. Would each of the following groups be happy or

unhappy if the U.S. dollar appreciated? Explain.

a. Dutch pension funds holding U.S. government

bonds

b. U.S. manufacturing industries

c. Australian tourists planning a trip to the United

States

d. an American firm trying to purchase property

overseas

6. What is happening to the U.S. real exchange rate in

each of the following situations? Explain.

a. The U.S. nominal exchange rate is unchanged, but

prices rise faster in the United States than abroad.

b. The U.S. nominal exchange rate is unchanged, but

prices rise faster abroad than in the United States.

c. The U.S. nominal exchange rate declines, and

prices are unchanged in the United States and

abroad.

d. The U.S. nominal exchange rate declines, and

prices rise faster abroad than in the United States.

7. A can of soda costs $1.25 in the United States and

25 pesos in Mexico. What is the peso–dollar exchange

rate (measured in pesos per dollar) if purchasing-

power parity holds? If a monetary expansion caused

all prices in Mexico to double, so that soda rose to

50 pesos, what would happen to the peso–dollar

exchange rate?

l fl

QUESTIONS FOR REVIEW

PROBLEMS AND APPLICATIONS

675CHAPTER 31 OPEN-ECONOMY MACROECONOMICS: BASIC CONCEPTS

8. A case study in the chapter analyzed purchasing-

power parity for several countries using the price of

Big Macs. Here are data for a few more countries:

Country

Price of a

Big Mac

Predicted

Exchange

Rate

Actual

Exchange

Rate

Chile 2,100 pesos _____ pesos/$ 715 pesos/$

Hungary 900 forints _____ forints/$ 293 forints/$

Czech

Republic

75 korunas _____ korunas/$ 25.1 korunas/$

Brazil 13.5 real _____ real/$ 4.02 real/$

Canada 5.84 C$ _____ C$/$ 1.41 C$/$

a. For each country, compute the predicted exchange

rate of the local currency per U.S. dollar. (Recall

that the U.S. price of a Big Mac was $4.93.)

b. According to purchasing-power parity, what is the

predicted exchange rate between the Hungarian

forint and the Canadian dollar? What is the actual

exchange rate?

c. How well does the theory of purchasing-power

parity explain exchange rates?

9. Purchasing-power parity holds between the nations

of Ectenia and Wiknam, where the only commodity is

Spam.

a. In 2015, a can of Spam costs 4 dollars in Ectenia

and 24 pesos in Wiknam. What is the exchange

rate between Ectenian dollars and Wiknamian

pesos?

b. Over the next 20 years, inflation is expected to be

3.5 percent per year in Ectenia and 7 percent per

year in Wiknam. If this inflation comes to pass,

what will the price of Spam and the exchange

rate be in 2035? (Hint: Recall the rule of 70 from Chapter 27.)

c. Which of these two nations will likely have a

higher nominal interest rate? Why?

d. A friend of yours suggests a get-rich-quick

scheme: Borrow from the nation with the lower

nominal interest rate, invest in the nation with the

higher nominal interest rate, and profit from the

interest-rate differential. Do you see any potential

problems with this idea? Explain.

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

A Macroeconomic Theory of the Open Economy

CHAPTER

32 O

ver the past three decades, the United States has consistently imported more goods and services than it has exported. That is, U.S. net exports have been negative. While economists debate whether these trade deficits are a problem

for the U.S. economy, the nation’s business community often has a strong opinion. Many business leaders claim that the trade deficits reflect unfair competition : Foreign firms are allowed to sell their products in U.S. markets, they contend, while foreign governments impede U.S. firms from selling U.S. products abroad.

Imagine that you are the president and you want to end these trade deficits. What should you do? Should you try to limit imports, perhaps by imposing a quota on textiles from China or cars from Japan? Or should you try to influence the nation’s trade deficit in some other way?

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678 PART XI THE MACROECONOMICS OF OPEN ECONOMIES

To understand the factors that determine a country’s trade balance and how government policies can affect it, we need a macroeconomic theory that explains how an open economy works. The preceding chapter introduced some of the key macroeconomic variables that describe an economy’s relationship with other economies, including net exports, net capital outflow, and the real and nominal exchange rates. This chapter develops a model that identifies the forces that deter- mine these variables and explains how these variables are related to one another.

To develop this macroeconomic model of an open economy, we build on our previous analysis in two ways. First, the model takes the economy’s GDP as given. We assume that the economy’s output of goods and services, as measured by real GDP, is determined by the supplies of the factors of production and by the available production technology that turns these inputs into output. Second, the model takes the economy’s price level as given. We assume that the price level adjusts to bring the supply and demand for money into balance. In other words, this chapter takes as a starting point the lessons learned in previous chapters about the determination of the economy’s output and price level.

The goal of the model in this chapter is to highlight the forces that determine the economy’s trade balance and exchange rate. In one sense, the model is simple : It applies the tools of supply and demand to an open economy. Yet the model is also more complicated than others we have seen because it involves looking simultaneously at two related markets: the market for loanable funds and the market for foreign-currency exchange. After we develop this model of the open economy, we use it to examine how various events and policies affect the econ- omy’s trade balance and exchange rate. We will then be able to determine the government policies that are most likely to reverse the trade deficits that the U.S. economy has experienced over the past three decades.

32-1 Supply and Demand for Loanable Funds and for Foreign-Currency Exchange

To understand the forces at work in an open economy, we focus on supply and demand in two markets. The first is the market for loanable funds, which coordinates the economy’s saving, investment, and flow of loanable funds abroad (called the net capital outflow). The second is the market for foreign-currency exchange, which coordinates people who want to exchange the domestic currency for the currency of other countries. In this section, we discuss supply and demand in each of these markets separately. In the next section, we put these markets together to explain the overall equilibrium for an open economy.

32-1a The Market for Loanable Funds When we first analyzed the role of the financial system in Chapter 26, we made the simplifying assumption that the financial system consists of only one market, called the market for loanable funds. All savers go to this market to deposit their saving, and all borrowers go to this market to get their loans. In this market, there is one interest rate, which is both the return to saving and the cost of borrowing.

To understand the market for loanable funds in an open economy, the place to start is the identity discussed in the preceding chapter:

S 5 I 1 NCO

Domestic Net capital Saving 5 1 .

investment outflow

679CHAPTER 32 A MACROECONOMIC THEORY OF THE OPEN ECONOMY

Whenever a nation saves a dollar of its income, it can use that dollar to finance the purchase of domestic capital or to finance the purchase of an asset abroad. The two sides of this identity represent the two sides of the market for loanable funds. The supply of loanable funds comes from national saving (S), and the demand for loanable funds comes from domestic investment (I) and net capital outflow (NCO).

Loanable funds should be interpreted as the domestically generated flow of resources available for capital accumulation. The purchase of a capital asset adds to the demand for loanable funds, regardless of whether that asset is located at home (I) or abroad (NCO). Because net capital outflow can be either positive or negative, it can either add to or subtract from the demand for loanable funds that arises from domestic investment. When NCO > 0, the country is experiencing a net outflow of capital; the net purchase of capital overseas adds to the demand for domestically generated loanable funds. When NCO < 0, the country is experiencing a net inflow of capital; the capital resources coming from abroad reduce the demand for domestically generated loanable funds.

As we learned in our earlier discussion of the market for loanable funds, the quantity of loanable funds supplied and the quantity of loanable funds demanded depend on the real interest rate. A higher real interest rate encourages people to save and, therefore, raises the quantity of loanable funds supplied. A higher interest rate also makes borrowing to finance capital projects more costly; thus, it discourages investment and reduces the quantity of loanable funds demanded.

In addition to influencing national saving and domestic investment, the real interest rate in a country affects that country’s net capital outflow. To see why, consider two mutual funds—one in the United States and one in Germany— deciding whether to buy a U.S. government bond or a German government bond. Each mutual fund manager would make this decision in part by comparing the real interest rates in the United States and Germany. When the U.S. real interest rate rises, the U.S. bond becomes more attractive to both mutual funds. Thus, an increase in the U.S. real interest rate discourages Americans from buying foreign assets and encourages foreigners to buy U.S. assets. For both reasons, a high U.S. real interest rate reduces U.S. net capital outflow.

We illustrate the market for loanable funds with the familiar supply-and- demand diagram in Figure 1. As in our earlier analysis of the financial system, the supply curve slopes upward because a higher interest rate increases the quantity of loanable funds supplied, and the demand curve slopes downward because a higher interest rate decreases the quantity of loanable funds demanded. Unlike the situation in our previous discussion, however, the demand side of the market now represents both domestic investment and net capital outflow. That is, in an open economy, the demand for loanable funds comes not only from those who want loanable funds to buy domestic capital goods but also from those who want loanable funds to buy foreign assets.

The interest rate adjusts to bring the supply and demand for loanable funds into balance. If the interest rate were below the equilibrium level, the quantity of loanable funds supplied would be less than the quantity demanded. The resulting shortage of loanable funds would push the interest rate upward. Conversely, if the interest rate were above the equilibrium level, the quantity of loanable funds supplied would exceed the quantity demanded. The surplus of loanable funds would drive the interest rate downward. At the equilibrium interest rate, the supply of loanable funds exactly balances the demand. In other words, at the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of domestic investment and net capital outflow.

680 PART XI THE MACROECONOMICS OF OPEN ECONOMIES

32-1b The Market for Foreign-Currency Exchange The second market in our model of the open economy is the market for foreign- currency exchange. Participants in this market trade U.S. dollars in exchange for foreign currencies. To understand the market for foreign-currency exchange, we begin with another identity from the last chapter:

NCO 5 NX

Net capital outflow 5 Net exports.

This identity states that the imbalance between the purchase and sale of capital assets abroad (NCO) equals the imbalance between exports and imports of goods and services (NX). For example, when the U.S. economy is running a trade surplus (NX . 0), foreigners are buying more U.S. goods and services than Americans are buying foreign goods and services. What are Americans doing with the foreign currency they are getting from this net sale of goods and services abroad? They must be buying foreign assets, so U.S. capital is flowing abroad (NCO . 0). Conversely, if the United States is running a trade deficit (NX , 0), Americans are spending more on foreign goods and services than they are earning from selling abroad. Some of this spending must be financed by selling American assets abroad, so foreign capital is flowing into the United States (NCO , 0).

Our model of the open economy treats the two sides of this identity as representing the two sides of the market for foreign-currency exchange. Net capital outflow represents the quantity of dollars supplied for the purpose of buying foreign assets. For example, when a U.S. mutual fund wants to buy a Japanese government bond, it needs to change dollars into yen, so it supplies dollars in the market for foreign-currency exchange. Net exports represent the quantity of dollars demanded for the purpose of buying U.S. net exports of goods and services. For example, when a Japanese airline wants to buy a plane made by Boeing, it needs to change its yen into dollars, so it demands dollars in the market for foreign-currency exchange.

FIGURE 1

The Market for Loanable Funds

The interest rate in an open economy,

as in a closed economy, is determined

by the supply and demand for

loanable funds. National saving is

the source of the supply of loanable

funds. Domestic investment and net

capital outflow are the sources of the

demand for loanable funds. At the

equilibrium interest rate, the amount

that people want to save exactly

balances the amount that people want

to borrow for the purpose of buying

domestic capital and foreign assets.

Equilibrium quantity

Quantity of Loanable Funds

Real Interest

Rate

Equilibrium real interest

rate

Supply of loanable funds (from national saving)

Demand for loanable funds (for domestic investment and net

capital outflow)

681CHAPTER 32 A MACROECONOMIC THEORY OF THE OPEN ECONOMY

What price balances the supply and demand in the market for foreign-currency exchange? The answer is the real exchange rate. As we saw in the preceding chapter, the real exchange rate is the relative price of domestic and foreign goods and, therefore, is a key determinant of net exports. When the U.S. real exchange rate appreciates, U.S. goods become more expensive relative to foreign goods, making U.S. goods less attractive to consumers both at home and abroad. As a result, exports from the United States fall, and imports into the United States rise. For both reasons, net exports fall. Hence, an appreciation of the real exchange rate reduces the quantity of dollars demanded in the market for foreign-currency exchange.

Figure 2 shows supply and demand in the market for foreign-currency exchange. The demand curve slopes downward for the reason we just discussed : A higher real exchange rate makes U.S. goods more expensive and reduces the quantity of dollars demanded to buy those goods. The supply curve is vertical because the quantity of dollars supplied for net capital outflow does not depend on the real exchange rate. (As discussed earlier, net capital outflow depends on the real interest rate. When discussing the market for foreign-currency exchange, we take the real interest rate and net capital outflow as given.)

It might seem strange at first that net capital outflow does not depend on the exchange rate. After all, a higher exchange value of the U.S. dollar not only makes foreign goods less expensive for American buyers but also makes foreign assets less expensive. One might guess that this would make foreign assets more attractive. But remember that an American investor will eventually want to

FIGURE 2

The Market for Foreign-Currency

Exchange

The real exchange rate is determined by the supply and demand for foreign-currency

exchange. The supply of dollars to be exchanged into foreign currency comes from net

capital outflow. Because net capital outflow does not depend on the real exchange rate, the

supply curve is vertical. The demand for dollars comes from net exports. Because a lower real

exchange rate stimulates net exports (and thus increases the quantity of dollars demanded

to pay for these net exports), the demand curve slopes downward. At the equilibrium real

exchange rate, the number of dollars people supply to buy foreign assets exactly balances the

number of dollars people demand to buy net exports.

Equilibrium quantity

Quantity of Dollars Exchanged into Foreign Currency

Real Exchange

Rate

Equilibrium real exchange

rate

Supply of dollars (from net capital outflow)

Demand for dollars (for net exports)

682 PART XI THE MACROECONOMICS OF OPEN ECONOMIES

turn the foreign asset, as well as any profits earned on it, back into dollars. For example, a high value of the dollar makes it less expensive for an American to buy stock in a Japanese company, but when that stock pays dividends, those will be in yen. As these yen are exchanged for dollars, the high value of the dollar means that the dividend will buy fewer dollars. Thus, changes in the exchange rate influence both the cost of buying foreign assets and the benefit of owning them, and these two effects offset each other. For these reasons, our model of the open economy posits that net capital outflow does not depend on the real exchange rate, as represented by the vertical supply curve in Figure 2.

The real exchange rate moves to ensure equilibrium in this market. It adjusts to balance the supply and demand for dollars just as the price of any good adjusts to balance supply and demand for that good. If the real exchange rate were below the equilibrium level, the quantity of dollars supplied would be less than the quantity demanded. The resulting shortage of dollars would push the value of the dollar upward. Conversely, if the real exchange rate were above the equilibrium level, the quantity of dollars supplied would exceed the quantity demanded. The surplus of dollars would drive the value of the dollar downward. At the equilibrium real exchange rate, the demand for dollars by foreigners arising from the U.S. net exports of goods and services exactly balances the supply of dollars from Americans arising from U.S. net capital outflow.

QuickQuiz Describe the sources of supply and demand in the market for loanable

funds and the market for foreign-currency exchange.

Purchasing-Power Parity as a Special Case

A n alert reader of this book might ask: Why are we developing a theory

of the exchange rate here? Didn’t we already do that in the preceding

chapter?

As you may recall, the preceding chapter developed a theory of the

exchange rate called purchasing-power parity. This theory asserts that a

dollar (or any other currency) must buy the same quantity of goods and

services in every country. As a result, the real exchange rate is fixed, and

all changes in the nominal exchange rate between two currencies reflect

changes in the price levels in the two countries.

The model of the exchange rate developed here is related to the

theory of purchasing-power parity. According to the theory of purchasing-

power parity, international trade responds quickly to international price

differences. If goods were cheaper in one country than in another, they

would be exported from the first country and imported into the second

until the price difference disappeared. In other words, the theory of

purchasing-power parity assumes that net exports are highly responsive

to small changes in the real exchange rate. If net exports were in fact so

responsive, the demand curve in Figure 2 would be horizontal.

T h u s , t h e t h e o r y o f

purchasing-power parity

can be viewed as a special

case of the model considered

here. In that special case,

the demand curve for foreign-

currency exchange, instead of sloping

downward, is horizontal at the level of the real exchange rate that

ensures parity of purchasing power at home and abroad.

While this special case is a good place to start when studying

exchange rates, it is far from the end of the story. In practice, foreign

and domestic goods are not always perfect substitutes, and there are

costs that impede trade. This chapter, therefore, assumes that the

demand curve for foreign-currency exchange slopes downward. This

allows for the possibility that the real exchange rate changes over time,

as in fact it often does in the real world. ■

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683CHAPTER 32 A MACROECONOMIC THEORY OF THE OPEN ECONOMY

32-2 Equilibrium in the Open Economy So far, we have discussed supply and demand in two markets: the market for loanable funds and the market for foreign-currency exchange. Let’s now consider how these markets are related to each other.

32-2a Net Capital Outflow: The Link between the Two Markets We begin by recapping what we’ve learned so far in this chapter. We have been discussing how the economy coordinates four important macroeconomic variables: national saving (S), domestic investment (I), net capital outflow (NCO), and net exports (NX). Keep in mind the following identities:

S 5 I 1 NCO

and

NCO 5 NX.

In the market for loanable funds, supply comes from national saving (S), demand comes from domestic investment (I) and net capital outflow (NCO), and the real interest rate balances supply and demand. In the market for foreign-currency exchange, supply comes from net capital outflow (NCO), demand comes from net exports (NX), and the real exchange rate balances supply and demand.

Net capital outflow is the variable that links these two markets. In the market for loanable funds, net capital outflow is a piece of demand. An American who wants to buy an asset abroad must finance this purchase by obtaining resources in the U.S. market for loanable funds. In the market for foreign-currency exchange, net capital outflow is the source of supply. An American who wants to buy an asset in another country must supply dollars to exchange them for the currency of that country.

The key determinant of net capital outflow, as we have discussed, is the real interest rate. When the U.S. interest rate is high, owning U.S. assets is more attractive, and U.S. net capital outflow is low. Figure 3 shows this negative relationship between the

FIGURE 3

How Net Capital Outflow Depends on the

Interest Rate

Because a higher domestic real interest

rate makes domestic assets more

attractive, it reduces net capital outflow.

Note the position of zero on the horizontal

axis: Net capital outflow can be positive

or negative. A negative value of net

capital outflow means that the economy

is experiencing a net inflow of capital.

0 Net Capital Outflow

Net capital outflow is negative.

Net capital outflow is positive.

Real Interest

Rate

684 PART XI THE MACROECONOMICS OF OPEN ECONOMIES

interest rate and net capital outflow. This net-capital-outflow curve is the link between the market for loanable funds and the market for foreign-currency exchange.

32-2b Simultaneous Equilibrium in Two Markets We can now put all the pieces of our model together in Figure 4. This figure shows how the market for loanable funds and the market for foreign-currency exchange jointly determine the important macroeconomic variables of an open economy.

Panel (a) of the figure shows the market for loanable funds (taken from Figure 1). As before, national saving is the source of the supply of loanable funds. Domestic investment and net capital outflow are the source of the demand for loanable funds. The equilibrium real interest rate (r1) brings the quantity of loanable funds supplied and the quantity of loanable funds demanded into balance.

FIGURE 4

The Real Equilibrium in an Open Economy

In panel (a), the supply and demand for loanable funds determine the real interest

rate. In panel (b), the interest rate determines net capital outflow, which provides

the supply of dollars in the market for foreign-currency exchange. In panel (c),

the supply and demand for dollars in the market for foreign-currency exchange

determine the real exchange rate.

(a) The Market for Loanable Funds (b) Net Capital Outflow

Net capital outflow, NCO

Real Interest

Rate

Real Interest

Rate

Quantity of Dollars

Quantity of Loanable Funds

Net Capital Outflow

Real Exchange

Rate

r1 r1

Supply

Demand

685CHAPTER 32 A MACROECONOMIC THEORY OF THE OPEN ECONOMY

Panel (b) of the figure shows net capital outflow (taken from Figure 3). The interest rate comes from panel (a) and then determines net capital outflow. A higher interest rate at home makes domestic assets more attractive, and this in turn reduces net capital outflow. Therefore, the net-capital-outflow curve in panel (b) slopes downward.

Panel (c) of the figure shows the market for foreign-currency exchange (taken from Figure 2). Because foreign assets must be purchased with foreign currency, the quantity of net capital outflow from panel (b) determines the supply of dollars to be exchanged into foreign currencies. The real exchange rate does not affect net capital outflow, so the supply curve is vertical. The demand for dollars comes from net exports. Because a depreciation of the real exchange rate increases net exports, the demand curve for foreign-currency exchange slopes downward. The equilibrium real exchange rate (E1) brings into balance the quantity of dollars supplied and the quantity of dollars demanded in the market for foreign-currency exchange.

The two markets shown in Figure 4 determine two relative prices: the real interest rate and the real exchange rate. The real interest rate determined in panel (a) is the price of goods and services in the present relative to goods and services in the future. The real exchange rate determined in panel (c) is the price of domestic goods and services relative to foreign goods and services. These two relative prices adjust simultaneously to balance supply and demand in these two markets. As they do so, they determine national saving, domestic investment, net capital outflow, and net exports. We can use this model to see how all these variables change when some policy or event causes one of these curves to shift.

QuickQuiz In the model of the open economy just developed, two markets determine

two relative prices. What are the markets? What are the two relative prices?

Disentangling Supply and Demand

S uppose the owner of an apple orchard decides to consume some of his

own apples. Does this decision represent an increase in the demand

for apples or a decrease in the supply? Either answer is defensible, and

as long as we are careful in our subsequent analysis, nothing important

will hinge on which answer we choose. Sometimes how we divide things

between supply and demand is a bit arbitrary.

In the macroeconomic model of the open economy developed in this

chapter, the division of transactions between “supply” and “demand”

is also a bit arbitrary. This is true both in the market for loanable funds

and in the market for foreign-currency exchange.

Consider first the market for loanable funds. The model treats the

net capital outflow as part of the demand for loanable funds. Yet instead

of writing S 5 I 1 NCO, we could just as easily have written S 2 NCO 5 I .

When the equation is rewritten in this way, a capital outflow looks like a

reduction in the supply of loanable funds. Either way would have worked.

The first interpretation (S 5 I 1 NCO) emphasizes loanable funds

generated domestically whether used at home or abroad. The second

interpretation (S 2 NCO 5 I) emphasizes loanable funds available

for domestic investment

whether generated at home

or abroad. The difference

i s m o r e s e m a n t i c t h a n

substantive.

Similarly, consider the

market for foreign-currency exchange.

In our model, net exports are the source of the demand for dollars,

and net capital outflow is the source of the supply. Thus, when a U.S.

resident imports a car made in Japan, our model treats that transaction

as a decrease in the quantity of dollars demanded (because net

exports fall) rather than an increase in the quantity of dollars supplied.

Similarly, when a Japanese citizen buys a U.S. government bond, our

model treats that transaction as a decrease in the quantity of dollars

supplied (because net capital outflow falls) rather than an increase in

the quantity of dollars demanded. This definition of terms may seem

somewhat unnatural at first, but it will prove useful when analyzing the

effects of various policies. ■

F Y I

686 PART XI THE MACROECONOMICS OF OPEN ECONOMIES

32-3 How Policies and Events Affect an Open Economy Having developed a model to explain how key macroeconomic variables are determined in an open economy, we can now use the model to analyze how changes in policy and other events alter the economy’s equilibrium. As we proceed, keep in mind that our model is just supply and demand in two markets : the market for loanable funds and the market for foreign-currency exchange. When using the model to analyze any event, we can apply the three steps outlined in Chapter 4. First, we determine which of the supply and demand curves the event affects. Second, we determine the direction in which the curves shift. Third, we use the supply-and-demand diagrams to examine how these shifts alter the economy’s equilibrium.

32-3a Government Budget Deficits When we first discussed the supply and demand for loanable funds earlier in the book, we examined the effects of government budget deficits, which occur when government spending exceeds government revenue. Because a government budget deficit represents negative public saving, it reduces national saving (the sum of public and private saving). Thus, a government budget deficit reduces the supply of loanable funds, drives up the interest rate, and crowds out investment.

Now let’s consider the effects of a budget deficit in an open economy. First, which curve in our model shifts? As in a closed economy, the initial impact of the budget deficit is on national saving and, therefore, on the supply curve for loanable funds. Second, in which direction does this supply curve shift? Again as in a closed economy, a budget deficit represents negative public saving, so it reduces national saving and shifts the supply curve for loanable funds to the left. This is shown as the shift from S1 to S2 in panel (a) of Figure 5.

Our third and final step is to compare the old and new equilibria. Panel (a) shows the impact of a U.S. budget deficit on the U.S. market for loanable funds. With fewer funds available for borrowers in U.S. financial markets, the interest rate rises from r1 to r2 to balance supply and demand. Faced with a higher interest rate, borrowers in the market for loanable funds choose to borrow less. This change is represented in the figure as the movement from point A to point B along the demand curve for loanable funds. In particular, households and firms reduce their purchases of capital goods. As in a closed economy, budget deficits crowd out domestic investment.

In an open economy, however, the reduced supply of loanable funds has additional effects. Panel (b) shows that the increase in the interest rate from r1 to r2 reduces net capital outflow. (This fall in net capital outflow is also part of the decrease in the quantity of loanable funds demanded in the movement from point A to point B in panel (a).) Because saving kept at home now earns higher rates of return, investing abroad is less attractive, and domestic residents buy fewer foreign assets. Higher interest rates also attract foreign investors, who want to earn the higher returns on U.S. assets. Thus, when budget deficits raise interest rates, both domestic and foreign behaviors cause U.S. net capital outflow to fall.

Panel (c) shows how budget deficits affect the market for foreign-currency exchange. Because net capital outflow is reduced, Americans need less foreign currency to buy foreign assets and, therefore, supply fewer dollars in the market for foreign-currency exchange. The supply curve for dollars shifts leftward from S1 to S2. The reduced supply of dollars causes the real exchange rate to appreciate from E1 to E2. That is, the dollar becomes more valuable compared to

687CHAPTER 32 A MACROECONOMIC THEORY OF THE OPEN ECONOMY

foreign currencies. This appreciation, in turn, makes U.S. goods more expensive compared to foreign goods. Because people both in the United States and abroad switch their purchases away from the more expensive U.S. goods, exports from the United States fall and imports into the United States rise. For both reasons, U.S. net exports fall. Hence, in an open economy, government budget deficits raise real interest rates, crowd out domestic investment, cause the currency to appreciate, and push the trade balance toward deficit.

FIGURE 5

The Effects of a Government

Budget Deficit

When the government runs a budget deficit, it reduces the supply of loanable funds from S1

to S2 in panel (a). The interest rate rises from r1 to r2 to balance the supply and demand for

loanable funds. In panel (b), the higher interest rate reduces net capital outflow. Reduced

net capital outflow, in turn, reduces the supply of dollars in the market for foreign-currency

exchange from S1 to S2 in panel (c). This fall in the supply of dollars causes the real

exchange rate to appreciate from E1 to E2. The appreciation of the exchange rate pushes the

trade balance toward deficit.

(a) The Market for Loanable Funds (b) Net Capital Outflow

Real Interest

Rate

Real Interest

Rate

Quantity of Dollars

Quantity of Loanable Funds

Net Capital Outflow

Real Exchange

Rate

r1 r1

Demand

r2 r2

NCO

S1S2

S2 S1

1. A budget deficit reduces the supply of loanable funds . . .

2. . . . which increases the real interest rate . . .

4. The decrease in net capital outflow reduces the supply of dollars to be exchanged into foreign currency . . .

5. . . . which causes the real exchange rate to appreciate.

3. . . . which in turn reduces net capital outflow.

688 PART XI THE MACROECONOMICS OF OPEN ECONOMIES

An important example of this lesson occurred in the United States in the 1980s. Shortly after Ronald Reagan was elected president in 1980, the fiscal policy of the U.S. federal government changed dramatically. The president and Congress enacted large cuts in taxes, but they did not cut government spending by nearly as much. The result was a large budget deficit. Our model of the open economy predicts that such a policy should have led to a trade deficit, and in fact it did, as we saw in a case study in the preceding chapter. Because the budget deficit and trade deficit during this period were so closely related in both theory and practice, they were nicknamed the twin deficits. We should not, however, view these twins as identical, for many factors beyond fiscal policy can influence the trade deficit.

32-3b Trade Policy A trade policy is a government policy that directly influences the quantity of goods and services that a country imports or exports. Trade policy takes various forms, usually with the purpose of supporting a particular domestic industry. One common trade policy is a tariff, a tax on imported goods. Another is an import quota, a limit on the quantity of a good produced abroad that can be sold domestically.

Let’s consider the macroeconomic impact of trade policy. Suppose that the U.S. auto industry, concerned about competition from Japanese automakers, convinces the U.S. government to impose a quota on the number of cars that can be imported from Japan. In making their case, lobbyists for the auto industry assert that the trade restriction would shrink the size of the U.S. trade deficit. Are they right? Our model, illustrated in Figure 6, offers an answer.

The first step in analyzing the trade policy is to determine which curve shifts. The initial impact of the import restriction is, not surprisingly, on imports. Because net exports equal exports minus imports, the policy also affects net exports. And because net exports are the source of demand for dollars in the market for foreign- currency exchange, the policy affects the demand curve in this market.

The second step is to determine the direction in which this demand curve shifts. Because the quota restricts the number of Japanese cars sold in the United States, it reduces imports at any given real exchange rate. Net exports, which equal exports minus imports, will therefore rise for any given real exchange rate. Because foreigners need dollars to buy U.S. net exports, there is an increased demand for dollars in the market for foreign-currency exchange. This increase in the demand for dollars is shown in panel (c) of Figure 6 as the shift from D1 to D2.

The third step is to compare the old and new equilibria. As we can see in panel (c), the increase in the demand for dollars causes the real exchange rate to appreciate from E1 to E2. Because nothing has happened in the market for loanable funds in panel (a), there is no change in the real interest rate. Because there is no change in the real interest rate, there is also no change in net capital outflow, shown in panel (b). And because there is no change in net capital outflow, there can be no change in net exports, even though the import quota has reduced imports.

It might seem puzzling that net exports stay the same while imports fall. This puzzle is resolved by noting the change in the real exchange rate: When the dollar appreciates in value in the market for foreign-currency exchange, domestic goods become more expensive relative to foreign goods. This appreciation encourages imports and discourages exports, and both of these changes work to offset the direct increase in net exports due to the import quota. In the end, an import quota reduces both imports and exports, but net exports (exports minus imports) are unchanged.

trade policy

a government policy that

directly influences the

quantity of goods and

services that a country

imports or exports

689CHAPTER 32 A MACROECONOMIC THEORY OF THE OPEN ECONOMY

We have thus come to a surprising implication: Trade policies do not affect the trade balance. That is, policies that directly influence exports or imports do not alter net exports. This conclusion seems less surprising if one recalls the accounting identity:

NX 5 NCO 5 S 2 I.

Net exports equal net capital outflow, which equals national saving minus domestic investment. Trade policies do not alter the trade balance because they

FIGURE 6

The Effects of an Import Quota

When the U.S. government imposes a quota on the import of Japanese cars, nothing happens

in the market for loanable funds in panel (a) or to net capital outflow in panel (b). The only

effect is a rise in net exports (exports minus imports) for any given real exchange rate. As a

result, the demand for dollars in the market for foreign-currency exchange rises, as shown by

the shift from D1 to D2 in panel (c). This increase in the demand for dollars causes the value

of the dollar to appreciate from E1 to E2. This appreciation of the dollar tends to reduce net

exports, offsetting the direct effect of the import quota on the trade balance.

(a) The Market for Loanable Funds (b) Net Capital Outflow

Real Interest

Rate

Real Interest

Rate

Quantity of Dollars

Quantity of Loanable Funds

Net Capital Outflow

Real Exchange

Rate

r1 r1

Supply

Demand NCO

3. Net exports, however, remain the same.

2. . . . and causes the real exchange rate to appreciate.

1. An import quota increases the demand for dollars . . .

690 PART XI THE MACROECONOMICS OF OPEN ECONOMIES

do not alter national saving or domestic investment. For given levels of national saving and domestic investment, the real exchange rate adjusts to keep the trade balance the same, regardless of the trade policies the government puts in place.

Although trade policies do not affect a country’s overall trade balance, these policies do affect specific firms, industries, and countries. When the U.S. government imposes an import quota on Japanese cars, General Motors has less competition from abroad and will sell more cars. At the same time, because the dollar has appreciated in value, Boeing, the U.S. aircraft maker, will find it harder to compete with Airbus, the European aircraft maker. U.S. exports of aircraft will fall, and U.S. imports of aircraft will rise. In this case, the import quota on Japanese cars will increase net exports of cars and decrease net exports of planes. In addition, it will increase net exports from the United States to Japan and decrease net exports from the United States to Europe. The overall trade balance of the U.S. economy, however, stays the same.

The effects of trade policies are, therefore, more microeconomic than macroeconomic. Although advocates of trade policies sometimes suggest (contrary to what our model predicts) that these policies can alter a country’s trade balance, they are usually more motivated by concerns about particular firms or industries. One should not be surprised, for instance, to hear an executive from General Motors advocating import quotas for Japanese cars. Economists usually oppose such trade policies. Free trade allows economies to specialize in doing what they do best, making residents of all countries better off. Trade restrictions interfere with these gains from trade and, thus, reduce overall economic well-being.

32-3c Political Instability and Capital Flight In 1994, political instability in Mexico, including the assassination of a prominent political leader, made world financial markets nervous. People began to view Mexico as a much less stable country than they had previously thought. They decided to pull some of their assets out of Mexico and move these funds to the United States and other “safe havens.” Such a large and sudden movement of funds out of a country is called capital flight. To see the implications of capital flight for the Mexican economy, we again follow our three steps for analyzing a change in equilibrium, but this time, we apply our model of the open economy from the perspective of Mexico rather than the United States.

Consider first which curves in our model capital flight affects. When investors around the world observe political problems in Mexico, they decide to sell some of their Mexican assets and use the proceeds to buy U.S. assets. This act increases Mexican net capital outflow and, therefore, affects both markets in our model. Most obviously, it affects the net-capital-outflow curve, and this in turn influences the supply of pesos in the market for foreign-currency exchange. In addition, because the demand for loanable funds comes from both domestic investment and net capital outflow, capital flight affects the demand curve in the market for loanable funds.

Now consider the direction in which these curves shift. When net capital outflow increases, there is greater demand for loanable funds to finance these purchases of capital assets abroad. Thus, as panel (a) of Figure 7 shows, the demand curve for loanable funds shifts to the right from D1 to D2. In addition, because net capital outflow is higher for any interest rate, the net-capital-outflow curve also shifts to the right from NCO1 to NCO2, as in panel (b).

capital flight

a large and sudden

reduction in the demand

for assets located in a

country

691CHAPTER 32 A MACROECONOMIC THEORY OF THE OPEN ECONOMY

To see the effects of capital flight on the Mexican economy, we compare the old and new equilibria. Panel (a) of Figure 7 shows that the increased demand for loanable funds causes the interest rate in Mexico to rise from r1 to r2. Panel (b) shows that Mexican net capital outflow increases. (Although the rise in the interest rate does make Mexican assets more attractive, this only partly offsets the impact of

FIGURE 7

The Effects of Capital Flight

If people decide that Mexico is a risky place to keep their savings, they will move their

capital to safe havens such as the United States, resulting in an increase in Mexican net

capital outflow. Consequently, the demand for loanable funds in Mexico rises from D1 to D2,

as shown in panel (a), driving up the Mexican real interest rate from r1 to r2. Because net

capital outflow is higher for any interest rate, that curve also shifts to the right from NCO1 to

NCO2 in panel (b). At the same time, in the market for foreign-currency exchange, the supply

of pesos rises from S1 to S2, as shown in panel (c). This increase in the supply of pesos

causes the peso to depreciate from E1 to E2, so the peso becomes less valuable compared to

other currencies.

(a) The Market for Loanable Funds in Mexico (b) Mexican Net Capital Outflow

Real Interest

Rate

Real Interest

Rate

Quantity of Pesos

Quantity of Loanable Funds

Net Capital Outflow

Real Exchange

Rate

r1 r1

Demand

r2 r2

S1 S2

Supply

NCO2NCO1

1. An increase in net capital outflow . . .

3. . . . which increases the interest rate.

2. . . . increases the demand for loanable funds . . .

4. At the same time, the increase in net capital outflow increases the supply of pesos . . . 5. . . . which

causes the peso to depreciate.

692 PART XI THE MACROECONOMICS OF OPEN ECONOMIES

capital flight on net capital outflow.) Panel (c) shows that the increase in net capital outflow raises the supply of pesos in the market for foreign-currency exchange from S1 to S2. That is, as people try to get out of Mexican assets, there is a large supply of pesos to be converted into dollars. This increase in supply causes the peso to depreciate from E1 to E2. Thus, capital flight from Mexico increases Mexican interest rates and decreases the value of the Mexican peso in the market for foreign-currency exchange. This is exactly what was observed in 1994. From November 1994 to March 1995, the interest rate on short-term Mexican government bonds rose from 14 percent to 70 percent, and the peso depreciated in value from 29 to 15 U.S. cents per peso.

An economist tries to decode the polit-

ical rhetoric about the exchange rate.

(This piece was written in 2011, when

the U.S. economy was struggling to

recover from a deep recession, but the

insights here are timeless.)

Needed: Plain Talk about the

Dollar

By Christina D. Romer

A t a recent news conference, Ben S.

Bernanke, the Federal Reserve chairman,

was asked about the falling dollar. He par-

ried the question, saying that the Treasury

secretary was the government’s spokesman

on the exchange rate—and, of course, that

the United States favors a strong dollar.

Listening to that statement, I flashed

back to one of my first experiences as an

adviser to Barack Obama. In November 2008,

I was sharing a cab in Chicago with Larry

Summers, the former Treasury secretary and

a fellow economic adviser to the president-

elect. To help prepare me for the interviews

and the hearings to come, Larry graciously

a s k e d m e q u e s t i o n s a n d c r i t i q u e d m y

answers.

When he asked about the exchange rate

for the dollar, I began: “The exchange rate

is a price much like any other price, and is

determined by market forces.”

“Wrong!” Larry boomed. “The exchange

rate is the purview of the Treasury. The United

States is in favor of a strong dollar.”

For the record, my initial answer was

much more reasonable. Our exchange rate is

just a price—the price of the dollar in terms

of other currencies. It is not controlled by

anyone. And a high price for the dollar, which

is what we mean by a strong dollar, is not

always desirable.

Some countries, like China, essentially

fix the price of their currency. But since the

early 1970s, the United States has let the

dollar’s value move in response to changes

in the supply and demand of dollars in the

foreign exchange market. The Treasury no

more determines the price of the dollar than

the Department of Energy determines the price

of gasoline. Both departments have a small

reserve that they can use to combat market

instability, but neither has the resources or the

mandate to hold the relevant price away from

its market equilibrium value for very long.

In practice, all that “the exchange rate

is the purview of the Treasury” means is

that no official other than the Treasury

secretary is supposed to talk about it (and

even he isn’t supposed to say very much).

That strikes me as a shame. Perhaps if

government officials could talk about the

exchange rate forthrightly, there would be

more understanding of the issues and more

rational policy discussions.

Such discussions would start with some

basic economics. The desire to trade with

other countries or invest in them is what

gives rise to the market for foreign exchange.

You need euros to travel in Spain or to buy a

German government bond, so you need a way

to exchange currencies.

The supply of dollars to the foreign exchange

market comes from Americans who want to buy

goods, services or assets from abroad. The

demand for dollars comes from foreigners who

want to buy from the United States.

Anything that increases the demand

for dollars or reduces the supply drives up

the dollar’s price. Anything that lowers the

demand for dollars or raises the supply

causes the dollar to weaken.

Consider two examples. Suppose American

entrepreneurs create many products that

foreigners want to buy, and start many companies

they want to invest in. That will increase the

demand for dollars and so cause the dollar’s price

to rise. Such innovation will also make Americans

want to buy more goods and assets in the United

States—and fewer abroad. The supply of dollars

to the foreign exchange market will fall, further

strengthening the dollar. This example describes

Is a Strong Currency Always in a Nation’s Interest?

IN THE NEWS

693CHAPTER 32 A MACROECONOMIC THEORY OF THE OPEN ECONOMY

very well the conditions of the late 1990s—when

the dollar was indeed strong.

Now suppose the United States runs a

large budget deficit that causes domestic

interest rates to rise. Higher American interest

rates make both foreigners and Americans

want to buy more American bonds and fewer

foreign bonds. Thus the demand for dollars

increases and the supply decreases. The price

of the dollar will again rise.

This example describes conditions in the

early 1980s, when President Ronald Reagan’s

tax cuts and military buildup led to large deficits.

Those deficits, along with the anti-inflationary

policies of the Fed, where Paul A. Volcker was

then the chairman, led to high American interest

rates. The dollar was very strong in this period.

Both developments—brilliant American

i n n o v a t i o n a n d t r o u b l e s o m e A m e r i c a n

b u d g e t d e f i c i t s — c a u s e d t h e d o l l a r t o

strengthen. Yet one is clearly a positive for

the American economy, the other a negative.

The point is that there is no universal good

or bad direction for the dollar to move. The

desirability of any shift in the exchange rate

depends on why the dollar is moving.

It also depends on the state of the

economy. At full employment, a strong dollar

is good for standards of living. A high price

for the dollar means that our currency buys a

lot in foreign countries.

But in a depressed economy, it isn’t so clear

that a strong dollar is desirable. A weaker dollar

means that our goods are cheaper relative to

foreign goods. That stimulates our exports and

reduces our imports. Higher net exports raise

domestic production and employment. Foreign

goods are more expensive, but more Americans

are working. Given the desperate need for jobs,

on net we are almost surely better off with a

weaker dollar for a while.

Fed policy is determined by inflation and

unemployment in the United States. But if

Mr. Bernanke could discuss the exchange

rate openly, he would probably tell you that

one way any monetary expansion helps a

distressed economy is by weakening the

dollar. That is taught in every introductory

economics course, yet the Fed is asked to

pretend it isn’t true.

Likewise, fiscal policy is determined by

domestic considerations. But trimming our

budget deficit, as we should over the coming

years, would also weaken the dollar. And that,

in turn, would blunt the negative impact of

deficit reduction on employment and output

in the short run.

Strangely, every politician seems to

understand that it would be desirable for the

dollar to weaken against one particular currency:

the Chinese renminbi. For years, China has

deliberately accumulated United States Treasury

bonds to keep the dollar’s value high in renminbi

terms. The United States would export more and

grow faster if China allowed the dollar’s price

to fall. Congress routinely threatens retaliation

if China doesn’t take steps that amount to

weakening the dollar.

But in the very next breath, the same

members of Congress shout about the

importance of a strong dollar. If a decline in

its value relative to the renminbi would be

beneficial, a fall relative to the currency of

many countries would help even more in the

current situation.

To say this openly risks being branded

n o t j u s t a n e x t r e m i s t b u t p o s s i b l y

un-American. Perhaps it is time for a more

adult conversation. The exchange rate is

the purview of market economics, not of the

Treasury or strong-dollar ideologues. ■

Ms. Romer is an economics professor at Uni-

versity of California at Berkeley and was chair

of President Obama’s Council of Economic

Advisers from 2009 to 2010.

protected by the Copyright Laws of the United States. The

printing, copying, redistribution, or retransmission of this

content without express written permission is prohibited.

Christina Romer

BL O

O M

BE RG

/G ET

TY IM

A G

These price changes that result from capital flight influence some key macroeconomic quantities. The depreciation of the currency makes exports cheaper and imports more expensive, pushing the trade balance toward surplus. At the same time, the increase in the interest rate reduces domestic investment, slowing capital accumulation and economic growth.

Capital flight has its largest impact on the country from which capital is fleeing, but it also affects other countries. When capital flows out of Mexico into the United States, for instance, it has the opposite effect on the U.S. economy as it has on the Mexican economy. In particular, the rise in Mexican net capital outflow

694 PART XI THE MACROECONOMICS OF OPEN ECONOMIES

coincides with a fall in U.S. net capital outflow. As the peso depreciates in value and Mexican interest rates rise, the dollar appreciates in value and U.S. interest rates fall. The size of this impact on the U.S. economy is small, however, because the economy of the United States is much larger than that of Mexico.

The events that we have been describing in Mexico could happen to any economy in the world, and, in fact, they do from time to time. In 1997, the world learned that the banking systems of several Asian economies, including Thailand, South Korea, and Indonesia, were at or near the point of bankruptcy, and this news induced capital to flee from these nations. In 1998, the Russian government defaulted on its debt, prompting international investors to take whatever money they could and run. A similar (but more complicated) set of events unfolded in Argentina in 2002. In each of these cases of capital flight, the results were much as our model predicts: rising interest rates and a falling currency.

CAPITAL FLOWS FROM CHINA According to our analysis of capital flight, a nation that experiences an outflow of capital sees its currency weaken in foreign exchange

markets, and this depreciation in turn increases the nation’s net exports. The country into which the capital is flowing sees its currency

strengthen, and this appreciation pushes its trade balance toward deficit. With these lessons in mind, consider this question: Suppose a nation’s

government, as a matter of policy, encourages capital to flow to another country, perhaps by making foreign investments itself. What effects would this policy have? The answer is much the same: Other things being equal, it leads to a weaker currency and a trade surplus for the nation encouraging the capital outflows and a stronger currency and a trade deficit for the recipient of those capital flows.

This analysis sheds light on a policy dispute between the United States and China. The Chinese government has sometimes tried to depress the value of its currency, the renminbi, in foreign exchange markets to promote its export industries. It did this by accumulating foreign assets, including substantial amounts of U.S government bonds. From 2000 to 2014, China’s total reserves of foreign assets rose from $160 billion to about $4 trillion.

The U.S. government at times objected to China’s interventions in foreign exchange markets. By holding down the value of the renminbi, the policy made Chinese goods less expensive, which in turn contributed to the U.S. trade deficit and hurt American producers who made products that compete with imports from China. Because of these effects, the U.S. government encouraged China to stop influencing the exchange value of its currency with government-sponsored capital flows. Some members of Congress even went so far as to advocate tariffs on Chinese imports unless China ceased its “currency manipulation.”

Yet the impact of the Chinese policy on the U.S. economy was not all bad. American consumers of Chinese imports benefited from lower prices. In addition, the inflow of capital from China reduced U.S. interest rates, which in turn increased investment in the U.S. economy. To some extent, the Chinese government was financing U.S. economic growth. The Chinese policy of investing in the U.S. economy created winners and losers among Americans. All things considered, the net impact on the U.S. economy was probably small.

The harder question concerns the motives behind the policy: Why were the Chinese leaders interested in producing for export and investing abroad

CASE STUDY

695CHAPTER 32 A MACROECONOMIC THEORY OF THE OPEN ECONOMY

1. Holding other things constant, an increase in a

nation’s interest rate reduces

a. national saving and domestic investment.

b. national saving and the net capital outflow.

c. domestic investment and the net capital outflow.

d. national saving only.

2. Holding other things constant, an appreciation of a

nation’s currency causes

a. exports to rise and imports to fall.

b. exports to fall and imports to rise.

c. both exports and imports to rise.

d. both exports and imports to fall.

CHAPTER QuickQuiz

rather than producing for domestic consumption and investing at home? One possibility is that China wanted to accumulate a reserve of foreign assets on which it could draw in emergencies—a kind of national “rainy-day fund.” Indeed, in 2015, as the Chinese economy started to falter, the Chinese government started to spend some of the fund, causing its reserves of foreign assets to fall by about $500 billion. ●

QuickQuiz Suppose that Americans decided to spend a smaller

fraction of their incomes. What would be the effect

on saving, investment, interest rates, the real exchange rate, and the

trade balance?

32-4 Conclusion International economics is a topic of increasing importance. More and more, American citizens are buying goods produced abroad and producing goods to be sold overseas. Through mutual funds and other financial institutions, they borrow and lend in world financial markets. As a result, a full analysis of the U.S. economy requires an understanding of how the U.S. economy interacts with other economies in the world. This chapter has provided a basic model for thinking about the macroeconomics of open economies.

The study of international economics is valuable, but we should be careful not to exaggerate its importance. Policymakers and commentators are often quick to blame foreigners for problems facing the U.S. economy. By contrast, economists more often view these problems as homegrown. For example, politicians often discuss foreign competition as a threat to American living standards, while economists are more likely to lament the low level of national saving. Low saving impedes growth in capital, productivity, and living standards, regardless of whether the economy is open or closed. Foreigners are a convenient target for politicians because blaming foreigners provides a way to avoid responsibility without insulting any domestic constituency. Whenever you hear popular discussions of international trade and finance, therefore, it is especially important to separate myth from reality. The tools you have learned in the past two chapters should help in that endeavor.

“Economic analysis can identify whether countries are using

their exchange rates to benefit their own people at the expense

of their trading partners’ welfare.”

What do economists say?

36% uncertain

30% agree

34% disagree

Source: IGM Economic Experts Panel, June 16, 2015.

Currency Manipulation

ASK THE EXPERTS

696 PART XI THE MACROECONOMICS OF OPEN ECONOMIES

3. The government in an open economy cuts spending

to reduce the budget deficit. As a result, the interest

rate ________, leading to a capital ________ and a

real exchange rate ________.

a. falls, outflow, appreciation

b. falls, outflow, depreciation

c. falls, inflow, appreciation

d. rises, inflow, appreciation

4. The nation of Ectenia has long banned the export of

its highly prized puka shells. A newly elected presi-

dent, however, removes the export ban. This change

in policy will cause the nation’s currency to ________,

making the goods Ectenia imports ________

expensive.

a. appreciate, less

b. appreciate, more

c. depreciate, less

d. depreciate, more

5. A civil war abroad causes foreign investors to seek a

safe haven for their funds in the United States, lead-

ing to ________ U.S. interest rates and a ________

U.S. dollar.

a. higher, weaker

b. higher, stronger

c. lower, weaker

d. lower, stronger

6. If business leaders in Great Britain become more

confident in their economy, their optimism will induce

them to increase investment, causing the British

pound to ________ and pushing the British trade bal-

ance toward ________.

a. appreciate, deficit

b. appreciate, surplus

c. depreciate, deficit

d. depreciate, surplus

• Two markets are central to the macroeconomics

of open economies: the market for loanable funds

and the market for foreign-currency exchange. In

the market for loanable funds, the real interest rate

adjusts to balance the supply of loanable funds (from

national saving) and the demand for loanable funds

(for domestic investment and net capital outflow).

In the market for foreign-currency exchange, the real

exchange rate adjusts to balance the supply of dollars

(from net capital outflow) and the demand for dollars

(for net exports). Because net capital outflow is part of

the demand for loanable funds and because it provides

the supply of dollars for foreign-currency exchange, it

is the variable that connects these two markets.

• A policy that reduces national saving, such as a

government budget deficit, reduces the supply of

loanable funds and drives up the interest rate. The higher

interest rate reduces net capital outflow, which reduces

the supply of dollars in the market for foreign-currency

exchange. The dollar appreciates, and net exports fall.

• Although restrictive trade policies, such as tariffs or

quotas on imports, are sometimes advocated as a way

to alter the trade balance, they do not necessarily have

that effect. A trade restriction increases net exports for

any given exchange rate and, therefore, increases the

demand for dollars in the market for foreign-currency

exchange. As a result, the dollar appreciates in value,

making domestic goods more expensive relative to

foreign goods. This appreciation offsets the initial

impact of the trade restriction on net exports.

• When investors change their attitudes about holding

assets of a country, the ramifications for the country’s

economy can be profound. In particular, political

instability can lead to capital flight, which tends

to increase interest rates and cause the currency to

depreciate.

SUMMARY

trade policy, p. 688 capital flight, p. 690

KEY CONCEPTS

1. Describe supply and demand in the market for

loanable funds and the market for foreign-currency

exchange. How are these markets linked?

2. Why are budget deficits and trade deficits sometimes

called the twin deficits?

3. Suppose that a textile workers’ union encourages

people to buy only American-made clothes. What

would this policy do to the trade balance and the

real exchange rate? What is the impact on the textile

industry? What is the impact on the auto industry?

4. What is capital flight? When a country experiences

capital flight, what is the effect on its interest rate and

exchange rate?

1 D ib l d d d i th k t f 3 S th t t til k ’ i

QUESTIONS FOR REVIEW

697CHAPTER 32 A MACROECONOMIC THEORY OF THE OPEN ECONOMY

1. Japan generally runs a significant trade surplus.

Do you think this is most related to high foreign

demand for Japanese goods, low Japanese demand

for foreign goods, a high Japanese saving rate

relative to Japanese investment, or structural

barriers against imports into Japan? Explain your

answer.

2. Suppose that Congress is considering an

investment tax credit, which subsidizes domestic

investment.

a. How does this policy affect national saving, domestic

investment, net capital outflow, the interest rate, the

exchange rate, and the trade balance?

b. Representatives of several large exporters oppose

the policy. Why might that be the case?

3. The chapter notes that the rise in the U.S. trade

deficit during the 1980s was due largely to the

rise in the U.S. budget deficit. On the other hand,

the popular press sometimes claims that the

increased trade deficit resulted from a decline in

the quality of U.S. products relative to foreign

products.

a. Assume that U.S. products did decline in relative

quality during the 1980s. How did this affect net

exports at any given exchange rate? b. Draw a three-panel diagram to show the effect of

this shift in net exports on the U.S. real exchange

rate and trade balance.

c. Is the claim in the popular press consistent with

the model in this chapter? Does a decline in the

quality of U.S. products have any effect on our

standard of living? (Hint: When we sell our goods to foreigners, what do we receive in return?)

4. An economist discussing trade policy in The New Republic wrote: “One of the benefits of the United States removing its trade restrictions [is] the gain to

U.S. industries that produce goods for export. Export

industries would find it easier to sell their goods

abroad—even if other countries didn’t follow our

example and reduce their trade barriers.” Explain in

words why U.S. export industries would benefit from a reduction in restrictions on imports to the United States.

5. Suppose the French suddenly develop a strong taste

for California wines. Answer the following questions

in words and with a diagram.

a. What happens to the demand for dollars in the

market for foreign-currency exchange?

b. What happens to the value of the dollar in the

market for foreign-currency exchange?

c. What happens to U.S. net exports?

6. A senator renounces his past support for

protectionism: “The U.S. trade deficit must be

reduced, but import quotas only annoy our trading

partners. If we subsidize U.S. exports instead, we can

reduce the deficit by increasing our competitiveness.”

Using a three-panel diagram, show the effect of an

export subsidy on net exports and the real exchange

rate. Do you agree with the senator?

7. Suppose the United States decides to subsidize the

export of U.S. agricultural products, but it does not

increase taxes or decrease any other government

spending to offset this expenditure. Using a three-

panel diagram, show what happens to national

saving, domestic investment, net capital outflow, the

interest rate, the exchange rate, and the trade balance.

Also explain in words how this U.S. policy affects the

amount of imports, exports, and net exports.

8. Suppose that real interest rates increase across Europe.

Explain how this development will affect U.S. net

capital outflow. Then explain how it will affect U.S. net

exports by using a formula from the chapter and by

drawing a diagram. What will happen to the U.S. real

interest rate and real exchange rate?

9. Suppose that Americans decide to increase their saving.

a. If the elasticity of U.S. net capital outflow with

respect to the real interest rate is very high, will

this increase in private saving have a large or

small effect on U.S. domestic investment?

b. If the elasticity of U.S. exports with respect to the

real exchange rate is very low, will this increase in

private saving have a large or small effect on the

U.S. real exchange rate?

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

h h dd l d l

PROBLEMS AND APPLICATIONS

Short-Run Economic Fluctuations

PART XII

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Aggregate Demand and Aggregate Supply

CHAPTER

33 E

conomic activity fluctuates from year to year. In most years, the production of goods and services rises. Because of increases in the labor force, increases in the capital stock, and advances in technological knowledge, the economy can

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702 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

they reduce production. Workers are laid off, unemployment becomes wide- spread, and factories are left idle. With the economy producing fewer goods and services, real GDP and other measures of income decline. Such a period of falling incomes and rising unemployment is called a recession if it is relatively mild and a depression if it is more severe.

An example of such a downturn occurred in 2008 and 2009. From the fourth quarter of 2007 to the second quarter of 2009, real GDP for the U.S. economy fell by 4.2 percent. The rate of unemployment rose from 4.4 percent in May 2007 to 10.0 percent in October 2009—the highest level in more than a quarter century. Not surprisingly, students graduating during this time found that desirable jobs were hard to come by.

What causes short-run fluctuations in economic activity? What, if anything, can public policy do to prevent periods of falling incomes and rising unemploy- ment? When recessions and depressions occur, how can policymakers reduce their length and severity? These are the questions we take up now.

The variables that we study are largely those we have seen in previous chapters. They include GDP, unemployment, interest rates, and the price level. Also familiar are the policy instruments of government spending, taxes, and the money supply. What differs from our earlier analysis is the time horizon. So far, our goal has been to explain the behavior of these variables in the long run. Our goal now is to explain their short-run deviations from long-run trends. In other words, instead of focusing on the forces that explain economic growth from generation to gener- ation, we are now interested in the forces that explain economic fluctuations from year to year.

There is some debate among economists about how best to analyze short-run fluctuations, but most economists use the model of aggregate demand and aggre- gate supply. Learning how to use this model for analyzing the short-run effects of various events and policies is the primary task ahead. This chapter introduces the model’s two pieces: the aggregate-demand curve and the aggregate-supply curve. Before turning to the model, however, let’s look at some of the key facts that describe the ups and downs of the economy.

recession

a period of declining

real incomes and rising

unemployment

depression

a severe recession

33-1 Three Key Facts about Economic Fluctuations Short-run fluctuations in economic activity have occurred in all countries throughout history. As a starting point for understanding these year-to-year fluctuations, let’s discuss some of their most important properties.

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

Fluctuations in the economy are often called the business cycle. As this term suggests, economic fluctuations correspond to changes in business conditions. When real GDP grows rapidly, business is good. During such periods of economic expansion, most firms find that customers are plentiful and that profits are growing. When real GDP falls during recessions, businesses have trouble. During such periods of economic contraction, most firms experience declining sales and dwindling profits.

The term business cycle is somewhat misleading because it suggests that economic fluctuations follow a regular, predictable pattern. In fact, economic fluctuations are not at all regular, and they are almost impossible to predict with much accuracy. Panel (a) of Figure 1 shows the real GDP of the

703CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

FIGURE 1

A Look at Short-Run

Economic Fluctuations

This figure shows real GDP

in panel (a), investment

spending in panel (b), and

unemployment in panel (c)

for the U.S. economy.

Recessions are shown

as the shaded areas.

Notice that real GDP and

investment spending

decline during recessions,

while unemployment rises.

Source: U.S. Department of Commerce;

U.S. Department of Labor.

1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

(b) Investment SpendingBillions of 2009 Dollars

500

1,000

1,500

2,000

$3,000

2,500

Investment spending

(a) Real GDPBillions of 2009 Dollars

4,000

6,000

8,000

10,000

5,000

7,000

9,000

11,000

12,000

13,000

$17,000

16,000

14,000

15,000

Real GDP

1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

Percent of Labor Force

12%

Unemployment rate

704 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

U.S. economy since 1972. The shaded areas represent times of recession. As the figure shows, recessions do not come at regular intervals. Sometimes recessions are close together, such as the recessions of 1980 and 1982. Sometimes the economy goes many years without a recession. The longest period in U.S. history without a recession was the economic expansion from 1991 to 2001.

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

Real GDP is the variable most commonly used to monitor short-run changes in the economy because it is the most comprehensive measure of economic activity. Real GDP measures the value of all final goods and services produced within a given period of time. It also measures the total income (adjusted for inflation) of everyone in the economy.

It turns out, however, that for monitoring short-run fluctuations, it does not really matter which measure of economic activity one looks at. Most macroeco- nomic variables that measure some type of income, spending, or production fluctuate closely together. When real GDP falls in a recession, so do personal income, corporate profits, consumer spending, investment spending, industrial production, retail sales, home sales, auto sales, and so on. Because recessions are economy-wide phenomena, they show up in many sources of macroeconomic data.

Although many macroeconomic variables fluctuate together, they fluctuate by different amounts. In particular, as panel (b) of Figure 1 shows, investment spending varies greatly over the business cycle. Even though investment averages about one-sixth of GDP, declines in investment account for about two-thirds of the declines in GDP during recessions. In other words, when economic conditions deteriorate, much of the decline is attributable to reductions in spending on new factories, housing, and inventories.

33-1c Fact 3: As Output Falls, Unemployment Rises Changes in the economy’s output of goods and services are strongly correlated with changes in the economy’s utilization of its labor force. In other words, when real GDP declines, the rate of unemployment rises. This fact is hardly surprising: When firms choose to produce a smaller quantity of goods and services, they lay off workers, expanding the pool of unemployed.

Panel (c) of Figure 1 shows the unemployment rate in the U.S. economy since 1972. Once again, the shaded areas in the figure indicate periods of recession. The figure shows clearly the impact of recessions on unemployment. In each of the recessions, the unemployment rate rises substantially. When the recession ends and real GDP starts to expand, the unemployment rate gradually declines. Because there are always some workers between jobs, the unemployment rate never approaches zero. Instead, it fluctuates around its natural rate of about 5 or 6 percent.

QuickQuiz List and discuss three key facts about economic fluctuations.

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705CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

Describing what happens to economies as they fluctuate over time is easy. Explaining what causes these fluctuations is more difficult. Indeed, compared to the topics we have studied in previous chapters, the theory of economic fluctuations remains controversial. In this chapter, we begin to develop the model that most economists use to explain short-run fluctuations in economic activity.

33-2a The Assumptions of Classical Economics In previous chapters, we developed theories to explain what determines most important macroeconomic variables in the long run. Chapter 25 explained the level and growth of productivity and real GDP. Chapters 26 and 27 explained how the financial system works and how the real interest rate adjusts to balance saving and investment. Chapter 28 explained why there is always some unemployment in the economy. Chapters 29 and 30 explained the monetary system and how changes in the money supply affect the price level, the inflation rate, and the nominal interest rate.

All of this previous analysis was based on two related ideas: the classical dichotomy and monetary neutrality. Recall that the classical dichotomy is the separation of variables into real variables (those that measure quantities or relative prices) and nominal variables (those measured in terms of money). According to classical macroeconomic theory, changes in the money supply affect nominal variables but not real variables. As a result of this monetary neutrality, Chapters 25 through 28 were able to examine the determinants of real variables (real GDP, the real interest rate, and unemployment) without introducing nominal variables (the money supply and the price level).

In a sense, money does not matter in a classical world. If the quantity of money in the economy were to double, everything would cost twice as much, and everyone’s income would be twice as high. But so what? The change would be nominal (by the standard meaning of “nearly insignificant”). The things that people really care about—whether they have a job, how many goods and services they can afford, and so on—would be exactly the same.

This classical view is sometimes described by the saying, “Money is a veil.” That is, nominal variables may be the first things we see when we observe an economy because economic variables are often expressed in units of money. But what’s important are the real variables and the economic forces that determine them. According to classical theory, to understand these real variables, we need to look behind the veil.

33-2b The Reality of Short-Run Fluctuations Do these assumptions of classical macroeconomic theory apply to the world in which we live? The answer to this question is of central importance to understanding how the economy works. Most economists believe that classical theory describes the world in the long run but not in the short run.

Consider again the impact of money on the economy. Most economists believe that, beyond a period of several years, changes in the money supply affect prices and other nominal variables but do not affect real GDP, unemployment, and other real variables—just as classical theory says. When studying year-to-year changes

33-2 Explaining Short-Run Economic Fluctuations

706 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

in the economy, however, the assumption of monetary neutrality is no longer appropriate. In the short run, real and nominal variables are highly intertwined, and changes in the money supply can temporarily push real GDP away from its long-run trend.

Even the classical economists themselves, such as David Hume, realized that classical economic theory did not hold in the short run. From his vantage point in 18th-century England, Hume observed that when the money supply expanded after gold discoveries, it took some time for prices to rise, and in the meantime, the economy enjoyed higher employment and production.

To understand how the economy works in the short run, we need a new model. This new model can be built using many of the tools we developed in previous chapters, but it must abandon the classical dichotomy and the neutrality of money. We can no longer separate our analysis of real variables such as output and employment from our analysis of nominal variables such as money and the price level. Our new model focuses on how real and nominal variables interact.

33-2c The Model of Aggregate Demand and Aggregate Supply Our model of short-run economic fluctuations focuses on the behavior of two variables. The first variable is the economy’s output of goods and services, as measured by real GDP. The second is the average level of prices, as measured by the CPI or the GDP deflator. Notice that output is a real variable, whereas the price level is a nominal variable. By focusing on the relationship between these two variables, we are departing from the classical assumption that real and nominal variables can be studied separately.

We analyze fluctuations in the economy as a whole with the model of aggregate demand and aggregate supply, which is illustrated in Figure 2. On the vertical axis is the overall price level in the economy. On the horizontal axis is the overall quantity of goods and services produced in the economy. The aggregate- demand curve shows the quantity of goods and services that households, firms,

model of aggregate

demand and aggregate

supply

the model that most

economists use to explain

short-run fluctuations in

economic activity around

its long-run trend

aggregate-demand curve

a curve that shows the

quantity of goods and

services that households,

firms, the government,

and customers abroad

want to buy at each

price level

FIGURE 2

Aggregate Demand and Aggregate Supply

Economists use the model of aggregate

demand and aggregate supply to analyze

economic fluctuations. On the vertical

axis is the overall level of prices. On the

horizontal axis is the economy’s total

output of goods and services. Output

and the price level adjust to the point

at which the aggregate-supply and

aggregate-demand curves intersect.

Equilibrium output

Quantity of Output

Price Level

Equilibrium price level

Aggregate supply

Aggregate demand

707CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

the government, and customers abroad want to buy at each price level. The aggregate-supply curve shows the quantity of goods and services that firms produce and sell at each price level. According to this model, the price level and the quantity of output adjust to bring aggregate demand and aggregate supply into balance.

It is tempting to view the model of aggregate demand and aggregate supply as nothing more than a large version of the model of market demand and market supply introduced in Chapter 4. But in fact, this model is quite different. When we consider demand and supply in a specific market—ice cream, for instance—the behavior of buyers and sellers depends on the ability of resources to move from one market to another. When the price of ice cream rises, the quantity demanded falls because buyers will use their incomes to buy products other than ice cream. Similarly, a higher price of ice cream raises the quantity supplied because firms that produce ice cream can increase production by hiring workers away from other parts of the economy. This microeconomic substitution from one market to another is impossible for the economy as a whole. After all, the quantity that our model is trying to explain—real GDP—measures the total quantity of goods and services produced by all firms in all markets. To understand why the aggregate- demand curve slopes downward and why the aggregate-supply curve slopes upward, we need a macroeconomic theory that explains the total quantity of goods and services demanded and the total quantity of goods and services supplied. Developing such a theory is our next task.

QuickQuiz How does the economy’s behavior in the short run differ from its behavior

in the long run? • Draw the model of aggregate demand and aggregate

supply. What variables are on the two axes?

aggregate-supply curve

a curve that shows the

quantity of goods and ser-

vices that firms choose to

produce and sell at each

price level

33-3 The Aggregate-Demand Curve The aggregate-demand curve tells us the quantity of all goods and services demanded in the economy at any given price level. As Figure 3 illustrates, the aggregate-demand curve slopes downward. This means that, other things being equal, a decrease in the economy’s overall level of prices (from, say, P

1 to P

2 ) raises

the quantity of goods and services demanded (from Y 1 to Y

2 ). Conversely, an

increase in the price level reduces the quantity of goods and services demanded.

33-3a Why the Aggregate-Demand Curve Slopes Downward Why does a change in the price level move the quantity of goods and services demanded in the opposite direction? To answer this question, it is useful to recall that an economy’s GDP (which we denote as Y) is the sum of its consumption (C), investment (I), government purchases (G), and net exports (NX):

Y 5 C 1 I 1 G 1 NX.

Each of these four components contributes to the aggregate demand for goods and services. For now, we assume that government spending is fixed by policy. The other three components of spending—consumption, investment, and net exports—depend on economic conditions and, in particular, on the price level. Therefore, to understand the downward slope of the aggregate-demand curve, we must examine how the price level affects the quantity of goods and services demanded for consumption, investment, and net exports.

708 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

The Price Level and Consumption: The Wealth Effect Consider the money that you hold in your wallet and your bank account. The nominal value of this money is fixed: One dollar is always worth one dollar. Yet the real value of a dollar is not fixed. If a candy bar costs one dollar, then a dollar is worth one candy bar. If the price of a candy bar falls to 50 cents, then one dollar is worth two candy bars. Thus, when the price level falls, the dollars you are holding rise in value, which increases your real wealth and your ability to buy goods and services.

This logic gives us the first reason the aggregate-demand curve slopes downward. A decrease in the price level raises the real value of money and makes consumers wealthier, which in turn encourages them to spend more. The increase in consumer spending means a larger quantity of goods and services demanded. Conversely, an increase in the price level reduces the real value of money and makes consumers poorer, which in turn reduces consumer spending and the quantity of goods and services demanded.

The Price Level and Investment: The Interest-Rate Effect The price level is one determinant of the quantity of money demanded. When the price level is lower, households do not need to hold as much money to buy the goods and services they want. Therefore, when the price level falls, households try to reduce their holdings of money by lending some of it out. For instance, a household might use its excess money to buy interest-bearing bonds. Or it might deposit its excess money in an interest-bearing savings account, and the bank would use these funds to make more loans. In either case, as households try to convert some of their money into interest-bearing assets, they drive down interest rates. (The next chapter analyzes this process in more detail.)

Interest rates, in turn, affect spending on goods and services. Because a lower interest rate makes borrowing less expensive, it encourages firms to borrow

FIGURE 3

The Aggregate-Demand Curve

A fall in the price level from P 1 to P

increases the quantity of goods and

services demanded from Y 1 to Y

2 . There

are three reasons for this negative

relationship. As the price level falls,

real wealth rises, interest rates fall,

and the exchange rate depreciates.

These effects stimulate spending on

consumption, investment, and net

exports. Increased spending on any

or all of these components of output

means a larger quantity of goods and

services demanded.

Quantity of Output

Price Level

Aggregate demand

Y1 Y2

1. A decrease in the price level . . .

2. . . . increases the quantity of goods and services demanded.

709CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

more to invest in new plants and equipment, and it encourages households to borrow more to invest in new housing. (A lower interest rate might also stimulate consumer spending, especially spending on large durable purchases such as cars, which are often bought on credit.) Thus, a lower interest rate increases the quantity of goods and services demanded.

This logic gives us the second reason the aggregate-demand curve slopes downward. A lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the quantity of goods and services demanded. Conversely, a higher price level raises the interest rate, discourages investment spending, and decreases the quantity of goods and services demanded.

The Price Level and Net E xports : The E xchange-Rate Effect As we have just discussed, a lower price level in the United States lowers the U.S. interest rate. In response to the lower interest rate, some U.S. investors will seek higher returns by investing abroad. For instance, as the interest rate on U.S. government bonds falls, a mutual fund might sell U.S. government bonds to buy German government bonds. As the mutual fund tries to convert its dollars into euros to buy the German bonds, it increases the supply of dollars in the market for foreign- currency exchange.

The increased supply of dollars to be turned into euros causes the dollar to depreciate relative to the euro. This leads to a change in the real exchange rate— the relative price of domestic and foreign goods. Because each dollar buys fewer units of foreign currencies, foreign goods become more expensive relative to domestic goods.

The change in relative prices affects spending, both at home and abroad. Because foreign goods are now more expensive, Americans buy less from other countries, causing U.S. imports of goods and services to decrease. At the same time, because U.S. goods are now cheaper, foreigners buy more from the United States, so U.S. exports increase. Net exports equal exports minus imports, so both of these changes cause U.S. net exports to increase. Thus, the fall in the real exchange value of the dollar leads to an increase in the quantity of goods and services demanded.

This logic yields the third reason the aggregate-demand curve slopes downward. When a fall in the U.S. price level causes U.S. interest rates to fall, the real value of the dollar declines in foreign exchange markets. This depreciation stimulates U.S. net exports and thereby increases the quantity of goods and services demanded. Conversely, when the U.S. price level rises and causes U.S. interest rates to rise, the real value of the dollar increases, and this appreciation reduces U.S. net exports and the quantity of goods and services demanded.

Summing Up There are three distinct but related reasons a fall in the price level increases the quantity of goods and services demanded:

1. Consumers are wealthier, which stimulates the demand for consumption goods.

2. Interest rates fall, which stimulates the demand for investment goods. 3. The currency depreciates, which stimulates the demand for net exports.

The same three effects work in reverse: When the price level rises, decreased wealth depresses consumer spending, higher interest rates depress investment spending, and a currency appreciation depresses net exports.

710 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

Here is a thought experiment to hone your intuition about these effects. Imagine that one day you wake up and notice that, for some mysterious reason, the prices of all goods and services have fallen by half, so the dollars you are holding are worth twice as much. In real terms, you now have twice as much money as you had when you went to bed the night before. What would you do with the extra money? You could spend it at your favorite restaurant, increasing consumer spending. You could lend it out (by buying a bond or depositing it in your bank), reducing interest rates and increasing investment spending. Or you could invest it overseas (by buying shares in an international mutual fund), reducing the real exchange value of the dollar and increasing net exports. Whichever of these three responses you choose, the fall in the price level leads to an increase in the quantity of goods and services demanded. This is what the downward slope of the aggregate-demand curve represents.

It is important to keep in mind that the aggregate-demand curve (like all demand curves) is drawn holding “other things equal.” In particular, our three explanations of the downward-sloping aggregate-demand curve assume that the money supply is fixed. That is, we have been considering how a change in the price level affects the demand for goods and services, holding the amount of money in the economy constant. As we will see, a change in the quantity of money shifts the aggregate-demand curve. At this point, just keep in mind that the aggregate-demand curve is drawn for a given quantity of the money supply.

33-3b Why the Aggregate-Demand Curve Might Shift The downward slope of the aggregate-demand curve shows that a fall in the price level raises the overall quantity of goods and services demanded. Many other factors, however, affect the quantity of goods and services demanded at a given price level. When one of these other factors changes, the quantity of goods and services demanded at every price level changes and the aggregate-demand curve shifts.

Let’s consider some examples of events that shift aggregate demand. We can categorize them according to the component of spending that is most directly affected.

Shifts Arising from Changes in Consumption Suppose Americans suddenly become more concerned about saving for retirement and, as a result, reduce their current consumption. Because the quantity of goods and services demanded at any price level is lower, the aggregate-demand curve shifts to the left. Conversely, imagine that a stock market boom makes people wealthier and less concerned about saving. The resulting increase in consumer spending means a greater quantity of goods and services demanded at any given price level, so the aggregate-demand curve shifts to the right.

Thus, any event that changes how much people want to consume at a given price level shifts the aggregate-demand curve. One policy variable that has this effect is the level of taxation. When the government cuts taxes, it encourages people to spend more, so the aggregate-demand curve shifts to the right. When the government raises taxes, people cut back on their spending and the aggregate- demand curve shifts to the left.

Shifts Arising from Changes in Investment Any event that changes how much firms want to invest at a given price level also shifts the aggregate-demand curve. For instance, imagine that the computer industry introduces a faster

711CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

line of computers and many firms decide to invest in new computer systems. Because the quantity of goods and services demanded at any price level is higher, the aggregate-demand curve shifts to the right. Conversely, if firms become pessimistic about future business conditions, they may cut back on investment spending, shifting the aggregate-demand curve to the left.

Tax policy can also influence aggregate demand through investment. For example, an investment tax credit (a tax rebate tied to a firm’s investment spending) increases the quantity of investment goods that firms demand at any given interest rate and therefore shifts the aggregate-demand curve to the right. The repeal of an investment tax credit reduces investment and shifts the aggregate-demand curve to the left.

Another policy variable that can influence investment and aggregate demand is the money supply. As we discuss more fully in the next chapter, an increase in the money supply lowers the interest rate in the short run. This decrease in the interest rate makes borrowing less costly, which stimulates investment spending and thereby shifts the aggregate-demand curve to the right. Conversely, a decrease in the money supply raises the interest rate, discourages investment spending, and thereby shifts the aggregate-demand curve to the left. Many economists believe that throughout U.S. history, changes in monetary policy have been an important source of shifts in aggregate demand.

Shifts Arising from Changes in Government Purchases The most direct way that policymakers shift the aggregate-demand curve is through government purchases. For example, suppose Congress decides to reduce purchases of new weapons systems. Because the quantity of goods and services demanded at any price level is lower, the aggregate-demand curve shifts to the left. Conversely, if state governments start building more highways, the result is a greater quantity of goods and services demanded at any price level, so the aggregate-demand curve shifts to the right.

Shifts Arising from Changes in Net Exports Any event that changes net exports for a given price level also shifts aggregate demand. For instance, when Europe experiences a recession, it buys fewer goods from the United States. This reduces U.S. net exports at every price level and shifts the aggregate-demand curve for the U.S. economy to the left. When Europe recovers from its recession, it starts buying U.S. goods again and the aggregate-demand curve shifts to the right.

Net exports can also change because international speculators cause movements in the exchange rate. Suppose, for instance, that these speculators lose confidence in foreign economies and want to move some of their wealth into the U.S. economy. In doing so, they bid up the value of the U.S. dollar in the foreign exchange market. This appreciation of the dollar makes U.S. goods more expensive compared to foreign goods, which depresses net exports and shifts the aggregate- demand curve to the left. Conversely, speculation that causes a depreciation of the dollar stimulates net exports and shifts the aggregate-demand curve to the right.

Summing Up In the next chapter, we analyze the aggregate-demand curve in more detail. There we examine more precisely how the tools of monetary and fiscal policy can shift aggregate demand and whether policymakers should use these tools for that purpose. At this point, however, you should have some idea about why the aggregate- demand curve slopes downward and what kinds of events and policies can shift this curve. Table 1 summarizes what we have learned so far.

712 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

QuickQuiz Explain the three reasons the aggregate-demand curve slopes downward.

• Give an example of an event that would shift the aggregate-demand

curve. In which direction would this event shift the curve?

TABLE 1

The Aggregate-Demand

Curve: Summary

Why Does the Aggregate-Demand Curve Slope Downward?

1. The Wealth Effect: A lower price level increases real wealth, which stimulates spending

on consumption.

2. The Interest-Rate Effect: A lower price level reduces the interest rate, which stimulates

spending on investment.

3. The Exchange-Rate Effect: A lower price level causes the real exchange rate to

depreciate, which stimulates spending on net exports.

Why Might the Aggregate-Demand Curve Shift?

1. Shifts Arising from Changes in Consumption: An event that causes consumers to spend

more at a given price level (a tax cut, a stock market boom) shifts the aggregate-demand

curve to the right. An event that causes consumers to spend less at a given price level (a

tax hike, a stock market decline) shifts the aggregate-demand curve to the left.

2. Shifts Arising from Changes in Investment: An event that causes firms to invest more at a

given price level (optimism about the future, a fall in interest rates due to an increase in

the money supply) shifts the aggregate-demand curve to the right. An event that causes

firms to invest less at a given price level (pessimism about the future, a rise in interest

rates due to a decrease in the money supply) shifts the aggregate-demand curve to the left.

3. Shifts Arising from Changes in Government Purchases: An increase in government

purchases of goods and services (greater spending on defense or highway construction)

shifts the aggregate-demand curve to the right. A decrease in government purchases

on goods and services (a cutback in defense or highway spending) shifts the aggregate-

demand curve to the left.

4. Shifts Arising from Changes in Net Exports: An event that raises spending on net

exports at a given price level (a boom overseas, speculation that causes an exchange-

rate depreciation) shifts the aggregate-demand curve to the right. An event that reduces

spending on net exports at a given price level (a recession overseas, speculation that

causes an exchange-rate appreciation) shifts the aggregate-demand curve to the left.

33-4 The Aggregate-Supply Curve The aggregate-supply curve tells us the total quantity of goods and services that firms produce and sell at any given price level. Unlike the aggregate-demand curve, which always slopes downward, the aggregate-supply curve shows a relationship that depends crucially on the time horizon examined. In the long run, the aggregate- supply curve is vertical, whereas in the short run, the aggregate-supply curve slopes upward. To understand short-run economic fluctuations, and how the short-run behavior of the economy deviates from its long-run behavior, we need to examine both the long-run aggregate-supply curve and the short-run aggregate-supply curve.

33-4a Why the Aggregate-Supply Curve Is Vertical in the Long Run What determines the quantity of goods and services supplied in the long run? We implicitly answered this question earlier in the book when we analyzed the process of economic growth. In the long run, an economy’s production of goods and services

713CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

(its real GDP) depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services.

When we analyzed these forces that govern long-run growth, we did not need to make any reference to the overall level of prices. We examined the price level in a separate chapter, where we saw that it was determined by the quantity of money. We learned that if two economies were identical except that one had twice as much money in circulation, the price level would be twice as high in the economy with more money. But since the amount of money does not affect technology or the supplies of labor, capital, and natural resources, the output of goods and services in the two economies would be the same.

Because the price level does not affect the long-run determinants of real GDP, the long-run aggregate-supply curve is vertical, as in Figure 4. In other words, in the long run, the economy’s labor, capital, natural resources, and technology determine the total quantity of goods and services supplied, and this quantity supplied is the same regardless of what the price level happens to be.

The vertical long-run aggregate-supply curve is a graphical representation of the classical dichotomy and monetary neutrality. As we have already discussed, classical macroeconomic theory is based on the assumption that real variables do not depend on nominal variables. The long-run aggregate-supply curve is consistent with this idea because it implies that the quantity of output (a real variable) does not depend on the level of prices (a nominal variable). As noted earlier, most economists believe this principle works well when studying the economy over a period of many years but not when studying year-to-year changes. Thus, the aggregate-supply curve is vertical only in the long run.

33-4b Why the Long-Run Aggregate-Supply Curve Might Shift Because classical macroeconomic theory predicts the quantity of goods and services produced by an economy in the long run, it also explains the position of the long-run aggregate-supply curve. The long-run level of production is

FIGURE 4

The Long-Run Aggregate-Supply Curve

In the long run, the quantity of output

supplied depends on the economy’s

quantities of labor, capital, and natural

resources and on the technology for

turning these inputs into output.

Because the quantity supplied does

not depend on the overall price level,

the long-run aggregate-supply curve is

vertical at the natural level of output.

Quantity of Output

Natural level of output

Price Level

Long-run aggregate

supply

1. A change in the price level . . .

2. . . . does not affect the quantity of goods and services supplied in the long run.

714 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

sometimes called potential output or full-employment output. To be more precise, we call it the natural level of output because it shows what the economy produces when unemployment is at its natural, or normal, rate. The natural level of output is the rate of production toward which the economy gravitates in the long run.

Any change in the economy that alters the natural level of output shifts the long-run aggregate-supply curve. Because output in the classical model depends on labor, capital, natural resources, and technological knowledge, we can categorize shifts in the long-run aggregate-supply curve as arising from these four sources.

Shifts Arising from Changes in Labor Imagine that an economy experiences an increase in immigration. Because there would be a greater number of workers, the quantity of goods and services supplied would increase. As a result, the long-run aggregate-supply curve would shift to the right. Conversely, if many workers left the economy to go abroad, the long-run aggregate-supply curve would shift to the left.

The position of the long-run aggregate-supply curve also depends on the natural rate of unemployment, so any change in the natural rate of unemployment shifts the long-run aggregate-supply curve. For example, if Congress were to raise the minimum wage substantially, the natural rate of unemployment would rise and the economy would produce a smaller quantity of goods and services. As a result, the long-run aggregate-supply curve would shift to the left. Conversely, if a reform of the unemployment insurance system were to encourage unemployed workers to search harder for new jobs, the natural rate of unemployment would fall and the long-run aggregate-supply curve would shift to the right.

Shifts Arising from Changes in Capital An increase in the economy’s capital stock increases productivity and, thereby, the quantity of goods and services supplied. As a result, the long-run aggregate-supply curve shifts to the right. Conversely, a decrease in the economy’s capital stock decreases productivity and the quantity of goods and services supplied, shifting the long-run aggregate- supply curve to the left.

Notice that the same logic applies regardless of whether we are discussing physical capital such as machines and factories or human capital such as college degrees. An increase in either type of capital will raise the economy’s ability to produce goods and services and, thus, shift the long-run aggregate-supply curve to the right.

Shifts Arising from Changes in Natural Resources An economy’s production depends on its natural resources, including its land, minerals, and weather. The discovery of a new mineral deposit shifts the long-run aggregate-supply curve to the right. A change in weather patterns that makes farming more difficult shifts the long-run aggregate-supply curve to the left.

In many countries, crucial natural resources are imported. A change in the availability of these resources can also shift the aggregate-supply curve. For example, as we discuss later in this chapter, events occurring in the world oil market have historically been an important source of shifts in aggregate supply for the United States and other oil-importing nations.

natural level of output

the production of goods

and services that an

economy achieves in the

long run when unemploy-

ment is at its normal rate

715CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

Shifts Arising from Changes in Technological Knowledge Perhaps the most important reason that the economy today produces more than it did a generation ago is that our technological knowledge has advanced. The invention of the computer, for instance, has allowed us to produce more goods and services from any given amounts of labor, capital, and natural resources. As computer use has spread throughout the economy, it has shifted the long-run aggregate-supply curve to the right.

Although not literally technological, many other events act like changes in technology. For instance, opening up international trade has effects similar to inventing new production processes because it allows a country to specialize in higher-productivity industries; therefore, it also shifts the long-run aggregate- supply curve to the right. Conversely, if the government passes new regulations preventing firms from using some production methods, perhaps to address worker safety or environmental concerns, the result is a leftward shift in the long- run aggregate-supply curve.

Summing Up Because the long-run aggregate-supply curve reflects the classical model of the economy we developed in previous chapters, it provides a new way to describe our earlier analysis. Any policy or event that raised real GDP in previous chapters can now be described as increasing the quantity of goods and services supplied and shifting the long-run aggregate-supply curve to the right. Any policy or event that lowered real GDP in previous chapters can now be described as decreasing the quantity of goods and services supplied and shifting the long-run aggregate-supply curve to the left.

33-4c Using Aggregate Demand and Aggregate Supply to Depict Long-Run Growth and Inflation

Having introduced the economy’s aggregate-demand curve and the long-run aggregate-supply curve, we now have a new way to describe the economy’s long- run trends. Figure 5 illustrates the changes that occur in an economy from decade to decade. Notice that both curves are shifting. Although many forces influence the economy in the long run and can in theory cause such shifts, the two most important forces in practice are technology and monetary policy. Technological progress enhances an economy’s ability to produce goods and services, and the resulting increases in output are reflected in continual shifts of the long-run aggregate-supply curve to the right. At the same time, because the Fed increases the money supply over time, the aggregate-demand curve also shifts to the right. As the figure illustrates, the result is continuing growth in output (as shown by increasing Y) and continuing inflation (as shown by increasing P). This is just another way of representing the classical analysis of growth and inflation we conducted in earlier chapters.

The purpose of developing the model of aggregate demand and aggregate supply, however, is not to dress our previous long-run conclusions in new clothing. Instead, it is to provide a framework for short-run analysis, as we will see in a moment. As we develop the short-run model, we keep the analysis simple by omitting the continuing growth and inflation shown by the shifts in Figure 5. But always remember that long-run trends are the background on which short- run fluctuations are superimposed. The short-run fluctuations in output and the price level that we will be studying should be viewed as deviations from the long-run trends of output growth and inflation.

716 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

33-4d Why the Aggregate-Supply Curve Slopes Upward in the Short Run

The key difference between the economy in the short run and in the long run is the behavior of aggregate supply. The long-run aggregate-supply curve is vertical because, in the long run, the overall level of prices does not affect the economy’s ability to produce goods and services. By contrast, in the short run, the price level does affect the economy’s output. That is, over a period of a year or two, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied, and a decrease in the level of prices tends to reduce the quantity of goods and services supplied. As a result, the short-run aggregate- supply curve slopes upward, as shown in Figure 6.

Why do changes in the price level affect output in the short run? Macro- economists have proposed three theories for the upward slope of the short-run

Quantity of Output

Y1990

AD1990

Y2000

AD2000

Y2010

Aggregate demand, AD2010

Price Level

Long-run aggregate

supply, LRAS1990 LRAS2000 LRAS2010

P1990

1. In the long run, technological progress shifts long-run aggregate supply . . .

4. . . . and ongoing inflation.

3. . . . leading to growth in output . . .

P2000

P2010

2. . . . and growth in the money supply shifts aggregate demand . . .

FIGURE 5

Long-Run Growth and Inflation in

the Model of Aggregate Demand

and Aggregate Supply

As the economy becomes better able to produce goods and services over time,

primarily because of technological progress, the long-run aggregate-supply curve

shifts to the right. At the same time, as the Fed increases the money supply, the

aggregate-demand curve also shifts to the right. In this figure, output grows from

Y 1990

to Y 2000

and then to Y 2010

and the price level rises from P 1990

to P 2000

and then

to P 2010

. Thus, the model of aggregate demand and aggregate supply offers a new

way to describe the classical analysis of growth and inflation.

717CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

aggregate-supply curve. In each theory, a specific market imperfection causes the supply side of the economy to behave differently in the short run than it does in the long run. The following theories differ in their details, but they share a common theme: The quantity of output supplied deviates from its long-run, or natural, level when the actual price level in the economy deviates from the price level that people expected to prevail. When the price level rises above the level that people expected, output rises above its natural level, and when the price level falls below the expected level, output falls below its natural level.

The Sticky-Wage Theory The first explanation of the upward slope of the short- run aggregate-supply curve is the sticky-wage theory. This theory is the simplest of the three approaches to aggregate supply, and some economists believe it highlights the most important reason why the economy in the short run differs from the economy in the long run. Therefore, it is the theory of short-run aggregate supply that we emphasize in this book.

According to this theory, the short-run aggregate-supply curve slopes upward because nominal wages are slow to adjust to changing economic conditions. In other words, wages are “sticky” in the short run. To some extent, the slow adjustment of nominal wages is attributable to long-term contracts between workers and firms that fix nominal wages, sometimes for as long as 3 years. In addition, this prolonged adjustment may be attributable to slowly changing social norms and notions of fairness that influence wage setting.

An example can help explain how sticky nominal wages can result in a short- run aggregate-supply curve that slopes upward. Imagine that a year ago a firm expected the price level today to be 100, and based on this expectation, it signed a contract with its workers agreeing to pay them, say, $20 an hour. In fact, the price level turns out to be only 95. Because prices have fallen below expectations, the firm gets 5 percent less than expected for each unit of its product that it sells. The cost of labor used to make the output, however, is stuck at $20 per hour. Production is now less profitable, so the firm hires fewer workers and reduces

FIGURE 6

The Short-Run Aggregate-Supply Curve

In the short run, a fall in the price level

from P 1 to P

2 reduces the quantity

of output supplied from Y 1 to Y

2 .

This positive relationship could be

due to sticky wages, sticky prices, or

misperceptions. Over time, wages,

prices, and perceptions adjust, so this

positive relationship is only temporary.

Quantity of Output

Price Level

Short-run aggregate

supply

Y2 Y1

1. A decrease in the price level . . .

2. . . . reduces the quantity of goods and services supplied in the short run.

718 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

the quantity of output supplied. Over time, the labor contract will expire, and the firm can renegotiate with its workers for a lower wage (which they may accept because prices are lower), but in the meantime, employment and production will remain below their long-run levels.

The same logic works in reverse. Suppose the price level turns out to be 105 and the wage remains stuck at $20. The firm sees that the amount it is paid for each unit sold is up by 5 percent, while its labor costs are not. In response, it hires more workers and increases the quantity of output supplied. Eventually, the workers will demand higher nominal wages to compensate for the higher price level, but for a while, the firm can take advantage of the profit opportunity by increasing employment and production above their long-run levels.

In short, according to the sticky-wage theory, the short-run aggregate-supply curve slopes upward because nominal wages are based on expected prices and do not respond immediately when the actual price level turns out to be different from what was expected. This stickiness of wages gives firms an incentive to produce less output when the price level turns out lower than expected and to produce more when the price level turns out higher than expected.

The Sticky-Price Theory Some economists have advocated another approach to explaining the upward slope of the short-run aggregate-supply curve, called the sticky-price theory. As we just discussed, the sticky-wage theory emphasizes that nominal wages adjust slowly over time. The sticky-price theory emphasizes that the prices of some goods and services also adjust sluggishly in response to changing economic conditions. This slow adjustment of prices occurs in part because there are costs to adjusting prices, called menu costs. These menu costs include the cost of printing and distributing catalogs and the time required to change price tags. As a result of these costs, prices as well as wages may be sticky in the short run.

To see how sticky prices explain the aggregate-supply curve’s upward slope, suppose that each firm in the economy announces its prices in advance based on the economic conditions it expects to prevail over the coming year. Suppose further that after prices are announced, the economy experiences an unexpected contraction in the money supply, which (as we have learned) will reduce the overall price level in the long run. What happens in the short run? Although some firms reduce their prices quickly in response to the unexpected change in economic conditions, many other firms want to avoid additional menu costs. As a result, they temporarily lag behind in cutting their prices. Because these lagging firms have prices that are too high, their sales decline. Declining sales, in turn, cause these firms to cut back on production and employment. In other words, because not all prices adjust immediately to changing conditions, an unexpected fall in the price level leaves some firms with higher-than-desired prices, and these higher-than-desired prices depress sales and induce firms to reduce the quantity of goods and services they produce.

Similar reasoning applies when the money supply and price level turn out to be above what firms expected when they originally set their prices. While some firms raise their prices quickly in response to the new economic environment, other firms lag behind, keeping their prices at the lower-than-desired levels. These low prices attract customers, which induces these firms to increase employment and production. Thus, during the time these lagging firms are operating with outdated prices, there is a positive association between the overall price level and the quantity of output. This positive association is represented by the upward slope of the short-run aggregate-supply curve.

719CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

The Misperceptions Theory A third approach to explaining the upward slope of the short-run aggregate-supply curve is the misperceptions theory. According to this theory, changes in the overall price level can temporarily mislead suppliers about what is happening in the individual markets in which they sell their output. As a result of these short-run misperceptions, suppliers respond to changes in the level of prices, and this response leads to an upward-sloping aggregate-supply curve.

To see how this might work, suppose the overall price level falls below the level that suppliers expected. When suppliers see the prices of their products fall, they may mistakenly believe that their relative prices have fallen; that is, they may believe that their prices have fallen compared to other prices in the economy. For example, wheat farmers may notice a fall in the price of wheat before they notice a fall in the prices of the many items they buy as consumers. They may infer from this observation that the reward for producing wheat is temporarily low, and they may respond by reducing the quantity of wheat they supply. Similarly, workers may notice a fall in their nominal wages before they notice that the prices of the goods they buy are also falling. They may infer that the reward for working is temporarily low and respond by reducing the quantity of labor they supply. In both cases, a lower price level causes misperceptions about relative prices, and these misperceptions induce suppliers to respond to the lower price level by decreasing the quantity of goods and services supplied.

Similar misperceptions arise when the price level is above what was expected. Suppliers of goods and services may notice the price of their output rising and infer, mistakenly, that their relative prices are rising. They would conclude that it is a good time to produce. Until their misperceptions are corrected, they respond to the higher price level by increasing the quantity of goods and services supplied. This behavior results in a short-run aggregate-supply curve that slopes upward.

Summing Up There are three alternative explanations for the upward slope of the short-run aggregate-supply curve: (1) sticky wages, (2) sticky prices, and (3) misperceptions about relative prices. Economists debate which of these theories is correct, and it is possible that each contains an element of truth. For our purposes in this book, the similarities of the theories are more important than the differences. All three theories suggest that output deviates in the short run from its natural level when the actual price level deviates from the price level that people had expected to prevail. We can express this mathematically as follows:

Quantity Natural Actual Expected of output = level of + a price – price supplied output level level

where a is a number that determines how much output responds to unexpected changes in the price level.

Notice that each of the three theories of short-run aggregate supply emphasizes a problem that is likely to be temporary. Whether the upward slope of the aggregate-supply curve is attributable to sticky wages, sticky prices, or misperceptions, these conditions will not persist forever. Over time, nominal wages will become unstuck, prices will become unstuck, and misperceptions about relative prices will be corrected. In the long run, it is reasonable to assume that wages and prices are flexible rather than sticky and that people are not confused about relative prices. Thus, while we have several good theories to explain why the short-run aggregate-supply curve slopes upward, they are all consistent with a long-run aggregate-supply curve that is vertical.

720 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

33-4e Why the Short-Run Aggregate-Supply Curve Might Shift The short-run aggregate-supply curve tells us the quantity of goods and services supplied in the short run for any given level of prices. This curve is similar to the long- run aggregate-supply curve, but it is upward-sloping rather than vertical because of sticky wages, sticky prices, and misperceptions. Thus, when thinking about what shifts the short-run aggregate-supply curve, we have to consider all those variables that shift the long-run aggregate-supply curve. In addition, we have to consider a new variable—the expected price level—that influences the wages that are stuck, the prices that are stuck, and the perceptions about relative prices that may be flawed.

Let’s start with what we know about the long-run aggregate-supply curve. As we discussed earlier, shifts in the long-run aggregate-supply curve normally arise from changes in labor, capital, natural resources, or technological knowl- edge. These same variables shift the short-run aggregate-supply curve. For ex- ample, when an increase in the economy’s capital stock increases productivity, the economy is able to produce more output, so both the long-run and short-run aggregate-supply curves shift to the right. When an increase in the minimum wage raises the natural rate of unemployment, the economy has fewer employed workers and thus produces less output, so both the long-run and short-run aggre- gate-supply curves shift to the left.

The important new variable that affects the position of the short-run aggre- gate-supply curve is the price level that people expected to prevail. As we have discussed, the quantity of goods and services supplied depends, in the short run, on sticky wages, sticky prices, and misperceptions. Yet wages, prices, and per- ceptions are set based on the expected price level. So when people change their expectations of the price level, the short-run aggregate-supply curve shifts.

To make this idea more concrete, let’s consider a specific theory of aggregate supply—the sticky-wage theory. According to this theory, when workers and firms expect the price level to be high, they are likely to reach a bargain with a higher level of nominal wages. Higher wages raise firms’ costs, and for any given actual price level, higher costs reduce the quantity of goods and services supplied. Thus, when the expected price level rises, wages are higher, costs increase, and firms produce a smaller quantity of goods and services at any given actual price level. Thus, the short-run aggregate-supply curve shifts to the left. Conversely, when the expected price level falls, wages are lower, costs decline, firms increase output at any given price level, and the short-run aggregate-supply curve shifts to the right.

A similar logic applies in each theory of aggregate supply. The general lesson is the following: An increase in the expected price level reduces the quantity of goods and services supplied and shifts the short-run aggregate-supply curve to the left. A decrease in the expected price level raises the quantity of goods and services supplied and shifts the short- run aggregate-supply curve to the right. As we will see in the next section, the influence of expectations on the position of the short-run aggregate-supply curve plays a key role in explaining how the economy makes the transition from the short run to the long run. In the short run, expectations are fixed and the economy finds itself at the intersection of the aggregate-demand curve and the short-run aggregate-supply curve. In the long run, if people observe that the price level is different from what they expected, their expectations adjust and the short-run aggregate-supply curve shifts. This shift ensures that the economy eventually finds itself at the intersection of the aggregate-demand curve and the long-run aggregate-supply curve.

You should now have some understanding about why the short-run aggregate- supply curve slopes upward and what events and policies can cause this curve to shift. Table 2 summarizes our discussion.

721CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

QuickQuiz Explain why the long-run aggregate-supply curve is vertical. • Explain

three theories for why the short-run aggregate-supply curve slopes upward.

• What variables shift both the long-run and short-run aggregate-supply curves? • What

variable shifts the short-run aggregate-supply curve but not the long-run aggregate-supply

curve?

TABLE 2

The Short-Run Aggregate-

Supply Curve: Summary

Why Does the Short-Run Aggregate-Supply Curve Slope Upward?

1. The Sticky-Wage Theory: An unexpectedly low price level raises the real wage, which

causes firms to hire fewer workers and produce a smaller quantity of goods and services.

2. The Sticky-Price Theory: An unexpectedly low price level leaves some firms with higher-

than-desired prices, which depresses their sales and leads them to cut back production.

3. The Misperceptions Theory: An unexpectedly low price level leads some suppliers to

think their relative prices have fallen, which induces a fall in production.

Why Might the Short-Run Aggregate-Supply Curve Shift?

1. Shifts Arising from Changes in Labor: An increase in the quantity of labor available

(perhaps due to a fall in the natural rate of unemployment) shifts the aggregate-supply

curve to the right. A decrease in the quantity of labor available (perhaps due to a rise in

the natural rate of unemployment) shifts the aggregate-supply curve to the left.

2. Shifts Arising from Changes in Capital: An increase in physical or human capital shifts

the aggregate-supply curve to the right. A decrease in physical or human capital shifts

the aggregate-supply curve to the left.

3. Shifts Arising from Changes in Natural Resources: An increase in the availability of

natural resources shifts the aggregate-supply curve to the right. A decrease in the

availability of natural resources shifts the aggregate-supply curve to the left.

4. Shifts Arising from Changes in Technology: An advance in technological knowledge shifts

the aggregate-supply curve to the right. A decrease in the available technology (perhaps

due to government regulation) shifts the aggregate-supply curve to the left.

5. Shifts Arising from Changes in the Expected Price Level: A decrease in the expected

price level shifts the short-run aggregate-supply curve to the right. An increase in the

expected price level shifts the short-run aggregate-supply curve to the left.

33-5 Two Causes of Economic Fluctuations Now that we have introduced the model of aggregate demand and aggregate supply, we have the basic tools we need to analyze fluctuations in economic activity. In particular, we can use what we have learned about aggregate demand and aggregate supply to examine the two basic causes of short-run fluctuations : shifts in aggregate demand and shifts in aggregate supply.

To keep things simple, we assume the economy begins in long-run equilibrium, as shown in Figure 7. Output and the price level are determined in the long run by the intersection of the aggregate-demand curve and the long-run aggregate- supply curve, shown as point A in the figure. At this point, output is at its natural level. Because the economy is always in a short-run equilibrium, the short-run aggregate-supply curve passes through this point as well, indicating that the expected price level has adjusted to this long-run equilibrium. That is, when an economy is in its long-run equilibrium, the expected price level must equal the actual price level so that the intersection of aggregate demand with short-run

722 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

aggregate supply is the same as the intersection of aggregate demand with long- run aggregate supply.

33-5a The Effects of a Shift in Aggregate Demand Suppose that a wave of pessimism suddenly overtakes the economy. The cause might be a scandal in the White House, a crash in the stock market, or the outbreak of war overseas. Because of this event, many people lose confidence in the future and alter their plans. Households cut back on their spending and delay major purchases, and firms put off buying new equipment.

What is the macroeconomic impact of such a wave of pessimism? In answering this question, we can follow the three steps we used in Chapter 4 when analyzing supply and demand in specific markets. First, we determine whether the event affects aggregate demand or aggregate supply. Second, we determine the direction that the curve shifts. Third, we use the diagram of aggregate demand and aggregate supply to compare the initial and the new equilibrium. The new wrinkle is that we need to add a fourth step: We have to keep track of a new short- run equilibrium, a new long-run equilibrium, and the transition between them. Table 3 summarizes the four steps to analyzing economic fluctuations.

FIGURE 7

The Long-Run Equilibrium

The long-run equilibrium of the

economy is found where the aggregate-

demand curve crosses the long-run

aggregate-supply curve (point A).

When the economy reaches this

long-run equilibrium, the expected

price level will have adjusted to equal

the actual price level. As a result,

the short-run aggregate-supply curve

crosses this point as well.

Natural level of output

Quantity of Output

Price Level

Equilibrium price

Short-run aggregate

supply

Long-run aggregate

supply

Aggregate demand

TABLE 3

Four Steps for Analyzing

Macroeconomic

Fluctuations

1. Decide whether the event shifts the aggregate-demand curve or the aggregate-supply

curve (or perhaps both).

2. Decide the direction in which the curve shifts.

3. Use the diagram of aggregate demand and aggregate supply to determine the impact on

output and the price level in the short run.

4. Use the diagram of aggregate demand and aggregate supply to analyze how the economy

moves from its new short-run equilibrium to its new long-run equilibrium.

723CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

The first two steps are straightforward. First, because the wave of pessimism affects spending plans, it affects the aggregate-demand curve. Second, because households and firms now want to buy a smaller quantity of goods and services for any given price level, the event reduces aggregate demand. As Figure 8 shows, the aggregate-demand curve shifts to the left from AD

1 to AD

2 .

With this figure, we can perform step three: By comparing the initial and the new equilibrium, we can see the effects of the fall in aggregate demand. In the short run, the economy moves along the initial short-run aggregate-supply curve, AS

1 , going

from point A to point B. As the economy moves between these two points, output falls from Y

1 to Y

2 and the price level falls from P

1 to P

2 . The falling level of output

indicates that the economy is in a recession. Although not shown in the figure, firms respond to lower sales and production by reducing employment. Thus, the pessimism that caused the shift in aggregate demand is, to some extent, self-fulfilling: Pessimism about the future leads to falling incomes and rising unemployment.

Now comes step four—the transition from the short-run equilibrium to the new long-run equilibrium. Because of the reduction in aggregate demand, the price level initially falls from P

1 to P

2 . The price level is thus below the level that

people were expecting (P 1 ) before the sudden fall in aggregate demand. People

can be surprised in the short run, but they will not remain surprised. Over time, their expectations catch up with this new reality, and the expected price level falls as well. The fall in the expected price level alters wages, prices, and perceptions, which in turn influences the position of the short-run aggregate-supply curve. For example, according to the sticky-wage theory, once workers and firms come to expect a lower level of prices, they start to strike bargains for lower nominal wages; the reduction in labor costs encourages firms to hire more workers and expand production at any given level of prices. Thus, the fall in the expected price level shifts the short-run aggregate-supply curve to the right from AS

1 to AS

in Figure 8. This shift allows the economy to approach point C, where the new aggregate-demand curve (AD

2 ) crosses the long-run aggregate-supply curve.

FIGURE 8

A Contraction in Aggregate Demand

A fall in aggregate demand is represented

with a leftward shift in the aggregate-

demand curve from AD 1 to AD

2 . In the

short run, the economy moves from point A

to point B. Output falls from Y 1 to Y

2 , and

the price level falls from P 1 to P

2 . Over time,

as the expected price level adjusts, the

short-run aggregate-supply curve shifts to

the right from AS 1 to AS

2 , and the economy

reaches point C, where the new aggregate-

demand curve crosses the long-run

aggregate-supply curve. In the long run, the

price level falls to P 3 , and output returns to

its natural level, Y 1 .

Quantity of Output

Price Level

Short-run aggregate supply, AS1

Long-run aggregate

supply

Aggregate demand, AD1

Y1Y2

AD2

AS2

1. A decrease in aggregate demand . . .

2. . . . causes output to fall in the short run . . .

3. . . . but over time, the short-run aggregate-supply curve shifts . . .

4. . . . and output returns to its natural level.

724 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

In the new long-run equilibrium, point C, output is back to its natural level. The economy has corrected itself: The decline in output is reversed in the long run, even without action by policymakers. Although the wave of pessimism has reduced aggregate demand, the price level has fallen sufficiently (to P

3 ) to offset

the shift in the aggregate-demand curve, and people have come to expect this new lower price level as well. Thus, in the long run, the shift in aggregate demand is reflected fully in the price level and not at all in the level of output. In other words, the long-run effect of a shift in aggregate demand is a nominal change (the price level is lower) but not a real change (output is the same).

What should policymakers do when faced with a sudden fall in aggregate demand? In this analysis, we assumed they did nothing. Another possibility is that, as soon as the economy heads into recession (moving from point A to point B), policymakers could take action to increase aggregate demand. As we noted earlier, an increase in government spending or an increase in the money supply would increase the quantity of goods and services demanded at any price and, therefore, would shift the aggregate-demand curve to the right. If policymakers act with sufficient speed and precision, they can offset the initial shift in aggregate demand, return the aggregate-demand curve to AD

1 , and bring the economy back to point A.

If the policy is successful, the painful period of depressed output and employment can be reduced in length and severity. The next chapter discusses in more detail the ways in which monetary and fiscal policy influence aggregate demand, as well as some of the practical difficulties in using these policy instruments.

To sum up, this story about shifts in aggregate demand has three important lessons:

• In the short run, shifts in aggregate demand cause fluctuations in the economy’s output of goods and services.

• In the long run, shifts in aggregate demand affect the overall price level but do not affect output.

• Because policymakers influence aggregate demand, they can potentially mitigate the severity of economic fluctuations.

Monetary Neutrality Revisited

A ccording to classical economic theory, money is neutral. That is,

changes in the quantity of money affect nominal variables such

as the price level but not real variables such as output. Earlier in this

chapter, we noted that most economists accept this conclusion as a

description of how the economy works in the long run but not in the short

run. With the model of aggregate demand and aggregate supply, we can

illustrate this conclusion and explain it more fully.

Suppose that the Federal Reserve reduces the quantity of money in

the economy. What effect does this change have? As we discussed, the

money supply is one determinant of aggregate demand. The reduction in

the money supply shifts the aggregate-demand curve to the left.

The analysis looks just like Figure 8. Even though the cause of the

shift in aggregate demand is different, we would observe the same

effects on output and the price level. In the short run, both output and

the price level fall. The economy experiences a recession. But over time,

the expected price level falls as

well. Firms and workers respond

to their new expectations by, for

instance, agreeing to lower nominal

wages. As they do so, the short-

run aggregate-supply curve shifts

to the right. Eventually, the economy finds itself back on the long-run

aggregate-supply curve.

Figure 8 shows when money matters for real variables and when

it does not. In the long run, money is neutral, as represented by the

movement of the economy from point A to point C. But in the short

run, a change in the money supply has real effects, as represented by

the movement of the economy from point A to point B. An old saying

summarizes the analysis: “Money is a veil, but when the veil flutters,

real output sputters.” ■

F Y I

725CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

TWO BIG SHIFTS IN AGGREGATE DEMAND: THE GREAT DEPRESSION AND WORLD WAR II At the beginning of this chapter, we established three key facts about

economic fluctuations by looking at data since 1972. Let’s now take a longer look at U.S. economic history. Figure 9 shows data since 1900

on the percentage change in real GDP over the previous 3 years. In an average 3-year period, real GDP grows about 10 percent—a bit more than 3 percent per year. The business cycle, however, causes fluctuations around this average. Two episodes jump out as being particularly significant: the large drop in real GDP in the early 1930s and the large increase in real GDP in the early 1940s. Both of these events are attributable to shifts in aggregate demand.

The economic calamity of the early 1930s is called the Great Depression, and it is by far the largest economic downturn in U.S. history. Real GDP fell by 27 percent from 1929 to 1933, and unemployment rose from 3 percent to 25 percent. At the same time, the price level fell by 22 percent over these 4 years. Many other coun- tries experienced similar declines in output and prices during this period.

Economic historians continue to debate the causes of the Great Depression, but most explanations center on a large decline in aggregate demand. What caused aggregate demand to contract? Here is where the disagreement arises.

Many economists place primary blame on the decline in the money supply: From 1929 to 1933, the money supply fell by 28 percent. As you may recall from our discussion of the monetary system, this decline in the money supply was due to problems in the banking system. As households withdrew their money from finan- cially shaky banks and bankers became more cautious and started holding greater reserves, the process of money creation under fractional-reserve banking went into reverse. The Fed, meanwhile, failed to offset this fall in the money multiplier with expansionary open-market operations. As a result, the money supply declined. Many economists blame the Fed’s failure to act for the Great Depression’s severity.

CASE STUDY

FIGURE 9

U.S. Real GDP Growth since 1900

Percent Change in Real GDP from

3 Years Earlier

1900 1910 1920 1930 1940 1950 19901960 2000 20101970 1980

The Great Depression

The World War II Boom

Three-year percent change

–20

–30

–10

Average growth

Over the course of U.S. economic history, two fluctuations stand out as especially large.

During the early 1930s, the economy went through the Great Depression, when the

production of goods and services plummeted. During the early 1940s, the United States

entered World War II and the economy experienced rapidly rising production. Both of

these events are usually explained by large shifts in aggregate demand. Source: Louis D. Johnston and Samuel H. Williamson, “What Was GDP Then?” http://www.measuringworth.com/usgdp/; Department of Commerce (Bureau

of Economic Analysis).

726 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

Other economists have suggested alternative reasons for the collapse in aggre- gate demand. For example, stock prices fell about 90 percent during this period, depressing household wealth and thereby consumer spending. In addition, the banking problems may have prevented some firms from obtaining the financ- ing they wanted for new projects and business expansions, reducing investment spending. It is possible that all these forces may have acted together to contract aggregate demand during the Great Depression.

The second significant episode in Figure 9—the economic boom of the early 1940s—is easier to explain. The cause of this event was World War II. As the United States entered the war overseas, the federal government had to devote more resources to the military. Government purchases of goods and services increased almost fivefold from 1939 to 1944. This huge expansion in aggregate demand almost doubled the economy’s production of goods and services and led to a 20 percent increase in the price level (although widespread government price controls limited the rise in prices). Unemployment fell from 17 percent in 1939 to about 1 percent in 1944—the lowest level in U.S. history. ●

THE GREAT RECESSION OF 2008–2009 In 2008 and 2009, the U.S. economy experienced a financial crisis and a severe downturn in economic activity. In many ways, it was the

worst macroeconomic event in more than half a century. The story of this downturn begins a few years earlier with a substantial boom in the

housing market. The boom was, in part, fueled by low interest rates. In the aftermath of the recession of 2001, the Federal Reserve lowered interest rates to historically low lev- els. Low interest rates helped the economy recover, but by making it less expensive to get a mortgage and buy a home, they also contributed to a rise in housing prices.

In addition to low interest rates, various developments in the mortgage market made it easier for subprime borrowers—those borrowers with a higher risk of default based on their income and credit history—to get loans to buy homes. One develop- ment was securitization, the process by which a financial institution (specifically, a mortgage originator) makes loans and then (with the help of an investment bank) bundles them together into financial instruments called mortgage-backed securities. These mortgage-backed securities were then sold to other institutions (such as banks and insurance companies), which may not have fully appreciated the risks in these securities. Some economists blame inadequate regulation for these high-risk loans. Others blame misguided government policy: Certain policies encouraged this high- risk lending to make the goal of homeownership more attainable for low-income families. Together, these many forces drove up housing demand and housing prices. From 1995 to 2006, average housing prices in the United States more than doubled.

The high price of housing, however, proved unsustainable. From 2006 to 2009, housing prices nationwide fell about 30 percent. Such price fluctuations should not necessarily be a problem in a market economy. After all, price movements are how markets equilibrate supply and demand. In this case, however, the price decline had two related repercussions that caused a sizable fall in aggregate demand.

The first repercussion was a substantial rise in mortgage defaults and home fore- closures. During the housing boom, many homeowners had bought their homes with mostly borrowed money and minimal down payments. When housing prices declined, these homeowners were underwater (they owed more on their mortgages than their homes were worth). Many of these homeowners stopped repaying their loans. The banks servicing the mortgages responded to these defaults by taking the houses away in foreclosure procedures and then selling them off. The banks’

The outcome of a massive decrease in aggregate demand

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goal was to recoup whatever they could from the bad loans. As you might have expected from your study of supply and demand, the increase in the number of homes for sale exacerbated the downward spiral of house prices. As house prices fell, spending on the construction of housing also collapsed.

A second repercussion was that the various financial institutions that owned mortgage-backed securities suffered huge losses. In essence, by borrowing large sums to buy high-risk mortgages, these companies had bet that house prices would keep rising; when this bet turned bad, they found themselves at or near the point of bankruptcy. Because of these large losses, many financial institutions did not have funds to loan out and the ability of the financial system to channel resources to those who could best use them was impaired. Even creditworthy customers found themselves unable to borrow to finance investment spending.

As a result of all these events, the economy experienced a large contractionary shift in aggregate demand. Real GDP and employment both fell sharply. The intro- duction to this chapter has already cited the figures, but they are worth repeating: Real GDP declined by 4.2 percent between the fourth quarter of 2007 and the sec- ond quarter of 2009, and the rate of unemployment rose from 4.4 percent in May 2007 to 10.0 percent in October 2009. This experience served as a vivid reminder that deep economic downturns and personal hardship they cause are not a relic of history but a constant risk in the modern economy.

As the crisis unfolded, the U.S. government responded in a variety of ways. Three policy actions—all aimed in part at returning aggregate demand to its previ- ous level—are most noteworthy.

First, the Fed cut its target for the federal funds rate from 5.25 percent in September 2007 to about zero in December 2008. The Federal Reserve also started buying mort- gage-backed securities and other private loans in open-market operations. By purchas- ing these instruments from the banking system, the Fed provided banks with additional funds in the hope that the banks would makes loans more readily available.

Second, in an even more unusual move in October 2008, Congress appropriated $700 billion for the Treasury to use to rescue the financial system. Much of this money was used for equity injections into banks. That is, the Treasury put funds into the banking system, which the banks could use to make loans and otherwise continue their normal operations; in exchange for these funds, the U.S. government became a part owner of these banks, at least temporarily. The goal of this policy was to stem the crisis on Wall Street and make it easier for businesses and individuals to obtain loans.

Finally, when Barack Obama became president in January 2009, his first major ini- tiative was a large increase in government spending. After a relatively brief congres- sional debate over the form of the legislation, the new president signed a $787 billion stimulus bill on February 17, 2009. This policy move is discussed more fully in the next chapter when we consider the impact of fiscal policy on aggregate demand.

The recovery from this recession officially began in June 2009. But it was, by historical standards, only a meager recovery. From the second quarter of 2009 to the fourth quarter of 2015, real GDP growth averaged only 2.1 percent per year, well below the average rate of growth over the past half century of about 3 per- cent. Although unemployment fell to 5.0 percent by the end of 2015, much of the decline was attributable to individuals leaving the labor force rather than finding jobs. In December 2015, the employment-to-population ratio was only 1.3 percent- age points higher than at its trough during the Great Recession and was more than 3 percentage points lower than before the downturn began.

Which, if any, of the many policy moves were most important for ending the reces- sion? And what other policies might have promoted a more robust recovery? These are surely questions that macroeconomic historians will debate in the years to come. ●

728 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

Since the financial crisis and Great

Recession of 2008–2009, economists

have asked themselves how this

episode should change the field of

macroeconomics.

Olivier Blanchard’s Five

Lessons for Economists from

the Financial Crisis

By David Wessel

W hat did the worst financial crisis and

deepest recession in 75 years teach

academic economists and policymakers

on whose watch it happened? At a recent

London School of Economics forum, con-

vened to honor Bank of England Governor

Mervyn King, Olivier Blanchard offered some

answers.

Mr. Blanchard, 64 years old, is well

positioned to offer such reconsideration. An

internationally prominent macroeconomist,

he spent 25 years on the MIT faculty before

becoming chief economist at the International

Monetary Fund in September 2008, just before

the collapse of Lehman Brothers.

Here are Mr. Blanchard’s five lessons

in his own words, lightly edited by The Wall

Street Journal’s David Wessel:

#1: Humility is in order.

The Great Moderation [the economically

tranquil period from 1987 to 2007] convinced

too many of us that the large-economy

crisis—a financial crisis, a banking crisis—

was a thing of the past. It wasn’t going to

happen again, except maybe in emerging

markets. History was marching on.

My generation, which was born after World

War II, lived with the notion that the world

was getting to be a better and better place.

We knew how to do things better, not only in

economics but in other fields as well. What we

have learned is that’s not true. History repeats

itself. We should have known.

#2: The financial system matters— a lot.

It’s not the first time that we’re

confronted with what [former U.S. Defense

Secretary Donald] Rumsfeld called “unknown

unknowns,” things that happened that

we hadn’t thought about. There is another

example in macroeconomics:

The oil shocks of the 1970s during which

we were students and we hadn’t thought

about it. It took a few years, more than a few

years, for economists to understand what was

going on. After a few years, we concluded that

we could think of the oil shock as yet another

macroeconomic shock. We did not need to

understand the plumbing. We didn’t need to

understand the details of the oil market. When

there’s an increase in the price of energy or

materials, we can just integrate it into our

macro models—the implications of energy

prices on inflation and so on.

This is different. What we have learned

about the financial system is that the problem

is in the plumbing and that we have to

understand the plumbing. Before I came to

the Fund, I thought of the financial system

as a set of arbitrage equations. Basically the

Federal Reserve would choose one interest

rate, and then the expectations hypothesis

would give all the rates everywhere else with

premia which might vary, but not very much.

It was really easy. I thought of people on Wall

Street as basically doing this for me so I didn’t

have to think about it.

What we have learned is that that’s not

the case. In the financial system, a myriad

of distortions or small shocks build on each

other. When there are enough small shocks,

enough distortions, things can go very

bad. This has fundamental implications

for macroeconomics. We do macro on the

assumption that we can look at aggregates

in some way and then just have them interact

in simple models. I still think that’s the way to

go, but this shows the limits of that approach.

When it comes to the financial system, it’s

very clear that the details of the plumbing

matter.

#3 Interconnectedness matters.

This crisis started in the U.S. and across

the ocean in a matter of days and weeks. Each

crisis, even in small islands, potentially has

effects on the rest of the world. The complexity

of the cross border claims by creditors and

by debtors clearly is something that many

of us had not fully realized: the cross border

movements triggered by the risk-on/risk-off

movements, which countries are safe havens,

and when and why? Understanding this has

become absolutely essential. What happens in

one part of the world cannot be ignored by the

rest of the world. The fact that we all spend so

What Have We Learned?

IN THE NEWS

33-5b The Effects of a Shift in Aggregate Supply Imagine once again an economy in its long-run equilibrium. Now suppose that suddenly some firms experience an increase in their costs of production. For example, bad weather in farm states might destroy some crops, driving up the

729CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

much time thinking about Cyprus in the last

few days is an example of that.

It’s also true on the trade side. We used

to think if one country was doing badly, then

exports to that country would do badly and

therefore the exporting countries would do

badly. In our models, the effect was relatively

small. One absolutely striking fact of the crisis

is the collapse of trade in 2009. Output went

down. Trade collapsed. Countries which felt

they were not terribly exposed through trade

turned out to be enormously exposed.

#4 We don’t know if macro-prudential

tools work.

It’s very clear that the traditional monetary

and fiscal tools are just not good enough to

deal with the very specific problems in

the financial system. This has led to the

development of macro-prudential tools,

which may or may not become the third leg of

macroeconomic policies.

[Macro-prudential tools allow a central

bank to restrain lending in specific sectors

without raising interest rates for the whole

economy, such as increasing the minimum

down payment required to get a mortgage,

which reduces the loan-to-value ratio.] In

principle, they can address specific issues

in the financial sector. If there is a problem

somewhere you can target the tool at the

problem and not use the policy interest rate,

which basically is kind of an atomic bomb

without any precision.

The big question here is: How reliable are

these tools? How much can they be used?

The answer—from some experiments before

the crisis with loan-to-value ratios and

during the crisis with variations in cyclical

bank capital ratios or loan-to-value ratios or

capital controls, such as in Brazil—is this:

They work but they don’t work great. People

and institutions find ways around them. In the

process of reducing the problem somewhere

you tend to create distortions elsewhere.

#5 Central bank independence wasn’t

designed for what central banks are

now asked to do.

There is two-way interaction between

monetary policy and macro-prudential

tools. When [Fed chair] Ben Bernanke does

expansionary monetary policy, quantitative

easing, and interest rates on many assets

are close to zero, there’s a tendency by many

players to take risks to increase their rate of

return. Some of this risk actually we want

them to take. Some we don’t want them to

take. That is the interaction of monetary policy

on the financial system.

You also have it the other way around. If

you use macro-prudential tools to, say, slow

down the building in the housing sector you

have an effect on aggregate demand, which is

going to decrease output.

The question is: How do you organize

the use of these tools? It makes sense to

have them under the same roof. In practice

this means the central bank. But that poses

questions not only about coordination between

the two functions, but also about central bank

independence.

One of the major achievements of the

last 20 years is that most central banks have

become independent of elected governments.

Independence was given because the

mandate and the tools were very clear. The

mandate was primarily inflation, which

can be observed over time. The tool was

some short-term interest rate that could be

used by the central bank to try to achieve

the inflation target. In this case, you can

give some independence to the institution

in charge of this because the objective is

perfectly well defined, and everybody can

basically observe how well the central bank

does..

If you think now of central banks as having

a much larger set of responsibilities and a

much larger set of tools, then the issue of

central bank independence becomes much

more difficult. Do you actually want to give the

central bank the independence to choose loan-

to-value ratios without any supervision from

the political process? Isn’t this going to lead

to a democratic deficit in a way in which the

central bank becomes too powerful? I’m sure

there are ways out. Perhaps there could be

independence with respect to some dimensions

of monetary policy—the traditional ones—

and some supervision for the rest or some

interaction with a political process. ■

Source: Republished with permission of The Wall Street

Journal, from, “What Have We Learned? The Wall Street

Journal, April 1, 2013”; permission conveyed through

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cost of producing food products. Or a war in the Middle East might interrupt the shipping of crude oil, driving up the cost of producing oil products.

To analyze the macroeconomic impact of such an increase in production costs, we follow the same four steps as always. First, which curve is affected? Because production costs affect the firms that supply goods and services, changes in

730 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

production costs alter the position of the aggregate-supply curve. Second, in which direction does the curve shift? Because higher production costs make selling goods and services less profitable, firms now supply a smaller quantity of output for any given price level. Thus, as Figure 10 shows, the short-run aggregate- supply curve shifts to the left, from AS

1 to AS

2 . (Depending on the event, the long-

run aggregate-supply curve might also shift. To keep things simple, however, we will assume that it does not.)

The figure allows us to perform step three of comparing the initial and the new equilibrium. In the short run, the economy goes from point A to point B, moving along the existing aggregate-demand curve. The output of the economy falls from Y

1 to Y

2 , and the price level rises from P

1 to P

2 . Because the economy is

experiencing both stagnation (falling output) and inflation (rising prices), such an event is sometimes called stagflation.

Now consider step four—the transition from the short-run equilibrium to the long-run equilibrium. According to the sticky-wage theory, the key issue is how stagflation affects nominal wages. Firms and workers may at first respond to the higher level of prices by raising their expectations of the price level and setting higher nominal wages. In this case, firms’ costs will rise yet again, and the short- run aggregate-supply curve will shift farther to the left, making the problem of stagflation even worse. This phenomenon of higher prices leading to higher wages, in turn leading to even higher prices, is sometimes called a wage-price spiral.

At some point, this spiral of ever-rising wages and prices will slow. The low level of output and employment will put downward pressure on workers’ wages because workers have less bargaining power when unemployment is high. As nominal wages fall, producing goods and services becomes more profitable and the short-run aggregate-supply curve shifts to the right. As it shifts back toward AS

1 , the price level falls and the quantity of output approaches its natural level. In

stagflation

a period of falling output

and rising prices

FIGURE 10

An Adverse Shift in Aggregate Supply

When some event increases firms’

costs, the short-run aggregate-supply

curve shifts to the left from AS1 to

AS2. The economy moves from point A

to point B. The result is stagflation:

Output falls from Y1 to Y2, and the

price level rises from P1 to P2.

Quantity of Output

Price Level

Aggregate demand

Y1Y2

3. . . . and the price level to rise.

2. . . . causes output to fall . . .

1. An adverse shift in the short- run aggregate-supply curve . . .

Short-run aggregate

supply, AS1

Long-run aggregate

supply

AS2

731CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

the long run, the economy returns to point A, where the aggregate-demand curve crosses the long-run aggregate-supply curve.

This transition back to the initial equilibrium assumes, however, that aggregate demand is held constant throughout the process. In the real world, that may not be the case. Policymakers who control monetary and fiscal policy might attempt to offset some of the effects of the shift in the short-run aggregate-supply curve by shifting the aggregate-demand curve. This possibility is shown in Figure 11. In this case, changes in policy shift the aggregate-demand curve to the right, from AD1 to AD2—exactly enough to prevent the shift in aggregate supply from affecting output. The economy moves directly from point A to point C. Output remains at its natural level, and the price level rises from P1 to P3. In this case, policymakers are said to accommodate the shift in aggregate supply. An accommodative policy accepts a permanently higher level of prices to maintain a higher level of output and employment.

To sum up, this story about shifts in aggregate supply has two important lessons:

• Shifts in aggregate supply can cause stagflation—a combination of recession (falling output) and inflation (rising prices).

• Policymakers who can influence aggregate demand can potentially mitigate the adverse impact on output but only at the cost of exacerbating the problem of inflation.

CASE STUDY

OIL AND THE ECONOMY Some of the largest economic fluctuations in the U.S. economy since 1970 have originated in the oil fields of the Middle East. Crude oil is a key input into the production of many goods and services, and

much of the world’s oil comes from Saudi Arabia, Kuwait, and other Middle Eastern countries. When some event (usually political in origin) reduces the

FIGURE 11

Accommodating an Adverse

Shift in Aggregate Supply

Faced with an adverse shift in

aggregate supply from AS1 to AS2,

policymakers who can influence

aggregate demand might try to shift

the aggregate-demand curve to the

right from AD1 to AD2. The economy

would move from point A to point C.

This policy would prevent the supply

shift from reducing output in the

short run, but the price level would

permanently rise from P1 to P3.

Quantity of Output

Natural level of output

Price Level

Short-run aggregate

supply, AS1

Long-run aggregate

supply

Aggregate demand, AD1

AS2

3. . . . which causes the price level to rise further . . .

4. . . . but keeps output at its natural level.

2. . . . policymakers can accommodate the shift by expanding aggregate demand . . .

1. When short-run aggregate supply falls . . .

AD2

732 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

supply of crude oil flowing from this region, the price of oil rises around the world. Firms in the United States that produce gasoline, tires, and many other products experience rising costs, and they find it less profitable to supply their output of goods and services at any given price level. The result is a leftward shift in the aggregate-supply curve, which in turn leads to stagflation.

The first episode of this sort occurred in the mid-1970s. The countries with large oil reserves got together as members of OPEC, the Organization of the Petroleum Exporting Countries. OPEC is a cartel—a group of sellers that at- tempts to thwart competition and reduce production to raise prices. And in- deed, oil prices rose substantially. From 1973 to 1975, oil approximately doubled in price. Oil-importing countries around the world experienced simultaneous inflation and recession. The U.S. inflation rate as measured by the CPI exceeded 10 percent for the first time in decades. Unemployment rose from 4.9 percent in 1973 to 8.5 percent in 1975.

Almost the same thing happened a few years later. In the late 1970s, the OPEC countries again restricted the supply of oil to raise the price. From 1978 to 1981, the price of oil more than doubled. Once again, the result was stagflation. Infla- tion, which had subsided somewhat after the first OPEC event, again rose above 10 percent per year. But because the Fed was not willing to accommodate such a large rise in inflation, a recession was soon to follow. Unemployment rose from about 6 percent in 1978 and 1979 to about 10 percent a few years later.

The world market for oil can also be a source of favorable shifts in aggre- gate supply. In 1986, squabbling broke out among members of OPEC. Mem- ber countries reneged on their agreements to restrict oil production. In the world market for crude oil, prices fell by about half. This fall in oil prices reduced costs to U.S. firms, which now found it more profitable to supply goods and services at any given price level. As a result, the aggregate-supply

The Origins of the Model of Aggregate Demand and Aggregate Supply

N ow that we have a preliminary

understanding of the model of

aggregate demand and aggregate

supply, it is worthwhile to step

back from it and consider its

history. How did this model of

short-run fluctuations develop?

The answer is that this model, to

a large extent, is a by-product of

the Great Depression of the 1930s.

Economists and policymakers at

the time were puzzled about what

had caused this calamity and were

uncertain about how to deal with it.

In 1936, economist John Maynard Keynes published a book titled The

General Theory of Employment, Interest, and Money, which attempted to

explain short-run economic fluctuations in general and the Great Depression

in particular. Keynes’s primary message was that recessions and depressions

can occur because of inadequate aggregate demand for goods and services.

K e y n e s h a d l o n g b e e n a

critic of classical economic

theory—the theory we examined

earlier in the book—because it

could explain only the long-run

effects of policies. A few years before offering The General Theory, Keynes had written the following about classical economics:

The long run is a misleading guide to current affairs. In the long run

we are all dead. Economists set themselves too easy, too useless a

task if in tempestuous seasons they can only tell us when the storm

is long past, the ocean will be flat.

Keynes’s message was aimed at policymakers as well as economists.

As the world’s economies suffered with high unemployment, Keynes

advocated policies to increase aggregate demand, including government

spending on public works.

In the next chapter, we examine in detail how policymakers can use

the tools of monetary and fiscal policy to influence aggregate demand.

The analysis in the next chapter, as well as in this one, owes much to the

legacy of John Maynard Keynes. ■

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Changes in Middle East oil production are one source of U.S. economic fluctuations.

1. When the economy goes into a recession, real GDP

________ and unemployment ________.

a. rises, rises

b. rises, falls

c. falls, rises

d. falls, falls

2. A sudden crash in the stock market shifts

a. the aggregate-demand curve.

b. the short-run aggregate-supply curve, but not the

long-run aggregate-supply curve.

c. the long-run aggregate-supply curve, but not the

short-run aggregate-supply curve.

d. both the short-run and the long-run aggregate- supply

curves.

3. A change in the expected price level shifts

a. the aggregate-demand curve.

b. the short-run aggregate-supply curve, but not the

long-run aggregate-supply curve.

c. the long-run aggregate-supply curve, but not the

short-run aggregate-supply curve.

d. both the short-run and the long-run aggregate- supply

curves.

4. An increase in the aggregate demand for goods and

services has a larger impact on output ________ and

a larger impact on the price level ________.

a. in the short run, in the long run

b. in the long run, in the short run

c. in the short run, also in the short run

d. in the long run, also in the long run

5. Stagflation is caused by

a. a leftward shift in the aggregate-demand

curve.

b. a rightward shift in the aggregate-demand

curve.

c. a leftward shift in the aggregate-supply curve.

d. a rightward shift in the aggregate-supply curve.

6. The idea that economic downturns result from an

inadequate aggregate demand for goods and services is

derived from the work of which economist?

a. Adam Smith

b. David Hume

c. David Ricardo

d. John Maynard Keynes

CHAPTER QuickQuiz

curve shifted to the right. The U.S. economy experienced the opposite of stagflation: Output grew rapidly, unemployment fell, and the inflation rate reached its lowest level in many years.

In recent years, the world market for oil has not been as important a source of economic fluctuations for the U.S. economy. Part of the reason is that conservation efforts, changes in technology, and the availability of alternative energy sources have reduced the economy’s dependence on oil. The amount of oil used to produce a unit of real GDP has declined by more than 50 percent since the OPEC shocks of the 1970s. As a result, the economic impact of any change in oil prices on the U.S. economy is much smaller today than it was in the past. (Of course, some na- tions rely on oil exports as a major source of their income, and this makes oil prices crucial for them, but that is another story.) ●

QuickQuiz Suppose that the election of a popular presidential candidate suddenly

increases people’s confidence in the future. Use the model of aggregate

demand and aggregate supply to analyze the effect on the economy.

33-6 Conclusion This chapter has achieved two goals. First, we have discussed some of the important facts about short-run fluctuations in economic activity. Second, we have introduced a basic model to explain those fluctuations, called the model of aggregate demand and aggregate supply. We continue our study of this model in the next chapter to understand more fully what causes fluctuations in the economy and how policymakers might respond to these fluctuations.

734 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

• All societies experience short-run economic fluc-

tuations around long-run trends. These fluctuations are

irregular and largely unpredictable. When recessions

occur, real GDP and other measures of income,

spending, and production fall, while unemployment

rises.

• Classical economic theory is based on the assumption

that nominal variables such as the money supply and

the price level do not influence real variables such as

output and employment. Most economists believe that

this assumption is accurate in the long run but not in

the short run. Economists analyze short-run economic

fluctuations using the model of aggregate demand and

aggregate supply. According to this model, the output

of goods and services and the overall level of prices

adjust to balance aggregate demand and aggregate

supply.

• The aggregate-demand curve slopes downward for

three reasons. The first is the wealth effect: A lower

price level raises the real value of households’ money

holdings, which stimulates consumer spending. The

second is the interest-rate effect: A lower price level

reduces the quantity of money households demand;

as households try to convert money into interest-

bearing assets, interest rates fall, which stimulates

investment spending. The third is the exchange-rate

effect: As a lower price level reduces interest rates, the

dollar depreciates in the market for foreign-currency

exchange, which stimulates net exports.

• Any event or policy that raises consumption,

investment, government purchases, or net exports at

a given price level increases aggregate demand. Any

event or policy that reduces consumption, investment,

government purchases, or net exports at a given price

level decreases aggregate demand.

• The long-run aggregate-supply curve is vertical. In the

long run, the quantity of goods and services supplied

depends on the economy’s labor, capital, natural

resources, and technology but not on the overall level

of prices.

• Three theories have been proposed to explain the

upward slope of the short-run aggregate-supply curve.

According to the sticky-wage theory, an unexpected fall

in the price level temporarily raises real wages, which

induces firms to reduce employment and production.

According to the sticky-price theory, an unexpected

fall in the price level leaves some firms with prices that

are temporarily too high, which reduces their sales

and causes them to cut back production. According

to the misperceptions theory, an unexpected fall in the

price level leads suppliers to mistakenly believe that

their relative prices have fallen, which induces them

to reduce production. All three theories imply that

output deviates from its natural level when the actual

price level deviates from the price level that people

expected.

• Events that alter the economy’s ability to produce

output, such as changes in labor, capital, natural

resources, or technology, shift the short-run aggregate-

supply curve (and may shift the long-run aggregate-

supply curve as well). In addition, the position of the

short-run aggregate-supply curve depends on the

expected price level.

• One possible cause of economic fluctuations is a shift

in aggregate demand. When the aggregate-demand

curve shifts to the left, for instance, output and

prices fall in the short run. Over time, as a change in

the expected price level causes wages, prices, and

perceptions to adjust, the short-run aggregate-supply

curve shifts to the right. This shift returns the economy

to its natural level of output at a new, lower price level.

• A second possible cause of economic fluctuations

is a shift in aggregate supply. When the short-run

aggregate-supply curve shifts to the left, the effect

is falling output and rising prices—a combination

called stagflation. Over time, as wages, prices, and

perceptions adjust, the short-run aggregate-supply

curve shifts back to the right, returning the price level

and output to their original levels.

h h h b d l h

SUMMARY

KEY CONCEPTS

recession, p. 702

depression, p. 702

model of aggregate demand and

aggregate supply, p. 706

aggregate-demand curve, p. 706

aggregate-supply curve, p. 707

natural level of output, p. 714

stagflation, p. 730

735CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

1. Name two macroeconomic variables that decline

when the economy goes into a recession. Name one

macroeconomic variable that rises during a recession.

2. Draw a diagram with aggregate demand, short-run

aggregate supply, and long-run aggregate supply. Be

careful to label the axes correctly.

3. List and explain the three reasons the aggregate-

demand curve slopes downward.

4. Explain why the long-run aggregate-supply curve is

vertical.

5. List and explain the three theories for why the short-

run aggregate-supply curve slopes upward.

6. What might shift the aggregate-demand curve to the

left? Use the model of aggregate demand and aggregate

supply to trace through the short-run and long-run

effects of such a shift on output and the price level.

7. What might shift the aggregate-supply curve to

the left? Use the model of aggregate demand and

aggregate supply to trace through the short-run and

long-run effects of such a shift on output and the price

level.

1. Suppose the economy is in a long-run equilibrium.

a. Draw a diagram to illustrate the state of the

economy. Be sure to show aggregate demand,

short-run aggregate supply, and long-run

aggregate supply.

b. Now suppose that a stock market crash causes

aggregate demand to fall. Use your diagram

to show what happens to output and the price

level in the short run. What happens to the

unemployment rate?

c. Use the sticky-wage theory of aggregate supply

to explain what will happen to output and the

price level in the long run (assuming no change

in policy). What role does the expected price level

play in this adjustment? Be sure to illustrate your

analysis in a graph.

2. Explain whether each of the following events will

increase, decrease, or have no effect on long-run

aggregate supply.

a. The United States experiences a wave of

immigration.

b. Congress raises the minimum wage to $15 per hour.

c. Intel invents a new and more powerful computer

chip.

d. A severe hurricane damages factories along the

East Coast.

3. Suppose an economy is in long-run equilibrium.

a. Use the model of aggregate demand and

aggregate supply to illustrate the initial

equilibrium (call it point A). Be sure to include

both short-run and long-run aggregate supply.

b. The central bank raises the money supply by

5 percent. Use your diagram to show what

happens to output and the price level as the

economy moves from the initial to the new short-

run equilibrium (call it point B).

c. Now show the new long-run equilibrium (call it

point C). What causes the economy to move from

point B to point C?

d. According to the sticky-wage theory of aggregate

supply, how do nominal wages at point A

compare to nominal wages at point B? How do

nominal wages at point A compare to nominal

wages at point C?

e. According to the sticky-wage theory of aggregate

supply, how do real wages at point A compare to

real wages at point B? How do real wages at point

A compare to real wages at point C?

f. Judging by the impact of the money supply on

nominal and real wages, is this analysis consistent

with the proposition that money has real effects in

the short run but is neutral in the long run?

4. In 1939, with the U.S. economy not yet fully recovered

from the Great Depression, President Roosevelt

proclaimed that Thanksgiving would fall a week

earlier than usual so that the shopping period before

Christmas would be longer. Explain what President

Roosevelt might have been trying to achieve, using the

model of aggregate demand and aggregate supply.

5. Explain why the following statements are false.

a. “The aggregate-demand curve slopes downward

because it is the horizontal sum of the demand

curves for individual goods.”

b. “The long-run aggregate-supply curve is vertical

because economic forces do not affect long-run

aggregate supply.”

c. “If firms adjusted their prices every day, then

the short-run aggregate-supply curve would be

horizontal.”

d. “Whenever the economy enters a recession, its

long-run aggregate-supply curve shifts to the left.”

h h l l b ( ll

QUESTIONS FOR REVIEW

PROBLEMS AND APPLICATIONS

736 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

6. For each of the three theories for the upward slope

of the short-run aggregate-supply curve, carefully

explain the following:

a. how the economy recovers from a recession and

returns to its long-run equilibrium without any

policy intervention

b. what determines the speed of that recovery

7. The economy begins in long-run equilibrium. Then

one day, the president appoints a new chair of the

Federal Reserve. This new chairman is well known for

her view that inflation is not a major problem for an

economy.

a. How would this news affect the price level that

people would expect to prevail?

b. How would this change in the expected price

level affect the nominal wage that workers and

firms agree to in their new labor contracts?

c. How would this change in the nominal wage

affect the profitability of producing goods and

services at any given price level?

d. How does this change in profitability affect the

short-run aggregate-supply curve?

e. If aggregate demand is held constant, how does

this shift in the aggregate-supply curve affect the

price level and the quantity of output produced?

f. Do you think this Fed chairman was a good

appointment?

8. Explain whether each of the following events shifts

the short-run aggregate-supply curve, the aggregate-

demand curve, both, or neither. For each event that

does shift a curve, draw a diagram to illustrate the

effect on the economy.

a. Households decide to save a larger share of their

income.

b. Florida orange groves suffer a prolonged period

of below-freezing temperatures.

c. Increased job opportunities overseas cause many

people to leave the country.

9. For each of the following events, explain the short-run

and long-run effects on output and the price level,

assuming policymakers take no action.

a. The stock market declines sharply, reducing

consumers’ wealth.

b. The federal government increases spending on

national defense.

c. A technological improvement raises productivity.

d. A recession overseas causes foreigners to buy

fewer U.S. goods.

10. Suppose firms become very optimistic about future

business conditions and invest heavily in new capital

equipment.

a. Draw an aggregate-demand/aggregate-supply

diagram to show the short-run effect of this

optimism on the economy. Label the new levels of

prices and real output. Explain in words why the

aggregate quantity of output supplied changes. b. Now use the diagram from part (a) to show the

new long-run equilibrium of the economy. (For

now, assume there is no change in the long-

run aggregate-supply curve.) Explain in words

why the aggregate quantity of output demanded changes between the short run and the long run.

c. How might the investment boom affect the long-

run aggregate-supply curve? Explain.

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

737

CHAPTER

34 The Influence of Monetary and Fiscal Policy on Aggregate Demand

I magine that you are a member of the Federal Open Market Committee, the group at the Federal Reserve that sets monetary policy. You observe that the president and Congress have agreed to raise taxes. How should the Fed re-

spond to this change in fiscal policy? Should it expand the money supply, contract the money supply, or leave it unchanged?

To answer this question, you need to consider the impact of monetary and fiscal policy on the economy. In the preceding chapter, we used the model of aggregate demand and aggregate supply to explain short-run economic

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738 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

fluctuations. We saw that shifts in the aggregate-demand curve or the aggregate- supply curve cause fluctuations in the economy’s overall output of goods and services and its overall level of prices. As we noted in the previous chapter, both monetary and fiscal policy influence aggregate demand. Thus, a change in one of these policies can lead to short-run fluctuations in output and prices. Policy- makers will want to anticipate this effect and, perhaps, adjust the other policy in response.

In this chapter, we examine in more detail how the government’s policy tools influence the position of the aggregate-demand curve. These tools include mon- etary policy (the supply of money set by the central bank) and fiscal policy (the levels of government spending and taxation set by the president and Congress). We have previously discussed the long-run effects of these policies. In Chapters 25 and 26, we saw how fiscal policy affects saving, investment, and long-run economic growth. In Chapters 29 and 30, we saw how monetary policy influences the price level in the long run. We now look at how these policy tools can shift the aggregate-demand curve and thereby affect macroeconomic variables in the short run.

As we have already learned, many factors influence aggregate demand be- sides monetary and fiscal policy. In particular, desired spending by households and firms determines the overall demand for goods and services. When desired spending changes, aggregate demand shifts. If policymakers do not respond, such shifts in aggregate demand cause short-run fluctuations in output and employment. As a result, monetary and fiscal policymakers sometimes use the policy levers at their disposal to try to offset these shifts in aggregate demand and stabilize the economy. Here we discuss the theory behind these policy actions and some of the difficulties that arise in using this theory in practice.

34-1 How Monetary Policy Influences Aggregate Demand The aggregate-demand curve shows the total quantity of goods and services demanded in the economy for any price level. The preceding chapter discussed three reasons why the aggregate-demand curve slopes downward:

• The wealth effect: A lower price level raises the real value of households’ money holdings, which are part of their wealth. Higher real wealth stimu- lates consumer spending and thus increases the quantity of goods and ser- vices demanded.

• The interest-rate effect: A lower price level reduces the amount of money peo- ple want to hold. As people try to lend out their excess money holdings, the interest rate falls. The lower interest rate stimulates investment spending and thus increases the quantity of goods and services demanded.

• The exchange-rate effect: When a lower price level reduces the interest rate, inves- tors move some of their funds overseas in search of higher returns. This move- ment of funds causes the real value of the domestic currency to fall in the market for foreign-currency exchange. Domestic goods become less expensive relative to foreign goods. This change in the real exchange rate stimulates spending on net exports and thus increases the quantity of goods and services demanded.

These three effects occur simultaneously to increase the quantity of goods and services demanded when the price level falls and to decrease it when the price level rises.

739CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND

Although all three effects work together to explain the downward slope of the aggregate-demand curve, they are not of equal importance. Because money hold- ings are a small part of household wealth, the wealth effect is the least important of the three. In addition, because exports and imports represent only a small frac- tion of U.S. GDP, the exchange-rate effect is not large for the U.S. economy. (This effect is more important for smaller countries, which typically export and import a higher fraction of their GDP.) For the U.S. economy, the most important reason for the downward slope of the aggregate-demand curve is the interest-rate effect.

To better understand aggregate demand, we now examine the short-run deter- mination of interest rates in more detail. Here we develop the theory of liquidity preference. This theory of interest rates helps explain the downward slope of the aggregate-demand curve, as well as how monetary and fiscal policy can shift this curve. By shedding new light on aggregate demand, the theory of liquidity pref- erence expands our understanding of what causes short-run economic fluctua- tions and what policymakers can potentially do about them.

34-1a The Theory of Liquidity Preference In his classic book The General Theory of Employment, Interest, and Money, John May- nard Keynes proposed the theory of liquidity preference to explain the factors that determine an economy’s interest rate. The theory is, in essence, an application of supply and demand. According to Keynes, the interest rate adjusts to balance the supply of and demand for money.

You may recall that economists distinguish between two interest rates: The nom- inal interest rate is the interest rate as usually reported, and the real interest rate is the interest rate corrected for the effects of inflation. When there is no inflation, the two rates are the same. But when borrowers and lenders expect prices to rise over the course of the loan, they agree to a nominal interest rate that exceeds the real interest rate by the expected rate of inflation. The higher nominal interest rate com- pensates for the fact that they expect the loan to be repaid in less valuable dollars.

Which interest rate are we now trying to explain with the theory of liquidity pref- erence? The answer is both. In the analysis that follows, we hold constant the ex- pected rate of inflation. This assumption is reasonable for studying the economy in the short run, because expected inflation is typically stable over short periods of time. In this case, nominal and real interest rates differ by a constant. When the nom- inal interest rate rises or falls, the real interest rate that people expect to earn rises or falls by a similar amount. For the rest of this chapter, when we discuss changes in the interest rate, these changes refer to both the real and nominal interest rates.

Let’s now develop the theory of liquidity preference by considering the supply and demand for money and how each depends on the interest rate.

Money Supply The first piece of the theory of liquidity preference is the supply of money. As we first discussed in Chapter 29, the money supply in the U.S. economy is controlled by the Federal Reserve. The Fed alters the money supply primarily by changing the quantity of reserves in the banking system through the purchase and sale of government bonds in open-market operations. When the Fed buys govern- ment bonds, the dollars it pays for the bonds are typically deposited in banks, and these dollars are added to bank reserves. When the Fed sells government bonds, the dollars it receives for the bonds are withdrawn from the banking system, and bank reserves fall. These changes in bank reserves, in turn, lead to changes in banks’ ability to make loans and create money. Thus, by buying and selling bonds in open-market operations, the Fed alters the supply of money in the economy.

theory of liquidity

preference

Keynes’s theory that

the interest rate adjusts

to bring money supply

and money demand

into balance

740 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

In addition to open-market operations, the Fed can influence the money supply using a variety of other tools. One option is for the Fed to change how much it lends to banks. For example, a decrease in the discount rate (the interest rate at which banks can borrow reserves from the Fed) encourages more bank borrow- ing, which increases bank reserves and thereby the money supply. Conversely, an increase in the discount rate discourages bank borrowing, which decreases bank reserves and the money supply. The Fed also alters the money supply by changing reserve requirements (the amount of reserves banks must hold against deposits) and by changing the interest rate it pays banks on the reserves they are holding.

These details of monetary control are important for the implementation of Fed policy, but they are not crucial for the analysis in this chapter. Our goal here is to examine how changes in the money supply affect the aggregate demand for goods and services. For this purpose, we can ignore the details of how Fed policy is implemented and assume that the Fed controls the money supply directly. In other words, the quantity of money supplied in the economy is fixed at whatever level the Fed decides to set it.

Because the quantity of money supplied is fixed by Fed policy, it does not de- pend on other economic variables. In particular, it does not depend on the interest rate. Once the Fed has made its policy decision, the quantity of money supplied is the same, regardless of the prevailing interest rate. We represent a fixed money supply with a vertical supply curve, as in Figure 1.

FIGURE 1

Equilibrium in the Money

Market

Quantity of Money

Interest Rate

Equilibrium interest

rate

Money demand

Quantity fixed by the Fed

Money supply

Md1 M d 2

According to the theory of liquidity preference, the interest rate adjusts to bring the quan-

tity of money supplied and the quantity of money demanded into balance. If the interest

rate is above the equilibrium level (such as at r1), the quantity of money people want to

hold (Md1) is less than the quantity the Fed has created, and this surplus of money puts

downward pressure on the interest rate. Conversely, if the interest rate is below the equi-

librium level (such as at r2), the quantity of money people want to hold (M d 2) is greater

than the quantity the Fed has created, and this shortage of money puts upward pressure

on the interest rate. Thus, the forces of supply and demand in the market for money push

the interest rate toward the equilibrium interest rate, at which people are content holding

the quantity of money the Fed has created.

741CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND

Money Demand The second piece of the theory of liquidity preference is the demand for money. As a starting point for understanding money demand, recall that an asset’s liquidity refers to the ease with which that asset can be converted into the economy’s medium of exchange. Because money is the economy’s me- dium of exchange, it is by definition the most liquid asset available. The liquidity of money explains the demand for it: People choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services.

Although many factors determine the quantity of money demanded, the one emphasized by the theory of liquidity preference is the interest rate. The reason is that the interest rate is the opportunity cost of holding money. That is, when you hold wealth as cash in your wallet, instead of as an interest-bearing bond, you lose the interest you could have earned. An increase in the interest rate raises the cost of holding money and, as a result, reduces the quantity of money demanded. A decrease in the interest rate reduces the cost of holding money and raises the quantity demanded. Thus, as shown in Figure 1, the money demand curve slopes downward.

Equilibrium in the Money Market According to the theory of liquidity prefer- ence, the interest rate adjusts to balance the supply and demand for money. There is one interest rate, called the equilibrium interest rate, at which the quantity of money demanded exactly balances the quantity of money supplied. If the interest rate is at any other level, people will try to adjust their portfolios of assets and, as a result, drive the interest rate toward the equilibrium.

For example, suppose that the interest rate is above the equilibrium level, such as r1 in Figure 1. In this case, the quantity of money that people want to hold, Md1, is less than the quantity of money that the Fed has supplied. Those people who are holding the surplus of money will try to get rid of it by buying interest- bearing bonds or by depositing it in interest-bearing bank accounts. Be- cause bond issuers and banks prefer to pay lower interest rates, they respond to this surplus of money by lowering the interest rates they offer. As the interest rate falls, people become more willing to hold money until, at the equilibrium interest rate, people are happy to hold exactly the amount of money the Fed has supplied.

Conversely, at interest rates below the equilibrium level, such as r2 in Figure 1, the quantity of money that people want to hold, Md2, is greater than the quantity of money that the Fed has supplied. As a result, people try to increase their holdings of money by reducing their holdings of bonds and other interest-bearing assets. As people cut back on their holdings of bonds, bond issuers find that they have to offer higher interest rates to attract buyers. Thus, the interest rate rises until it reaches the equilibrium level.

34-1b The Downward Slope of the Aggregate-Demand Curve Having seen how the theory of liquidity preference explains the economy’s equi- librium interest rate, we now consider the theory’s implications for the aggre- gate demand for goods and services. As a warm-up exercise, let’s begin by using the theory to reexamine a topic we already understand—the interest-rate effect and the downward slope of the aggregate-demand curve. In particular, suppose that the overall level of prices in the economy rises. What happens to the interest rate that balances the supply and demand for money, and how does that change affect the quantity of goods and services demanded?

742 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

As we discussed in Chapter 30, the price level is one determinant of the quan- tity of money demanded. At higher prices, more money is exchanged every time a good or service is sold. As a result, people will choose to hold a larger quantity of money. That is, a higher price level increases the quantity of money demanded for any given interest rate. Thus, an increase in the price level from P1 to P2 shifts the money demand curve to the right from MD1 to MD2, as shown in panel (a) of Figure 2.

Notice how this shift in money demand affects the equilibrium in the money market. For a fixed money supply, the interest rate must rise to balance money supply and money demand. Because the higher price level has increased the amount of money people want to hold, it has shifted the money demand curve to the right. Yet the quantity of money supplied is unchanged, so the interest rate must rise from r1 to r2 to discourage the additional demand.

This increase in the interest rate has ramifications not only for the money market but also for the quantity of goods and services demanded, as shown in panel (b). At

Interest Rates in the Long Run and the Short Run

I n an earlier chapter, we said that the interest rate adjusts to balance the

supply of loanable funds (national saving) and the demand for loanable

funds (desired investment). Here we just said that the interest rate adjusts

to balance the supply of and demand for money. Can we reconcile these

two theories?

To answer this question, we need to focus on three macroeconomic

variables: the economy’s output of goods and services, the interest rate,

and the price level. According to the classical macroeconomic theory we

developed earlier in the book, these variables are determined as follows:

1. Output is determined by the supplies of capital and labor and the

available production technology for turning capital and labor into

output. (We call this the natural level of output.)

2. For any given level of output, the interest rate adjusts to balance the

supply and demand for loanable funds.

3. Given output and the interest rate, the price level adjusts to balance the

supply and demand for money. Changes in the supply of money lead to

proportionate changes in the price level.

These are three of the essential propositions of classical economic theory.

Most economists believe that these propositions do a good job of describ-

ing how the economy works in the long run.

Yet these propositions do not hold in the short run. As we discussed in the

preceding chapter, many prices are slow to adjust to changes in the money

supply; this fact is reflected in a short-run aggregate-supply curve that is

upward-sloping rather than vertical. As a result, in the short run, the overall

price level cannot, by itself, move to balance the supply of and demand for

money. This stickiness of the price level requires the interest rate to move to

bring the money market into equilibrium. These changes in the interest rate,

in turn, affect the aggre-

gate demand for goods

and services. As aggre-

gate demand fluctuates,

the economy’s output

of goods and services

moves away from the level determined by factor supplies and technology.

To think about the operation of the economy in the short run (day to

day, week to week, month to month, or quarter to quarter), it is best to keep

in mind the following logic:

1. The price level is stuck at some level (based on previously formed

expectations) and, in the short run, is relatively unresponsive to

changing economic conditions.

2. For any given (stuck) price level, the interest rate adjusts to balance

the supply of and demand for money.

3. The interest rate that balances the money market influences the

quantity of goods and services demanded and thus the level of

output.

Notice that this precisely reverses the order of analysis used to study the

economy in the long run.

The two different theories of the interest rate are useful for different

purposes. When thinking about the long-run determinants of the interest

rate, it is best to keep in mind the loanable-funds theory, which high-

lights the importance of an economy’s saving propensities and investment

opportunities. By contrast, when thinking about the short-run determi-

nants of the interest rate, it is best to keep in mind the liquidity-preference

theory, which highlights the importance of monetary policy. ■

F Y I

743CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND

a higher interest rate, the cost of borrowing and the return to saving are greater. Fewer households choose to borrow to buy a new house, and those who do buy smaller houses, so the demand for residential investment falls. Fewer firms choose to borrow to build new factories and buy new equipment, so business investment falls. Thus, when the price level rises from P1 to P2, increasing money demand from MD1 to MD2 and raising the interest rate from r1 to r2, the quantity of goods and services demanded falls from Y1 to Y2.

This analysis of the interest-rate effect can be summarized in three steps: (1) A higher price level raises money demand. (2) Higher money demand leads to a higher interest rate. (3) A higher interest rate reduces the quantity of goods and services demanded. The same logic works for a decline in the price level: A lower price level reduces money demand, which leads to a lower interest rate, and this in turn increases the quantity of goods and services demanded. The result of this analysis is a negative relationship between the price level and the quantity of goods and services demanded, as illustrated by a downward-sloping aggregate-demand curve.

34-1c Changes in the Money Supply So far, we have used the theory of liquidity preference to explain more fully how the total quantity of goods and services demanded in the economy changes as the price level changes. That is, we have examined movements along a downward-sloping aggregate-demand curve. The theory also sheds light, how- ever, on some of the other events that alter the quantity of goods and services demanded. Whenever the quantity of goods and services demanded changes for any given price level, the aggregate-demand curve shifts.

FIGURE 2

The Money Market and the

Slope of the Aggregate-

Demand Curve

Quantity of Money

Quantity fixed by the Fed

Interest Rate

Money demand at price level P2, MD2

Money demand at price level P1, MD1

Money supply

(a) The Money Market

3. . . . which increases the equilibrium interest rate . . .

2. . . . increases the demand for money . . .

(b) The Aggregate-Demand Curve

Quantity of Output

Price Level

Aggregate demand

Y2 Y1

4. . . . which in turn reduces the quantity of goods and services demanded.

1. An increase in the price level . . .

An increase in the price level from P1 to P2 shifts the money demand curve to the right, as

in panel (a). This increase in money demand causes the interest rate to rise from r1 to r2.

Because the interest rate is the cost of borrowing, the increase in the interest rate reduces

the quantity of goods and services demanded from Y1 to Y2. This negative relationship

between the price level and quantity demanded is represented with a downward-sloping

aggregate-demand curve, as in panel (b).

744 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

One important variable that shifts the aggregate-demand curve is monetary policy. To see how monetary policy affects the economy in the short run, sup- pose that the Fed increases the money supply by buying government bonds in open-market operations. (Why the Fed might do this will become clear later, after we understand the effects of such a move.) Let’s consider how this monetary in- jection influences the equilibrium interest rate for a given price level. This will tell us what the injection does to the position of the aggregate-demand curve.

As panel (a) of Figure 3 shows, an increase in the money supply shifts the money supply curve to the right from MS1 to MS2. Because the money demand curve has not changed, the interest rate falls from r1 to r2 to balance money supply and money demand. That is, the interest rate must fall to induce people to hold the additional money the Fed has created, restoring equilibrium in the money market.

Once again, the interest rate influences the quantity of goods and services de- manded, as shown in panel (b) of Figure 3. The lower interest rate reduces the cost of borrowing and the return to saving. Households spend more on new homes, stimulating the demand for residential investment. Firms spend more on new factories and new equipment, stimulating business investment. As a result, the quantity of goods and services demanded at a given price level, P, rises from Y1 to Y2. Of course, there is nothing special about P: The monetary injection raises the quantity of goods and services demanded at every price level. Thus, the entire aggregate-demand curve shifts to the right.

To sum up: When the Fed increases the money supply, it lowers the interest rate and increases the quantity of goods and services demanded for any given price level, shifting the aggregate-demand curve to the right. Conversely, when the Fed contracts the money supply, it raises the interest rate and reduces the quantity of goods and services demanded for any given price level, shifting the aggregate-demand curve to the left.

FIGURE 3

A Monetary Injection

MS2Money supply, MS1

Money demand at price level P

Quantity of Money

Interest Rate

(a) The Money Market

2. . . . the equilibrium interest rate falls . . .

1. When the Fed increases the money supply . . .

Aggregate demand, AD1

AD2

(b) The Aggregate-Demand Curve

Quantity of Output

Price Level

3. . . . which increases the quantity of goods and services demanded at a given price level.

In panel (a), an increase in the money supply from MS1 to MS2 reduces the equilibrium

interest rate from r1 to r2. Because the interest rate is the cost of borrowing, the fall in

the interest rate raises the quantity of goods and services demanded at a given price

level from Y1 to Y2. Thus, in panel (b), the aggregate-demand curve shifts to the right

from AD1 to AD2.

745CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND

34-1d The Role of Interest-Rate Targets in Fed Policy How does the Federal Reserve affect the economy? Our discussion here and ear- lier in the book has treated the money supply as the Fed’s policy instrument. When the Fed buys government bonds in open-market operations, it increases the money supply and expands aggregate demand. When the Fed sells government bonds in open-market operations, it decreases the money supply and contracts aggregate demand.

Discussions of Fed policy often treat the interest rate, rather than the money supply, as the Fed’s policy instrument. Indeed, in recent years, the Federal Reserve has conducted policy by setting a target for the federal funds rate—the interest rate that banks charge one another for short-term loans. This target is reevaluated ev- ery six weeks at meetings of the Federal Open Market Committee (FOMC). The FOMC has chosen to set a target for the federal funds rate, rather than for the money supply, as it did at times in the past.

There are several related reasons for the Fed’s decision to use the federal funds rate as its target. One is that the money supply is hard to measure with sufficient precision. Another is that money demand fluctuates over time. For any given money supply, fluctuations in money demand would lead to fluctuations in inter- est rates, aggregate demand, and output. By contrast, when the Fed announces a target for the federal funds rate, it essentially accommodates the day-to-day shifts in money demand by adjusting the money supply accordingly.

The Fed’s decision to target an interest rate does not fundamentally alter our anal- ysis of monetary policy. The theory of liquidity preference illustrates an important principle: Monetary policy can be described either in terms of the money supply or in terms of the interest rate. When the FOMC sets a target for the federal funds rate of, say, 6 percent, the Fed’s bond traders are told: “Conduct whatever open-market opera- tions are necessary to ensure that the equilibrium interest rate is 6 percent.” In other words, when the Fed sets a target for the interest rate, it commits itself to adjusting the money supply to make the equilibrium in the money market hit that target.

As a result, changes in monetary policy can be viewed either in terms of changing the interest rate target or in terms of changing the money supply. When you read in the newspaper that “the Fed has lowered the federal funds rate from 6 to 5 percent,” you should understand that this occurs only because the Fed’s bond traders are do- ing what it takes to make it happen. To lower the federal funds rate, the Fed’s bond traders buy government bonds, and this purchase increases the money supply and lowers the equilibrium interest rate (just as in Figure 3). Similarly, when the FOMC raises the target for the federal funds rate, the bond traders sell government bonds, and this sale decreases the money supply and raises the equilibrium interest rate.

The lessons from this analysis are simple: Changes in monetary policy aimed at expanding aggregate demand can be described either as increasing the money supply or as lowering the interest rate. Changes in monetary policy aimed at contracting aggregate de- mand can be described either as decreasing the money supply or as raising the interest rate.

CASE STUDY

WHY THE FED WATCHES THE STOCK MARKET (AND VICE VERSA) “The stock market has predicted nine out of the past five recessions.” So quipped Paul Samuelson, the famed economist (and textbook au-

thor). Samuelson was right that the stock market is highly volatile and can give wrong signals about the economy. But fluctuations in stock prices are often a sign of broader economic developments. The economic boom of the 1990s, for example, appeared not only in rapid GDP growth and falling unemployment but also in rising stock prices, which increased about fourfold during this decade.

746 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

Similarly, the deep recession of 2008 and 2009 was reflected in falling stock prices: From November 2007 to March 2009, the stock market lost about half its value.

How should the Fed respond to stock market fluctuations? The Fed has no rea- son to care about stock prices in themselves, but it does have the job of monitoring and responding to developments in the overall economy, and the stock market is a piece of that puzzle. When the stock market booms, households become wealthier, and this increased wealth stimulates consumer spending. In addition, a rise in stock prices makes it more attractive for firms to sell new shares of stock, and this stimu- lates investment spending. For both reasons, a booming stock market expands the aggregate demand for goods and services.

As we discuss more fully later in the chapter, one of the Fed’s goals is to stabilize aggregate demand, because greater stability in aggregate demand means greater stability in output and the price level. To promote stability, the Fed might respond to a stock market boom by keeping the money supply lower and interest rates higher than it otherwise would. The contractionary effects of higher interest rates would offset the expansionary effects of higher stock prices. In fact, this analysis does describe Fed behavior: Real interest rates were kept high by historical stan- dards during the stock market boom of the late 1990s.

The opposite occurs when the stock market falls. Spending on consumption and investment tends to decline, depressing aggregate demand and pushing the econ- omy toward recession. To stabilize aggregate demand, the Fed would increase the money supply and lower interest rates. And indeed, that is what it typically does. For example, on October 19, 1987, the stock market fell by 22.6 percent—one of the biggest one-day drops in history. The Fed responded to the market crash by increasing the money supply and lowering interest rates. The federal funds rate fell from 7.7 percent at the beginning of October to 6.6 percent at the end of the month. In part because of the Fed’s quick action, the economy avoided a recession. Similarly, as we discussed in a case study in the preceding chapter, the Fed also reduced interest rates during the economic downturn and stock market decline of 2008 and 2009, but this time monetary policy was not sufficient to avert a deep recession.

While the Fed keeps an eye on the stock market, stock market participants also keep an eye on the Fed. Because the Fed can influence interest rates and economic activity, it can alter the value of stocks. For example, when the Fed raises interest rates by reducing the money supply, it makes owning stocks less attractive for two reasons. First, a higher interest rate means that bonds, the alternative to stocks, are earning a higher return. Second, the Fed’s tightening of monetary policy reduces the demand for goods and services, which reduces profits. As a result, stock prices often fall when the Fed raises interest rates. ●

QuickQuiz Use the theory of liquidity preference to explain how a decrease in the

money supply affects the equilibrium interest rate. How does this change

in monetary policy affect the aggregate-demand curve?

34-1e The Zero Lower Bound As we have just seen, monetary policy works through interest rates. This con- clusion raises a question: What if the Fed’s target interest rate has fallen as far as it can? In the recession of 2008 and 2009, the federal funds rate fell to about zero. In this situation, what, if anything, can monetary policy do to stimulate the economy?

747CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND

Some economists describe this situation as a liquidity trap. According to the the- ory of liquidity preference, expansionary monetary policy works by reducing inter- est rates and stimulating investment spending. But if interest rates have already fallen to around zero, monetary policy may no longer be effective. Nominal in- terest rates cannot fall much below zero: Rather than making a loan at a negative nominal interest rate, a person would just hold cash. In this environment, expan- sionary monetary policy raises the supply of money, making the public’s asset portfolio more liquid, but because interest rates can’t fall any further, the extra liquidity might not have any effect. Aggregate demand, production, and employ- ment may be “trapped” at low levels.

Other economists are skeptical about the relevance of liquidity traps and be- lieve that a central bank continues to have tools to expand the economy, even after its interest rate target hits its lower bound of zero. One possibility is that the cen- tral bank could commit itself to keeping interest rates low for an extended period of time. Such a policy is sometimes called forward guidance. Even if the central bank’s current target for the interest rate cannot fall any further, the promise that interest rates will remain low may help stimulate investment spending.

A second possibility is that the central bank could conduct expansionary open-market operations with a larger variety of financial instruments. Normally, the Fed conducts expansionary open-market operations by buying short-term government bonds. But it could also buy mortgages, corporate debt, and longer-term government bonds and thereby lower the interest rates on these kinds of loans. The Federal Reserve actively pursued this last option in the aftermath of the financial crisis of 2008 and 2009. This type of unconventional monetary policy is sometimes called quantitative easing because it increases the quantity of bank reserves.

Some economists have suggested that the possibility of hitting the zero lower bound for interest rates justifies setting the target rate of inflation well above zero. Under zero inflation, the real interest rate, like the nominal interest, can never fall below zero. But if the normal rate of inflation is, say, 4 percent, then the central bank can easily push the real interest rate to negative 4 percent by lowering the nominal interest rate toward zero. Thus, moderate inflation gives monetary policymakers more room to stimulate the economy when needed, re- ducing the risk of hitting the zero lower bound and having the economy fall into a liquidity trap.

34-2 How Fiscal Policy Influences Aggregate Demand The government can influence the behavior of the economy not only with mon- etary policy but also with fiscal policy. Fiscal policy refers to the government’s choices regarding the overall level of government purchases and taxes. Earlier in the book, we examined how fiscal policy influences saving, investment, and growth in the long run. In the short run, however, the primary effect of fiscal pol- icy is on the aggregate demand for goods and services.

34-2a Changes in Government Purchases When policymakers change the money supply or the level of taxes, they shift the aggregate-demand curve indirectly by influencing the spending decisions of firms or households. By contrast, when the government alters its own purchases of goods and services, it shifts the aggregate-demand curve directly.

fiscal policy

the setting of the level of

government spending and

taxation by government

policymakers

748 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

Suppose, for instance, that the U.S. Department of Defense places a $20 billion order for new fighter planes with Boeing, the large aircraft manufacturer. This order raises the demand for the output produced by Boeing, which induces the company to hire more workers and increase production. Because Boeing is part of the economy, the increase in the demand for Boeing planes means an increase in the total quantity of goods and services demanded at each price level. As a result, the aggregate-demand curve shifts to the right.

By how much does this $20 billion order from the government shift the aggregate-demand curve? At first, one might guess that the aggregate-demand curve shifts to the right by exactly $20 billion. It turns out, however, that this is not the case. There are two macroeconomic effects that cause the size of the shift in aggregate demand to differ from the change in government purchases. The first— the multiplier effect—suggests the shift in aggregate demand could be larger than $20 billion. The second—the crowding-out effect—suggests the shift in aggregate demand could be smaller than $20 billion. We now discuss these two effects in turn.

34-2b The Multiplier Effect When the government buys $20 billion of goods from Boeing, that purchase has repercussions. The immediate impact of the higher demand from the government is to raise employment and profits at Boeing. Then, as the workers see higher earnings and the firm owners see higher profits, they respond to this increase in income by raising their own spending on consumer goods. As a result, the gov- ernment purchase from Boeing raises the demand for the products of many other firms in the economy. Because each dollar spent by the government can raise the aggregate demand for goods and services by more than a dollar, government purchases are said to have a multiplier effect on aggregate demand.

This multiplier effect continues even after this first round. When consumer spending rises, the firms that produce these consumer goods hire more people and experience higher profits. Higher earnings and profits stimulate consumer spend- ing once again and so on. Thus, there is positive feedback as higher demand leads to higher income, which in turn leads to even higher demand. Once all these effects are added together, the total impact on the quantity of goods and services demanded can be much larger than the initial impulse from higher government spending.

Figure 4 illustrates the multiplier effect. The increase in government purchases of $20 billion initially shifts the aggregate-demand curve to the right from AD1 to AD2 by exactly $20 billion. But when consumers respond by increasing their spending, the aggregate-demand curve shifts still further to AD3.

This multiplier effect arising from the response of consumer spending can be strengthened by the response of investment to higher levels of demand. For in- stance, Boeing might respond to the higher demand for planes by deciding to buy more equipment or build another plant. In this case, higher government demand spurs higher demand for investment goods. This positive feedback from demand to investment is sometimes called the investment accelerator.

34-2c A Formula for the Spending Multiplier Some simple algebra permits us to derive a formula for the size of the multiplier effect that arises when an increase in government purchases induces increases in consumer spending. An important number in this formula is the marginal propen- sity to consume (MPC)—the fraction of extra income that a household consumes rather than saves. For example, suppose that the marginal propensity to consume is ¾. This means that for every extra dollar that a household earns, the household

multiplier effect

the additional shifts in

aggregate demand that

result when expansionary

fiscal policy increases

income and thereby

increases consumer

spending

749CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND

spends $0.75 (¾ of the dollar) and saves $0.25. With an MPC of ¾, when the work- ers and owners of Boeing earn $20 billion from the government contract, they in- crease their consumer spending by ¾ × $20 billion, or $15 billion.

To gauge the impact on aggregate demand of a change in government pur- chases, we follow the effects step-by-step. The process begins when the govern- ment spends $20 billion, which implies that national income (earnings and profits) also rises by this amount. This increase in income in turn raises consumer spend- ing by MPC × $20 billion, which raises the income for the workers and owners of the firms that produce the consumption goods. This second increase in income again raises consumer spending, this time by MPC × (MPC × $20 billion). These feedback effects go on and on.

To find the total impact on the demand for goods and services, we add up all these effects:

Change in government purchases = $20 billion First change in consumption = MPC × $20 billion Second change in consumption = MPC2 × $20 billion Third change in consumption = MPC3 × $20 billion

• • • • • •

Total change in demand

= (1 + MPC + MPC2 + MPC3 + . . .) × $20 billion.

Here “. . .” represents an infinite number of similar terms. Thus, we can write the multiplier as follows:

Multiplier = 1 + MPC + MPC2 + MPC3 + . . . .

FIGURE 4

The Multiplier Effect

An increase in government purchases

of $20 billion can shift the aggregate-

demand curve to the right by more

than $20 billion. This multiplier effect

arises because increases in aggregate

income stimulate additional spending

by consumers.

Quantity of Output

Price Level

Aggregate demand, AD1

$20 billion

AD2

AD3

1. An increase in government purchases of $20 billion initially increases aggregate demand by $20 billion . . .

2. . . . but the multiplier effect can amplify the shift in aggregate demand.

750 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

This multiplier tells us the demand for goods and services that each dollar of gov- ernment purchases generates.

To simplify this equation for the multiplier, recall from math class that this ex- pression is an infinite geometric series. For x between −1 and +1,

1 + x + x2 + x3 + . . . = 1 / (1 − x).

In our case, x = MPC. Thus,

Multiplier = 1/(1 − MPC).

For example, if MPC is ¾, the multiplier is 1/(1 − ¾), which is 4. In this case, the $20 billion of government spending generates $80 billion of demand for goods and services.

This formula for the multiplier shows that the size of the multiplier depends on the marginal propensity to consume. While an MPC of ¾ leads to a multiplier of 4, an MPC of ½ leads to a multiplier of only 2. Thus, a larger MPC means a larger multiplier. To see why this is true, remember that the multiplier arises because higher income induces greater spending on consumption. With a larger MPC, consumption responds more to a change in income, and so the multiplier is larger.

34-2d Other Applications of the Multiplier Effect Because of the multiplier effect, a dollar of government purchases can generate more than a dollar of aggregate demand. The logic of the multiplier effect, how- ever, is not restricted to changes in government purchases. Instead, it applies to any event that alters spending on any component of GDP—consumption, invest- ment, government purchases, or net exports.

For example, suppose that a recession overseas reduces the demand for U.S. net exports by $10 billion. This reduced spending on U.S. goods and services de- presses U.S. national income, which reduces spending by U.S. consumers. If the marginal propensity to consume is ¾ and the multiplier is 4, then the $10 billion fall in net exports leads to a $40 billion contraction in aggregate demand.

As another example, suppose that a stock market boom increases households’ wealth and stimulates their spending on goods and services by $20 billion. This extra consumer spending increases national income, which in turn generates even more consumer spending. If the marginal propensity to consume is ¾ and the multiplier is 4, then the initial impulse of $20 billion in consumer spending trans- lates into an $80 billion increase in aggregate demand.

The multiplier is an important concept in macroeconomics because it shows how the economy can amplify the impact of changes in spending. A small initial change in consumption, investment, government purchases, or net exports can end up having a large effect on aggregate demand and, therefore, the economy’s production of goods and services.

34-2e The Crowding-Out Effect The multiplier effect seems to suggest that when the government buys $20 billion of planes from Boeing, the resulting expansion in aggregate demand is necessarily larger than $20 billion. Yet another effect works in the opposite direction. While an increase in government purchases stimulates the aggregate demand for goods and services, it also causes the interest rate to rise, which reduces investment spending and puts downward pressure on aggregate demand. The reduction in

751CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND

aggregate demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect.

To see why crowding out occurs, let’s consider what happens in the money market when the government buys planes from Boeing. As we have discussed, this increase in demand raises the incomes of the workers and owners of this firm (and, because of the multiplier effect, of other firms as well). As incomes rise, households plan to buy more goods and services and, as a result, choose to hold more of their wealth in liquid form. That is, the increase in income caused by the fiscal expansion raises the demand for money.

The effect of the increase in money demand is shown in panel (a) of Figure 5. Because the Fed has not changed the money supply, the vertical supply curve remains the same. When the higher level of income shifts the money demand curve to the right from MD

1 to MD2, the interest rate must rise from r1 to r2 to keep

supply and demand in balance. The increase in the interest rate, in turn, reduces the quantity of goods and

services demanded. In particular, because borrowing is more expensive, the de- mand for residential and business investment goods declines. In other words, as the increase in government purchases increases the demand for goods and ser- vices, it may also crowd out investment. This crowding-out effect partially off- sets the impact of government purchases on aggregate demand, as illustrated in panel (b) of Figure 5. The increase in government purchases initially shifts the aggregate-demand curve from AD1 to AD2, but once crowding out takes place, the aggregate-demand curve drops back to AD3.

crowding-out effect

the offset in aggregate

demand that results

when expansionary fiscal

policy raises the interest

rate and thereby reduces

investment spending

FIGURE 5

The Crowding-Out Effect

Quantity of Money

Quantity fixed by the Fed

Interest Rate

Money demand, MD1

Money supply

(a) The Money Market

3. . . . which increases the equilibrium interest rate . . .

2. . . . the increase in spending raises money demand . . .

MD2

Panel (a) shows the money market. When the government increases its purchases of goods and

services, the resulting increase in income raises the demand for money from MD1 to MD2, and this

causes the equilibrium interest rate to rise from r1 to r2. Panel (b) shows the effects on aggregate

demand. The initial impact of the increase in government purchases shifts the aggregate-demand

curve from AD1 to AD2. Yet because the interest rate is the cost of borrowing, the increase in the

interest rate tends to reduce the quantity of goods and services demanded, particularly for invest-

ment goods. This crowding out of investment partially offsets the impact of the fiscal expansion on

aggregate demand. In the end, the aggregate-demand curve shifts only to AD3.

Quantity of Output

Price Level

Aggregate demand, AD1

(b) The Shift in Aggregate Demand

4. . . . which in turn partly offsets the initial increase in aggregate demand.

AD2

AD3

$20 billion

1. When an increase in government purchases raises aggregate demand . . .

752 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

To sum up: When the government increases its purchases by $20 billion, the aggregate demand for goods and services could rise by more or less than $20 billion depending on the sizes of the multiplier and crowding-out effects. The multiplier effect makes the shift in aggregate demand greater than $20 billion. The crowding-out effect pushes the aggregate-demand curve in the opposite direction and, if large enough, could re- sult in an aggregate-demand shift of less than $20 billion.

34-2f Changes in Taxes The other important instrument of fiscal policy, besides the level of government purchases, is the level of taxation. When the government cuts personal income taxes, for instance, it increases households’ take-home pay. Households will save some of this additional income, but they will also spend some of it on con- sumer goods. Because it increases consumer spending, the tax cut shifts the ag- gregate-demand curve to the right. Similarly, a tax increase depresses consumer spending and shifts the aggregate-demand curve to the left.

The size of the shift in aggregate demand resulting from a tax change is also affected by the multiplier and crowding-out effects. When the government cuts taxes and stimulates consumer spending, earnings and profits rise, which further stimulates consumer spending. This is the multiplier effect. At the same time, higher income leads to higher money demand, which tends to raise interest rates. Higher interest rates make borrowing more costly, which reduces investment spending. This is the crowding-out effect. Depending on the sizes of the multi- plier and crowding-out effects, the shift in aggregate demand could be larger or smaller than the tax change that causes it.

How Fiscal Policy Might Affect Aggregate Supply

S o far, our discussion of fiscal policy has stressed how changes in gov-

ernment purchases and changes in taxes influence the quantity of

goods and services demanded. Most economists believe that the short-

run macroeconomic effects of fiscal policy work primarily through aggre-

gate demand. Yet fiscal policy can potentially influence the quantity of

goods and services supplied as well.

For instance, consider the effects of tax changes on aggregate sup-

ply. One of the Ten Principles of Economics in Chapter 1 is that people

respond to incentives. When government policymakers cut tax rates,

workers get to keep more of each dollar they earn, so they have a greater

incentive to work and produce goods and services. If they respond to this

incentive, the quantity of goods and services supplied will be greater at

each price level, and the aggregate-supply curve will shift to the right.

Some economists, called supply siders, have argued that the influence

of tax cuts on aggregate supply is large. According to some supply siders,

the influence is so large that a cut in tax rates will stimulate enough addi-

tional production and income that tax revenue will actually increase. This

is certainly a theoretical possibility, but most economists do not consider

it the normal case. While the

supply-side effects of taxes

are important to consider,

they are usually not large

enough to cause tax revenue

to rise when tax rates fall.

Like changes in taxes, changes

in government purchases can also potentially affect aggregate supply.

Suppose, for instance, that the government increases expenditure on a

form of government-provided capital, such as roads. Roads are used by

private businesses to make deliveries to their customers; an increase in

the quantity of roads increases these businesses’ productivity. Hence,

when the government spends more on roads, it increases the quantity of

goods and services supplied at any given price level and, thus, shifts the

aggregate-supply curve to the right. This effect on aggregate supply is

probably more important in the long run than in the short run, however,

because it takes time for the government to build new roads and put

them into use. ■

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753CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND

In addition to the multiplier and crowding-out effects, there is another import- ant determinant of the size of the shift in aggregate demand that results from a tax change: households’ perceptions about whether the tax change is permanent or temporary. For example, suppose that the government announces a tax cut of $1,000 per household. In deciding how much of this $1,000 to spend, households must ask themselves how long this extra income will last. If they expect the tax cut to be permanent, they will view it as adding substantially to their financial re- sources and, therefore, increase their spending by a large amount. In this case, the tax cut will have a large impact on aggregate demand. By contrast, if households expect the tax change to be temporary, they will view it as adding only slightly to their financial resources and, therefore, will increase their spending by only a small amount. In this case, the tax cut will have a small impact on aggregate demand.

An extreme example of a temporary tax cut was the one announced in 1992. In that year, President George H. W. Bush faced a lingering recession and an upcom- ing reelection campaign. He responded to these circumstances by announcing a reduction in the amount of income tax that the federal government was withhold- ing from workers’ paychecks. Because legislated income tax rates did not change, however, every dollar of reduced withholding in 1992 meant an extra dollar of taxes due on April 15, 1993, when income tax returns for 1992 were to be filed. Thus, this “tax cut” actually represented only a short-term loan from the govern- ment. Not surprisingly, the impact of the policy on consumer spending and ag- gregate demand was relatively small.

QuickQuiz Suppose that the government reduces spending on highway construction

by $10 billion. Which way does the aggregate-demand curve shift?

Explain why the shift might be larger or smaller than $10 billion.

34-3 Using Policy to Stabilize the Economy We have seen how monetary and fiscal policy can affect the economy’s aggregate demand for goods and services. These theoretical insights raise some important policy questions: Should policymakers use these instruments to control aggregate demand and stabilize the economy? If so, when? If not, why not?

34-3a The Case for Active Stabilization Policy Let’s return to the question that began this chapter: When the president and Congress raise taxes, how should the Federal Reserve respond? As we have seen, the level of taxation is one determinant of the position of the aggregate-demand curve. When the government raises taxes, aggregate demand will fall, depress- ing production and employment in the short run. If the Federal Reserve wants to prevent this adverse effect of the fiscal policy, it can expand aggregate demand by increasing the money supply. A monetary expansion would reduce interest rates, stimulate investment spending, and expand aggregate demand. If monetary pol- icy is set appropriately, the combined changes in monetary and fiscal policy could leave the aggregate demand for goods and services unaffected.

This analysis is exactly the sort followed by members of the Federal Open Market Committee. They know that monetary policy is an important determinant of aggregate demand. They also know that there are other important determinants as well, including fiscal policy set by the president and Congress. As a result, the FOMC watches the debates over fiscal policy with a keen eye.

754 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

This response of monetary policy to the change in fiscal policy is an example of a more general phenomenon: the use of policy instruments to stabilize aggregate demand and, as a result, production and employment. Economic stabilization has been an explicit goal of U.S. policy since the Employment Act of 1946. This act states that “it is the continuing policy and responsibility of the federal government to . . . promote full employment and production.” In essence, the government has chosen to hold itself accountable for short-run macroeconomic performance.

The Employment Act has two implications. The first, more modest, implication is that the government should avoid being a cause of economic fluctuations. Thus, most economists advise against large and sudden changes in monetary and fis- cal policy, for such changes are likely to cause fluctuations in aggregate demand. Moreover, when large changes do occur, it is important that monetary and fiscal policymakers be aware of and respond to each others’ actions.

The second, more ambitious, implication of the Employment Act is that the government should respond to changes in the private economy to stabilize aggre- gate demand. The act was passed not long after the publication of Keynes’s The General Theory of Employment, Interest, and Money, which has been one of the most influential books ever written about economics. In it, Keynes emphasized the key role of aggregate demand in explaining short-run economic fluctuations. Keynes

In the global economic downturn of

2008 and 2009, governments around

the world turned to fiscal policy to

prop up aggregate demand. This epi-

sode ignited a debate about the size of

the multipliers, which remains a topic

of much research.

Much Ado about Multipliers

I t is the biggest peacetime fiscal expansion in

history. Across the globe countries have coun-

tered the recession by cutting taxes and by

boosting government spending. The G20 group

of economies, whose leaders meet this week in

Pittsburgh, have introduced stimulus packages

worth an average of 2% of GDP this year [2009]

and 1.6% of GDP in 2010. Coordinated action on

this scale might suggest a consensus about the

effects of fiscal stimulus. But economists are in

fact deeply divided about how well, or indeed

whether, such stimulus works.

The debate hinges on the scale of the “fis-

cal multiplier.” This measure, first formalised

in 1931 by Richard Kahn, a student of John

Maynard Keynes, captures how effectively tax

cuts or increases in government spending

stimulate output. A multiplier of one means

that a $1 billion increase in government

spending will increase a country’s GDP by $1

billion.

The size of the multiplier is bound to vary

according to economic conditions. For an

economy operating at full capacity, the fiscal

multiplier should be zero. Since there are no

spare resources, any increase in government

demand would just replace spending else-

where. But in a recession, when workers and

factories lie idle, a fiscal boost can increase

overall demand. And if the initial stimulus

triggers a cascade of expenditure among con-

sumers and businesses, the multiplier can be

well above one.

The multiplier is also likely to vary accord-

ing to the type of fiscal action. Government

spending on building a bridge may have a

bigger multiplier than a tax cut if consumers

save a portion of their tax windfall. A tax cut

targeted at poorer people may have a bigger

impact on spending than one for the affluent,

since poorer folk tend to spend a higher share

of their income.

Crucially, the overall size of the fiscal

multiplier also depends on how people react

to higher government borrowing. If the gov-

ernment’s actions bolster confidence and re-

vive animal spirits, the multiplier could rise

as demand goes up and private investment

is “crowded in.” But if interest rates climb

in response to government borrowing then

some private investment that would otherwise

have occurred could get “crowded out.” And if

consumers expect higher future taxes in order

to finance new government borrowing, they

could spend less today. All that would reduce

the fiscal multiplier, potentially to below zero.

How Large Is the Fiscal Policy Multiplier?

IN THE NEWS

755CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND

claimed that the government should actively stimulate aggregate demand when aggregate demand appeared insufficient to maintain production at its full-em- ployment level.

Keynes (and his many followers) argued that aggregate demand fluctuates be- cause of largely irrational waves of pessimism and optimism. He used the term “an- imal spirits” to refer to these arbitrary changes in attitude. When pessimism reigns, households reduce consumption spending and firms reduce investment spending. The result is reduced aggregate demand, lower production, and higher unemploy- ment. Conversely, when optimism reigns, households and firms increase spending. The result is higher aggregate demand, higher production, and inflationary pres- sure. Notice that these changes in attitude are, to some extent, self-fulfilling.

In principle, the government can adjust its monetary and fiscal policy in response to these waves of optimism and pessimism and, thereby, stabilize the economy. For example, when people are excessively pessimistic, the Fed can expand the money supply to lower interest rates and expand aggregate demand. When they are excessively optimistic, it can contract the money supply to raise interest rates and dampen aggregate demand. Former Fed Chairman William McChesney Martin described this view of monetary policy very simply: “The Federal Reserve’s job is to take away the punch bowl just as the party gets going.”

Different assumptions about the impact

of higher government borrowing on interest

rates and private spending explain wild vari-

ations in the estimates of multipliers from

today’s stimulus spending. Economists in

the Obama administration, who assume that

the federal funds rate stays constant for a

four-year period, expect a multiplier of 1.6 for

government purchases and 1.0 for tax cuts

from America’s fiscal stimulus. An alterna-

tive assessment by John Cogan, Tobias Cwik,

John Taylor and Volker Wieland uses models

in which interest rates and taxes rise more

quickly in response to higher public borrow-

ing. Their multipliers are much smaller. They

think America’s stimulus will boost GDP by

only one-sixth as much as the Obama team

expects.

When forward-looking models disagree

so dramatically, careful analysis of previous

fiscal stimuli ought to help settle the debate.

Unfortunately, it is extremely tricky to iso-

late the impact of changes in fiscal policy.

One approach is to use microeconomic case

studies to examine consumer behaviour in

response to specific tax rebates and cuts.

These studies, largely based on tax changes

in America, find that permanent cuts have

a bigger impact on consumer spending than

temporary ones and that consumers who find

it hard to borrow, such as those close to their

credit-card limit, tend to spend more of their

tax windfall. But case studies do not measure

the overall impact of tax cuts or spending in-

creases on output.

An alternative approach is to try to

tease out the statistical impact of changes

in government spending or tax cuts on GDP.

The difficulty here is to isolate the effects

of fiscal-stimulus measures from the rises

in social-security spending and falls in tax

revenues that naturally accompany reces-

sions. This empirical approach has narrowed

the range of estimates in some areas. It has

also yielded interesting cross-country com-

parisons. Multipliers are bigger in closed

economies than open ones (because less of

the stimulus leaks abroad via imports). They

have traditionally been bigger in rich coun-

tries than emerging ones (where investors

tend to take fright more quickly, pushing in-

terest rates up). But overall economists find

as big a range of multipliers from empirical

estimates as they do from theoretical models.

To add to the confusion, the post-war ex-

periences from which statistical analyses are

drawn differ in vital respects from the current

situation. Most of the evidence on multipliers

for government spending is based on military

outlays, but today’s stimulus packages are

heavily focused on infrastructure. Interest

rates in many rich countries are now close to

zero, which may increase the potency of, as

well as the need for, fiscal stimulus. Because

of the financial crisis relatively more people

face borrowing constraints, which would in-

crease the effectiveness of a tax cut. At the

same time, highly indebted consumers may

now be keen to cut their borrowing, leading to

a lower multiplier. And investors today have

more reason to be worried about rich coun-

tries’ fiscal positions than those of emerging

markets.

Add all this together and the truth is that

economists are flying blind. They can make

relative judgments with some confidence.

Temporary tax cuts pack less punch than per-

manent ones, for instance. Fiscal multipliers

will probably be lower in heavily indebted

economies than in prudent ones. But poli-

cymakers looking for precise estimates are

deluding themselves. ■

Source: The Economist, September 24, 2009.

756 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

CASE STUDY

KEYNESIANS IN THE WHITE HOUSE When a reporter in 1961 asked President John F. Kennedy why he ad- vocated a tax cut, Kennedy replied, “To stimulate the economy. Don’t

you remember your Economics 101?” Kennedy’s policy was, in fact, based on the analysis of fiscal policy we have developed in this chapter. His goal was to enact a tax cut, which would raise consumer spending, expand aggregate demand, and increase the economy’s production and employment.

In choosing this policy, Kennedy was relying on his team of economic advisers. This team included such prominent economists as James Tobin and Robert Solow, both of whom would later win Nobel Prizes for their contributions to the field. As students in the 1940s, these economists had closely studied John Maynard Keynes’s General Theory, which was then only a few years old. When the Kennedy advisers proposed cutting taxes, they were putting Keynes’s ideas into action.

Although tax changes can have a potent influence on ag- gregate demand, they have other effects as well. In particular, by changing the incentives that people face, taxes can alter the aggregate supply of goods and services. Part of the Kennedy proposal was an investment tax credit, which gives a tax break to firms that invest in new capital. Higher investment would not only stimulate aggregate demand immediately but also increase the economy’s productive capacity over time. Thus, the short- run goal of increasing production through higher aggregate demand was coupled with a long-run goal of increasing pro- duction through higher aggregate supply. And indeed, when the tax cut Kennedy proposed was finally enacted in 1964, it helped usher in a period of robust economic growth.

Since the 1964 tax cut, policymakers have from time to time used fiscal policy as a tool for controlling aggregate demand. For example, when President Barack Obama moved into the Oval Office in 2009, he faced an economy in the midst of a reces- sion. One of his first policy initiatives was a stimulus bill, called the American Recovery and Reinvestment Act (ARRA), which included substantial increases in government spending. The In the News box on the preceding two pages discusses some of the debate over this policy initiative. ●

34-3b The Case against Active Stabilization Policy Some economists argue that the government should avoid ac- tive use of monetary and fiscal policy to try to stabilize the economy. They claim that these policy instruments should be set to achieve long-run goals, such as rapid economic growth and low inflation, and that the economy should be left to deal with short-run fluctuations on its own. These economists may admit that monetary and fiscal policy can stabilize the economy in theory, but they doubt whether it can do so in practice.

The primary argument against active monetary and fiscal policy is that these policies affect the economy with a long lag. As we have seen, monetary policy works by changing interest rates, which in turn influence investment spending. But many

Economic Stimulus

ASK THE EXPERTS

“Because of the American Recovery and Reinvestment Act of

2009, the U.S. unemployment rate was lower at the end of 2010

than it would have been without the stimulus bill.”

“Taking into account all of the ARRA’s economic conse-

quences—including the economic costs of raising taxes to pay

for the spending, its effects on future spending, and any other

likely future effects—the benefits of the stimulus will end up

exceeding its costs.”

Source: IGM Economic Experts Panel, July 29, 2014.

What do economists say?

19% uncertain6% disagree

75% agree

97% agree

3% disagree 0% uncertain

What do economists say?

757CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND

firms make investment plans far in advance. Thus, most economists believe that it takes at least 6 months for changes in monetary policy to have much effect on out- put and employment. Moreover, once these effects occur, they can last for several years. Critics of stabilization policy argue that because of this lag, the Fed should not try to fine-tune the economy. They claim that the Fed often reacts too late to changing economic conditions and, as a result, ends up being a cause of rather than a cure for economic fluctuations. These critics advocate a passive monetary policy, such as slow and steady growth in the money supply.

Fiscal policy also works with a lag, but unlike the lag in monetary policy, the lag in fiscal policy is largely attributable to the political process. In the United States, most changes in government spending and taxes must go through con- gressional committees in both the House and the Senate, be passed by both legislative bodies, and then be signed by the president. Completing this pro- cess can take months or, in some cases, years. By the time the change in fiscal policy is passed and ready to implement, the condition of the economy may have changed.

These lags in monetary and fiscal policy are a problem in part because economic forecasting is so imprecise. If forecasters could accurately predict the condition of the economy a year in advance, then monetary and fiscal policymakers could look ahead when making policy decisions. In this case, policymakers could stabilize the economy despite the lags they face. In practice, however, major recessions and depressions arrive without much advance warning. The best that policymakers can do is to respond to economic changes as they occur.

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758 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

34-3c Automatic Stabilizers All economists—both advocates and critics of stabilization policy—agree that the lags in implementation reduce the efficacy of policy as a tool for short-run stabili- zation. The economy would be more stable, therefore, if policymakers could find a way to avoid some of these lags. In fact, they have. Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action.

The most important automatic stabilizer is the tax system. When the economy goes into a recession, the amount of taxes collected by the government falls auto- matically because almost all taxes are closely tied to economic activity. The per- sonal income tax depends on households’ incomes, the payroll tax depends on workers’ earnings, and the corporate income tax depends on firms’ profits. Be- cause incomes, earnings, and profits all fall in a recession, the government’s tax revenue falls as well. This automatic tax cut stimulates aggregate demand and, thereby, reduces the magnitude of economic fluctuations.

Some government spending also acts as an automatic stabilizer. In particular, when the economy goes into a recession and workers are laid off, more people apply for unemployment insurance benefits, welfare benefits, and other forms of income support. This automatic increase in government spending stimulates aggregate demand at exactly the time when aggregate demand is insufficient to maintain full employment. Indeed, when the unemployment insurance system was first enacted in the 1930s, economists who advocated this policy did so in part because of its power as an automatic stabilizer.

The automatic stabilizers in the U.S. economy are not sufficiently strong to pre- vent recessions completely. Nonetheless, without these automatic stabilizers, output and employment would probably be more volatile than they are. For this reason, many economists oppose a constitutional amendment that would require the federal government always to run a balanced budget, as some politicians have proposed. When the economy goes into a recession, taxes fall, government spending rises, and the government’s budget moves toward deficit. If the government faced a strict bal- anced-budget rule, it would be forced to look for ways to raise taxes or cut spending in a recession. In other words, a strict balanced-budget rule would eliminate the au- tomatic stabilizers inherent in our current system of taxes and government spending.

QuickQuiz Suppose a wave of negative “animal spirits” overruns the economy, and

people become pessimistic about the future. What happens to aggregate

demand? If the Fed wants to stabilize aggregate demand, how should it alter the money

supply? If it does this, what happens to the interest rate? Why might the Fed choose not to

respond in this way?

automatic stabilizers

changes in fiscal policy

that stimulate aggregate

demand when the

economy goes into

a recession without

policymakers having to

take any deliberate action

34-4 Conclusion Before policymakers make any change in policy, they need to consider all the ef- fects of their decisions. Earlier in the book, we examined classical models of the economy, which describe the long-run effects of monetary and fiscal policy. There we saw how fiscal policy influences saving, investment, and long-run growth and how monetary policy influences the price level and the inflation rate.

In this chapter, we examined the short-run effects of monetary and fiscal pol- icy. We saw how these policy instruments can change the aggregate demand for goods and services and alter the economy’s production and employment in the

759CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND

CHAPTER QuickQuiz

1. If the central bank wants to expand aggregate de-

mand, it can ________ the money supply, which

would ________ the interest rate.

a. increase, increase

b. increase, decrease

c. decrease, increase

d. decrease, decrease

2. If the government wants to contract aggregate

demand, it can ________ government purchases

or ________ taxes.

a. increase, increase

b. increase, decrease

c. decrease, increase

d. decrease, decrease

3. The Federal Reserve’s target rate for the federal funds

rate

a. is an extra policy tool for the central bank, in addi-

tion to and independent of the money supply.

b. commits the Fed to set a particular money supply

so that it hits the announced target.

c. is a goal that is rarely achieved, because the Fed

can determine only the money supply.

d. matters to banks that borrow and lend federal

funds but does not influence aggregate demand.

4. With the economy in a recession because of inade-

quate aggregate demand, the government increases

its purchases by $1,200. Suppose the central bank

adjusts the money supply to hold the interest rate

constant, investment spending is fixed, and the mar-

ginal propensity to consume is 2/ 3 . How large is the

increase in aggregate demand?

a. $400

b. $800

c. $1,800

d. $3,600

5. If the central bank in the preceding question instead

holds the money supply constant and allows the interest

rate to adjust, the change in aggregate demand result-

ing from the increase in government purchases will be

a. larger.

b. the same.

c. smaller but still positive.

d. negative.

6. Which of the following is an example of an automatic

stabilizer? When the economy goes into a recession,

a. more people become eligible for unemployment

insurance benefits.

b. stock prices decline, particularly for firms in cycli-

cal industries.

c. Congress begins hearings about a possible stimu-

lus package.

d. the Federal Reserve changes its target for the fed-

eral funds rate.

short run. When Congress reduces government spending to balance the budget, it needs to consider both the long-run effects on saving and growth and the short- run effects on aggregate demand and employment. When the Fed reduces the growth rate of the money supply, it must take into account the long-run effect on inflation as well as the short-run effect on production. In all parts of government, policymakers must keep in mind both long-run and short-run goals.

• In developing a theory of short-run economic fluctu-

ations, Keynes proposed the theory of liquidity pref-

erence to explain the determinants of the interest rate.

According to this theory, the interest rate adjusts to bal-

ance the supply and demand for money.

• An increase in the price level raises money demand

and increases the interest rate that brings the money

market into equilibrium. Because the interest rate rep-

resents the cost of borrowing, a higher interest rate re-

duces investment and, thereby, the quantity of goods

and services demanded. The downward-sloping

aggregate-demand curve expresses this negative re-

lationship between the price level and the quantity

demanded.

• Policymakers can influence aggregate demand with

monetary policy. An increase in the money supply re-

duces the equilibrium interest rate for any given price

level. Because a lower interest rate stimulates invest-

ment spending, the aggregate-demand curve shifts to

the right. Conversely, a decrease in the money supply

raises the equilibrium interest rate for any given price

level and shifts the aggregate-demand curve to the left.

SUMMARY

760 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

theory of liquidity preference, p. 739

fiscal policy, p. 747

multiplier effect, p. 748

crowding-out effect, p. 751

automatic stabilizers, p. 758

KEY CONCEPTS

1. What is the theory of liquidity preference? How

does it help explain the downward slope of the

aggregate-demand curve?

2. Use the theory of liquidity preference to explain how

a decrease in the money supply affects the aggregate-

demand curve.

3. The government spends $3 billion to buy police cars.

Explain why aggregate demand might increase by

more or less than $3 billion.

4. Suppose that survey measures of consumer confidence

indicate a wave of pessimism is sweeping the country. If

policymakers do nothing, what will happen to aggregate

demand? What should the Fed do if it wants to stabi-

lize aggregate demand? If the Fed does nothing, what

might Congress do to stabilize aggregate demand?

5. Give an example of a government policy that acts as

an automatic stabilizer. Explain why the policy has

this effect.

1. Explain how each of the following developments

would affect the supply of money, the demand for

money, and the interest rate. Illustrate your answers

with diagrams.

a. The Fed’s bond traders buy bonds in open-market

operations.

b. An increase in credit-card availability reduces the

amount of cash people want to hold.

c. The Federal Reserve reduces banks’ reserve

requirements.

d. Households decide to hold more money to use for

holiday shopping.

e. A wave of optimism boosts business investment

and expands aggregate demand.

2. The Federal Reserve expands the money supply by

5 percent.

a. Use the theory of liquidity preference to illustrate

in a graph the impact of this policy on the interest

rate.

b. Use the model of aggregate demand and aggre-

gate supply to illustrate the impact of this change

in the interest rate on output and the price level in

the short run.

c. When the economy makes the transition from

its short-run equilibrium to its new long-run

equilibrium, what will happen to the price

level?

1 Wh t i th th f li idit f ? H 4 S th t f fid

1 E l i h h f th f ll i d l t 2 Th F d l R d th l b

QUESTIONS FOR REVIEW

PROBLEMS AND APPLICATIONS

• Policymakers can also influence aggregate demand

with fiscal policy. An increase in government pur-

chases or a cut in taxes shifts the aggregate-demand

curve to the right. A decrease in government purchases

or an increase in taxes shifts the aggregate-demand

curve to the left.

• When the government alters spending or taxes, the

resulting shift in aggregate demand can be larger

or smaller than the fiscal change. The multiplier ef-

fect tends to amplify the effects of fiscal policy on

aggregate demand. The crowding-out effect tends

to dampen the effects of fiscal policy on aggregate

demand.

• Because monetary and fiscal policy can influence

aggregate demand, the government sometimes uses

these policy instruments in an attempt to stabilize

the economy. Economists disagree about how active

the government should be in this effort. According

to advocates of active stabilization policy, changes in

attitudes by households and firms shift aggregate de-

mand; if the government does not respond, the result

is undesirable and unnecessary fluctuations in output

and employment. According to critics of active stabi-

lization policy, monetary and fiscal policy work with

such long lags that attempts at stabilizing the econ-

omy often end up being destabilizing.

761CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND

d. How will this change in the price level affect the

demand for money and the equilibrium interest

rate?

e. Is this analysis consistent with the proposition

that money has real effects in the short run but is

neutral in the long run?

3. Suppose a computer virus disables the nation’s auto-

matic teller machines, making withdrawals from bank

accounts less convenient. As a result, people want

to keep more cash on hand, increasing the demand

for money.

a. Assume the Fed does not change the money

supply. According to the theory of liquidity

preference, what happens to the interest rate?

What happens to aggregate demand?

b. If instead the Fed wants to stabilize aggregate

demand, how should it change the money

supply?

c. If it wants to accomplish this change in the money

supply using open-market operations, what

should it do?

4. Consider two policies—a tax cut that will last for

only one year and a tax cut that is expected to be

permanent. Which policy will stimulate greater

spending by consumers? Which policy will have

the greater impact on aggregate demand?

Explain.

5. The economy is in a recession with high unemploy-

ment and low output.

a. Draw a graph of aggregate demand and aggregate

supply to illustrate the current situation. Be sure

to include the aggregate-demand curve, the short-

run aggregate-supply curve, and the long-run

aggregate-supply curve.

b. Identify an open-market operation that would

restore the economy to its natural rate.

c. Draw a graph of the money market to illustrate

the effect of this open-market operation. Show the

resulting change in the interest rate.

d. Draw a graph similar to the one in part a to show the effect of the open-market operation on output

and the price level. Explain in words why the

policy has the effect that you have shown in the

graph.

6. In the early 1980s, new legislation allowed banks to

pay interest on checking deposits, which they could

not do previously.

a. If we define money to include checking deposits,

what effect did this legislation have on money

demand? Explain.

b. If the Federal Reserve had maintained a constant

money supply in the face of this change, what

would have happened to the interest rate? What

would have happened to aggregate demand and

aggregate output?

c. If the Federal Reserve had maintained a constant

market interest rate (the interest rate on nonmone-

tary assets) in the face of this change, what change

in the money supply would have been necessary?

What would have happened to aggregate demand

and aggregate output?

7. Suppose economists observe that an increase in

government spending of $10 billion raises the total

demand for goods and services by $30 billion.

a. If these economists ignore the possibility of

crowding out, what would they estimate the mar-

ginal propensity to consume (MPC) to be? b. Now suppose the economists allow for crowding

out. Would their new estimate of the MPC be larger or smaller than their initial one?

8. An economy is operating with output that is $400

billion below its natural level, and fiscal policymakers

want to close this recessionary gap. The central bank

agrees to adjust the money supply to hold the interest

rate constant, so there is no crowding out. The mar-

ginal propensity to consume is 4/ 5 , and the price level

is completely fixed in the short run. In what direction

and by how much would government spending need

to change to close the recessionary gap? Explain your

thinking.

9. Suppose government spending increases. Would the

effect on aggregate demand be larger if the Federal

Reserve held the money supply constant in response

or if the Fed were committed to maintaining a fixed

interest rate? Explain.

10. In which of the following circumstances is expan-

sionary fiscal policy more likely to lead to a short-run

increase in investment? Explain.

a. When the investment accelerator is large or when

it is small?

b. When the interest sensitivity of investment is large

or when it is small?

11. Consider an economy described by the following

equations:

Y = C + I + G

C = 100 + 0.75(Y − T)

I = 500 – 50 r

G = 125

T = 100

where Y is GDP, C is consumption, I is invest- ment, G is government purchases, T is taxes, and r is the interest rate. If the economy were at full

762 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

employment (that is, at its natural rate), GDP would

be 2,000.

a. Explain the meaning of each of these equations.

b. What is the marginal propensity to consume in

this economy?

c. Suppose the central bank’s policy is to adjust

the money supply to maintain the interest rate

at 4 percent, so r = 4. Solve for GDP. How does it compare to the full-employment level?

d. Assuming no change in monetary policy, what

change in government purchases would restore

full employment?

e. Assuming no change in fiscal policy, what

change in the interest rate would restore full

employment?

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

763

CHAPTER

35 The Short-Run Trade-off between Inflation and Unemployment

T wo closely watched indicators of economic performance are inflation and unemployment. When the Bureau of Labor Statistics releases data on these variables each month, policymakers are eager to hear the news. Some com-

mentators have added together the inflation rate and the unemployment rate to produce a misery index, which they use to gauge the health of the economy.

How are these two measures of economic performance related to each other? Earlier in the book, we discussed the long-run determinants of unemployment and the long-run determinants of inflation. We saw that the natural rate of

764 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

unemployment depends on various features of the labor market, such as mini- mum-wage laws, the market power of unions, the role of efficiency wages, and the effectiveness of job search. By contrast, the inflation rate depends primarily on growth in the money supply, which a nation’s central bank controls. In the long run, therefore, inflation and unemployment are largely unrelated problems.

In the short run, just the opposite is true. One of the Ten Principles of Economics discussed in Chapter 1 is that society faces a short-run trade-off between infla- tion and unemployment. If monetary and fiscal policymakers expand aggregate demand and move the economy up along the short-run aggregate-supply curve, they can expand output and reduce unemployment for a while, but only at the cost of a more rapidly rising price level. If policymakers contract aggregate de- mand and move the economy down the short-run aggregate-supply curve, they can reduce inflation, but only at the cost of temporarily lower output and higher unemployment.

In this chapter, we examine the inflation–unemployment trade-off more closely. The relationship between inflation and unemployment has attracted the attention of some of the most brilliant economists of the last half century. The best way to understand this relationship is to see how thinking about it has evolved. As we will see, the history of thought regarding inflation and unemployment since the 1950s is inextricably connected to the history of the U.S. economy. These two his- tories will show why the trade-off between inflation and unemployment holds in the short run, why it does not hold in the long run, and what issues the trade-off raises for economic policymakers.

35-1 The Phillips Curve “Probably the single most important macroeconomic relationship is the Phillips curve.” These are the words of economist George Akerlof from the lecture he gave when he received the Nobel Prize in 2001. The Phillips curve is the short-run relationship between inflation and unemployment. We begin our story with the discovery of the Phillips curve and its migration to America.

35-1a Origins of the Phillips Curve In 1958, economist A. W. Phillips published an article in the British journal Economica that would make him famous. The article was titled “The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom, 1861–1957.” In it, Phillips showed a negative correlation between the rate of unemployment and the rate of inflation. That is, Phillips showed that years with low unemployment tend to have high inflation, and years with high unemployment tend to have low inflation. (Phillips examined inflation in nominal wages rather than inflation in prices. For our purposes, the distinction is not important because these two measures of inflation usually move together.) Phillips concluded that two important macroeconomic variables—inflation and unemployment—were linked in a way that economists had not previously appreciated.

Although Phillips’s discovery was based on data for the United Kingdom, researchers quickly extended his finding to other countries. Two years after Phillips published his article, economists Paul Samuelson and Robert Solow published an article in the American Economic Review called “Analytics of Anti- Inflation Policy” in which they showed a similar negative correlation between inflation and unemployment in data for the United States. They reasoned that this

Phillips curve

a curve that shows

the short-run trade-off

between inflation and

unemployment

765CHAPTER 35 THE SHORT-RUN TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT

correlation arose because low unemployment was associated with high aggregate demand, which in turn put upward pressure on wages and prices throughout the economy. Samuelson and Solow dubbed the negative association between inflation and unemployment the Phillips curve. Figure 1 shows an example of a Phillips curve like the one found by Samuelson and Solow.

As the title of their paper suggests, Samuelson and Solow were interested in the Phillips curve because they believed it held important lessons for policymak- ers. In particular, they suggested that the Phillips curve offers policymakers a menu of possible economic outcomes. By altering monetary and fiscal policy to influence aggregate demand, policymakers could choose any point on this curve. Point A offers high unemployment and low inflation. Point B offers low unem- ployment and high inflation. Policymakers might prefer both low inflation and low unemployment, but the historical data as summarized by the Phillips curve indicate that this combination is impossible. According to Samuelson and Solow, policymakers face a trade-off between inflation and unemployment, and the Phil- lips curve illustrates that trade-off.

35-1b Aggregate Demand, Aggregate Supply, and the Phillips Curve

The model of aggregate demand and aggregate supply provides an easy expla- nation for the menu of possible outcomes described by the Phillips curve. The Phillips curve shows the combinations of inflation and unemployment that arise in the short run as shifts in the aggregate-demand curve move the economy along the short-run aggregate-supply curve. As we saw in the preceding two chapters, an increase in the aggregate demand for goods and services leads, in the short run, to a larger out- put of goods and services and a higher price level. Larger output means greater employment and, thus, a lower rate of unemployment. In addition, a higher price level translates into a higher rate of inflation. Thus, shifts in aggregate demand push inflation and unemployment in opposite directions in the short run—a relationship illustrated by the Phillips curve.

To see more fully how this works, let’s consider an example. To keep the numbers simple, imagine that the price level (as measured, for instance, by the

FIGURE 1

The Phillips Curve

The Phillips curve illustrates a negative

association between the inflation rate and

the unemployment rate. At point A, inflation

is low and unemployment is high. At point B,

inflation is high and unemployment is low.

Unemployment Rate (percent)

0 4% 7%

Inflation Rate

(percent per year)

Phillips curve

766 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

consumer price index) equals 100 in the year 2020. Figure 2 shows two possible outcomes that might occur in the year 2021 depending of the strength of aggre- gate demand. One outcome occurs if aggregate demand is high, and the other occurs if aggregate demand is low. Panel (a) shows these two outcomes using the model of aggregate demand and aggregate supply. Panel (b) illustrates the same two outcomes using the Phillips curve.

Panel (a) of the figure shows what happens to output and the price level in the year 2021. If the aggregate demand for goods and services is low, the economy experiences outcome A. The economy produces output of 15,000, and the price level is 102. By contrast, if aggregate demand is high, the economy experiences outcome B. Output is 16,000, and the price level is 106. This is an example of a familiar conclusion: Higher aggregate demand moves the economy to an equilib- rium with higher output and a higher price level.

Panel (b) shows what these two possible outcomes mean for unemployment and inflation. Because firms need more workers when they produce a greater output of goods and services, unemployment is lower in outcome B than in outcome A. In this example, when output rises from 15,000 to 16,000, unemployment falls from 7 percent to 4 percent. Moreover, because the price level is higher at outcome B than at outcome A, the inflation rate (the percentage change in the price level from the previous year) is also higher. In particular, since the price level was 100 in the year 2020, outcome A has an inflation rate of 2 percent and outcome B has an inflation rate of 6 percent. The two possible outcomes for the economy can be compared either in terms of output and the price level (using the model of

FIGURE 2

How the Phillips Curve Is Related

to the Model of Aggregate Demand

and Aggregate Supply

Unemployment Rate (percent)

Inflation Rate

(percent per year)

(b) The Phillips Curve

4% (output is 16,000)

7% (output is 15,000)

Phillips curve

Quantity of Output

16,00015,0000

106

102

Short-run aggregate

supply

(a) The Model of Aggregate Demand and Aggregate Supply

Price Level

Low aggregate demand

High aggregate demand

(unemployment is 7%)

(unemployment is 4%)

This figure assumes a price level of 100 for the year 2020 and charts possible out-

comes for the year 2021. Panel (a) shows the model of aggregate demand and ag-

gregate supply. If aggregate demand is low, the economy is at point A; output is low

(15,000), and the price level is low (102). If aggregate demand is high, the economy

is at point B; output is high (16,000), and the price level is high (106). Panel (b)

shows the implications for the Phillips curve. Point A, which arises when aggregate

demand is low, has high unemployment (7 percent) and low inflation (2 percent).

Point B, which arises when aggregate demand is high, has low unemployment

(4 percent) and high inflation (6 percent).

767CHAPTER 35 THE SHORT-RUN TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT

aggregate demand and aggregate supply) or in terms of unemployment and infla- tion (using the Phillips curve).

Because monetary and fiscal policy can shift the aggregate-demand curve, they can move an economy along the Phillips curve. Increases in the money supply, increases in government spending, or cuts in taxes expand aggregate demand and move the economy to a point on the Phillips curve with higher inflation and lower unemployment. Decreases in the money supply, cuts in government spend- ing, or increases in taxes contract aggregate demand and move the economy to a point on the Phillips curve with lower inflation and higher unemployment. In this sense, the Phillips curve offers policymakers a menu of combinations of inflation and unemployment.

QuickQuiz Draw the Phillips curve. Use the model of aggregate demand and aggre-

gate supply to show how policy can move the economy from a point on

this curve with high inflation to a point with low inflation.

Although the Phillips curve seems to offer policymakers a menu of inflation– unemployment outcomes, it raises a crucial question: Does this set of possible choices remain the same over time? In other words, is the downward-sloping Phillips curve a stable relationship on which policymakers can rely? Economists took up this issue in the late 1960s, shortly after Samuelson and Solow had intro- duced the Phillips curve into the macroeconomic policy debate.

35-2a The Long-Run Phillips Curve In 1968, economist Milton Friedman published a paper in the American Economic Review based on an address he had recently given as president of the American Economic Association. The paper, titled “The Role of Monetary Policy,” contained sections on “What Monetary Policy Can Do” and “What Monetary Policy Cannot Do.” Friedman argued that one thing monetary policy cannot do, other than for a short time, is lower unemployment by raising inflation. At about the same time, another economist, Edmund Phelps, also published a paper denying the existence of a long-run trade-off between inflation and unemployment.

Both Friedman and Phelps based their conclusions on classical principles of macroeconomics. Classical theory points to growth in the money supply as the primary determinant of inflation. But classical theory also states that monetary growth does not affect real variables such as output and employment; it merely alters all prices and nominal incomes proportionately. In particular, monetary growth does not influence those factors that determine the economy’s unemploy- ment rate, such as the market power of unions, the role of efficiency wages, or the process of job search. As a result, Friedman and Phelps concluded that, in the long run, the rate of inflation and the rate of unemployment would not be related.

Here, in his own words, is Friedman’s view about what the Federal Reserve can hope to accomplish for the economy in the long run:

The monetary authority controls nominal quantities—directly, the quantity of its own liabilities [currency plus bank reserves]. In principle, it can use this control to peg a nominal quantity—an exchange rate, the price level, the nominal level of national income, the quantity of money by one definition or another—or to peg the change in a nominal quantity—the rate of inflation or deflation, the

35-2 Shifts in the Phillips Curve: The Role of Expectations

768 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

rate of growth or decline in nominal national income, the rate of growth of the quantity of money. It cannot use its control over nominal quantities to peg a real quantity—the real rate of interest, the rate of unemployment, the level of real national income, the real quantity of money, the rate of growth of real national income, or the rate of growth of the real quantity of money.

According to Friedman, monetary policymakers face a long-run Phillips curve that is vertical, as in Figure 3. If the Fed increases the money supply slowly, the inflation rate is low and the economy finds itself at point A. If the Fed increases the money supply quickly, the inflation rate is high and the economy finds itself at point B. In either case, the unemployment rate tends toward its normal level, called the natural rate of unemployment. The vertical long-run Phillips curve illus- trates the conclusion that unemployment does not depend on money growth and inflation in the long run.

The vertical long-run Phillips curve is, in essence, one expression of the clas- sical idea of monetary neutrality. Previously, we expressed monetary neutrality with a vertical long-run aggregate-supply curve. Figure 4 shows that the verti- cal long-run Phillips curve and the vertical long-run aggregate-supply curve are two sides of the same coin. In panel (a) of this figure, an increase in the money supply shifts the aggregate-demand curve to the right from AD1 to AD2. As a result of this shift, the long-run equilibrium moves from point A to point B. The price level rises from P1 to P2, but because the aggregate-supply curve is ver- tical, output remains the same. In panel (b), more rapid growth in the money supply raises the inflation rate by moving the economy from point A to point B. But because the Phillips curve is vertical, the rate of unemployment is the same at these two points. Thus, the vertical long-run aggregate-supply curve and the vertical long-run Phillips curve both imply that monetary policy influences nominal variables (the price level and the inflation rate) but not real variables (output and unemployment). In the long run, regardless of the monetary policy pursued by the Fed, output is at its natural level and unemployment is at its natural rate.

FIGURE 3

The Long-Run Phillips Curve

According to Friedman and Phelps,

there is no trade-off between inflation

and unemployment in the long run.

Growth in the money supply deter-

mines the inflation rate. Regardless of

the inflation rate, the unemployment

rate gravitates toward its natural rate.

As a result, the long-run Phillips curve

is vertical.

Unemployment Rate

0 Natural rate of unemployment

Inflation Rate

Long-run Phillips curve

High inflation

Low inflation

2. . . . but unemployment remains at its natural rate in the long run.

1. When the Fed increases the growth rate of the money supply, the rate of inflation increases . . .

769CHAPTER 35 THE SHORT-RUN TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT

35-2b The Meaning of “Natural” What is so “natural” about the natural rate of unemployment? Friedman and Phelps used this adjective to describe the unemployment rate toward which the economy gravitates in the long run. Yet the natural rate of unemployment is not necessarily the socially desirable rate of unemployment. Nor is the natural rate of unemployment constant over time.

For example, suppose that a newly formed union uses its market power to raise the real wages of some workers above the equilibrium level. The result is an excess supply of workers and, therefore, a higher natural rate of unemployment. This unemployment is natural not because it is good but because it is beyond the influence of monetary policy. More rapid money growth would reduce neither the market power of the union nor the level of unemployment; it would lead only to more inflation.

Although monetary policy cannot influence the natural rate of unemployment, other types of policy can. To reduce the natural rate of unemployment, policy- makers should look to policies that improve the functioning of the labor mar- ket. Earlier in the book, we discussed how various labor-market policies, such as minimum-wage laws, collective-bargaining laws, unemployment insurance, and job-training programs, affect the natural rate of unemployment. A policy change that reduced the natural rate of unemployment would shift the long-run Phillips curve to the left. In addition, because lower unemployment means more workers are producing goods and services, the quantity of goods and services supplied would be larger at any given price level and the long-run aggregate-supply curve

FIGURE 4

How the Long-Run Phillips Curve Is

Related to the Model of Aggregate

Demand and Aggregate Supply

Quantity of Output

Natural level of output

Natural rate of unemployment

Price Level

Aggregate demand, AD1

Long-run aggregate supply

Long-run Phillips curve

(a) The Model of Aggregate Demand and Aggregate Supply

Unemployment Rate

Inflation Rate

(b) The Phillips Curve

2. . . . raises the price level . . .

1. An increase in the money supply increases aggregate demand . . .

A AD2

4. . . . but leaves output at its natural level and unemployment at its natural rate.

3. . . . and increases the inflation rate . . .

Panel (a) shows the model of aggregate demand and aggregate supply with a vertical

aggregate-supply curve. When expansionary monetary policy shifts the aggregate-

demand curve to the right from AD1 to AD2, the equilibrium moves from point A

to point B. The price level rises from P1 to P2, while output remains the same. Panel (b)

shows the long-run Phillips curve, which is vertical at the natural rate of unem-

ployment. In the long run, expansionary monetary policy moves the economy from

lower inflation (point A) to higher inflation (point B) without changing the rate of

unemployment.

770 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

would shift to the right. The economy could then enjoy lower unemployment and higher output for any given rate of money growth and inflation.

35-2c Reconciling Theory and Evidence At first, Friedman and Phelps’s conclusion that there is no long-run trade-off between inflation and unemployment might not seem persuasive. Their argument was based on an appeal to theory, specifically classical theory’s prediction of monetary neutrality. By contrast, the negative correlation between inflation and unemployment documented by Phillips, Samuelson, and Solow was based on actual evidence from the real world. Why should anyone believe that policymakers faced a vertical Phillips curve when the world seemed to offer a downward- sloping one? Shouldn’t the findings of Phillips, Samuelson, and Solow lead us to reject monetary neutrality?

Friedman and Phelps were well aware of these questions, and they offered a way to reconcile classical macroeconomic theory with the finding of a down- ward-sloping Phillips curve in data from the United Kingdom and the United States. They claimed that a negative relationship between inflation and unem- ployment exists in the short run but that it cannot be used by policymakers as a menu of outcomes in the long run. Policymakers can pursue expansionary monetary policy to achieve lower unemployment for a while, but eventually, unemployment will return to its natural rate. In the long run, more expansionary monetary policy leads only to higher inflation.

Friedman and Phelps’s work was the basis of our discussion of the difference between the short-run and long-run aggregate-supply curves in Chapter 33. As you may recall, the long-run aggregate-supply curve is vertical, indicating that the price level does not influence quantity supplied in the long run. But the short-run aggregate-supply curve slopes upward, indicating that an increase in the price level raises the quantity of goods and services that firms supply. According to the sticky-wage theory of aggregate supply, for instance, nominal wages are set in advance based on the price level that workers and firms expected to prevail. When prices are higher than expected, firms have an incentive to increase production and employment; when prices are lower than expected, firms reduce production and employment. Yet because the expected price level and nominal wages will even- tually adjust, the positive relationship between the actual price level and quantity supplied exists only in the short run.

Friedman and Phelps applied this same logic to the Phillips curve. Just as the aggregate-supply curve slopes upward only in the short run, the trade-off between inflation and unemployment holds only in the short run. And just as the long-run aggregate-supply curve is vertical, the long-run Phillips curve is also vertical. Once again, expectations are the key for understanding how the short run and the long run are related.

Friedman and Phelps introduced a new variable into the analysis of the inflation–unemployment trade-off: expected inflation. Expected inflation measures how much people expect the overall price level to change. Because the expected price level affects nominal wages, expected inflation is one factor that determines the position of the short-run aggregate-supply curve. In the short run, the Fed can take expected inflation (and, thus, the short-run aggregate-supply curve) as already determined. When the money supply changes, the aggregate-demand curve shifts and the economy moves along a given short-run aggregate-supply curve. In the short run, therefore, monetary changes lead to unexpected fluctua- tions in output, prices, unemployment, and inflation. In this way, Friedman and

771CHAPTER 35 THE SHORT-RUN TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT

Phelps explained the downward-sloping Phillips curve that Phillips, Samuelson, and Solow had documented.

The Fed’s ability to create unexpected inflation by increasing the money supply exists only in the short run. In the long run, people come to expect whatever inflation rate the Fed chooses to produce and nominal wages will adjust to keep pace with inflation. As a result, the long-run aggregate-supply curve is vertical. Changes in aggregate demand, such as those due to changes in the money supply, affect neither the economy’s output of goods and services nor the number of workers that firms need to hire to produce those goods and services. Friedman and Phelps concluded that unemployment returns to its nat- ural rate in the long run.

35-2d The Short-Run Phillips Curve The analysis of Friedman and Phelps can be summarized by the following equation:

Unemployment Natural rate of Actual Expected rate

= unemployment

− a inflation

− inflation

This equation (which is, in essence, another expression of the aggregate-supply equation we have seen previously) relates the unemployment rate to the natural rate of unemployment, actual inflation, and expected inflation. In the short run, expected inflation is given, so higher actual inflation is associated with lower unemployment. (The variable a is a parameter that measures how much unem- ployment responds to unexpected inflation.) In the long run, people come to expect whatever inflation the Fed produces, so actual inflation equals expected inflation, and unemployment is at its natural rate.

This equation implies there can be no stable short-run Phillips curve. Each short-run Phillips curve reflects a particular expected rate of inflation. (To be pre- cise, if you graph the equation, you’ll find that the downward-sloping short-run Phillips curve intersects the vertical long-run Phillips curve at the expected rate of inflation.) When expected inflation changes, the short-run Phillips curve shifts.

According to Friedman and Phelps, it is dangerous to view the Phillips curve as a menu of options available to policymakers. To see why, imagine an economy that starts with low inflation, with an equally low rate of expected inflation, and with unemployment at its natural rate. In Figure 5, the economy is at point A. Now suppose that policymakers try to take advantage of the trade-off between inflation and unemployment by using monetary or fiscal policy to expand aggregate demand. In the short run, when expected inflation is given, the econ- omy goes from point A to point B. Unemployment falls below its natural rate, and the actual inflation rate rises above expected inflation. As the economy moves from point A to point B, policymakers might think they have achieved perma- nently lower unemployment at the cost of higher inflation—a bargain that, if pos- sible, might be worth making.

This situation, however, will not persist. Over time, people get used to this higher inflation rate, and they raise their expectations of inflation. When expected inflation rises, firms and workers start taking higher inflation into account when setting wages and prices. The short-run Phillips curve then shifts to the right, as shown in the figure. The economy ends up at point C, with higher inflation than at point A but with the same level of unemployment. Thus, Friedman and Phelps concluded that policymakers face only a temporary trade-off between inflation

a b

772 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

and unemployment. In the long run, expanding aggregate demand more rapidly will yield higher inflation without any reduction in unemployment.

35-2e The Natural Experiment for the Natural-Rate Hypothesis Friedman and Phelps had made a bold prediction in 1968: If policymakers try to take advantage of the Phillips curve by choosing higher inflation to reduce unemployment, they will succeed at reducing unemployment only temporarily. This view—that unemployment eventually returns to its natural rate, regardless of the rate of inflation—is called the natural-rate hypothesis. A few years after Friedman and Phelps proposed this hypothesis, monetary and fiscal policy- makers inadvertently created a natural experiment to test it. Their laboratory was the U.S. economy.

Before we examine the outcome of this test, however, let’s look at the data that Friedman and Phelps had when they made their prediction in 1968. Figure 6 shows the unemployment and inflation rates for the period from 1961 to 1968. These data trace out an almost perfect Phillips curve. As inflation rose over these 8 years, unemployment fell. The economic data from this era seemed to confirm that policymakers faced a trade-off between inflation and unemployment.

The apparent success of the Phillips curve in the 1960s made the prediction of Friedman and Phelps all the bolder. In 1958, Phillips had suggested a negative association between inflation and unemployment. In 1960, Samuelson and Solow had shown that it existed in U.S. data. Another decade of data had confirmed the relationship. To some economists at the time, it seemed ridiculous to claim that the historically reliable Phillips curve would start shifting once policymakers tried to take advantage of it.

In fact, that is exactly what happened. Beginning in the late 1960s, the govern- ment followed policies that expanded the aggregate demand for goods and ser- vices. In part, this expansion was due to fiscal policy: Government spending rose as the Vietnam War heated up. In part, it was due to monetary policy: Because the

natural-rate hypothesis

the claim that unemploy-

ment eventually returns

to its normal, or natural,

rate, regardless of the

rate of inflation

FIGURE 5

How Expected Inflation Shifts the

Short-Run Phillips Curve

The higher the expected rate of inflation, the

higher the curve representing the short-run

trade-off between inflation and unemploy-

ment. At point A, expected inflation and

actual inflation are equal at a low rate and

unemployment is at its natural rate. If the Fed

pursues an expansionary monetary policy, the

economy moves from point A to point B in

the short run. At point B, expected inflation

is still low, but actual inflation is high. Unem-

ployment is below its natural rate. In the long

run, expected inflation rises, and the economy

moves to point C. At point C, expected infla-

tion and actual inflation are both high, and

unemployment is back to its natural rate.

Unemployment Rate

0 Natural rate of unemployment

Inflation Rate

C B

Long-run Phillips curve

Short-run Phillips curve with high expected

inflation

Short-run Phillips curve with low expected

inflation

1. Expansionary policy moves the economy up along the short-run Phillips curve . . .

2. . . . but in the long run, expected inflation rises, and the short-run Phillips curve shifts to the right.

773CHAPTER 35 THE SHORT-RUN TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT

Fed was trying to hold down interest rates in the face of expansionary fiscal pol- icy, the money supply (as measured by M2) rose about 13 percent per year during the period from 1970 to 1972, compared to 7 percent per year in the early 1960s. As a result, inflation stayed high (about 5 to 6 percent per year in the late 1960s and early 1970s, compared to about 1 to 2 percent per year in the early 1960s). But as Friedman and Phelps had predicted, unemployment did not stay low.

Figure 7 displays the history of inflation and unemployment from 1961 to 1973. It shows that the simple negative relationship between these two variables started to break down around 1970. In particular, as inflation remained high in the early 1970s, people’s expectations of inflation caught up with reality, and the unem- ployment rate reverted to the 5 percent to 6 percent range that had prevailed in the early 1960s. Notice that the history illustrated in Figure 7 resembles the theory of a shifting short-run Phillips curve shown in Figure 5. By 1973, policymakers had learned that Friedman and Phelps were right: There is no trade-off between inflation and unemployment in the long run.

QuickQuiz Draw the short-run Phillips curve and the long-run Phillips curve. Explain

why they are different.

FIGURE 6

The Phillips Curve in the 1960s

This figure uses annual data from 1961 to

1968 on the unemployment rate and on

the inflation rate (as measured by the GDP

deflator) to show the negative relationship

between inflation and unemployment.

Source: U.S. Department of Labor; U.S. Department of Commerce.

Unemployment Rate (percent)

Inflation Rate (percent per year)

1968

1966

1961 1962

1963

1967

1965 1964

1% 2 3 4 5 6 7 8 9 100

10%

35-3 Shifts in the Phillips Curve: The Role of Supply Shocks Friedman and Phelps had suggested in 1968 that changes in expected inflation shift the short-run Phillips curve, and the experience of the early 1970s convinced most economists that Friedman and Phelps were right. Within a few years, how- ever, the economics profession would turn its attention to a different source of shifts in the short-run Phillips curve: shocks to aggregate supply.

This time, the change in focus came not from two American economics pro- fessors but from a group of Arab sheiks. In 1974, the Organization of Petroleum

774 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

Exporting Countries (OPEC) began to exert its market power as a cartel in the world oil market to increase its members’ profits. The countries of OPEC, including Saudi Arabia, Kuwait, and Iraq, restricted the amount of crude oil they pumped and sold on world markets. Within a few years, this reduction in supply caused the world price of oil to almost double.

A large increase in the world price of oil is an example of a supply shock. A supply shock is an event that directly affects firms’ costs of production and thus the prices they charge; it shifts the economy’s aggregate-supply curve and, as a result, the Phillips curve. For example, when an oil price increase raises the cost of producing gasoline, heating oil, tires, and many other products, it reduces the quantity of goods and services supplied at any given price level. As panel (a) of Figure 8 shows, this reduction in supply is represented by the leftward shift in the aggregate-supply curve from AS1 to AS2. Output falls from Y1 to Y2, and the price level rises from P1 to P2. The economy experiences stagflation—the combination of falling output (stagnation) and rising prices (inflation).

This shift in aggregate supply is associated with a similar shift in the short- run Phillips curve, shown in panel (b). Because firms need fewer workers to pro- duce the smaller output, employment falls and unemployment rises. Because the price level is higher, the inflation rate—the percentage change in the price level from the previous year—is also higher. Thus, the shift in aggregate supply leads to higher unemployment and higher inflation. The short-run trade-off between inflation and unemployment shifts to the right from PC1 to PC2.

Confronted with an adverse shift in aggregate supply, policymakers face a dif- ficult choice between fighting inflation and fighting unemployment. If they con- tract aggregate demand to fight inflation, they will raise unemployment further. If they expand aggregate demand to fight unemployment, they will raise inflation further. In other words, policymakers face a less favorable trade-off between infla- tion and unemployment than they did before the shift in aggregate supply: They

supply shock

an event that directly

alters firms’ costs and

prices, shifting the econ-

omy’s aggregate-supply

curve and thus the

Phillips curve

FIGURE 7

The Breakdown of the Phillips Curve

This figure shows annual data from 1961 to

1973 on the unemployment rate and on the

inflation rate (as measured by the GDP defla-

tor). The Phillips curve of the 1960s breaks

down in the early 1970s, just as Friedman

and Phelps had predicted. Notice that the

points labeled A, B, and C in this figure corre-

spond roughly to the points in Figure 5.

Source: U.S. Department of Labor; U.S. Department of Commerce.

Unemployment Rate (percent)

Inflation Rate (percent per year)

1973

1966

1972

1971

1961 1962

1963

1967

1968 1969 1970

1965 1964

1% 2 3 4 5 6 7 8 9 100

10%

B C

775CHAPTER 35 THE SHORT-RUN TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT

have to live with a higher rate of inflation for a given rate of unemployment, a higher rate of unemployment for a given rate of inflation, or some combination of higher unemployment and higher inflation.

Faced with such an adverse shift in the Phillips curve, policymakers will ask whether the shift is temporary or permanent. The answer depends on how people adjust their expectations of inflation. If people view the rise in inflation due to the supply shock as a temporary aberration, expected inflation will not change and the Phillips curve will soon revert to its former position. But if people believe the shock will lead to a new era of higher inflation, then expected inflation will rise and the Phillips curve will remain at its new, less desirable position.

In the United States during the 1970s, expected inflation did rise substantially. This rise in expected inflation was partly attributable to the Fed’s decision to accommodate the supply shock with higher money growth. (Recall that policymakers are said to accommodate an adverse supply shock when they respond to it by increasing aggregate demand in an effort to keep output from falling.) Because of this policy decision, the recession that resulted from the supply shock was smaller than it otherwise might have been, but the U.S. economy faced an unfavorable trade-off between inflation and unemployment for many years. The problem was compounded in 1979 when OPEC once again started to exert its market power, more than doubling the price of oil. Figure 9 shows inflation and unemployment in the U.S. economy during this period.

In 1980, after two OPEC supply shocks, the U.S. economy had an inflation rate of more than 9 percent and an unemployment rate of about 7 percent. This combination of inflation and unemployment was not at all near the trade-off that seemed possible in the 1960s. (In the 1960s, the Phillips curve suggested that an

FIGURE 8

An Adverse Shock to

Aggregate Supply

Quantity of Output

Price Level

Aggregate demand

(a) The Model of Aggregate Demand and Aggregate Supply

Unemployment Rate

Inflation Rate

(b) The Phillips Curve

3. . . . and raises the price level . . .

AS2 Aggregate supply, AS1

1. An adverse shift in aggregate supply . . .

2. . . . lowers output . . .

4. . . . giving policymakers a less favorable trade-off between unemployment and inflation.

Y2 Y1

PC2

Phillips curve, PC 1

Panel (a) shows the model of aggregate demand and aggregate supply. When the

aggregate-supply curve shifts to the left from AS1 to AS2, the equilibrium moves from point A

to point B. Output falls from Y1 to Y2, and the price level rises from P1 to P2. Panel (b) shows

the short-run trade-off between inflation and unemployment. The adverse shift in aggregate

supply moves the economy from a point with lower unemployment and lower inflation

(point A) to a point with higher unemployment and higher inflation (point B). The short-

run Phillips curve shifts to the right from PC1 to PC2. Policymakers now face a worse set of

options for inflation and unemployment.

776 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

unemployment rate of 7 percent would be associated with an inflation rate of only 1 percent. Inflation of more than 9 percent was unthinkable.) With the misery index in 1980 near a historic high, the public was widely dissatisfied with the per- formance of the economy. Largely because of this dissatisfaction, President Jimmy Carter lost his bid for reelection in November 1980 and was replaced by Ronald Reagan. Something had to be done, and soon it would be.

QuickQuiz Give an example of a favorable shock to aggregate supply. Use the model

of aggregate demand and aggregate supply to explain the effects of such

a shock. How does it affect the Phillips curve?

35-4 The Cost of Reducing Inflation In October 1979, as OPEC was imposing adverse supply shocks on the world’s economies for the second time in a decade, Fed Chairman Paul Volcker decided that the time for action had come. Volcker had been appointed chairman by President Carter only two months earlier, and he had taken the job knowing that inflation had reached unacceptable levels. As guardian of the nation’s monetary system, he felt he had little choice but to pursue a policy of disinflation. Disinflation is a reduction in the rate of inflation, and it should not be confused with deflation, a reduction in the price level. To draw an analogy to a car’s motion, disinflation is like slowing down, whereas deflation is like going in reverse. Chairman Volcker, along with many other Americans, wanted the economy’s rising level of prices to slow down.

Volcker had no doubt that the Fed could reduce inflation through its ability to control the quantity of money. But what would be the short-run cost of disinfla- tion? The answer to this question was much less certain.

FIGURE 9

The Supply Shocks of the 1970s

This figure shows annual data from 1972

to 1981 on the unemployment rate and on

the inflation rate (as measured by the GDP

deflator). In the periods 1973–1975 and

1978–1981, increases in world oil prices led

to higher inflation and higher unemployment.

Source: U.S. Department of Labor; U.S. Department of Commerce.

Unemployment Rate (percent)

Inflation Rate (percent per year)

1972

19751981

1976

1978

1979

1980

1973

1974

1977

1% 2 3 4 5 6 7 8 9 100

10%

777CHAPTER 35 THE SHORT-RUN TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT

35-4a The Sacrifice Ratio To reduce the inflation rate, the Fed has to pursue contractionary monetary policy. Figure 10 shows some of the effects of such a decision. When the Fed slows the rate at which the money supply is growing, it contracts aggregate demand. The fall in aggregate demand, in turn, reduces the quantity of goods and services that firms produce, and this fall in production leads to a rise in unemployment. The economy begins at point A in the figure and moves along the short-run Phillips curve to point B, which has lower inflation and higher unemployment. Over time, as people come to understand that prices are rising more slowly, expected infla- tion falls, and the short-run Phillips curve shifts downward. The economy moves from point B to point C. Inflation is lower than it was initially at point A, and unemployment is back at its natural rate.

Thus, if a nation wants to reduce inflation, it must endure a period of high unemployment and low output. In Figure 10, this cost is represented by the move- ment of the economy through point B as it travels from point A to point C. The size of this cost depends on the slope of the Phillips curve and how quickly expec- tations of inflation adjust to the new monetary policy.

Many studies have examined the data on inflation and unemployment to estimate the cost of reducing inflation. The findings of these studies are often summarized in a statistic called the sacrifice ratio. The sacrifice ratio is the num- ber of percentage points of annual output lost in the process of reducing inflation by 1 percentage point. A typical estimate of the sacrifice ratio is 5. That is, for each percentage point that inflation is reduced, 5 percent of annual output must be sac- rificed in the transition.

Such estimates surely must have made Paul Volcker apprehensive as he con- fronted the task of reducing inflation. Inflation was running at almost 10 percent per year. To reach moderate inflation of, say, 4 percent per year would mean re- ducing inflation by 6 percentage points. If each percentage point costs 5 percent

sacrifice ratio

the number of percentage

points of annual output

lost in the process of

reducing inflation by

1 percentage point

FIGURE 10

Disinflationary Monetary Policy

in the Short Run and Long Run

When the Fed pursues contractionary

monetary policy to reduce inflation,

the economy moves along a short-run

Phillips curve from point A to point B.

Over time, expected inflation falls,

and the short-run Phillips curve shifts

downward. When the economy reaches

point C, unemployment is back at its

natural rate.

Unemployment Rate

0 Natural rate of unemployment

Inflation Rate

Long-run Phillips curve

Short-run Phillips curve with high expected

inflation

Short-run Phillips curve with low expected

inflation

1. Contractionary policy moves the economy down along the short-run Phillips curve . . .

2. . . . but in the long run, expected inflation falls, and the short-run Phillips curve shifts to the left.

778 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

of the economy’s annual output, then reducing inflation by 6 percentage points would require sacrificing 30 percent of annual output.

According to studies of the Phillips curve and the cost of disinflation, this sac- rifice could be paid in various ways. An immediate reduction in inflation would depress output by 30 percent for a single year, but that outcome was surely too harsh even for an inflation hawk like Paul Volcker. It would be better, many argued, to spread out the cost over several years. If the reduction in inflation took place over 5 years, for instance, then output would have to average only 6 percent below trend during that period to add up to a sacrifice of 30 percent. An even more gradual approach would be to reduce inflation slowly over a decade so that output would have to be only 3 percent below trend. Whatever path was chosen, however, it seemed that reducing inflation would not be easy.

35-4b Rational Expectations and the Possibility of Costless Disinflation

Just as Paul Volcker was pondering how costly reducing inflation might be, a group of economics professors was leading an intellectual revolution that would challenge the conventional wisdom on the sacrifice ratio. This group included such prominent economists as Robert Lucas, Thomas Sargent, and Robert Barro. Their revolution was based on a new approach to economic theory and policy called rational expectations. According to the theory of rational expectations, people optimally use all the information they have, including information about government policies, when forecasting the future.

This new approach has had profound implications for many areas of macroeco- nomics, but none is more important than its application to the trade-off between inflation and unemployment. As Friedman and Phelps had first emphasized, expected inflation is an important variable that explains why there is a trade-off between inflation and unemployment in the short run but not in the long run. How quickly the short-run trade-off disappears depends on how quickly peo- ple adjust their expectations of inflation. Proponents of rational expectations ex- panded upon the Friedman-Phelps analysis to argue that when economic policies change, people adjust their expectations of inflation accordingly. The studies of inflation and unemployment that had tried to estimate the sacrifice ratio had failed to take account of the direct effect of the policy regime on expectations. As a result, estimates of the sacrifice ratio were, according to the rational-expectations theorists, unreliable guides for policy.

In a 1981 paper titled “The End of Four Big Inflations,” Thomas Sargent described this new view as follows:

An alternative “rational expectations” view denies that there is any inherent momentum to the present process of inflation. This view maintains that firms and workers have now come to expect high rates of inflation in the future and that they strike inflationary bargains in light of these expectations. However, it is held that people expect high rates of inflation in the future precisely because the government’s current and prospective monetary and fiscal policies warrant those expectations. . . . An implication of this view is that inflation can be stopped much more quickly than advocates of the “momentum” view have indicated and that their estimates of the length of time and the costs of stopping inflation in terms of forgone output are erroneous. . . . This is not to say that it would be easy to eradicate inflation. On the contrary, it would require more than a few temporary restrictive fiscal and monetary actions. It would require a

rational expectations

the theory that people

optimally use all the

information they have,

including information

about government pol-

icies, when forecasting

the future

779CHAPTER 35 THE SHORT-RUN TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT

change in the policy regime. . . . How costly such a move would be in terms of forgone output and how long it would be in taking effect would depend partly on how resolute and evident the government’s commitment was.

According to Sargent, the sacrifice ratio could be much smaller than suggested by previous estimates. Indeed, in the most extreme case, it could be zero: If the gov- ernment made a credible commitment to a policy of low inflation, people would be rational enough to lower their expectations of inflation immediately. The short-run Phillips curve would shift downward, and the economy would reach low inflation quickly without the cost of temporarily high unemployment and low output.

35-4c The Volcker Disinflation As we have seen, when Paul Volcker faced the prospect of reducing inflation from its peak of about 10 percent, the economics profession offered two conflicting pre- dictions. One group of economists offered estimates of the sacrifice ratio and con- cluded that reducing inflation would have great cost in terms of lost output and high unemployment. Another group offered the theory of rational expectations and concluded that reducing inflation could be much less costly and, perhaps, could even have no cost at all. Who was right?

Figure 11 shows inflation and unemployment from 1979 to 1987. As you can see, Volcker did succeed at reducing inflation. Inflation came down from almost 10 percent in 1981 and 1982 to about 4 percent in 1983 and 1984. Credit for this reduction in inflation goes completely to monetary policy. Fiscal policy at this time was acting in the opposite direction: The increases in the budget deficit during the Reagan administration were expanding aggregate demand, which tends to raise inflation. The fall in inflation from 1981 to 1984 is attributable to the tough anti- inflation policies of Fed Chairman Paul Volcker.

The figure shows that the Volcker disinflation did come at the cost of high unemployment. In 1982 and 1983, the unemployment rate was about 10 percent— about 4 percentage points above its level when Paul Volcker was appointed Fed

FIGURE 11

The Volcker Disinflation

This figure shows annual data from 1979

to 1987 on the unemployment rate and on

the inflation rate (as measured by the GDP

deflator). The reduction in inflation during

this period came at the cost of very high

unemployment in 1982 and 1983. Note

that the points labeled A, B, and C in this

figure correspond roughly to the points in

Figure 10.

Source: U.S. Department of Labor; U.S. Department of Commerce.

Unemployment Rate (percent)

Inflation Rate (percent per year)

1979

1980

1983

1981

1982

1984

1986

1987 1985

1% 2 3 4 5 6 7 8 9 100

10%

780 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

chairman. At the same time, the production of goods and services as measured by real GDP was well below its trend level. The Volcker disinflation produced a recession that was, at the time, the deepest the United States had experienced since the Great Depression of the 1930s.

Does this episode refute the possibility of costless disinflation as suggested by the rational-expectations theorists? Some economists have argued that the answer to this question is a resounding yes. Indeed, the pattern of disinflation shown in Figure 11 is similar to the pattern predicted in Figure 10. To make the transition from high inflation (point A in both figures) to low inflation (point C), the econ- omy had to experience a painful period of high unemployment (point B).

Yet there are two reasons not to reject the conclusions of the rational-expectations theorists so quickly. First, even though the Volcker disinflation did impose a cost of temporarily high unemployment, the cost was not as large as many econo- mists had predicted. Most estimates of the sacrifice ratio based on the Volcker disinflation are smaller than estimates that had been obtained from previous data. Perhaps Volcker’s tough stand on inflation did have some direct effect on expecta- tions, as the rational-expectations theorists claimed.

Second, and more important, even though Volcker announced that he would aim monetary policy to lower inflation, much of the public did not believe him. Because few people thought Volcker would reduce inflation as quickly as he did, expected inflation did not fall immediately; as a result, the short-run Phillips curve did not shift down as quickly as it might have. Some evidence for this hypothesis comes from the forecasts made by commercial forecasting firms: Their forecasts of inflation fell more slowly in the 1980s than did actual inflation. Thus, the Volcker disinflation does not necessarily refute the rational-expectations view that credible disinflation can be costless. It does show, however, that policymakers cannot count on people to immediately believe them when they announce a policy of disinflation.

35-4d The Greenspan Era Since the OPEC inflation of the 1970s and the Volcker disinflation of the 1980s, the U.S. economy has experienced relatively mild fluctuations in inflation and unem- ployment. Figure 12 shows inflation and unemployment from 1984 to 2005. This period is called the Greenspan era, after Alan Greenspan who in 1987 followed Paul Volcker as chairman of the Federal Reserve.

This period began with a favorable supply shock. In 1986, OPEC members started arguing over production levels, and their long-standing agreement to restrict sup- ply broke down. Oil prices fell by about half. As the figure shows, this favorable supply shock led to falling inflation and falling unemployment from 1984 to 1986.

Throughout the Greenspan era, the Fed was careful to avoid repeating the pol- icy mistakes of the 1960s, when excessive aggregate demand pushed unemploy- ment below the natural rate and raised inflation. When unemployment fell and inflation rose in 1989 and 1990, the Fed raised interest rates and contracted aggre- gate demand, leading to a small recession in 1991 and 1992. Unemployment then rose above most estimates of the natural rate, and inflation fell once again.

The rest of the 1990s witnessed a period of economic prosperity. Inflation grad- ually drifted downward, approaching zero by the end of the decade. Unemploy- ment also drifted downward, leading many observers to believe that the natural rate of unemployment had fallen. Part of the credit for this good economic per- formance goes to Alan Greenspan and his colleagues at the Fed, for low inflation can be achieved only with prudent monetary policy. But good luck in the form of favorable supply shocks is also part of the story.

781CHAPTER 35 THE SHORT-RUN TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT

In 2001, however, the economy ran into problems. The end of the dot-com stock market bubble, the 9/11 terrorist attacks, and corporate accounting scandals all depressed aggregate demand. Unemployment rose as the economy experienced its first recession in a decade. But a combination of expansionary monetary and fiscal policies helped end the downturn, and by early 2005, unemployment was close to most estimates of the natural rate.

In 2005, President Bush nominated Ben Bernanke to follow Alan Greenspan as the chairman of the Fed. Bernanke was sworn in on February 1, 2006. In 2009, Ber- nanke was reappointed by President Obama. At the time of his initial nomination, Bernanke said, “My first priority will be to maintain continuity with the policies and policy strategies established during the Greenspan years.”

35-4e A Financial Crisis Takes Us for a Ride along the Phillips Curve

Ben Bernanke may have hoped to continue the policies of the Greenspan era and to enjoy the relative calm of those years, but his wishes would not be fulfilled. During his first few years on the job, the new Fed chairman faced some significant and daunting economic challenges.

As we have seen in previous chapters, the main challenge arose from prob- lems in the housing market and financial system. From 1995 to 2006, the U.S. housing market boomed and average U.S. house prices more than doubled. But this housing boom proved unsustainable, and from 2006 to 2009 house prices fell by about one-third. This large fall led to declines in household wealth and difficulties for many financial institutions that had bet (through the purchase of mortgage-backed securities) that house prices would continue to rise. The result- ing financial crisis resulted in a large decline in aggregate demand and a steep increase in unemployment.

We have already looked at the story of the crisis and the policy responses to it in previous chapters, but Figure 13 shows what these events meant for inflation

FIGURE 12

The Greenspan Era

This figure shows annual data from 1984

to 2005 on the unemployment rate and on

the inflation rate (as measured by the GDP

deflator). During most of this period, Alan

Greenspan was chairman of the Federal

Reserve. Fluctuations in inflation and

unemployment were relatively small.

Source: U.S. Department of Labor; U.S. Department of Commerce.

Unemployment Rate (percent)

Inflation Rate (percent per year)

19841991

1985

1992

19861993

1994

1988 1987

1995 1996

2004

2005

1998 1999

2002

2001 2000

2003

1989 1990

1% 2 3 4 5 6 7 8 9 100

10%

1997

782 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

and unemployment. From 2007 to 2010, as the decline in aggregate demand raised unemployment from below 5 percent to about 10 percent, it also reduced the rate of inflation from about 3 percent to about 1 percent. In essence, the economy rode down the short-run Phillips curve.

From 2010 to 2015, the economy slowly recovered. Unemployment fell back to about 5 percent, while the rate of inflation remained between 1 and 2 percent. One notable feature of this period is that the very low inflation of 2009 and 2010 does not appear to have substantially reduced expected inflation and shifted the short-run Phillips curve downward. Instead, expected inflation appears to have remained steady at about 2 percent, which kept the short-run Phillips curve relatively stable. A common explanation for this phenomenon is that the Federal Reserve had, over the previous 20 years, established a lot of credibility in its commitment to keep inflation at about 2 percent. As a result, expected inflation and the position of the short-run Phillips curve reacted less to the dramatic short-run events.

QuickQuiz What is the sacrifice ratio? How might the credibility of the Fed’s commit-

ment to reduce inflation affect the sacrifice ratio?

FIGURE 13

The Phillips Curve during and after

the Recession of 2008–2009

This figure shows annual data from

2006 to 2015 on the unemploy-

ment rate and on the inflation rate

(as measured by the GDP deflator).

A financial crisis caused aggregate

demand to plummet, leading to much

higher unemployment and pushing

inflation down to a very low level.

Source: U.S. Department of Labor; U.S. Department of Commerce.

Unemployment Rate (percent)

Inflation Rate (percent per year)

2006 2007

2008

2009

2010

2011

2012 2014

2013

2015

1% 2 3 4 5 6 7 8 9 100

10%

11 12

35-5 Conclusion This chapter has examined how economists’ thinking about inflation and unem- ployment has evolved. We have discussed the ideas of many of the best econ- omists of the 20th century: from the Phillips curve of Phillips, Samuelson, and Solow, to the natural-rate hypothesis of Friedman and Phelps, to the rational- expectations theory of Lucas, Sargent, and Barro. Six members of this group won Nobel Prizes for their work in economics.

Although the trade-off between inflation and unemployment has generated much intellectual turmoil, certain principles have developed that command

783CHAPTER 35 THE SHORT-RUN TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT

consensus. Here is how Milton Friedman expressed the relationship between inflation and unemployment in 1968:

There is always a temporary tradeoff between inflation and unemployment; there is no permanent tradeoff. The temporary tradeoff comes not from inflation per se, but from unanticipated inflation, which generally means, from a rising rate of inflation. The widespread belief that there is a permanent tradeoff is a sophisticated version of the confusion between “high” and “rising” that we all recognize in simpler forms. A rising rate of inflation may reduce unemployment, a high rate will not.

But how long, you will say, is “temporary”? . . . I can at most venture a personal judgment, based on some examination of the historical evidence, that the initial effects of a higher and unanticipated rate of inflation last for something like two to five years.

Today, about a half century later, this statement still summarizes the view of most macroeconomists.

CHAPTER QuickQuiz

1. When the Federal Reserve increases the money

supply and expands aggregate demand, it moves

the economy along the Phillips curve to a point with

________ inflation and ________ unemployment.

a. higher, higher

b. higher, lower

c. lower, higher

d. lower, lower

2. If the Federal Reserve increases the rate of money

growth and maintains it at the new higher rate,

eventually expected inflation will ________ and the

short-run Phillips curve will shift ________.

a. decrease, downward

b. decrease, upward

c. increase, downward

d. increase, upward

3. When an adverse supply shock shifts the short-run

aggregate-supply curve to the left, it also

a. moves the economy along the short-run Phillips

curve to a point with higher inflation and lower

unemployment.

b. moves the economy along the short-run Phillips

curve to a point with lower inflation and higher

unemployment.

c. shifts the short-run Phillips curve to the right.

d. shifts the short-run Phillips curve to the left.

4. Advocates of the theory of rational expectations

believe that

a. the sacrifice ratio can be much smaller if policymak-

ers make a credible commitment to low inflation.

b. if disinflation catches people by surprise, it will

have minimal impact on unemployment.

c. wage and price setters never expect the central

bank to follow through on its announcements.

d. expected inflation depends on the rates of inflation

that people have recently observed.

5. From one year to the next, inflation falls from

5 to 4 percent, while unemployment rises from

6 to 7 percent. Which of the following events could

be responsible for this change?

a. The central bank increases the growth rate of the

money supply.

b. The government cuts spending and raises taxes to

reduce the budget deficit.

c. Newly discovered oil reserves cause world oil

prices to plummet.

d. The appointment of a new Fed chair increases

expected inflation.

6. From one year to the next, inflation rises from

4 to 5 percent, while unemployment rises from

6 to 7 percent. Which of the following events could

be responsible for this change?

a. The central bank increases the growth rate of the

money supply.

b. The government cuts spending and raises taxes to

reduce the budget deficit.

c. Newly discovered oil reserves cause world oil

prices to plummet.

d. The appointment of a new Fed chair increases

expected inflation.

784 PART XII SHORT-RUN ECONOMIC FLUCTUATIONS

SUMMARY

KEY CONCEPTS

QUESTIONS FOR REVIEW

PROBLEMS AND APPLICATIONS

The Phillips curve describes a negative relationship

between inflation and unemployment. By expanding

aggregate demand, policymakers can choose a point

on the Phillips curve with higher inflation and lower

unemployment. By contracting aggregate demand,

policymakers can choose a point on the Phillips curve

with lower inflation and higher unemployment.

The trade-off between inflation and unemployment

described by the Phillips curve holds only in the short

run. In the long run, expected inflation adjusts to

changes in actual inflation, and the short-run Phillips

curve shifts. As a result, the long-run Phillips curve is

vertical at the natural rate of unemployment.

The short-run Phillips curve also shifts because of

shocks to aggregate supply. An adverse supply shock,

such as an increase in world oil prices, gives policy-

makers a less favorable trade-off between inflation and

unemployment. That is, after an adverse supply shock,

policymakers have to accept a higher rate of inflation

for any given rate of unemployment or a higher rate of

unemployment for any given rate of inflation.

When the Fed contracts growth in the money supply

to reduce inflation, it moves the economy along the

short-run Phillips curve, which results in temporarily

high unemployment. The cost of disinflation depends

on how quickly expectations of inflation fall. Some

economists argue that a credible commitment to low

inflation can reduce the cost of disinflation by inducing

a quick adjustment of expectations.

Phillips curve, p. 764

natural-rate hypothesis, p. 772

supply shock, p. 774

sacrifice ratio, p. 777

rational expectations, p. 778

1. Draw the short-run trade-off between inflation and

unemployment. How might the Fed move the econ-

omy from one point on this curve to another?

2. Draw the long-run trade-off between inflation and

unemployment. Explain how the short-run and

long-run trade-offs are related.

3. What is “natural” about the natural rate of unemploy-

ment? Why might the natural rate of unemployment

differ across countries?

4. Suppose a drought destroys farm crops and drives up

the price of food. What is the effect on the short-run

trade-off between inflation and unemployment?

5. The Fed decides to reduce inflation. Use the Phillips

curve to show the short-run and long-run effects of

this policy. How might the short-run costs be reduced?

1. Suppose the natural rate of unemployment is 6 per-

cent. On one graph, draw two Phillips curves that

describe the four situations listed here. Label the point

that shows the position of the economy in each case.

a. Actual inflation is 5 percent, and expected inflation

is 3 percent.

b. Actual inflation is 3 percent, and expected inflation

is 5 percent.

c. Actual inflation is 5 percent, and expected inflation

is 5 percent.

d. Actual inflation is 3 percent, and expected inflation

is 3 percent.

2. Illustrate the effects of the following developments on

both the short-run and long-run Phillips curves. Give

the economic reasoning underlying your answers.

a. a rise in the natural rate of unemployment

b. a decline in the price of imported oil

c. a rise in government spending

d. a decline in expected inflation

3. Suppose that a fall in consumer spending causes a

recession.

a. Illustrate the immediate change in the economy

using both an aggregate-supply/aggregate-

demand diagram and a Phillips-curve diagram.

785CHAPTER 35 THE SHORT-RUN TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT

On both graphs, label the initial long-run equilib-

rium as point A and the resulting short-run equi-

librium as point B. What happens to inflation and

unemployment in the short run?

b. Now suppose that over time expected inflation

changes in the same direction that actual infla-

tion changes. What happens to the position of

the short-run Phillips curve? After the recession

is over, does the economy face a better or worse

set of inflation–unemployment combinations?

Explain.

4. Suppose the economy is in a long-run equilibrium.

a. Draw the economy’s short-run and long-run

Phillips curves.

b. Suppose a wave of business pessimism reduces

aggregate demand. Show the effect of this shock

on your diagram from part a. If the Fed under- takes expansionary monetary policy, can it return

the economy to its original inflation rate and origi-

nal unemployment rate?

c. Now suppose the economy is back in long-run

equilibrium and then the price of imported oil

rises. Show the effect of this shock with a new

diagram like that in part a. If the Fed undertakes expansionary monetary policy, can it return the

economy to its original inflation rate and origi-

nal unemployment rate? If the Fed undertakes

contractionary monetary policy, can it return the

economy to its original inflation rate and original

unemployment rate? Explain why this situation

differs from that in part b.

5. The inflation rate is 10 percent, and the central bank

is considering slowing the rate of money growth

to reduce inflation to 5 percent. Economist Milton

believes that expectations of inflation change quickly

in response to new policies, whereas economist James

believes that expectations are very sluggish. Which

economist is more likely to favor the proposed change

in monetary policy? Why?

6. Suppose the Federal Reserve’s policy is to maintain

low and stable inflation by keeping unemployment

at its natural rate. However, the Fed believes that the

natural rate of unemployment is 4 percent when the

actual natural rate is 5 percent. If the Fed based its

policy decisions on its belief, what would happen to

the economy? How might the Fed come to realize that

its belief about the natural rate was mistaken?

7. Suppose the Federal Reserve announced that it would

pursue contractionary monetary policy to reduce the

inflation rate. Would the following conditions make

the ensuing recession more or less severe? Explain.

a. Wage contracts have short durations.

b. There is little confidence in the Fed’s determina-

tion to reduce inflation.

c. Expectations of inflation adjust quickly to actual

inflation.

8. As described in the chapter, the Federal Reserve in

2008 faced a decrease in aggregate demand caused

by the housing and financial crises and a decrease in

short-run aggregate supply caused by rising commod-

ity prices.

a. Starting from a long-run equilibrium, illustrate the

effects of these two changes using both an aggre-

gate-supply/aggregate-demand diagram and a

Phillips-curve diagram. On both diagrams, label

the initial long-run equilibrium as point A and

the resulting short-run equilibrium as point B. For

each of the following variables, state whether it

rises or falls or whether the impact is ambiguous:

output, unemployment, the price level, the infla-

tion rate.

b. Suppose the Fed responds quickly to these shocks

and adjusts monetary policy to keep unemploy-

ment and output at their natural rates. What

action would it take? On the same set of graphs

from part a, show the results. Label the new equilibrium as point C.

c. Why might the Fed choose not to pursue the

course of action described in part b?

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

Final Thoughts

PART XIII

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I t is hard to follow the news without finding some politician or editorial writer advocating a change in economic policy. The president should raise taxes to reduce the budget deficit, or he should stop worrying about the budget deficit.

The Federal Reserve should cut interest rates to stimulate a flagging economy, or it should avoid such moves in order not to risk higher inflation. Congress should reform the tax system to promote faster economic growth, or it should reform the tax system to achieve a more equal distribution of income. Such economic issues are central to the continuing political debate in the United States and other countries around the world.

Six Debates over Macroeconomic Policy

CHAPTER

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790 PART XIII FINAL THOUGHTS

Previous chapters have developed the tools that economists use to analyze the behavior of the economy as a whole and the impact of policies on the econ- omy. This final chapter considers six classic questions about macroeconomic pol- icy. Economists have long debated these questions, and they will likely continue to do so for years to come. The knowledge you have accumulated in this course provides the foundation upon which we can discuss these important, unsettled issues. It should help you choose a side in these debates or, at least, help you see why choosing a side is so difficult.

36-1 Should Monetary and Fiscal Policymakers Try to Stabilize the Economy?

In the preceding three chapters, we saw how changes in aggregate demand and aggregate supply can lead to short-run fluctuations in production and employ- ment. We also saw how monetary and fiscal policy can shift aggregate demand and, thereby, influence these fluctuations. But even if policymakers can influence short-run economic fluctuations, does that mean they should? Our first debate concerns whether monetary and fiscal policymakers should use the tools at their disposal in an attempt to smooth the ups and downs of the business cycle.

36-1a Pro: Policymakers Should Try to Stabilize the Economy Left on their own, economies fluctuate. When households and firms become pessimistic, for instance, they cut back on spending, and this reduces the aggregate demand for goods and services. The fall in aggregate demand, in turn, reduces the production of goods and services. Firms lay off workers, and the unemployment rate rises. Real GDP and other measures of income fall. Rising unemployment and falling income help confirm the pessimism that initially generated the economic downturn.

Such a recession has no benefit for society—it represents a sheer waste of resources. Workers who lose their jobs because of declining aggregate demand would rather be working. Business owners whose factories are idle during a recession would rather be producing valuable goods and services and selling them at a profit.

There is no reason for society to suffer through the booms and busts of the busi- ness cycle. Macroeconomic theory shows policymakers how to reduce the sever- ity of economic fluctuations. By “leaning against the wind” of economic change, monetary and fiscal policy can stabilize aggregate demand and, thereby, pro- duction and employment. When aggregate demand is inadequate to ensure full employment, policymakers should boost government spending, cut taxes, and expand the money supply. When aggregate demand is excessive, risking higher inflation, policymakers should cut government spending, raise taxes, and reduce the money supply. Such policy actions put macroeconomic theory to its best use by leading to a more stable economy, which benefits everyone.

36-1b Con: Policymakers Should Not Try to Stabilize the Economy Monetary and fiscal policy can be used to stabilize the economy in theory, but there are substantial obstacles to the use of such policies in practice.

One problem is that monetary and fiscal policies do not affect the economy immediately but instead work with a long lag. Monetary policy affects aggre- gate demand primarily by changing interest rates, which in turn affect spending,

791CHAPTER 36 SIX DEBATES OVER MACROECONOMIC POLICY

particularly residential and business investment. But many households and firms set their spending plans in advance. As a result, it takes time for changes in interest rates to alter the aggregate demand for goods and services. Many studies indicate that changes in monetary policy have little effect on aggregate demand until about 6 months after the change is made.

Fiscal policy works with a lag because of the long political process that governs changes in spending and taxes. To make any change in fiscal policy, a bill must go through congressional committees, pass both the House and the Senate, and be signed by the president. It can take years to propose, pass, and implement a major change in fiscal policy.

Because of these long lags, policymakers who want to stabilize the economy need to look ahead to economic conditions that are likely to prevail when their actions will take effect. Unfortunately, economic forecasting is highly imprecise, in part because macroeconomics is such a primitive science and in part because the shocks that cause economic fluctuations are intrinsically unpredictable. Thus, when policymakers change monetary or fiscal policy, they must rely on educated guesses about future economic conditions.

Too often, policymakers trying to stabilize the economy end up having the oppo- site effect. Economic conditions can easily change between the time a policy action begins and the time it takes effect. Because of this, policymakers can inadvertently exacerbate rather than mitigate the magnitude of economic fluctuations. Some econ- omists have claimed that many of the major economic fluctuations in history, includ- ing the Great Depression of the 1930s, can be traced to destabilizing policy actions.

A rule that all physicians learn early in their training is “first, do no harm.” The human body has natural restorative powers. Confronted with a sick patient and an uncertain diagnosis, often a doctor should do nothing but leave the patient’s body to its own devices. Intervening in the absence of reliable knowledge merely risks making matters worse.

The same can be said about treating an ailing economy. It might be desirable if policymakers could eliminate all economic fluctuations, but that is not a realistic

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goal given the limits of macroeconomic knowledge and the inherent unpredict- ability of world events. Economic policymakers should refrain from intervening often with monetary and fiscal policy and be content if they do no harm.

QuickQuiz Explain why monetary and fiscal policies work with a lag. Why do these

lags matter in the choice between active and passive policy?

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

When George W. Bush became president in 2001, the economy was slipping into a recession. He responded by cutting tax rates. When Barack Obama became pres- ident in 2009, the economy was in the middle of the Great Recession, the worst economic downturn in many decades. He responded with a stimulus package that offered some tax reductions but also included substantial increases in government spending. The contrast between these two policies illustrates a classic question of macroeconomics: Which instrument of fiscal policy—government spending or taxes—is better for reducing the severity of economic downturns?

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

John Maynard Keynes transformed economics when he wrote The General The- ory of Employment, Interest and Money in the midst of the Great Depression of the 1930s, the worst economic downturn in U.S. history. Since then, economists have understood that the fundamental problem during recessions is inadequate aggre- gate demand. When firms are unable to sell a sufficient quantity of goods and services, they reduce production and employment. The key to ending recessions is to restore aggregate demand to a level consistent with full employment of the economy’s labor force.

To be sure, monetary policy is the first line of defense against economic down- turns. By increasing the money supply, the central bank reduces interest rates. Lower interest rates in turn reduce the cost of borrowing to finance investment projects, such as new factories and new housing. Increased spending on invest- ment adds to aggregate demand and helps to restore normal levels of production and employment.

Fiscal policy provides an additional tool to combat recessions. When the govern- ment cuts taxes, it increases households’ disposable income, which encourages them to increase spending on consumption. When the government buys goods and ser- vices, it adds directly to aggregate demand. Moreover, these fiscal actions can have multiplier effects: Higher aggregate demand leads to higher incomes, which in turn induces additional consumer spending and further increases in aggregate demand.

Fiscal policy is particularly useful when the tools of monetary policy lose their effectiveness. During the Great Recession of 2008 and 2009, for example, the Federal Reserve cut its target interest rate to about zero. The Fed cannot reduce interest rates below zero, because people would hold onto their cash rather than lending it out at a negative interest rate. Thus, once interest rates are at zero, the Fed loses its most powerful tool for stimulating the economy. In this circumstance, it is natural for the government to turn to fiscal policy—taxes and government spending—to prop up aggregate demand.

President Barack Obama delivers remarks at the groundbreaking of a road project funded by the American Recovery and Reinvestment Act, Friday, June 18, 2010, in Columbus, Ohio.

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793CHAPTER 36 SIX DEBATES OVER MACROECONOMIC POLICY

Traditional Keynesian analysis indicates that increases in government pur- chases are a more potent tool than decreases in taxes. When the government gives a dollar in tax cuts to a household, part of that dollar may be saved rather than spent. (That is especially true if households view the tax reduction as temporary rather than permanent.) The part of the dollar that is saved does not contribute to the aggregate demand for goods and services. By contrast, when the government spends a dollar buying a good or service, that dollar immediately and fully adds to aggregate demand.

In 2009, economists in the Obama administration used a conventional macro- economic model to calculate the magnitude of these effects. According to their computer simulations, each dollar of tax cuts increases GDP by $0.99, whereas each dollar of government purchases increases GDP by $1.59. Thus, increases in government spending offer a bigger “bang for the buck” than decreases in taxes. For this reason, the policy response in 2009 featured fewer federal tax cuts and more increases in federal spending.

Policymakers focused on three kinds of spending. First, there was spending on “shovel-ready” projects. These were public works projects such as repairs to highways and bridges on which construction could begin immediately, putting the unemployed back to work. Second, there was federal aid to state and local governments. Because many of these governments are constitutionally required to run balanced budgets, falling tax revenues during recessions can make it neces- sary for them to lay off teachers, police, and other public workers; federal aid pre- vented that outcome or, at least, reduced its severity. Third, there were increased payments to the jobless through the unemployment insurance system. Because the unemployed are often financially stretched, they were thought to be likely to spend rather than save this extra income. Thus, these transfer payments were thought to contribute more to aggregate demand—and thereby production and employment—than tax cuts would. According to the macroeconomic model used by the Obama administration, the $800 billion stimulus package would create or save more than 3 million jobs by the end of the president’s second year in office.

It is impossible to know for sure what effect the stimulus in fact had. Because we get only one run at history, we cannot observe what would have happened without the stimulus package. Yet one thing is clear: While the economic down- turn of 2008–2009 was severe, it could have been worse. In the Great Depression of the 1930s, real GDP fell by 27 percent and unemployment reached 25 percent. In the Great Recession, real GDP fell by only 4 percent and unemployment reached only 10 percent. As judged by either GDP or unemployment, the Great Recession did not approach the magnitude of the Great Depression.

36-2b Con: The Government Should Fight Recessions with Tax Cuts There is a long tradition of using tax policy to stimulate a moribund economy. President Kennedy proposed a tax reduction as one of his major economic initia- tives; it eventually passed under President Johnson in 1964. President Reagan also signed into law significant tax cuts when he became president in 1981. Both of these tax reductions were soon followed by robust economic growth.

Tax cuts have a powerful influence on both aggregate demand and aggregate supply. They increase aggregate demand by increasing households’ disposable income, as emphasized in traditional Keynesian analysis. But they can also increase aggregate demand by altering incentives. For example, if the tax reductions take the form of an expanded investment tax credit, they can induce increased spending on investment goods. Because investment spending is the

794 PART XIII FINAL THOUGHTS

most volatile component of GDP over the business cycle, stimulating investment is a key to ending recessions. Policymakers can target investment specifically with well-designed tax policy.

At the same time that tax cuts increase aggregate demand, they can also increase aggregate supply. When the government reduces marginal tax rates, workers keep a higher fraction of any income they earn. As a result, the unemployed have a greater incentive to search for jobs, and the employed have a greater incentive to work longer hours. Increased aggregate supply, along with the increased aggregate demand, means that the production of goods and services can expand without putting upward pressure on the rate of inflation.

There are various problems with increasing government spending during recessions. First of all, consumers understand that higher government spending, together with the government borrowing needed to finance it, will likely lead to higher taxes in the future. The anticipation of those future taxes will induce con- sumers to cut back spending today. Moreover, like most taxes, those in the future are likely to cause a variety of deadweight losses. As businesses look ahead to a more highly distorted future economy, they may reduce their expectations of fu- ture profits and reduce investment spending today. Because of these various effects, government-spending multipliers may be smaller than is conventionally believed.

It is also far from clear whether the government can spend money both wisely and quickly. Large government spending projects often require years of planning, as policymakers and voters weigh the costs and benefits of the many alternative courses of action. By contrast, when unemployment soars during recessions, the need for additional aggregate demand is immediate. If the government increases spending quickly, it may end up buying things of little public value. But if it tries to be careful and deliberate in planning its expenditures, it may fail to increase aggregate demand in a timely fashion.

Tax cuts have the advantage of decentralizing spending decisions, rather than relying on a centralized and highly imperfect political process. Households spend their disposable income on things they value. Firms spend their investment dol- lars on projects they expect to be profitable. By contrast, when the government tries to spend large sums of money fast, subject to various political pressures, it may end up building “bridges to nowhere.” Ill-conceived public projects may employ some workers, but they create little lasting value. Moreover, they will leave future generations of taxpayers with significant additional debts. In the end, the short-run benefits of additional aggregate demand from increased govern- ment spending may fail to compensate for the long-run costs.

QuickQuiz According to traditional Keynesian analysis, which has a larger impact on

GDP—a dollar of tax cuts or a dollar of additional government spending?

Why?

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

As we learned in the chapter on the monetary system, the Federal Open Mar- ket Committee sets monetary policy in the United States. The committee meets about every 6 weeks to evaluate the state of the economy. Based on this evaluation and forecasts of future economic conditions, it chooses whether to raise, lower, or leave unchanged the level of short-term interest rates. The Fed then adjusts

795CHAPTER 36 SIX DEBATES OVER MACROECONOMIC POLICY

the money supply to reach that interest-rate target, which will normally remain unchanged until the next meeting.

The Federal Open Market Committee operates with almost complete discre- tion over how to conduct monetary policy. The laws that created the Fed give the institution only vague recommendations about what goals it should pursue. A 1977 amendment to the 1913 Federal Reserve Act said the Fed “shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term inter- est rates.” But the act does not specify how to weight these various goals, nor does it tell the Fed how to pursue whatever objective it might choose.

Some economists are critical of this institutional design. Our next debate over macroeconomic policy, therefore, focuses on whether the Federal Reserve should have its discretionary powers reduced and, instead, be committed to following a rule for how it conducts monetary policy.

36-3a Pro: Monetary Policy Should Be Made by Rule Discretion in the conduct of monetary policy has two problems. The first is that it does not limit incompetence and abuse of power. When the government sends police into a community to maintain civic order, it gives them strict guidelines about how to carry out their job. Because police have great power, allowing them to exercise that power however they wanted would be dangerous. Yet when the gov- ernment gives central bankers the authority to maintain economic order, it gives them few guidelines. Monetary policymakers are allowed undisciplined discretion.

One example of the abuse of power is that central bankers are sometimes tempted to use monetary policy to affect the outcome of elections. Suppose that the vote for the incumbent president is based on economic conditions at the time he is up for reelection. A central banker sympathetic to the incumbent might be tempted to pursue expansionary policies just before the election to stimulate pro- duction and employment, knowing that the resulting inflation will not show up until after the election. Thus, to the extent that central bankers ally themselves with politicians, discretionary policy can lead to economic fluctuations that reflect the electoral calendar. Economists call such fluctuations the political business cycle. Prior to the election of 1972, for instance, President Richard Nixon pressured Fed- eral Reserve Chairman Arthur Burns to pursue a more expansionary monetary policy, presumably to bolster Nixon’s reelection chances.

The second and subtler problem with discretionary monetary policy is that it might lead to more inflation than is desirable. Central bankers, knowing that there is no long-run trade-off between inflation and unemployment, often announce that their goal is zero inflation. Yet they rarely achieve price stability. Why? Per- haps it is because, once the public forms expectations of inflation, policymakers face a short-run trade-off between inflation and unemployment. They are tempted to renege on their announcement of price stability to achieve lower unemploy- ment. This discrepancy between announcements (what policymakers say they are going to do) and actions (what they subsequently in fact do) is called the time inconsistency of policy. Because policymakers are so often time inconsistent, people are skeptical when central bankers announce their intentions to reduce the rate of inflation. As a result, people always expect more inflation than monetary policy- makers claim they are trying to achieve. Higher expectations of inflation, in turn, shift the short-run Phillips curve upward, making the short-run trade-off between inflation and unemployment less favorable than it otherwise might be.

796 PART XIII FINAL THOUGHTS

One way to avoid these two problems with discretionary policy is to commit the central bank to a policy rule. For example, suppose that Congress passed a law requiring the Fed to increase the money supply by exactly 3 percent per year. (Why 3 percent? Because real GDP grows on average about 3 percent per year, and because money demand grows with real GDP, 3 percent growth in the money supply is roughly the rate necessary to produce long-run price stability.) Such a law would eliminate incompetence and abuse of power on the part of the Fed, and it would make the political business cycle impossible. In addition, policy could no longer be time inconsistent. People would now believe the Fed’s announcement of low inflation because the Fed would be legally required to pursue a low-inflation monetary policy. With low expected inflation, the economy would face a more favorable short-run trade-off between inflation and unemployment.

Other rules for monetary policy are also possible. A more active rule might allow some feedback from the state of the economy to changes in monetary pol- icy. For example, a more active rule might require the Fed to increase monetary growth by 1 percentage point for every percentage point that unemployment rises above its natural rate. Regardless of the precise form of the rule, committing the Fed to some rule would yield advantages by limiting incompetence, abuse of power, and time inconsistency in the conduct of monetary policy.

36-3b Con: Monetary Policy Should Not Be Made by Rule There may be pitfalls with discretionary monetary policy, but there is also an important advantage to it: flexibility. The Fed has to confront various circum- stances, not all of which can be foreseen. In the 1930s, banks failed in record num- bers. In the 1970s, the price of oil skyrocketed around the world. In October 1987, the stock market fell by 22 percent in a single day. From 2007 to 2009, house prices dropped, home foreclosures soared, and the financial system experienced signifi- cant problems. The Fed must decide how to respond to these shocks to the econ- omy. A designer of a policy rule could not possibly consider all the contingencies and specify in advance the right policy response. It is better to appoint good people to conduct monetary policy and then give them the freedom to do the best they can.

Moreover, the alleged problems with discretion are largely hypothetical. The practical importance of the political business cycle, for instance, is far from clear. While it is true that Nixon tried to pressure Burns in 1972, it is not clear that he succeeded: Interest rates rose significantly during the election year. Moreover, in some cases, just the opposite seems to occur. President Jimmy Carter appointed Paul Volcker to head the Federal Reserve in 1979. Nonetheless, in October of that year, Volcker switched to a contractionary monetary policy to combat the high rate of inflation that he had inherited from his predecessor. The predictable result of Volcker ’s decision was a recession, and the predictable result of the recession was a decline in Carter ’s popularity. Rather than using monetary policy to help the president who had appointed him, Volcker took actions he thought were in the national interest, even though they contributed to Carter ’s defeat by Ronald Reagan in the November 1980 election.

The practical importance of time inconsistency is also far from clear. Although most people are skeptical of central-bank announcements, central bankers can achieve credibility over time by backing up their words with actions. In the 1990s and 2000s, the Fed achieved and maintained a low rate of inflation, despite the ever-present temptation to take advantage of the short-run trade-off between inflation and unemployment. This experience shows that low inflation does not require that the Fed be committed to a policy rule.

797CHAPTER 36 SIX DEBATES OVER MACROECONOMIC POLICY

Any attempt to replace discretion with a rule must confront the difficult task of specifying a precise rule. Despite much research examining the costs and benefits of alternative rules, economists have not reached consensus about what a good rule would be. Until there is consensus, society has little choice but to give central bankers discretion to conduct monetary policy as they see fit.

QuickQuiz Give an example of a monetary policy rule. Why might your rule be better

than discretionary policy? Why might it be worse?

Inflation Targeting

O ver the past few decades, many central banks around the world have

adopted a policy called inflation targeting. Sometimes this takes the

form of a central bank announcing its intentions regarding the inflation

rate over the next few years. At other times it takes the form of a national

law that specifies an inflation goal for the central bank.

Inflation targeting is not a commitment to an ironclad rule. In all the

countries that have adopted inflation targeting, central banks are left

with a fair amount of discretion. Inflation targets are usually set as a

range—an inflation rate of 1 to 3 percent, for example—rather than a

particular number. Thus, the central bank can choose where in the range

it wants to be. Moreover, the central bank is sometimes allowed to adjust

its target for inflation, at least temporarily, if some event (such as a

shock to world oil prices) pushes inflation outside the target range.

Although inflation targeting leaves the central bank with some discre-

tion, the policy does constrain how that discretion is used. When a central

bank is told simply to “do the right thing,” it is hard to hold the central

bank accountable, because people can argue forever about what is right.

By contrast, when a central bank has an inflation target, the public can

more easily judge whether the central bank is meeting its goals. Inflation

targeting does not tie the hands of the central bank, but it does increase

the transparency and accountability of monetary policy. In a sense, infla-

tion targeting is a compromise in the debate over rules versus discretion.

C o m p a r e d w i t h o t h e r

central banks around the

world, the Federal Reserve

was slow to adopt a policy

of inflation targeting, al-

though some commentators

had long suggested that the

Fed had an implicit inflation target of about 2 percent. In January 2012,

the Federal Open Market Committee made the policy more explicit. Its

press release read as follows:

The inflation rate over the longer run is primarily determined by mon-

etary policy, and hence the Committee has the ability to specify a

longer-run goal for inflation. The Committee judges that inflation at

the rate of 2 percent, as measured by the annual change in the price

index for personal consumption expenditures, is most consistent

over the longer run with the Federal Reserve’s statutory mandate.

Communicating this inflation goal clearly to the public helps keep

longer-term inflation expectations firmly anchored, thereby fostering

price stability and moderate long-term interest rates and enhancing

the Committee’s ability to promote maximum employment in the face

of significant economic disturbances. ■

36-4 Should the Central Bank Aim for Zero Inflation? One of the Ten Principles of Economics discussed in Chapter 1, and developed more fully in the chapter on money growth and inflation, is that prices rise when the government prints too much money. Another of the Ten Principles of Economics dis- cussed in Chapter 1, and developed more fully in the preceding chapter, is that society faces a short-run trade-off between inflation and unemployment. Put to- gether, these two principles raise a question for policymakers: How much infla- tion should the central bank be willing to tolerate? Our next debate is whether zero is the right target for the inflation rate.

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798 PART XIII FINAL THOUGHTS

36-4a Pro: The Central Bank Should Aim for Zero Inflation Inflation confers no benefit on society, but it imposes several real costs. As we have discussed, economists have identified six costs of inflation:

• Shoeleather costs associated with reduced money holdings • Menu costs associated with more frequent adjustment of prices • Increased variability of relative prices • Unintended changes in tax liabilities due to nonindexation of the tax code • Confusion and inconvenience resulting from a changing unit of account • Arbitrary redistributions of wealth associated with dollar-denominated debts

Some economists argue that these costs are small, at least for moderate rates of inflation, such as the 3 percent inflation experienced in the United States during the 1990s and 2000s. But other economists claim these costs can be substantial, even for moderate inflation. Moreover, there is no doubt that the public dislikes inflation. When inflation heats up, opinion polls identify inflation as one of the nation’s leading problems.

The benefits of zero inflation have to be weighed against the costs of achiev- ing it. Reducing inflation usually requires a period of high unemployment and low output, as illustrated by the short-run Phillips curve. But this disinflationary recession is only temporary. Once people come to understand that policymakers are aiming for zero inflation, expectations of inflation will fall and the short-run trade-off will improve. Because expectations adjust, there is no trade-off between inflation and unemployment in the long run.

Reducing inflation is, therefore, a policy with temporary costs and permanent benefits. Once the disinflationary recession is over, the benefits of zero inflation persist into the future. If policymakers are farsighted, they should be willing to incur the temporary costs for the permanent benefits. This was precisely the cal- culation made by Paul Volcker in the early 1980s, when he tightened monetary policy and reduced inflation from about 10 percent in 1980 to about 4 percent in 1983. Although in 1982 unemployment reached its highest level since the Great Depression, the economy eventually recovered from the recession, leaving a leg- acy of low inflation. Today, Volcker is considered a hero among central bankers.

Moreover, the costs of reducing inflation need not be as large as some econo- mists claim. If the Fed announces a credible commitment to zero inflation, it can directly influence expectations of inflation. Such a change in expectations can improve the short-run trade-off between inflation and unemployment, allowing the economy to reach lower inflation at a reduced cost. The key to this strategy is credibility: People must believe that the Fed is actually going to carry through on its announced policy. Congress could help in this regard by passing legislation that makes price stability the Fed’s primary goal. Such a law would decrease the cost of achieving zero inflation without reducing any of the resulting benefits.

One advantage of a zero-inflation target is that zero provides a more natural focal point for policymakers than any other number. Suppose, for instance, that the Fed were to announce that it would keep inflation at 3 percent—the rate expe- rienced during much of the previous two decades. Would the Fed really stick to that 3 percent target? If events inadvertently pushed inflation up to 4 or 5 percent, why wouldn’t it just raise the target? There is, after all, nothing special about the number 3. By contrast, zero is the only number for the inflation rate at which the Fed can claim that it has achieved price stability and fully eliminated the costs of inflation.

799CHAPTER 36 SIX DEBATES OVER MACROECONOMIC POLICY

36-4b Con: The Central Bank Should Not Aim for Zero Inflation Price stability may be desirable, but the benefits of zero inflation compared to moderate inflation are small, whereas the costs of reaching zero inflation are large. Estimates of the sacrifice ratio suggest that reducing inflation by 1 per- centage point requires giving up about 5 percent of one year ’s output. Reduc- ing inflation from, say, 4 percent to zero requires a loss of 20 percent of a year ’s output. People might dislike inflation of 4 percent, but it is not at all clear that they would (or should) be willing to pay 20 percent of a year ’s income to get rid of it.

The social costs of disinflation are even larger than this 20 percent figure suggests, for the lost income is not spread equitably over the population. When the economy goes into recession, all incomes do not fall proportionately. Instead, the fall in aggregate income is concentrated on those workers who lose their jobs. The vulnerable workers are often those with the least skills and experience. Hence, much of the cost of reducing inflation is borne by those who can least afford to pay it.

Economists can list several costs of inflation, but there is no professional con- sensus that these costs are substantial. The shoeleather costs, menu costs, and others that economists have identified do not seem great, at least for moderate rates of inflation. It is true that the public dislikes inflation, but the public may be misled into believing the inflation fallacy—the view that inflation erodes living standards. Economists understand that living standards depend on productiv- ity, not monetary policy. Because inflation in nominal incomes goes hand in hand with inflation in prices, reducing inflation would not cause real incomes to rise more rapidly.

Moreover, policymakers can reduce many of the costs of inflation without actually reducing inflation. They can eliminate the problems associated with the nonindexed tax system by rewriting the tax laws to take account of the effects of inflation. They can also reduce the arbitrary redistributions of wealth between creditors and debtors caused by unexpected inflation by issuing indexed gov- ernment bonds, as the Clinton administration did in 1997. Such an act insulates holders of government debt from inflation. In addition, by setting an example, the policy might encourage private borrowers and lenders to write debt contracts indexed for inflation.

Reducing inflation might be desirable if it could be done at no cost, as some economists argue is possible. Yet this trick seems hard to carry out in practice. When economies reduce their rate of inflation, they almost always experience a period of high unemployment and low output. It is risky to believe that the cen- tral bank could achieve credibility so quickly as to make disinflation painless.

Indeed, a disinflationary recession can potentially leave permanent scars on the economy. Firms in all industries reduce their spending on new plants and equipment substantially during recessions, making investment the most volatile component of GDP. Even after the recession is over, the smaller stock of capital reduces productivity, incomes, and living standards below the levels they other- wise would have achieved. In addition, when workers become unemployed in recessions, they lose job skills, permanently reducing their value as workers.

A little bit of inflation may even be a good thing. Some economists believe that inflation “greases the wheels” of the labor market. Because workers resist cuts in nominal wages, a fall in real wages is more easily accomplished with a rising price level. Inflation thus makes it easier for real wages to adjust to changes in labor-market conditions.

800 PART XIII FINAL THOUGHTS

How do central bankers choose a rate

of inflation to target?

The Goal of 2% Inflation,

Rethought

By Neil Irwin

S ometimes, decisions that shape the world’s

economic future are made with great pomp

and gain widespread attention. Other times,

they are made through a quick, unanimous vote

by members of the New Zealand Parliament who

were eager to get home for Christmas.

That is what happened 25 years ago this

Sunday, when New Zealand became the first

country to set a formal target for how much

prices should rise each year—zero to 2 percent

in its initial action. The practice was so success-

ful in making the high inflation of the 1970s and

’80s a thing of the past that all of the world’s

most advanced nations have emulated it in one

form or another. A 2 percent inflation target is

now the norm across much of the world, having

become virtually an economic religion….

Yet even as the idea of a 2 percent target

has become the orthodoxy, a worrying possibility

is becoming clear: What if it’s wrong? What if it

is one of the reasons that the global economy

has been locked in five years of slow growth?

Some economists are beginning to consider

the possibility that 2 percent inflation at all

times leaves central banks with too little flexibil-

ity to adequately fight a deep economic malaise.

To understand that thinking, it’s worth

understanding how New Zealand’s 2 percent tar-

get became so entrenched in the world economic

order to begin with. The story starts in that South-

ern Hemisphere nation in the summer of 1989,

with a kiwi farmer and banker named Don Brash.

When Mr. Brash stepped down as man-

aging director of the New Zealand Kiwifruit

Authority to lead the country’s central bank in

1988, he was taking the helm of an economy

that had been through a rough two decades,

with high inflation and disappointing growth.

Mr. Brash tells the story of an uncle who

sold an apple orchard in 1971 and put the

money into long-term government bonds to

finance his retirement, only to see inflation

wipe out 90 percent of his life savings by the

time the bonds matured.

In the years before Mr. Brash took the

helm of the central bank—the Reserve Bank

of New Zealand—his predecessor had made

progress in bringing down inflation and

making the bank more independent from the

whims of politicians. But that independence

had not been codified in law.

That’s what the Reserve Bank Act of 1989

was supposed to do. It directed the finance min-

ister and the head of the central bank to arrive at

a formal target for how high inflation should be,

and granted the central bank political indepen-

dence to guide interest rates to achieve that infla-

tion level. The head of the central bank could be

dismissed for failure to reach the inflation goal.

For David Caygill, New Zealand’s finance

minister at the time, the essential part of the

law was establishing the bank’s independence

from the political process. “Inflation targeting

wasn’t from our point of view the main point

of the act,” he said in an interview this month.

The debate over the legislation was con-

tentious. Labor unions feared that focusing so

pointedly on inflation would lead to higher unem-

ployment. Some business interests agreed….

Ultimately, however, the leaders of the

majority party in Parliament decided to brush

off the concerns. It helped the cause that one of

the bill’s strongest opponents was laid up in the

hospital. And Christmas was around the corner.

Once the law was enacted, though, there

was the difficult question of what the inflation

target should be. Zero percent? Two percent?

Five percent?

Mr. Brash and Mr. Caygill got a head start

on an answer from an offhand comment made

during a television interview in 1988. Roger

Douglas, Mr. Caygill’s predecessor as finance

minister, had been seeking to dissuade New

Zealanders from thinking that the central bank

would be content with high inflation, and so

he said in an interview that he was aiming for

inflation of around zero to 1 percent.

“It was almost a chance remark,” Mr. Brash

said in a recent interview. “The figure was

plucked out of the air to influence the public’s

expectations.”

With Mr. Douglas’s figures as a starting point,

Mr. Brash and Mr. Caygill agreed that it would be

best to expand the range to give them more room

to maneuver, but only a bit. New Zealand would

aim for inflation between zero and 2 percent.

Not surprisingly, the passage of a law

to reform the central bank governance of an

archipelago of 3.4 million people received no

coverage in the major American papers. But

across the close-knit world of global central

bankers, people started to notice the Kiwis’

monetary policy experiment.

At the time, the idea of a central bank

simply announcing how much inflation it was

aiming for was an almost radical idea. After

all, central bankers had long considered a

certain man-behind-the-curtain mystique as

one of their tools of power.

The inflation goal may have reduced that

mystique, but it created a kind of magic of

its own. Merely by announcing its goals for

inflation, and giving the central bank the

independent authority to reach that goal,

New Zealand made that result a reality. In

negotiations over wages or making plans

for price increases, businesses and labor

unions across New Zealand started assum-

ing that inflation would indeed be around 2

percent. It thus became self-fulfilling, with

wages and prices rising more slowly.

Inflation was 7.6 percent at the end of

1989 when the law was passed. By the end

of 1991, it was 2 percent. Mr. Brash did a

bit of a global campaigning, describing

New Zealand’s success to his fellow central

bankers at a conference in Jackson Hole,

Wyo.—and to anyone else who would listen.

On Kiwis and Currencies

IN THE NEWS

801CHAPTER 36 SIX DEBATES OVER MACROECONOMIC POLICY

One by one, more countries adopted

the approach. Canada, grappling with per-

sistently high inflation, set an inflation tar-

get of 2 percent in 1991. Countries including

Sweden and Britain soon followed….

But the more that countries set about

announcing a target, the more keen was the

discussion about the actual number.

One view was that zero inflation should be

the goal—that a dollar today should have the

same buying power as a dollar in a decade, or

two or three. That was the view embraced by,

among others, Paul A. Volcker, the former Fed

chairman. Alan Greenspan, Mr. Volcker’s suc-

cessor at the Fed, argued that inflation needed

to be low enough that it didn’t have to be fac-

tored into business decisions.

Either of those approaches would imply

that a proper target would be zero, or perhaps

0.5 percent or 1 percent, given the difficulty

of measuring inflation precisely.

But there was an alternate view—that keep-

ing inflation that low might be dangerous. And

the person mounting that argument most force-

fully within the Federal Reserve in the 1990s was

a Fed governor named Janet L. Yellen.

Behind the oversize doors of the Federal

Reserve’s boardroom on Constitution Avenue

in Washington, the fight over whether the

world’s largest economy should emulate the

likes of Canada and New Zealand took place

in 1995 and 1996.

Ms. Yellen, who now runs the institution,

worried that announcing an inflation target

would make the Fed focus only on inflation and

neglect its responsibilities to bolster growth and

jobs. She worried that zero inflation could par-

alyze the economy, particularly during slumps,

and felt that some inflation was necessary.

“To my mind the most important argument

for some low inflation rate is the ‘greasing-the-

wheels argument,’” Ms. Yellen said in a closed-

door meeting of Fed policy makers in July 1996.

When businesses run into rough times, they

may be inclined to cut workers’ pay. But in prac-

tice, that doesn’t happen much. Even in a severe

downturn, businesses are more likely to cut hours,

conduct layoffs or keep positions vacant than cut

pay. That’s one reason recessions tend to lead to

higher unemployment instead of lower wages.

Inflation helps deal with this problem.

When there is a bit of inflation, employers

can hold workers’ pay steady during a down-

turn yet have it decline in inflation-adjusted

terms. Inflation creates an adjustment mech-

anism: An assembly line worker may keep

making exactly $20 an hour through a down-

turn, but in inflation-adjusted terms that pay

falls by 2 percent a year, which could make

the factory less likely to resort to layoffs.

In that 1996 debate, another argument that

Ms. Yellen raised against a zero percent target

was particularly prescient. The higher the level

of inflation, the more that central banks can

stimulate the economy during a downturn.

Imagine that there is a severe recession and

the Fed cuts interest rates to zero, so that when

you put money in the bank you get no return. If

there is no inflation, your money will retain its

purchasing power and be worth the same when

you withdraw it. But if there is inflation, the

value of your money sitting in the bank becomes

steadily less valuable, meaning that you have

more incentive to spend or invest it.

“A little inflation permits real interest rates

to become negative on the rare occasions when

required to counter a recession,” Ms. Yellen

said in 1996. “This could be important.”

She, along with her colleagues across the

world of central banking, had no idea just

how important.

Ms. Yellen’s argument—that some infla-

tion would help grease the economy’s wheels

and give central banks more flexibility to

respond to a downturn—prevailed, in the

sense that 2 percent became the widespread

target of global central banks.

But even as that target was embraced,

signs started to emerge that it wasn’t high

enough to avoid the kinds of problems that

Ms. Yellen and others had described.

Starting in the late 1990s, Japan found itself

stuck in a pattern of falling prices, or deflation,

even after it cut interest rates all the way to zero.

The United States suffered a mild recession in

2001, and the Fed cut interest rates to 1 percent

to help spur a recovery. Then came the global

financial crisis of 2007 to 2009, spurring a

steep downturn across the planet and causing

central banks to slash interest rates.

All of this has quite a few smart econo-

mists wondering whether the central bank-

ers got the target number wrong. If they had

set it a bit higher, perhaps at 3 or 4 percent,

they might have been better able to combat

the Great Recession because they could cut

inflation-adjusted interest rates by more.

“Should policy makers therefore aim for a

higher target inflation rate in normal times, in

order to increase the room for monetary policy to

react to such shocks?” asked Olivier Blanchard,

the chief economist of the International Mone-

tary Fund, in a 2010 paper with two co-authors.

“To be concrete, are the net costs of inflation

much higher at, say, 4 percent than at 2 percent,

the current target range?”…

Such a shift would come at a cost. At 2 per-

cent inflation, it is easy to enter into many finan-

cial transactions without really having to adjust

for inflation. At 2 percent inflation, the value of

a dollar falls by half over 35 years, whereas at

4 percent it falls in half every 18 years. On the

other hand, inflation also hovered in the range

of 3 to 4 percent through the mid-1980s, hardly

remembered as an economic nightmare.

A shift in the target, furthermore, could

well cause disruptions in financial markets

and potentially a sharp, sudden rise in lon-

ger-term interest rates that could slow growth.

Current central bankers view the cost of

raising the target as too high to pay. The Fed’s

vice chairman, Stanley Fischer, reasserted

his support of a 2 percent target earlier this

month. And Ms. Yellen has given no indication

that she wishes to rethink the target. ■

Source: New York Times, December 21, 2014.

Janet Yellen

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802 PART XIII FINAL THOUGHTS

In addition, inflation allows for the possibility of negative real interest rates. Nominal interest rates can never fall below zero, because lenders can always hold on to their money rather than lending it out at a negative return. If inflation is zero, real interest rates can also never be negative. However, if inflation is posi- tive, then a cut in nominal interest rates below the inflation rate produces nega- tive real interest rates. Sometimes the economy may need negative real interest rates to provide sufficient stimulus to aggregate demand—an option ruled out by zero inflation.

In light of all these arguments, why should policymakers put the economy through a costly and inequitable disinflationary recession to achieve zero infla- tion? Economist Alan Blinder, who was once vice chairman of the Federal Reserve, argued in his book Hard Heads, Soft Hearts that policymakers should not make this choice:

The costs that attend the low and moderate inflation rates experienced in the United States and in other industrial countries appear to be quite modest— more like a bad cold than a cancer on society. . . . As rational individuals, we do not volunteer for a lobotomy to cure a head cold. Yet, as a collectivity, we routinely prescribe the economic equivalent of lobotomy (high unemployment) as a cure for the inflationary cold.

Blinder concludes that it is better to learn to live with moderate inflation.

QuickQuiz Explain the costs and benefits of reducing inflation to zero. Which are

temporary and which are permanent?

36-5 Should the Government Balance Its Budget? A persistent macroeconomic debate concerns the government’s finances. Whenever the government spends more than it collects in tax revenue, it cov- ers this budget deficit by issuing government debt. In our study of financial markets, we saw how budget deficits affect saving, investment, and interest rates. But how big a problem are budget deficits? Our next debate concerns whether fiscal policymakers should make balancing the government’s budget a high priority.

36-5a Pro: The Government Should Balance Its Budget The U.S. federal government is far more indebted today than it was three decades ago. In 1980, the federal debt was $712 billion; in 2015, it was $13.1 trillion. If we divide today’s debt by the size of the population, we learn that each person’s share of the government debt is about $41,000.

The most direct effect of the government debt is to place a burden on future generations of taxpayers. When these debts and accumulated interest come due, future taxpayers will face a difficult choice. They can choose some combination of higher taxes and less government spending to make resources available to pay off the debt and accumulated interest. Or, instead, they can delay the day of reck- oning and put the government into even deeper debt by borrowing once again to pay off the old debt and interest. In essence, when the government runs a budget deficit and issues government debt, it allows current taxpayers to pass the bill for some of their government spending on to future taxpayers. Inheriting such a large debt will lower the living standard of future generations.

803CHAPTER 36 SIX DEBATES OVER MACROECONOMIC POLICY

In addition to this direct effect, budget deficits have various macroeconomic effects. Because budget deficits represent negative public saving, they lower national saving (the sum of private and public saving). Reduced national sav- ing causes real interest rates to rise and investment to fall. Reduced investment leads over time to a smaller stock of capital. A lower capital stock reduces labor productivity, real wages, and the economy’s production of goods and services. Thus, when the government increases its debt, future generations are born into an economy with lower incomes as well as higher taxes.

There are, nevertheless, situations in which running a budget deficit is justi- fiable. Throughout history, the most common cause of increased government debt has been war. When a military conflict raises government spending tempo- rarily, it is reasonable to finance this extra spending by borrowing. Otherwise, taxes during wartime would have to rise precipitously. Such high tax rates would greatly distort the incentives faced by those who are taxed, leading to large dead- weight losses. In addition, such high tax rates would be unfair to current citizens who are making the sacrifice of fighting the war to ensure security and freedom not only for themselves but also for future generations.

Similarly, it is reasonable to allow a budget deficit during a temporary down- turn in economic activity. When the economy goes into a recession, tax revenue falls automatically because the income tax and the payroll tax are levied on mea- sures of income. If the government tried to balance its budget during a recession, it would have to raise taxes or cut spending at a time of high unemployment. Such a policy would tend to depress aggregate demand at precisely the time it needed to be stimulated and, therefore, would tend to increase the magnitude of economic fluctuations.

Yet not all budget deficits can be justified as a result of war or recession. U.S. government debt as a percentage of GDP increased from 26 percent in 1980 to 50 percent in 1995. During this period, the United States experienced neither a major military conflict nor a major economic downturn. Yet the government consistently ran a sizable budget deficit, largely because the president and Congress found it easier to increase government spending than to increase taxes.

The budget deficits that the U.S. government has run in recent years can, per- haps, be rationalized by the wars in Iraq and Afghanistan and the effects of the recessions in 2001 and 2008–2009. But it is imperative that this deficit not signal a return to the unsustainable fiscal policy of an earlier era. As the economy recovers from the most recent recession and unemployment returns to its natural rate, the government should bring spending in line with tax revenue. Compared to the alternative of ongoing budget deficits, a balanced budget means greater national saving, investment, and economic growth. It means that future college graduates will enter a more prosperous economy.

36-5b Con: The Government Should Not Balance Its Budget The problem of government debt is often exaggerated. Although the government debt does represent a tax burden on younger generations, it is not large compared to the average person’s lifetime income. The debt of the U.S. federal government is about $41,000 per person. A person who works 40 years for $50,000 a year will earn $2 million over his lifetime. His share of the government debt represents only about 2 percent of his lifetime resources.

Moreover, it is misleading to view the effects of budget deficits in isolation. The budget deficit is just one piece of a large picture of how the government chooses to raise and spend money. In making these decisions about fiscal policy,

“What?!? My share of the government debt is $41,000?”

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804 PART XIII FINAL THOUGHTS

policymakers affect different generations of taxpayers in many ways. The govern- ment’s budget deficit or surplus should be considered together with these other policies.

For example, suppose the government reduces the budget deficit by cut- ting spending on public investments, such as education. Does this policy make younger generations better off? The government debt will be smaller when they enter the labor force, which means a smaller tax burden. Yet if they are less edu cated than they could be, their productivity and incomes will be lower. Many estimates of the return from schooling (the increase in a worker ’s wage that re- sults from an additional year in school) find that it is quite large. Reducing the budget deficit rather than funding more education spending could, all things con- sidered, make future generations worse off.

Single-minded concern about the budget deficit is also dangerous because it draws attention away from various other policies that redistribute income across generations. For example, in the 1960s and 1970s, the U.S. federal government raised Social Security benefits for the elderly. It financed this higher spending by increasing the payroll tax on the working-age population. This policy redis- tributed income away from younger generations toward older generations, even though it did not affect the government debt. Thus, the budget deficit is only a small part of the larger issue of how government policy affects the welfare of dif- ferent generations.

To some extent, forward-looking parents can reverse the adverse effects of gov- ernment debt. Parents can offset the impact simply by saving and leaving a larger bequest. The bequest would enhance their children’s ability to bear the burden of future taxes. Some economists claim that people do in fact behave this way. If this were true, higher private saving by parents would offset the public dissaving of budget deficits; as a result, deficits would not affect the economy. Most econo- mists doubt that parents are so farsighted, but some people probably do act this way, and anyone could. Deficits give people the opportunity to consume at the expense of their children, but deficits do not require them to do so. If the govern- ment debt were actually a great problem facing future generations, some parents would help to solve it.

Critics of budget deficits sometimes assert that the government debt cannot continue to rise forever, but in fact, it can. Just as a bank evaluating a loan appli- cation would compare a person’s debts to his income, we should judge the bur- den of the government debt relative to the size of the nation’s income. Population growth and technological progress cause the total income of the U.S. economy to grow over time. As a result, the nation’s ability to pay the interest on the govern- ment debt grows over time as well. As long as the government debt grows more slowly than the nation’s income, there is nothing to prevent the government debt from growing forever.

Some numbers can put this into perspective. The real output of the U.S. econ- omy grows on average about 3 percent per year. If the inflation rate is 2 percent per year, then nominal income grows at a rate of 5 percent per year. The govern- ment debt, therefore, can rise by 5 percent per year without increasing the ratio of debt to income. In 2015, the federal government debt was $13.1 trillion; 5 percent of this figure is $655 billion. As long as the federal budget deficit is smaller than $655 billion, the policy is sustainable.

To be sure, very large budget deficits cannot persist forever. From 2009 to 2012, the federal budget deficit was over $1 trillion every year, but this astonishing num- ber was driven by extraordinary circumstances: a major financial crisis, a deep

805CHAPTER 36 SIX DEBATES OVER MACROECONOMIC POLICY

economic downturn, and the policy responses to these events. No one suggests that a deficit of this magnitude can continue. But zero is the wrong target for fiscal policymakers. As long as the deficit is only moderate in size, there will never be a day of reckoning that forces government borrowing to end or the economy to collapse.

QuickQuiz Explain how reducing a government budget deficit makes future genera-

tions better off. What fiscal policy might improve the lives of future gener-

ations more than reducing a government budget deficit?

36-6 Should the Tax Laws Be Reformed to Encourage Saving? A nation’s standard of living depends on its ability to produce goods and services. This was one of the Ten Principles of Economics in Chapter 1. As we saw in the chapter on production and growth, a nation’s productive capability, in turn, is determined largely by how much it saves and invests for the future. Our last debate is whether policymakers should reform the tax laws to encourage greater saving and investment.

36-6a Pro: The Tax Laws Should Be Reformed to Encourage Saving A nation’s saving rate is a key determinant of its long-run economic prosperity. When the saving rate is higher, more resources are available for investment in new plant and equipment. A larger stock of plant and equipment, in turn, raises labor productivity, wages, and incomes. It is, therefore, no surprise that interna- tional data show a strong correlation between national saving rates and measures of economic well-being.

Another of the Ten Principles of Economics presented in Chapter 1 is that people respond to incentives. This lesson should apply to people’s decisions about how much to save. If a nation’s laws make saving attractive, people will save a higher fraction of their incomes, and this higher saving will lead to a more prosperous future.

Unfortunately, the U.S. tax system discourages saving by taxing the return to saving quite heavily. For example, consider a 25-year-old worker who saves $1,000 of his income to have a more comfortable retirement at the age of 70. If he buys a bond that pays an interest rate of 10 percent, the $1,000 will accumulate at the end of 45 years to $72,900 in the absence of taxes on interest. But suppose he faces a marginal tax rate on interest income of 40 percent, which is typical for many workers once federal and state income taxes are added together. In this case, his after-tax interest rate is only 6 percent, and the $1,000 will accumulate at the end of 45 years to only $13,800. That is, accumulated over this long span of time, the tax rate on interest income reduces the benefit of saving $1,000 from $72,900 to $13,800—or by about 80 percent.

The tax code further discourages saving by taxing some forms of capital in- come twice. Suppose a person uses some of his saving to buy stock in a corpora- tion. When the corporation earns a profit from its capital investments, it first pays tax on this profit in the form of the corporate income tax. If the corporation pays out the rest of the profit to the stockholder in the form of dividends, the stock- holder pays tax on this income a second time in the form of the individual in- come tax. This double taxation substantially reduces the return to the stockholder, thereby reducing the incentive to save.

806 PART XIII FINAL THOUGHTS

Taxing Capital and Labor

ASK THE EXPERTS

“One drawback of taxing capital income at a lower rate than labor

income is that it gives people incentives to relabel income that pol-

icymakers find hard to categorize as ‘capital’ rather than ‘labor’.”

“Despite relabeling concerns, taxing capital income at a per-

manently lower rate than labor income would result in higher

average long-term prosperity, relative to an alternative that

generated the same amount of tax revenue by permanently tax-

ing capital and labor income at equal rates instead.”

What do economists say?

21% disagree

46% agree

33% uncertain

“Although they do not always agree about the precise likely

effects of different tax policies, another reason why economists

often give disparate advice on tax policy is because they hold

differing views about choices between raising average prosper-

ity and redistributing income.”

2% uncertain

98% agree

0% disagree

What do economists say?

Source: IGM Economic Experts Panel, October 9, 2012.

The tax laws again discourage saving if a person wants to leave his accumulated wealth to his children (or anyone else) rather than consuming it during his lifetime. Parents can bequeath some money to their children tax-free, but if the bequest becomes large, the estate tax rate can be as high as 40 percent. To a large extent, concern about national saving is motivated by a desire to ensure economic prosperity for future generations. It is odd, therefore, that the tax laws discourage the most direct way in which one generation can help the next.

In addition to the tax code, many other policies and insti- tutions in our society reduce the incentive for households to save. Some government benefits, such as welfare and Med- icaid, are means-tested; that is, the benefits are reduced for those who in the past have been prudent enough to save some of their income. Colleges and universities grant financial aid as a function of the wealth of the students and their parents. Such a policy is like a tax on wealth and, as such, discourages stu- dents and parents from saving.

There are various ways in which the tax code could provide an incentive to save, or at least reduce the disincentive that house- holds now face. Already the tax laws give preferential treat- ment to some types of retirement saving. When a taxpayer puts income into an Individual Retirement Account (IRA), for in- stance, that income and the interest it earns are not taxed until the funds are withdrawn at retirement. The tax code gives a similar tax advantage to retirement accounts that go by other names, such as 401(k), 403(b), and profit-sharing plans. There are, how- ever, limits to who is eligible to use these plans and, for those who are eligible, limits on the amount that can be put in them. More- over, because there are penalties for withdrawal before retirement age, these retirement plans provide little incentive for other types of saving, such as saving to buy a house or pay for college. A small step to encourage greater saving would be to expand the ability of households to use such tax-advantaged savings accounts.

A more comprehensive approach would be to reconsider the entire basis by which the government collects revenue. The centerpiece of the U.S. tax system is the income tax. A dollar earned is taxed the same whether it is spent or saved. An alternative advocated by many economists is a consump- tion tax. Under a consumption tax, a household pays taxes only on the basis of what it spends. Income that is saved is exempt from taxation until the saving is later withdrawn and spent on consumption goods. In essence, a consumption tax automatically puts all saving into a tax-advantaged savings account, much like an IRA. A switch from income to consump- tion taxation would greatly increase the incentive to save.

36-6b Con: The Tax Laws Should Not Be Reformed to Encourage Saving

Increasing saving may be desirable, but it is not the only goal of tax policy. Policymakers also must be sure to distribute the tax

3% disagree

96% agree

1% uncertain

What do economists say?

807CHAPTER 36 SIX DEBATES OVER MACROECONOMIC POLICY

burden fairly. The problem with proposals to increase the incentive to save is that they increase the tax burden on those who can least afford it.

It is undeniable that high-income households save a greater fraction of their income than low-income households. As a result, any tax change that favors people who save will also tend to favor people with high income. Policies such as tax-advantaged retirement accounts may seem appealing, but they lead to a less egalitarian society. By reducing the tax burden on the wealthy who can take advantage of these accounts, they force the government to raise the tax burden on the poor.

Moreover, tax policies designed to encourage saving may not be effective at achieving that goal. Economic theory does not give a clear prediction about whether a higher rate of return would increase saving. The outcome depends on the relative size of two conflicting forces, called the substitution effect and the income effect. On the one hand, a higher rate of return raises the benefit of saving: Each dollar saved today produces more consumption in the future. This substitution effect tends to increase saving. On the other hand, a higher rate of return lowers the need for saving: A household has to save less to achieve any target level of consumption in the future. This income effect tends to reduce saving. If the substitution and income effects approximately cancel each other, as some studies suggest, then saving will not change when lower taxation of capital income raises the rate of return.

There are ways to increase national saving other than by giving tax breaks to the rich. National saving is the sum of private and public saving. Instead of trying to alter the tax code to encourage greater private saving, policymakers can simply raise public saving by reducing the budget deficit, perhaps by raising taxes on the wealthy. This offers a direct way of raising national saving and increasing prosper- ity for future generations.

Indeed, once public saving is taken into account, tax provisions to encourage saving might backfire. Tax changes that reduce the taxation of capital income reduce government revenue and, thereby, lead to a larger budget deficit. To increase national saving, such a change in the tax code must stimulate private saving by more than the decline in public saving. If this is not the case, so-called saving incentives can potentially make matters worse.

QuickQuiz Give three examples of how our society discourages saving. What are the

drawbacks of eliminating these disincentives?

36-7 Conclusion This chapter has considered six classic debates over macroeconomic policy. For each, it began with a controversial proposition and then offered the arguments pro and con. If you find it hard to choose a side in these debates, you may find some comfort in the fact that you are not alone. The study of economics does not always make it easy to choose among alternative policies. Indeed, by clarifying the inevi- table trade-offs that policymakers face, it can make the choice more difficult.

Difficult choices, however, have no right to seem easy. When you hear politi- cians or commentators proposing something that sounds too good to be true, it probably is. If they sound like they are offering you a free lunch, you should look for the hidden price tag. Few if any policies come with benefits but no costs. By helping you see through the fog of rhetoric so common in political discourse, the study of economics should make you a better participant in our national debates.

808 PART XIII FINAL THOUGHTS

CHAPTER QuickQuiz

1. Approximately how long does it take a change in mon-

etary policy to influence aggregate demand?

a. 1 month

b. 6 months

c. 2 years

d. 5 years

2. According to traditional Keynesian analysis, which

of the following will increase aggregate demand the

most?

a. $100 billion increase in taxation

b. $100 billion decrease in taxation

c. $100 billion increase in government spending

d. $100 billion decrease in government spending

3. Advocates for setting monetary policy by rule rather

than discretion often argue that

a. central bankers with discretion are tempted to

renege on their announced commitments to low

inflation.

b. central bankers following a rule will be more re-

sponsive to the needs of the political process.

c. fiscal policy is a much better tool for economic

stabilization than is monetary policy.

d. it is sometimes useful to give the economy a burst

of surprise inflation.

4. Which of the following is NOT an argument for main-

taining a positive rate of inflation?

a. It permits real interest rates to be negative.

b. It allows real wages to fall without cuts in nominal

wages.

c. It increases the variability of relative prices.

d. It would be costly to reduce inflation to zero.

5. Throughout U.S. history, what has been the most

common cause of substantial increases in government

debt?

a. recessions

b. wars

c. financial crises

d. tax cuts

6. Advocates of taxing consumption rather than income

argue that

a. a consumption tax is a better automatic

stabilizer.

b. taxing consumption does not cause any dead-

weight losses.

c. the rich consume a higher fraction of income than

the poor.

d. the current tax code discourages people from

saving.

• Advocates of active monetary and fiscal policies

view the economy as inherently unstable and believe

that policy can manage aggregate demand to offset

the inherent instability. Critics of active monetary

and fiscal policies emphasize that policy affects the

economy with a lag and that our ability to forecast

future economic conditions is poor. As a result,

attempts to stabilize the economy can end up being

destabilizing.

• Advocates of increased government spending to

fight recessions argue that because tax cuts may

be saved rather than spent, direct government

s p e n d i n g d o e s m o r e t o i n c r e a s e a g g r e g a t e

demand, which is key to promoting production

and employment. Critics of spending hikes argue

that tax cuts can expand both aggregate demand

and aggregate supply and that hasty increases in

government spending may lead to wasteful public

projects.

• Advocates of rules for monetary policy argue that dis-

cretionary policy can suffer from incompetence, the

abuse of power, and time inconsistency. Critics of rules

for monetary policy argue that discretionary policy

is more flexible in responding to changing economic

circumstances.

• Advocates of a zero-inflation target emphasize

that inflation has many costs and few if any bene-

fits. Moreover, the cost of eliminating inflation—

d e p r e s s e d o u t p u t a n d e m p l o y m e n t — i s o n l y

temporary. Even this cost can be reduced if the

central bank announces a credible plan to reduce

inflation, thereby directly lowering expectations of

inflation. Critics of a zero- inflation target claim that

moderate inflation imposes only small costs on soci-

ety, whereas the recession necessary to reduce infla-

tion is quite costly. The critics also point out several

ways in which moderate inflation may be helpful to

an economy.

d f d f l l d f l f l h d

SUMMARY

809CHAPTER 36 SIX DEBATES OVER MACROECONOMIC POLICY

QUESTIONS FOR REVIEW

1. What causes the lags in the effect of monetary and fis-

cal policies on aggregate demand? What are the impli-

cations of these lags for the debate over active versus

passive policy?

2. According to traditional Keynesian analysis, why does

a tax cut have a smaller effect on GDP than a similarly

sized increase in government spending? Why might

the opposite be the case?

3. What might motivate a central banker to cause a

political business cycle? What does the political busi-

ness cycle imply for the debate over policy rules?

4. Explain how credibility might affect the cost of reduc-

ing inflation.

5. Why are some economists against a target of zero

inflation?

6. Explain two ways in which a government budget defi-

cit hurts a future worker.

7. What are two situations in which most economists

view a budget deficit as justifiable?

8. Some economists say that the government can con-

tinue running a budget deficit forever. How is that

possible?

9. Some income from capital is taxed twice. Explain.

10. What adverse effect might be caused by tax incentives

to increase saving?

• Advocates of a balanced government budget argue

that budget deficits impose an unjustifiable burden

on future generations by raising their taxes and low-

ering their incomes. Critics of a balanced government

budget argue that the deficit is only one small piece of

fiscal policy. Single-minded concern about the budget

deficit can obscure the many ways in which policy, in-

cluding various spending programs, affects different

generations.

• Advocates of tax incentives for saving point out that

our society discourages saving in many ways, such

as by heavily taxing capital income and by reducing

benefits for those who have accumulated wealth.

They endorse reforming the tax laws to encourage

saving, perhaps by switching from an income tax

to a consumption tax. Critics of tax incentives for

saving argue that many proposed changes to stim-

ulate saving would primarily benefit the wealthy,

who do not need a tax break. They also argue that

such changes might have only a small effect on pri-

vate saving. Raising public saving by decreasing

the government’s budget deficit would provide a

more direct and equitable way to increase national

saving.

1. The chapter suggests that the economy, like the

human body, has “natural restorative powers.”

a. Illustrate the short-run effect of a fall in aggregate

demand using an aggregate-demand/ aggregate-

supply diagram. What happens to total output,

income, and employment?

b. If the government does not use stabilization policy,

what happens to the economy over time? Illustrate

this adjustment on your diagram. Does it generally

occur in a matter of months or a matter of years?

c. Do you think the “natural restorative powers” of

the economy mean that policymakers should be

passive in response to the business cycle?

2. Policymakers who want to stabilize the economy

must decide how much to change the money supply,

government spending, or taxes. Why is it difficult for

policymakers to choose the appropriate strength of

their actions?

3. The problem of time inconsistency applies to fiscal

policy as well as to monetary policy. Suppose the

government announced a reduction in taxes on

income from capital investments, like new factories.

a. If investors believed that capital taxes would

remain low, how would the government’s action

affect the level of investment?

l k h b l h

PROBLEMS AND APPLICATIONS

810 PART XIII FINAL THOUGHTS

b. After investors have responded to the announced

tax reduction, does the government have an

incentive to renege on its policy? Explain.

c. Given your answer to part b, would investors believe the government’s announcement? What

can the government do to increase the credibility

of announced policy changes?

d. Explain why this situation is similar to the

time-inconsistency problem faced by monetary

policymakers.

4. Chapter 2 explains the difference between positive

analysis and normative analysis. In the debate

about whether the central bank should aim for

zero inflation, which areas of disagreement involve

positive statements and which involve normative

judgments?

5. Why are the benefits of reducing inflation permanent

and the costs temporary? Why are the costs of

increasing inflation permanent and the benefits tem-

porary? Use Phillips-curve diagrams in your answer.

6. Suppose the federal government cuts taxes and

increases spending, raising the budget deficit to

12 percent of GDP. If nominal GDP is rising 5 percent

per year, are such budget deficits sustainable forever?

Explain. If budget deficits of this size are maintained

for 20 years, what is likely to happen to your taxes

and your children’s taxes in the future? Can you

personally do something today to offset this future

effect?

7. Explain how each of the following policies redistrib-

utes income across generations. Is the redistribution

from young to old or from old to young?

a. an increase in the budget deficit

b. more generous subsidies for education loans

c. greater investments in highways and bridges

d. an increase in Social Security benefits

8. What is the fundamental trade-off that society faces if

it chooses to save more? How might the government

increase national saving?

To find additional study resources, visit cengagebrain.com,

and search for “Mankiw.”

811

A 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 ability to pro- duce a good using fewer inputs than

another producer

accounting profit total revenue minus total explicit cost

adverse selection the tendency for the mix of unobserved attributes to become

undesirable from the standpoint of an

uninformed party

agent a person who is performing an act for another person, called the principal

aggregate-demand curve a curve that shows the quantity of goods and ser-

vices that households, firms, the gov-

ernment, and customers abroad want to

buy at each price level

aggregate-supply curve a curve that shows the quantity of goods and ser-

vices that firms choose to produce and

sell at each price level

appreciation an increase in the value of a currency as measured by the amount

of foreign currency it can buy

Arrow’s impossibility theorem a mathe- matical result showing that, under certain

assumed conditions, there is no scheme

for aggregating individual preferences

into a valid set of social preferences

automatic stabilizers changes in fiscal policy that stimulate aggregate demand

when the economy goes into a recession

without policymakers having to take

any deliberate action

average fixed cost fixed cost 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 cost divided by the quantity of output

B balanced trade a situation in which exports equal imports

bank capital the resources a bank’s owners have put into the institution

behavioral economics the subfield of economics that integrates the insights of

psychology

benefits principle the idea that people should pay taxes based on the benefits

they receive from government services

bond a certificate of indebtedness

budget constraint the limit on the con- sumption bundles that a consumer can

afford

budget deficit a shortfall of tax reve- nue from government spending

budget surplus an excess of tax reve- nue over government spending

business cycle fluctuations in eco- nomic activity, such as employment and

production

C capital the equipment and structures used to produce goods and services

capital flight a large and sudden reduction in the demand for assets

located in a country

capital requirement a government reg- ulation specifying a minimum amount

of bank capital

cartel a group of firms acting in unison

catch-up effect the property whereby countries that start off poor tend to

grow more rapidly than countries that

start off rich

central bank an institution designed to oversee the banking system and

regulate the quantity of money in the

economy

circular-flow diagram a visual model of the economy that shows how dollars

flow through markets among house-

holds and firms

classical dichotomy the theoretical sep- aration of nominal and real variables

closed economy an economy that does not interact with other economies in the

world

club goods goods that are excludable but not rival in consumption

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

collective bargaining the process by which unions and firms agree on the

terms of employment

collusion an agreement among firms in a market about quantities to produce or

prices to charge

commodity money money that takes the form of a commodity with intrinsic

value

common resources goods that are rival in consumption but not excludable

Glossary

812 GLOSSARY

comparative advantage the ability to produce a good at a lower opportunity

cost than another producer

compensating differential a differ- ence in wages that arises to offset

the nonmonetary characteristics of

different jobs

competitive market a market with many buyers and sellers trading iden-

tical 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

compounding the accumulation of a sum of money in, say, a bank account,

where the interest earned remains in the

account to earn additional interest in

the future

Condorcet paradox the failure of majority rule to produce transitive

preferences for society

constant returns to scale the property whereby long-run average total cost

stays the same as the quantity of output

changes

consumer price index (CPI) a measure of the overall cost of the goods and

services bought by a typical consumer

consumer surplus the amount a buyer is willing to pay for a good

minus the amount the buyer actually

pays for it

consumption spending by households on goods and services, with the excep-

tion of purchases of new housing

core CPI a measure of the overall cost of consumer goods and services exclud-

ing food and energy

corrective tax a tax designed to induce private decision makers to take into

account the social costs that arise from a

negative externality

cost the value of everything a seller must give up to produce a good

cost–benefit analysis a study that com- pares 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

price of the second good

crowding out a decrease in invest- ment that results from government

borrowing

crowding-out effect the offset in aggre- gate demand that results when expan-

sionary fiscal policy raises the interest

rate and thereby reduces investment

spending

currency the paper bills and coins in the hands of the public

cyclical unemployment the deviation of unemployment from its natural rate

D deadweight loss the fall in total sur- plus that results from a market distor-

tion, such as a tax

demand curve a graph of the relation- ship between the price of a good and

the quantity demanded

demand deposits balances in bank accounts that depositors can access on

demand by writing a check

demand schedule a table that shows the relationship between the price of a

good and the quantity demanded

depreciation a decrease in the value of a currency as measured by the amount

of foreign currency it can buy

depression a severe recession

diminishing marginal product the property whereby the marginal product

of an input declines as the quantity of

the input increases

diminishing returns the property whereby the benefit from an extra unit

of an input declines as the quantity of

the input increases

discount rate the interest rate on the loans that the Fed makes to banks

discouraged workers individuals who would like to work but have given up

looking for a job

discrimination the offering of differ- ent opportunities to similar individ-

uals 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

diversification the reduction of risk achieved by replacing a single risk with a

large number of smaller, unrelated risks

dominant strategy a strategy that is best for a player in a game regardless

of the strategies chosen by the other

players

E 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 a resource allocation of maximizing the total sur-

plus received by all members of society

efficiency wages above-equilibrium wages paid by firms to increase worker

productivity

efficient markets hypothesis the the- ory that asset prices reflect all publicly

available information about the value of

an asset

efficient scale the quantity of output that minimizes average total cost

elasticity a measure of the responsive- ness of quantity demanded or quan-

tity supplied to a change in one of its

determinants

equality the property of distributing economic prosperity uniformly among

the members of society

813GLOSSARY

equilibrium a situation in which the market price has reached the level at

which quantity supplied equals quantity

demanded

equilibrium price the price that bal- ances quantity supplied and quantity

demanded

equilibrium quantity the quantity sup- plied and the quantity demanded at the

equilibrium price

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 uncompensated impact of one person’s actions on the well-

being of a bystander

F factors of production the inputs used to produce goods and services

federal funds rate the interest rate at which banks make overnight loans to

one another

Federal Reserve (Fed) the central bank of the United States

fiat money money without intrinsic value that is used as money by govern-

ment decree

finance the field that studies how people make decisions regarding the

allocation of resources over time and

the handling of risk

financial intermediaries financial institutions through which savers can

indirectly provide funds to borrowers

financial markets financial institutions through which savers can directly pro-

vide funds to borrowers

financial system the group of institu- tions in the economy that help to match

one person’s saving with another per-

son’s investment

firm-specific risk risk that affects only a single company

fiscal policy the setting of the level of government spending and taxation by

government policymakers

Fisher effect the one-for-one adjustment of the nominal interest rate to the infla-

tion rate

fixed costs costs that do not vary with the quantity of output produced

fractional-reserve banking a banking system in which banks hold only a frac-

tion of deposits as reserves

free rider a person who receives the benefit of a good but avoids paying for it

frictional unemployment unemploy- ment that results because it takes time

for workers to search for the jobs that

best suit their tastes and skills

fundamental analysis the study of a company’s accounting statements and

future prospects to determine its value

future value the amount of money in the future that an amount of money today

will yield, given prevailing interest rates

G game theory the study of how people behave in strategic situations

GDP deflator a measure of the price level calculated as the ratio of nominal

GDP to real GDP times 100

Giffen good a good for which an increase in the price raises the quantity

demanded

government purchases spending on goods and services by local, state, and

federal governments

gross domestic product (GDP) the market value of all final goods and

services produced within a country in a

given period of time

H horizontal equity the idea that taxpay- ers 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

I implicit costs input costs that do not require an outlay of money by

the firm

imports goods and services that are produced abroad and sold

domestically

incentive something that induces a person to act

income effect the change in consump- tion that results when a price change

moves the consumer to a higher or

lower indifference curve

income elasticity of demand a mea- sure of how much the quantity de-

manded 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

indexation the automatic correction by law or contract of a dollar amount for

the effects of inflation

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 being equal, an increase

in income leads to a decrease in

demand

inflation an increase in the overall level of prices in the economy

inflation rate the percentage change in the price index from the preceding

period

inflation tax the revenue the govern- ment raises by creating money

informational efficiency the descrip- tion of asset prices that rationally reflect

all available information

in-kind transfers transfers to the poor given in the form of goods and services

rather than cash

814 GLOSSARY

internalizing the externality altering incentives so that people take into

account the external effects of their

actions

investment spending on business capital, residential capital, and

inventories

J job search the process by which workers find appropriate jobs given

their tastes and skills

L labor force the total number of workers, including both the employed

and the unemployed

labor-force participation rate the percentage of the adult population that

is in the labor force

law of demand the claim that, other things being equal, the quantity

demanded of a good falls when the

price of the good rises

law of supply the claim that, other things being equal, the quantity sup-

plied 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 quantity supplied and the

quantity demanded for that good into

balance

leverage the use of borrowed money to supplement existing funds for

purposes of investment

leverage ratio the ratio of assets to bank capital

liberalism the political philosophy according to which the government

should choose policies deemed 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 vol-

untary agreements but not redistribute

income

life cycle the regular pattern of income variation over a person’s life

liquidity the ease with which an asset can be converted into the economy’s

medium of exchange

lump-sum tax a tax that is the same amount for every person

M macroeconomics the study of econo- my-wide phenomena, including inflation,

unemployment, and economic growth

marginal change a small incremental adjustment 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 out- put that arises from an additional unit

of input

marginal product of labor the increase in the amount of output from an addi-

tional 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 amount by which taxes increase from 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 decen-

tralized 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 for loanable funds the market in which those who want to save sup-

ply funds and those who want to bor-

row to invest demand funds

market power the ability of a single economic actor (or small group of

actors) to have a substantial influence

on market prices

market risk risk that affects all compa- nies in the stock market

maximin criterion the claim that the government should aim to maximize

the well-being of the worst-off person

in society

median voter theorem a mathematical result showing that if voters are choosing

a point along a line and each voter wants

the point closest to his most preferred

point, then majority rule will pick the

most preferred point of the median voter

medium of exchange an item that buyers give to sellers when they want

to purchase goods and services

menu costs the costs of changing prices

microeconomics the study of how households and firms make decisions

and how they interact in markets

model of aggregate demand and aggregate supply the model that most economists use to explain short-

run fluctuations in economic activity

around its long-run trend

monetary neutrality the proposition that changes in the money supply do

not affect real variables

monetary policy the setting of the money supply by policymakers in the

central bank

money the set of assets in an economy that people regularly use to buy goods

and services from other people

money multiplier the amount of money the banking system generates

with each dollar of reserves

money supply the quantity of money available in the economy

monopolistic competition a mar- ket 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 any close substitutes

moral hazard the tendency of a person who is imperfectly monitored to engage

in dishonest or otherwise undesirable

behavior

multiplier effect the additional shifts in aggregate demand that result when

expansionary fiscal policy increases in-

come and thereby increases consumer

spending

815GLOSSARY

mutual fund an institution that sells shares to the public and uses the pro-

ceeds to buy a portfolio of stocks and

bonds

N 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

national saving (saving) the total income in the economy that remains

after paying for consumption and

government purchases

natural level of output the production of goods and services that an economy

achieves in the long run when unem-

ployment is at its normal rate

natural monopoly a type of monopoly that arises because a single firm can

supply a good or service to an entire

market at a lower cost than could two

or more firms

natural-rate hypothesis the claim that unemployment eventually returns to its

normal, or natural, rate, regardless of

the rate of inflation

natural rate of unemployment the normal rate of unemployment around

which the unemployment rate

fluctuates

natural resources the inputs into the production of goods and services that

are provided by nature, such as land,

rivers, and mineral deposits

negative income tax a tax system that collects revenue from high-income

households and gives subsidies to

low-income households

net capital outflow the purchase of foreign assets by domestic residents

minus the purchase of domestic assets

by foreigners

net exports spending on domestically produced goods by foreigners (exports)

minus spending on foreign goods by

domestic residents (imports)

nominal exchange rate the rate at which a person can trade the currency of

one country for the currency of another

nominal GDP the production of goods and services valued at current prices

nominal interest rate the interest rate as usually reported without a correction

for the effects of inflation

nominal variables variables measured in monetary units

normal good a good for which, other things being equal, an increase in

income leads to an increase in demand

normative statements claims that attempt to prescribe how the world

should be

O oligopoly a market structure in which only a few sellers offer similar or identi-

cal products

open economy an economy that inter- acts freely with other economies around

the world

open-market operations the purchase and sale of U.S. government bonds by

the Fed

opportunity cost whatever must be given up to obtain some item

P 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 trade-off between inflation

and unemployment

physical capital the stock of equipment and structures that are used to produce

goods and services

political economy the study of gov- ernment using the analytic methods of

economics

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 falls

below an absolute level called the pov-

erty line

present value the amount of money today that would be needed, using pre-

vailing interest rates, to produce a given

future amount of money

price ceiling a legal maximum on the price at which a good can be sold

price discrimination the business prac- tice 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

principal a person for whom another person, called the agent, is performing

some act

prisoners’ dilemma a particular “game” between two captured pris-

oners that illustrates why cooperation

is difficult to maintain even when it is

mutually beneficial

private goods goods that are both excludable and rival in consumption

private saving the income that house- holds have left after paying for taxes

and consumption

producer price index a measure of the cost of a basket of goods and services

bought by firms

producer surplus the amount a seller is paid for a good minus the seller’s cost

of providing it

production function the relationship between the quantity of inputs used to

make a good and the quantity of output

of that good

816 GLOSSARY

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 produc-

tion technology

productivity the quantity of goods and services produced from each unit of

labor input

profit total revenue minus total cost

progressive tax a tax for which high- income taxpayers pay a larger fraction

of their income than do low-income

taxpayers

property rights the ability of an indi- vidual to own and exercise control over

scarce resources

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 in consumption

public saving the tax revenue that the government has left after paying for its

spending

purchasing-power parity a theory of exchange rates whereby a unit of

any given currency should be able to

buy the same quantity of goods in all

countries

Q quantity demanded the amount of a good that buyers are willing and able to

purchase

quantity equation the equation M × V = P × Y, which relates the quantity of money, the velocity of money, and the

dollar value of the economy’s output of

goods and services

quantity supplied the amount of a good that sellers are willing and able

to sell

quantity theory of money a theory asserting that the quantity of money

available determines the price level and

that the growth rate in the quantity of

money available determines the infla-

tion rate

R random walk the path of a variable whose changes are impossible to

predict

rational expectations the theory that people optimally use all the information

they have, including information about

government policies, when forecasting

the future

rational people people who systemati- cally and purposefully do the best they

can to achieve their objectives

real exchange rate the rate at which a person can trade the goods and services

of one country for the goods and ser-

vices of another

real GDP the production of goods and services valued at constant prices

real interest rate the interest rate cor- rected for the effects of inflation

real variables variables measured in physical units

recession a period of declining real incomes and rising unemployment

regressive tax a tax for which high- income taxpayers pay a smaller fraction

of their income than do low-income

taxpayers

reserve ratio the fraction of deposits that banks hold as reserves

reserve requirements regulations on the minimum amount of reserves that

banks must hold against deposits

reserves deposits that banks have received but have not loaned out

risk aversion a dislike of uncertainty

rivalry in consumption the property of a good whereby one person’s use

diminishes other people’s use

S sacrifice ratio the number of percent- age points of annual output lost in the

process of reducing inflation by 1 per-

centage point

scarcity the limited nature of society’s resources

screening an action taken by an uninformed party to induce an

informed party to reveal information

shoeleather costs the resources wasted when inflation encourages people to

reduce their money holdings

shortage a situation in which quantity demanded is greater than quantity

supplied

signaling an action taken by an informed party to reveal private

information to an uninformed party

social insurance government policy aimed at protecting people against the

risk of adverse events

stagflation a period of falling output and rising prices

stock a claim to partial ownership in a firm

store of value an item that people can use to transfer purchasing power from

the present to the future

strike the organized withdrawal of labor from a firm by a union

structural unemployment unemploy- ment that results because the number of

jobs available in some labor markets is

insufficient to provide a job for every-

one who wants one

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 con- sumption 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 relation- ship 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

supply shock an event that directly alters firms’ costs and prices, shifting

the economy’s aggregate-supply curve

and thus the Phillips curve

817GLOSSARY

surplus a situation in which quan- tity supplied is greater than quantity

demanded

T tariff a tax on goods produced abroad and sold domestically

tax incidence the manner in which the burden of a tax is shared among partici-

pants in a market

technological knowledge society’s understanding of the best ways to

produce goods and services

theory of liquidity preference Keynes’s theory that the interest rate

adjusts to bring money supply and

money demand into balance

total cost the market value of the inputs a firm uses in production

total revenue the amount paid by buy- ers and received by sellers of a good,

computed as the price of the good times

the quantity sold

trade balance the value of a nation’s exports minus the value of its imports;

also called net exports

trade deficit an excess of imports over exports

trade policy a government policy that directly influences the quantity

of goods and services that a country

imports or exports

trade surplus an excess of exports over imports

Tragedy of the Commons a parable that illustrates why common resources

are used more than is desirable from the

standpoint of society as a whole

transaction costs the costs that parties incur during the process of

agreeing to and following through

on a bargain

U unemployment insurance a govern- ment program that partially protects

workers’ incomes when they become

unemployed

unemployment rate the percentage of the labor force that is unemployed

union a worker association that bargains with employers over wages,

benefits, and working conditions

unit of account the yardstick people use to post prices and record debts

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

V 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

velocity of money the rate at which money changes hands

vertical equity the idea that taxpay- ers with a greater ability to pay taxes

should pay larger amounts

W welfare government programs that supplement the incomes of the needy

welfare economics the study of how the allocation of resources affects eco-

nomic 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

819

A Ability, wages and, 388–389 Ability-to-pay principle, 237, 237–239

horizontal equity, 239 vertical equity, 237–239

Absolute advantage, 52 Absolute value, 91–92 Accidents, associated with driving,

197–198 Account, unit of, 605 Accountants, economists vs., 249–250 Accounting, 547 Accounting profit, 250, 250–251 Adjustment process, 632–633 Administrative burden, 234–235 Adverse selection, 454, 568 Advertising, 328–332

brand names and, 331–332 critique of, 328–329 debate over, 328–329 defense of, 329 and price of eyeglasses, 329 signaling theory of, 389 as signal of quality, 330–331

Aeppel, Timothy, 486, 532 Agents, 452, 452–454 Aggregate demand. See also Model of

aggregate demand and aggregate supply

automatic stabilizers, 758 changes in government purchases,

747–748 changes in taxes, 752–753 contraction in, 723 crowding-out effect, 750–752 depicting long-run growth and

inflation, 715–716 economic fluctuations, 702–707 effects of shift in, 722–724 fiscal policy and, 747–758 Great Depression, 725–726 monetary policy and, 738–747 multiplier effect, 748 Phillips curve and, 765–767 recession of 2008-2009, 726–727 spending multiplier, formula for,

748–750 stabilization policy, 753–758 theory of liquidity preference, 739–741

World War II, 725–726 Aggregate-demand curve, 706, 707–712.

See also Aggregate demand; Model of aggregate demand and aggregate supply

downward slope of, 707–710, 712, 741–743

exchange-rate effect, 709, 712 interest-rate effect, 708–709, 712 shifts in, 710–712 wealth effect, 708, 712

Aggregate supply. See also Model of aggregate demand and aggregate supply

adverse shock, 775 depicting long-run growth and

inflation, 715–716 economic fluctuations, 702–707 effects of shift in, 728–731 fiscal policy and, 752 oil and the economy, 731–733 Phillips curve and, 765–767 stagflation, 730 wage-price spiral, 730

Aggregate-supply curve, 707, 712–721. See also Aggregate supply; Model of aggregate demand and aggregate supply

menu costs, 718 misperceptions theory, 719 natural rate of output, 714 shifts in, 713–715, 720–721 short-run, 717 slopes upward in short run, 716–719 sticky-price theory, 718 sticky-wage theory, 717–718 vertical in long run, 712–713

Aid, using experiments to evaluate, 536–537

Airline prices, price discrimination and, 307

Aldrich, Nelson W., 620–621 Allin, Paul, 488 American Airlines, 350 American Association of Ice-Cream

Eaters, 121 American Economic Association, 488 American Economic Review, 388, 393, 764,

767 American Heritage, 518

American Recovery and Reinvestment Act (ARRA), 756, 792

“Analytics of Anti-Inflation Policy” (Samuelson & Solow), 764

Analytics of price discrimination, 305–306 Angrist, Joshua, 371 Animals as common resources, 221–222 Annuity, 567 Antipoverty programs

fighting poverty is public good, 215–216

minimum-wage laws, 413 negative income tax, 414–415 welfare, 414 work incentives, 415–418

Antitrust laws increasing competition with, 308–309 restraint of trade and, 349–350

Antitrust policy controversies over, 350–353 predatory pricing, 351–352 resale price maintenance, 351 tying, 352

Appreciation, 665 Arbitrage, 305, 668 Argentina

economic growth of, 531 GDP, 517, 531 inward-oriented policies of trade, 531

Arms races, as example of prisoners’ dilemma, 346

ARRA. See American Recovery and Reinvestment Act

Arrow, Kenneth, 459 Arrow’s impossibility theorem, 458–459, 459 Asset valuation, 571–574 Assumptions, 21–22, 705 Asymmetric information, 452–457

adverse selection, 454 agents, 452–454 gifts as signals, 455–456 lemons problem, 454 moral hazards, 452–454 principals, 452–454 and public policy, 456–457 screening to uncover private

information, 456 signaling, 455–456

AT&T, 309 Austria, hyperinflation in, 636–637

Index

Page numbers in boldface refer to pages where key terms are defined.

820 INDEX

Automatic stabilizers, 758 Automobile industry, safety laws, 7–8 Autor, David H., 405 Avatar, 504 Avengers, The, 352 Average cost, 6–7

and marginal-cost curves, 257 Average fixed cost, 256, 262 Average-fixed-cost (AFC) curve, 257 Average revenue, 270, 294 Average tax rates, 235 Average total cost, 256, 262, 271–272

related to marginal cost and, 258 related to short- and long-run,

260–261 U-shaped, 257–258

Average total cost (ATC) curve, 257, 271–272

Average variable cost, 256, 262 Average variable cost (AVC) curve, 257,

259 Axelrod, Robert, 349

B Baker, Greg, 393 Balance budget debate, 802–805 Balanced budget, 554 Balanced trade, 655 Balance sheet, 612 Bangladesh

economic growth of, 516–517 income inequality in, 404

Bank capital, 615 Banks. See also Central bank; European

Central Bank bank capital, leverage, and financial

crisis of 2008-2009, 615–616 Fed lending to, 617–618 as financial intermediaries, 544–545 100-percent-reserve banking, 611–612 money creation with fractional-

reserve banking, 612–613 money multiplier, 613–614 money supply and, 611–616 runs, money supply and, 619–621

Bar graph, 37, 38 Barro, Josh, 205 Barro, Robert, 778 Barter, 604 Bartlett, Bruce, 417 Base year, 483 Basket of goods and services, 498 Baum, L. Frank, 647 Bauman, Yoram, 199 BEA. See Bureau of Economic Analysis Beautiful Mind, A, 340 Beauty, benefits of, 388–389 Beauty premium, 389 Behavioral economics, 461, 461–466

fairness and, 463–465

inconsistency and, 466 rationality and, 462–463, 464–465

Benefits principle, 236, 236–237 Benevolent social planner, 143–144 Benham, Lee, 329 Bentham, Jeremy, 410 Bernanke, Ben S., 621, 692–693, 781 Berra, Yogi, 508 Bertrand, Marianne, 393 Biddle, Jeff, 388–389 Billion Prices Project, 501 Black Death, economics of, 377–378 Blacks, economics of discrimination,

391–396 Blanchard, Olivier, 728–729, 801 Blinder, Alan, 802 BLS. See Bureau of Labor Statistics BMW, 342 Bolivia, hyperinflation in, 642 Bond, 543 Bond market, 543 Borda count, 458–459 Borjas, George, 405 Botswana, elephants as private good,

222 Brain drain, 528 Brand names, 331–332 Braniff Airways, 350 Brash, Don, 800 Brazil

economic growth of, 517 income inequality in, 404

Brooks, Arthur C., 177 Bryan, William Jennings, 646 Budget, 802–805

constraint, 427, 427–428 Budget deficits, 548

crowding out, 555 market for loanable funds and,

554–556 Budget surplus, 548, 554

market for loanable funds and, 554–556

Bureau of Economic Analysis (BEA), 482 Bureau of Labor Statistics (BLS), 578, 585,

763 computing CPI, 496, 498, 500

Bush, George H. W., 417, 753 Bush, George W., 242, 781, 788

government debt under, 557 tax cuts under, 242, 792

Bush, Jeb, 656 Business cycle, 14, 702 Business-stealing externality, 327 Buyers

marginal, 135–136 number of, and shifts in demand, 71 taxes on, affect market outcomes,

122–124 variables that influence, 71 willingness to pay, 134–135

C Cameron, David, 488 Canada

economic growth of, 517 income inequality in, 404 NAFTA and, 181

Capital, 362, 375 aggregate-supply curve shifts and,

714 cost of, 249–250 defined, 362 equilibrium in markets for,

375–376 factor of production, 375–378 human, 385–386, 519, 522, 524, 528 international flows of, 654–664 physical, 519–522

Capital flight, 690 effects of, 691 political instability and, 690–694

Capital flow China, 694–695 Capital gains, 643 Capital income, 376 Capital outflow, net

equality of net exports and, 659–660 interest rates, 683 link between two markets, 683–684

Capital requirement, 616 Capital stock, population growth diluting

of, 534–535 Carbon tax, 199 Carnegie, Andrew, 444 Carney, John, 84 Carson, Ben, 656 Cartels, 339, 732. See also Organization of

the Petroleum Exporting Countries (OPEC)

competition and, 339–340 monopolies and, 339–340 union as type of, 592–593

Carter, Jimmy, 628, 796 Catch-up effect, 525–527, 526 Cause and effect, 43–45 Cavallo, Alberto, 501 Caygill, David, 800 CBO. See Congressional Budget Office Central bank, 609. See also Federal Reserve

(Fed) zero inflation debate, 797–802

Centrally planned economies, 9 Chamberlin, Edward, 331 Chance, wages and, 388–389 Charities, private solution to externalities,

203 Chew, Victor, 146 Chile, unilateral approach to free trade,

181 China

capital flow, 694–695 economic growth of, 516–517

821INDEX

economic growth rate of, 516 income inequality in, 404 living standards in, 13 one child per family policy of, 535

Choice. See Consumer choice; Optimization

Christie, Chris, 84 Circular-flow diagram, 22, 22–24, 475 Classical dichotomy, 633, 633–634 Classical economics, assumptions of, 705 Clayton Antitrust Act, 309, 350 Clean Air Act, 199, 201 Clean air and water as common resources,

219 Climate change, 199 Clinton, Bill, 242

government debt, 557 Clinton, Hillary Rodham, 656 Closed economy, 547, 654 Club goods, 213, 292 Coase, Ronald, 203 Coase theorem, 203, 203–204, 205 Coca-Cola Company, 308, 523 Cogan, John, 755 Cold War, 346 Collective bargaining, 592 College education, cost of, 385–386, 389,

392 Collins, Suzanne, 319 Collusion, 339 Columbus, Christopher, 536 Command-and-control policies,

195–196 Commodity money, 605 Common resources, 213, 218–222

as an example of prisoners’ dilemma, 347

animals as, 221–222 clean air and water, 219 congested roads, 219–221 elephants, 222 fish, whales, and other wildlife,

221–222 importance of property rights, 223 oceans least regulated, 222 Tragedy of the Commons, 218–219

Communism, collapse in Soviet Union and Eastern Europe, 9

Comparative advantage, 53 absolute advantage, 52 applications of, 55–58 opportunity cost and, 52–53 trade and, 53–54 world price and, 169

Compensating differentials, 384 wage differences and, 384

Competition, 66–67 cartels and, 339–340 with differentiated products,

322–328 gender differences and, 389, 392

increasing with antitrust laws, 308–309

international trade increases, 176 markets and, 66–67 monopolistic vs. perfect, 324–327 monopoly vs., 293–294, 312

Competitive firms demand curves for, 294 demand for labor, 362–368 long-run decision to exit or enter a

market, 276–277 long-run supply curve, 277, 282–284 marginal-cost curve, 271–273 marginal-cost curve and supply

decision of, 271–273 market supply with entry and exit,

279–280 market supply with fixed number

of, 279 measuring profit in graph, 277–278 profit maximization and, 270–278,

363 revenue of, 269–270 shift in demand in short run and long

run, 281–282 short-run decision to shut down,

273–275 short-run supply curve, 275 sunk costs and, 274, 275–276 supply curve, marginal cost as,

271–273 supply decision, 271–273 zero profit and, 280–281

Competitive market, 66, 268, 268–270 characteristics of, 268 firms in, 267–284 long-run supply curve, 282–284 market supply with entry and exit,

279–280 market supply with fixed number of

firms, 279 meaning of, 268 revenue of competitive firm,

269–270 shift in demand in short run and long

run, 281–282 supply curve in, 279–284 zero profit and, 280–281

Complements, 70 cross-price elasticity of demand, 98

Compounding, 564 magic of, 566 rule of 70, 566

Concentration ratio, 320 Condorcet, Marquis de, 457 Condorcet paradox, 458 Congestion

common resource and, 220–221 gas tax and, 197 pricing, 219, 220 traffic and toll roads, 220–221

Congressional Budget Office (CBO), 29, 238, 239, 581

Constant returns to scale, 261, 523 Consumer choice

budget constraint, 426–427 consumer optimal choices, 432–434 deriving demand curve, 438–439 Giffen goods, 440 income changes and, 434–435 income effect, 436–438 indifference curve, 428–432 inferior good, 435 interest rates and household saving,

444–446 marginal rate of substitution, 428 normal good, 434 optimization, 432–439 perfect complements, 431–432 perfect substitutes, 431 preferences, 428–432 price changes and, 435–436 substitution effect, 436–438 theory of, 439–446 wages affect labor supply, 440–443

Consumer price index (CPI), 496, 496–503 basket of, 498 calculating, 496–499 core, 499 defined, 496 GDP deflator vs., 502

Consumer surplus, 134–138, 135, 300 evaluating market equilibrium,

144–146 lower price raises, 136–137 market efficiency and, 142–148 measure, 137–138 price affects, 138 using demand curve to measure,

135–136, 137 willingness to pay, 134–135

Consumption, 479 aggregate-demand curve shifts due

to changes in, 710, 712 as component of GDP, 479, 482 price level and, 708 rivalry in, 212 trade expands set of opportunities, 51

Consumption-saving decision, 444 Consumption tax, 234 Cooper, Michael, 146 Cooperation, economics of, 342–349 Coordinate system, 37–39 Coordination problems, 261–262 Core CPI, 499 Core inflation, 501 Cornwell, Patricia, 319 Corporate income taxes, 231, 240–241 Corporation, defined, 231 Corrective taxes, 196, 196–198 Correlation, positive and negative, 39 Cost(s), 139, 248–251

822 INDEX

average fixed, 256, 262 average total, 256, 262, 271–272 average variable, 256, 262 of capital, 249–250 economic profit vs. accounting profit,

250–251 economies of scale and, 176 explicit, 249, 250, 262 fixed, 255, 262 implicit, 249, 262 of inflation, 640–647 marginal (See Marginal cost (MC)) menu, 642, 718 opportunity (See Opportunity cost(s)) of possible sellers, 139 production and, 251–253 shoeleather, 641–642 in short run and long run, 259–262 social, 192–193 sunk, 274, 275–276 of taxation, 153–164 total, 248–249 transaction, 204 variable, 255, 262 various measures of, 254–259

Costanza, George, 147 Cost-benefit analysis, 216–218, 217 Cost curves

and their shapes, 256–258 typical, 258–259

Cost of living allowance (COLA), 506 consumer price index, 496–503 measuring, 495–512 problems in measuring, 499–501 regional differences in, 505–506

Cost of reducing inflation, 776 costless disinflation, possibility of,

778–779 Greenspan era, 780–781 rational expectations, 778–779 recession of 2008–2009, 782 sacrifice ratio, 777, 777–778 Volcker disinflation, 779–780

Council of Economic Advisers (CEA), 28 Countries

application of supply, demand, and elasticity, 104–105

failure to keep price of oil high, 104–105

increase in price of crude oil, 114–115 Cowen, Tyler, 405 CPI. See Consumer price index Crandall, Robert, 350 Credit cards, 609 Credit crunch, 616 Credit risk, bonds, 543 Cross-price elasticity of demand, 98 Crowding out, 555 Crowding-out effect, 750–752, 751 Cruz, Ted, 656

Currency, 607 Currency manipulation, 695 Current Population Survey, 578 Curves, 39–41

movements along, 40–41 shifts of, 40–41 slope of, 41–43

Customers, discrimination by, 395–396 Cwik, Tobias, 755 Cyclical unemployment, 578, 581

D Dairy industry, 268, 269 Date of maturity, bonds, 543 Deadweight loss, 157, 228, 232–234

changes in welfare, 157 debate, 160–161 determinants of, 158–161 elasticity and, 158–161 gains from trade and, 157–158 in monopoly, 301–302 source of, 158 tariffs and, 174–175 of taxation, 154–158 tax revenue and, 161–163

Deaton, Angus, 489 DeBeers, 291 Debt(s)

dealing with, 802–805 dollar-denominated, 798 government, 554, 556–557, 799,

802–805 Debt finance, stock, 545 Debt-to-GDP ratio, 556–557 Default, bonds, 543 Deferring payment method, 609 Deficits

budget (See Budget deficits) dealing with, 802–805 trade, 654

Deflation, 628, 776 measuring a nation’s income, 474

Defoe, Daniel, 518 Demand, 67–72. See also Model of

aggregate demand and aggregate supply

applications of, 102–107 change in, 80 cross-price elasticity of, 98 decrease in, 69 derived, 362 disentangling supply and, 685 elastic, 90, 93, 94, 97 elasticity of (See Demand elasticity) equilibrium of supply and, 76–78 excess, 77, 78 expectations and, 70–71 income changes, 69–70 increase in, 69, 79–80, 283 individual, 68–69

inelastic, 90, 93, 94, 97 for labor, 362–368 law of, 67 market, 68–69 market forces of supply and, 65–85 number of buyers and, 71 perfectly inelastic, 93, 94 price elasticity of, 94 prices of related goods and, 70 reducing smoking, 71–72 relationship between price and

quantity demanded, 67–68 supply and, 76–83, 111–112, 363, 367 tastes and, 70

Demand curve(s), 39–40, 67–68, 68 for competitive firms, 294 demand schedule and, 136 deriving, 438–439 elasticity of linear, 97 measuring consumer surplus with,

135–136, 137 for monopoly firms, 294 price elasticity of demand and, 92,

93, 94 shifts in, 40–41, 69–72 shifts in vs. movements along, 72 variety of, 93–94

Demand deposits, 607 Demand elasticity, 90–98

income, 98 price, 90–91

Demand schedule, 67 demand curve and, 68, 136

Department of Commerce, 482 Department of Justice, 28, 290, 308–309,

350, 353 Department of Labor, 28, 496, 578, 589 Department of the Treasury, 28 Depreciation, 478, 665 Depression, 702 Derived demand, 362 Determinants of productivity

human capital per worker, 522 natural resources per worker, 522 physical capital per worker,

519–522 technological knowledge, 523–524

Differentiated products competition with, 322–328

Diminishing marginal product, 253, 364 Diminishing marginal utility, 410 Diminishing returns, 525, 525–527 Discount coupons, price discrimination

and, 307 Discounting, 565 Discount rate, 617 Discount window, 617 Discouraged workers, 583 Discrimination, 391

by customers and governments, 395–396

823INDEX

earnings and, 383–396 economics of, 391–396 by employers, 393–395 in labor market, 391–393 measuring labor-market

discrimination, 391–393 profit motive and, 394–395 in sports, 395–396

Diseconomies of scale, 261, 261–262 Disinflation, 776

rational expectations and possibility of costless, 778–779

Volcker, 779–780 Disinflationary monetary policy, 777 Disposable personal income, 478 Distribution

of income, worldwide view of, 405 of income in U.S., 402–403 neoclassical theory of, 378

Diversification, 568, 573 risk reduction, 569

Dividends, 545, 571 Dominant strategy, 343 Dorn, David, 405 Double coincidence of wants, 604 Doucleff, Michaeleen, 536–537 Dow Jones Industrial Average, 544 Downey, Robert, Jr., 390 Downs, Anthony, 220 Drug interdiction, applications of supply,

demand, and elasticity, 105–107 Drugs

generic vs. monopoly, 299–300 Duopoly, 338–339

E Earned income tax credit (EITC), 120, 415,

590–591 Earnings per share, 545 Easterlin, Richard, 488 ECB. See European Central Bank Economica, 764 Economic fluctuations

causes of, 721–733 facts about, 702–704 irregular and unpredictable, 702–704 as output falls, unemployment rises,

704 short-run, 705–707

Economic growth around world, 516–518 diminishing returns and catch-up

effect, 525–527 education and, 528 experiences, variety of, 517 free trade and, 530–531 health and nutrition, 528–529 importance of long-run growth, 538 investment from abroad, 527–528 natural resources as limit to, 524

population growth and, 534–537 production possibilities frontier and,

24–26 productivity and, 518–524 property rights and political stability,

529–530 public policy and, 525–537 research and development, 531–534 saving and investment, 525

Economic life cycle, 407–408 Economic mobility, 409 Economic models, 22–26 Economic profit, 250, 250–251 Economic Report of the President, 28 Economics, 4. See also Welfare economics

assumptions of, 705 behavioral, 461–466 of Black Death, 377–378 of cooperation, 342–349 of discrimination, 391–396 of immigration, 372–373 within a marriage, 56–57 studying, 33 supply-side, and Laffer curve,

162–163 ten principles of, 3–15 of union, 592–593

Economic variables, 503–508 Economic welfare

total surplus and, 143 Economies of scale, 261, 261–262

as a cause of monopoly, 292 lower costs through, 176 specialization and, 261–262

Economists vs. accountants, 249–250 disagreement among, 30–32 follow-up on advice of, 29 as policy adviser, 27–29 propositions which most agree about,

31 as scientist, 20–27 thinking like, 19–33 in Washington, 28–29

Economy centrally planned, 9 closed, 547, 654 increasing openness of U.S., 655–657 inflation and, 628 interest rates in U.S., 508 labor-force participation of men and

women in U.S., 581–582 market, 9–10 money in U.S., 607–609 open, 547, 654 parable for modern, 48–52 political, 457–461 underground, 161 unions, good or bad for, 593 U.S. deep economic downturn, 14 using policy to stabilize, 790–792

Education alternative view of, 389–390 cost of college, 5–6 economic growth and, 528 as positive externality, 193–194, 528 public policy and, 528 signaling theory of, 389–390 social optimum and, 194 type of human capital, 385–387 wages and, 389–390

Efficiency, 5, 143 of equilibrium quantity, 145 government intervention and, 12 informational, 572 market (See Market efficiency) production possibilities frontier and,

25 taxes and, 232–236 total surplus and, 143 trade-off between equity and, 242

Efficiency wages, 390–391, 594, 594–596 Efficiency wages theory, 594–596 Efficient markets hypothesis, 571, 571–573 Efficient scale, 258, 280, 325 Efforts

wages and, 388–389 worker, 595

Einstein, Albert, 20 EITC. See Earned income tax credit Elastic demand, 90, 93, 94, 97 Elasticity, 90

along a linear demand curve, 96–98 applications of, 89–107 deadweight loss and, 158–161 of demand (See Demand elasticity) income elasticity of demand, 98 real world, 93 of supply, 99–101 tax incidence and, 124–126

Elephants, common resource, 222 Employers, discrimination by, 393–395 Entry/exit into market

firm’s long-run decision to, 276–277 long run market supply with,

279–280 Environmental Protection Agency (EPA),

196 Environmental regulations, 196 EPA. See Environmental Protection

Agency Equality, 5, 143

government intervention and, 12 of net exports and net capital outflow,

659–660 Equilibrium, 76, 76–78

analyzing changes in, 78–82 for an oligopoly, 340–341 consumer and producer surplus in

market, 144 decrease in supply affects, 81 increase in demand affects, 80

824 INDEX

interest rate, 741 in labor market, 369–374 long-run, 323–324, 722 market, and shift in supply, 80–81 in markets for land and capital,

375–376 markets not in, 78 monetary, 630–631 money market, 740, 741 in open economy, 683–685 of supply and demand, 76–78 without international trade,

167–169 zero-profit, 281

Equilibrium price, 76 Equilibrium quantity, 76, 145 Equilibrium wages, 391

ability, effort, and chance, 388–389 above-equilibrium wages, 390–391 compensating differentials, 384 determinants of, 384–391 human capital, 385–386 signaling, 389–390 superstar phenomenon, 390

Equity horizontal, 237, 239 taxes and, 236–242 trade-off between efficiency and, 242 vertical, 237–239

Equity finance, stock, 545 Essay on the Principle of Population as It

Affects the Future Improvement of Society (Malthus), 534

Ethiopia, income inequality in, 404 EU. See European Union Euro, 666 Europe, 354

vs. Google, 354 European Central Bank (ECB), 666 European Commission, 354 European Union (EU), 353, 354 Excess capacity, 325–326 Excess supply and demand, 77 Exchange-rate effect, 709, 712, 738 Excise taxes, 231 Excludability, 212, 213, 215, 216 Expansionary monetary policy, 747 Expectations

of free trade, 179 rational, 778–779 role of, 767–773 shift in Phillips curve, 767–776 shifts in demand curve, 70–71 shifts in supply curve, 75

Expected inflation, 770 short-run Phillips curve and, 772

Expenditures, nation’s overall economy and, 474–475

Explicit costs, 249, 250, 262 Exports, 57, 654. See also International

trade

gains and losses from exporting country, 170–171

net, 480–482, 654 Externalities, 12, 149, 189–206, 190, 528

business-stealing, 327 carbon tax, 199 Coase theorem, 203–204 command-and-control policies,

195–196 corrective taxes and subsidies,

196–198 education as, 193–194 gas tax and, 197–198 internalizing, 193 market inefficiency and, 191–195 negative, 190, 192–193 positive, 190, 193–195 private solutions to, 202–206 product-variety, 327 public policies toward, 195–202 technology spillovers, 194–195 tradable pollution permits, 200–202 transaction costs, 204

Exxon, 347 Eyeglasses, 329

F Factors of production, 22–24, 362, 522

competitive profit-maximizing firm, 363

demand for labor, 362–368 equilibrium in labor market, 369–374 land and capital, 375–378 linkages among, 377–378 markets for, 22–24, 361–378 production function and marginal

product of labor, 363–365 shifting labor-demand curve, 366–368 supply of labor, 368–369 value of marginal product, 365–366

Fair Labor Standards Act of 1938, 118 Fairly valued stock, 571 Fairness, behavioral economics and,

463–465 Farming, applications of supply, demand,

and elasticity, 102–104 FDIC. See Federal Deposit Insurance

Corporation Federal Deposit Insurance Corporation

(FDIC), 621 Federal funds rate, 621, 621–622, 745 Federal government

receipts of, 230 taxes collected by, 228–231

Federal Open Market Committee (FOMC), 610–611, 745, 794–795

Federal Reserve (Fed), 29, 609 cost of reducing inflation, 776–782 federal funds rate, 621–622 FOMC, 610–611

100-percent-reserve banking, 611–612 lending to banks, 617–618 monetary policy and, 794–797 organization of, 609–610 Phillips curve during financial crisis,

781–782 problems in controlling money

supply, 619–621 quantity of reserves, 617–618 reserve ratio, 612, 618–619 role of interest-rate target in, 745 stock market, 745–746 system, 609–611 tools of monetary control, 616–622 zero inflation debate, 798

Fiat money, 606 FICA (Federal Insurance Contributions

Act), 124 Final good, GDP includes value of,

476–477 Finance, 564 Financial aid, price discrimination and,

307 Financial intermediaries, 544

banks, 544–545 mutual funds, 545–546

Financial markets, 542 bond market, 543 stock market, 543–544

Financial system, 542 Financial Times, 501 Firm(s). See also Competitive firms

in circular-flow diagram, 22–24 efficient scale of, 325 marginal, 284 market supply with fixed number

of, 279 profit-maximizing, 363

Firm-specific risk, 569 diversification of, 568–569

Fiscal policy, 747. See also Government spending

aggregate demand and, 747–758 aggregate supply and, 752 automatic stabilizers, 758 changes in government purchases,

747–748 changes in taxes, 752–753 crowding-out effect, 750–752 multiplier effect, 748 savings and, 555 spending multiplier, formula for,

748–750 stabilization, 753–758, 790–792 unbalanced, 662

Fisher, Franklin, 353 Fisher, Irving, 639 Fisher effect, 639, 639–640 Fixed costs, 255, 262

average, 256, 262 Flypaper theory of tax incidence, 239

825INDEX

Fogel, Robert, 528–529 FOMC. See Federal Open Market

Committee Food aid, 537 Food Stamp program, 215 Ford, Gerald, 14 Ford, Henry, 523, 595–596, 628 Ford Motor Company, 260, 342, 527 Foreign-currency exchange

market for, 680–682 supply and demand, 678–682

Foreign investment direct, 527 economic growth and, 527–528 portfolio, 527

401(k) plans, 234, 806 403(b), 806 Fractional-reserve banking, 612, 612–613 France, income inequality in, 404 Franklin, Ben, 227 Free rider, 214 Free-silver debate, 646–647 Free To Be You and Me style, 56 Free trade, 167–183

economic growth and, 530–531 Frictional unemployment, 585, 586 Friedman, Milton, 628, 646, 767 Friedman rule, 646 Fundamental analysis, 571 Future value, 564

G Gains from trade

comparative advantage, 52–58 deadweight losses and, 157–158 of exporting country, 170–171 of importing country, 171–173 production possibilities, 49–50 specialization, 50–52

Gale, William, 417 Game theory, 338 Gasoline prices, incentive effects of, 7 Gasoline tax, 236

as corrective tax, 197–198 road congestion and, 197

Gates, Bill, 353, 518 GATT. See General Agreement on Tariffs

and Trade GDP. See Gross domestic product GDP deflator, 484, 484–485

computing inflation rate, 484 vs. consumer price index, 502

Gender, 389, 392. See also Women General Agreement on Tariffs and Trade

(GATT), 181–182, 657 General Mills, 330 General Motors, 342 General Theory of Employment, Interest and

Money, The (Keynes), 739, 754, 792

Generic drugs vs. monopoly drugs, 299–300

Germany average income in, 517 economic growth of, 517 hyperinflation in, 636–637 income inequality in, 404 inflation in, 13–14

Giffen, Robert, 440 Giffen goods, 440 Gifts as signals, 455–456 GNP. See Gross national product Gold standard, 605, 606 Goldstein, Jacob, 606 Gone with the Wind, 504 Good(s), 70

club, 213, 292 complements, 70 CPI basket of, 498 currently produced, GDP includes,

477 different kinds of, 212–213 excludability of, 212, 213, 215, 216 final, 476–477 inferior, 70, 98, 435 intermediate, 477 international flows of, 654–664 international trade increases variety

of, 176 markets for, 22–24 normal, 70, 98, 434 private, 212, 213 public, 212, 213, 214–218, 531 related, 70 rivalry in consumption, 212 substitutes, 70 tangible, 477 types of, 212–213

Google, 290, 354, 486, 500–501 Europe vs., 354

Google Price Index, 501 Gordon, Robert, 532–533 Government. See also Federal government

balance budget debate, 802–805 benefits of, 11–12 debate over spending hikes, 792–794 discrimination by, 395–396

Government budget deficits, 686–688 Government-created monopolies,

291–292 Government debt, 554

crowding out, 555 history of U.S., 556–557

Government policies price control and, 112–120 supply, demand, and, 111–112 taxes and, 120–127

Government purchases, 480 aggregate-demand curve shifts due

to changes in, 711, 712 as component of GDP, 480, 482

fiscal policy changes in, 747–748 Government spending, 793. See also Fiscal

policy Graham, Carol, 488 Graph(s), 37–45

cause and effect, 43–45 curves in, 39–41 measuring profit in, 277–278 of single variable, 37, 38 slope of, 41–43 of two variable, 37–39

Great Britain caloric consumption and height of

population, 528–529 malnutrition and, 529 unilateral approach to free trade, 181

Great Depression, 495, 791, 792, 793, 798 bank runs during, 620 shift in aggregate demand, 725–726

Great Recession, 793 Greenspan, Alan, 234, 573, 618, 780, 801 Greenspan era, 780–781 Gross domestic product (GDP), 474, 476,

515–516, 519–520, 527, 547–548 components of, 479–482 consumption, 479, 482 drugs and, 480–481 as economy’s income and

expenditure, 474–475 GDP deflator, 484–485 government purchases, 480, 482 international differences in, 490 investment, 479–480, 482 measurement of, 476–478 as measure of economic well-being,

486–490 net exports, 480–482 nominal (See Nominal GDP) prostitution and, 480–481 quality of life and, 490 U.S., components of, 481–482

Gross national product (GNP), 478, 527 Growth, production and, 515–538 “Guns and butter” tradeoff, 5

H Hamermesh, Daniel, 388–389 Hamlet, 352 Hanson, Gordon H., 405 Hard Heads, Soft Hearts (Blinder), 802 Health

economic growth and, 528–529 efficiency wages and, 594

Health insurance, 567–568 Hemingway, Mark, 205 Higher education

price discrimination in, 308 Holmes, Oliver Wendell, Jr., 153 Homo economicus, 462, 464 Homo sapiens, 462

826 INDEX

Honda, 342 Hoover, Herbert, 495, 504 Horizontal equity, 237, 239 Households

in circular-flow diagram, 22–24 decisions faced by, 3

Housing in basket of goods of CPI, 498 rent control, 115–116

Hsu, Shi-Ling, 199 Human capital, 385, 385–386, 519, 522,

524, 528 as determinant of productivity, 522 economic growth and, 522 education as, 385–387, 528 health and nutrition as investment

in, 528 role of, 392

Human-capital theory, 389 Human life, value of, 217–218 Human organs, market for, 147–148 Hume, David, 628 Hungary, hyperinflation in, 636–637 Hyperinflation, 628

money and prices during, 636–637 nominal exchange rates, 670

I Immigration, 369 Imperfect competition, 320 Implicit costs, 249, 262 Import quota, 32, 689

compared to tariff, 175 Imports, 57, 654. See also International trade

gains and losses of importing country, 171–173

Incentives, 7, 7–8 Income. See also Wages

capital, 376 changes in affect consumers’ choices,

434–435 disposable personal, 478 economic life cycle, 407–408 effect, 436–438, 807 in-kind transfers as, 407 measuring a nation’s, 473–491 national, 478 nation’s overall economy and,

474–475 other measures of, 478 permanent, 408 personal, 478 political philosophy of redistributing,

409–413 shifts in demand and, 70 transitory vs. permanent, 408 U.S. distribution of, 402–403

Income distribution, worldwide view of, 405

Income effect, 436–438, 807

Income elasticity of demand, 98 Income inequality

alternative measures of, 408–409 around world, 403–404 economic mobility, 409 measurement of, 402–409 poverty and, 406–407 in U.S., 402–403

Income or consumption debate, taxation, 233–234

Income redistribution, international differences in, 416–417

Income tax, negative, 414–415 Inconsistency, behavioral economics

and, 466 Indexation, 506 Index funds, 546

random walk and, 572–573 India

average income in, 515 economic growth of, 517 income inequality in, 404

Indifference curve(s), 428 extreme examples of, 430–432 income effect, 428–432 perfect complements, 431–432 perfect substitutes, 431 properties of, 429–430

Individual demand, 68–69 Individual retirement account (IRA),

234, 806 Individual supply vs. market supply, 74 Indonesia

average income in, 517 economic growth of, 517 income inequality in, 404

Industrial organization, 248 Industrial policy, 194–195 Inefficiency, externalities and, 191–195 Inelastic demand, 90, 93, 94, 97 Inelastic supply, 99 Inequality

alternative measures of, 408–409 around world, 403–404

Infant-industry argument for trade restrictions, 180–181

Inferior goods, 70, 435 income elasticity of demand and, 98

Inflation, 13, 13–14, 484, 496, 627–628 arbitrary redistributions of

wealth, 645 brief look at adjustment process,

632–633 classical dichotomy, 633–634 confusion and inconvenience,

644–645 core inflation, 501 correcting economic variables for

effect of, 503–508 cost of reducing, 776–782 costs of, 640–647

economy and, 628 effects of monetary injection, 631–632 effects of on box office receipts, 504 expected, 770 fall in purchasing power, 641 Fisher effect, 639–640 inflation-induced tax distortions,

643–644 inflation tax, 637–638 level of prices and value of money,

629 measures of, 502–503 measuring a nation’s income, 474 menu costs, 642 monetary neutrality, 633–634 money growth and, 627–628 money supply, money demand, and

monetary equilibrium, 630–631 money supply and, 14 monitoring inflation in internet age,

500–501 online-based measures, 501 quantity equation, 634–636 raises tax burden on saving, 644 relative-price variability and

misallocation of resources, 642–643

shoeleather costs, 641–642 short-run-trade-off between

unemployment and, 14–15, 763–784

six costs of, 798 special cost of unexpected, 645 theory of, 629–640 velocity of money, 634–636 zero, 797–802

Inflation fallacy, 641 Inflation-induced tax distortions, 643–644 Inflation rate, 484, 496, 498

calculating, 496–498 equilibrium price level and, 636 high, 507 nominal interest rate and, 640 in U.S. economy, 508

Inflation targeting, 797 Inflation tax, 637, 637–638 Information, asymmetry. See Asymmetric

information Informational efficiency, 572 In-kind transfers, 407

policies to reduce poverty, 415 problems in measuring inequality, 407

Input demand and output supply, 367 Input prices and supply, 75 Inquiry into the Nature and Causes of the

Wealth of Nations, An (Smith), 9, 10, 55, 261

Insolvency, 616 Insurance

adverse selection, 568 health, 567–568

827INDEX

market for, 567–568 social (See Social insurance taxes) unemployment, 587–588

Intangible services, GDP includes, 477 Interest rate(s), 506–508, 507

equilibrium, 741 federal funds rate, 621, 745 in long run, 742 market for loanable funds, 551 net capital outflow, 683 nominal, 506–508, 551, 639, 739 real, 551, 639, 739 in short run, 742 supply and demand for loanable

funds, 550–551 targets in Fed policy, role of, 745 in U.S. economy, 508

Interest-rate effect, 708–709, 712, 738 Intermediate good, 477 Internalizing the externality, 193 International Monetary Fund (IMF), 528 International trade, 167–183

benefits of, 176–178 comparative advantage, 169 determinants of, 168–169 effects of tariffs, 173–175 equilibrium without, 168–169 gains and losses of exporting country,

170–171 gains and losses of importing

country, 171–173 import quota compared to tariff,

175 lessons for policy of, 175–176 multilateral approach to free trade,

181 relative demand for skilled and

unskilled labor and, 386 restriction of, 175 of United States, 57–58 winners and losers from, 170–178 world price, 169

International transactions, prices for, 664–667

Internet and inflation, 500–501 shopping through, 500

Intrinsic value, 605 Intuit, 309 Inventory, GDP and, 479 Investment, 479, 479–480

from abroad, 527–528 aggregate-demand curve shifts due

to changes in, 710–711, 712 as component of GDP, 479–480, 482 as demand for loanable funds, 550 economic growth and, 525 foreign, 527–528 incentives, 553–554 national income accounts, 547–549 in people, 385

price level and, aggregate-demand curve downward slope, 708–709

saving, and their relationship to international flows, 660–661

savings and, 549 schooling as, 387

Investment accelerator, 748 Investment tax credit, 553 Invisible hand, 10, 11–12, 146–147 Inward-oriented policies, 530 IRA. See Individual retirement account Irwin, Neil, 800–801 Israel, shifts in labor supply and, 371 Italy, income inequality in, 404

J Jackson, Penfield, 353 Japan

average income in, 515 economic growth of, 517 income inequality in, 404 inflation, 646

Jensen, Robert, 440 Job(s)

argument for trade restrictions, 178–180 characteristics of, 388, 393 number, 585

Job search, 586 public policy and, 586–587 some frictional unemployment is

inevitable, 586 unemployment insurance, 587–588

Johnson, David W. (Otis), 827 Jones, Charles, 488 Journal of Economic History, 394 Journal of Labor Economics, 396 Journal of Law and Economics, The, 329 Junk bonds, 543

K Karabell, Zachary, 480–481 Karlan, Dean, 536–537 Kasich, John, 656 Kellogg, 330 Kennedy, John F., 756 Kennedy, Robert, 486–487 Kenya, elephant poaching, 222 Kershaw, Clayton, 495 Kestenbaum, David, 606 Keynes, John Maynard, 29, 32–33, 573,

732, 739, 756, 792 Keynesians in White House, 756 King, Stephen, 319 Klenow, Peter, 488 Knee, Defender, 205 Kremer, Michael, 535–536 Kumar, Sanat, 606–607

L Labor

aggregate-supply curve shifts and, 714

demand for, 362–368 international trade and demand for

skilled and unskilled, 386 jobs argument for trade restrictions,

178–180 marginal product of, 363–365 measures of underutilization, 583 supply of, 368–369 taxes on, 160–161 technology and demand for skilled

and unskilled, 386 Labor demand

minimum wage and, 119 shifts in, 371–374

Labor-demand curve output price, 366 supply of other factors, 367–368 technological change, 366–367

Labor force, 579 Labor-force participation rate, 580 Labor market

discrimination, measuring, 391–393 equilibrium in, 369–374 minimum wage effects on, 118–119 racial discrimination in, 394, 396

Labor supply shifts in, 370–371

Labor-supply curve changes in alternative opportunities,

369 changes in tastes, 368–369 immigration, 369 shift in, 368–369

Labor tax, deadweight loss of, 160–161 Laffer, Arthur, 162–163, 199 Laffer curve, 162–163 Laffer curve and supply-side economics,

163 Laissez faire, 145 Lakner, Christoph, 405 Land

equilibrium in markets for factors of production, 375–378

Landsburg, Steven E., 179 Law of demand, 67, 439 Law of one price, 668 Law of supply, 73 Law of supply and demand, 78 Learning by doing, 57 Leisure, trade-off between work and, 368 Lemons problem, 454 Lender of last resort, 610 Leverage, 615 Leverage ratio, 615 Liberalism, 411–412 Libertarianism, 412–413

828 INDEX

Life cycle, 407 Lighthouses as public goods, 216 Liquidity, 605

of asset, 741 of money, 741 theory of liquidity preference,

739–741 trap, 747

Loanable funds, 549 market for, 678–680 supply and demand, 678–682

Local government, taxes collected by, 231–232

Logarithmic scales, 637 Long, Russell, 236 Long run

costs in, 259–262 decision to exit or enter a market,

276–277 disinflationary monetary policy, 777 interest rates, 742 market supply, 279–280, 281 Phillips curve, 767–769 rent control, 115–116 shift in demand, 281–282 supply curve, 277, 282–284

Long-run equilibrium, 323–324, 722 Los Angeles Dodgers, 495 Losses. See also Deadweight loss

of exporting country, 170–171 of importing country, 171–173

Lowenstein, Roger, 620 Lowrey, Annie, 500 Lucas, Robert, 516, 778 Lump-sum taxes, 235, 235–236 Luxuries

income elasticity of demand and, 98 price elasticity of demand and, 90–91

Luxury tax, 126–127

M Macroeconomics, 26–27, 27, 474

quantities fluctuate together in, 704 six debates over policy for, 789–807

Malawi, elephants as private good, 222 Mali, poor country, 520, 521 Malthus, Thomas Robert, 534 Mankiw, N. Gregory, 199, 240 Margin, defined, 6 Marginal benefits, 6 Marginal buyers, 135–136 Marginal change, 6 Marginal cost (MC), 6–7, 255–256, 256,

262, 367 markup over, 326–327 related to average total cost, 258 rising, 257

Marginal-cost (MC) curve and average-cost curves, 257 firm’s supply decision and, 271–273

Marginal firm, 284 Marginally attached workers, 583 Marginal product, 252

demand for labor and value of, 365–366

diminishing, 253, 364 Marginal product of labor (MPL), 364

production function and, 363–365 value of, 365–366

Marginal propensity to consume (MPC), 748 Marginal rate of substitution (MRS), 428 Marginal revenue (MR), 270, 295

for competitive firm, 269–270 Marginal revenue product, 365 Marginal seller, 140 Marginal tax rates, 160, 230, 235

vs. average tax rates, 235 Market(s), 66. See also Competitive market

bond, 543 competition and, 66–67 definition of, 91 efficiency of, 133–148 financial, 542 firm’s long-run decision to exit or

enter, 276–277 for foreign-currency exchange,

680–682 for goods and services, 22–24 for insurance, 567–568 for land and capital, equilibrium in,

375–376 for loanable funds, 678–680 with only few sellers, 338–342 perfectly competitive, 66 risk, 569 size of oligopoly affecting, 341–342 stock, 543–544

Market demand, 68–69 Market economy, 9, 9–10 Market efficiency, 142–149

consumer surplus and, 142–148 market failure and, 148–149 producer surplus and, 142–148

Market equilibrium, evaluating, 144–148 Market failure, 12, 148–149. See also

Externalities Market for loanable funds, 549, 678–680

government budget deficits and surpluses, 554–557

investment incentives, 553–554 saving incentives, 551–553 supply and demand for loanable

funds, 550–551 Market irrationality, 573–574 Market power, 12, 148, 268 Market risk, 569 Market structure, types of, 321 Market supply

with entry and exit, long run, 279–280 with fixed number of firms, short

run, 279

vs. individual supply, 74 as sum of individual supplies, 74

Markup over marginal cost, 326–327 Marron, Donald, 205 Martin, William McChesney, 755 Massey, Joseph A., 657 Maximin criterion, 411 MC. See Marginal cost McDonald’s, 331–332 McGinty, Jo Craven, 146 McKinley, William, 647 McManus, Doyle, 656 McTeer, Robert D., Jr., 33 Median voter theorem, 459–461, 460 Medicaid, 232, 415 Medicare, 124, 160, 231 Medium of exchange, 545, 605 Menu costs, 642, 718 Mexico

economic growth of, 517 effect of capital flight on economy,

691 income inequality in, 404 living standards in, 13 middle-income country, 520, 521 NAFTA and, 181 political instability, 690

Microeconomics, 26–27, 27, 474 asymmetric information, 452–457 behavioral economics, 461–466 political economy, 457–461

Microsoft Corporation, 289–290, 309, 352–353

Midpoint method, 92 Milanovic, Branko, 405 Mill, John Stuart, 410 Miller, Nolan, 440 Minimum wage, 118–120

advocates and opponents of, 119–120 Fair Labor Standards Act of 1938, 118 labor market and, 118–119 price floor, 118–120 teenage labor market and, 119 who earns, 589–591

Minimum-wage laws, 588–591 determinant of equilibrium wages,

390–391 evaluating price controls, 120 policies to reduce poverty, 413

Misery index, 763 Misperceptions theory, 719 Model of aggregate demand and

aggregate supply, 702, 706, 706–707 aggregate-demand curve, 707–712 aggregate-supply curve, 712–721 long-run Phillips Curve, 769 Phillips curve, 766

Mokyr, Joel, 532–533 Monetary equilibrium, 630–631 Monetary income, 407 Monetary injection, 744

829INDEX

Monetary neutrality, 633–634, 634 Fischer effect, 639–640 revisited, 724

Monetary policy, 610 aggregate demand and, 738–747 changes in money supply, 743–744 debate, policy made by rule or

discretion, 794–797 disinflationary, 777 effects of monetary injection,

631–632 expansionary, 747 free-silver debate, 646–647 inflation targeting, 797 monetary injection, 744 role of interest-rate targets in Fed

policy, 745 stabilization policy arguments,

790–792 theory of liquidity preference,

739–741 zero lower bound, 746–747

Monetary system, 604 banks and the money supply, 611–616 Federal Reserve system, 609–611,

616–622 meaning of money, 604–609

Money, 604 commodity, 605 creation with fractional-reserve

banking, 612–613 credit cards and, 609 fiat, 606 functions of, 605 future value, 564–566 during hyperinflations, 636–637 kinds of, 605–606 liquidity of, 741 measuring time value of, 564–566 present value, 564–566 quantity theory of, 628, 631 stock, 607 in U.S. economy, 607–609 value of, 629 velocity of, 634–636

Money demand, 630–631 theory of liquidity preference, 741

Money market equilibrium in, 740, 741 slope of the aggregate-demand curve,

743 Money multiplier, 613, 613–614 Money supply, 610, 630–631

bank capital, leverage, and financial crisis of 2008-2009, 615–616

bank runs and, 619–621 banks and, 611–616 creation with fractional-reserve

banking, 612–613 discount rate, 617 excess reserves, 612

Fed’s tools of monetary control, 616–622

inflation and, 14 monetary neutrality, 634 money multiplier, 613–614 open-market operations, 610, 617 paying interest on reserves, 619 problems in controlling, 619–621 reserve requirements, 612, 618–619 theory of liquidity preference,

739–740 Monopolistically competitive firms

in the short run, 322–323 Monopolistic competition, 319–333, 321

advertising, 328–332 competition with differentiated

products, 322–328 excess capacity, 325–326 free entry and exit of firms, 321 long-run equilibrium, 323–324 many sellers, 321 markup over marginal cost, 326–327 between monopoly and perfect

competition, 320–322 vs. perfect competition, 324–327 product differentiation, 321 and welfare of society, 327–328

Monopolistic competitors in the short run, 322–323

Monopoly(ies), 67, 289–312, 290, 320–322 arising, 290–293 cartels and, 339–340 vs. competition, 293–294 competition vs., 312 deadweight loss in, 301–302 demand and marginal-revenue

curves for, 296 economies of scale as a cause of, 292 government-created, 291–292 inefficiency of, 302 marginal-cost pricing for a natural,

310 natural, 213, 292–293 parable about pricing, 304 prevalence of, 311–312 price discrimination and, 303–308 production and pricing decisions in,

293–300 profit, 298–300 profit as social cost, 303 profit maximization for, 297 profit maximization in, 296–298 public ownership and, 310–311 public policy toward, 308–311 regulation, 309–310 resources, 291 revenue, 294–296 supply curve, 298 welfare cost of, 300–303

Monopoly drugs vs. generic drugs, 299–300

Monopoly firms, demand curves for, 294 Monopsony, 374 Moral hazards, 452, 452–454

insurance, 568 Morris, Eric A., 220 Movie tickets, price discrimination and,

306–307 MPC. See Marginal propensity to

consume MPL. See Marginal product of labor MR. See Marginal revenue MRS. See Marginal rate of substitution Mullainathan, Sendhil, 393 Multiplier effects, 748, 792

aggregate demand, 748 formula for spending, 748–750 other applications of, 750

Municipal bonds, 543 Muskie, Edmund, 202 Mutual funds, 545

as financial intermediaries, 545–546 index funds, 546 portfolio, 545

N Nader, Ralph, 8 NAFTA. See North American Free Trade

Agreement Namibia, elephants as private good, 222 NASA, 531 NASDQA. See National Association

of Securities Dealers Automated Quotations

Nash, John, 340 Nash equilibrium, 340, 341 National Association of Securities Dealers

Automated Quotations (NASDAQ), 544

National defense important public goods, 214–215

National Highway Traffic Safety Administration, 197

National income, 361, 478 National Institutes of Health (NSF), 215,

531 National Labor Relations Board (NLRB),

593 National saving, 548, 803, 805–807

economic well-being and, 805 ways to increase, 807

National Science Foundation, 215, 531 National-security argument for trade

restrictions, 180 Natural disasters, price and, 84–85 Natural level of output, 714 Natural monopolies, 213, 292, 292–293

marginal-cost pricing for, 310 Natural-rate hypothesis, 772

natural experiment for, 772–773

830 INDEX

Natural rate of unemployment, 578, 581, 768

natural-rate hypothesis, 772–773 Natural resources, 522

aggregate-supply curve shifts and, 714

as determinant of productivity, 522 limit to growth, 524 population growth stretching of, 534

Negative correlation, 39 Negative externalities, 190, 192–193 Negative income tax, 414–415 Negative public saving, 803 Neoclassical theory of distribution, 378 Net capital outflow, 658

equality of net exports, 659–660 flow of financial resources, 658–659 interest rates, 683 link between two markets, 683–684

Net exports, 480, 480–482, 654 aggregate-demand curve shifts due

to changes in, 711, 712 as component of GDP, 480–482 equality of, 659–660 price level and, aggregate-demand

curve downward slope, 709 trade policy, 688–690

Net foreign investment, 658 Net national product (NNP), 478 Newton, Isaac, 20 New York Stock Exchange, 544 New York Times, 350 New York Yankees, 495 New Zealand, 800–801 New Zealand Kiwifruit Authority, 800 Nigeria

average income in, 515 income inequality in, 404 living standards in, 13

NLRB. See National Labor Relations Board NNP. See Net national product Nominal exchange rates, 665

during hyperinflations, 670 Nominal GDP, 482, 633

numerical example of real vs., 482–484

real GDP vs., 482–486 velocity and quantity equation, 635

Nominal interest rates, 506–508, 507, 551, 639, 739

Fisher effect, 639–640 inflation rate and, 640 in U.S. economy, 508

Nominal variables, 633 Normal goods, 70, 434

income elasticity of demand and, 98 Normative statements, 27–28, 28 North American Free Trade Agreement

(NAFTA), 181, 657 Nozick, Robert, 412 Nutrition, health and, 528–529

O Obama, Barack, 14–15, 239, 242, 610, 656,

657, 692, 756, 792–793 Observation, 20–21 Oceans, common resources, 222 Office of Management and Budget, 28 Office of National Statistics, 488 Oikonomos, 3 Oligopoly, 320, 337

economics of cooperation, 342–349 equilibrium for, 340–341 markets with only a few sellers,

338–342 as prisoners’ dilemma, 344–345 public policy toward, 349–354 size of, affecting market outcome,

341–342 Omitted variable, 43–44 OPEC. See Organization of the Petroleum

Exporting Countries Open economy, 547, 654

equality of net exports and net capital outflow, 659–660

equilibrium, 683–685 Euro, 666 flow of financial resources, 658–659 flow of goods, 654–664 government budget deficits, 686–688 how policies and events affect,

686–695 increasing openness of U.S. economy,

655–657 international flows of goods and

capital, 654–664 market for foreign-currency

exchange, 680–682 market for loanable funds, 678–680 nominal exchange rates, 665 political instability and capital flight,

690–694 prices for international transactions,

664–667 purchasing-power parity, 667–672 real equilibrium, 684–685 real exchange rates, 665–667 trade policy, 688–690

Open-market operations, 610, 617, 739– 740, 745

Opportunity cost(s), 6, 52, 52–53, 249–250 comparative advantage and, 52–53 cost of capital as, 249–250 costs as, 249 economists vs. accountants, 249–250 explicit and implicit costs, 249–250,

262 production possibilities frontier and,

24–26 Optimization

consumer optimal choice, 432–434 deriving demand curve, 438–439

income changes and, 434–435 income effect, 436–438 price changes and, 435–436 substitution effect, 436–438 utility of, 433

Optimum, 192, 432 Ordered pair, 37 Organization of the Petroleum Exporting

Countries (OPEC), 345 inflation, 780 and price of oil, 104–105 supply shocks and, 774–775 and world oil market, 345 world oil market and price ceilings

and lines at gas pump, 114–115 Organs (human), market for, 147–148 Origin, of graph, 38 Orrenius, Pia, 372–373 Orszag, Peter, 199 Oster, Emily, 56–57 Output, 742 Output effect, 295, 341 Output price, 366 Outsourcing, 179 Outward-oriented policies, 530 Overvalued stock, 571 Owners’ equity, 615

P Pakistan

economic growth of, 516–517 income inequality in, 404

Palestine, shifts in labor supply and, 371 Parity, 668 Parking spots, 146–147 Patent protection, 194–195 Payroll taxes, 230–231

burden of, 124 Peltzman, Sam, 8 PepsiCo, 308 Perception vs. reality, 31–32 Perfect competition, 320–322

excess capacity, 325–326 markup over marginal cost, 326–327 vs. monopolistic competition,

324–327 Perfect complements, 431–432 Perfectly competitive markets, 66, 268 Perfectly elastic supply, 100 Perfectly inelastic demand, 93, 94 Perfectly inelastic supply, 100 Perfect price discrimination, 305 Perfect substitutes, 431 Permanent income, 408 Perpetuity, bonds, 543 Personal income, 478 Personal income taxes, 230 Philbrick, Nathaniel, 319 Philippines, income inequality in, 404 Phillips, A. W., 764

831INDEX

Phillips curve, 764 in 1960s, 773 aggregate demand, aggregate supply,

and, 765–767 breakdown of, 774 during financial crisis, 781–782 long-run, 767–769 natural-rate hypothesis, 772–773 origins of, 764–765 rational expectations, 778–779 reconciling theory and evidence,

770–771 sacrifice ratio, 777–778 shifts in, 767–776 short-run, 771–772 supply shocks and, 773–776

Physical capital, 519 as determinant of productivity,

519–522 Pie chart, 37, 38 Pigou, Arthur, 196, 197 Pigovian taxes, 196 Pin factory, 261 Poland, hyperinflation in, 636–637 Political business cycle, 795–796 Political economy, 457, 457–461

Arrow’s impossibility theorem, 458–459

Condorcet voting paradox, 457–458 median voter theorem, 459–461 politicians’ behavior, 461

Political instability, capital flight and, 690–694

Political stability, economic growth and, 529–530

Politicians, behavior of, 461 Pollution

clean air and water as common resource, 219

corrective taxes and, 196–198 Environmental Protection Agency

(EPA), 196 gas tax, 198 as negative externality, 219 objections to economic analysis of, 202 regulation and, 196–197 social optimum and, 192 tradable pollution permits, 200–202

Population growth diluting the capital stock, 534–535 economic growth and, 534–537 promoting technological progress,

535–537 stretching natural resources, 534

Porter, Eduardo, 416 Portfolio, mutual funds, 545 Positive correlation, 39 Positive externalities, 190, 193–195

technology spillovers, industrial policy, and patent protection, 194–195

Positive statements, 27–28, 28 Poverty

correlated with age, race, and family composition, 406–407

fighting, as public good, 215–216 income inequality and, 406–407 in-kind transfers, 415 policies to reduce, 413–418

Poverty line, 406 Poverty rate, 406 Predatory pricing, 351–352 Preferences

consumer choices, 428–432 marginal rate of substitution, 428 representing with indifference

curves, 428–429 utility and, 433

Present value, 564, 564–566 Prevalence of monopolies, 311–312 Price(s). See also Consumer price index

(CPI) allocation of resources and, 83–84 changes in consumer choices, 435–436 control on, 112–120 equilibrium, 76 higher price raises producer surplus,

141–142 during hyperinflations, 636–637 input prices and supply, 75 international transactions, 664–667 level of, 629 lower price raises consumer surplus,

136–137 market-clearing, 76 natural disasters and, 84–85 output, 366 purchase, of land or capital, 375–376 quantity demanded and, 67–68 quantity supplied and, 73 of related goods and demand, 70 relative, 642–643 rental, of land or capital, 375–377 shortages and, 77 surplus and, 77 of trade, 54 when supply and demand shifts,

81–82 willingness to pay, 134–135 world, 169

Price ceiling, 112 binding constraint, 113 lines at gas pump, 114–115 market outcomes and, 112–113 not binding, 112 rent control, 115–116

Price controls, evaluating, 120 Price discrimination, 303

airline prices, 307 analytics of, 305–306 discount coupons, 307 examples of, 306–307

financial aid, 307 in higher education, 308 monopolies and, 303–308 movie tickets, 306–307 quantity discounts, 307 welfare with and without, 306

Price-earnings ratio, 545 Price effect, 295, 341 Price elasticity of demand, 90, 90–91

computing, 91–92 determinants of, 90–91 elasticity and total revenue along a

linear demand curve, 96–98 midpoint method, 92 total revenue and, 95–96 variety of demand curves, 93–94

Price elasticity of supply, 99 computing, 99 determinants of, 99 variety of supply curves, 100–101

Price floor, 112 market outcomes and, 116–117 minimum wage, 118–120

Price gouging, 83, 84–85 Price level, 742

consumption and, 708 exchange-rate effect, 709 investment and, 708–709 net exports and, 709

Price maker, 290 Price takers, 67, 170, 268, 290 Pricing

congestion, 219, 220 in monopoly, 304 predatory, 351–352 value, 220

Pricing decisions in monopolies, 293–300

Principal, bonds, 543 Principals, 452, 452–454 Principles of Political Economy and Taxation

(Ricardo), 55 Prisoners’ dilemma, 342, 343–344

arms races, 346 common resources, 347 cooperation and, 348–349 examples of, 346–347 oligopolies as, 344–345 and the welfare of society, 347–348

Prisoners’ dilemma tournament, 348–349 Private goods, 212, 213 Private saving, 548 Producer price index, 499 Producer surplus, 139, 139–142, 300

cost and willingness to sell, 139–140 evaluating market equilibrium,

144–146 higher price raises, 141–142 market efficiency and, 142–148 using supply curve to measure,

140–141

832 INDEX

Product differentiation, 321 Production

cost of, 247–248 and costs, 251–253 within country, GDP measures value

of, 477 factors of, 22–24, 361–378, 522 growth and, 515–538 in market economies, 529–530 resources, limited quantities of, 282 within specific interval of time, GDP

measures value of, 477–478 Production decisions

in monopolies, 293–300 Production function, 252, 364, 523

from, to the total-cost curve, 253 illustration, 526 marginal product of labor and,

363–365 total cost and, 251–253

Production possibilities frontier, 24, 24–26 economic growth and, 24–26 efficiency and, 25 gains from trade, 49–50 opportunity costs and, 24–26 trade-offs and, 25–26

Productivity, 13, 519 determinants of, 519–524 health and nutrition affects, 528–529 importance of, 518–519 living standards and, 518–519 production function, 523 relationship between living standards

and, 13 role of, 518–524 wages and, 373–374

Product-variety externality, 327 Profit, 248, 248–249

accounting, 250–251 as area between price and average

total cost, 278 economic, 250–251 measuring in graph for competitive

firm, 277–278 in monopoly, 298–300

Profit maximization competitive firm’s supply curve and,

270–278 example of, 270–271 in monopoly, 296–298

Progressive tax, 237 Property rights, 11, 11–12

economic growth and, 529–530 importance of, 223 technology and, 195

Property taxes, 231–232 Proportional tax, 237 Prostitution, GDP and, 480–481 Protection-as-a-bargaining-chip argument

for trade restrictions, 181 Public good(s), 212, 531

antipoverty programs, 215–216 basic research, 215 cost-benefit analysis, 216–218 free-rider problem, 214 importance of property rights, 223 lighthouses as, 216 national defense, 214–215 value of human life, 217–218

Public investment, schooling as, 387 Public ownership, monopolies and,

310–311 Public policy, 12, 456–457. See also

Antitrust laws; Fiscal policy; Monetary policy

diminishing returns and catch-up effect, 525–527

economic growth and, 525–537 education and, 528 free trade and, 530–531 health and nutrition, 528–529 investment from abroad, 527–528 job search and, 586–587 population growth and, 534–537 property rights and political stability,

529–530 research and development, 531–534 saving and investment, 525 toward externalities, 195–202 toward monopolies, 308–311 toward oligopolies, 349–354

Public policymakers, 7 Public saving, 548, 803–807

budget deficit and, 807 negative, 803 saving incentives and, 807

Purchase price, 375–376 Purchasing power, 668

inflation and, 641 Purchasing-power parity, 667–672, 668

basic logic of, 668 hamburger standard, 671–672 implications of, 668–670 limitations of, 671 as special case, 682

Putnam, Howard, 350

Q Quality

advertising as a signal of, 330–331 change in, and CPI, 500–501 theory of efficiency wages and

worker quality, 595 Quality of life, 490 Quantitative easing, 747 Quantity

equilibrium, 76 of reserves, Fed influences, 617–618

Quantity demanded, 67 change in, 80 relationship between price and, 67–68

Quantity discounts, price discrimination and, 307

Quantity equation, 634–636, 635 Quantity supplied, 73, 79 Quantity theory of money, 628, 631 Quarterly Journal of Economics, 396, 535 Quintile ratio, 404 Quintiles, 238, 402 Quotas, import, 32, 175

R Race

discrimination in labor market, 394, 396

discrimination in sports, 395–396 median annual earnings by, 392 segregated streetcars and, 394–395

Randlett, Tom, 147 Random walk, 572

index funds and, 572–573 Rational expectations, 778

and possibility of costless disinflation, 778–779

Rationality, behavioral economics and, 462–463, 464–465

Rational people, 6, 6–7 Rawls, John, 411 Reagan, Ronald, 30, 242, 628, 662, 693, 793,

796 government debt, 557 tax cuts under, 163

Real exchange rates, 665, 665–667 Real GDP, 483

half century of, 485 vs. nominal GDP, 482–486 numerical example of nominal vs.,

482–484 Real interest rates, 506–508, 507, 551, 639,

739 Fisher effect, 639–640 in U.S. economy, 508

Reality, perception vs., 31–32 Real variables, 633 Recession, 557, 702

government debate over spending hikes or tax cuts, 792–794

real GDP and, 485 Volcker’s decision, 796

Recession (2008–2009), 726–727 Phillips curve during and after, 782

Reconciling theory, 770–771 Regional differences, cost of living and,

505–506 Regional price parities, 505 Regressive tax, 237 Regulation of externalities, 195 “Relationship between Unemployment

and the Rate of Change of Money Wages in the United Kingdom, 1861– 1957” (Phillips), 764

833INDEX

Relative price misallocation of resources and, 642–643 variability, 642–643

Rental price, 375–376 Rent control, 32

evaluating price controls, 120 price ceiling, 115–116 in short run and long run, 115–116

Rent subsidies, 120 Resale price maintenance, 351 Research and development, economic

growth and, 531–534 Reserve Bank Act of 1989, 800 Reserve ratio, 612, 618–619 Reserve requirements, 612, 618–619 Reserves, 612 Resources

common, 213, 218–222, 347 flow of financial, 658–659 limited quantities of production, 282 monopoly, 291 natural, 522, 524, 534 prices and allocation of, 83–84 relative-price variability and

misallocation of, 642–643 scarcity of, 4

Restraint of trade, 349–350 Retained earnings, 478, 545 Revenue. See also Total revenue

average, 270, 294 of competitive firm, 269–270 marginal, 269–270, 295 monopoly, 294–296 tax, 155 total, 294

Reverse causality, 44–45 Rhodes, Cecil, 291 Ricardo, David, 55 Right-to-work laws, 593 Rigobon, Roberto, 501 Risk

diversification reduces, 569 firm-specific, 569 managing, 566–570 market, 569 and return, trade-off between, 569–570

Risk aversion, 566, 566–567 Rivalry in consumption, 212 Road congestion, gasoline tax and, 197 Roback, Jennifer, 394 Robinson Crusoe (Defoe), 518–519 Rockefeller, John D., 518 “Role of Monetary Policy, The”

(Friedman), 767 Romer, Christina D., 692–693 Rubio, Marco, 656 Rule of 70, 566 Russia

income inequality in, 404 inflation rate, 628

Ruth, Babe, 495–496, 503–504

S Sacks, Daniel, 488 Sacrifice ratio, 777, 777–778 Saldate, Edward, 147 Sales taxes, 231–232 Samsung, 290 Samuelson, Paul, 745, 764 Sanders, Bernie, 656 Sargent, Thomas, 778 Sarkozy, Nicolas, 488 Satisficers, 462 Saving(s), 548, 805–807

economic growth and, 525 fiscal policy and, 555 incentives, 551–553 inflation raises tax burden on, 644 investment, and their relationship

to international flows, 660–661

investment and, 549 national, 548, 803, 805–807 national income accounts, 547–549 negative public, 803 private, 548 public, 548, 803–807 as supply of loanable funds, 550 tax law reform debate to encourage

saving, 805–807 Scarcity, 4 Scatterplot, 38–39 Schmalensee, Richard, 353 Scientific judgments, differences among

economists, 30 Scientific method, 20–21 Screening, 456 Seasonal adjustment, 477 Sectoral shifts, 586 Segregation, segregated streetcars and

profit motive, 394–395 Seller(s)

number of, and shifts in supply curve, 76

taxes on, affect market outcomes, 121–122

variables that influence, 76 Sensible tax, 199 Services

CPI basket of, 498 currently produced, GDP includes,

477 intangible, 477 markets for, 22–24

Sex, median annual earnings by, 392 Sharapova, Maria, 390 Shaw, George Bernard, 30, 520 Sherman Antitrust Act, 309, 349–350 Shoeleather costs, 641, 641–642 Shortage, 77

lines at gas pump, 114–115 price ceilings and, 113

Short run aggregate-supply curve, 717 costs in, 259–262 disinflationary monetary policy, 777 economic fluctuations, 705–707 increase in demand, 283 interest rates, 742 market supply with fixed number of

firms, 279 monopolistically competitive firm in,

322–323 monopolistic competitors in, 322–323 Phillips curve, 771–772 rent control, 115–116 shift in demand, 281–282

Shoup, Donald, 147 Shut down

competitive firm’s short-run decision to, 273–275

near-empty restaurants and, 275–276 off-season miniature golf and, 275–276

Sierra Club, 203 Signaling, 455, 455–456

advertising, 389 education, 389–390

Silicon Valley, 486–487 Simon, Herbert, 462 Singapore, pursued outward-oriented

policies, 531 Skill-biased technological change, 386 Skills, increasing value of, 385–386 Slope, 41–43 Smith, Adam, 9–11, 55, 146, 261, 350 Smith, Noah, 387 Smoking, reducing, 71–72 SNAP. See Supplemental Nutrition

Assistance Program Social Choice and Individual Values (Arrow),

459 Social cost, 192–193

monopoly’s profit as, 303 Social insurance, 411–412 Social insurance taxes, 231 Social Security, 124, 231, 238

indexation of benefits under, 506 tax, 160

Society decisions faced by, 4 faces short-run trade-off between

inflation and unemployment, 14 Solow, Robert, 756, 764 Soltas, Evan, 308 Sound of Music, The, 504 South Africa, income inequality in, 404 South Korea

caloric consumption and height of population, 529

economic growth rate of, 526–527, 529 GDP to investment, 526 pursued outward-oriented policies, 531 unilateral approach to free trade, 181

834 INDEX

Soviet Union, collapse of communism in, 9 Specialization

driving force of, 52–58 economies of scale and, 261–262 trade and, 50–52

Speculative bubble, 573–574 Spending multiplier, formula for, 748–750 Sports, discrimination in, 395–396 SSI. See Supplemental Security Income Stabilization

automatic stabilizers, 758 debate, 790–792 policy arguments, 753–758

Stagflation, 730, 774 Standard of living

determinants of, 13 relationship between productivity

and, 13 Standard & Poor’s, 544 Starbucks, 23 Star Wars: The Force Awakens, 504 State government

taxes collected by, 231–232 Statistical discrepancy, 478 Stevenson, Betsey, 488 Sticky-price theory, 718 Sticky-wage theory, 717–718 Stigler, George, 311 Stiglitz, Joseph E., 199 Stock, 544

diversification of firm-specific risk, 568–569

efficient markets hypothesis, 571–573 fundamental analysis, 571 index funds, 572–573 market irrationality, 573–574 money, 607 random walks, 572–573

Stock index, 544 Stockman, David, 163 Stock market, 543–544

Federal Reserve (Fed), 745–746 Stone, Emma, 388 Store of value, 545, 605 Strike, 391, 592 Structural unemployment, 585 Subsidies

market-based policy, 196–198 rent, 120 wage, 120

Substitutes, 70 cross-price elasticity of demand, 98 price elasticity of demand, 90

Substitution bias, 499 Substitution effect, 436–438, 807 Sunk costs, 274, 275, 275–276 Superstar phenomenon, 390 Supplemental Nutrition Assistance

Program (SNAP), 415 Supplemental Security Income (SSI), 414

Supply, 73–76. See also Model of aggregate demand and aggregate supply

applications of, 102–107 change in, 80 decrease in, 75, 81 disentangling demand and, 685 elasticity of, 99–101 equilibrium of demand and, 77–78 excess, 77 increase in, 75, 103 individual, 74 inelastic, 99 input prices and, 75 of labor, 368–369 law of, 73 market vs. individual, 74 number of sellers and, 76 perfectly elastic, 100 perfectly inelastic, 100 price elasticity of, 100, 101 relationship between price and

quantity supplied, 73–74 shift in, and market equilibrium,

80–81 technology and, 75

Supply and demand, 76–82, 111–112 disentangling, 685 equilibrium of, 76–77 for foreign-currency exchange,

678–682 law of, 78 for loanable funds, 678–682 market forces of, 65–85 shift in, 81–82 versatility of, 363

Supply curve(s), 74 in competitive market, 279–284 price elasticity of supply, 100–101 shifts in, 75–76 shifts in vs. movements along, 80 supply schedule and, 73–74, 140 using to measure producer surplus,

140–141 variety of, 100–101

Supply schedule, 73 supply curve and, 73–74, 140

Supply shock(s), 774 of the 1970s, 776 accommodating adverse, 775 adverse shock to aggregate supply,

775 Phillips curve and, 773–776 role of, 773–776

Supply-side economics and Laffer curve, 163

Supply siders (economists), 752 Surplus, 77. See also Budget surplus;

Consumer surplus; Total surplus; Trade surplus

government budget deficits and, 554–556

price floors and, 118 producer (See Producer surplus) trade, 654

Sweden income inequality in, 404 Laffer curve, 163

Synergies, 309

T T-account, 612 Taiwan

economic growth rate of, 531 pursued outward-oriented policies,

531 TANF. See Temporary Assistance for

Needy Families Tangible goods, GDP includes, 477 Tanzania, elephant poaching, 222 Tariff(s), 32, 173, 688

compared to import quotas, 175 deadweight loss and, 174–175 effects of in international trade,

173–175 Tastes

changes in, 368–369 shifts in the demand curve and, 70

Tax burden distributed, 238–239 divided, 125–126

Tax cuts under George H. W. Bush, 753 under George W. Bush, 792 under Kennedy, 756 under Reagan, 163

Tax equity, 239–241 Taxes, 120–127

ability-to-pay principle, 237–239 administrative burden, 234–235 benefits principle, 236–237 on buyers, market outcomes and,

122–124 carbon, 199 collected by state and local

governments, 231–232 collected by the federal government,

228–231 consumption, 234 corporate income, 231, 240–241 corrective, 196–198 costs of, 153–164 cuts under Reagan, 163 deadweight losses, 232–234 deadweight loss of taxation, 154–158,

161–163 and efficiency, 232–236 and equity, 236–242 excise, 231 fiscal policy changes, 752–753 gas, 197–198 incidence, 121

835INDEX

income or consumption debate, 233–234

inflation, 637–638 on labor, 160–161 lump-sum, 235–236 luxury, 126–127 marginal tax rates vs. average tax

rates, 235 negative income, 414–415 payroll, 124, 230–231 personal income, 230 Pigovian, 196 progressive, 237 property, 231–232 proportional, 237 regressive, 237 sales, 231–232 on sellers, market outcomes and,

121–122 social insurance, 231 tax effects on market participants,

155–157 tax equity, 239–241 tax incidence, 239–241

Tax expenditures, 240–241 Tax incidence, 121, 239–241

elasticity and, 124–126 Tax laws debate, 805–807 Tax revenue, 155, 161–163 Tax systems, design of, 227–242 Tax treatment, bonds, 543 Taylor, John, 755 Technological change, 366–367 Technological knowledge, 523,

523–524 aggregate-supply curve shifts and,

715 specific, 215

Technology demand for skilled and unskilled

labor and, 386 population growth promoting of,

535–537 property rights and, 195 shifts in supply curve and, 75 spillovers, 194–195

Teenage labor market, minimum wage and, 119

Temporary Assistance for Needy Families (TANF), 215, 414

Term, bonds, 543 Term auction facility, 618 Texaco, 347 Textile market, 168–182 Thaler, Richard H., 464–465 Theory, 20–21 Theory of inflation, 629–640 Theory of liquidity preference, 739

equilibrium, money market, 741 money demand, 741 money supply, 739–740

Time horizon, price elasticity of demand, 91

Time inconsistency of policy, 795–796 practical importance of, 796–797

Time-series graph, 37, 38 Time value of money, measuring, 564–566 Titanic, 504 Tit-for-tat strategy, 349 T-Mobile, 309 Tobin, James, 756 Toll roads, 220–221 Tools of monetary control, 616–622 Total-cost curve, 253 Total costs, 248, 248–249

average, 256, 262 production function and

Total revenue, 95, 248, 248–249 along a linear demand curve, 96–98 changes with price changes, 96 for competitive firm, 269–270 price elasticity of demand and, 95–96

Total surplus, 143, 145, 300 Toyota, 342 Tradable pollution permits, 200–202 Trade. See also Free trade; Gains from

trade; International trade agreements and World Trade

Organization, 182 benefits of, 8–9 comparative advantage and, 53–54 deadweight losses and gains from,

157–158 equilibrium without international,

168–169 interdependence and gains from,

47–58 price of, 54 restraint of, 349–350 restrictions (See Trade restrictions) specialization and, 50–52 as a tool for economic development,

177 Trade balance, 654 Trade barriers, 32 Trade deficit, 654

measuring a nation’s income, 474 in U.S., 662–664

Trade-offs, 4–5 between equity and efficiency, 242 between inflation and

unemployment, 14–15 policy decisions and, 28 production possibilities frontier and,

25–26 between risk and return, 569–570 between work and leisure, 368

Trade policy, 688, 688–690 import quota, 689 tariff, 688

Trade restrictions arguments for, 178–182

infant-industry argument, 180–181 jobs argument for, 178–180 national-security argument, 180 protection-as-a-bargaining-chip

argument, 181 tariffs, 32 unfair-competition argument for, 181

Trade surplus, 654 Traffic, congested roads as public goods or

common resources, 220–221 Tragedy of the Commons, 218, 218–219 Transaction costs, 204 Transfer payments, 480 Transitivity, 458 Transitory income, 408 Transportation, 498 Truman, Harry, 28 Trumka, Richard, 656 Trump, Donald, 656 Turnover, efficiency wages and, 594–595 Tying, 352

U Uber, 11 Uganda, elephant poaching, 222 Ultimatum game, 463 Underground economy, 161 Undervalued stock, 571 Unemployment

benefits, 587–588 cyclical, 578, 581 efficiency wages and, 594–596 frictional, 585, 586 how long without work, 584 identifying, 578–585 insurance, 587–588 job search and, 586–588 measuring a nation’s income, 474 measuring of, 578–582 minimum-wage laws and, 588–591 natural rate of, 578, 581, 768 short-run trade-off between inflation

and, 14–15, 763–784 structural, 585 wages of, 588–589 why some people always experience,

584–585 Unemployment rate, 579

measures, 582–583 since 1960, 581

Unfair-competition argument for trade restrictions, 181

Unions, 391, 592 collective bargaining and, 592 determinant of equilibrium wages,

390–391 economics of, 592–593 good or bad for economy, 593 strike, 592 type of cartel, 592–593

836 INDEX

United Kingdom advanced economy, 520 economic growth of, 517 income inequality in, 404 real GDP per person, 517

United States average income in, 515, 516–517 carbon tax, 199 distribution of income in, 402–403 economic growth of, 517 GDP to investment, 526–527 government debt, 556–557 income inequality in, 402–404 inflation in, 14 inflation rate, 628 interest rates in, 508 internationalization of economy, 655 international trade and finance,

655–657 international trade with, 57–58 living standards in, 13 malnutrition in, 529 money in, 607–609 NAFTA and, 181 real GDP in, 485 trade deficit, 662–664 various laws to manage use of fish

and other wildlife, 222 United States Postal Service, 311 Unit of account, 605 Unmeasured quality change, 500 Unsafe at Any Speed (Nader), 8 U-shaped average total cost, 257–258 Utilitarianism, 410–411 Utility, 410

function of, 567 preferences and, 433

V Value-added tax (VAT), 234 Value of human life, cost-benefit analysis,

217–218 Value of marginal product, 365, 365–366 Value pricing, 220 Values, differences among economists in,

30–31 Vanderlip, Frank, 621 Variable costs, 255, 262

average, 256, 262 Variables

graphs of single, 37, 38 graphs of two, 37–39 nominal, 633 omitted, 43–44 real, 633 that influence buyers, 71 that influence sellers, 76

Variable tolling, 220 Varian, Hal, 486, 501

VAT. See value-added tax Velocity of money, 634, 634–636 Venezuela, inflation rate, 628 Vertical equity, 237, 237–239 Vestager, Margrethe, 354 Volcker, Paul A., 693, 776, 780, 801

decision led to recession, 796 disinflation, 779–780

Volkswagen, 342 Voting systems

Arrow’s impossibility theorem, 458–459

Condorcet voting paradox, 457–458 median voter theorem, 459–461

W Wage-price spiral, 730 Wages. See also Income

ability, effort, and chance, 388–389 above-equilibrium, 390–391 beauty and, 388–389 Black Death and, 377–378 compensating differentials, 384 determinants of equilibrium, 384–391 $5-a-day, 595–596 $15-an-hour, 590–591 education and, 389–390 efficiency, 390–391, 594–596 human capital, 385–386 immigration and, 369, 372–373 labor supply and, 440–443 minimum, 118–120 minimum-wage laws, 588–591 minimum-wage laws, unions, and

efficiency wages, 390–391 productivity and, 373–374 signaling, 389–390 superstar phenomenon, 390 of unemployment, 588–589

Wage subsidies, 120 Wagner Act, 593 Walsh, Emily, 393 Warburg, Paul, 621 Wealth

arbitrary redistributions of, 645 effect, 708, 712, 738

Wealth of Nations, The (Smith), 350 Welfare, 414

effects of free trade, 170 effects of tariffs, 173–175 policies to reduce poverty, 414 tax affects, 156–157

Welfare cost of monopolies, 300–303 Welfare economics, 134, 134–148, 155–157 Welfare of society

monopolistic competition and, 327–328

prisoners’ dilemma and, 347–348 Wessel, David, 728

Whitehouse, Mark, 488 Why gold, 606–607 Wieland, Volker, 755 Willingness to pay, 134, 134–135 Willingness to sell, cost and, 139–140 Wolfers, Justin, 488–489 Women

gender differences in competition, 389, 392

labor-force participation in U.S. economy of, 581–582

labor force participation rates since 1950, 582

Wonderful Wizard of Oz, The (Baum), 647 Work, trade-off between leisure and, 368 Workers

discouraged, 583 efforts, 595 health, 594 human capital per, 522 natural resources, 522 physical capital per, 519–522 quality, 595 turnover, 594–595

Work incentives, antipoverty programs and, 415–418

Work-leisure decision, 441 World Bank, 527–528 World price, 169 World Trade Organization (WTO), 182

trade agreements and, 182 World War II, 346, 528

shift in aggregate demand, 725–726 WTO. See World Trade Organization

X X-coordinate, 38

Y Y-coordinate, 38 Yellen, Janet L., 610, 801

Z Zero inflation, 797–802 Zero lower bound, 746–747 Zero profit

competitive firms stay in business with, 280–281

equilibrium, 281–282 Zimbabwe

income per person in, 516 inflation rate, 628, 638

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Cover
About the Author
Brief Contents
Preface: To the Student
Acknowledgments
Contents
Part I: Introduction

Ch 1: Ten Principles of Economics

1-1 How People Make Decisions
1-2 How People Interact
1-3 How the Economy as a Whole Works
1-4 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Ch 2: Thinking Like an Economist

2-1 The Economist as Scientist
2-2 The Economist as Policy Adviser
2-3 Why Economists Disagree
2-4 Let's Get Going
Summary
Key Concepts
Questions for Review
Problems and Applications
Appendix: Graphing: A Brief Review

Ch 3: Interdependence and the Gains from Trade

3-1 A Parable for the Modern Economy
3-2 Comparative Advantage: The Driving Force of Specialization
3-3 Applications of Comparative Advantage
3-4 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Part II: How Markets Work

Ch 4: The Market Forces of Supply and Demand

4-1 Markets and Competition
4-2 Demand
4-3 Supply
4-4 Supply and Demand Together
4-5 Conclusion: How Prices Allocate Resources
Summary
Key Concepts
Questions for Review
Problems and Applications

Ch 5: Elasticity and Its Application

5-1 The Elasticity of Demand
5-2 The Elasticity of Supply
5-3 Three Applications of Supply, Demand, and Elasticity
5-4 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Ch 6: Supply, Demand, and Government Policies

6-1 Controls on Prices
6-2 Taxes
6-3 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Part III: Markets and Welfare

Ch 7: Consumers, Producers, and the Efficiency of Markets

7-1 Consumer Surplus
7-2 Producer Surplus
7-3 Market Efficiency
7-4 Conclusion: Market Efficiency and Market Failure
Summary
Key Concepts
Questions for Review
Problems and Applications

Ch 8: Application: The Costs of Taxation

8-1 The Deadweight Loss of Taxation
8-2 The Determinants of the Deadweight Loss
8-3 Deadweight Loss and Tax Revenue as Taxes Vary
8-4 Conclusion
Summary
Key Concept
Questions for Review
Problems and Applications

Ch 9: Application: International Trade

9-1 The Determinants of Trade
9-2 The Winners and Losers from Trade
9-3 The Arguments for Restricting Trade
9-4 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Part IV: The Economics of the Public Sector

Ch 10: Externalities

10-1 Externalities and Market Inefficiency
10-2 Public Policies toward Externalities
10-3 Private Solutions to Externalities
10-4 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Ch 11: Public Goods and Common Resources

11-1 The Different Kinds of Goods
11-2 Public Goods
11-3 Common Resources
11-4 Conclusion: The Importance of Property Rights
Summary
Key Concepts
Questions for Review
Problems and Applications

Ch 12: The Design of the Tax System

12-1 An Overview of U.S. Taxation
12-2 Taxes and Efficiency
12-3 Taxes and Equity
12-4 Conclusion: The Trade-off between Equity and Efficiency
Summary
Key Concepts
Questions for Review
Problems and Applications

Part V: Firm Behavior and the Organization of Industry

Ch 13: The Costs of Production

13-1 What Are Costs?
13-2 Production and Costs
13-3 The Various Measures of Cost
13-4 Costs in the Short Run and in the Long Run
13-5 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Ch 14: Firms in Competitive Markets

14-1 What Is a Competitive Market?
14-2 Profit Maximization and the Competitive Firm's Supply Curve
14-3 The Supply Curve in a Competitive Market
14-4 Conclusion: Behind the Supply Curve
Summary
Key Concepts
Questions for Review
Problems and Applications

Ch 15: Monopoly

15-1 Why Monopolies Arise
15-2 How Monopolies Make Production and Pricing Decisions
15-3 The Welfare Cost of Monopolies
15-4 Price Discrimination
15-5 Public Policy toward Monopolies
15-6 Conclusion: The Prevalence of Monopolies
Summary
Key Concepts
Questions for Review
Problems and Applications

Ch 16: Monopolistic Competition

16-1 Between Monopoly and Perfect Competition
16-2 Competition with Differentiated Products
16-3 Advertising
16-4 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Ch 17: Oligopoly

17-1 Markets with Only a Few Sellers
17-2 The Economics of Cooperation
17-3 Public Policy toward Oligopolies
17-4 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Part VI: The Economics of Labor Markets

Ch 18: The Markets for the Factors of Production

18-1 The Demand for Labor
18-2 The Supply of Labor
18-3 Equilibrium in the Labor Market
18-4 The Other Factors of Production: Land and Capital
18-5 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Ch 19: Earnings and Discrimination

19-1 Some Determinants of Equilibrium Wages
19-2 The Economics of Discrimination
19-3 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Ch 20: Income Inequality and Poverty

20-1 The Measurement of Inequality
20-2 The Political Philosophy of Redistributing Income
20-3 Policies to Reduce Poverty
20-4 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Part VII: Topics for Further Study

Ch 21: The Theory of Consumer Choice

21-1 The Budget Constraint: What the Consumer Can Afford
21-2 Preferences: What the Consumer Wants
21-3 Optimization: What the Consumer Chooses
21-4 Three Applications
21-5 Conclusion: Do People Really Think This Way?
Summary
Key Concepts
Questions for Review
Problems and Applications

Ch 22: Frontiers of Microeconomics

22-1 Asymmetric Information
22-2 Political Economy
22-3 Behavioral Economics
22-4 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Part VIII: The Data of Macroeconomics

Ch 23: Measuring a Nation's Income

23-1 The Economy's Income and Expenditure
23-2 The Measurement of GDP
23-3 The Components of GDP
23-4 Real versus Nominal GDP
23-5 Is GDP a Good Measure of Economic Well-Being?
23-6 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Ch 24: Measuring the Cost of Living

24-1 The Consumer Price Index
24-2 Correcting Economic Variables for the Effects of Inflation
24-3 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Part IX: The Real Economy in the Long Run

Ch 25: Production and Growth

25-1 Economic Growth around the World
25-2 Productivity: Its Role and Determinants
25-3 Economic Growth and Public Policy
25-4 Conclusion: The Importance of Long-Run Growth
Summary
Key Concepts
Questions for Review
Problems and Applications

Ch 26: Saving, Investment, and the Financial System

26-1 Financial Institutions in the U.S. Economy
26-2 Saving and Investment in the National Income Accounts
26-3 The Market for Loanable Funds
26-4 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Ch 27: The Basic Tools of Finance

27-1 Present Value: Measuring the Time Value of Money
27-2 Managing Risk
27-3 Asset Valuation
27-4 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Ch 28: Unemployment

28-1 Identifying Unemployment
28-2 Job Search
28-3 Minimum-Wage Laws
28-4 Unions and Collective Bargaining
28-5 The Theory of Efficiency Wages
28-6 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Part X: Money and Prices in the Long Run

Ch 29: The Monetary System

29-1 The Meaning of Money
29-2 The Federal Reserve System
29-3 Banks and the Money Supply
29-4 The Fed's Tools of Monetary Control
29-5 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Ch 30: Money Growth and Inflation

30-1 The Classical Theory of Inflation
30-2 The Costs of Inflation
30-3 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Part XI: The Macroeconomics of Open Economies

Ch 31: Open-Economy Macroeconomics: Basic Concepts

31-1 The International Flows of Goods and Capital
31-2 The Prices for International Transactions: Real and Nominal Exchange Rates
31-3 A First Theory of Exchange-Rate Determination: Purchasing-Power Parity
31-4 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Ch 32: A Macroeconomic Theory of the Open Economy

32-1 Supply and Demand for Loanable Funds and for Foreign-Currency Exchange
32-2 Equilibrium in the Open Economy
32-3 How Policies and Events Affect an Open Economy
32-4 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Part XII: Short-Run Economic Fluctuations

Ch 33: Aggregate Demand and Aggregate Supply

33-1 Three Key Facts about Economic Fluctuations
33-2 Explaining Short-Run Economic Fluctuations
33-3 The Aggregate-Demand Curve
33-4 The Aggregate-Supply Curve
33-5 Two Causes of Economic Fluctuations
33-6 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Ch 34: The Influence of Monetary and Fiscal Policy on Aggregate Demand

34-1 How Monetary Policy Influences Aggregate Demand
34-2 How Fiscal Policy Influences Aggregate Demand
34-3 Using Policy to Stabilize the Economy
34-4 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Ch 35: The Short-Run Trade-off between Inflation and Unemployment

35-1 The Phillips Curve
35-2 Shifts in the Phillips Curve: The Role of Expectations
35-3 Shifts in the Phillips Curve: The Role of Supply Shocks
35-4 The Cost of Reducing Inflation
35-5 Conclusion
Summary
Key Concepts
Questions for Review
Problems and Applications

Part XIII: Final Thoughts

Ch 36: Six Debates over Macroeconomic Policy

36-1 Should Monetary and Fiscal Policymakers Try to Stabilize the Economy?
36-2 Should the Government Fight Recessions with Spending Hikes Rather Than Tax Cuts?
36-3 Should Monetary Policy Be Made by Rule Rather Than by Discretion?
36-4 Should the Central Bank Aim for Zero Inflation?
36-5 Should the Government Balance Its Budget?
36-6 Should the Tax Laws Be Reformed to Encourage Saving?
36-7 Conclusion
Summary
Questions for Review
Problems and Applications

Glossary
Index