Economics 4th Edition

Many books seem to take the stance that students cannot “handle” the new topics—we believe that it is just a matter of explaining the ideas simply and clearly.


Joseph E. Stiglitz, Carl E.Walsh


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  • Joseph E. Stiglitz, Carl E.Walsh   
  • 971 Pages   
  • 18 Feb 2015
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    ∂ECONOMICSF O UR TH EDITI O N read more..

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    Joseph E. StiglitzCOLUMBIA UNIVERSITYCarl E.WalshUNIVERSITY OF CALIFORNIA, SANTA CRUZ read more..

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    ∂ECONOMICSF O UR TH EDITI O NBW. W. NORTON & COMPANYNEW YORK • LONDON read more..

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    BCopyright © 2006, 2002, 1997, 1993 by W. W. Norton & Company, Inc.All rights reservedPrinted in the United States of AmericaManufacturing by RR DonnelleyBook design by Rubina YehEditor: Jack RepcheckDirector of Manufacturing—College: Roy TedoProject Editor: Lory A. FrenkelManuscript Editor: Alice FalkEditorial Assistants: Sarah Solomon, Mik AwakePhoto Researcher: Kelly MitchellLibrary of Congress Cataloging-in Publication DataStiglitz, Joseph E.Economics / Joseph E. Stiglitz, Carl E. read more..

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    ABOUT THE AUTHORSJoseph E. Stiglitz is professor of economics, business, and international andpublic affairs at Columbia University. Before joining the Columbia faculty, he heldappointments at Yale, Oxford, Princeton, and Stanford. Internationally recognizedas one of the leading economists of his generation, Professor Stiglitz has made impor-tant contributions to virtually all of the major subfields of economics, in particularthe economics of information, one of the key topics highlighted in read more..

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    CONTENTS IN BRIEF∂ viiPART 1INTRODUCTION1Chapter 1Modern Economics • 3Chapter 2Thinking Like an Economist • 25PART 2PERFECT MARKETS51Chapter 3Demand, Supply, and Price • 53Chapter 4Using Demand and Supply • 77Chapter 5The Consumption Decision • 101Chapter 6The Firm’s Costs • 131Chapter 7The Competitive Firm • 155Chapter 8Labor Markets • 175Chapter 9Capital Markets • 191Chapter 10The Efficiency of Competitive Markets • 215PART 3IMPERFECT MARKETS237Chapter 11Introduction to read more..

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    PART 6FULL-EMPLOYMENT MACROECONOMICS523Chapter 24The Full-Employment Model • 525Chapter 25Government Finance at Full Employment • 547Chapter 26The Open Economy at Full Employment • 567Chapter 27Growth and Productivity • 585Chapter 28Money, the Price Level, and the Federal Reserve • 605PART 7MACROECONOMIC FLUCTUATIONS635Chapter 29Introduction to Macroeconomic Fluctuations • 637Chapter 30Aggregate Expenditures and Income • 661Chapter 31Aggregate Demand and Inflation • 689Chapter read more..

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    CONTENTS∂ ixCONTENTSPREFACEXXXVPART 1INTRODUCTION 1CHAPTER 1MODERN ECONOMICS3INTERNET CONNECTION:Tracking the DigitalEconomy6What Is Economics?6Trade-offs7Incentives8THINKING LIKE AN ECONOMIST:Incentives andthe Price of AOL9Exchange10INTERNET CONNECTION:Auction Sites11Information13Distribution14The Three Major Markets15Keeping Track of Tricky Terms16Microeconomics and Macroeconomics: The TwoBranches of Economics17The Science of Economics18Discovering and Interpreting Relationships18Causation read more..

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    CHAPTER 2THINKING LIKE AN ECONOMIST25The Basic Competitive Model25Rational Consumers and Profit-Maximizing Firms26Competitive Markets27e-INSIGHT:Markets, Exchange, and e-Commerce27Efficiency and Distribution in the Basic CompetitiveModel28The Basic Competitive Model as a Benchmark28Incentives and Information: Prices, Property Rights, andProfits29Incentives Versus Equality31When Property Rights Fail31Alternatives to the Price System32Opportunity Sets and Trade-Offs34Budget and Time read more..

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    Sources of Shifts in Demand Curves57CASE IN POINT:Gasoline Prices and the Demand forSUVs59Shifts in a Demand Curve Versus Movements along aDemand Curve60FUNDAMENTALS OF DEMAND, SUPPLY, ANDPRICE 1:Demand Declines as Price Rises61Supply61e-INSIGHT:The Demand for Computers andInformation Technology62Market Supply64Shifts in Supply Curves65Sources of Shifts in Supply Curves65Shifts in a Supply Curve Versus Movements along aSupply Curve67FUNDAMENTALS OF DEMAND, SUPPLY, ANDPRICE 2:Supply Increases as read more..

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    Price Floors93INTERNET CONNECTION:Flawed Deregulation94Alternative Solutions94REVIEW AND PRACTICE96APPENDIX:Elasticity and Slope98CHAPTER 5THE CONSUMPTION DECISION101The Basic Problem of Consumer Choice101The Budget Constraint102Choosing a Point on the Budget Constraint: IndividualPreferences104What Happens to Consumption When Income Changes?105CASE IN POINT:The Fate of the BTU Tax107INTERNET CONNECTION:What We Consume109A Closer Look at the Demand Curve109Deriving Demand Curves110The Importance read more..

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    Short-Run and Long-Run Cost Curves141Short-Run Cost Curves142Long-Run Cost Curves142INTERNET CONNECTION:Economic Definitions146Production with Many Factors146Cost Minimization147The Principle of Substitution147CASE IN POINT:The Principle of Substitution andGlobal Warming148Economies of Scope150REVIEW AND PRACTICE151CHAPTER 7THE COMPETITIVE FIRM155Revenue155Costs156INTERNET CONNECTION:Firms’ Profit-and-LossStatements157Basic Conditions of Competitive Supply158Entry, Exit, and Market read more..

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    From the Firm’s Factor Demand to the Market’s FactorDemand184Labor Supply, Demand, and the Equilibrium Wage184REVIEW AND PRACTICE186APPENDIX:Indifference Curves and the Labor SupplyDecision188Deciding Whether to Work188CHAPTER 9CAPITAL MARKETS191Supply in the Capital Market191The Household Decision to Save192THINKING LIKE AN ECONOMIST:WealthDistribution and Interest Rates197INTERNET CONNECTION:Household Saving198CASE IN POINT:Why is the U.S. Saving Rate So Low?198Demand in the Capital read more..

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    Conditions for the Pareto Efficiency of the MarketEconomy222THINKING LIKE AN ECONOMIST:Exchange andDistribution224Competitive Markets and Pareto Efficiency225FUNDAMENTALS OF COMPETITIVE MARKETS 3:The Competitive Market Economy is ParetoEfficient225Competitive Markets and Income Distribution225General Equilibrium Analysis227The Basic Competitive Equilibrium Model227THINKING LIKE AN ECONOMIST:Indirect Trade-Offs and Air Safety for Children228CASE IN POINT:The Labor Market and the WideningWage read more..

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    How Prices Convey Information248Markets for Information249e-INSIGHT:Information, Competition, and the Internet249Government Policies250FUNDAMENTALS OF IMPERFECT MARKETS 3:Imperfect Information251Externalities252Government Policies Toward Externalities252THINKING LIKE AN ECONOMIST:Incentives andthe Environment253FUNDAMENTALS OF IMPERFECT MARKETS 4:Externalities254Public Goods254FUNDAMENTALS OF IMPERFECT MARKETS 5:Public Goods255Looking Ahead256REVIEW AND PRACTICE257CHAPTER 12MONOPOLY, read more..

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    THINKING LIKE AN ECONOMIST:Trade-Offs,American Airlines, and Predation283The Importance of Imperfections in Competition284REVIEW AND PRACTICE285CHAPTER 13GOVERNMENT POLICIES TOWARDCOMPETITION289The Drawbacks of Monopolies and Limited Competition289Restricted Output289Managerial Slack291Reduced Research and Development291Rent Seeking292Further Drawbacks of Limited Competition292e-INSIGHT:Using the Internet to Enhance PriceDiscrimination293Policies Toward Natural Monopolies293Public read more..

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    Nash Equilibrium313Strategic Behavior in More General Games316Games With Only One Dominant Strategy316INTERNATIONAL PERSPECTIVE:Beggar-Thy-Neighbor Tariff Policies317Games Without Dominant Strategies318INTERNET CONNECTION:The Zero-Sum GameSolver319Repeated Games320Reputations321Tit for Tat321INTERNET CONNECTION:The Prisoner’s Dilemma321Institutions322CASE IN POINT:Banking Panics322Sequential Moves324THINKING LIKE AN ECONOMIST:Information andThinking Strategically326Time read more..

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    Search and Information Intermediaries 346Advertising347Advertising and Competition348Advertising and Profits348The Importance of Imperfect Information350REVIEW AND PRACTICE351CHAPTER 16IMPERFECTIONS IN THE LABOR MARKET355Labor Unions355A Brief History356INTERNET CONNECTION:Unions on the Internet358Economic Effects359Limits on Union Power360Wage Differentials362Discrimination363Motivating Workers364Piece Rates and Incentives365Efficiency Wages366CASE IN POINT:Minimum Wages367Other read more..

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    Characteristics of a Good Tax System382The Scope of the U.S. Tax System383Grading the U.S. Tax System383Transfers386Welfare387Housing388Social Insurance389Designing Government Programs390Government Failures391Incentives and Constraints392Budgeting and Spending Procedures393Imperfections of Information393Collective Decision Making394Current and Recent Controversies in the Economics ofthe Public Sector395Dealing With the Deficit395Social Security396Health Care398INTERNET CONNECTION:Policy read more..

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    CHAPTER 19INTERNATIONAL TRADE AND TRADEPOLICY423Trade Between Countries423Interdependence in the Product Market424Interdependence in the Labor Market424Interdependence in the Capital Market425Multilateral Trade425Comparative Advantage426INTERNET CONNECTION:David Ricardo427Production Possibilities Curves and ComparativeAdvantage427Comparative Advantage and Specialization428e-INSIGHT:The United States’ Comparative Advantagein the Internet Age429What Determines Comparative Advantage?430The read more..

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    The Growing Protest Against the WTO446CASE IN POINT:The Banana War447Regional Trading Blocs448INTERNET CONNECTION:The World TradeOrganization449REVIEW AND PRACTICE450CHAPTER 20TECHNOLOGICAL CHANGE453Links Between Technological Change and ImperfectCompetition454e-INSIGHT:The New Economy and Innovation455Patents and the Production of Ideas455THINKING LIKE AN ECONOMIST:IntellectualProperty Rights and Distribution456The Trade-Off Between Short-term Efficiency andInnovation457CASE IN POINT:Eli read more..

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    Government Deficits and Trade Deficits479Getting the Economy Moving (Again)479New Challenges480The Three Key Goals of Macroeconomic Performance481A Look Ahead482REVIEW AND PRACTICE483CHAPTER 22MEASURING OUTPUT ANDUNEMPLOYMENT485Measuring Output and Growth485Gross Domestic Product486Measuring GDP: The Value of Output489INTERNET CONNECTION:The Bureau of EconomicAnalysis489CASE IN POINT:Is Software a Final Good or anIntermediate Good?491Potential GDP494INTERNATIONAL PERSPECTIVE:What GetsMeasured in read more..

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    Alternative Measures of Inflation517INTERNET CONNECTION:The Inflation Calculator517e-INSIGHT:Measuring the Price and Quantity ofSoftware518The American Experience with Inflation519REVIEW AND PRACTICE521PART 6FULL-EMPLOYMENTMACROECONOMICS 523CHAPTER 24THE FULL-EMPLOYMENT MODEL525Macroeconomic Equilibrium526The Labor Market527Shifts in the Demand and Supply of Labor529CASE IN POINT:Mass Migration in the NineteenthCentury531e-INSIGHT:Labor Markets and the Internet532The Product Market532Potential read more..

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    Evaluating Government Deficits and Surpluses557Government Deficits and Surpluses: Our RecentExperiences558Factors Affecting the Federal Budget561Risk Factors for the Federal Budget562REVIEW AND PRACTICE563CHAPTER 26THE OPEN ECONOMY AT FULLEMPLOYMENT567The Open Economy568The Capital Market in the Open Economy568The Basic Trade Identity572INTERNET CONNECTION:U.S. Trade Data573CASE IN POINT:The Trade Deficit574e-INSIGHT:High-Tech Exports and Imports576Exchange Rates577THINKING LIKE AN ECONOMIST:Net read more..

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    Are There Limits to Economic Growth?600THINKING LIKE AN ECONOMIST:Trade-Offs andthe Costs of Economic Growth601REVIEW AND PRACTICE602CHAPTER 28MONEY, THE PRICE LEVEL, AND THEFEDERAL RESERVE605Prices and Inflation606Money Demand607Money Supply609The Price Level609INTERNET CONNECTION:How Much Cash Do WeHold?610The Financial System in Modern Economies612CASE IN POINT:When Atlanta Printed Money614Creating Money in Modern Economies615Money Is What Money Does615Measuring the Money Supply617Money and read more..

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    PART 7MACROECONOMICFLUCTUATIONS 635CHAPTER 29INTRODUCTION TOMACROECONOMIC FLUCTUATIONS637Economic Fluctuations638INTERNET CONNECTION:Dating Business CyclePeaks and Troughs642CASE IN POINT:Estimating the Output Costs of aRecession642THINKING LIKE AN ECONOMIST:EmploymentFluctuations and Trade-Offs643Why Economies Experience Fluctuations643Nominal Versus Real Wages645The Slow Adjustment of Nominal Wages645The Slow Adjustment of Prices645THINKING LIKE AN ECONOMIST:Information andMeasuring the read more..

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    CHAPTER 30AGGREGATE EXPENDITURES ANDINCOME661Income-Expenditure Analysis661The National Income-Output Identity663Equilibrium Output663Shifts in the Aggregate Expenditures Schedule664Mathematical Formulation665A Look Forward666Consumption667Disposable Income667Expectations of Future Income671Wealth671Investment672Investment and the Real Interest Rate673Inventory Investment674Macroeconomic Implications of Investment675Government Purchases676Net Exports676Exports678Imports678Macroeconomic read more..

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    An Expansionary Shift in the ADI Curve701CASE IN POINT:The Kennedy Tax Cut701THINKING LIKE AN ECONOMIST:Tough Trade-Offs703Macroeconomic Policy and Shifts in the ADI Curve703Shifts in the Inflation Adjustment Curve704Changes in Energy Prices704CASE IN POINT:Oil Price Shocks of the 1970s705A Shift in Potential GDP705CASE IN POINT:The 1990s707e-INSIGHT:Productivity Growth and the Punch Bowl708INTERNET CONNECTION:The FOMC710REVIEW AND PRACTICE711CHAPTER 32THE FEDERAL RESERVE AND INTERESTRATES715The read more..

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    INTERNATIONAL PERSPECTIVE:Fiscal Transfers734Monetary Policy736Behind the ADI Curve—The Role of Monetary Policy736INTERNET CONNECTION:The Beige Book738CASE IN POINT:Announcing the Fed’s Decisions738Real Interest Rates and Nominal Interest Rates739The Central Bank Policy Rule740THINKING LIKE AN ECONOMIST:Real ValuesMatter for Incentives742CASE IN POINT:The Interest Rate Cut of January 3,2001743CASE IN POINT:September 11, 2001743e-INSIGHT:The Dot-Com Bubble and MacroeconomicStability744The read more..

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    CHAPTER 35POLICY IN THE OPEN ECONOMY779The ADI Curve and the Open Economy780Inflation, the Interest Rate, and the Exchange Rate780The Exchange Rate and Aggregate Expenditures781The Exchange Rate and Inflation783Imported Inputs783THINKING LIKE AN ECONOMIST:Interest Parityand Incentives784Consumer Price Inflation and the Exchange Rate784INTERNET CONNECTION:Foreign Exchange Rates785Comparing Monetary and Fiscal Policies in the OpenEconomy785Monetary Policy with Flexible Exchange read more..

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    PART 9FURTHER TOPICS INMACROECONOMICS 817CHAPTER 37INFLATION AND UNEMPLOYMENT819Short-Run Inflation Adjustment820The Role of Expectations: Shifts in the Short-Run InflationAdjustment Curve824THINKING LIKE AN ECONOMIST:DistributionalEffects of Inflation and Unemployment826CASE IN POINT:Nobel Views on Inflation andUnemployment827INTERNET CONNECTION:Winners of the NobelPrize in Economics829Shifts in the Natural Rate829CASE IN POINT:The Baby Boomers and the NaturalRate829Shifts in Potential read more..

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    CASE IN POINT:Fed Policy Statements—BalancingPolicy Goals851INTERNET CONNECTION:Banks and InflationTargeting852Consequences of Inflation Targeting853INTERNATIONAL PERSPECTIVE:Central BankMandates855Demand Versus Supply Disturbances and Policy Trade-Offs857e-INSIGHT:e-Time and Macroeconomic Policy858REVIEW AND PRACTICE860APPENDIX:Price Level Targeting862CHAPTER 39A STUDENT’S GUIDE TO INVESTING865Investment Alternatives866Bank Deposits866Housing866INTERNET CONNECTION:Calculating Interest read more..

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    GLOSSARYA-1CREDITSA-13INDEXA-15 read more..

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    PREFACEThe study of economics has always been fascinating, yet it is difficult toremember a more exciting or important time in the discipline. Think of today’s major economic issues—the huge American trade and budgetdeficits, global warming, the debate between proponents of conservation and energyexploration, ensuring adequate health care, ending global poverty, reforming SocialSecurity, outsourcing, rethinking the nature of competition and regulation in theInternet age, and copyright read more..

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    Mission Statement for the FourthEditionOur text has always strived for two goals: One, to be transparently accessible and inter-esting, dare we say a “good read,” for the student reader; and two, to not shy awayfrom teaching students the latest exciting insights of the discipline, to teach them thesubstance of economics as a field of study. Many books seem to take the stance thatstudents cannot “handle” the new topics—we believe that it is just a matter of explain-ing the ideas simply read more..

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    of the economist’s approach to imperfect competition, the chapter onstrategic behavior has been moved into Part 3 (Chapter 14). ∂ Part 4, now titled Issues in Public Policy, is more closely organized aroundthe theme of public policy, rather than simply including a set of “topics.”Part 4 includes chapters on the public sector (Chapter 17), environmentalpolicy (Chapter 18), and international trade and trade policy (Chapter 19).Changes to the Fourth Edition—MacroeconomicsThe new edition read more..

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    government, Chapter 26 extending the results to the case of the openeconomy, and Chapter 27 providing a discussion of economic growth. Thematerial on money and prices then follows in Chapter 28.∂ Part 7 on Macroeconomic Fluctuations has been extensively rewritten toimprove the exposition. Many users of the Third Edition felt that too muchmaterial was introduced in the chapters on the aggregate demand–inflationrelationship and the short-run inflation adjustment relationship. To addressthis read more..

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    ture also allows an instructor who does not wish to devote too much time to a topicsuch as imperfect information to still give students a sense of the its importance andthe lessons economists have learned about this important topic. Finally, both themicroeconomics and macroeconomics sections end with topics chapters that offeradditional flexibility for the instructor in fine-tuning the readings from the text tothe context of his or her course structure, while a new and expanded treatment ofthe read more..

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    FUNDAMENTALS OF . . .sections distill the essence of particularly importantand tricky topics.WRAP-UPSprovide a short summary of the key points presented in a section. ECONOMICS, FOURTH EDITION e-BOOKSame Great Content, Half the PriceThe e-book version of Economics,Fourth Edition, offers the full content of the print version, at half the price.In addition, a variety of features make the Norton e-book a powerful tool forstudy and review.∂ Zoomable images allow students to get a closer look at read more..

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    With SmartWork’s intuitive interface, instructors can also customize Norton’s ready-made assignments or write their own exercises with remarkable ease. Access toSmartWork is free to all students who purchase a new textbook or e-book.Student Web SiteThis free companion Web site offers students powerfulreview materials. Practice quizzes feature diagnostic feedback indicating which sec-tions in the chapter the student should review. The student Web site also provideschapter reviews, a glossary, read more..

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    INSTRUCTOR’S MANUALBY GERALD McINTYRE, OCCIDENTAL COLLEGEPRINCIPLES OF MICROECONOMICS 0-393-92805-5 • PAPERPRINCIPLES OF MACROECONOMICS 0-393-92821-7 • PAPERFor each chapter of the textbook the Instructor’s Manual contains lecture advice,lecture modules, lecture applications, problem sets, and solutions. The extensivelecture modules can be used with a set of PowerPoint slides that Gerald McIntyrehas prepared. These lecture notes are far more extensive than what other publish-ers offer, read more..

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    AcknowledgmentsThe book’s first three editions were improved immeasurable by the input of numer-ous reviewers. In particular, we thank Robert T. Averitt, Smith College; MohsenBahmani-Oskoose, University of Wisconsin, Milwaukee; Richard Barret, Universityof Montana; H. Scott Bierman, Carleton College; John Payne Bigelow, University ofMissouri; Howard Bodenhorn, Lafayette College; Bruce R. Bolnick, NortheasternUniversity; Adhip Chaudhuri, Georgetown University; Michael D. Curley, KennesawState read more..

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    Richard Stahnke, Hamilton College; Maristella Botticini, Boston University; ChrisNiggle, University of Redlands; Santanu Roy, Southern Methodist University; RogerWhite, Franklin and Marshall College; Geoffrey Carliner, Boston University; RobertL. Pennington, University of Central Florida; Roger A. McCain, Drexel University;Nancy A. Jianakoplos, Colorado State University; Sudeshna C. Bandyopadhyay,West Virginia University; Jennifer Thacher, University of New Mexico; AlanGummerson, Florida read more..

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    Alternative Course OutlineIn the Fourth Edition, we have further improved the flexibility of the book, allow-ing it to be easily adapted to courses of varying length and objectives. Part 4, Issuesin Public Policy and Part 9, Further Topics in Macroeconomics, contain chap-ters that can be covered at the end of a course, time permitting, or integrated withthe core discussions of microeconomics and macroeconomics. Part 8, The GlobalEconomy, provides instructors with the option of constructing a read more..

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    OUTLINE FOR A SHORT COURSE INMICROECONOMICS AND MACROECONOMICSCHAPTERTITLE1Modern Economics2Thinking Like an Economist3Demand, Supply, and Price4Using Demand and Supply5The Consumption Decision6The Firm’s Costs7The Competitive Firm10The Efficiency of Competitive Markets11Introduction to Imperfect Markets21Macroeconomics and the Economic Perspective22 Measuring Economic Output and Unemployment23 The Cost of Living and Inflation24The Full-Employment Model25Government Finance at Full read more..

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    Plus any of the optional chapters comprising Part 4.17The Public Sector18Environmental Economics19International Trade and Trade Policy20Technological Change39A Student’s Guide to InvestingOUTLINE FOR A SHORT COURSE INMICROECONOMICSCHAPTERTITLE1Modern Economics2Thinking Like an Economist3Demand, Supply, and Price4Using Demand and Supply5The Consumption Decision6The Firm’s Costs7The Competitive Firm8Labor Markets 9Capital Markets10The Efficiency of Competitive Markets11Introduction to read more..

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    31Aggregate Demand and Inflation32The Federal Reserve and Interest Rates33The Role of Macroeconomic PolicyPlus any of the optional chapters comprising Parts 8 and 934The International Financial System35Policy in the Open Economy36Economic Development and Transition37Inflation and Unemployment38Controversies in Macroeconomics39A Student’s Guide to InvestingOUTLINE FOR A SHORT COURSE INMACROECONOMICSCHAPTERTITLE21Macroeconomics and the Economic PerspectiveCore macroeconomics read more..

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    ∂∂1Part 1INTRODUCTION read more..

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    Learning GoalsIn this chapter, you will learnWhat economics is, and whatthe key concepts that definecore ideas in economics areWhat markets are, and whichare the principal markets thatmake up the economyWhy economics is called ascience, and why it is thateconomists often disagree 321 read more..

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    Chapter 1 MODERNECONOMICS∂The past decade has seen tremendous changes in the world economy. Manyof these changes are linked to new technological advances that have trans-formed what the global economy produces, the ways in which many goodsand services are produced, where they are produced, and how goods and servicesare transferred from the firms that produce them to the households, governments,and other firms that buy them. New technologies are transforming everything, fromhow airlines sell read more..

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    customers are being affected too. Assembly lines now rely on robots aided and controlled by computers. Car repair shops with grease-stained floors have beenreplaced by clean, quiet garages where computers diagnose a car’s problems. Theway we buy things is also changing. Whether an individual purchases a car, book,or CD over the Web; books a hotel or plane reservation; or even applies to a collegethrough the Internet, the relationship between people and firms is evolving. Newtechnologies are read more..

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    the illegal online sharing of music and other files. This proposed legislationrepresents just the latest development in the running battle between the com-panies that own the rights to the music and consumers who want to freelyshare music files. After all, it doesn’t cost the music company any more tohave a file shared by a thousand people than it does to have it shared by two.So why, many ask, should they have to pay for music files? The advent of digi-tal music has made it possible for read more..

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    Internet Connection TRACKING THE DIGITAL ECONOMYSince 1998, the U.S. Department of Commerce has issued anannual report on the digital economy. You can find the latestreport at actionURI(www.esa.doc.gov/reports.cfm):www.esa.doc.gov/reports.cfm.This mechanism grants the employee the opportunity to purchase shares inthe company at a set price. If the company does well and its shares go up invalue, the employee can sell the stock for a profit—a prospect that creates anincentive to work hard and read more..

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    2. In making choices, individuals respond to incentives. If the price of Zen MP3players falls relative to the price of iPods, there is a greater incentive to buy aZen. If the salaries for engineers rise relative to the salaries of people with anMBA, there is an increased incentive to choose to study for an engineeringdegree rather than a business degree. 3. When we exchange with others, our range of choices becomes larger. 4. Making intelligent choices requires that we have, and utilize, read more..

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    INCENTIVES It is one thing to say we all face trade-offs in the choices we make. It is quite anotherto understand how individuals and firms make choices and how those choices mightchange as economic circumstances change. If new technologies are developed, willfirms decide to increase or decrease the amount of labor they employ? If the priceof gasoline rises, will individuals decide to buy different types of automobiles?When faced with a choice, people evaluate the pros and cons of the read more..

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    gal activity, and on the other side are the companies producing the software thatallows file sharing and the millions of music lovers who do not want to pay for music.The debates now also encompass the movie industry, as digitized movies can beshared as easily as music files. The legal battle between MGM and Grokster, a dis-tributor of peer-to-peer file-sharing software, reached the United States SupremeCourt in 2005.Incentives are at the heart of the case against file sharing. Record read more..

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    Napster’s place has been taken by services such as Grokster and Morpheus thatoffer peer-to-peer (p2p) file sharing. In their legal battles with the music industry, theseservices have argued that they should not be held liable simply becuse their prod-ucts might be used to duplicate copyrighted materials illegally. However, in July2005, the U.S. Supreme Court ruled that the services could be found liable becausethey knowingly promoted products that were designed to infringe on the rights read more..

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    Internet Connection AUCTION SITES An auction is one form of market that used to require potentialbuyers to be physically present in a single location. Now, auc-tions are held over the Internet and can involve participantsfrom around the world. Some sites, such as eBay actionURI(www.ebay.com):(www.actionURI(www.ebay.com):ebay.com), offer just about everything for sale. Other sites spe-cialize. For instance, Heritage Coins read more..

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    firms make the decisions. Individuals make decisions that reflect their own desiresas they respond to the incentives they face. Firms make decisions that maximize theirprofits, and to do so they strive to produce the goods that consumers want at thelowest possible cost. This process determines what is produced, how it is produced,and for whom. As firms compete in the quest for profits, consumers benefit, bothfrom the kinds of goods produced and from the prices at which they are supplied.On the read more..

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    and products. It is hard to imagine government bureaucrats developing MP3 play-ers or iMacs in neon colors. Markets also generally ensure that resources are usedefficiently. Exchange in markets is a key to understanding how resources are allocated, what isproduced, and who earns what. INFORMATION Making informed choices requires information. After all, it is hard to weigh the costsand benefits of alternative choices if you do not know what they are! A firm that iscontemplating the purchase of a read more..

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    home in 2005 when the drug manufacturer Merck had to pull its pain relief drugVioxx off the market after studies suggested it increased the risk of heart attacks andstrokes. Critics of the FDA argued that the agency is not adequately monitoring thesafety of drugs once they are approved, and proposals have been made to establisha new government review board whose job it will be to decide when new informationwarrants removing a drug from the market. Even in the absence of regulation, firms have read more..

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    The primary reliance on private decision making in the United States reflectseconomists’ beliefs that this reliance is appropriate and necessary for economic efficiency. However, economists also believe that certain interventions by govern-ment are desirable. Like the appropriate balance between public and private sec-tors, the appropriate balance between concerns about equality (often referred toas equity concerns) and efficiency is a central issue of modern economies. As elsewhere, read more..

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    As Figure 1.1 shows, individuals participate in all three markets. When individu-als buy goods and services, they act as consumers in the product market. When peopleact as workers, economists say they “sell their labor services” in the labor market.When people buy shares of stock in a firm, deposit money in a savings account, orlend money to a business, they are participating in the capital market as investors. KEEPING TRACK OF TRICKY TERMS Terms in economics often are similar to terms in read more..

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    Microeconomics andMacroeconomics:The Two Branches of Economics Economists have developed two different ways to look at the economy. The detailedstudy of the decisions of firms and households, and of prices and production in spe-cific industries, is called microeconomics. Microeconomics (micro is derived fromthe Greek word meaning “small”) focuses on the behavior of the units—the firms,households, and individuals—that make up the economy. It is concerned with howthe individual units make read more..

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    The Science of Economics Economics is a social science. It studies the social problem of choice from a scientificviewpoint, which means that it is built on a systematic exploration of the problem ofchoice. This systematic exploration involves both the formulation of theories andthe examination of data. A theory consists of a set of assumptions (or hypotheses) and conclusions derivedfrom those assumptions. Theories are logical exercises: if the assumptions are correct, then the results follow. If read more..

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    does not prove that the coin is not weighted. The evidence is not strong enoughfor either conclusion. But if you flip the coin 100 times and get 80 heads, statisti-cal tests will tell you that the possibility of this happening by blind chance with afair coin is extremely small. The evidence supports the assertion that the coin is weighted. A similar logic can be used on correlations among economic variables. Peoplewith more education tend to earn higher wages. Is the connection merely read more..

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    20 ∂CHAPTER 1 MODERN ECONOMICSprofits of U.S. textile manufacturers, and the reduced employment among textileworkers in developing countries. Economists might disagree over the consequencesof restricting imports because they disagree over the magnitude of the effects, perhaps agreeing that prices to consumers would rise but disagreeing over the sizeof that rise.In the end, though, the policy question is, Should there be restraints on textileimports? This is a normative question. Normative read more..

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    Review and Practice SUMMARY 1. Economics is the study of how individuals, firms, andgovernments within our society make choices. Choices,and therefore trade-offs are unavoidable becausedesired goods, services, and resources are inevitablyscarce.2. Economists study how individuals, firms, and govern-ments within our society make choices by focusing onincentives. People respond to changes in incentives byaltering the decisions they make.3. Exchange occurs in markets. Voluntary exchange canbenefit read more..

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    4. Why might there be a trade-off between equity and efficiency?5. What is a mixed economy? Describe some of the rolesgovernment might play, or not play, in a mixed economy. 6. Name the three main economic markets, and describehow an individual might participate in each one as abuyer or a seller.7. Give two examples of economic issues that are primarilymicroeconomic and two examples that are primarilymacroeconomic. What is the general difference betweenmicroeconomics and macroeconomics?8. What read more..

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    Learning goalsIn this chapter, you will learnWhat economists mean bythe “basic competitivemodel”The role played by incen-tives, property rights, prices,and the profit motive in amarket economyAbout alternatives to the market system for allocatingresourcesAbout some of the basic toolsthat economists use to studyhow people make choices4321 read more..

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    Chapter 2THINKING LIKE ANECONOMIST∂Economists have a distinctive way of thinking about issues, and the best wayto learn economics is to understand how to think like an economist. Thinkinglike an economist involves focusing on trade-offs, incentives, exchange, infor-mation, and distribution—the five key concepts introduced in Chapter 1—and more.Economists focus on the choices individuals and business make when they are facedwith scarcity. These choices can involve a decision to eat at home read more..

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    your favorite café will have milk and espresso for your morning latte? And how can you be sure that the grocery store won’t charge you $20 for that loaf of bread orthat your espresso won’t cost $10?The answer can be given in one word—competition. When firms competewith one another for customers, they will offer customers the desired productsat the lowest possible price. Consumers also compete with one another. Only alimited number of goods are available, and they come at a price. read more..

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    COMPETITIVE MARKETSTo complete the model, economists make assumptions about the places where self-interested consumers and profit-maximizing firms meet: markets. Economists beginby focusing on the case of many buyers and sellers, all buying and selling the samething. Picture a crowded farmers’ market with everyone buying and selling just onegood. Let’s say we are in Florida, and the booths are full of oranges.Each of the farmers would like to raise her prices. That way, if she can still read more..

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    (Later in the book, we will encounter markets with limited or no competition, likemonopolies, in which firms can raise prices without losing all their sales.)On the other side of our farmers’ market are rational individuals, each of whomwould like to pay as little as possible for oranges. But no consumer can pay less thanthe going price, because the seller sees another buyer in the crowd who will pay it.Thus, the consumers also have to compete against each other for the limited numberof read more..

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    new insights into markets and situations that the basic competitive model cannot fullyaddress. Differences between the predictions of the basic competitive model andobserved outcomes can help guide us to other models that provide a better under-standing of particular markets and circumstances. While the basic competitivemodel may not provide a perfect description of some markets, most economistsbelieve that it gives us tremendous insights into a wide range of economic issues;for that reason, it read more..

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    has increased demand. Or perhaps troubles in the Middle East have decreasedsupply. In either case, the higher price signals consumers to reduce their purchasesof oil products. If the price of home heating oil rises, that increase signals oil refiner-ies to produce more heating oil. Prices provide the information that individuals andfirms need to make rational decisions.For the profit motive to be effective, there must be private property, with itsattendant property rights. Under a system of read more..

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    INCENTIVES VERSUS EQUALITYWhile incentives are at the heart of market economies, they come with a cost: inequal-ity. Any system of incentives must tie compensation to performance. Whether throughvariations in luck or ability, the performances of individuals will differ. In many cases,the reason for high performance is unclear. The successful salesperson may point tohis superior skill and effort, while his colleague may view him as lucky.If pay is tied to performance, inequalities are inevitable. read more..

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    Restricted Property Rights In California, the government allocates waterrights among various groups. Because water is scarce in California, these rights arevery valuable. But they come with a restriction: they are not transferable. Waterrights allow farmers to purchase water at much lower rates than the price chargedto nonfarm households. What thirsty urban consumers would be willing to pay foradditional water exceeds the profits from many of the crops the water is being usedto grow. If water read more..

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    line up to buy at that price. (The high price that scalpers can get for hot tickets is a good indication of how much more than the ticket price (some) people would bewilling to pay.1)Rationing by queues is thought by many to be a more desirable way of supplyingmedical services than the price system. Why, it is argued, should the rich—who aremost able to pay for medical services—be the ones to get better or more medicalcare? Using this reasoning, Britain provides free medical care to everyone read more..

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    Opportunity Sets and Trade-offsMarket economic systems leave to individuals and firms the question of what toconsume and what to produce. How are these decisions made?For a rational individual or firm, the first step in the economic analysis of anychoice is to identify what is possible—what economists call the opportunity set,which is simply the group of available options. If you want a sandwich and have onlytuna fish and cheese in the refrigerator, then your opportunity set consists of a read more..

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    she has more of both goods than at point D. She would be even happierat point F, where she has still more DVDs and CDs, but that point, by definition, is unattainable.Figure 2.2 depicts a time constraint. The most common time con-straint simply says that the sum of what an individual spends her timeon each day—including sleep—must add up to 24 hours. The figure plotsthe hours spent watching television on the horizontal axis and the hoursspent on all other activities on the vertical axis. read more..

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    It will be drawing these resources out of the production of other goods, in this case,butter. Thus, when the economy increases its production of guns from 40 million a year (point A) to 70 million (B), butter production falls by 20 million tons, from 90 million tons to 70 million tons. But if production of guns is increased further,to 90 million (C), an increase of only 20 million, butter production has to decreaseby 30 million tons, to only 40 million tons. For each increase in the number of read more..

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    Diminishing returns is an important concept in economics. Thephenomenon occurs in many situations. You have probably discov-ered that you usually get more out of the first hour of studying thanthe tenth, and that studying a few hours may bring big payoffs whenyou are preparing for an exam; but if you stay up all night to cram,your concentration is likely to decrease, and you may be so tiredin the morning that you actually do worse on the exam than if youhad quit studying sooner. Having one of read more..

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    the firm, or society is operating on the constraint or curve, then it is possible to getmore of one thing only by sacrificing some of another. The “cost” of one more unitof one good is how much you have to give up of the other.Economists think about costs in terms of trade-offs within opportunity sets.Let’s go back to Michelle choosing between CDs and DVDs in Figure 2.1. Thetrade-off is given by the relative price, the ratio of the prices of CDs and DVDs.In our example, a CD costs $10, and read more..

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    The analysis can be applied to the government as well. The federal governmentowns a vast amount of wilderness. In deciding whether it is worthwhile to convertsome of the land into a national park, the government needs to take into accountthe opportunity cost of the land. The land might be used for growing timber or forgrazing sheep. Whatever the value of the land in its next-best use, this is the eco-nomic cost of the national park. The fact that the government does not have to buythe land does read more..

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    3U.S. Census Bureau, Annual Demographic Survey, Table PINC-04, March 2004 actionURI(http://pubdb3.census.gov/macro/032004/perinc/new04_001.htm):(http://pubdb3.census.gov/actionURI(http://pubdb3.census.gov/macro/032004/perinc/new04_001.htm):macro/032004/perinc/new04_001.htm).Case in PointTHE OPPORTUNITY COST OF ATTENDINGCOLLEGEOpportunity cost is a key concept in economics. It is the correct measure of the costof everything we do. As a college student, what is your opportunity cost of read more..

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    computers and textiles. The developed country is more productive than the less-developed country at producing both computers and textiles. Despite the fact thatNorth can produce either good more efficiently than South can, economists arguethat it will still pay for the two countries to trade, and opportunity cost provides thekey to understanding why.Let’s make our example more concrete by assuming that in North, 100 hours oflabor can produce either 5 computers or 100 shirts. In South, 100 read more..

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    42 ∂CHAPTER 2 THINKING LIKE AN ECONOMISTNorth will be willing to accept no less than 20 shirts from South in exchange for 1 com-puter. If South were to offer fewer than 20 shirts for a computer, North would bebetter off producing its own shirts. Because the opportunity cost of a computer inSouth is 50 shirts, South will be willing to pay no more than 50 shirts to obtain acomputer from North. As long as the price for a computer lies between 20 and 50shirts per computer, both countries can gain read more..

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    Internet ConnectionTHE ECONOMISTS' VOICEOne way to start thinking like an economist is to read whateconomists have to say about current events. The Economists’Voice at actionURI(www.bepress.com/ev/):www.bepress.com/ev/ provides articles about currenteconomic issues.To understand sunk costs, let’s go back to the movies, assuming now that youhave spent $10 to buy a movie ticket. You were skeptical about whether the moviewas worth $10. Half an hour into the movie, your worst suspicions are read more..

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    44 ∂CHAPTER 2 THINKING LIKE AN ECONOMISTPeople, consciously or not, think about the trade-offs at the margin in most oftheir decisions. Economists, however, bring them into the foreground. Like oppor-tunity costs and sunk costs, marginal analysis is one of the critical concepts thatenable economists to think systematically about the costs of alternative choices.This kind of marginal analysis has come to play an increasingly important rolein policy discussions. For instance, the key issue in read more..

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    perfect competitionprice takerprice systemprivate propertyproperty rightstragedy of the commonsrationing systemsopportunity setbudget constraintstime constraintsproduction possibilitiesproduction possibilities curvediminishing returnsrelative priceopportunity costsunk costsmarginal costsmarginal benefitsREVIEW QUESTIONS1. What are the essential elements of the basic competitivemodel?2. Consider a lake in a state park where everyone isallowed to fish as much as they want. What outcome doyou read more..

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    or on gasoline at $2 per gallon. Draw Kathy’s opportu-nity set. What is the trade-off between junk food andgasoline? Now draw each new budget constraint shewould face if(a) a kind relative started sending her an additional $10per week;(b) the price of a junk food snack fell to $2;(c) the price of gasoline rose to $2.50 per gallon.In each case, how does the trade-off between junk foodand gasoline change?6. Why is the opportunity cost of going to medical schoollikely to be greater than the read more..

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    APPENDIX: READING GRAPHS∂ 47= Rise––––Run6 – 8–––––3 – 2= – 21412108642E1 2 3 4 5 6 7CDs0DVDsASlope = –2Michelle’sbudgetconstraint862 3EAFigure 2.5READING A GRAPH: THE BUDGET CONSTRAINTGraphs can be used to show the relationship between two variables. This one shows therelationship between the variable on the vertical axis (the number of CDs) and the vari-able on the horizontal axis (the number of DVDs). The slope of the curve—here, thebudget constraint—gives read more..

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    Sometimes, of course, not every point on the graph is economically meaningful.You cannot buy half a DVD or half a CD. For the most part, we ignore these consid-erations when drawing our graphs; we simply pretend that any point on the budgetconstraint is actually possible.SLOPEIn any diagram, the amount by which the value along the vertical axis increasesfrom a change in a unit along the horizontal axis is called the slope, just like the slopeof a mountain. Slope is sometimes described as “rise read more..

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    Now look at point A, where the economy is producing more butter. The area aroundA has been blown up in panel C. Here, we see that when we increase butter by 1 moreunit, the reduction in guns is greater than before. The slope at A (again, millions offewer guns produced per extra ton of butter) is With curves such as the production possibilities curve, the slope differs as we movealong the curve.INTERPRETING CURVESLook at Figure 2.9. Which of the two curves has a steeper slope? The one on the read more..

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    In fact, both panels represent the same budget constraint. They have exactly thesame slope.This kind of cautionary tale is also important in looking at graphs of data.Compare, for instance, panels Aand Bof Figure 2.10. Both graphs show the level ofpassenger car production from 1980 to 1990. Which one exhibits more variability?Which looks more stable? Panel Bappears to show that car production does notchange much over time. But again, a closer look reveals that the axis has beenstretched in panel read more..

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    ∂∂51Part 2PERFECT MARKETS read more..

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    Learning goalsIn this chapter, you will learnWhat a demand curve is, whydemand curves normallyslope downward, and whatother factors, besides price,affect the quantity demandedWhat a supply curve is, whysupply curves normally slopeupward, and what other fac-tors, besides price, affect thequantity suppliedHow the demand and supplycurves can be used to deter-mine the equilibrium price ofa goodHow shifts in the demand and supply curve affect theequilibrium price4321 read more..

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    Chapter 3DEMAND, SUPPLY,AND PRICE∂Choice in the face of scarcity is the fundamental concern of economics. Butif scarcity is such a concern for economists, why is it that whenever I go tomy local grocery store it has all the tomatoes I want to buy? Tomatoes mightbe more expensive one week and less expensive the next, but they are always avail-able. In what sense are tomatoes scarce? The same is true for most goods most ofthe time; as long as I am willing to pay the market price, I can buy the read more..

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    Prices are the way participants in the economy communicate with one another.Assume a drought hits the country, drastically reducing the supply of corn. Householdswill need to lower their consumption of corn or there will not be enough to go around.But how will they know this? Suppose newspapers across the country ran an articleinforming people they would have to eat less corn because of a drought. What incen-tive would they have to pay attention to it? How would each family know how muchit ought read more..

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    you might buy a few, and if the price declined to $0.50, you mightbuy a lot. The table in Figure 3.1 summarizes the weekly demand ofone individual, Roger, for candy bars at these different prices. Wecan see that the lower the price, the larger the quantity demanded.We can also draw a graph that shows the quantity Roger demandsat each price. The quantity demanded is measured along the hori-zontal axis, and the price is measured along the vertical axis. Thegraph in Figure 3.1 plots the points.A read more..

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    bars; it gives the total quantity of candy bars demanded by everybody in the econ-omy at various prices. If we had a table like the one in Figure 3.1 for each person inthe economy, we would construct Figure 3.3 by adding up, at each price, the totalquantity of candy bars purchased. Figure 3.3 tells us, for instance, that at a price of$3.00 per candy bar, the total market demand for candy bars is 1 million candy bars, and that lowering the price to $2.00 increases market demand to 3 millioncandy read more..

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    SHIFTS IN DEMAND CURVESWhen the price of a good increases, the demand for that gooddecreases—when everything else is held constant. But in the realworld, everything is not held constant. Any changes other than in theprice of the good in question shift the (whole) demand curve—thatis, they alter the amount that will be demanded at each price. Howthe demand curve for candy has shifted as Americans have becomemore weight conscious provides a good example. Figure 3.4 showshypothetical demand read more..

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    demand curve for coffee to the left: at each price, the demand for coffee is less.Similarly a decrease in the price of sugar shifts the demand curve for coffee to the right.Market demand curves can also be shifted by noneconomic factors. The majorones are changes in tastes, cultural factors, and changes in the composition of thepopulation. The candy example discussed earlier reflected a change in tastes. Othertaste changes in recent years in the United States include shifts in food choices asa read more..

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    Case in PointGASOLINE PRICES AND THE DEMAND FOR SUVSWhen demand for several products is intertwined, conditions affecting the price ofone will affect the demand for the other. Changes in gasoline prices in the UnitedStates, for example, have affected the types of cars Americans buy. Gasoline prices soared twice in the 1970s, once when the Organization of PetroleumExporting Countries (OPEC) shut off the flow of oil to the United States in 1973 andagain when the overthrow of the shah of Iran in read more..

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    gas prices are adjusted for inflation, the real price of gasoline—the price of gas relative to the prices of other goods—was lower in the 1990s than it had been beforethe big price increases of the 1970s (Figure 3.6). As a consequence, the demand curve for large cars shifted back to the right. This time, the change in demand wasreflected in booming sales of sports utility vehicles, or SUVs. The registrations oflight-duty trucks (which include SUVs, minivans, and pickups) jumped from lessthan read more..

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    In practice, both effects are often present. Thus, in panel Cof Fig-ure 3.7, the movement from point A to point C—where the quantitydemanded has been increased from Q0 to Q2—consists of two parts: achange in quantity demanded resulting from a shift in the demandcurve (the increase in quantity from Q0 to Q1), and a movement along the demand curve due to a change in the price (the increase inquantity from Q1 to Q2).The distinction will be important for understanding how quantitiesand prices read more..

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    e-InsightTHE DEMAND FOR COMPUTERS AND INFORMATION TECHNOLOGYThe demand for computers and other information technol-ogy investments rose markedly during the 1980s and 1990s.Panel Ashows an index of real investment in computers and related equipment; the index is scaled so that it equals100 in the year 2000. Real investment has grown an aver-age of 29 percent over the period shown (1990–2003). Thisgrowth in the demand for computers occurred for a simplereason: the effective price of computers read more..

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    disparate choices as the number of candy bars a firm wants to sell and the number of hours a worker is willing to work. As withdemand, the first question economists ask is, How does the quan-tity supplied change when price changes, if everything else is keptthe same?Figure 3.8 shows the number of candy bars that a candy com-pany would like to sell, or supply to the market, at each price. If the price of a candy bar is only 75 cents, the firm does not find it profitable to produce and sell any read more..

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    64 ∂CHAPTER 3 DEMAND, SUPPLY, AND PRICEMARKET SUPPLYThe market supply of a good is the total quantity that all the firms in the economyare willing to supply at a given price. Similarly, the market supply of labor is thetotal quantity of labor that all the households in the economy are willing to supplyat a given wage. Figure 3.9 tells us, for instance, that at a price of $2.00, firms willsupply 70 million candy bars, while at a price of $0.50, they will supply only 5 million.Figure 3.9 also read more..

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    SUPPLY∂ 65Wrap-UpSUPPLY CURVEThe supply curve gives the quantity of the good supplied at each price.SHIFTS IN SUPPLY CURVESJust as demand curves can shift, supply curves too can shift, so that the quantitysupplied at each price increases or decreases. Suppose a drought hits the bread-basket states of mid-America. Figure 3.10 illustrates the situation. The supply curvefor wheat shifts to the left, which means that at each price of wheat, the quantityfirms are willing to supply is read more..

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    66 ∂CHAPTER 3 DEMAND, SUPPLY, AND PRICEa greater quantity. That is why the quantity supplied along the curve S1 is greater thanthe quantity supplied, at the same price, along the curve S0.Another source of shifts is changes in technology. The technological improve-ments in the computer industry over the past two decades have led to a rightwardshift in the market supply curve. Yet another source of shifts is nature. The supplycurve for agricultural goods may shift to the right or left depending read more..

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    LAW OF SUPPLY AND DEMAND∂ 67A change in the natural environmentA change in the availability of creditA change in expectationsSHIFTS IN A SUPPLY CURVE VERSUSMOVEMENTS ALONG A SUPPLY CURVEDistinguishing between a movement along a curve and a shift in the curve itself is justas important for supply curves as it is for demand curves. In Figure 3.12A, the priceof candy bars has gone up, with a corresponding increase in quantity supplied. Thus,there has been a movement along the supply curve.By read more..

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    it up. When the weight is at rest, it is in equilibrium, with the twoforces just offsetting each other. If someone pulls the weight downa little bit, the force of the spring will be greater than the force of gravity, and the weight will spring up. In the absence of anyfurther interventions, the weight will bob back and forth andeventually return to its equilibrium position.An economic equilibrium is established in the same way. Atthe equilibrium price, consumers get precisely the quantity ofthe read more..

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    LAW OF SUPPLY AND DEMAND∂ 69USING DEMAND AND SUPPLY CURVESThe concepts of demand and supply curves—and market equilibrium as the inter-section of demand and supply curves—constitute the economist’s basic model ofdemand and supply. This model has proved to be extremely useful. It helps explainwhy the price of a given commodity is high, and that of some other commodity islow. It also helps predict the consequences of certain changes. Its predictions canthen be tested against what actually read more..

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    CONSENSUS ON THE DETERMINATION OF PRICESThe law of supply and demand plays such a prominent role in economics that thereis a joke about teaching a parrot to be an economist simply by training it to say“supply and demand.” That prices are determined by the law of supply and demandis one of the most long-standing and widely accepted ideas of economists. In com-petitive markets, prices are determined by the law of supply and demand. Shifts in thedemand and supply curves lead to changes in the read more..

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    Internet ConnectionTHE DEMAND AND SUPPLY IN THE OIL MARKET The U.S. Energy Information Administration (EIA) has a slidepresentation aactionURI(www.eia.doe.gov/emeu/25opec/anniversary.html):t www.eia.doe.gov/emeu/25opec/anniversary.htmlthat illustrates some of the major ways that the energy priceincreases during the 1970s affected the types of cars Americansbought and how they heated their homes.PRICE, VALUE, AND COST∂ 71exchange.” Figure 3.15 presents a demand and a supply curve for water. read more..

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    Review and PracticeSUMMARY1. An individual’s demand curve gives the quantity demandedof a good at each possible price. It normally slopes down,which means that the person demands a greater quan-tity of the good at lower prices and a lesser quantity athigher prices.2. The market demand curve gives the total quantity of a good demanded by all individuals in an economy ateach price. As the price rises, demand falls, bothbecause each person demands less of the good andbecause some people exit the read more..

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    REVIEW AND PRACTICE∂ 73the demand and supply curves. What is the equilibriumprice and quantity? Find a price at which excess demandwould exist and a price at which excess supply wouldexist, and plot them on your diagram.2. Suppose a severe drought hits the sugarcane crop. Predicthow this will affect the equilibrium price and quantity inthe market for sugar and the market for honey. Drawsupply and demand diagrams to illustrate your answers.3. Imagine that a new invention allows each mine read more..

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    74 ∂CHAPTER 3 DEMAND, SUPPLY, AND PRICE(a) What is the equilibrium rental for a one-bedroomapartment?(b) Suppose 200 new one-bedroom apartments are con-structed. What happens to the equilibrium rent?(c) Suppose more people move into the town, increas-ing the demand for one-bedroom apartments by200 units at each price. What is the new equilib-rium price? (Assume the supply remains fixed at1,200 units.)10. Suppose a town decides to give a $100 subsidy to eachrenter to help with rent payments. read more..

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    Learning GoalsIn this chapter, you will learnWhat is meant by the conceptof elasticityHow elasticity helps explainthe effects on prices andquantities of shifts in demandand supplyHow government policiessuch as rent control or agri-cultural price supports thatinterfere with market out-comes lead to shortages andsurpluses 321 read more..

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    Chapter 4USING DEMANDAND SUPPLY∂Why are doctors, on average, paid more than lawyers? And why are lawyerspaid more than schoolteachers? Why does your economics professorprobably make more than your literature professor? And why has thewage gap between college graduates and those with only a high school educationwidened in recent years? The concepts of demand and supply developed in the pre-vious chapter can help us answer these questions. Moreover, these concepts helpus predict what will happen read more..

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    in question. If the price of orange juice rises, consumers have an incentive to buyless orange juice and to buy apple juice, cranberry juice, or any one of a number ofother drinks instead. If a new tax pushes up the price of gasoline, drivers likewise havean incentive to reduce their consumption of gas; but doing so may be difficult forthose who have to drive to work in cars with conventional engines. Some may beable to ride the bus, but many will be hard-pressed to find an alternative means read more..

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    PRICE ELASTICITY AND REVENUESThe revenue received by a firm in selling a good is its price times the quantity sold.We can write this definition in a simple equation. Letting R denote revenues, p price,and Q quantity:R= pQ.Thus when price goes up by 1 percent, the effect on revenues depends on the mag-nitude of the decrease in quantity. If quantity decreases by more than 1 percent,then total revenues decrease; by less than 1 percent, they increase.We can express this result in terms of the read more..

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    revenues. We say the demand for these goods is relatively inelastic, or insensitiveto price changes.Business firms must pay attention to the price elasticity of demand for theirproducts. Suppose a cement producer, the only one in town, is considering a 1 per-cent increase in price. The firm hires an economist to estimate the elasticity ofdemand so that it will know what will happen to sales after the increase. The econ-omist tells the firm that its demand elasticity is 2. This means that if the read more..

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    goods, and in airplane frames because it is lightweight. As the price increases, cus-tomers seek out substitutes. At first, substitutes are easy to find, and the demandfor the product is greatly reduced. For example, plastic wrap frequently can be usedinstead of aluminum foil. As the price rises still further, tin replaces aluminum forcans. At very high prices, say near point A, aluminum is used only where its prop-erties are essential, such as in airplane frames. At this point, it may take a read more..

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    temperatures, installed better insulation in their homes, and turned to alternativeenergy sources. The long-run demand curve was therefore much more elastic (flat)than the short-run curve. Indeed, the long-run elasticity turned out to be much largerthan anticipated.The duration of “the long run” will vary from product to product. In some cases,adjustments can occur rapidly; in other cases, they are very gradual. As old gas-guzzlers wore out, they were replaced with fuel-efficient compact read more..

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    THE PRICE ELASTICITY OF SUPPLY∂ 83International Perspective COMPARING REACTIONS TO THE OIL PRICE SHOCK OF 2000When gasoline prices soared in the fall of 2000, in responseto the increase in oil prices, people in Great Britain and othercountries in Europe took to the streets. Truckers blocked roadsand entrances to refineries. There was a massive politicaloutcry. One might have thought, given Americans’ greaterdependence on oil (Americans use far more gasoline per capita)and given the far read more..

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    elasticity; and in the extreme case of a horizontal supply curve, the curveis said to be perfectly elastic, or to have infinite elasticity. Table 4.2 summarizes the different cases for the price elasticity ofsupply. Paintings by Rembrandt, who died in 1669, and new songs by JohnLennon, who died in 1980, have a zero elasticity of supply because no moreoriginal Rembrandts can be produced or Lennon songs written. The supplyelasticity of labor is estimated to be low; a 1 percent increase in read more..

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    the supply curve becomes close to vertical (inelastic). That is, however much theprice increases, the supply will not change very much. Short Run Versus Long Run Economists distinguish between the respon-siveness of supply to price in the short run and in the long run, just as they do withdemand. Here, too, the long-run elasticity is greater than the short-run elasticity.We define the short-run supply curve as the supply response given the current stockof machines and buildings. The long-run read more..

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    less—there is an increase in the equilibrium price of corn and a decrease in quantity.Knowing that the shifts in the demand or supply curve will lead to an adjustment inboth price and quantity is helpful, but it is even more useful to know whether most ofthe impact of a change will be on price or on quantity. To make this determination, wehave to consider the price elasticity of both the demand and supply curves.Figure 4.7 illustrates the typical range of outcomes. If the supply curve is read more..

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    USING DEMAND AND SUPPLY ELASTICITIES∂ 87be reflected more in changes in quantity than in price. If the supply curve is relatively inelastic (approaching the vertical, as in panel B), shifts in the demandcurve will be reflected more in changes in price than in quantity. If the demandcurve is highly elastic (approaching the horizontal, as in panel C), shifts in the supply curve will be reflected more in changes in quantity than in price. Finally, if the demand curve is relatively inelastic read more..

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    10¢Price paid byconsumersPRICE OF CIGARETTESSupply curveafter taxSupply curvebefore taxPrice receivedby producersPricewithout taxA A tax on cigarettesDemandcurveQ1Price paid byconsumersPRICE OF CHEDDARSupply curveafter taxSupply curvebefore tax10¢Price receivedby producersPricewithout taxBA tax on cheddar cheeseDemandcurveQUANTITY OF CHEDDAR (Q )QUANTITY OF CIGARETTES (Q )Q0Q1Q0A tax on the output of an industry shifts the supply curve up by the amount of the tax.Panel Ashows that if the read more..

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    to illustrate the market’s failure to work in fact often underscore most forcefully theimportance of the law of supply and demand. The problem is that the “going price”is not the market equilibrium price.Shortages and surpluses can be seen in the standard supply and demand dia-grams shown in Figure 4.9. In both panels Aand B, the market equilibrium price isp*. In panel A, the going price, p1, is below p*. At this price, demand exceeds supply;you can see this by reading down to the read more..

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    Thinking Like an EconomistINCENTIVES AND THE WINDOW TAXThe city of Bath in England predates the Roman occupation ofthe British Isles. Because naturally heated springs are locatedat its site, the Romans built baths there. During the late eigh-teenth and early nineteenth centuries, the city became a popular watering hole for the well-to-do.One of the city’s striking features is the beautiful brickused to build many of the buildings. But a visitor’s atten-tion is also caught by the number of read more..

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    New York City leads, in the short run (when supply is inelastic), to an increase inrents, a consequence again of the law of supply and demand—one that will please landlords and leave tenants angry. In each of these cases, pressure from those who did not like the outcome ofsupply and demand has led government to act. The price of oil and natural gas was,at one time, regulated; minimum wage laws set a minimum limit on what employ-ers can pay, even if the workers are willing to work for less; and read more..

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    for example—is illustrated by Figure 4.10. In panel A, R* is the market equilibriumrental rate, at which the demand for housing equals the supply. However, the localgovernment is concerned that at R*, many poor people cannot afford housing in thecity; it therefore passes a law that caps rents at R1. But at R1, there is an excessdemand for apartments. While the motives behind its action may well have beenpraiseworthy, the government has created an artificial scarcity.The problems caused by rent read more..

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    Case in PointRENT CONTROL IN NEW YORK CITYRent control creates a housing shortage while, at the same time, it discouragesthe construction of new rental housing. In cities with rent control such as NewYork, vacancy rates for rental units are quite low, usually around 2 to 3 percent. Incontrast, the vacancy rate normally averages around 7 percent in cities such asChicago, San Diego, and Philadelphia that do not have rent control. With manypeople struggling to obtain one of the few available read more..

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    Internet ConnectionFLAWED DEREGULATIONThe California electricity market became a major nationalnews story in 2001 as Californians suffered rolling blackouts,a major utility declared bankruptcy, and the state govern-ment spent as much as $70 million per day to purchase elec-tricity. Rising demand, shrinking supply, and a price ceiling onwhat utilities could charge consumers produced electricityshortages. Information on the California electric industrymay be found at the California Public read more..

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    ment is concerned with low wages paid to unskilled workers, it can try to increasethe demand for these workers. A shift to the right in the demand curve will increasetheir price—that is, the wages they receive. The government can either subsidizefirms that hire unskilled workers or provide more training to these workers andthus increase their productivity.If the government wants to increase the supply of housing to the poor, it can pro-vide them with housing subsidies, which will elicit a read more..

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    Review and PracticeSUMMARY1. The price elasticity of demand describes how sensitivethe quantity demanded of a good is to changes in theprice of the good. When demand is inelastic, an increasein the price has little effect on the quantity demandedand the demand curve is steep; when demand is elastic,an increase in the price has a large effect on the quantitydemanded and the curve is flat.2. The price elasticity of supply describes how sensitivethe quantity supplied of a good is to changes in the read more..

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    2. Imagine that the short-run price elasticity of supply fora farmer’s corn is 0.3, while the long-run price elasticityis 2. If prices for corn fall 30 percent, what are the short-run and long-run changes in quantity supplied? Whatare the short- and long-run changes in quantity suppliedif prices rise by 15 percent? What happens to thefarmer’s revenues in each of these situations?3. Assume that the demand curve for hard liquor is highlyinelastic and the supply curve for hard liquor is read more..

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    Appendix: Elasticity andSlopeThe elasticity of a curve is not the same as its slope. The best way to seethe distinction is to look at a linear demand curve. A linear demandcurve is a straight line, as depicted in Figure 4.12. With a linear demandcurve, a $1 change in price always leads to the same change in quantitydemanded, whether we start from a price of $2 or a price of $10. Table4.3 contains information on price and quantity demanded for such acurve, and we can use this information to read more..

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    APPENDIX: ELASTICITY AND SLOPE∂ 99fall represents a larger percentage change in demand. Thus, at higher prices, the elas-ticity—the percentage change in quantity divided by the percentage change inprice—becomes larger. At times, however, we can use information about the slope of the demand curveto draw a conclusion about elasticity. Figure 4.13 shows two demand curves goingthrough the same point. Consider a 1 percentage point change in the price at thepoint of intersection. The quantity read more..

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    Learning GoalsIn this chapter, you will learnWhere demand curves comefromWhy demand curves aredownward slopingWhat factors cause demandcurves to shiftWhat is meant by behavioraleconomics4321 read more..

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    Chapter 5THE CONSUMPTIONDECISION∂How many economic decisions have you made today? Did you decide to ridethe bus to campus rather than drive, buy a bagel for breakfast rather thana muffin, or eat in a local café rather than at home? Perhaps you decidedto look for a new job or ask for more hours at your current one. You may have decidedto take out another student loan, or apply for a bank loan to buy a car. Maybe you setaside some money to finance a trip this summer. If so, you then had to read more..

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    play such an important role in making decisions, this chapter begins by reviewinghow they are defined. We then ask how the opportunity set changes when incomeand prices change, and how these changes affect the choices that consumers make.THE BUDGET CONSTRAINTThe individual’s opportunity set is defined by the budget constraint. If, after taxes,a person’s weekly paycheck comes to $300 and he has no other income, that sum ishis budget constraint. Total expenditures on food, clothing, rent, read more..

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    As we learned in Chapter 2, a budget constraint diagram has two important fea-tures. First, although any point in the shaded area of Figure 5.1A is feasible, only thepoints on the line BC are really relevant, because Fran is not consuming her entirebudget if she is inside her budget constraint. Second, by looking along the budgetconstraint, we can see her trade-offs—how many candy bars she has to give up toget 1 more CD, and vice versa. Look at points F and A, a part of the budget read more..

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    CHOOSING A POINT ON THE BUDGETCONSTRAINT: INDIVIDUAL PREFERENCESThe budget constraint and a recognition of possible trade-offs are the starting pointsfor the study of consumer behavior. The process of identifying the budget constraintsand the trade-offs is the same for any two people. Any individual will choose some pointalong the budget constraint. But the point actually chosen depends on the indi-vidual’s preferences: Fran, who likes to listen to music, might choose point F inFigure 5.1, read more..

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    WHAT HAPPENS TO CONSUMPTION WHENINCOME CHANGES?When an individual’s income increases, he has more to spend on consumption. Figure5.3 shows the effect on the budget constraint of an increase in income. The originalbudget line is the same as that used in Figure 5.2: Gary and Fran have $300 to spendon CDs or other goods. If the total amount they have to spend increases to $450, thenew budget line is farther to the right. Now, Gary and Fran could purchase 30 CDsif they spend the entire $450 on read more..

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    The income elasticity of demand (which parallels the price elasticity of demandpresented in Chapter 4) measures how much consumption of a particular goodincreases with income:income elasticity of demand =.The income elasticity of demand, in other words, is the percentage change in con-sumption that would result from a 1 percent increase in income. If the income elas-ticity of demand of a certain good is greater than 1, a 1 percent increase in anindividual’s income results in a more than 1 read more..

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    The consumption of some goods actually decreases as income increases andincreases as income decreases; these are called inferior goods. In sharp contrast,the consumption of normal goods increases with income. In other words, goods forwhich the income elasticity is negative are, by definition, inferior, while all other goodsare called normal. For instance, if Fran, who has been riding the bus to work, gets alarge raise, she may find that she can afford a car. After buying the car, she will read more..

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    town, buys more gas and spends more on cars than does Tom, who travels fromhome to work by subway in New York City.Understanding such systematic determinants in how people spend their moneyhelps us understand the markedly different responses in different regions of the coun-try to government proposals to tax different goods. A case in point arose in 1993 afterthe Clinton administration took office with a pledge to reduce the huge federal deficit.Many policy analysts, both inside and outside read more..

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    A Closer Look at the DemandCurveIn Chapter 3, we saw the principal characteristic of the demand curve: when pricesrise, the quantity of a good demanded normally falls. Here, we take a closer look atwhy. Doing so will help us understand why some goods respond more strongly toprice changes, that is, have a greater price elasticity.Let us return to our earlier example of Fran buying CDs, shown in Figure 5.2. Ifthe price of CDs rises from $15 to $20, Fran will face a new budget constraint. If read more..

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    is spent on the good—and how large the income elasticity is. Since, inmost cases, individuals spend a relatively small fraction of their incomeon any particular good, the income effect is relatively small. But some-times the income effect of a price increase can be significant—in thecase of housing, for example, a good on which most individuals spendbetween a fourth and a third of their income.Let us return to Fran and the CDs. At the higher price, giving upone CD gets her more of other read more..

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    tive or negative. Generally, though, as individuals become better off, they typicallyreduce their consumption of these goods.THE IMPORTANCE OF DISTINGUISHINGBETWEEN INCOME AND SUBSTITUTIONEFFECTSDistinguishing between the income and substitution effects of a change in price isimportant for two reasons.Understanding Responses to Price Changes First, the distinctionimproves our understanding of consumption responses to price changes. Thinkingabout the substitution effect helps us understand why read more..

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    Wrap-UpINCOME AND SUBSTITUTION EFFECTS ANDTHE SHAPE OF DEMAND CURVESThe income effect refers to a change in consumption arising from a change in theconsumer’s real income. When the price of a good you consume increases, your realincome is reduced because you can no longer afford the same level of consumption.By the same logic, when the price of a good that you consume falls, your real incomeis increased.The substitution effect refers to a change in consumption arising from a changein the read more..

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    Normally, demand curves are downward sloping. As the price is lowered, con-sumers are better off and so consume more of the good (the income effect); and thelower relative price induces a further increase in consumption (the substitution effect).Utility and the Description ofPreferencesWe have seen that people choose a point along their budget constraint by weighingthe benefits of consuming more of one good against the costs—what they have toforgo of other goods. Economists refer to the read more..

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    utility of 400, 6 a utility of 456, and 7 sweatshirts a utility of 508. Mary’s willingness topay increases with the number of sweatshirts, reflecting the fact that additional sweat-shirts give her additional utility. The extra utility of an additional sweatshirt, meas-ured here by the additional amount she is willing to pay, is the marginal utility. Thenumbers in the third column of Table 5.1 give the marginal (or extra) utility she receivedfrom her most recently purchased sweatshirt. When read more..

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    is 30, and that of the last pizza is also 30. At this point, she will not want to switchanymore. If she buys another sweatshirt, she gains 28, but the last pizza, her 3rd,which she will have to give up, has a marginal utility of 30; she loses more than shegains. If she buys another pizza, she gains 28, but the last sweatshirt (her 17th) gaveher a marginal utility of 30; again, she loses in net. We can thus see that with herbudget, she is best off when the marginal utility of the two goods is the read more..

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    We can write this result simply as=,where MUx is the marginal utility of good x, MUy is the marginal utility of good y, Pxis the price of good x, and Py is the price of good y. The ratio of marginal utility toprice should be the same for all goods. When this condition is met, Mary’s consump-tion problem is solved—she has found the combination of the two goods that makeher best off.We have already seen that when the prices of sweatshirts and pizzas are thesame, Mary is best off when she buys read more..

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    UTILITY AND THE DESCRIPTION OF PREFERENCES∂ 117CONSUMER SURPLUSIn Chapter 1, we learned that one of the basic principles of economics is thatpeople are better off as a result of voluntary trade. Now that we have devel-oped the fundamental ideas of consumer choice, we can use the demand curveto show how we can measure some of the gains that arise from economicexchange.Assume you go into a store to buy a can of soda. The store charges you $0.75.If you are particularly thirsty, you might be read more..

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    using demand and supply. Figure 5.9 shows the demand and supplycurves for wheat. For the sake of simplicity, supply is drawn as a ver-tical line (inelastic supply). In the absence of a price floor, the equi-librium price will be pc, and the consumer surplus is the total of theyellow and orange areas. If the government imposes a price floor, atpf, then the quantity demanded is Qf . Consumer surplus is equal tothe yellow area, the area under the demand curve from the verticalaxis to the quantity read more..

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    nomic model of consumer choice can be used to make accurate predictions. By andlarge, it can. Many businesses, for example, have found the model useful for predict-ing the demand for their products. And economists have used the model with remark-able success to predict consumer behavior in a variety of circumstances. Sometimes,however, it does not make reliable predictions, and we will consider some of theseinstances when we discuss behavioral economics. The second criticism questions the read more..

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    model of consumer choice that was developed in this chapter. Instead, they argue thata theory of consumer choice should be based on how people actually make decisions.Behavioral economists therefore draw on the findings of psychologists who conductlaboratory experiments to study that question. As a sign of the growing importanceof this work, the 2002 Nobel Prize in Economics was shared by a psychologist, DanielKahneman, whose research has heavily influenced the new field.Behavioral economics read more..

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    The Status Quo Bias Loss aversion and endowment effects lead to behaviorthat exhibits a bias in favor of the status quo. In the example just given, the statusquo or reference point of the first person is the $1,100 he had, so he feels worse offwhen he has only $1,000. The reference level of the second person was $900, so shefeels better off when she has $1,000. In the basic model of consumer choice outlinedin this chapter, we assumed that individuals’ utility depended on the absolute levelof read more..

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    REVIEW QUESTIONS1. How is the slope of the budget constraint related to the relative prices of the goods on the horizontal andvertical axes?2. How can the budget constraint appear the same even for individuals whose tastes and preferences differ dramatically?3. Is the income elasticity of demand positive or negativefor an inferior good?4. If the price of a normal good increases, how will theincome effect cause the quantity demanded of that goodto change?5. What is the substitution effect? Why do read more..

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    REVIEW AND PRACTICE∂ 123of $60,000 per year. Imagine that the poor person drinks15 bottles of wine per year at an average price of $10 perbottle, while the wealthy person drinks 50 bottles of wineper year at an average price of $20 per bottle. If a tax of$1 per bottle is imposed on wine, who pays more in taxes?Who pays the greater amount as a percentage of income?If a tax equal to 10 percent of the value of the wine isimposed, who pays more in taxes? Who pays the greateramount as a percentage read more..

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    Appendix: Indifference Curvesand the Consumption Decision5This chapter explained the consumption decision in terms of the budget constraintfacing the individual and the individual’s choice of her most preferred point on thebudget constraint. Effects of changes in prices on the quantity demanded were analyzed in terms of income and substitution effects.To help them more rigorously analyze choices and the consequences of changes inprices, economists have developed an extremely useful tool called read more..

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    Moving along the curve in one direction, Fran is willing to accept more CDs inexchange for fewer candy bars; moving in the other direction, she is willing to acceptmore candy bars in exchange for fewer CDs. Any point on the same indifferencecurve, by definition, makes her just as happy as any other—whether it is point A orC or an extreme point like D, where she has many candy bars and very few CDs, orF, where she has relatively few candy bars but more CDs.However, if Fran were to receive the read more..

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    Indifference Curves and MarginalRates of SubstitutionThe slope of the indifference curve measures the number of candy bars that the indi-vidual is willing to give up to get another compact disc. The technical term for theslope of an indifference curve is the marginal rate of substitution. The marginal rateof substitution tells us how much of one good an individual is willing to give up in returnfor one more unit of another. The concept is quite distinct from the amount a con-sumer must give up, read more..

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    number of CDs, having an additional one is less important. She would rather havesome candy bars instead. Her marginal rate of substitution of candy bars for CDs atF is very low; for the sake of illustration, let’s say that she would be willing to give upthe marginal CD for only 10 candy bars. Her marginal rate of substitution is 10 to 1(candy bars per CD).The opposite holds true when Fran has lots of candy bars and few CDs. Sinceshe is eating several candy bars almost every day, the chance to read more..

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    rate of substitution is 20, Fran is willing to give up 20 candy bars to get1 more CD, but only has to give up 15; it clearly pays her to buy moreCDs and fewer candy bars. If her marginal rate of substitution is 10, sheis willing to give up 1 CD for just 10 candy bars; but if she gives up 1 CD,she can get 15 candy bars. She will be better off buying more candy barsand fewer CDs. Thus, if the marginal rate of substitution exceeds the rel-ative price, Fran is better off if she buys more CDs; if it read more..

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    APPENDIX: INDIFFERENCE CURVES AND THE CONSUMPTION DECISION∂ 129candy increases. Now he can buy fewer candy bars; but the number ofCDs he can buy, were he to spend all of his income on CDs, is unchanged.Thus, his budget constraint becomes flatter; it is now line B2C. WhileJeremy originally chose point E0 on the indifference curve I0, now hechooses E1 on the lower indifference curve I1.The price change has moved Jeremy’s choice from E0 to E1 for tworeasons: the substitution effect and the read more..

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    Learning GoalsIn this chapter, you will learnThe different types of costs afirm facesThe relationship between average and marginal costsHow costs differ in the shortrun and long runHow firms minimize costwhen they have many factorsof production4321 read more..

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    Chapter 6THE FIRM’S COSTS∂Imagine the situation facing a firm in the basic competitive model. There aremany other firms that make the identical product, all trying to sell what theyproduce to well-informed consumers who respond to any price differences.Each firm must accept the price set by the forces of supply and demand in the marketas a whole. In a competitive market, a firm will lose all its customers if it charges aprice even slightly above the market price. And there is no point in read more..

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    Profits, Costs, and Factors ofProductionA business that over time continually incurs losses will cease to exist, because it willnot have enough money to pay its bills. Businesses are under constant pressure tomake money. The need to make as much money as possible—maximizing profits—provides a useful starting point for discussing the behavior of firms in competitivemarkets. The definition of profits is simple. Profits are equal to the money the businessreceives from selling its products—its read more..

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    The relationship between the quantity of inputs used in productionand the level of output is called the production function. Figure 6.1shows the farmer’s production function; the data supporting the figureare set forth in Table 6.1. The increase in output corresponding to aunit increase in any factor of production, labor in this case, is the mar-ginal product of that factor. For example, when the number of hoursworked per year rises from 8,000 to 9,000, output increases by 10,000bushels, from read more..

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    Wrap-UpDIMINISHING RETURNSAs more and more of one input is added, while other inputs remain unchanged, themarginal product of the added input diminishes.Increasing Returns Although a production function with diminishing returnsis the most important case, other functions are possible. Figure 6.2 shows a produc-tion function where increasing an input (here, labor) raises output more than pro-portionately. A firm with this kind of production function has increasing returns. Inthe single-input case read more..

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    TYPES OF COSTS AND COST CURVESThe production function is important to the firm because the inputs determine thecost of production. These costs are key determinants of the firm’s profits and itsdecisions about how much to produce.Fixed and Variable Costs Some costs associated with inputs do not vary asthe firm changes the level of production. For instance, the firm may need to hire some-one to run the personnel office and someone to supervise the workers, and the costof these inputs remain read more..

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    total costs = total variable costs + fixed costs.The total cost curve, summarizing these points, is shown in Figure 6.4C.Marginal Cost and the Marginal Cost Curve Having come this far instudying economics, you know that rational decision making depends on evaluat-ing trade-offs in terms of marginal costs and marginal benefits. If you have the oppor-tunity to work more hours at your part-time job, you need to evaluate the marginalcost—the other things you could do during those extra hours you read more..

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    gives the marginal cost of Q1. Thus, the marginal cost curve represents the slope ofthe total cost curve at each quantity of output.Panel Cof Figure 6.5 shows the marginal cost curve for the wheat farm example.Note that the curve is upward sloping, like the total cost curve, which reflects the factthat as more is produced, it becomes harder and harder to increase output further.This is an application of the familiar principle of diminishing marginal returns. In ourwheat farm example, suppose the read more..

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    Average Cost and the Average Cost Curve A businessfirm also is concerned with its average cost. This is the total cost(TC ) divided by output (Q), oraverage cost = TC/Q.The average cost curve gives average costs corresponding to differ-ent levels of output. Figure 6.6 shows the average cost curve for ourwheat farm example (along with the marginal cost curve, for rea-sons indicated below). Working from the total cost curve (see Figure6.4C and Table 6.2), we derive the average cost curve by read more..

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    average costs are declining at output levels that are less than the minimum aver-age cost level of production. Thus an industry producing less than the output thatresults in minimum average costs will be operating in the region where averagecosts are declining. When economists say that an industry has declining averagecosts, they usually do not mean that average costs are declining at all levels of output.Instead, they typically mean that costs are declining at the output levels at whichthe read more..

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    Example: Deborah’s Web Consulting Business A simple example illus-trates these various cost concepts and relates them to the notions of opportunitycosts introduced in Chapter 2.Deborah tutors for the computer science department at her college, earning $5per hour. She works a total of 20 hours per week, which is the most she can devoteto working while still maintaining good grades in her own courses. Recently, shedecided to start her own business helping professors create Web pages for read more..

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    $400 − $285 = $115. So she would be better off working the entire 20 hours she hasavailable for her new business and quitting her tutoring job completely. Note that sinceDeborah has $185 in sunk costs, she is better off consulting for 10 hours than closing up her business entirely. If she works 10 hours doing Web consulting, herrevenues are $200, more than enough to cover her variable costs of $50.Wrap-UpCOST CONCEPTSFixed costs:Costs that do not depend on output, such as office spaceVariable read more..

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    costs, may be fixed for some period of time but can vary with production over alonger period. Take the inputs of labor and machines, for example. In the short run,the supply of machines may be fixed. Output is then increased only by increasinglabor. In the longer run, the numbers of both machines and workers can be adjusted.The short-run cost curve, then, is the cost of production with a given stock of machines.The long-run cost curve is the cost of production when all factors are read more..

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    decided how much output it plans to produce, it will choose the number of plantsthat minimizes its average costs. Thus, if the firm plans to produce less than Q1, it builds only one plant; AC1 is less than AC2 for all outputs less than Q1. If the firm plans to produce between Q1 and Q2, it builds two plants, because in this interval, AC2 is less than either AC1 or AC3. For outputs greater than Q2, the firmbuilds three plants. The long-run average cost curve is the darker bumpy curve inFigure read more..

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    adjust its fixed costs, the bumps in the long-run average cost curve will become progressively smaller, enabling us to ignore them in most cases. Thus, when wedraw a long-run average cost curve, we will typically ignore the bumps and draw asmooth curve.But what does a smooth long-run average cost curve look like? Does it slopeupward or downward? Or is it flat? A good way to answer these questions is to askwhat happens to average costs if the firm doubles all its inputs. That is, it doublesthe read more..

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    There is one last case to consider. Suppose that increasing all inputs in proportionleads to a more than proportionate increase in output. Suppose, for example, that whenall inputs are increased by 20 percent, output jumps by 25 percent. This is a case ofincreasing returns to scale, sometimes described as economies of scale. Big is beau-tiful in this case, since average costs decline as the scale of the firm is increased.Increasing returns to scale are common at low and moderate levels of read more..

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    Wrap-UpTHE FIRM’S COSTS: KEY IDEAS1. Profits are equal to total revenues minus total costs.2. Marginal cost is the extra cost of producing one more unit of output. Marginal cost normally increases at higher levels of output as diminishingreturns set in.3. Average fixed costs decline as output increases, but average variable costseventually rise. As a result, the average total cost curve is typically U-shaped.4. The long-run average cost curve traces out the lower boundaries of the short-run read more..

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    produce the same output in several different ways. To minimize cost, firms musttherefore weigh the costs of different mixes of inputs.COST MINIMIZATIONThere are usually several ways a good can be produced, using different quantitiesof various inputs. Table 6.5 illustrates two alternative ways of making car frames,one a highly automated process requiring little labor and the other a less-automated process that uses more assembly-line workers. The table shows thedaily wage and capital costs for read more..

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    machines increases to $3,500 each. Then, the more-automated process will cost$17,500, while the less-automated process will cost $17,000. Both processes rise in cost,but the less-automated process rises less. It now becomes the less costly method. Asa consequence, firms will switch from the more-automated process to the less-automated process. In this way, they are able to substitute away from the factorwhose price has risen (machines, in this case).An increase in the price of any input shifts read more..

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    1992 to work toward limiting the growth of greenhouse gases; in a subsequent meet-ing in 1997, in Kyoto, Japan, an effort was made to strengthen the international com-mitment to greenhouse gas reductions. In order for it to take effect, the Kyotoagreement had to first be ratified by countries that account for at least 55 percentof the world’s greenhouse gas emissions. While President Bill Clinton supported theaims of the Kyoto agreement, he did not submit it for approval to the Senate, whereit read more..

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    Economies of ScopeMost firms produce more than one good. Deciding which goods to produce and in whatquantities, as well as how to produce them, are central problems facing firm man-agers. The problems would be fairly straightforward were it not for some impor-tant interrelations among the products. The production of one product may affectthe costs of producing another.In some cases, products are produced naturally together; we say they are jointproducts. From crude oil, a petroleum refinery can read more..

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    REVIEW AND PRACTICE∂ 151Review and PracticeSUMMARY1. A firm’s production function specifies the level of outputresulting from any combination of inputs. The increasein output corresponding to a unit increase in any input isthe marginal product of that input.2. Short-run marginal cost curves are generally upwardsloping, because diminishing returns to a factor of pro-duction imply that it will take ever-increasing amountsof the input to produce a marginal unit of output.3. The typical read more..

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    152 ∂CHAPTER 6 THE FIRM'S COSTSThe production function for their barbershop looks likethis:in this order: Output, Labor required, Total variablecost, Total cost, Marginal cost, Average variable cost,and Average cost. If the price of a haircut is $10 and theshop sells 80 per day, what is its daily profit?3. Using the information in Problems 1 and 2, draw the totalcost curve for the Tom, Dick, and Hairy Barbershop onone graph. On a second graph, draw the marginal costcurve, the average cost read more..

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    Learning GoalsIn this chapter, you will learnWhat determines the level ofoutput a firm will supply atany given priceWhat determines whether afirm enters or exits a marketHow the market supply curve is derived and why it is upward sloping How competition drives economic profits to zero,and how economic profitsand accounting profits differ4321 read more..

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    Chapter 7THE COMPETITIVEFIRM∂Whether it is a flower seller at a local farmer’s market, a memory chipmanufacturer in China, or a huge corporation such as Microsoft, Citibank,or Intel, every firm is in business to make profits. In competitive mar-kets, firms are price takers—they are too small to affect the market price of thegoods they produce. They also take as given the prices they have to pay for the inputsthey purchase. The chief decision such a firm needs to make is how much to read more..

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    The relationship between revenue and output is shown by therevenue curve in Figure 7.1. The horizontal axis measures thefirm’s output, while the vertical axis measures the revenues. Whenthe price of a violin is $40,000 and the firm sells 9 violins, its revenue is $360,000; when it sells 10, revenue rises to $400,000.The extra revenue that a firm receives from selling an extraunit is called its marginal revenue. Thus, $40,000 is the extra(or marginal) revenue from selling the tenth violin. It read more..

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    COSTS∂ 157Table 7.2HIGH STRUNG VIOLIN COMPANY’S COSTS OF PRODUCTION (THOUSANDS OF DOLLARS)(1)(2)(3)(4)(5)TotalAverageTotalAverage MarginalvariablevariableOutputcostcostcostcostcost0901100100.0101010.0211055.0102010.0312040.0103010.0413032.5104010.0514028.0105010.0615025.010 6010.0717525.0258512.1821526.94012515.6927030.05518020.01040040.013031031.0Internet ConnectionFIRMS’ PROFIT-AND-LOSS STATEMENTSCorporations issue annual reports each year, and these reportsinclude their profit-and-loss read more..

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    158 ∂CHAPTER 7 THE COMPETITIVE FIRMBut after 7 violins, average costs begin to increase, as the effect of the increasingaverage variable costs dominates the effect of the fixed costs.Basic Conditions of Competitive SupplyIn choosing how much to produce, a profit-maximizing firm will focus its decision atthe margin. Because it has already incurred the fixed cost of getting into this market,its decision is generally not the stark one of whether or not to produce, but whetherto produce one more read more..

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    Figure 7.3 develops the graphical analysis underlying this principle. Panel Ashows the firm’s marginal cost curve. If the price of the good in a competitive marketis p1, the profit-maximizing output level will be Q1. This is the level of output at whichprice and marginal cost are equal. An upward-sloping marginal cost curve clearlyleads the firm to produce more as price increases.The marginal cost curve is upward sloping, just as the supply curves in Chapter 3were upward sloping. This too is read more..

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    output where that distance is greatest. This occurs at Q1. Below Q1, price (the slopeof the revenue curve), exceeds marginal costs (the slope of the total cost curve), soprofits increase as output increases; above Q1, price is less than marginal cost, so profits decrease as output increases.Wrap-UpEQUILIBRIUM OUTPUT FOR COMPETITIVE FIRMSIn competitive markets, firms produce at the level where price equals marginal cost.Entry, Exit, and Market SupplyWe are now in a position to tackle the market read more..

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    SUNK COSTS AND EXITThe converse of the decision of a firm to enter the market is the decision of a firmalready producing to exit the market. Sunk costs are costs that are not recoverable,even if a firm goes out of business. The High Strung Violin Company, for example,may have had an extensive television advertising campaign. The cost of this cam-paign is a sunk cost. There is no way this expenditure can be recouped even if pro-duction ceases. If there were no sunk costs, the decision to enter read more..

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    between average variable costs and average costs, the firm will continue to pro-duce, even though it will show a loss. It continues to produce because it wouldshow an even bigger loss if it ceased operating. Since price exceeds average variable costs, the revenues it obtains exceed the additional costs it incurs fromproducing.Different firms in an industry will have different average variable costs, and sowill find it desirable to exit the market at different prices. Figure 7.5B shows theaverage read more..

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    marginal cost, so the firm’s supply curve coincides with the marginal cost curve.For a firm that has incurred sunk costs in entering the market (panel B), the supplycurve coincides with the marginal cost curve so long as price exceeds the minimumvalue of average variable costs; when price is below the minimum value of averagevariable costs, the firm exits, so supply is again zero.THE MARKET SUPPLY CURVEWith this information about the cost curves of individual firms, wecan derive the overall read more..

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    Long-Run Versus Short-Run SupplyAs we saw in Chapter 6, in the short run the typical firm will have a U-shaped average cost curve, and a rising marginal cost curve at outputlevels above the lowest point of the U. But its long-run marginal costcurve is flatter because adjustments to changes in market conditionstake time, and some adjustments take longer than others. In the shortrun, a firm can add workers, work more shifts, and run the machinesharder (or reduce the rate at which these things are read more..

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    product at close to the same price, as additional plants are constructed and additional firms enter the market.Thus, the market supply curve is much more elastic in the long run than in theshort run. Indeed, in the very short run, a firm may find it impossible to hire moreskilled labor or to increase its capacity. Its supply curve, and the market supplycurve, would be nearly vertical. In the short run, machines and the number of firmsare fixed, but labor and other inputs can be varied. Figure read more..

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    computer-aided design and manufacturing, have made it possible for many compa-nies to change what they are producing more rapidly, and thus have reduced thelength of the long run and made supply curves more elastic than they had been in thepast.Wrap-UpADJUSTMENTS IN THE SHORT RUN AND THELONG RUNIn the very short run, firms may be unable to adjust production at all; only the pricechanges.In the short run, firms may be able to hire more labor and adjust other variableinputs.In the long run, firms read more..

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    invested in this enterprise would produce in another investment. These are the truecosts of the owner’s time and capital investment. To calculate the firm’s profits as theeconomist sees them, these opportunity costs have to be subtracted out.One can easily imagine a business whose accountant reports a profit equal to 3 percent of the capital investment. An economist would note that if the investmentcapital had been put in a bank account, it would have earned at least 5 percent. Thus,the read more..

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    ECONOMIC RENTA second difference between an economist’s and an accountant’s definition of profitconcerns economic rent. Economic rent is the difference between the price that isactually paid and the price that would have to be paid in order for the good or serv-ice to be produced.Economic rent has far broader applications than its historic use to refer to pay-ments made by farmers to their landlords for the use of their land, but the exampleof rent for land use is still instructive. The read more..

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    In some cases, supplies of inputs are inelastic in the short run but elastic in thelong run. An example is payment for the use of a building. In the short run, the supplyof buildings does not depend on the return, and hence payments for the use of thebuilding are rents, in the economist’s sense. But in the long run, the supply of build-ings does depend on the return—investors will not construct new buildings unlessthey receive a return equal to what they could obtain elsewhere. So the read more..

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    costs of buying additional paint and brushes—but for the sake of simplicity, let’sassume that he started off the summer with all the paint he needed. Thus, his variable costs were related to the labor he needed to hire.Variable costs are also related to the amount of time it takes to paint a house,which depends in part on the quality of the labor available. The variable costs forPresto Painters were as follows:HousesHours of paintedlabor hiredPayroll cost5100$ 1,00010300$ 3,00015600$ read more..

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    Wrap-UpACCOUNTANTS’ VERSUS ECONOMISTS’PROFITSAccounting profits:revenues minus expendituresEconomic profits:revenues minus rents minus economic costs (includingopportunity costs of labor and capital)The Theory of the Competitive FirmWe now have completed half of our description of the theory of the competitive firm.The firm takes as given the prices it pays for the inputs it uses, including the wagesit pays workers and the costs of capital goods. From these figures, it can calculatethe costs read more..

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    Review and PracticeSUMMARY1. A revenue curve shows the relationship between a firm’stotal output and its revenue. For a competitive firm, themarginal revenue it receives from selling an additionalunit of output is the price of that unit.2. A firm in a competitive market will choose the level ofoutput at which the market price—the marginal revenueit receives from producing an extra unit—equals themarginal cost.3. A firm will enter a market if the market price for a goodexceeds its minimum read more..

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    ant, who helps him to draw up the following chart withtheir best predictions about costs and revenues.Predicted annual costsPredicted annual revenuesBasic wage$20,000$75,000Rent of space$12,000Rent of equipment$18,000Utilities$ 2,000Miscellaneous$ 5,000REVIEW AND PRACTICE∂ 173The basic wage does seem a bit low, the accountantadmits, but she tells José to remember that as owner of the business, José will get to keep any profits as well. From an economist’s point of view, is the read more..

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    Learning GoalsIn this chapter, you will learnWhat determines the numberof hours an individual worksHow income and substitutionaffect labor supply decisionsin opposing waysWhat determines a firm’s demand for laborHow wages ensure that demand and supply balancein the labor market4321 read more..

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    CHAPTER 8LABOR MARKETS∂The previous three chapters examined demand and supply in the marketsfor goods and services. Choosing what goods to purchase and how much ofthem are among the most basic decisions of households. The amount ofmoney available to spend depends on two other basic decisions: how much to work(and earn) and how much to save (or spend from savings). The decisions that peoplemake about work determine the economy’s supply of labor. Their decisions aboutsaving determine the read more..

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    even delaying graduation. Understanding the forces that affect decisions about howmuch to work—how much labor to supply to the market—is central to understandinghow labor markets function.The increase in student employment is just one of many changes in the patternof labor supply that have taken place over the past half century. The average work-week has declined from 39 hours in 1959 to just under 34 hours in 2004. At the sametime, the fraction of women in the labor force has increased read more..

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    “standard” workweek—the 40-hour week that has become the 35-hour week—respond over time to the attitudes (preferences) of workers.We now apply the analysis of Chapter 5 to an individual’s choice between workand leisure. Figure 8.1 shows the budget constraint of Steve, who earns an hourlywage of $7. Accordingly, for each hour less of leisure Steve enjoys—for each extra hourhe works—he earns $7 more. That is, his consumption increases by $7. Underlyingthis budget constraint is his read more..

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    Labor supply curveWAGE (DOLLARS PER HOUR)WAGE (DOLLARS PER HOUR)Labor supply curve00HOURS WORKEDBAHOURS WORKEDFigure 8.2THE LABOR SUPPLY CURVEPanel Ashows the case where the substi-tution effect exceeds the income effectby just a bit, so increases in wages leadto only a small change in labor supply,and the labor supply curve is very steep.In panel B, the substitution effect domi-nates the income effect at low wages, sothat the labor supply curve is upwardsloping; and the income effect read more..

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    Wrap-UpWAGE CHANGES AND LABOR SUPPLYLabor supply decisions depend on the real wage—the nominal wage corrected forthe price of consumer goods.As real wages rise, individuals become better off. This income effect inducesthem to work less. Offsetting it is the substitution effect—the higher return toworking provides an incentive to work longer hours. Either effect may domi-nate. Thus, the quantity of labor supplied may increase or decrease with wageincreases.LABOR FORCE PARTICIPATIONThe read more..

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    The decision about whether to work is called the labor force participation deci-sion. Figure 8.3 shows the labor supply curve for an individual—it shows how manyhours that person is willing to supply at each real wage. The minimum wage at whichthe individual is willing to work, WR, is called the reservation wage. Below thereservation wage, the individual does not participate in the labor force. For men,the reservation wage traditionally has been very low.Today, most women also work for pay, read more..

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    The labor supply curve for women also has shifted, increasing the labor supplyat each value of the wage. Two changes have shifted the labor supply curve to the rightand contributed to the dramatic increase in labor force participation of women thatis shown in Figure 8.4. Beginning around 1973, (real) wages stopped growing at therate they had been increasing during the period following World War II. Individualsand families had come to expect regular increases in their material standards ofliving. read more..

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    we have examined these decisions, the basic law of supply and demandcan be used to show how the wage is determined in the labor market.Labor is one of the primary inputs that firms use in producing output.So our discussion begins by considering what determines a firm’sdemand for inputs.FACTOR DEMANDIn the process of deciding how much of each good to supply anddetermining the lowest-cost method of producing those goods, firms also decide how much of various inputs they will use. This iscalled read more..

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    Thus, in Figure 8.5, at the price p1, the output is Q1 (panel A), and the labor requiredto produce that output (factor demand) is L1 (panel B).There is another way to derive the demand for a factor. If the firm hires onemore worker, for example, the extra (or marginal) cost to the firm is her wage. Theextra benefit of the worker is the additional revenue that the firm receives from sell-ing the output she produces. This is equal to the price at which the good sells mul-tiplied by the amount of read more..

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    If we divide both sides of the previous equation giving the equilibrium conditionby the price, we obtain the conditionMPL= w/p.The wage divided by the price of the good being produced is defined as the realproduct wage. It measures what firms pay workers in terms of the goods the workerproduces rather than in dollar terms. Thus, the firm hires workers up to the pointat which the real product wage equals the marginal product of labor.This principle is illustrated in Figure 8.8, which shows the read more..

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    market is in equilibrium, the demand for labor equals the supply of labor. No workerwho wishes to get a job (for which he is qualified) at the going market wage will fail to get one. No firm that wants to hire a worker at the going wage will fail to finda qualified employee. If demand and supply are not equal at the going market wage, the wage willadjust. If, at the going wage, the number of hours of labor that households wish tosupply is greater than the number of hours of labor that firms wish read more..

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    Review and PracticeSUMMARY1. The decision about how to allocate time between workand leisure can be analyzed using the basic ideas ofbudget constraints and preferences. Individuals face atrade-off along a budget constraint between leisure andincome. The amount of income a person can obtain bygiving up leisure is determined by the wage rate.2. In labor markets, the substitution and income effects of a change in wages work in opposite directions. Anincrease in wages makes people better-off, and read more..

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    REVIEW AND PRACTICE∂ 187constraint has a kink at 37 hours of work. Discuss theconsequences of the kink in the budget constraint. 3. Under current economic conditions, let’s say that anunskilled worker will be able to get a job at a wage of $6per hour. Now assume the government decides that allpeople with a weekly income of less than $180 will begiven a check from the government to bring them up tothe $180 level. Draw one such worker’s original budgetconstraint and the constraint with the read more..

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    188 ∂CHAPTER 8 LABOR MARKETSAppendix: Indifference Curvesand the Labor Supply Decision2This appendix investigates the labor supply decision using the indifferencecurve approach applied in the appendix to Chapter 5 to the consumptiondecision. Figure 8.9 shows Tom’s budget constraint between leisure and consump-tion. The slope of the budget constraint is the wage. The figure also showstwo indifference curves; each gives the combination of leisure and consump-tion choices toward which Tom is read more..

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    APPENDIX: INDIFFERENCE CURVES AND THE LABOR SUPPLY DECISION∂ 189A(Welfarethresholdlevel)Original budget constraintE0IndifferencecurvesBudget constraint withwelfare programINCOME (CONSUMPTION)B(Welfarethresholdlevel)Original budget constraintIndifferencecurvesBudget constraint withwelfare programC(Welfarethresholdlevel)Original budget constraintIndifferencecurvesBudget constraint withwelfare programLeisureLaborLeisureLaborLEISURE (HOURS)LeisureLaborE1I1I0E1I1E0I0E1I0I1E0INCOME read more..

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    Learning GoalsIn this chapter, you will learnHow the basic tools intro-duced in Chapter 5 can beused to analyze decisionsabout saving and educationWhat economists mean bythe time value of moneyHow income and substitutionaffect saving decisions in opposing waysWhat determines the firm’sdemand for capitalHow interest rates ensure thatdemand and supply balancein capital marketsWhy education is an invest-ment that leads to what economists call human capital654321 read more..

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    Chapter 9CAPITAL MARKETS∂At any given time, there are some people and companies who would like toborrow to enable them to spend more than their current income. John hashis first job and knows he needs a car for transportation; Jill is borrowingmoney to buy a new home; Chad needs to purchase kitchen equipment, tables, andchairs to open his new restaurant; Intel needs to build a new chip-assembly plant.Others would like to save, spending less than their current income. Julie is puttingmoney read more..

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    typically save. This is not always the case, though: in 1999 U.S. households actuallydissaved, spending more than they earned in income. We will focus on firms as themajor borrowers in the economy.THE HOUSEHOLD DECISION TO SAVEThe assumption that individuals spend their money in a rational manner, thinkingthrough the alternatives clearly, holds for decisions about saving as well as aboutspending and working. In making their saving decisions, individuals are making achoice about when to spend or read more..

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    Joan chooses among the points on this budget constraint according to her per-sonal preferences. Consider, for example, point D, where Joan is consuming verylittle during her working life. Since she is spending very little in the present, anyadditional consumption now will have a high marginal value. She will be relativelyeager to substitute present consumption for future consumption. At the otherextreme, if she is consuming a great deal in the present, say at point F, additionalconsumption today read more..

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    To check this formula, consider the present discounted value of $100. Accordingto the formula, it is $100/(1 + r). In other words, take the present discounted value,$100/ (1 + r), and put it in a bank. At the end of the year you will haveconfirming our conclusion that $100/(1 + r) today is worth the same as $100 one yearfrom now.We can now evaluate the two options for purchasing the stereo. To compare$400 today with $425 in one year, we need to calculate the present discounted valueof $425. If read more..

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    past twenty years computer prices have fallen while housing prices in many parts ofthe country have risen very rapidly. The inflation rate measures what is happeningon average to prices in the economy.Individuals want to know how much consumption they get tomorrow if they giveup a dollar’s worth of consumption today. The answer is given by the real rate ofinterest. This is distinguished from the nominal rate of interest, the rate postedat banks and printed in newspapers, which simply describes read more..

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    To focus on the key factors important for understanding savingdecisions, we will continue to distinguish current from future con-sumption and apply interest only once. This simplification cap-tures the essential characteristic of the saving decision, the choicebetween consumption now and in the future.When the interest rate increases, Joan’s budget constraintchanges. Her new budget constraint is shown in Figure 9.2A as lineB′C. If she does not save, the interest rate has no effect on her read more..

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    The slope of the budget constraint between consumption today and consumptiontomorrow is determined by the real rate of interest.A principal motive of saving is to smooth consumption to ensure that one’s consumption while working and during retirement is about the same.Other Factors Affecting Saving We have now seen how the techniques of con-sumer choice analysis presented in Chapter 5 can be applied to individuals’ deci-sions about saving. The two basic determinants are income and interest read more..

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    Internet ConnectionHOUSEHOLD SAVINGThe Federal Reserve Board conducts a survey of householdsevery three years, called the Survey of Consumer Finances.Each one provides a wealth of information on household saving.The most recently available survey was conducted in 2001,and you can find it and information about it at read more..

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    gests that the personal saving rate rose after the stock market crashed in 2001.Finally, there is the effect of the new economy. Many who observed increases in pro-ductivity as a result of new technologies concluded that the economy would growfaster, leading to higher incomes in the future. The income effect of higher expectedfuture income works to increase current consumption, reducing saving today.Aggregate Saving The sum of the saving of all individuals in society is aggre-gate saving. At any read more..

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    want to save, you can put money into a savings account at a bank. This earns inter-est and is very safe, because the federal government insures savings accounts withbalances up to $100,000. The tremendous boom in the stock market in the 1990sencouraged many people to put some of their savings into stocks. Stocks earn ahigher return on average than savings accounts, but they are much riskier. The stockmarket can go down as well as up. Real estate has also been an attractive place to putsavings, read more..

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    would have earned $1,000 in interest over the year. This opportunitycost must be included in calculating the cost of capital. So when theinterest rate is 5 percent, the total cost of the server is $9,000, regard-less of whether they borrow from the bank or use their own funds. Anincrease in the interest rate raises the cost (including opportunity costs)of using the server.This simple example illustrates an important point—the user costof capital will increase with the interest rate. At a read more..

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    A Behavioral Perspective on SavingIn Chapter 5, we introduced some of the new insights on how people behave that havecome from research in psychology and behavioral economics. Many of these insightshave proven particularly useful in understanding household saving decisions. Earlier we discussed the importance of the desire to smooth consumption overa person’s lifetime in influencing saving. A basic implication of the economist’s stan-dard model of saving is that people should save during read more..

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    Despite offering important insights into how people actually make choices, behav-ioral economics in some ways may explain too much. Lack of self-control makes intu-itive sense as an explanation for low savings, but how do we then account for the manycountries with high rates of saving? Many Asian countries, for example, have savingrates that average 30 to 40 percent of income. A traditional economic approach wouldfocus on differences in the returns to saving (perhaps due to differences in the read more..

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    those who only have a high school degree; those with a college degree earn morethan those who started college but never finished. A student has lower income whilein school but can expect to earn high incomes in the future. In addition, workingharder in school, and giving up leisure, may result in better grades and skills, whichin turn will result in higher wages in the future. Thus, students face a trade-offbetween leisure and income today and income and consumption in the future.Spending a year read more..

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    EDUCATION AND HUMAN CAPITAL∂ 205e-InsightFINANCING THE NEW ECONOMYWe have seen how the capital market links households whosave with firms that invest, so that saving equals investmentat the equilibrium interest rate. But how do firms actually gettheir hands on household saving? The answer is that financialintermediaries such as banks and investment companies per-form the function of transferring funds between householdsand firms. Their job is to make sure that the households’ moneyis well read more..

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    206 ∂CHAPTER 9 CAPITAL MARKETSEDUCATION AND ECONOMIC TRADE-OFFSThe production possibilities curve introduced in Chapter 2 can illustrate howdecisions concerning investments in human capital are made. To accomplish this,we divide an individual’s life into two periods: “youth” and “later working years.”Figure 9.6 depicts the relationship between consumption in youth and in laterlife. As the individual gives up consumption in his youth, staying in school longerincreases his expected read more..

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    REVIEW QUESTIONS1. How does a choice to consume in the present determinethe amount of consumption in the future?2. What is the price of future consumption in terms ofpresent consumption?3. For savers, how will the income effect of a higher inter-est rate affect current saving? How will the substitutioneffect of a higher interest rate affect current savings?4. What are some of the factors, besides incomes and interest rates, that affect saving?5. Describe how students invest time and money to read more..

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    7. We have all heard about winners of $10 million jackpotlotteries. The winner, however, does not get $10 millionin cash on the spot, but rather typically gets a measly$500,000 for twenty years. Why is the present dis-counted value of the prize much less than $10 million?Calculate the present discounted value if r = 5 percent.8. Consider an individual who is borrowing. Assume the nominal interest rate remains the same but the rate of inflation increases. What happens to the realinterest rate? read more..

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    Appendix A: IndifferenceCurves and the SavingDecision1This appendix investigates the saving decision using the indifference curveapproach applied in the appendix to Chapter 5 to the consumption decisionand in Chapter 8 to the labor supply discussion. Let’s first look at the choicebetween leisure and consumption.DECIDING HOW MUCH TO SAVEChoosing how much to save is a decision about how much of lifetime incometo consume now and how much to consume in the future. This trade-off issummarized in read more..

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    CHANGING THE INTEREST RATEIndifference curves and budget constraints enable us to see the effect of an increasein the interest rate. Figure 9.8 shows the case of an individual, Maggie, who workswhile she is young and saves for her retirement. The vertical axis gives consumptionduring retirement years, the horizontal axis consumption during working years. Anincrease in the rate of interest rotates the budget constraint, moving it from BC toB2C. It is useful to break the change down into two read more..

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    increase in the interest rate, we needed to reduce her income. Her true budget con-straint, after the interest rate increase, is B2C, parallel to B1C1. The two budget con-straints have the same slope because the after-tax interest rates are the same. Themovement from B1C1 to B2C is the second step. It induces Maggie to increase herconsumption from E2 to E1. At higher incomes and the same relative prices (inter-est rates), people consume more every period, which implies that they save less. read more..

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    If the rate of interest is 10 percent and is compounded annually, $100 today isworth $110 a year from now and $121 (not $120) in two years’ time. Thus, the presentdiscounted value today of $121 two years from now is $100. Table 9.2 shows how tocalculate the present discounted value of $100 received next year, two years from now,and three years from now.We can now see how to calculate the value of an investment project that will yielda return over several years. We look at what the returns will read more..

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    Learning GoalsIn this chapter, you will learnHow competitive marketsmaximize consumer and produce surplus How competitive markets result in economic efficiencyHow taxes create deadweightlosses that reduce efficiencyHow governments may inter-vene in markets to combineefficiency with acceptabledistribution of wealth and incomeHow markets are interrelated,and how changes in one mar-ket will affect other marketsin the economy54321 read more..

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    Chapter 10THE EFFICIENCY OFCOMPETITIVEMARKETS∂In earlier chapters, we focused on the product market and saw that supplyand demand come into balance at an equilibrium price and quantity. In equi-librium, the quantity of goods demanded by consumers equals the quantitysupplied by firms. We have also seen that labor and capital markets achieve equi-librium similarly. In the labor market, labor supply and demand come into bal-ance at an equilibrium wage; in equilibrium, the supply of labor by read more..

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    Competitive Markets andEconomic EfficiencyThe forces of demand and supply determine what is produced, how it is produced,and who receives the goods that are produced. To many people, relying on compet-itive markets seems like an undesirable way of addressing the fundamental eco-nomic questions. Such critics often complain that markets result in too much ofsome goods being produced, or too few of others; that allowing markets free reinleads to inequalities in income and wealth; or that read more..

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    CONSUMER AND PRODUCERSURPLUSTo understand why competitive markets are efficient, we need tomeasure the benefit that consumers gain from buying goods in sucha market, as well as measure the benefits that firms gain from sell-ing in it. We will then show that equilibrium in the competitivemarket leads to the greatest possible total gain for consumers and firms. To evaluate the outcome in a competitive market, we can makeuse of Figure 10.1, which shows the market demand and supplycurves for a read more..

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    than Qc , the marginal cost exceeds what consumers are willing topay for the last unit, and so total surplus would be increased byreducing output. At Qc and pc, the sum of consumer and producer surplus reaches its highest level.Fundamentals of Competitive Markets 1HOUSEHOLDS AND FIRMS ARE PRICE TAKERSIn competitive markets, there are many firms and many consumers.Because each consumer and each firm is small relative to the size ofthe market, each takes prices as given. Firms, maximizing read more..

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    Internet ConnectionDIGITAL ECONOMISTThe Digital Economist provides an online graphic demonstra-tion of consumer surplus. You can test your understand-ing of how consumer surplus is calculated at actionURI(www.digitaleconomist.com/cs_4010.html):www.digitalactionURI(www.digitaleconomist.com/cs_4010.html):economist.com/cs_4010.html.unable to find an apartment when rent control is imposed. Few apartments are avail-able at or below the median rental in cities with rent control; in cities without read more..

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    TAXES AND EFFICIENCYEconomists use the law of demand and supply to study the impact of taxes on consumers and producers. In Chapter 4 we learned that taxes imposed on produc-ers can be passed on, or shifted, to consumers in the form of higher prices. There,two examples were contrasted. In the first, the law of supply and demand was usedto study the impact of a tax on cigarette producers. When the demand for the taxedgood is very inelastic, as is true of cigarettes, most of the burden of the tax read more..

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    EfficiencyIn the basic competitive model, with each consumer and each firm taking the marketprice as given, the equilibrium between demand and supply ensures the largest pos-sible joint gain to consumers and firms. This is why most economists believe thatthe basic competitive model provides an important benchmark for evaluating howwell resources are allocated. Taxes on specific goods create efficiency losses, as doesinterfering with the law of supply and demand through policies such as rent read more..

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    PARETO EFFICIENCYIn everyday usage, we say something is efficient if it involves little waste. Economistsrelate the concept of efficiency to concern with the well-being of those in the econ-omy. When no one can be made better off without making someone else worse off,the allocation of resources is called Pareto efficient, after the great Italian econo-mist and sociologist Vilfredo Pareto (1848–1923). Typically, economists’ use of theterm refers to Pareto efficiency. Saying that a market is read more..

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    Exchange Efficiency Exchange efficiency requires that whatever the econ-omy produces must be distributed among individuals in an efficient way. If I likechocolate ice cream and you like vanilla ice cream, exchange efficiency requires thatI get the chocolate and you get the vanilla. When there is exchange efficiency, thereis no scope for further trade among individuals.The price system ensures that exchange efficiency is attained. In deciding howmuch of a good to buy, people balance the marginal read more..

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    Changes in preferences are reflected quickly—through the operation of demandand supply curves—in changes in prices. These changes are then translated by firmsinto changes in production. Assume that the economy is initially producing at pointE along the production possibilities curve in Figure 10.4. Consumers decide thatthey like SUVs more and sedans less. The increased demand for SUVs will result inthe price of SUVs increasing, and this price rise will lead to an increased output ofSUVs; at read more..

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    COMPETITIVE MARKETS AND PARETO EFFICIENCYWe now know that when economists say that market economies are efficient, or thatthe price system results in economic efficiency, they mean that the economy is Paretoefficient: no one can be made better off without making someone else worse off. Wehave also shown why competitive markets ensure that all three of the basic condi-tions for Pareto efficiency—exchange efficiency, production efficiency, and product-mix efficiency—are attained.The argument read more..

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    Knowing how the distribution of income is determined is important, because it tellsus how the nation’s economic pie is divided: it provides the answer to the question“For whom are goods produced?” While competitive markets produce economicefficiency—no one can be made better off without making someone else worse off—competitive markets may also produce distributions of income that seem, at least tosome, morally repugnant. An economy in which some individuals live in mansionswhile read more..

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    more extensive government interventions may be required to obtain Pareto-efficientallocations. Later chapters will explore these circumstance in greater detail.Still, two important lessons that emerge are worth noting here: there are costsassociated with redistributions that entail interventions in market mechanisms,and those costs have to be weighed against the benefits; and redistributions canmake use of the price mechanism, rather than trying to override it. One cannotrepeal the laws of read more..

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    Thinking Like an EconomistINDIRECT TRADE-OFFS AND AIR SAFETY FOR CHILDRENGeneral equilibrium analysis calls attention to the fact that trade-offs often exist across markets. The benefits of an action takenin one market may be offset by related costs that arise in anothermarket. This same reasoning applies to government policies, aspolicymakers work to balance the costs and benefits of expendi-ture programs and regulations. Sometimes the costs of a policyarise through its indirect repercussions. read more..

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    households determine their saving, which in turn determines the available supply ofcapital. The supply of capital is affected, in general, by the return it yields (the inter-est rate r) plus the income individuals have from other sources, in particular fromwages. Since the amount individuals are willing to save may depend on how well-off they feel, and how well-off they feel depends on the wage rate relative to prices,we can think of the supply of capital, too, as depending on wages, interest read more..

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    Wrap-UpEQUILIBRIUM IN THE BASIC COMPETITIVEMODELThe labor market clearing condition: The demand for labor must equal the supply.The capital market clearing condition: The demand for capital must equal the supply.The goods market clearing condition: The demand for goods must equal the supply.Case in PointTHE LABOR MARKET AND THE WIDENINGWAGE GAPA general equilibrium perspective can help us understand how changes in one marketaffect other markets. Often those repercussions on other markets feed read more..

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    there may be further shifts in the demand curves, exacerbating wage differences.The question is, How long will it take for the wage gap to be reduced to the levels thatprevailed in the 1960s? In the meantime, many worry about the social consequencesof steadily increasing wage (and income) inequality. Case in PointTHE MINIMUM WAGE AND GENERALEQUILIBRIUMWhen the first minimum wage law was adopted by passage of the Fair LaborStandards Act of 1938, it had general equilibrium effects that altered the read more..

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    the South was to raise the productivity of the workforce, so southern states wereeager to attract new capital investment that would increase labor productivity andrestore employment.Gavin Wright, a professor of economics at Stanford University, described thesituation this way: “The overall effect of this history on black Americans is complex,mixed, and ironic. Displacement and suffering were severe. Yet in abolishing thelow-wage South, the federal government also destroyed the nation’s most read more..

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    today, but it will also depend on prices expected in the future. The role played byprices expected in the future is important for understanding how quickly the limitedsupply of a natural resource will be used.Just as we did in Chapter 9 when we discussed household saving, we will sim-plify by considering only two periods, today and the future. Let’s also assume thatknown reserves of oil are one billion barrels. The oil can be sold now or left in theground and sold in the future. Oil producers read more..

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    WHEN PARTIAL EQUILIBRIUM ANALYSIS WILL DOIn the examples of the widening wage gap and the price of oil, general equilibriumanalysis is clearly important. But can we ever focus on what goes on in a singlemarket, without worrying about the reverberations in the rest of the economy? Arethere circumstances in which partial equilibrium analysis will provide a fairly accu-rate answer to the effect of, say, a change in a tax? When will the sort of analysis we used earlier in this chapter to analyze the read more..

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    Review and PracticeSUMMARY1. General equilibrium in the basic competitive modeloccurs when wages, interest rates, and prices are suchthat demand is equal to supply in all labor, capital, andproduct markets. All markets clear.2. The competitive equilibrium maximizes the sum of con-sumer and producer surplus.3. Under the conditions of the basic competitive model,the economy’s resource allocation is Pareto efficient:that is, no one can be made better off without makingsomeone worse off.4. The read more..

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    236 ∂CHAPTER 10 THE EFFICIENCY OF COMPETITIVE MARKETSgoods can be increased by shifting machines and laborbetween industries.4. Consider three ways of helping poor people to buy food,clothing, and shelter. The first way is to pass laws set-ting price ceilings to keep these basic goods affordable.The second is to have the government distributecoupons that give poor people a discount when they buy these necessities. The third is for the government to distribute income to poor people. Which read more..

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    ∂∂237Part 3IMPERFECT MARKETS read more..

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    Learning GoalsIn this chapter, you will learnThe key ways many marketsfall short of the perfect com-petition envisioned in thebasic competitive modelThe different forms of imper-fect competition and theirconsequencesHow imperfect informationcan affect marketsWhat economists mean byexternalities, and how theyaffect marketsWhat a public good is, andwhy markets undersupplypublic goods.54321 read more..

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    Chapter 11 INTRODUCTION TOIMPERFECTMARKETS∂In the two centuries since Adam Smith enunciated the view that markets ensureeconomic efficiency, economists have investigated the basic competitive modelwith great care. Nothing they have discovered has shaken their belief that mar-kets are, by and large, the most efficient way to coordinate an economy. However,economists have also found significant ways in which modern economies do not fitthe basic competitive model. These differences can cause read more..

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    As we explore the economics of imperfect markets, the five key concepts intro-duced in Chapter 1—trade-offs, incentives, exchange, information, and distribution—continue to serve as guides to thinking like an economist. Individuals, firms, andgovernment still face trade-offs when markets are imperfect, though perhaps dif-ferent ones from those in the world of the basic competitive model, and they mustbe weighed in any economic analysis. Trade-offs necessitate choices, which we canunderstand read more..

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    price. The basic competitive model focuses on products such as wheat or pig iron,which may be produced by different firms but are essentially identical and are per-fect substitutes for one another. If a firm raises its price slightly above that of otherfirms, it loses all its customers. In that model, there is no room for brand loyalty, yetit is hard to think of a consumer product without attaching a brand name to it. IfBMW raises the price of its cars, it may lose some customers to other makes, read more..

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    goods also have the property of nonexcludability—that is, it costs a great deal toexclude any individual from enjoying the benefits of a public good. The standardexample of a public good is national defense. Once the United States is protectedfrom attack, it costs nothing extra to protect each new baby from foreign invasion.Furthermore, it would be virtually impossible to exclude a newborn from the benefits of this protection.Imperfect competition, imperfect information, externalities, and read more..

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    is called monopoly. Your local electrical company may have a monopoly in supply-ing electricity in your area. In a court case in 1999, Microsoft was found to have anear monopoly in the market for personal computer operating systems. Becausethe profits of a monopolist would normally attract other businesses into the market,the firm must take advantage of some barrier to entry to maintain its monopolyposition. In Chapter 12, we will discuss some of those barriers.In the second structure, several read more..

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    Monopolistic competition: Sufficiently many firms that each believes that its rivalswill not change the price they charge should it lower its own price; competitionstrong enough that profits may be driven down to zero.PRICE AND QUANTITY WITH IMPERFECTCOMPETITIONIn the basic model of perfect competition, each firm takes the market price as given.If one firm tries to raise its price, even slightly, it will lose all of its customers. Whencompetition is imperfect, a firm will lose some but not all read more..

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    Internet ConnectionTHE FEDERAL TRADE COMMISSIONThe Federal Trade Commission (FTC) enforces consumer pro-tection and antitrust laws and plays an important role in elim-inating unfair or deceptive practices while ensuring thatAmerican markets function competitively. The FTC providesarticles at actionURI(www.ftc.gov/bcp/menu-internet.htm):www.ftc.gov/bcp/menu-internet.htm on what towatch out for in e-commerce and when making purchases orseeking information over the Internet.How much the price must read more..

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    In some cases, the government may decide not to break up a firm even if it is amonopoly. It may believe, for instance, that it is more efficient for a single firm toprovide the service. In this case, the firm is called a natural monopoly. Typicallythe government establishes a regulatory body to oversee such a monopoly. Industriesthat have been characterized in the past as regulated monopolies include local cableTV, electrical utility, and telephone. Firms in these industries normally must read more..

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    Imperfect InformationThe model of perfect competition that was developed in Part Two assumed thatmarket participants, whether consumers, firms, or the government, had perfect infor-mation. They had full information about the goods being bought and sold. Seldomdo we actually approach this standard, and economists have gained new insightsinto how markets function by incorporating imperfect information into their models.Interestingly, economists’ understanding of the importance of imperfect read more..

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    imperfect information? Are there important predictions of the model that are incorrect as a result of the assumption that consumers and firms are well informed?Increasingly, over the past two decades, economists have come to believe thatthe answer to these questions is yes. For example, college graduates receive a higherincome on average than high school graduates, perhaps not only because they havelearned things in college that make them more productive but also because theircollege degree read more..

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    MARKETS FOR INFORMATIONInformation has value; people are willing to pay for it. In this sense, we can considerinformation to be a good like any other. There is a market for information, at a price—just as there is a market for labor and a market for capital. Indeed, our economy issometimes referred to as an information economy. And every year, investors spendmillions of dollars on newsletters that give them information about stocks, bonds, andother investment opportunities. Magazines sell read more..

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    Some cases present a basic problem of credibility. You might think, If a stocktipster really knows that a stock’s price is going to go up, why should he tell me, evenif I pay him for the information? Why doesn’t he go out and make his fortune with theinformation? Or is it that he really is not sure, and would just as soon have me riskmy money rather than risk his?Most important, even after the firm or consumer buys all the information thoughtto be worth paying for, the information is still read more..

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    ness scandals in recent years have involved misleading accounting practices. Thebest-known case is that of the energy-trading firm Enron. Between 1996 and 1999,Enron used accounting tricks to report profits of $2.3 billion to potential investors, whilereporting to the U.S. tax authorities that it had lost $3 billion. In one of the many legalcases that resulted from Enron’s collapse, the accounting firm Arthur Andersen,once one of the world’s five largest, was found guilty of obstructing read more..

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    ExternalitiesEven when there is perfect competition and information, the market may supplytoo much of some goods and too little of others. One of the reasons for this is exter-nalities. Externalities arise whenever an individual or firm can take an action thatdirectly affects others without paying for a harmful outcome or being paid for a ben-eficial one. When externalities are present, firms and individuals do not bear all theconsequences of their action.A common example of a negative read more..

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    When the production of a good involves positive externalities, the market level of production is too low, and the government can try to enlarge the supply. The renovation of an apartment building in a decaying part of a city is an exam-ple of a positive externality; it will probably enhance the value of the buildingssurrounding it. A government subsidy can lower the cost of rejuvenating old buildings. In equilibrium, the subsidy will increase the number of buildings that are read more..

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    Fundamentals of Imperfect Markets 4EXTERNALITIESWhen individuals or firms do not have to pay for the actions they take that directlyaffect others, the market outcome will be inefficient. In the presence of externalities,the producer takes into account the private goods of production but fails to take intoaccount all the social costs. When the direct effect of production on others is nega-tive, as in the case of pollutants generated by a firm or second-hand smoke caused bya cigarette smoker, too read more..

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    PUBLIC GOODS∂ 2552New technologies enable drivers to be charged for tolls without stopping at tollbooths. Scanners identify carsequipped with special tags as they pass, automatically billing the driver. Thus, new technologies can convertwhat was a public good into a private good.practical matter, this can be done only on toll roads, and ironically, the tollboothsoften contribute to the congestion.2Many of the goods that are publicly provided, such as education and health serv-ices, have high read more..

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    256 ∂CHAPTER 11 INTRODUCTION TO IMPERFECT MARKETSLooking AheadWe have now examined four situations in which markets may fail to develop an efficient allocation of society’s scarce resources. In each of these cases—imperfectcompetition, imperfect information, externalities, and public goods—a role for gov-ernment exists. Government can employ a variety of policies to promote competi-tion, address the problems created by externalities and imperfect information, andsupply public goods.In read more..

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    Review and PracticeSUMMARY1. By and large, private markets allocate resources effi-ciently. However, in a number of areas they do not, as in the cases of imperfect competition, imperfect information, externalities, and public goods.2. Economists identify four broad categories of marketstructure: perfect competition, monopoly, oligopoly, andmonopolistic competition.3. When competition is imperfect, the market will producetoo little of a good and the market price will be too high.4. The basic read more..

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    4. Each of the situations below involves an externality. Tellwhether it is a positive or a negative externality, or both,and explain why a free market will overproduce orunderproduce the good in question.(a) A business undertaking research and developmentprojects(b) A business that discharges waste into a nearbyriver(c) A concert given in the middle of a large city park(d) An individual who smokes cigarettes in a meeting5. When some activity causes a negative externality likepollution, would it read more..

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    Learning GoalsIn this chapter, you will learnWhy monopolies produce toolittle at too high a priceThe economic factors thatlead to monopoliesHow economists measure thedegree of competition in amarketHow monopolistic compe-tition differs from perfectcompetition and pure monopolyWhy oligopolies need tothink strategicallyWhat factors lead to barriersto entry654321 read more..

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    Chapter 12MONOPOLY,MONOPOLISTICCOMPETITION, ANDOLIGOPOLY∂As we discussed in Chapter 11, many markets in our economy are not welldescribed by the perfectly competitive model. For years, AT&T was theonly long-distance telephone carrier. Kodak controlled the market for film,and Alcoa the market for aluminum. Some firms so dominated a product that theirbrand name became synonymous with the product—for example, Kleenex, or Jell-O. These firms did not simply take the market price as given: read more..

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    are higher as well. To understand these concerns, we consider amonopolist that charges the same price to all its customers, and showhow it decides on its level of output.A monopolist, just like a competitive firm, will try to maximize prof-its. Both compare the marginal revenue and the marginal cost of pro-ducing more. For both, the basic principle for determining output isthe same. Each produces at the output level at which marginal revenueequals marginal cost. The key difference lies in their read more..

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    In Chapter 7, we used a graph that showed the firm’s marginal cost together withthe market price to determine how much output the firm should produce to maxi-mize profits (see Figure 7.3). We can use a similar graph to illustrate how much amonopoly will produce, once we recognize that for a monopolist, marginal revenuewill be less than the market price. Figure 12.1 shows the relationship between the demand curve and the marginal rev-enue of the monopolist. If the monopolist wants to sell the read more..

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    The extent to which output is curtailed depends on the magnitude of the differ-ence between marginal revenue and price. This in turn depends on the shape of thedemand curve. When demand curves are very elastic (relatively flat), prices do notfall much when output increases. As shown in Figure 12.3A, marginal revenue is notmuch less than price. The firm produces at Qm, where marginal revenue equals mar-ginal cost. Qm is slightly less than the competitive output, Qc, where price equalsmarginal read more..

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    of $9,000, it sells 2 units; and at a price of $8,000, 3 units. Thethird column of the table shows the total revenues at each ofthese levels of production. The total revenues are just price mul-tiplied by quantity. The marginal revenue from producing anextra unit (of 1,000 cubic yards) is just the difference between,say, the revenues received at 3 units and 2 units or 2 units and1 unit. Note that in each case, the marginal revenue is less thanthe price.Figure 12.4 shows the firm’s demand and read more..

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    266 ∂CHAPTER 12 MONOPOLY, MONOPOLISTIC COMPETITION, AND OLIGOPOLYPRICE DISCRIMINATIONThe basic objective of monopolists is to maximize profits, and they accomplish thisby setting marginal revenue equal to marginal cost, so price exceeds marginal cost.Monopolists can also engage in a variety of other practices to increase their prof-its. Among the most important is price discrimination: that is, charging differentprices to different customers or in different markets.Figure 12.6 shows a read more..

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    customer uses. If the company worries that large customers charged the same highprices as its small customers might install their own electric generators, or switch tosome other energy source, it may lower the price to them. An airline with a monop-oly on a particular route may not know whether a customer is buying a ticket forbusiness purposes or for a holiday trip, but by charging more for refundable ticketsor tickets purchased at the last minute, it can effectively discriminate between read more..

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    268 ∂CHAPTER 12 MONOPOLY, MONOPOLISTIC COMPETITION, AND OLIGOPOLYInternational Perspective SOUTH AFRICA, AIDS, AND PRICE DISCRIMINATIONIn perfectly competitive and well-functioning markets, goods cannot be sold at two different prices. Those who purchased the good at the low price could resell the good inthe high-price market, making a pure profit. But in somemarkets, reselling the good is difficult; in others, govern-ments prohibit or limit resale.Research and testing account for the major read more..

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    A natural monopoly occurs whenever the average costs of produc-tion for a single firm decline as output increases up to levels beyondthose likely to emerge in the market. When the average costs of pro-duction fall as the scale of production increases, we say there areeconomies of scale, a concept first introduced in Chapter 6. In Figure12.7, the demand curve facing a monopoly intersects the average costcurve at an output level at which average costs are still declining. Atlarge enough outputs, read more..

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    The size of the market depends largely on transportation costs. If, somehow, thecost of transporting cement were lowered to close to zero, then there would be anational cement market. Many firms then would be competing against each other—the size of the national market is far larger than the output at which average costsare minimized.The size of output at which costs are minimized depends in part on the magni-tude of fixed costs. Since research is a fixed cost, its growing importance in read more..

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    produced by the top four firms in a variety of industries ranging from books to furniture. This fraction is called the four-firm concentration ratio, one of severalmeasures used to study industry concentration. When the four-firm percentage ishigh, as in the automobile or book publishing industry, companies have considerablemarket power. When it is low, as in the case of furniture or florists, market power islow; each firm faces a practically horizontal demand curve.2PRODUCT DIFFERENTIATIONThe read more..

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    e-InsightNETWORK EXTERNALITIES, THE NEW ECONOMY, ANDMONOPOLY POWERNetwork externalities arise whenever an individual benefitsfrom an increase in the number of individuals that are part ofthe network. A telephone is not much use if there is no one atthe other end of the line. The value of a telephone is increasedas more people have telephones.Assume there are two different telephone systems that donot interconnect. A new subscriber having to decide betweenthem is likely to sign up with the one read more..

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    Equilibrium with MonopolisticCompetitionIn most industries there is some but limited competition. The number of firms in theindustry is perhaps the most important determinant of the nature of competition. Ifthe fixed costs are large—not so large as to result in a single firm but sufficientlylarge that there are only two, three, or four firms—then the outcome is a natural oli-gopoly. We discuss oligopolies in the next section; we here consider the case in whichfixed costs are relatively read more..

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    occurs at exactly the level of output at which the demand curve is tangent to the aver-age cost curve. At any other point, average costs exceed price, so profits are negative.Only at this point are profits zero. Accordingly, this is the profit-maximizing output.The monopolistic competition equilibrium has some interesting characteristics.Note that in equilibrium, price and average costs exceed the minimum average costsat which the goods could be produced. Less is produced at a higher price. But read more..

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    A firm that is part of an oligopolistic market must think strategically. In decid-ing what to do, it faces four key questions: (1) Should it cooperate with other firmsor compete? When firms cooperate rather than compete, economists say the firmsare colluding. (2) If it cannot collude explicitly (because there are laws barring suchbehavior), how can it reduce the effectiveness of competition through restrictivepractices or other means? (3) How can it deter entry? Like a monopolist, it knowsthat read more..

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    that the long-run gains from “cooperation” (that is, collusion) are worth the tempo-rary sacrifice. For instance, if a firm cuts its price or expands its output and thecheating is detected, the other firms in the cartel may match, or even more thanmatch, the price cuts or capacity expansions. The cheater ends up not only withlower profits than anticipated but also with lower profits than it would have obtainedhad it cooperated. A variety of facilitating practices can make collusion easier by read more..

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    and still be better off. However, these side payments are also illegal, and thus mustbe subtle and hard to detect if they occur at all. While perfect coordination is seldompossible, some industries have found a partial solution by allowing one firm to playthe role of the price leader. In the airline industry, American Airlines for a long timeacted as a price leader. As it increased or decreased prices, others followed suit.Using Game Theory to Model Collusion Economists apply a branch read more..

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    worse off, each serving three years. The prisoner’s dilemma is asimple game in which both parties are made worse off by independ-ently following their own self-interest. Both would be better off ifthey could get together to agree on a story, and to threaten the otherif he deviated from the story.The prisoner’s dilemma game can be used to illustrate the prob-lem of collusion among oligopolists. Let us work with the example ofa duopoly, which is a market with two firms. Figure 12.10 shows read more..

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    backward through time, this logic will lead collusion to break down almost immediately. However, if there is no certain date at which the collusion will end, itis possible for collusion to carry on indefinitely. Whenever the firms contemplatecheating, on any agreement to collude, each will compare the initial increase in prof-its from cheating with the future reduction in profits when the other firm retaliates.The firms therefore may decide to continue colluding.It is not just among traditional read more..

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    not Texaco or Sunoco. Like most refiners, Exxon requires stations that want to sellonly its brand of gasoline.A third example of a restrictive practice is tie-ins, which force a customer whobuys one product to buy another. Mortgage companies, for example, used to insistthat those who obtained mortgages from them purchase fire insurance as well.Nintendo designs its console so that it can be used with only Nintendo games. Ineffect, it forces a tie-in sale between the console and the software. In read more..

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    Internet ConnectionKEEPING TRACK OF OLIGOPOLIESThe Web actionURI(www.oligopolywatch.com):site www.oligopolywatch.com provides numerousarticles and news stories about oligopolies. Many of the sto-ries report on the latest mergers and acquisitions by large cor-porations, describing how these often serve to reduce thenumber of sellers in a market to just a few different producers.For example, more than 80 percent of all the music titles pro-duced in the United States are controlled by just five read more..

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    282 ∂CHAPTER 12 MONOPOLY, MONOPOLISTIC COMPETITION, AND OLIGOPOLYgovernment gave the East India Company a monopoly on trade with India. Morerecently, governments have often granted monopolies to providers of such servicesas electricity, telephones, and cable television. Today, however, the most importantmonopolies granted by governments are patents. A patent gives inventors the exclu-sive right to produce or license others to produce their discoveries for a limitedperiod of time (generally read more..

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    Thinking Like an EconomistTRADE-OFFS, AMERICAN AIRLINES, AND PREDATIONFirms with market power like to keep it that way, as they canearn high profits by being the only, or the dominant, firm in amarket. One of the ways in which they do this is to be a pred-ator. Like a predatory animal that eats up rivals, predatoryfirms lower their prices in an attempt to drive out competi-tors. A firm may find it can earn higher profits overall if it sac-rifices some profit in the short run by cutting its read more..

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    with marginal costs equal to those of the incumbent, will realize that once it enters,it too must set price equal to marginal cost and therefore will be unable to recovereven a small sunk cost. Hence, it chooses not to enter. And the incumbent firm,aware of this calculation, can charge a monopoly price unchallenged. Wrap-UpENTRY DETERRENCEGovernment policies: These include grants of monopoly (patents) and restrictionson entry (licensing).Single ownership of an essential input: When a single firm read more..

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    REVIEW AND PRACTICE∂ 285collusion—for example, by relying on price leaders and“meeting-the-competition” pricing policies.8. Even when they do not collude, firms attempt to restrictcompetition with practices such as exclusive territories,exclusive dealing, tie-ins, and resale price maintenance.In some cases, a firm’s profits may be increased by rais-ing its rival’s costs and making the rival a less effectivecompetitor.KEY TERMSpure profit or monopoly rentsprice discriminationnatural read more..

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    6. Describe market equilibrium under monopolistic com-petition. Why does the price charged by the typical firmexceed the minimum average cost, even though otherfirms may enter the market?7. What are the gains from collusion? Why is there anincentive for each member of a cartel to cheat by pro-ducing more than the agreed-on amount? What is the “prisoner’s dilemma” and how is it related to theproblem of cheating? What are the other problemsfacing cartels?8. Name some ways that firms might read more..

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    9. Explain why frequent-flier programs (in which airlinesgive credits, convertible into travel awards for each mile traveled) might reduce competition among airlines.Put yourself in the role of consultant to one of the air-lines in the days before any airline had such programs.Would you have recommended that the airline adopt the program? What would you have assumed about the responses of other airlines? Would this have beenimportant to your assessment?10. At various times, Nintendo has been read more..

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    Learning GoalsIn this chapter, you will learnThe sources of economic inefficiency that result fromimperfect competitionThe different policies thatgovernments have adopted to deal with imperfect competitionThe role of antitrust policiesin limiting market dominationand curbing practices that restrict competition321 read more..

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    Chapter 13GOVERNMENTPOLICIES TOWARDCOMPETITION∂Motivated by both political and economic concerns, governments havetaken an active role in promoting competition and in limiting the abusesof market power. In this chapter, we review the economic effects of limited competition and look at government policies to reduce its negative effects.The Drawbacks of Monopolies andLimited CompetitionFour major sources of economic inefficiency result from monopolies and other imper-fectly competitive read more..

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    A monopolist who sets marginal revenue equal to marginal costproduces at a lower level of output than a corresponding competitiveindustry—an industry with the same demand curve and costs but inwhich there are many producers rather than one—where price equalsmarginal cost. Figure 13.1 shows that the monopoly output, Qm, issmaller than the competitive output, Qc, where the price under competition, pc, equals marginal cost. The price under monopoly, pm,is higher than pc.The price of a good, by read more..

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    MANAGERIAL SLACKChapter 6 argued that any company wants to minimize the cost of producing what-ever level of output it chooses to produce. But in practice, companies already earn-ing a great deal of money without much competition often lack the incentive to holdcosts as low as possible. The lack of efficiency when firms are insulated from thepressures of competition is referred to as managerial slack.In the absence of competition, it can be difficult to tell whether managers arebeing efficient. read more..

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    deliberately try to inhibit innovative activities of potential rivals, they may stifleprogress indirectly. Some of the most important inputs into the innovation processare prior innovations themselves, and by raising the “price” associated with theseearlier discoveries (through their market power), monopolists reduce the incentivesfor follow-up inventions.RENT SEEKINGThe final source of economic inefficiency under monopoly is the temptation formonopolists to expend resources in economically read more..

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    Policies Toward NaturalMonopoliesIf imperfect competition is as disadvantageous as the previous analysis has sug-gested, why not simply require that competition be perfect? To answer this ques-tion, we need to recall the reasons, discussed in Chapter 11, why competition is imperfect.One reason is that the cost of production may be lower if there is a single firm inthe industry, leading to a natural monopoly. In the case depicted in Figure 13.3, aver-age costs are declining throughout the read more..

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    marginal cost, as would be true under perfect competition (the outputlevel Qc and the price pc in the figure).However, a decreasing average cost curve necessarily precludesperfect competition. To understand why, recall that under perfectcompetition, price equals marginal cost. Now look again at Figure 13.3and consider what would happen if price were driven down to mar-ginal cost. In the figure, marginal cost is equal to pc . At a price equalto pc , the quantity demanded is equal to Qc . But at read more..

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    marginal cost and to make up the deficit with revenues from other services, a prac-tice referred to as cross subsidization. Thus, business customers of utilities aresometimes charged more, relative to the actual costs of serving them, than are house-holds. This practice in effect involves a hidden tax and a hidden subsidy; businessesare taxed to subsidize households. The same phenomenon can be seen in our mostimportant public monopoly, the U.S. Postal Service. It charges the same price read more..

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    International PerspectiveTHE DARKER SIDE OF PRIVATIZATIONIn many countries around the world, where government usedto own a large share of industry, privatization has had a markedimpact on the economic landscape. Those favoring privatiza-tion argued that it would not only improve efficiency but alsoreduce corruption, by eliminating government enterprises asa source of income and patronage. But privatization itself has turned out to be a major sourceof corruption; indeed, in many parts of the read more..

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    let us first review why competition may not be viable when average costs are declining over the relevant range of output.If two firms divide the market between them, each faces higher average coststhan if either one controlled the whole market. By undercutting its rival, a firm wouldbe able to capture the entire market and reduce its average costs. By the same token,a natural monopolist knows that it can charge a price above its average cost with-out worrying about entry. Rivals that might enter read more..

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    travelers from these communities often must pay extremely high fares. A pattern of discriminatory pricing has developed, and businesspeople who cannot make reser-vations weeks in advance are charged four or more times the fare of a vacationerfor the same seat.Deregulation has not yet extended to natural monopolies like water. But thederegulation of electricity is well under way, implemented in more than half the U.S. states.Case in PointCALIFORNIA ELECTRICITY DEREGULATIONCalifornia was among the read more..

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    deregulation, government had retained too large a role—it had put ceilings on theprices companies could charge consumers and prevented the use of long-termcontracts. Well-intentioned or not, these restrictions exposed electricity compa-nies like Pacific Gas and Electric to an impossible squeeze: high gas prices led tohigh wholesale prices for electricity that were greater than the controlled retailprices. And the way deregulation was done allowed energy traders like Enron tomanipulate the read more..

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    LIMITING MARKET DOMINATIONIn this section, we look at how government tries to limit economic power. In thedecades following the Civil War, entrepreneurs in several industries attempted toform trusts. These were organizations that controlled a market. One individual hada controlling interest in a firm, which in turn had a controlling interest in all theother firms in the industry. Through the addition of more layers—firms that con-trolled firms that controlled firms, and so on—a relatively read more..

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    Internet ConnectionU.S. DEPARTMENT OF JUSTICE AND ANTITRUST LAWSAactionURI(www.usdoj.gov/atr/overview.html):t www.usdoj.gov/atr/overview.html, the Department of Justiceexplains the mission of its Antitrust Division and its role inpreventing monopolies from depriving consumers of the benefits of competition.ANTITRUST POLICIES∂ 301demeanor.” (A 1974 amendment made violations felonies.) Two important decisionsbased on the Sherman Act led to the breakups of Standard Oil and American Tobaccoin read more..

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    Market Bounds and Globalization Over the past two hundred years, thegeographical scope of markets has grown enormously. Technological improvementsin transportation, from steam-powered ships to railroads to airplanes, have loweredthe cost of transportation and expanded the boundaries of markets. As a marketexpands, it may become more competitive—as happened in the U.S. auto industryduring the 1980s and 1990s, when the big three domestic firms (Ford, General Motors,and Chrysler) faced increasing read more..

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    ous when goods produced by different firms are imperfect substitutes. What, forexample, is the market for beer? Those in the industry might claim that premiumbeers and discount beers really constitute two different markets, as relatively fewcustomers cross over from one to the other. In the 1950s, DuPont had a virtual monop-oly on the market for clear wrapping paper, but it fought off charges of monopoly byarguing that its product was one among several “wrapping materials.” It claimedthat read more..

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    Before one large company can acquire or merge with a competitor, it must con-vince the government that the acquisition would not seriously interfere with theoverall competitiveness of the market. CURBING RESTRICTIVE PRACTICESIn addition to promoting competition by limiting the degree of concentration withinan industry, the government works to limit restrictive practices. The history herebegins with the 1914 Federal Trade Commission Act. The first ten words of the actread: “Unfair methods of read more..

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    arguments brought by a small Virginia winery against New York’s laws restrictingdirect sales by out-of-state wineries to residents of New York. A challenge to a sim-ilar law in Michigan was also heard by the courts. The states argued that they weregiven regulatory power over the sale of alcoholic beverages by the Twenty-firstAmendment to the Constitution, adopted to repeal Prohibition in 1933. However,because the New York and Michigan restrictions apply only to out-of-state produc-ers while read more..

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    Wrap-UpANTITRUST POLICIESAntitrust policies are designed to ensure competition in the marketplace byLimiting market dominanceCurbing restrictive trade practicesThe problems faced in designing and enforcing antitrust policies includeThe problem of defining the marketDetermining how to deal with firm practices that may both reduce competitionand enhance efficiencyEnforcement of antitrust regulations can involve criminal or civil penalties.Case in PointCOKE AND PEPSI PLAY MERGERThe Coca-Cola read more..

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    If we plug in the 34 percent share that PepsiCo would have after acquiring 7-Up, thePepsiCo–7-Up merger would raise the HHI to 2,766. The two proposed mergerstogether would raise the HHI to 3,312.After the FTC announced its opposition, PepsiCo immediately gave up on pur-chasing 7-Up. Coca-Cola pushed ahead with its plan to buy Dr. Pepper until a fed-eral judge ruled that it was a “stark, unvarnished” attempt to eliminate competitionthat “totally [lacked] any apparent redeeming read more..

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    308 ∂CHAPTER 13 GOVERNMENT POLICIES TOWARD COMPETITIONReview and PracticeSUMMARY1. Economists have identified four major problems resultingfrom monopolies and imperfect competition: restrictedoutput, managerial slack, lack of incentives to maketechnological progress, and wasteful rent-seekingexpenditures.2. Since for a natural monopoly average costs are declin-ing over the range of market demand, a large firm canundercut its rivals. And since marginal cost for a natu-ral monopoly lies below read more..

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    long-distance service between major cities more cheaplythan AT&T, but AT&T argued against allowing firms toenter only the long-distance market. If those other firms(which had no technological advantage) could actuallyhave offered long-distance service more cheaply, whatdoes that imply about cross subsidies in AT&T’s pricingof local and long-distance service? What would havehappened if AT&T had been required to continue offer-ing local service at the same price, but competition read more..

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    Learning GoalsIn this chapter, you will learnHow game theory can help us understand strategic behaviorWhat the Nash equilibrium is in the prisoner’s dilemmagameWhy backward induction is critical for thinking strategicallyHow reputation can play arole in repeated gamesHow game theory can help us understand why threatsand promises may not always be credible54321 read more..

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    Chapter 14STRATEGICBEHAVIOR∂During the 2000 television season, viewers were enthralled by the firstseason of the show Survivor. Sixteen contestants were marooned on PulauTiga, an uninhabited island off the coast of Borneo, and at the end of eachepisode, the survivors voted to kick out one of their members. The last survivingcontestant collected $1 million. By episode 13, the original group had been reducedto just three final contestants: Kelly, Rudy, and Rich. In the course of a trial read more..

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    to understand the choices individuals and firms make, and researchers studyingstrategic behavior have extended the reach of economics into many new areas.Economists examine the choices made by rational individuals and profit-maximizing firms. In the basic competitive model presented in the first two parts ofthis book, individuals and firms do not need to behave strategically. Consumers andfirms can buy or sell as much as they want at the market price. A firm does not needto worry about how its read more..

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    Figure 14.1, which reproduces a diagram from Chapter 12, showsthe results of the deal the police have offered the prisoners. Thistype of grid, showing the payoffs to each player, is called a gametable. In Chapter 12, we saw that based on self-interest, each indi-vidual prisoner believes that confession is best, whether his partnerconfesses or not. But by following self-interest and confessing, eachends up worse off than if neither had confessed. The prisoner’sdilemma is a simple game in which read more..

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    simple when only one player has a dominant strategy, or when neither player hasone; we will learn about such games later. To predict the equilibrium outcomes in these more complex games, we need to look more closely at why confessing is the equilibrium in the prisoner’s dilemma.In the prisoner’s dilemma, each prisoner confesses because doing so leads to thebest, or optimal payoff—the least amount of time in prison—given what the otherprisoner can be expected to do. The outcome is an read more..

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    Consider the case of politicians A and B. If neither runs a negative campaign,the public thinks highly of both of them, but neither gains any advantage over theother. If both run negative campaign ads, the public thinks poorly of both, but againneither gains an advantage. Each is tarred by the other’s ads. If politician A runs aclean campaign, politician B can gain an advantage by running a negative ad thattarnishes A’s reputation. Conversely, A gains by running a negative ad if politician read more..

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    Wrap-UpTHE PRISONER’S DILEMMAIn the prisoner’s dilemma, each player has a dominant strategy. In a unique Nashequilibrium, the players choose their dominant strategy. Yet the players are worseoff in this Nash equilibrium than if they had chosen their alternative strategy.Applications of the prisoner’s dilemma arise in many branches of economics, as wellas in other social sciences and in everyday life.Strategic Behavior in MoreGeneral GamesIn the prisoner’s dilemma, both players have a read more..

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    STRATEGIC BEHAVIOR IN MORE GENERAL GAMES∂ 317International PerspectiveBEGGAR-THY-NEIGHBOR TARIFF POLICIESDuring the international depression of the 1930s, many coun-tries debated whether to impose restrictions on internationaltrade. Some argued that restricting imports from other countries would boost the demand for goods produced domes-tically. Increased demand, in turn, would enable domesticfirms to expand employment and production. By reducing thedemand for goods produced in other read more..

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    knows that Discounters Delux will reduce prices, since that isDiscounters Delux’s dominant strategy. So the fact that QualityBrands would find it best to keep prices high if Discounters Deluxkeeps its prices high is irrelevant. Quality Brands knows thatDiscounters Delux will cut prices, and therefore its best strategy isalso to cut prices. The outcome, or equilibrium, in this game will haveboth firms reducing their prices.GAMES WITHOUT DOMINANTSTRATEGIESBoth the prisoner’s dilemma game and read more..

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    Internet ConnectionTHE ZERO-SUM GAME SOLVERSome games have a fixed total payoff: in Survivor, the winnerreceives $1 million and the next few survivors receive smalleramounts. Nothing the contestants do can affect the totalprize money available. If one contestant receives more,another receives less. Games like this are called zero-sumgames. When we think of games, we usually think of sports orchess, or perhaps gambling—all zero-sum games. In sports,one team wins and the other loses. In read more..

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    runs a negative ad, the other candidate responds by running her own negative attackads. Can this threat of retaliation ensure that the two candidates run clean campaigns?Imagine that there are several weeks remaining until the date of the election.Each candidate will figure that she should run negative ads in the last week of thecampaign: this is her best strategy, because the threat of retaliation carries no forceafter the election. There is no longer any payoff in continuing to cooperate, read more..

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    REPUTATIONSDeveloping good reputations can be useful when players are engaged in repeatedinteractions. A firm that relies on local customers for repeat business has more ofan incentive to develop a reputation for good service than does one with little repeatbusiness. A car mechanic might have an incentive to pad the bill or otherwise cheata customer if he never expects to service that particular car again, but in the longrun he might profit more by gaining a reputation for good service and read more..

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    INSTITUTIONSIn many situations, institutions ensure that a cooperative outcome is reached.International organizations such as the World Trade Organization (WTO) serve toenforce agreements that promote international trade. Member countries agree toabide by certain rules that forbid the type of trade restrictions and beggar-thy-neighbor policies that proved so disastrous during the 1930s. Professional sportsleagues impose salary caps, which limit the ability of teams to boost salaries. read more..

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    If you have a deposit in a commercial bank today, the federal government insuresit (up to $100,000): if your bank makes bad investments and goes bankrupt, the fed-eral government will make sure that you receive all your money back. Before 1933,however, bank deposits were not insured. If your bank went bankrupt, you couldlose everything—that is, unless you acted at the first hint of trouble and withdrewyour deposits before the bank ran out of cash. Banks lend out most of the moneythey receive read more..

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    which is better than nothing.” So there is an equilibrium in which each rushes to thebank, and the bank is unable to fully meet its obligations to the two depositors. Thebank fails.In this example, there is a good equilibrium—the one in which the bank remainsopen and the depositors eventually receive all their money plus interest—and abad equilibrium, when the bank is forced to close. In the prisoner’s dilemma, in contrast, the only equilibrium was inferior to an alternative set of read more..

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    competes peacefully. Assume Microsoft will earn profits of $50billion and Redhat $10 billion on its operating system. If insteadMicrosoft engages in a price war, assume both firms will lose money,with Microsoft losing $1 billion and Redhat losing $500 million. IfRedhat decides not to enter, it earns $0, while Microsoft earnsprofits of $80 billion. Will Redhat enter? And will Microsoft engagein a price war?To simplify this complex scenario we can use a game tree dia-gram, which is the standard read more..

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    Time InconsistencyThreats and promises are common components of strategic behavior. We havealready discussed the case of a monopolist who threatens to wage a price war ifanother firm enters its market (our Redhat and Microsoft example). In that case,the firm that is considering entering the market understands that once it enters,the existing firm’s best strategy is to compete peacefully. Because the potentialentrant can use backward induction to make this determination, the initial threat read more..

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    to actually carry out the threat when it comes time to do so. The rival, knowing thatthe monopolist will not do as it threatened, knows that the threats can be ignored.Time inconsistency arises in many contexts, usually in situations in which oneplayer’s promise or threat is designed to influence the other player’s actions. Considerthe case of Sarah, who has just graduated from high school. Her parents believe thatholding down a summer job will help Sarah learn responsibility, so they offer read more..

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    other corner of a city’s downtown. To deter a potential rival, Pete’sCoffee, from opening stores on the empty corners, Northwest Coffeemight threaten a price war if a rival opens up competing stores.The game tree and payoffs are shown in Figure 14.6.Just as in our earlier example, Pete’s Coffee can use backwardinduction to determine that if it enters, Northwest will find it moreprofitable to compete peacefully. Any threat by Northwest Coffeewould not be credible.Now let’s change the game read more..

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    Review and PracticeSUMMARY1. In perfectly competitive markets, firms and consumerscan decide how much to produce and how much to con-sume without taking into account how others mightreact. In imperfectly competitive markets, firms musttake into account how their rivals will respond to thefirms’ production or pricing decisions. Firms mustbehave strategically in such situations. Individuals alsoface many situations in which they must behave stra-tegically. Economists use game theory to predict read more..

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    choices of how much to produce, their profits will be as follows:Explain how firm B will reason that it makes sense toproduce the high amount, regardless of what firm Achooses. Then explain how firm A will reason that itmakes sense to produce the high amount, regardless ofwhat firm B chooses. How might collusion assist the twofirms in this case?2. Use the prisoner’s dilemma analysis to describe whathappens in the following two situations:(a) Consider two rivals—say, producers of cigarettes. read more..

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    REVIEW AND PRACTICE∂ 331summer her parents decide whether or not to pay forSarah’s tuition. Using backward induction, what is theequilibrium for this game? Now add a new first stage inwhich Sarah’s parents announce that they will only payfor the tuition if Sarah works. Is this announcementcredible? Use this example to explain what is meant bytime inconsistency.6. “Tying one’s hands” can be a way to commit credibly to a certain course of action. In the 1960s film Dr. Strangelove, the read more..

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    Learning GoalsIn this chapter, you will learnAbout the critical ways information affects marketsWhat the adverse selectionproblem is, and how it affectsmarketsWhat the incentive problemis, and how it affects marketsHow search and advertisingare explained by imperfectinformation4321 read more..

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    Chapter 15IMPERFECT INFORMATION INTHE PRODUCTMARKET∂It was never any secret to economists that the real world did not match themodel of perfect competition. Theories of imperfect competition and monop-oly such as those covered in Chapters 11 and 12 have been put forth from AdamSmith’s time to the present.Another limitation of the model of perfect competition has recently attractedattention: its assumption of perfect information—that market participants are fullyinformed about the goods read more..

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    George Akerlof of the University of California at Berkeley has provided a simpleexplanation, based on imperfect information. Some cars are worse than others. Theyhave hidden defects that become apparent to the owners only after they have driventhe cars for a while. Such defective cars are called lemons. One thing after anothergoes wrong with them. While warranties may reduce the financial cost of having alemon, they do not eliminate the bother—the time it takes to bring the car into theshop, read more..

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    quantity demanded will actually fall as price falls—consumers are getting less for theirdollars. The equilibrium is depicted in panel B. The situation just described is characterized by asymmetric informationbetween sellers and buyers. That is, the seller of the used car has more informationabout the product than does the buyer. Many markets, and not just the market forused cars, are characterized by asymmetric information. The founders of a newhigh-tech start-up company may know more about read more..

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    Actions such as providing a better guarantee or a larger showroom are takennot just for the direct benefit that the consumer receives from them, but becausethey persuade consumers that the product is a better product or the firm is a betterbusiness to deal with. In a sense, the desire to convey information “distorts” decisions,insofar as they no longer conform to what they would have been in a world of per-fect information. For example, if customers receive no direct benefit from a read more..

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    The Incentive ProblemProviding incentives that motivate individuals to make the best choices is one of thecentral economic problems. The central problem of incentives, in turn, is that indi-viduals do not bear the full consequences of their actions. The multibillion-dollar collapse of many savings and loan associations in the 1980s—though fraud may haveplayed a part—is attributable largely to incorrect incentives. Because S & L depositswere guaranteed by the government, depositors had no read more..

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    wants to mow it. You want him to take good care of your power mower. When he sees a rock in the mower’s path, he should pick it up. But what incentive does hehave to take care of the mower? If you plan to charge him for repairs if the mowerdoes hit a rock, how can you tell whether the rock was hidden by the grass? If he owned his own mower, he would have the appropriate incentives—an illustrationof why private property combined with the price system provides such an effectivesolution to the read more..

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    REPUTATION SOLUTIONSReputation plays an extremely important role in providing incentives in marketeconomies. A reputation is a form of guarantee. Even though no particular individ-ual or firm can collect anything from this guarantee—it is not a “money-back” guarantee—all know that the reputation of the person or company will suffer if itdoes not perform well. The desire to maintain a good reputation is what providesfirms with an incentive to produce high-quality goods. It provides read more..

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    340 ∂CHAPTER 15 IMPERFECT INFORMATION IN THE PRODUCT MARKETTHE MARKET FOR HEALTH INSURANCEThe market for health insurance provides an illustration of the impact imperfectinformation can have. It is estimated that about 45 million Americans are withouthealth insurance, and even those with insurance often feel dissatisfied with theircoverage. Understanding the problems with health care and the policy debates thatthese problems have generated requires an understanding of the market for read more..

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    Health insurance is designed to let individuals share the risk ofneeding expensive health care, such as surgery.Case in PointBUYING HEALTH INSURANCEHave you ever seen an advertisement for health insurance which stresses that nophysical exam is required? What can economics, and the notion of adverse selec-tion, tell us about who is likely to buy such insurance and whether it is a “good” deal?Health insurance is designed to let individuals share the risks that are associ-ated with health read more..

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    for the insurance. A private company could offer this insurance since it will collectenough from selling the insurance to cover the amount it expects to have pay out.1Most people would probably find the option of paying $500 to avoid the much largercost of the operation a good deal.But suppose some people know that they are more likely than others to need theoperation. Perhaps, like heart disease, the likelihood of needing surgery is higher ifthere is a family history of the disease. Suppose read more..

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    Thinking Like an EconomistINCENTIVE AND INFORMATION PROBLEMS IN THE HOUSING MARKETFor most Americans, buying or selling a house is likely to bethe largest financial transaction they ever engage in. For peopleselling houses, setting the right price is critical. Set the pricetoo high, and the house may remain unsold for months; set ittoo low, and the house sells quickly but the seller ends up withless money. Most people rely on a real estate agent to helpthem sell their homes, and the agent’s read more..

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    e-InsightINFORMATION TECHNOLOGY AND MIDDLEMENPerhaps the defining characteristic of the new economy is therole of information technologies. These new technologies makepossible the collection, analysis, and transmission of vastamounts of information—more efficiently than anyone couldhave conceived even ten years ago. The new technologies nodoubt will improve the flow of information in all markets,including product markets. Some have suggested that it willcompletely eliminate the need for read more..

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    Internet ConnectionJOB SEARCHThe Internet’s ability to disseminate information makes it anatural way for workers seeking new jobs and firms seekingnew employees to exchange information. Several private com-panies have established sites for matching workers and jobs.One of the best known is Monster.com actionURI(www.monster.com):(www.monster.com).The Monster.com network consists of sites in more than adozen countries. The U.S. government has also taken advan-tage of the Internet; all current read more..

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    $5 simply to stop having to search. As the store raises its price to, say, $200, $205,or $210, some people who would have bought the MP3 player at $195 decide that itis worth it to continue shopping around. The store, as it raises its price, loses somebut not all of its customers. Thus, it faces a downward-sloping demand curve. Ifsearch were costless, everyone would go to the store selling the MP3 player at thelowest price, and any store charging more than that would have no sales. Marketsin read more..

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    ADVERTISING∂ 347stores’ buyers seek out literally hundreds of producers, looking for the best buysand the kinds of goods that their customers will like. Stores can earn a reputationfor the quality of the selection they offer their buyers. Customers still have a searchproblem—they may have to visit several stores—but doing so is far less costly thanif they had to search directly among producers. In addition, magazines like ConsumerReports provide readers with detailed information on read more..

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    To emphasize the different roles played by advertising, economists distinguishbetween informative advertising and persuasive advertising. The intent of the formeris to provide consumers with information about the price of a good, where it maybe acquired, or what its characteristics are. The intent of persuasive advertising isto make consumers feel good about the product. To that end, advertisers may evenprovide “disinformation,” seeking to confuse consumers into perceiving differencesamong read more..

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    remains the same, so the second source of extra profits is the shaded area EFG.The net increase in profits is the area ABCD plus the area EFG minus the cost of advertising.So far, in studying the effect of an increase in advertising on one firm’s profits,we have assumed that other firms keep their level of advertising constant.Determining the effect of advertising on both industry and firm profits is more prob-lematic once the reactions of other firms in the industry are taken into account. read more..

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    350 ∂CHAPTER 15 IMPERFECT INFORMATION IN THE PRODUCT MARKETThe Importance of ImperfectInformationThe modern economy has sometimes been called “the information economy.” Thename is justified in part because the major advances in computer technology havegreatly enhanced the capacity to process information, and in part because such alarge fraction of total economic activity now revolves around collecting, process-ing, and disseminating information. Personnel officers focus on finding out read more..

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    351 ∂CHAPTER 15 IMPERFECT INFORMATION IN THE PRODUCT MARKETREVIEW AND PRACTICE∂ 351Review and PracticeSUMMARY1. The basic competitive model assumes that participantsin the market have perfect information about the goodsbeing bought and sold and their prices. In the realworld, information is often imperfect. Economists havemodified the basic model so that it includes a number oflimitations on information.2. A problem of adverse selection may arise when con-sumers cannot judge the true quality read more..

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    PROBLEMS1. How does imperfect information help explain why usedcars cost more when sold by car dealers than by privateindividuals?2. For each situation, state whether it reflects a problem ofadverse selection or of moral hazard.(a) A person drives faster because his new car has airbags.(b) A high school football team visits an “all you caneat” restaurant.(c) A real estate agent who advertises that she will buyyour house from you if she fails to sell it in six weekssets a low selling price read more..

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    Learning GoalsIn this chapter, you will learnAbout the economic effects oflabor unions on wages andemploymentAbout the factors that limitunion powerAbout the factors that explainwage differentialsAbout the incentive problemsthat face firms seeking to motivate workers4321 read more..

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    Chapter 16IMPERFECTIONS INTHE LABOR MARKET∂Part Two emphasized the similarity between the labor market and markets forgoods. Households demand goods and firms supply them, with the price systemas intermediary. Likewise, firms demand labor and workers supply it, withthe wage as intermediary. Firms hire labor up to the point at which the value of the mar-ginal product of labor is equal to the wage, just as they would buy coal up to the pointat which the value of the marginal product of coal is read more..

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    A BRIEF HISTORYLabor unions are less important institutions in our economy than they used to be,and they have always played a smaller role in the United States than in manyEuropean countries. Unionization in the United States began in the late nineteenthand early twentieth centuries. A variety of craft unions were established, consistingof skilled workers such as carpenters, plumbers, and printers. In 1886, the AmericanFederation of Labor (AFL) was formed. Led by Samuel Gompers, the AFL read more..

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    unions had claimed that when they negotiated a better contract or better workingconditions, they were providing benefits to all workers at an establishment. Thus, theydemanded that all laborers at unionized companies join the union, a requirementthat established union shops. Critics of union shops thought that the right to workshould not be limited to members of unions. The Taft-Hartley Act left it to the indi-vidual states to decide whether to outlaw union shops, and many states read more..

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    Though total union membership has fallen, today’s union member is much morelikely to work in the public sector than was true in the past. In 1960, the percentageof union members working in the public sector was only 6 percent. Today it is closerto 40 percent, while only about one in ten nongovernmental workers belongs to aunion. Why the recent and continuing decline in union membership among workersin the private sector?One explanation is that working conditions for workers—whether as a read more..

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    ECONOMIC EFFECTSThe source of union power is collective action. When workers jointogether in a union, they no longer negotiate as isolated individuals. Thethreat of a strike (or a work slowdown) poses many more difficultiesfor an employer than does the threat of any single employee quitting.In the perfectly competitive model of labor markets, workers areprice takers; the market wage is given. But when there is a downward-sloping demand curve for labor, as in Figure 16.2,1 unions have somepower read more..

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    nonunion firms. The nonunion firms may, for instance, pay higher wages to reducethe likelihood of unionization. In particular sectors this effect is important, but mosteconomists believe that the overall impact of union gains on nonunion workers is negative.Job Security and Innovation The economy as a whole benefits from innova-tion, but particular groups within it are likely to suffer. In an innovative economy,those workers who are dislocated by new inventions are expected to learn new read more..

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    When a union goes on strike, the firm may be able to hire some workers, but it iscostly to bring in and train a whole new labor force. Indeed, most of the knowledgeneeded to train the new laborers is in the hands of the union members. While onebushel of wheat may be very much like another, one worker is not very much likeanother. Workers outside the firm are not perfect substitutes for other workers,particularly skilled ones, inside.The Threat of Replacement In industries in which skills are read more..

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    Determinants of union power:Political and legal environmentEconomic environment: salience of the threat of replacement and unemploymentWage DifferentialsThe basic competitive model suggests that if the goods being sold are the same,prices will also be the same. Wages are the price in the labor market; but even inthe absence of unions, similar types of workers performing similar types of jobs aresometimes paid quite different wages. For example, some secretaries are paid twiceas much as others. read more..

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    firm long enough to make his training worthwhile? These concerns again impedelabor mobility, leading employers to prefer to keep their existing labor force evenwhen there are lower-paid workers with similar credentials whom they might recruitat a lower wage.Different groups of individuals may differ in their mobility. For instance, olderworkers may be much more reluctant to move than younger workers. Sometimes,firms take advantage of these differences to cut their own costs. Knowing that read more..

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    If there are enough firms that put profits above prejudice, then the wages of womenwill be bid up toward the level of men of comparable productivity.Beginning in the 1960s, the government has taken an active stance in combatingdiscrimination. In 1964, Congress passed the Civil Rights Act, which banned employ-ment discrimination and set up the Equal Employment Opportunity Commissionto prosecute cases of discrimination. The reach of these laws was extended in 1975when the government prohibited age read more..

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    machines have one advantage over humans: except when they break down, they dowhat they are told. Workers, in contrast, have to be motivated if they are to workhard and to exercise good judgment.This requirement can be viewed as an information problem. In the basic compet-itive model of Part Two, workers were paid to perform particular tasks. The employerknew perfectly whether the worker performed the agreed-on task in the agreed-onmanner. If the worker failed to do so, he did not get paid. The read more..

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    In any case, most workers are engaged in a variety of tasks, only some of whichcan easily be defined and rewarded by means of a piece-rate system. For example,although employers would like experienced workers to train new workers, employ-ees who are paid on a piece-rate system have little incentive to do this, or to helptheir co-workers in other ways. Similarly, when salespeople are paid on the basis ofcommissions, they have little incentive to provide information and service to anypotential read more..

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    These “wages of trust” may explain why pay in more capital-intensive industries(which require massive investments) is higher for workers with otherwise compara-ble skills than it is in industries using less capital. They may also explain why workersentrusted with the care of much cash (that they could steal) earn higher wages thanother workers of comparable skills. It is not so much that they are paid more becausethey are trustworthy, but that they become more trustworthy because they are read more..

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    employee’s salary. Not only must the firm raise the wage offered to the new worker,it must also raise the wage paid to all existing workers. This cost discourages thefirm from hiring additional employees. The imposition of a minimum wage limitsthe expense of hiring an additional worker to just that employee’s wage. And becausetheir marginal cost of adding to their workforce is lower, firms that are required topay a minimum wage in fact will hire more workers.These perspectives are consistent read more..

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    e-InsightLABOR MARKETS AND THE INTERNETOne of the main imperfections in the labor market is that search-ing for a new job is costly. Information is imperfect and isexpensive to acquire. Help-wanted ads play an important rolein making the labor market work, but individuals in one cityoften cannot easily obtain current newspapers from othercities that might have job opportunities.Employment agencies and government employment serv-ices have helped make the labor market work better. But theInternet read more..

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    370 ∂CHAPTER 16 IMPERFECTIONS IN THE LABOR MARKETWrap-UpWAYS OF MOTIVATING WORKERSPiece rates, or pay based on measured output.Threats: firing workers whose efforts or performance are deemed inadequate.Efficiency wages: introducing an extra cost to those dismissed for unsatisfactory performance.Relative performance: promotions, contests.Fringe benefits, such as health insurance and retirement pay. read more..

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    Review and PracticeSUMMARY1. The proportion of U.S. workers in unions has declinedsince the 1950s. Possible reasons include laws that haveimproved working conditions in general; the decline ofmanufacturing industries, where unions have tradition-ally been stronger than in service industries; increasedcompetition in the product market, providing firms withless latitude to pay more than market wages; and a legalatmosphere that has shifted away from encouragingunions.2. Union gains in wages are read more..

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    372 ∂CHAPTER 16 IMPERFECTIONS IN THE LABOR MARKET3. How might each of the following factors affect the powerof unions?(a) A state passes a right-to-work law.(b) Foreign imports increase.(c) The national unemployment rate falls.(d) Corporate profits increase.4. Suppose a worker holding a job that pays $15 per hourapplies for a job with another company that pays $18 per hour. Why might the second company be suspiciousabout whether the worker is really worth $18 per hour? How might the worker read more..

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    ∂∂373Part 4ISSUES IN PUBLIC POLICY read more..

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    Learning GoalsIn this chapter, you will learnThe three basic reasons whygovernments intervene in theeconomyThe characteristics of a goodtax system and how the U.S.system measures upAbout the major transfer programs of the government About current controversiesin the economics of the public sector4321 read more..

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    Chapter 17THE PUBLIC SECTOR∂Throughout American history, the issue of the role of government in the econ-omy has been at the center of political discussions. Today’s debates focuson the sizable imbalance between the federal government’s spending andits tax revenues and on the future financial health of government programs thatprovide retirement income (Social Security) and health insurance (Medicare) to the elderly. The impact of the government on the economy is huge, much larger than read more..

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    government has become more involved in school reform, but most spending on edu-cation in the United States is undertaken by state and local governments; it accountsfor about 4 percent of federal spending. But as already noted, the impact of the federal government cannot be gaugedjust by taxes and expenditures. First, it provides the legal system that enables theprivate sector to function. For example, the government creates and enforces contract laws, which structure agreements between two read more..

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    Why Does the GovernmentIntervene in the Economy?There are three basic reasons why the government intervenes in the economy: (1) toimprove economic efficiency by correcting market failures; (2) to pursue socialvalues of fairness, or equity, by altering market outcomes; and (3) to pursue othersocial values by mandating the consumption of some goods, called merit goods, andprohibiting the consumption of other goods, called merit bads. The next three sectionsaddress each of these reasons for read more..

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    Correcting Market Failures Chapter 11 described four sources of marketfailure in the economy: imperfect competition, imperfect information, externalities,and public goods. Government programs are aimed at redressing market failuresin each of these major categories. For instance, under imperfect competition, firmsuse their market power to raise prices and reduce output. Antitrust policies set bygovernment attempt to maintain a competitive marketplace and restrain firms fromabusing their market read more..

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    Concern is particularly acute about two groups—the very poor and children.The public finds it especially disturbing that even in the United States, supposedlythe land of opportunity, the lifetime prospects of a child born into a poor family anda child born into a rich family are markedly different—and much bleaker for thepoor child. This troubling disparity helps explain the widespread support for high-quality public education; for Pell Grants, which help make a college education afford-able read more..

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    are called merit goods. Such merit goods (and bads) need to be distinguished fromexternalities: no one else may be harmed by someone smoking marijuana, yet manygovernments make it illegal. Moderate drinking or cigarette smoking may have anadverse effect only on the drinker or smoker, yet government still tries to discour-age the consumption of alcohol and tobacco through high taxes. In these instances,the government interferes with the general principle of consumer sovereignty,which holds that read more..

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    e-InsightTHE NEW ECONOMY AND INEQUALITYIncome inequality in the United States has increased significantly over the past twenty years. One reason for this change has been the increasing premium earned byskilled workers. In 1980, college graduates received a wage 43 percent higher, on average, than that received by thosewith only a high school education; by 1990, that premium had increased to just over 70 percent. Over the 1990s, it continued to increase, rising to 75 percent by the end of the read more..

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    CHARACTERISTICS OF A GOOD TAX SYSTEMWhile the design of the tax system is a perennial subject of controversy—views of how to balance the equity-efficiency trade-off differ markedly, as is wholly predictable—there is broad consensus on five principles of a good tax system.Fairness The first criterion is fairness. But fairness is not always easy to de-fine. Economists focus on two points: horizontal equity, the notion that indi-viduals who are in identical or similar situations should pay read more..

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    Wrap-UpCRITERIA FOR EVALUATING A TAX SYSTEMFairnessEfficiencyAdministrative simplicityFlexibilityTransparencyTHE SCOPE OF THE U.S. TAX SYSTEMThe U.S. government raises tax revenues from a variety of sources. The earningsof individuals and corporations yield individual income taxes and corporationincome taxes. Real estate—buildings and land—is subject to taxation by most states;these payments are known as property taxes. Large bequests and gifts are taxed,through gift and estate taxes. read more..

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    decade resulted in improvements? During the past quarter century, the U.S. incometax system has undergone five major reforms, in 1981, 1986, 1993, 1997, and 2001. Theannounced intent of each was to make the system more efficient, more fair, andadministratively more simple. But trade-offs always had to be made, and the reformsapproached them differently; indeed, each tended to undo what was widely viewedas the excesses of its predecessor. Meanwhile, worries about soaring governmentexpenditures read more..

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    The income tax is only one of several income-related taxes that U.S. citizens pay.The payroll (Social Security) tax is another that increases with income up to a fixedlevel. An earned-income tax credit is designed to supplement the income of low-income workers with families; as a person’s income increases beyond a given level,the payments she receives under this program decrease.To assess the overall progressivity of the U.S. tax system, we have to look notonly at federal taxes but at all read more..

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    just as if the government paid directly for child care or research. Accordingly, the revenue lost from a tax subsidy is called a tax expenditure.Administrative Simplicity Americans live in a complex society, and theirtax laws reflect and contribute to this complexity. As legislators have sought toensure that the tax laws are fair and apply uniformly to all people in similar situa-tions, the laws have become increasingly complex. High tax rates make it worth-while for individuals and businesses read more..

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    1997, the program commonly known as “welfare” was AFDC (Aid to Families withDependent Children), which provided cash assistance to poor families, mostly house-holds with only one parent present. It was replaced by a new program called TANF(Temporary Assistance to Needy Families). Medicaid provides health care to thepoor. The food stamp program offers vouchers for the purchase of food. SSI pro-vides cash assistance to the low-income elderly and disabled, to supplement theirSocial Security read more..

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    six rose significantly. The incidence of poverty among children, which had alreadybeen falling, continued to decline, although it rose slightly during the economicrecession in 2001. When the original TANF legislation was passed by Congress in 1996, the pro-gram was designed to expire in 2002. However, on nine occasions since 2002, Congresshas temporarily extended it. The most recent extension, passed in March 2005,reauthorized TANF until September 30, 2005. HOUSINGPublic housing projects have read more..

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    SOCIAL INSURANCEThe United States has a variety of what are referred to as middle-class entitlement programs, so named because individuals do nothave to demonstrate poverty to receive benefits. The most importantof these are the social insurance programs. Social insurance programsare like private insurance, in that people nominally pay for their ownprotection through a tax on wage income, the payroll tax. But in otherimportant ways, they are not like private insurance, as we will see inthe read more..

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    no one knows whether the upcoming year will bring serious illness. So people buy health insurance that covers hospitalization. Those who remain healthy essen-tially pay for the hospitalization of those who need it. But the premiums of an indi-vidual’s private insurance policy will, on average, cover the costs of what thepolicyholder can expect to receive (plus the costs of administration, which are oftensubstantial). Social insurance programs, in contrast, often lack a close connectionbetween read more..

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    Government FailuresDecisions about whether the government should intervene and how it should inter-vene thus depend on one’s views of the efficiency and efficacy of government. Oneof the main rationales for government action that we noted above is to correct marketfailures. But proponents of a limited role for government argue that governmentoften not only fails to correct the problems of the market but makes matters evenworse. Noting that many of the difficulties facing the private read more..

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    budgeting problems, information problems, and the nature of political decision making.While the first three can afflict any large organization, including private-sector businesses, they often have particularly severe effects in government programs. INCENTIVES AND CONSTRAINTSUnlike private organizations, government has the power of coercion. It can forcepeople to pay taxes, it can prohibit firms from paying less than the minimum wageif they engage in interstate commerce, and so on. But since this read more..

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    BUDGETING AND SPENDING PROCEDURESThe budgeting and spending constraints on government decision makers differfrom those of the private sector in three major ways. The first is in their severity.Unlike a private firm, which faces the prospect of bankruptcy if enough of its ventures yield losses, a public enterprise can more easily turn to the governmentfor budgetary help. This is the problem of soft budget constraints. Amtrak, for example, continues to lose money in its overall railroad read more..

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    COLLECTIVE DECISION MAKINGA fourth important reason for public failures relates to how government decisionsget made. Governments are not always consistent in their actions. This inconsis-tency may not be surprising, given that government choices do not reflect the pref-erences of a single individual. More fundamentally, majority voting may not yield adeterminate outcome even when only three people choose among only three alter-natives, as was noted more than two hundred years ago by the read more..

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    CURRENT AND RECENT CONTROVERSIES IN THE ECONOMICS OF THE PUBLIC SECTOR∂ 395campaign contributions affect the behavior of politicians, and thus the outcomes ofpolitical processes, has become widespread, growing numbers of legislators andactivists have argued for the need to reform campaign contribution laws.Wrap-UpSOURCES OF PUBLIC FAILURESIncentives and constraintsDue processConstrained ability to make long-term commitmentsPolitical pressuresPork barrel projectsPower of lobbyists who make read more..

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    396 ∂CHAPTER 17 THE PUBLIC SECTORWhen President Bill Clinton took office in 1993, he managed to slow the growthof expenditures, mainly by cutting defense spending (a task made far easier by theend of the cold war), and to increase taxes, mainly on individuals in the upper 2 per-cent of the income distribution. At the same time, the rate of growth of the U.S. economy picked up, increasing the growth in tax revenues.By 1998, the budget situation had improved so much that the government actu-ally read more..

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    CURRENT AND RECENT CONTROVERSIES IN THE ECONOMICS OF THE PUBLIC SECTOR∂ 397that point, additional sources of revenue will be needed if the current law’s prom-ises of benefits are to be honored. While all agree that some changes to Social Security will be needed, what formthose changes should take and how large they have to be are intensely debated.Calling the situation a crisis, President Bush has sought major changes to the verynature of the program. He has proposed that younger workers be read more..

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    A second adjustment often mentioned is to raise the age at which one can startcollecting retirement benefits. Currently, that age is being gradually increased. Forexample, anyone born before 1937 could start receiving full benefits at age sixty-five.Someone born in 1947, however, has to wait until she is sixty-six years old, an indi-vidual born in 1957 must wait until they are sixty-six and a half, and anyone born in1967 must be sixty-seven. The argument in favor of increasing the retirement age read more..

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    Health care is different from most other commodities in several respects. Mosthealth care is paid for by the government or insurance companies, not by individu-als. Hence, individuals do not have an incentive to economize on these expenditures.Individuals also are often not in a position to judge well the necessity or quality of theservices being provided. They must rely on the judgment of a physician. But underthe standard fee-for-service system, the physician has an incentive to provide read more..

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    Internet ConnectionPOLICY ANALYSISWashington, D.C., is home to many research groups that focuson government programs and policies. Among the betterknown are the Brookings IactionURI(www.brookings.org):nstitution (www.brookings.org), theAmerican Enterprise Institute actionURI(www.aei.org):(www.aei.org), and the UrbanInstitute actionURI(www.urban.org):(www.urban.org). These institutions post on theirWeb sites research and policy pieces dealing with major public-sector issues and debates. Some, read more..

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    KEY TERMStransfer programsmerit goodsconsumer sovereigntyprogressive tax systemregressive tax systemmarginal tax ratehorizontal equityvertical equityindividual income taxescorporation income taxesproperty taxesgift and estate taxespayroll taxexcise taxessin taxesbenefit taxesluxury taxessales taxaverage tax rateearned-income tax credittax subsidiestax expenditurematching programsblock grantsentitlement programsvoting paradoxpay-as-you-go programfully funded programREVIEW QUESTIONS1. Name some of read more..

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    4. How do tax and redistribution programs affect incentives?How do social insurance programs affect incentives?Describe some of the trade-offs involved.5. How can redistribution take place through an entitle-ment program like Social Security, to which all workerscontribute and from which all retirees receive benefits?6. What are some of the major controversies in the realmof policy and public-sector economics?PROBLEMS1. In each of the following areas, specify how the govern-ment is involved, read more..

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    Learning GoalsIn this chapter, you will learnWhy many environmentalproblems are the result of externalities that cause market failuresThe four types of policy responses to environmen-tal problems and their implications for economic efficiencyWhether natural resourcesare depleted too rapidly in amarket economy321 read more..

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    Chapter 18ENVIRONMENTALECONOMICS∂Among the most contentious issues today is the impact of the economy on theenvironment. Usually, the discussion portrays economic activity and environ-mental concerns as diametrically opposed. Producing more goods and serv-ices generates more pollution, uses up more and more land, and contributes to globalwarming. It may seem that the fundamental perspective of economics—that of scarcity—hardly applies to things like pollution. After all, most people think read more..

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    was explained in Chapter 11, the extra costs and benefits not captured by the markettransaction are called externalities.Externalities can be either positive or negative, depending on whether individ-uals enjoy extra benefits they did not pay for or suffer extra costs they did not incurthemselves. Goods for which there are positive externalities—such as research anddevelopment—will be undersupplied in the market (see Chapter 20). In decidinghow much of the good to purchase, each individual read more..

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    Consider what happens if, in the production of steel, there is an externality—producers are polluting the air and water without penalty.The social marginal cost—the marginal cost borne by all individuals inthe economy—will now exceed the private marginal cost—the marginalcost borne by the producer alone. Note that in a competitive industry,the supply curve corresponds to the horizontal sum of all producers’ pri-vate marginal cost curves. Panel Bcontrasts the two situations. It showsthe read more..

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    International PerspectiveGLOBAL WARMINGMany environmental problems are local in nature. The pollu-tion of a stream or a toxic waste site mainly affects people inthe neighborhood. But some environmental hazards have animpact on the entire planet and therefore require internationalcooperation. For instance, the Montreal Convention signed in1990 limited the emissions of chemicals that had led to thedepletion of ozone in the atmosphere. Ozone depletion waslinked to a higher incidence of certain read more..

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    matters? Some economists, led by the Nobel laureate Ronald Coase of the Universityof Chicago Law School, argue that government should simply rearrange propertyrights. Coase’s theorem says that with appropriately designed property rights,markets could take care of externalities without direct government intervention.Consider, for example, the case of a small lake in which anyone can fish withoutcharge. Each fisherman ignores the fact that the more fish he takes out of the lake,the fewer there read more..

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    Today there is general agreement that while assigning property rights clearlymay take care of some problems, most externalities, particularly those concerningthe environment, require more active government intervention.REGULATIONGovernment’s first response to the need for intervention to address environmentalexternalities was to regulate. Electric utilities that burned high-sulfur coal wouldnot be allowed to emit sulfur dioxide into the atmosphere. They would be requiredto install scrubbers, read more..

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    damage, since it often would not allow those technologies to be used, even if theydid a better job.1Moreover, politics inevitably intrudes into the setting of regulations, resultingin higher than necessary costs. High-sulfur coal producers worried that the costof scrubbers would put them at a competitive disadvantage relative to low-sulfurcoal producers. (This is the correct market outcome from the viewpoint of eco-nomic efficiency, because the social cost of high-sulfur coal—including its read more..

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    at cost and benefit, encouraging government to undertake regulations only whenbenefits exceed costs, and to focus on those areas where environmental risks aregreatest. These principles, supported by most economists, would seem to be unex-ceptionable, and are in fact reflected in presidential Executive Orders issued toguide the implementation of regulations. But some environmentalists take a “purist”stand. They argue that a child’s health should not be submitted to the cold calculusof costs read more..

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    the socially optimal level of production. The tax, t, increases the firm’s costs of pro-ducing steel, shifting up the market supply curve. The new market equilibrium isnow at the socially optimal quantity Qs. The equilibrium price is ps; purchasers ofsteel pay a price that correctly reflects the social cost of producing steel. Doing soensures that the marginal benefits are set equal to the marginal costs. Steel-producing firms receive the market price less the tax, ps – t, an amount that read more..

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    Case in PointREDUCING ACID RAINForests throughout the northeastern United States and Canada have been dam-aged by acid rain—that is, rain polluted by sulfuric and nitric acids. These acidsresult from the reaction of sulfur dioxide (SO2) and nitrogen oxides in the atmo-sphere. In the United States, coal-fired power plants in the Northeast and Midwestare the primary sources of the SO2 that contributes to acid rain. The Clean Air ActAmendments of 1990 established programs to reduce the emissions read more..

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    by 2 units and plant B by 4 units. The total cost is now only $3 + $5 or $8. We haveachieved the same overall reduction in pollution more efficiently by having the plantthat can cut emissions at a lower marginal cost (plant B) cut back the most.If the two plants can participate in a market for permits, plant A would find itadvantageous to purchase a permit from plant B. By cutting back by only 2 unitsinstead of 3, plant A can reduce its costs by $3. Plant B, having sold a permit to plantA, must read more..

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    Internet ConnectionTHE NATIONAL CENTER FOR ENVIRONMENTALECONOMICSThe National Center for Environmental Economics (NCEE)conducts and supervises economic research on environmentalissues. Its Web site is actionURI(www.epa.gov/economics/):www.epa.gov/economics/.Wrap-UpSOLVING THE PROBLEM OF EXTERNALITIESExternalities, which occur when the extra costs and benefits of a transaction arenot fully reflected in the market price, give rise to market failure. Four main solutionshave been proposed and read more..

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    operation causes. Thus, the price he charges will reflect both social and privatecosts. The question of resource depletion now boils down to the question of whetherhis bauxite is worth more to him in the market today or left in the ground for futureextraction. The answer depends on how much the owner of the bauxite thinks it willbe worth in the future, say thirty years from now. If the owner expects it to be suf-ficiently more valuable thirty years from now to compensate him both for waiting read more..

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    e-InsightINFORMATION AND THE ENVIRONMENTIn addition to employing regulation and taxation, some gov-ernments have sought to control pollution by requiring firmsto disclose the type and level of toxic substances they are emit-ting into the air or water. Such information disclosure hasproved to be extremely effective. Pressure brought by localcommunities, and worries on the part of firms about acquir-ing a bad reputation, have induced polluting firms to reducetheir levels of emissions. In this read more..

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    Review and PracticeSUMMARY1. Government may have a role in the economy when mar-kets fail to produce an efficient outcome. When positiveor negative externalities exist, markets will not providean efficient outcome.2. One way to deal with externalities is to assign clear-cutproperty rights.3. Governments may deal with environmental externalitiesby imposing regulatory measures (the command andcontrol approach), levying taxes and granting subsidies,or issuing marketable permits.4. In a perfect read more..

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    might you envision occurring if no smoking is allowedunless all the nonsmokers agree to allow it?5. The following table gives the demand for water for twohouseholds, the Joneses and the Lopezes. Suppose thesetwo households are the only ones in the market. Drawthe individual demand curves for each household andthe market demand curve. If the total quantity of wateravailable is 80 units, what price would equate demandand supply?Assume the local water authority has set the priceat 3. Now suppose read more..

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    Learning GoalsIn this chapter, you will learnHow international trade canbenefit all countriesThe role comparative advan-tage plays in determiningwhat countries produce and tradeWhy countries erect bar-riers to trade and who thewinners and losers are when international trade isrestrictedWhy international tradeagreements are often controversial4321 read more..

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    Chapter 19INTERNATIONALTRADE AND TRADEPOLICY∂Exchange was one of the core concepts in economics discussed in Chapter 1.Economists often use the words trade and exchange interchangeably. WhenChip goes to work, he exchanges, or trades, his labor services for income.When Juanita purchases a new cell phone, she exchanges, or trades, income for theproduct she chooses. The subject of international trade—the exchange of goods andservices across national borders—is an extension of the basic read more..

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    INTERDEPENDENCE IN THE PRODUCT MARKETForeign-produced goods are commonplace in U.S. markets. In the 1990s, for instance,more than one-fourth of the cars sold in the United States were imported (importsare goods produced abroad but bought domestically), along with a third of apparelitems, a third of the oil, and virtually all the diamonds. Many of the materials essen-tial for the U.S. economy must also be imported from abroad. At the same time,American farmers export almost two-fifths of the read more..

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    relative to the size of the population, has slowed since its peak a century ago, millionsstill arrive each year. The nations of Europe have increasingly recognized the benefits that result fromthis international movement of workers. One of the most important provisions ofthe treaty establishing the European Union, an agreement initially among most of the countries in western Europe but now extended to include many in easternEurope, allows for the free flow of workers within the member countries. read more..

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    newspaper columnists, union leaders, and business executivescomplain that because the United States imports more from aparticular country (often China or Japan) than it exports to thatcountry, the trade balance is “unfair.” According to a misguidedpopular cliché, “Trade is a two-way street.” But trade in theworld market is a complex network involving hundreds of pos-sible streets. While the overall U.S. trade deficit raises legiti-mate concerns, there is no reason why U.S. exports and read more..

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    Japan, it takes 15 times as many hours (120/8) to produce a computer as a ton ofwheat; in the United States, it takes 20 times as many hours (100/5) to produce acomputer as a ton of wheat. While Japan has an absolute disadvantage in producingcomputers, it has a comparative advantage.The principle of comparative advantage applies to individuals as well as countries.The president of a company might type faster than her secretary, but it still pays tohave the secretary type her letters, because the read more..

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    10,000 more garments can be produced. If the United States at the same timeincreases its airplane production by 100 from E to E′′, it will produce only 1,000fewer garments. In the new situation, the world production of airplanes isunchanged (100 + 300 = 200 + 200), but world production of garments has increasedby 9,000 (the difference between 20,000 + 9,000 and 10,000 + 10,000). So long asthe production trade-offs differ—that is, so long as the marginal rates of trans-formation differ—it read more..

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    e-InsightTHE UNITED STATES’ COMPARATIVE ADVANTAGE IN THEINTERNET AGEThe United States holds a comparative advantage in informa-tion technology and Internet-based commerce. Large U.S. firmssuch as Microsoft, Intel, and Sun Microsystems have led thesurge in information technology over the past two decades,and Internet-based businesses such as Amazon, Google, andeBay have come to define the so-called new economy. How hasthe United States established itself as a leader in this field?Let’s read more..

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    Limits of Specialization The extent of the division of labor, or specialization,is limited by the size of the market. Specialization has greater scope in mass-produced manufactured goods like picture frames than in custom-made items likethe artwork that gets framed. That is one reason why the costs of production ofmass-produced goods have declined so much. Similarly, there is greater scope forspecialization in a big city than a small town. That is why small stores specializingin a particular read more..

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    has a comparative advantage in fine lace; its workers have developed the requisiteskills. A quirk of fate might have led Belgium to acquire a comparative advantagein watches and Switzerland in lace.Specialization Earlier we saw how comparative advantage leads to specializa-tion. Specialization may also lead to comparative advantage. The Swiss make finewatches, and have a comparative advantage in that market because of years ofunique experience. Such superior knowledge, however, does not explain read more..

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    Thinking Like an EconomistEXCHANGE AND THE GLOBALIZATION CONTROVERSYIn recent decades, transportation and communication costshave come down markedly. So too have artificial barriers tothe movements of goods and services—trade barriers such astariffs and quotas. The result is that the economies of the worldare now more closely integrated than ever before.From an economic perspective, this trend toward global-ization would seem to offer a great benefit to the world. As weknow, one of the core read more..

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    tention, we have to recognize that it does not refute the basiceconomic principle about the benefits of voluntary exchange.A further criticism of globalization maintains that someindividuals are actually made worse off. Can this be? The answeris yes, and an example helps illustrate the point. The theory ofcomparative advantage says that countries should produce thegoods that they are relatively good at producing. But when theyare protected from foreign competition, firms may producegoods that read more..

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    Opponents of free trade are not swayed by these arguments,but instead stress the costs to workers and communities as partic-ular industries shrink in response to foreign imports. The textileworker in North Carolina who loses his job as a result of imports ofinexpensive clothing from China cannot instantly convert himselfinto a computer programmer in California or an aircraft engineerworking for Boeing. But the fact is that jobs are being destroyedand created all the time, irrespective of trade. read more..

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    restrict the importation of goods. Policies directed at affecting either imports orexports are referred to as commercial policies. This and the next section examinethe forms that trade barriers take, their economic costs, and their economic andpolitical rationale. The final section explores international attempts to reduce them. There are five major categories of trade barriers—tariffs, quotas, voluntaryexport restraints, other nontariff barriers, and a set of so-called fair trade laws that,by read more..

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    of resources resulting from the cost of domestic production exceeding the costs of purchasing the good abroad, as the economy expands production because of the tariff.QUOTASRather than setting tariffs, many countries impose quotas—limits on the amount offoreign goods that can be imported. For instance, in the 1950s, the United Statesimposed a quota on the amount of oil that could be imported, and until 2005 strictquotas controlled imports of textiles.Producers often prefer quotas. Because the read more..

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    OTHER NONTARIFF BARRIERSVERs and quotas are the clearest nontariff barriers, but today they are probablynot the most important. A host of regulations have the same effect of imposing bar-riers to trade. For instance, health-related regulations have been abused in waysthat restrict trade. When, in 1996, Russia threatened to halt U.S. exports of chick-ens on the grounds that its health regulations were not satisfied, U.S. chickenexporters were faced with a nontariff barrier. Various types of read more..

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    Antidumping Laws Dumping refers to the sale of products overseas atprices that are not only lower than those in the home country but below cost.Normally, consumers greet discounted sales with enthusiasm. If Russia is willingto sell aluminum to the United States at low prices, why should we complain? Onepossible concern is that by selling below cost, the foreign companies hope to driveAmerican firms out of business. Once they have established a monopoly position,438 ∂CHAPTER 19 INTERNATIONAL read more..

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    they can raise prices. In such a case, American consumers gain only in the shortrun. In competitive markets, however, this scenario simply cannot occur, for firmswill have no power to raise prices. In almost all of the cases in which dumping hasbeen found, markets are sufficiently competitive that foreign firms have no hopeof establishing monopoly positions.As administered, the antidumping laws are more frequently used as a protec-tionist tool. If dumping is discovered, a duty (tariff) is levied read more..

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    hence producers’ voices are heard more clearly in the political process than are consumers’.There is an important check on firms’ ability to use the political process toadvance their special interests: the interests of exporters, who realize that if theUnited States closes off its markets to imports, other countries will reciprocate.Thus, exporting firms like Boeing have forcefully advocated an international regimeof freer and fairer trade through the kind of international agreements that read more..

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    BEGGAR-THY-NEIGHBOR POLICIESConcerns about unemployment have provided the strongest motivation for protec-tionist policies. The argument is simple: if Americans do not buy foreign goods, theywill spend the money at home, thereby creating more jobs for Americans. Deliberateattempts to increase national output and employment by reducing imports are calledbeggar-thy-neighbor policies, because the jobs gained in one country are at theexpense of jobs lost in another. Such efforts ignore an important read more..

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    Wrap-UpINTERNATIONAL TRADE AND JOBSRestricting imports as a way of creating jobs tends to be counterproductive.It is the responsibility of macroeconomic policy, not trade policy, to maintain theeconomy at full employment.WAGES IN AFFECTED SECTORSBeyond these short-run problems of transition and unemployment, long-run prob-lems may face workers in affected sectors. The United States has a comparativeadvantage in producing goods such as airplanes and high-tech products that requirehighly skilled read more..

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    POLITICAL AND ECONOMIC RATIONALE FOR PROTECTION∂ 443Workers often receive some of these extra profits: particularly when the industries areunionized, they may earn wages far higher than workers of comparable skill employedelsewhere in the economy. After international trade introduces more competition,monopoly and oligopoly profits get competed away. Firms are forced to pay competitivewages—that is, the lowest wage that they can for workers with a given skill.From the perspective of the read more..

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    e-InsightsTRADE LIBERALIZATION IN INFORMATION TECHNOLOGY AND FINANCIAL SERVICESIn recent years, there have been important trade agreementsin information technology (IT) and financial services. This isa distinct change from the past, when trade agreementsfocused on traded goods, such as cars, steel, and textiles. Butthe two areas draw markedly different reactions in many devel-oping countries: while IT liberalization has been welcome,there is extensive opposition to liberalizations in financial read more..

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    parent: everyone can see that it is a subsidy to producers. Economists criticize pro-tection because it is a hidden tax on consumers, with the proceeds transferred toproducers. The lack of transparency encourages industries to spend resources onpersuading government to impose these hidden taxes that benefit themselves. STRATEGIC TRADE THEORYAnother argument for protection is that it can give a country a strategic trade advan-tage over rivals by helping to reduce domestic costs. There may be read more..

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    Brazil won a major WTO case in 2004 against U.S. cotton subsidies. That decision is under appeal; if the United States loses the appeal and then fails to remove its subsidies to cotton farmers, Brazil will be able to retaliate against U.S. exports to Brazil. The Doha Round began in 2001 and almost collapsed in 2003 when delegates fromdeveloping nations walked out in protest over the subsidies that developed nationssuch as the United States and members of the European Union provide to their read more..

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    Environmental and human rights issues were two other prominent areas of intensedebate. Environmentalists and human rights advocates wanted to use trade policy tohelp achieve their objectives. They worried that countries with inadequate protectionsof the environment or of labor rights would be able to undercut American firms, whoselosses would increase pressure within the United States to erode those standards here.The insistence by some on including clauses in trade agreements concerning labor read more..

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    REGIONAL TRADING BLOCSGATT and WTO have made some progress in reducing trade barriers among allcountries. But the difficulties of reaching agreements involving so many parties havemade progress slow. In the meantime, many countries have formed regional tradeblocs, agreeing with their more immediate neighbors not only to eliminate trade bar-riers but also to facilitate the flow of capital and labor. Perhaps the most importantof these is the European Union, the successor to the Common Market, read more..

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    Internet ConnectionTHE WORLD TRADE ORGANIZATIONThe World Trade Organization (WTO) is the global organiza-tion that deals with the rules of trade between nations. TheWTO’s Web siteactionURI(www.wto.org):, www.wto.org, contains material for a range ofusers, from the general public to students, academics, andtrade specialists. It includes introductions to WTO activitiesand a large database of official documents. In recent years,the WTO has become a focus of protest by those opposed to read more..

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    450 ∂CHAPTER 19 INTERNATIONAL TRADE AND TRADE POLICYReview and PracticeSUMMARY1. The benefits of economic interdependence apply to indi-viduals and firms within a country as well as to coun-tries within the world. No individual and no country isself-sufficient.2. The principle of comparative advantage asserts thatcountries should export the goods in which their production costs are relatively low.3. Specialization tends to increase productivity for threereasons: specializing eliminates the read more..

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    9. How is it possible that while there are gains to freetrade, some groups are harmed? Which are the groups in the United States that are most adverselyaffected?10. What are beggar-thy-neighbor policies? What are theirconsequences?11. What is meant by trade diversion versus trade creation?PROBLEMS1. David Ricardo illustrated the principle of comparativeadvantage in terms of the trade between England andPortugal in wine (port) and wool. Suppose in England it takes 120 laborers to produce a read more..

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    Learning GoalsIn this chapter, you will learnHow technological changeand imperfect competitionare linkedAbout the role of patents inpromoting innovationWhy basic research is a public goodHow governments promotetechnological progress4321 read more..

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    Chapter 20TECHNOLOGICALCHANGE∂For much of the twentieth century, the United States has led the world in dis-covering and applying new technologies. Alexander Graham Bell and thetelephone, the Wright brothers and the airplane, Thomas Edison and a hostof electrical devices, for example, are all familiar early success stories. This traditionof innovation and invention continued as Americans came up with products suchas the transistor and the laser. U.S. companies such as IBM, Eastman Kodak, read more..

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    half a millennium of slow progress at best, Thomas Malthus, one of the greatesteconomists of that time, saw population expanding more rapidly than the capacityof the economy to support it. His prediction of declining living standards earnedeconomics the nickname of “the dismal science.” Today, many continue to predict thatthe world economy will be unable to grow faster than the population and that livingstandards must inevitably decline. Such forecasts have been proved wrong over andover read more..

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    e-InsightTHE NEW ECONOMY AND INNOVATIONThe new economy sometimes has been characterized as aninnovation in the process of innovation. Just as the IndustrialRevolution represented a marked change in the way that goodsare produced, the new economy has strikingly changed howideas are produced and disseminated.A century ago, inventors like Edison, Westinghouse, and the Wright brothers, working alone or with a few assis-tants, created innovations that transformed the economy,but in the past hundred read more..

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    Thinking Like an EconomistINTELLECTUAL PROPERTY RIGHTS AND DISTRIBUTIONAs the importance of innovation in the economy has grown,so too has the importance of intellectual property rights.Hence, it was no surprise that the United States pushed forstronger intellectual property protection in the so-calledUruguay Round of the World Trade Organization’s trade nego-tiations, completed in 1994. Many developing countriesobjected to this initiative.The key to understanding this dispute lies in the read more..

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    uncertain about whether it will be allowed to capture the benefits of any new process,machine, or article of manufacture that it produces—then fewer resources will beinvested in research and the production of these innovations.Society has another consideration, however. Producing a new idea may be verycostly, but it needs to be produced only once. Your laptop embodies thousands of newideas, but these ideas do not have to be reproduced each time a new laptop is man-ufactured. The screen, memory read more..

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    turn requires that they possess some degree of monopoly power. Aneconomy in which short- and long-term concerns are appropriatelybalanced is said to have the property of dynamic efficiency.A key provision of the patent law that affects how static efficiencyis weighed against the incentives for innovation necessary for dynamicefficiency is the life of the patent. If the life of a patent is short, then firmscan appropriate the returns from their innovation only briefly. Theythus have less read more..

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    Soon after Henry Ford’s Model T had burst into the American marketplace—itssales rocketed from 58,000 in 1909 to 730,000 in 1916—Ford was taken to court forinfringing upon the patent of George Baldwin Selden, who argued that his patentcovered all self-propelled, gasoline-powered vehicles. Selden tried to force Ford andother pioneers of the automobile industry to pay royalties to him, but Ford success-fully challenged the patent claim. Recently controversies have concerned patentsin genetic read more..

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    Case in PointELI WHITNEY AND THE COTTON GINObtaining a patent does not necessarily guarantee the inventor a return on the dis-covery. Others may “infringe” on the patent—that is, use the idea without payingfor it—forcing the inventor to go to court for redress. The story of Eli Whitney andthe cotton gin provides a famous example.Late in the eighteenth century, the textile mills of England and the northernAmerican states were up and humming, but they seemed always to be short of read more..

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    Because expenditures on R & D are fixed costs, industries withlarge R & D expenditures face declining average cost curves up torelatively high levels of output. We saw in Chapter 6 that firms typ-ically have U-shaped average cost curves. The presence of fixedcosts means that average costs initially decline as firms producemore; but for all the reasons discussed in Chapter 6, there is somelevel of output beyond which average costs increase. When thereare large fixed costs, large firms read more..

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    This is the third reason why technological change and imperfect competition go together: the marginal cost falls as the scale of production (and the experience accumulated) increases. The first firm to enter an industry therefore has an advantage over other firms. Even if some of what the first company has learnedspills over into other firms, not all of it does. Because of the knowledge the first firm has gained, its costs will be below those of potential rivals, and thus it canalways undercut read more..

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    SCHUMPETERIAN COMPETITIONAlthough competition in markets in which innovation is important may not live upto the ideal of perfect competition discussed in Chapter 2, it still can be intense.Competition focuses on producing new products as much as on selling old productsat lower prices. This kind of competition is often referred to as Schumpeterian com-petition, after a great economist of the early twentieth century, Joseph Schumpeter.Schumpeter began his career in Austria (serving from spring to read more..

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    HOW TECHNOLOGICAL CHANGE AFFECTS COMPETITIONR & D spurs competition:R & D impedes competition:R & D provides an alternative to Patents give a single firm a protectedprices as a way for firms to compete; position for a number of years.it is one of the most important arenasfor competition in modern economies.The fixed costs of R & D give largefirms an advantage; thus industries inwhich R & D is important may have few firms.Learning by doing gives a decided advantage to the read more..

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    even the existence of certain materials that exhibit superconduc-tivity at temperatures considerably above absolute zero—cannotbe patented.Second, the marginal cost of an additional individual enjoyinga public good is zero (i.e., consumption is nonrivalrous). Informingan additional person of a basic discovery does not detract from theknowledge that the original discoverer has, though doing so mayreduce the potential profits she might earn from it. Indeed, sharingthe fruits of basic research as read more..

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    home, the U.S. government has spent billions of dollars in an unsuccessful attemptto develop synthetic fuels. Broad-based subsidies, such as R & D tax credits, do notdepend on government selection of particular projects, but their relatively high costto the government makes them controversial. Critics claim that little additionalresearch is generated per dollar of tax revenue lost.In response, supporters of more active involvement of government in R & D claimthat applied research has read more..

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    increasing awareness of the importance of R & D in modern industrial economies hasled some to reconsider this stance.A major argument for change is that cooperation aimed at sharing knowledge andcoordinating research among firms in an industry has the effect of internalizing theexternalities of R & D, thereby providing firms with an incentive to invest. Butantitrust authorities have long worried that cooperation in R & D could easily growinto cooperation in other areas, such as price read more..

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    Technological Change andEconomic GrowthLiving standards in the United States are far higher today than they were one hun-dred years ago. The reason is that productivity—the amount produced by the aver-age worker per hour—has increased enormously. Underlying these increases istechnological change. In the 1970s and 1980s the pace of growth in productivity inthe United States slowed down markedly, from almost 3 percent to around 1 percent.In the latter half of the 1990s, it picked up again, by read more..

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    Review and PracticeSUMMARY1. Ideas are different from the goods envisioned in thebasic competitive model—they are nonrivalrous.2. Industries in which technological change is importantare almost necessarily imperfectly competitive. Patentsare one way the government makes it difficult and costlyfor firms to copy the technological innovations of others.A firm with a patent will have a government-enforcedmonopoly. The expenditures on R & D are fixed costs;when they are large, there are likely read more..

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    inventor disclose the details of the invention. Underwhat conditions might a company (like Coca-Cola)prefer to use trade secrets rather than patents to protect its formulas?4. Why might a company invest in R & D even if it does notbelieve it will be able to patent its discovery?5. Learning by doing seems to be important in the semi-conductor industry, in which the United States andJapan are the main producers. Explain why U.S. andJapanese firms may race to try to bring out new genera-tions read more..

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    ∂∂471Part 5INTRODUCTION TO MACROECONOMICS read more..

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    Learning GoalsIn this chapter, you will learnHow important historicalevents such as the GreatDepression have shaped thefield of macroeconomicsThe three important goals of macroeconomic performanceWhat the key concepts that define core ideas in economics areWhat markets are, and whichare the principal markets thatmake up the economyWhy economics is called ascience, and why economistsoften disagree54321 read more..

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    Chapter 21MACROECONOMICSAND THEECONOMICPERSPECTIVE∂Macroeconomics is the study of the overall economy—not the study ofemployment levels and prices in a particular industry but the study oftotal employment and unemployment and the general level of pricesthroughout the economy. It is also concerned with the effects on the overall econ-omy of government policies. Macroeconomics deals with the aggregate economy. Tobegin to get a sense of the field of macroeconomics, it is useful to start with a read more..

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    Out of this catastrophe, macroeconomics was born. While the science of eco-nomics can be dated to the publication in 1776 of Adam Smith’s The Wealth of Nations,the birth of macroeconomics as a separate branch within economics can be datedto the publication in 1936 of John Maynard Keynes’s The General Theory of Employment,Interest, and Prices. Prior to Keynes’s time, economists had studied the behavior ofthe entire economy and placed special emphasis on understanding the role of moneyand read more..

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    talked of a “jobless recovery.” It was not until 2004 that employment growth fullyrecovered.When the Great Depression hit, it was not confined to the United States. Figure21.2 shows that production declined in all the major industrial economies, with theUnited States and Germany being hit the hardest. We often think of the “global econ-omy” and the close international linkages we have today as uniquely characteristicof the modern world, but the economies of Europe and North America were read more..

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    revert to the conditions of the Great Depression. The late 1940s saw strong growthin economic activity, in part fueled by household spending as Americans moved tothe suburbs, built homes, and had children. During the war years, few consumergoods had been available, purchases of some goods had been rationed, and householdshad been urged to save by buying war bonds to help finance the war effort. Americanswanted to enjoy the return of peace and prosperity by using the incomes they hadearned during read more..

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    Today, a slight rise in the unemployment rate brings demands for the govern-ment to do something to “get the economy moving again.” And for good reason: Intoday’s economy, when an extra 1 percent of the labor force becomes unemployed,incomes in the economy fall by about $160 billion. A commitment to maintainingfull employment was absent in the 1930s, or at least there was much less agreementover whether the government could (as well as whether it should) stimulate theeconomy.GETTING THE read more..

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    the 1970s saw unemployment and inflation both rise. During the first half of the1970s, unemployment averaged 5.4 percent, essentially the same level as before theKennedy tax cut; yet as unemployment rose from the low levels of the late 1960s,inflation remained high. Chapter 31 will explain why the unemployment–inflationtrade-off seemed to disappear in the 1970s. Policymakers found themselves confronting very different economic situations from those in the previous decade. One new situation was read more..

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    GOVERNMENT DEFICITS AND TRADE DEFICITSThe economy continued to expand during the rest of the 1980s, and inflation remainedunder control. New macroeconomic issues emerged, however, and the last half ofthe 1980s and much of the 1990s were dominated by concern over two deficits. Onewas the federal government’s budget deficit. Tax cuts and increases in defense spend-ing under President Reagan helped push the budget into deficit, as federal spendingexceeded tax revenues. Little success was achieved read more..

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    The information technology revolution was also having an impact on the distri-bution of income. New technologies increased the demand for better-educated work-ers, which helped increase the incomes of college-educated workers. At the sametime, many manufacturing jobs—jobs that had provided decent wages for workerswith less education—moved overseas as competition forced firms to shift produc-tion to lower-cost locations. The 1990s saw a widening of the income gap between college-educated read more..

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    significant periods of deflation since the Great Depression of the 1930s, and manywere concerned that falling prices would again be associated with depressed eco-nomic conditions. Many pointed to the experience of Japan, where deflation hadaccompanied a decade-long recession during the 1990s. The Federal Reserve underAlan Greenspan had shifted policy in early 2001 to help stimulate economic growthby lowering interest rates, but by 2003, interest rates were almost down to zero, andsome feared read more..

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    Wrap-UpTHREE GOALS OF MACROECONOMIC POLICYRapid growthFull employmentLow inflationA Look AheadOur task, taken up in the next three chapters, is to understand how economistsmeasure the aggregate economy’s performance. How do we measure the aggregateoutput of the entire economy? How do we measure unemployment? How do wemeasure the general level of prices and inflation?In Parts Six to Nine, we will learn about the factors that account for growth,inflation, and economic fluctuations. We also will read more..

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    Review and PracticeSUMMARY1. The three major goals of macroeconomic policy are highand sustainable economic growth, full employment, andlow inflation.KEY TERMSGreat DepressionstagflationdeflationREVIEW QUESTIONS1. What trade-off between inflation and unemployment didPresident Kennedy’s Council of Economic Advisorsbelieve they faced? What happened to inflation andunemployment after the 1964 tax cut?2. What is stagflation? When has the United States experienced stagflation? 3. When has the read more..

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    Learning GoalsIn this chapter, you will learnWhat gross domestic product (GDP) isThe three ways we can measure GDPThe difference between nominal and real GDPHow the unemployment rate is measuredThe four types of unemploymentWhat the natural rate of unemployment isWhat Okun’s Law tells us7654321 read more..

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    Chapter 22MEASURINGOUTPUT ANDUNEMPLOYMENT∂Every month, when the United States Bureau of Labor Statistics releasesits latest figures on the unemployment rate, newspapers and the radio andTV news give them significant coverage. The same is true when new dataon economic growth become available. Measures of unemployment and of growthin the economy are yardsticks that are used to gauge economic performance. Suchyardsticks help analysts judge how successful economies have been in achievingsuch read more..

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    GROSS DOMESTIC PRODUCTThe output of the economy consists of millions of different goods and services. Wecould report how much of each good or service the economy produced. This wouldyield a list that might include 1,362,478 hammers, 473,562,382 potatoes, 256,346 heartoperations, and so forth. Such a list might be useful for some purposes, but it wouldnot provide us with the information we want. If the following year the number ofhammers produced goes up by 5 percent, the potato crop yield goes read more..

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    Nominal vs. Real GDP There is one problem with using money as a meas-ure of the economy’s output. The value of a dollar changes over time. Candy bars,books, movie tickets, hammers, and heart operations all cost more today than theydid ten years ago. We do not want to be misled into believing the economy is pro-ducing more when, in fact, prices may simply have risen. In our example from Table22.1, for instance, one of the reasons why GDP was higher in year 2 than in year 1was that the prices of read more..

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    deflator. As we have already seen, nominal GDP reflects changes in prices and quan-tities, while real GDP is a measure of how much quantities have changed. Real GDPcan be defined by the equationIf nominal GDP has risen by 3 percent in the past year but prices have also risen by3 percent, then real GDP would be unchanged. Since we have calculated nominalGDP and real GDP for the economy of Tables 22.1 and 22.2, we can determine thatthe price index must equal 1.053 (see Table 22.2). This is read more..

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    Internet ConnectionTHE BUREAU OF ECONOMIC ANALYSISThe home page of the Bureau of Economic Analysis can befound at actionURI(www.bea.gov):www.bea.gov. You can find the latest GDP data at this site.MEASURING GDP: THE VALUE OF OUTPUTThe general accounting system we use to measure GDP is called the National Incomeand Product Accounts (NIPA) and is produced by the Bureau of Economic Analysis.In the national income accounts, there are three approaches to measuring GDP(whether real or nominal), each of read more..

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    produced). Some are government purchases. And some of the goods, called exports, goto other countries. If we did not import any goods (that is, buy goods produced inother countries), then GDP would simply consist of goods that went for private con-sumption, private investment, government purchases, or exports. But not all suchgoods are produced in this country. For instance, many consumer electronics and auto-mobiles that individuals purchase are produced in other countries. To calculateGDP read more..

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    Wrap-UpGDP equals consumption plus investment plus government purchases plusexports minus imports.Case in PointIS SOFTWARE A FINAL GOOD OR ANINTERMEDIATE GOOD?Measuring output might seem straightforward when the economy produces cars and wheat and houses, but what happens when it produces ideas? The new technologies and the new economy they have created have forced the econo-mists and statisticians at the Bureau of Economic Analysis to revise the NationalIncome and Product Accounts. Such updates read more..

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    The Value-Added Approach A second way to calculate the value of GDP isto study the intermediate goods directly. The production of most items occurs inseveral stages. Consider the automobile. At one stage in its production, iron ore,coal, and limestone are mined. At a second stage, these raw materials are shippedto a steel mill. A third stage involves a steel company combining these ingredientsto make steel. Finally, the steel and other inputs such as rubber and plastics arecombined by the auto read more..

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    spending represents income for those who produce the new equipment. Thus, the right side of this identity is the total income of all individuals and the govern-ment revenue from indirect taxes. This is an extremely important result, one economists use frequently, so it is worth highlighting: aggregate output equals aggregate income.Differences Between Individual Incomes and National IncomeThe notion of income used to calculate GDP differs slightly from the way individu-als commonly think about read more..

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    POTENTIAL GDPReal GDP is a measure of how much the economy actually produces. But sometimesworkers may not be fully employed, and some plants and equipment may be oper-ating at less than normal capacity. At other times, the economy may produce morethan would normally be sustainable. Firms may put on extra shifts, increase over-time, and delay maintenance in order to temporarily increase output. Another impor-tant macroeconomic measure of real output, potential GDP, indicates what theeconomy read more..

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    MEASURING OUTPUT AND GROWTH∂ 495International PerspectiveWHAT GETS MEASURED IN THE GDP?In the United States, illegal activity is not counted as part ofGDP. If we are trying to get a measure of market economicactivity, excluding occupations like the drug trade means that GDP misses one type of output. For the United States,this omission is unlikely to have a major impact on the use-fulness of GDP statistics. But if illegal activity is a major source of income in a given country, then failing to read more..

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    to have occurred when real GDP falls for at least two consecutive quarters. (For statistical purposes, a year is divided into quarters, each three months long.) Low utilization of capacity, like the unemployment of workers, represents a wasteof scarce economic resources. In recessions the economy operates well below itspotential. Unemployment is high and a large fraction of machines remain idle orunderutilized.Because the difference between the actual level of GDP the economy producesand its read more..

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    Measuring Nonmarket Goods Nonmarket goods and services, such ashousework done by family members, also present problems. The statistics underes-timate the true level of production in the economy, because they ignore such activ-ity. While GDP is designed primarily to measure only market economic activity,there are two important exceptions to this restriction. GDP does include a meas-ure of the value of owner-occupied housing, and it includes the value of homegrownfood consumed by farm families. In read more..

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    we may be able to measure the drop in the otter population, how do we value thisdecline? There is no market price that we can use. And unless we can value thechange in the otter population, the change in old-growth forests, the change in air quality, and the production of cars in a common measure (say dollars), we cannotadd them up to obtain an overall measure of a green GDP. So developing an environmental measure of the economy’s production is inherently problematic. UnemploymentDiscussions read more..

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    ment represents economic hardship. People unemployed for a long time will beunable to meet current expenses—utilities, rent, and so on—and will have to moveto less-expensive housing and otherwise reduce their standard of living. Unemployment not only costs individuals their paychecks, it can deal a power-ful blow to their self-respect, and their families may be forced to choose betweenpoverty and the bitter taste of government or private charity. Many families breakup under the strain. read more..

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    The unemployment rate does not include individuals who are not working but whoalso are not actively seeking a job. Such individuals are not counted as part of thelabor force.Figure 22.2 plots the unemployment rate for the United States since 1960. Thefigure illustrates two facts. First, unemployment is persistent; it has averaged justunder 6 percent since 1960, and the lowest it has been during this period was 3.5percent (in 1969). Second, the level of unemployment can fluctuate dramatically. read more..

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    the U.S. labor force was unemployed. The unemployment rate among those whoworked in manufacturing was even higher—at one point, one out of three workersin manufacturing had lost their jobs.In recent years, unemployment in other countries often was worse than in theUnited States (Figure 22.3). In the 1960s, U.S. unemployment rates exceeded thosein other major industrialized economies; but European unemployment rates rosedramatically during the 1980s and generally now exceed the rate in the read more..

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    Right before Christmas, there is a huge demand for retail salespeople to work indepartment stores and shopping malls across the nation. In many parts of the coun-try, construction slows down in the winter because the weather makes outdoor workimpossible. Conversely, tourism often increases in the summer, as does the numberof jobs that cater to tourists. The supply of labor also increases in the summer, as highschool and college students enter the labor force on a temporary basis. Unemploy-ment read more..

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    Wrap-UpFORMS OF UNEMPLOYMENTSeasonalFrictionalStructuralCyclicalOUTPUT GAPS AND THE NATURAL RATE OFUNEMPLOYMENTEarlier, we defined the output gap as the percentage gap between GDP and poten-tial GDP. When the output gap is zero, real GDP is equal to potential GDP and theeconomy is at full employment. Full employment means not that the total unemploy-ment rate will be zero—there will still be seasonal, frictional, and structural unem-ployment—but that there is no cyclical unemployment. The read more..

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    Figure 22.4 shows that when the output gap is zero, so that real GDP equalspotential GDP, the unemployment rate in the United States is usually around 5.5percent. If real GDP falls below potential GDP and the output gap becomes nega-tive, then unemployment rises above 5.5 percent. This makes sense—when theoutput gap is zero, the unemployment rate should be equal to the natural rate ofunemployment, which, as we have already noted, is usually estimated to be about5.5 percent. Okun’s Law read more..

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    FLOWS AND STOCKS∂ 505Flows and StocksGDP is a measure of output per year. Rate measurements such as these are calledflows. When a financial reporter says, “The quarterly GDP statistic, just released,shows that GDP was $10 trillion per year,” she does not mean that $10 trillion ofgoods and services were produced during the quarter. Rather, the production duringthe quarter was $2.5 trillion; and if that rate were sustained for a whole year, thetotal value of goods and services produced would read more..

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    Review and PracticeSUMMARY1. Gross domestic product (GDP) is the typical way of mea-suring the value of national output. Real GDP adjustsGDP for changes in the price level. 2. GDP can be calculated in three ways: the final goodsapproach, which adds the value of all final goods producedin the economy in a given year; the value-added approach,which adds the difference between firms’ revenues andcosts of intermediate goods; and the income approach,which adds together all income received by those read more..

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    produces two products, lectures and coffee. Output and pricesof these two goods for 2002 and 2003 are given in the table:5. Go to the Web site of the National Income Accounts at theBureau of Economic actionURI(www.bea.doc.gov/bea/dn1.htm):Analysis (www.bea.doc.gov/bea/actionURI(www.bea.doc.gov/bea/dn1.htm):dn1.htm). What is the latest figure on the economy’snominal GDP? On real GDP? What was the growth rateof real GDP during the most recently available quarter?6. Go to the Web site of the read more..

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    Learning GoalsIn this chapter, you will learnThe costs of inflationHow the consumer priceindex is measuredThe recent history of inflationin the United States321 read more..

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    Chapter 23THE COST OFLIVING ANDINFLATION∂In the 1920s, the years of silent pictures, a movie ticket cost a nickel. By thelate 1940s, in the heyday of the Hollywood studios, the price was up to $0.50.In the 1960s, the price of a movie was $2.00, and now it is more than $8.00.This steady rise is no anomaly. Most other goods have undergone similar priceincreases over time. This increase in the general level of prices is called inflation.While unemployment tends to be concentrated in certain read more..

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    receive in the future will be worth less than the dollars they invested, leaving themwith less than enough to live comfortably in their old age. When inflation is anticipated, many of its economic costs disappear. Workerswho know that prices will be rising by 5 percent this year, for example, may negoti-ate wages that rise fast enough to offset inflation. Firms may be willing to agree tothese larger wage increases since they anticipate being able to raise the prices ofthe goods they produce. read more..

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    a variety of transactions, inflation interferes with the efficiency of the economy bydiscouraging its holding. By taking away the real value of money, inflation acts as atax on those who hold money. Economists refer to this distortionary effect as aninflation tax.This distortion is not as important in modern economies, where individuals fre-quently put their money into interest-paying checking accounts instead of keepingtheir cash. As the rate of inflation increases, the interest rate paid on read more..

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    The Costs of DeflationOur focus has been on the costs of inflation—rising prices—since that has been theexperience of the United States and most other countries over the past fifty years.But inflation in many countries declined significantly during the 1980s, and fallingprices—deflation—has in some places become the concern. Japan, for instance,recently experienced several years of falling prices.Many of the costs associated with inflation also make deflation costly. Variabilityin read more..

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    Economic Consequences of the Peace, John Maynard Keynes, then an economic adviserto the British government, warned that the reparations were too large. To pay for someof Germany’s financial obligations, the German government started printing money.The resulting increase in both the amount of circulating currency and the pricelevel can be seen in Figure 23.1. From December 1921 to December 1923, the aver-age price level increased by a factor of 36 billion.1 People made desperate attemptsto read more..

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    Measuring InflationIf the prices of all goods and services rose by the same proportion, say, 5 percent, overa year, then measuring inflation would be easy: the rate of inflation that year wouldbe 5 percent. Difficulties arise because the prices of different goods rise at differ-ent rates, and the prices of some goods even decline. For example, since the years1982–1984, which the United States uses as a base reference period, the price ofapparel rose by 24 percent, the price of medical care by read more..

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    To see how a price index like the CPI is constructed, we can calculate one forBob, who spends all his income on rent, Big Macs, and CDs. Let’s suppose his totalexpenditures during 2003 were $1,500 each month, of which $1,000 went for rent,$200 for 100 Big Macs (which cost $2 each), and $300 for 15 CDs (which cost $20each). In 2004, his rent increases to $1,200 and Big Macs go up in price to $2.25,while the price of a CD falls to $18. What has happened to Bob’s price index? Wewant to know how read more..

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    On average, prices rose 305 percent from 1973 to 2002. Figure 23.2 shows the CPI since1913.Case in PointTHE PRICE INDEX MAKES A DIFFERENCEPrice indexes increasingly have come to play an important role in recent economicdebates. The Social Security benefits of the elderly rise with the cost of living index(the CPI),2 and tax brackets and tax exemptions also change with the index. If theindex overstates the increases in the cost of living, the real benefits (purchasingpower) of the elderly read more..

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    Internet ConnectionTHE INFLATION CALCULATORThe Bureau of Labor Statistics has a handy inflation calcula-tor that allows you to find out how much it costs today to pur-chase goods that cost $100 in some earlier year. For example,it takes $731 today to purchase goods you could have bought for$100 in 1949. Try it out aactionURI(www.bls.gov/cpi/home.htm):t www.bls.gov/cpi/home.htm.The second major problem is “quality adjustment.” New products, which bothoffer new functions and better perform the read more..

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    In Chapter 22 we observed that real GDP is nominal GDP adjusted for the pricelevel. The price index we used for calculating real GDP is called the GDP deflator.It represents a comparison between what it would cost to buy the total mix of goodsand services produced within the country today and what it cost in a base year. Inother words, the GDP deflator is a weighted average of the prices of different goodsand services, where the weights represent the importance of the goods and services in read more..

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    THE AMERICAN EXPERIENCE WITH INFLATION∂ 519RATE OF INFLATION IN CPI (%)1920 1930 1940 1950 1960 1970 1980 1990 200020151050–5–10– 15The inflation rate is the percentage increase in the price level in a given year. Notice thatinflation was low through most of the early part of the last century, although it was highduring both world wars. Inflation rose sharply in the 1970s, and then fell during the1980s. It has remained relatively low since the early 1990s. SOURCE:Bureau of Labor read more..

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    520 ∂CHAPTER 23 THE COST OF LIVING AND INFLATIONnineteenth century, the concern was deflation, which is a steady decline in the pricelevel. Borrowers at that time who were in debt and had not anticipated the fall in pricesfound that the dollars they had to pay back were worth far more than the dollarsthey had borrowed. They were as upset about this as investors (lenders) are wheninflation makes the value of the dollars they get back from an investment or loanworth less than the value of the read more..

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    REVIEW AND PRACTICE∂ 521Review and PracticeSUMMARY1. The inflation rate is the percentage increase of the pricelevel from one year to the next. 2. The economy-wide costs of inflation are related to thedistortions that inflation creates in relative prices and inthe increased risk and uncertainty it generates.3. The consumer price index (CPI) is a measure of the costof living for the typical household. The rate of change ofthe CPI is one of the most common measures of inflation. 4. U.S. read more..

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    ∂∂523PPaarrtt 66FULL-EMPLOYMENTMACROECONOMICS read more..

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    Learning GoalsIn this chapter, you will learnHow full employment isachieved in marketeconomiesThe factors that determinereal wages, output, and thereal interest rate at full employmentThe role that the capital mar-ket plays in maintaining fullemployment321 read more..

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    Chapter 24THE FULL-EMPLOYMENTMODEL∂Every year, about 1.7 million Americans enter the labor force. Creating jobsfor these workers is critically important for the health of the economy andfor the general welfare of society. With so many new workers each year, itmay seem amazing that market economies like that of the United States are able tocreate employment opportunities for almost all who seek them. Between 1955 and2000, for example, the American labor force grew by 117 percent, almost 76 read more..

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    chapter will be used in Chapter 25 to understand the implications of the large budget deficits that the U.S. government is currently running. Chapter 26 will ex-plore the role of international financial markets, the economy’s trade balance, andexchange rates, while Chapter 27 will focus on the factors that account for long-run economic growth. But to organize our discussion of these important economictopics, we will need a model that explains how the adjustment of real wages and the real read more..

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    In macroeconomics, we stress aggregates—the economy’s total output, rather thanthe output of individual industries or types of goods and services. We examine totalemployment, and average wages. In looking at these aggregates, we ignore the rich-ness of the microeconomic detail that captures the thousands of different productsthat the economy produces and the many characteristics that differentiate oneworker from another. The basic premise of macroeconomics is that we can learn agreat deal read more..

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    Wrap-UpREAL WAGESThe real wage is the nominal or dollar wage adjusted for prices. Workers care about the real wage that they receive because it measures the purchasing power of their wages.Firms care about the real wage because it measures the cost of labor.Figure 24.2 shows the aggregate labor market, with the real wage (w/P) on thevertical axis, the quantity of labor (L) on the horizontal axis, and the aggregatedemand and supply curves for labor. With a given set of equipment and read more..

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    duction and hire more workers. Second, as wages fall relative tothe cost of machines, it pays firms to substitute workers formachines. Thus, the demand curve for labor slopes down, as shownin the figure.The two reasons for the negative slope of the aggregate labordemand curve stress the importance of wages relative to the costsof other inputs and the price of the output being produced. Ifwages fall and all other prices in the economy also fall in proportion,the demand for labor will not change. read more..

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    outnumber old people retiring, because of new immigrants, orbecause of social changes such as the entry of more women intothe labor force. For example, the U.S. labor force expanded rap-idly in the 1970s as the baby boomers entered the labor force andmore and more women worked outside the home. The conse-quences of such a large shift in the labor supply curve are depictedin Figure 24.3. The supply curve of labor (shown here as vertical)shifts to the right. At each real wage, there are more read more..

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    Technological change or new investment increases the demand for labor (shifts thelabor demand curve to the right) at each real wage and increases the equilibriumreal wage. Increases in labor productivity increase aggregate labor demand andcause the equilibrium real wage to rise.Case in PointMASS MIGRATION IN THE NINETEENTHCENTURYThe nineteenth century provides a case study in how labor markets adjust to changesin labor supply. Between 1820 and 1920, 60 million emigrants left Europe for theNew read more..

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    inducement for workers to migrate from Europe to areas offering higher livingstandards.The mass migrations of the late nineteenth century shifted the North Americanlabor supply curve to the right and the European labor supply curve to the left. Ourtheory predicts that wages adjust to balance the quantity of labor demanded andthe quantity of labor supplied. Real wages needed to fall in the United States and rise in Europe in response to these shifts in labor supply.Did this adjustment of wages read more..

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    capital markets to ensure that the demand for goods equals the economy’s output whenit is at full employment.POTENTIAL GDPAt any point in time, the economy has a given capital stock (a set ofmachines, equipment, and buildings) that, together with labor and mate-rials, produces output. If more workers are hired, output increases. Therelationship between employment and output with a fixed amount ofcapital is called the short-run aggregate production function, depictedin panel Aof Figure 24.5. read more..

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    DEMAND AND EQUILIBRIUM OUTPUTFor the product market to be in equilibrium, the supply of goods and services pro-duced by firms in the economy must balance with the demand for the economy’sgoods and services. Firms will not continue to produce at the full-employment levelif their products go unsold. If the economy is to maintain full employment, the totallevel of demand in the economy must adjust to balance output at full employment.The economy’s financial sector—what we called the capital read more..

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    to firms and in return receive payments for those resources. We have already learnedin Chapter 22 that these income payments will equal the value of total production.This means that the household sector receives enough income to purchase all thegoods and services that firms have produced.Of course, households do not choose to spend all their income on goods and serv-ices; they save part of it. In our circular flow diagram, this action is shown by theflow of saving to the financial capital read more..

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    The Capital MarketWhen households save, they make funds available to borrowers. Whenever firmsundertake investment, they need to borrow.5 The financial capital market is themarket in which the supply of funds is allocated to those who wish to borrow. Forthis reason, it is also called the loanable funds market. In a closed economy withno government sector, equilibrium in the capital market requires that savings (thesupply of funds) equal investment (the demand for funds). Our analysis of read more..

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    est rate (perhaps rising slightly with it). For the sake of simplicity, then, we will oftenassume saving is completely inelastic—that is, it does not change at all as the realinterest rate varies. In this case, changes in the real rate of interest do not lead to anychange in saving. This results in a vertical saving function, as shown in Figure 24.7.The assumption that saving does not respond to changes in the real interest ratemight seem to be inconsistent with one of our key economic read more..

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    the firm could have obtained if, instead of making an investment, it had simplydecided to lend the funds to some other firm.The investment function gives the level of (real) investment at each value of the real rate of interest. The investment function slopes downward to the right;investment increases as the real interest rate decreases. This is depicted in Figure24.7, which shows the real interest rate on the vertical axis and the level of real invest-ment on the horizontal axis.Wrap-UpSAVING read more..

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    When the real interest rate adjusts to balance demand and supply in the capitalmarket, saving will equal investment. We can express this same result by sayingthat when the capital market is in equilibrium, leakages from the spending streamequal injections. This was the condition needed to ensure that the product marketwas in equilibrium. Therefore, the capital market plays a critical role in ensuringproduct market equilibrium.Wrap-UpCAPITAL MARKET EQUILIBRIUMIn long-run equilibrium, full read more..

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    The General Equilibrium ModelWe can now describe the general, long-run equilibrium of the economy. General equi-librium is a situation in which all the economy’s markets are in balance—the labor,product, and capital markets all clear. General equilibrium in the full-employmentmodel occurs when employment and the real wage have adjusted to ensure that the labor market is in equilibrium at full employment, output is equal to potential GDP,and the real interest rate is at the level ensuring read more..

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    USING THE GENERAL EQUILIBRIUM MODELThe general equilibrium model is useful because it enables us to understand theeffects of various changes in the economy—from the market in which these changesoriginate to all the other markets in the economy.Consider the effects on the economy of the introduction of personal computers.By making workers more productive, personal computers increase the marginalproduct of workers. This change increases the quantity of labor demanded at eachreal wage, causing a read more..

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    We have used the full-employment model to analyze the impacts of two impor-tant changes in the economy: those associated with the introduction of a new tech-nology (personal computers) and those associated with a change in the labor force.To focus on the effects each would have, we studied each change in isolation, assum-ing that nothing else was changing. In fact, both effects have been at work for morethan thirty years. Both have combined to expand employment and raise potentialGDP. Since the read more..

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    REVIEW AND PRACTICE∂ 543Review and PracticeSUMMARY1. Macroeconomic equilibrium focuses on equilibrium levels of aggregates: employment, output, saving, andinvestment.2. The real wage equates the demand for labor with thesupply of labor. Increases in labor supply at each realwage are reflected in lower real wages, which inducefirms to create additional jobs to match the increases in supply.3. The full-employment level of output is that level ofoutput which the economy can produce with its read more..

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    2. An increase in capital resulting from an increase ininvestment allows a given number of workers to pro-duce more. Show the effect on the short-run productionfunction and the full-employment level of output.3. Trace through how the effects of a change in onemarket—such as an increase in the supply of labor—have effects on other markets. How was it possible forthe labor supply to increase markedly, as occurredduring the 1970s and the 1980s, with relatively littlechange in real wages?4. The read more..

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    Learning GoalsIn this chapter, you will learnThe composition of gov-ernment expenditures and revenues in the UnitedStatesHow government deficits and surpluses affect the capital marketHow the government affectsthe economy’s full-employmentequilibriumThe consequences of fiscaldeficits and surpluses for out-put, investment, and futuregenerationsThe recent experiences withdeficits and surpluses in theUnited States54321 read more..

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    Chapter 25GOVERNMENTFINANCE AT FULLEMPLOYMENT∂News stories are filled with debates over government spending and tax poli-cies. In the United States, the federal government spends more than $2 tril-lion each year on everything from national defense to Social Security tonational parks to health and education. State and local governments spend another$1.5 trillion on schools and a variety of services, including police, fire, and health.To pay for these expenditures, governments levy taxes and, read more..

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    government to our full-employment model, we will learn how government decisionsabout taxes and spending affect the full-employment economy. The chapter concludes with a discussion of some of the major budgetary issues facing the U.S. federal government. The Composition of Spending and TaxesThe federal government spends more than $2 trillion per year. This total can bedivided into two basic categories: discretionary spending and nondiscretionaryspending. Discretionary expenditures—which include read more..

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    Adding the GovernmentIntroducing government into the analysis affects both the product market and thecapital market. In the product market, the government has an impact on the econ-omy in two ways. First, the government’s purchases of goods and services producedby firms affect demand in the product market. Second, taxes subtract from demandin the product market because they reduce disposable income, lowering consump-tion spending.1 In the capital market, governments affect the economy if they read more..

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    When the government runs a deficit, private saving (Sp) takes on two purposes—to finance private investment (I ) and to finance the government’s deficit (G− T ).Equilibrium in the capital market occurs when private saving is equal to investmentplus the deficit, orSp = I + (G− T ).Alternatively, we can think of the deficit as negative public government saving (Sg):G− T=−Sg.550 ∂CHAPTER 25 GOVERNMENT FINANCE AT FULL EMPLOYMENTGovernmentProduct read more..

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    From this perspective, the first equation can be rewritten asSp = I − Sg,orSp + Sg = I.The left side is called national saving, the combined saving of the pri-vate (households and businesses) and public (government) sectors.When the capital market in a closed economy is in equilibrium, nationalsaving equals investment.The effect in the capital market of a government deficit is illus-trated in Figure 25.4. The investment schedule is downward sloping.Saving is assumed to be unresponsive to the read more..

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    The Effects of Changes in Taxes While we have focused on changes inexpenditures, the same analysis enables us to understand how the economy wouldbe affected by a tax cut not balanced by a cut in government expenditures. A taxcut increases households’ disposable income. To make the example concrete, sup-pose taxes are reduced by $100 billion. As a result, disposable income rises by thefull $100 billion that households no longer need to pay to the government as taxes.They will use this read more..

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    revenues match expenditures. In 1998, for example, both U.S. federal governmentreceipts and expenditures were roughly $1.7 trillion. Now suppose that the govern-ment increases its expenditures, say, by $100 billion. To pay for these expenditures,suppose the government increases taxes by an equal amount. We would describethis as a balanced budget change in taxes and expenditures. Since both expendituresand revenues increase by the same amount, the government’s overall budget remainsin balance. read more..

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    economy has in the future, thereby lowering full-employment income in the future.When we discuss economic growth and productivity in Chapter 27, we will considersome types of government expenditures and taxes that might affect the discoveryof new technologies, the productivity of capital, and the demand for labor by firms. When we deal with these policies, we will need to investigate their impact onpotential GDP.LEAKAGES AND INJECTIONSWe have focused our discussion of government deficits on the read more..

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    ADDING THE GOVERNMENT∂ 555International PerspectiveDEFICITS IN OTHER COUNTRIESWhen the United States ran a huge budget deficit during the1980s, it was not alone. Most other major economies also wit-nessed the same problems of deficits and growing governmentdebt. The figure shows estimates from the InternationalMonetary Fund (IMF) of the “structural” budget deficit as apercentage of potential GDP for the United States, Japan, andother major industrialized economies (Canada, France,Germany, read more..

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    Wrap-UpGOVERNMENT DEFICITS AND SURPLUSESGovernment expenditures and taxes affect the capital market.Increases in taxes reduce disposable income, and thereby decrease private saving.The equilibrium real interest rate is higher and private investment is lower. When the government spends more than it receives in revenue, it must borrowto finance its deficit. A deficit reduces public saving, leading to higher real interestrates and lower private investment. The lower the level of private investment, read more..

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    investment increases the capital stock, thereby increasing potential GDP in the future.Evaluating Government Deficitsand SurplusesWe have seen that government deficits and surpluses have significant impacts.Deficits reduce national saving, increase the real interest rate, and reduce invest-ment, and surpluses have the opposite effect. But while our analysis tells us what theconsequences of deficits and surpluses are, it does not tell us whether governmentsshould or should not run read more..

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    interest rate reduces investment. As we will see in Chapter 27, lower investment inthe present can reduce economic growth in the future, leading to lower incomesand consumption. Reducing the deficit or actually running a surplus has the opposite effect. Itallows the real interest rate to fall, stimulating private investment and thereby promoting economic growth and better living standards in the future.Wrap-UpCONSEQUENCES OF GOVERNMENT DEFICITSIf the government runs deficits, Some of the burden read more..

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    GOVERNMENT DEFICITS AND SURPLUSES: OUR RECENT EXPERIENCES∂ 559The Federal Deficit–300–200–100010020030040019601965197019751980198519901995BILLIONS ($)2000The Federal Deficit as a Percentage of GDPAB–2–3–1032145619601965197019751980198519901995PERCENT2000Federal borrowing increased dramatically between 1975 and the early 1990s, fell sharplyin the late 1990s, and rose steeply again after 2000. Panel Ashows the nominal deficit;panel Bshows the deficit as a percentage of nominal read more..

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    560 ∂CHAPTER 25 GOVERNMENT FINANCE AT FULL EMPLOYMENT19451940195519501965The Federal DebtThe Federal Debt as a Percentage of GDPAB19601975197019851980199519902000406080100120PERCENT20019451940195519501965196019751970198519801995199020001,0001,5002,5002,0003,5003,0004,0004,500BILLIONS ($)5000Figure 25.6THE FEDERAL DEBTThe federal debt fell after World War II and rose rapidly after 1982 (panel A). Expressingthe debt relative to GDP, panel Bshows that the debt reached a peak relative to the read more..

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    collected fell; Congress passed a large tax cut in 2001 (followed by another in 2003);and the war on terrorism led to a rise in federal government spending.Panel Aof Figure 25.6 shows the U.S. federal debt, the accumulated effect of pastdeficits. The deficits of the 1980s and 1990s pushed the federal debt to record peace-time levels. Debt was reduced during 1998 to 2001 as the government enjoyed budgetsurpluses. Panel Bshows the debt as a percentage of GDP to adjust for the inflationand real read more..

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    for 2004. As of 2005, it was clear that the government, instead of running a surplusin 2004, saw the deficit soar above $400 billion. One reason budget projections often turn out wrong is that in making its calcu-lations the CBO, by law, must assume there will be no changes in tax or expenditureprograms. Yet these programs do change, partly in response to the CBO’s figures.In the 1990s, the large projected deficits led Congress to change taxes and curbgrowth in expenditures; in 2000, with the read more..

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    REVIEW AND PRACTICE∂ 563Review and PracticeSUMMARY1. When the government runs a deficit or a surplus, the cap-ital market is affected. If there is a deficit, the governmentmust borrow in the capital market to finance the deficit. 2. In the full-employment model, an increase in govern-ment expenditures matched by an increase in taxesreduces disposable income. This drop, in turn, reducesboth consumption and saving at full-employmentoutput. Saving decreases, the equilibrium real interestrate read more..

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    564 ∂CHAPTER 25 GOVERNMENT FINANCE AT FULL EMPLOYMENT(a) Assume the government reduces income taxes.What is the total impact on national saving, tak-ing into account the reduction in the surplus and the change in private saving? What is the impact on investment? (Hint: How does your answerdepend on the sensitivity of saving to the interestrate?)(b) Assume the government increases expenditures.What is the total impact on national saving, takinginto account the reduction in the surplus and read more..

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    Learning GoalsIn this chapter, you will learnThe role of the capital marketin an open economyHow the net exports and in-ternational capital flows arerelatedWhat exchange rates are, howthey are determined, and howthey affect the trade balance321 read more..

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    Chapter 26THE OPENECONOMY AT FULLEMPLOYMENT∂Modern economies are open economies—actively engaged in interna-tional trade and linked to international financial markets. The increas-ing globalization of the world’s economies, and what it means forindividual countries and their citizens, has occasioned often strident political debate.Because it is part of the global economy, the United States is affected by, and in turnaffects, international economic developments. A financial crisis abroad read more..

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    exports and imports. Finally, we will discuss how the value of the dollar relative toother currencies is determined in foreign exchange markets, and how the dollar’svalue affects U.S. exports and imports.The Open EconomyGlobalization and the increasing integration of the world economy are topics encoun-tered in the news all the time. Whether at our local auto dealer, computer store, orgrocery store, we find goods produced in many other countries. Financial markets,too, are global in nature. read more..

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    domestic economy is borrowing more from foreigners than it is lending to foreigners.In 2002, for example, national saving in the United States totaled $1.54 trillion (of whichprivate saving was $1.57 trillion and government saving was –$30 billion), while privateinvestment was $1.93 trillion. The difference between investment and national savingwas $390 billion, which was financed by a net capital inflow. Because this investmentwas financed by borrowing from abroad, it represents the amount read more..

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    matched by an equal increase in taxes likewise differs in the two economies. In aclosed economy, increased taxes reduce national saving, and hence reduce investment(see Figure 7.4 on p. 159). In a small open economy, investment is unchanged. Thefall in domestic national saving is fully offset by increased borrowing from abroad(resulting in a net capital inflow).We showed in Chapter 25 that in a closed economy, an increase in governmentexpenditures not matched by an increase in taxes reduces read more..

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    The discussion so far has also assumed that the world’s capital markets are fullyintegrated. However, this is far from the truth. Individuals know more about whatis going on in their own country than about what is going on abroad. Americaninvestors require slightly higher returns on foreign investments to compensate for this increased risk. In recent years, as the flow of information has increased, the magnitude of this risk premium—the extra return they must earn for taking the risk of read more..

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    The Basic Trade IdentityThe capital market balances saving and investment. In doing so it balances leak-ages and injections from the spending stream, ensuring that aggregate spendingequals potential GDP at full employment. In Chapter 25, we showed that this equa-tion remains valid when the government is added to the basic full-employment model.The same continues to hold true for an open economy. Reexamining the connectionbetween capital market equilibrium and aggregate spending in an open read more..

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    Internet ConnectionU.S. TRADE DATAYou can find the latest data on U.S. foreign trade, from infor-mation on the overall trade balance to the specifics of our tradewith individual countries, aactionURI(www.ita.doc.gov/td/tic/):t www.ita.doc.gov/td/tic/.to be a simple matter: the buyer pays American dollars to a car dealer. The cardealer buys the car—in dollars—from an importer. The importer buys the car fromthe German manufacturer, who wants to be paid in euros. For the importer, this isno read more..

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    country exported more than it imported. Europe and Japan did not receive enough dollars from selling exports to the United States to buy the imports theydesired, and they borrowed the difference from American households and firms.There was a net capital outflow from the United States that gradually accumu-lated. Japan now exports more than it imports, with the difference equal to itscapital outflow.The basic trade identity implies that if U.S. public saving and investment areunchanged and read more..

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    1982, it soared (in nominal terms) to $142 billion in 1987. It then fell to $20 billion in1991 before ballooning again, reaching $609 billion (5 percent of GDP) in 2004.Figure 26.2 shows the trade and federal budget deficits. The two have often movedtogether. This is no accident; we have already noted that for an open economy, anincrease in the government’s deficit results in increased foreign borrowing if domes-tic saving remains constant. But it is important to note that while the trade and read more..

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    e-InsightHIGH-TECH EXPORTS AND IMPORTSThe United States has emerged as the international leader inmany aspects of the new information and computer technolo-gies. Silicon Valley in northern California, home to such firmsas Intel, Apple, Sun Microsystems, and Google, has becomesynonymous with the information-based economy. We thusmight naturally expect the United States to be a major ex-porter of computer-related products. The figure shows theamount, in millions of dollars, of computer-related read more..

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    SOURCE:U.S. Census Bureau.EXCHANGE RATESIf a country borrows more (or less) from abroad, what ensures that net exportsadjust? The answer is the exchange rate. The exchange rate tells how much of onecurrency can be bought with a given amount of another currency. For instance, in2004, one dollar could be exchanged for approximately 108 Japanese yen. Exchangerates may change rapidly. In August 1998, a dollar could buy 144 yen. But in January1999, it could buy only 113 yen. This represents a 21 read more..

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    578 ∂CHAPTER 26 THE OPEN ECONOMY AT FULL EMPLOYMENTcountries. So, for example, the U.S. dollar–Canadian dollar exchangerate is given more weight in the measure than is the U.S. dollar–NewZealand dollar exchange rate because the United States engages inmuch more trade with Canada. Figure 26.4 shows the trade-weightedvalue of the U.S. dollar.Thus, the exchange rate is a price—the relative price of two cur-rencies. Like any price, the exchange rate is determined by the laws ofsupply and read more..

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    Thinking Like an EconomistNET EXPORTS AND THE EXCHANGE RATEIncentives matter, and that is why the balance between exportsand imports is affected by the exchange rate. Consumers havechoices—for most goods, they can buy a brand produced inthe United States, or they can buy a brand produced abroad.Similarly, firms may purchase the inputs they need for production from domestic suppliers or from foreign suppli-ers. In making choices, consumers and firms alike will respondto the incentives provided read more..

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    580 ∂CHAPTER 26 THE OPEN ECONOMY AT FULL EMPLOYMENTto the right, as depicted in Figure 26.6. The higher U.S. interest rates also will makeJapanese investments relatively less attractive to American investors, who willtherefore increase their investments at home. Americans will be willing to supplyfewer dollars at each exchange rate, shifting the supply curve for dollars to the left.These shifts in the supply and demand curves for dollars cause the exchange rateto rise from e0 to e1—the read more..

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    IS THE TRADE DEFICIT A PROBLEM?∂ 581Trade deficits mean the country is borrowing from abroad. As is true of bor-rowing from any other source, such borrowing can be sensible or not depending onits reason.In its first century, this country borrowed heavily from abroad. By contrast, formost of the twentieth century, the United States lent more money to foreign coun-tries and investors than it borrowed. This pattern is typical. In the early stages of eco-nomic development, countries borrow to read more..

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    582 ∂CHAPTER 26 THE OPEN ECONOMY AT FULL EMPLOYMENTBut is this good or bad? Suppose you borrow a large sum from a bank. In thefuture, unless you used the borrowed funds to make an investment that yielded areturn at least equal to the interest you had to pay the bank, you would be unableto consume as much as you would otherwise, for the simple reason that you mustpay the bank interest as well as principal. The same applies to foreign borrowing.During the 1980s, the large trade deficits were read more..

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    Review and PracticeSUMMARY1. In an open economy, investment can be financed fromdomestic national saving or borrowing from abroad.2. In a small open economy, changes in national saving willnot affect the international real interest rate or the levelof domestic investment. Changes in national saving willaffect the level of net capital inflows.3. In a large open economy such as the United States’, a fallin national saving will raise the real interest rate. Thisrise attracts net capital inflows read more..

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    Learning GoalsIn this chapter, you will learnThe role of labor productivityin raising living standardsThe factors that lead to pro-ductivity growthThe sources of economicgrowthThe role of technologicalchange and new ideas4321 read more..

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    Chapter 27GROWTH ANDPRODUCTIVITY∂The changes that took place in the U.S. standard of living during the twen-tieth century are hard to comprehend. In 1900, the average American’slevel of consumption was little higher than the average citizen’s in Mexicoor the Philippines today. Life expectancy was low, in part because diseases such assmallpox, diphtheria, typhoid fever, and whooping cough were still common. Peoplewere fifteen times more likely to catch measles in 1900 than they are today. read more..

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    shows how real wages and the real interest rate adjust to ensure that the economyproduces at potential GDP. Over time, new investment leads to more machines andbuildings, population growth and immigration lead to increases in the labor force,and innovation and research and development generate technological changes thatalter what the economy produces and how it is produced.Rising Standards of LivingTable 27.1 compares the United States in 1900 and 2000. Such a comparison revealsan enormous boost read more..

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    Output per hour (Y/H ) is what we identified in Chapter 22 as labor productivity.Hours per person (H/N ) reflects both the average number of hours people work andthe labor force participation rate. The labor force participation rate is the frac-tion of the population that is actually in the labor force. For income per capita torise, either labor productivity must rise or the number of hours worked must growfaster than the population.In many countries, rapid growth in income per capita follows read more..

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    Two important points stand out from Figure 27.2. First, overall growth declinedafter the 1960s but then picked up again in the late 1990s. Second, the decline duringthe 1970s and 1980s was attributable to a decline in productivity growth. This fall—the “productivity slowdown,” as it was called—began in 1973, and was not just anAmerican phenomenon: all the industrial economies grew more slowly after 1973.Wrap-UpGROWTH IN PER CAPITA INCOME The growth rate of per capita income is the sum of read more..

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    The growth rate of output is the sum of the growth rate of labor productivity and thegrowth rate of total hours worked.Growth in labor productivity is the key to rising standards of living.Explaining ProductivityFor almost a century, the United States has been at the center of the technologicaladvances that have changed the world. The telegraph, telephone, laser, transistor, air-plane, assembly line, jet engine, atomic reactor, memory chips . . . the list of U.S.technological achievements goes read more..

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    raise their income only by having both spouses working, for instance—reduction inleisure also leads to increased strain. In this case, to focus on the income increasesalone would exaggerate the rise in living standards.The critical role played by productivity growth in improving living standardsaccounts for the attention that has been given to the speedup in productivity growthsince the mid-1990s. Many commentators argue that the tremendous advances in computer and information technologies in read more..

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    production function: the relationship between employment and output, when theamount of capital is fixed. When we focus on economic growth, we need to take intoaccount the increases in the capital stock that come about through investment. Theeffect of having more capital per worker is shown in Figure 27.3. As each workerhas more capital to work with, output per worker (labor productivity) rises. Butbecause of diminishing returns, the effects on labor productivity become smalleras the economy read more..

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    592 ∂CHAPTER 27 GROWTH AND PRODUCTIVITYTHE QUALITY OF THE LABOR FORCEAs important as saving and investment rates are in explaining the growth rate oflabor productivity, capital deepening is not the whole story. Even more important todayis a second major source of productivity growth: a higher-quality labor force. Runninga modern industrial economy requires a well-educated workforce. In addition, aneconomy on the cutting edge of technological change needs trained scientists and engineers to read more..

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    telecommunications industry, other high-tech sectors, and export sectors is sub-stantially higher than that in other parts of the economy. Telecommunications dereg-ulation in the 1990s facilitated the movement of resources into that sector. Rapidinnovation in computer technology is affecting all sectors of the economy. Increasingglobalization will open up new opportunities for export growth. These changes arecontributing to the overall increase in productivity that the United States has read more..

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    the laser were developed. Indeed, most major firms spend about 3 percentof their gross revenues on research and development (R & D).We have become so accustomed to the current level of technolog-ical progress that it is hard to believe how different the view of rep-utable economists was in the early 1800s. Real wages of workers werelittle higher than they had been more than four centuries earlier, whenthe bubonic plague killed a large part of the population of Europe andthereby created a read more..

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    its marginal cost is therefore zero. So from society’s perspective, the idea should befreely available to everyone. After all, it costs nothing to let others use it.There is a tension, then, between providing incentives for the production of new ideas and ensuring that they can be widely used. Inventors need secure prop-erty rights that enable them to benefit from their ideas; they need to be able toexclude users who do not pay. Yet once an idea is invented, its zero marginal cost ofproduction read more..

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    Wrap-UpFACTORS CONTRIBUTING TO PRODUCTIVITYGROWTHSaving and investment (capital accumulation)Improved quality of the labor forceReallocation of labor from low-productivity to high-productivity sectorsTechnological progressTotal Factor Productivity:Measuring the Sources of GrowthIn an advanced economy like that of the United States, reallocation of resourcesfrom low- to high-productivity sectors is not viewed as a major source of furthergrowth. Investment in physical and human capital and read more..

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    residual (i.e., TFP). The decrease in TFP appears responsible formost of the growth slowdown in the 1970s and 1980s. Third, thedecline in productivity after 1973 was caused, in part, by a declinein the contribution of capital; but since 1995, increases in capitalhave, together with increases in TFP, accounted for the increase inthe growth rate of output. The rapid growth at the end of the 1990srepresented a return to the high growth rates of the 1950s and 1960safter two intervening decades of read more..

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    598 ∂CHAPTER 27 GROWTH AND PRODUCTIVITYe-InsightCOMPUTERS AND INCREASED PRODUCTIVITY GROWTHIf the recent increases in productivity growth are due to newinformation and computer technologies, then we might expectthat all the major industrialized economies would be benefit-ing from them. Panel Ashows average labor productivity growthfor the seven advanced economies known since 1976 as the“Group of Seven,” or the G-7 (the G-7 became the G-8 with theaddition of the Russian Federation in 1998). read more..

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    because the United States has been more successful in adopt-ing new technologies throughout the economy and has done somore quickly. For example, the Organization for EconomicCooperation and Development (OECD) estimated that in 1995the number of personal computers (PCs) per capita was almosttwice as high in the United States as in Canada and 75 per-cent higher than in the United Kingdom. As shown in Panel B,the change in productivity growth between the 1980–1995 and1995–1998 periods does read more..

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    GROWTH IN THE ECONOMY’S CAPITAL STOCKEconomic growth occurs when workers have more capital goods to work with. Thesuccess of many of the newly industrialized economies of Asia is due in large part to thier high rates of saving, which allowed them to invest and accumulate capital goods rapidly. TECHNOLOGICAL CHANGEPerhaps the most important sources of economic growth and rising standards ofliving are the productivity increases that arise from innovation and technologicalchange.Are There Limits read more..

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    Thinking Like an EconomistTRADE-OFFS AND THE COSTS OF ECONOMIC GROWTHFaith in the virtues of economic progress is widespread. Fewopenly embrace the alternative of economic stagnation andlower standards of living. Yet not everyone benefits fromchanges in technology, and there may be environmental andother costs associated with growth.In the early 1800s, English workmen destroyed labor-savingmachinery rather than see it take over their jobs. They werereferred to as Luddites, after their leader, read more..

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    Review and PracticeSUMMARY1. The United States experienced a marked slowdown in the rate of productivity growth in the early 1970s,compared with the preceding two decades. Since thelate 1990s there has been a remarkable increase in productivity growth. Even seemingly small changes inthe rate of increase in productivity will have powerfuleffects on the standard of living over a generation or two.2. There are four major sources of productivity growth:increases in the accumulation of capital goods read more..

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    2. Explain why a rapid influx of workers might result in alower output per worker (a reduction in productivity).Would the effect on productivity depend on the skilllevel of the new workers?3. Explain, using supply and demand diagrams, how atechnological change such as computerization couldlead to lower wages for unskilled workers and higherwages for skilled workers.4. Using the model of Chapter 26, discuss the effect on the level of investment for an open economy of (a) anincreased government read more..

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    Learning GoalsIn this chapter, you will learnHow the general level ofprices is related to the money supplyThe factors that determinethe money supply in a modern economyThe role of the FederalReserve, and the tools it can use to affect the supply of money321 read more..

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    Chapter 28MONEY, THE PRICELEVEL, AND THEFEDERAL RESERVE∂Our discussion of the full-employment model in Chapter 24 left out somecrucial dimensions of the macroeconomy: most importantly, the role ofmoney and the determination of the average level of prices and inflation.Most people find the topic of money fascinating, especially when they learn how banks“create” money. In modern economies, banks are active participants in the capitalmarket and are key to understanding how the supply of money read more..

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    conducted by the Federal Reserve System. In this chapter, you will learn about theFederal Reserve and the policy tools it can use to affect the money supply.Prices and InflationThe discussion of the long-run, full employment model in Chapter 24 was conductedentirely in real terms; real output, real employment, real saving and investment,real wages, and the real rate of interest. We were able to explain the factors that deter-mine the economy’s full-employment output level (potential GDP) read more..

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    PRICES AND INFLATION∂ 607Y fOUTPUT (Y )PRICE LEVEL (P)Figure 28.3POTENTIAL GDP AND THEAGGREGATE PRICE LEVELThe economy’s potential GDP does notdepend on the price level; this is repre-sented by drawing a vertical line atpotential GDP.RATE OF INFLATION IN CPI (%)1920 1930 1940 1950 1960 1970 1980 1990 200020151050–5–10–15Inflation has fluctuated considerably over the past ninety years. It reached significantlevels during World War I, World War II, and the Korean War, and was negative read more..

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    we need to hold. Money we do not need for transactions is better used to purchasefinancial assets that earn interest. Increases in the dollar value of transactionsincrease the demand for money; decreases in the dollar value of transactions decreasethe demand for money. A useful simplifying assumption is that the amount of money individuals holdis proportional to the dollar value, or nominal value, of their income. The same willbe true when we aggregate the economy; the overall demand for money read more..

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    PRICES AND INFLATION∂ 6091The inverse of velocity, 1/V, also has its own name—the Cambridge constant—after the formulation of moneydemand used by economists (including John Maynard Keynes) at Cambridge University in the early twentiethcentury, and it is usually denoted by k. We can then write the demand for money as kPY. The Cambridge constantis equal to the fraction of nominal income held as money. Since we are interested in the demand for money, we can rearrange the quantityequation to read more..

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    What happens if the supply of money increases? At the initial price level P, indi-viduals are now holding more money than they want to. The easiest way to reducethe amount of money you are holding is to spend it. From the perspective of firms,increased spending by consumers provides a signal to increase prices. Faced withhigher prices, workers demand high nominal wages. As prices rise, individuals musthold more money to carry out the same transactions. Equilibrium between demandand supply for read more..

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    PRICES AND INFLATION∂ 611INFLATION RATE (%)8070605040302010010 20 30 40 50 60 70 800MONEY GROWTH RATE (%)Figure 28.4MONEY GROWTH ANDINFLATIONMoney growth and inflation are closely related, as this figure shows. Each dot representsthe 1960–1990 average annual inflation rate and rate of money growth for a singlecountry. In all, 110 countries are shown.SOURCE:George T. McCandless Jr. and Warren E. Weber, “Some Monetary Facts,” Federal ReserveBank of Minneapolis Quarterly Review 19, no. 3 read more..

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    While the neutrality of money is a basic property of our full-employment modelwith flexible wages and prices, it is important to keep in mind the limitations of themodel. If price increases themselves really had no real consequences, then inflationwould not be a matter of much concern. But as we learned in Chapter 23, it is a con-cern. Later chapters will explore the more complicated effects of changes in themoney supply and prices when the economy is not at full employment and wagesand prices read more..

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    THE FINANCIAL SYSTEM IN MODERN ECONOMIES∂ 613Table 28.1A GLOSSARY OF FINANCIAL INTERMEDIARIESA variety of financial intermediaries take funds from the public and lend them to borrowers or otherwise invest them. Of themany legal differences between these institutions, the principal ones relate to the kinds of loans or investments made. Thefollowing list is ranked roughly by the asset size of each intermediary.Commercial banksBanks chartered by either the federal government (national banks) or a read more..

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    return, venture capitalists often receive a share in the ownership of the new firm. Forthe sake of simplicity, our discussion in the rest of this chapter will focus on one veryimportant group of financial intermediaries: commercial banks. Traditionally, banks have been the primary avenue for businesses to raise cap-ital. When the banking system collapses, as it did in the Great Depression in theUnited States, firms cannot obtain funds to make their investments, consumers losetheir deposits, and read more..

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    CREATING MONEY IN MODERN ECONOMIES∂ 6152See William Roberds, “Lenders of the Next-to-Last Resort: Scrip Issue in Georgia During the Great Depression,”Economic Review of the Federal Reserve Bank of Atlanta, September–October 1990, pp. 16–30.pay their workers. How could the local economy react to these sorts of financial disturbances?Each area adapted in its own way. Let’s consider Atlanta.2 The city printed about$2.5 million in scrip, in eight different issues, during the first half read more..

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    her income. Or we say someone has a lot of money, but what we really mean is thathe is wealthy, not that he has piles of currency stashed away. Economists define money by the functions it serves, and three functions are critical. Money as a Unit of Account Money serves as a means of measuring the rel-ative values of different goods and services. This is its unit of account function. Ifa laptop computer costs $1,800 and a desktop computer costs $900, then a laptopis worth twice as much as a read more..

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    CREATING MONEY IN MODERN ECONOMIES∂ 617Money as a Store of Value People will exchange what they have for moneyonly if they believe that they can later exchange money for things they need. Formoney to serve as a medium of exchange, it must hold its value. Economists call thisthird function of money the store of value function. Governments once feared thatpaper money by itself would not hold its value unless it was backed by a commod-ity such as gold. People had confidence in paper money because read more..

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    618 ∂CHAPTER 28 MONEY, THE PRICE LEVEL, AND THE FEDERAL RESERVECheckingaccounts$615.6Traveler’schecks$7.5Savingdeposits/money marketaccounts$3,144.9M1$1,287.1M2$6,044.6Small savingdeposits$805.8Other$744.9Largesavingdeposits$884.7Money marketmutual funds (gen)$806.8Money marketmutual funds (institutional)$1,102.6Currency$664.0ABCM1 (Billions, US$)M2 (Billions, US$)M3 (Billions, US$)Figure 28.5THE MEASURES OF MONEY IN2003The money supply can be measured inmany ways, including M1, M2, and read more..

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    CREATING MONEY IN MODERN ECONOMIES∂ 619Table 28.2GLOSSARY OF FINANCIAL TERMSOne of the problems in defining money is the wide variety of assets that are not directly used as a medium of exchange butcan be readily converted into something that could be so used. Should they be included in the money supply? There is noright or wrong answer. Below are definitions of eight terms, some of which have been introduced already. Each of these assets serves, in progressively less satisfactory ways, the read more..

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    dealer then resells the bill, the receipt, and the change. One such “transaction” soldfor $420,000! The British Museum, the Museum of Modern Art, and the Smithsonianare among the museums holding Boggs transaction pieces in their permanent collections.Boggs bills illustrate the social nature of fiat money—anything can serve asmoney if others are willing to accept it as money. As Boggs puts it, “Nobody knowswhat a dollar is, what the word means, what holds the thing up, what it stands read more..

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    CREATING MONEY IN MODERN ECONOMIES∂ 621with a look at the assets and liabilities of a typical bank. One convenient way to lookat the assets and liabilities of a bank (or a firm or individual, for that matter) is to organ-ize them in what is known as a balance sheet. A balance sheet simply lists all theassets of the bank in one column and the liabilities in a second column. The assets of the bank are what the bank owns, including what is owed to it byothers. Since the loans that the bank has read more..

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    required to hold reserves, at levels imposed by the Fed. Today, the amount of reservesthey hold is dictated more by regulations than by the banks’ own perceptions ofwhat is prudent. After all, holding T-bills is just as safe as holding reserves with theFed—and yields higher returns. And the level of reserves required by the Fed isdesigned primarily with an eye not to maximizing their profit but to controlling themoney supply and thereby the level of economic activity. Table 28.4 shows the read more..

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    e-InsightELECTRONIC CASHA TV ad shows a thirsty older gentleman who finds himselfshort of change for a soda trying to steal coins out of a fountain,while a young girl points her cellular phone at the same machineand retrieves a drink. The message? Cash is for old folks.Cold, hard cash is becoming a rarity in the United States.Americans increasingly rely on credit cards and ATM cardsfor all but the smallest transactions. Credit card purchasesare often an easy, if expensive, method of taking out a read more..

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    the $1 billion in currency to the Fed and is credited with the amount, so it now has$1 billion in reserves. Because its reserves have increased by $1 billion and its depositsby $10 billion, it has satisfied the 10 percent reserve requirement. The bank also has$9 billion in loans, so its assets have gone up by $10 billion, the $1 billion in reservesand the $9 billion in loans.This relationship between the change in reserves and the final change in depositsis called the money multiplier. We can read more..

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    CREATING MONEY IN MODERN ECONOMIES∂ 625Table 28.5SUPERBANK BALANCE SHEETBefore-deposit equilibriumAssets LiabilitiesLoans outstanding$ 91 billionDeposits$100 billionGovernment bonds2 billionReserves10 billionNet worth3 billionTotal103 billionTotal103 billionFirst round(Add $1 billion deposits, $0.9 billion loans)Assets read more..

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    626 ∂CHAPTER 28 MONEY, THE PRICE LEVEL, AND THE FEDERAL RESERVEfact, a process with a physical trail. Deposits are created by making entries inrecords; today, electronic impulses create these records in computer files. The rulesof deposit creation, which specify when certain entries can be made in these files—in particular, the fractional reserve requirements—also give rise to the system’sability to expand deposits by a multiple of the original deposit increase. The money multiplier read more..

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    The Federal Reserve was created by an act of Congress in 1913. In other coun-tries, the central bank is a purely governmental institution, similar to the U.S.Treasury or the Environmental Protection Agency. When Congress set up the UnitedStates’ central bank, however, it established a unique hybrid with both public and pri-vate aspects. The Federal Reserve is overseen by a seven-member Board of Governorsin Washington, D.C. Governors are appointed to fourteen-year terms (although theaverage read more..

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    of the Federal Reserve System is depicted in Figure 28.7. The FederalOpen Market Committee, or FOMC, is responsible for making monetarypolicy. The name of the FOMC comes from the way the committee oper-ates. The Fed engages in open market operations—so called because (asdiscussed in more detail below) they involve the Fed’s entering the capitalmarket directly, much as a private individual or firm would, to buy or sellgovernment bonds. Once the FOMC has set its policy targets, its opera-tions read more..

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    Internet ConnectionTHE FEDERAL RESERVE BANKS AND INTERNATIONALCENTRAL BANKSEach of the regional Federal Reserve banks maintains a Website that contains a variety of useful information related tomonetary policy and general economic conditions. The Website of the Board of Governors of the Federal Reserve Systemprovides links to all the regional banks aactionURI(www.federalreserve.gov):t www.federalreserve.gov.The Bank for International Settlements in Basel, Switzer-land, lists links to ninety-six read more..

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    Reserve Requirements Finally, the Fed establishes how much banks musthold as reserves. The reserve requirements are its third tool. If the Fed increasesreserve requirements, banks must set aside a larger fraction of their deposits asreserves and thus can lend out less. A rise in the reserve requirement reduces themoney multiplier and reduces the impact that a change in the level of reserves has on the money supply. A reduction in the reserve requirement increases the moneymultiplier and read more..

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    THE STABILITY OF THE U.S. BANKING SYSTEM∂ 631If (for good reasons or bad) many depositors lose confidence in a bank at thesame time, they will attempt to withdraw their funds all at once. The bank simplywill not have the money available, since most of it will have gone out in loans thatcannot be called in instantaneously. This situation is called a bank run. Bank runs wereas common in nineteenth-century America as they were in the old western movies,which often depicted customers in a small read more..

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    632 ∂CHAPTER 28 MONEY, THE PRICE LEVEL, AND THE FEDERAL RESERVEto borrow from the Fed protect against illiquidity; they ensure that if depositorswant cash, they can get it.) On occasion a bank will make so many bad loans that its net worth shrinks to the point at which it can no longer satisfy the capitalrequirements.As a fourth and final backstop, the government introduced the Federal DepositInsurance Corporation (FDIC) in 1933. Since then, federal banks and savings and loanshave had to read more..

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    Review and PracticeSUMMARY1. In the long run, the full-employment model implies thatmoney is neutral. Changes in the quantity of money affectthe price level and the level of nominal wages but leavereal output, real wages, and employment unaffected. 2. Money is anything that is generally accepted in a givensociety as a unit of account, a medium of exchange, and astore of value.3. The Federal Reserve is the central bank of the UnitedStates. Its policy actions affect the level of reserves andthe read more..

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    634 ∂CHAPTER 28 MONEY, THE PRICE LEVEL, AND THE FEDERAL RESERVEPROBLEMS1. Identify which of money’s three traits each of the followingassets shares, and which trait each does not share:(a) A house(b) A day pass for an amusement park(c) Russian rubles held by a resident of Dallas, Texas(d) A painting(e) Gold2. Why will only the price level and money wages beaffected by a change in the money supply in the full-employment economy? How is the rate of inflationrelated to the rate of growth of the read more..

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    ∂∂635Part 7MACROECONOMIC FLUCTUATIONS read more..

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    Learning GoalsIn this chapter, you will learnThe terms economists use to describe economic fluctuationsWhy economies experiencefluctuations in production and employmentThe four key concepts thathelp economists analyzeshort-run fluctuations in output and employment321 read more..

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    Chapter 29INTRODUCTION TOMACROECONOMICFLUCTUATIONS∂Modern economies are dynamic economies—new products are constantlybeing introduced, old ones disappear, consumer demand shifts fromone good to another, technological innovations lead to job losses insome sectors and the creation of new jobs in others. Most of the time, these devel-opments have effects that are primarily microeconomic in nature (felt in individualindustries, for example). But sometimes, major disruptions affect the entire read more..

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    industries are shrinking—jobs are being lost—at the same time that new jobs arebeing created. Workers voluntarily quit jobs to relocate or look for better positions.In the United States, analysts estimate that 8 to 10 percent of workers—more than10 million people—change jobs each year. Unemployment also varies seasonally. Wecall these normal patterns in unemployment structural, frictional, and seasonalunemployment. But at times the unemployment rate becomes much higher thanusual, as the read more..

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    ECONOMIC FLUCTUATIONS∂ 639196019654,0005,0006,0007,00011,000BILLIONS OF 2000 DOLLARS10,0009,0008,0003,0002,0001970197519801985Real GDP1960 –1961recession1974 – 1975recession1969 –1970recession1980 –1982back-to-backrecessions1990 –1991recession2001recessionPotentialGDP199019952000APanel Ashows how real GDP from 1960 to 2003 has moved above and below potentialGDP. Panel Bcompares the percentage deviations of GDP from potential (the outputgap) with the unemployment rate. When the output read more..

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    640 ∂CHAPTER 29 INTRODUCTION TO MACROECONOMIC FLUCTUATIONSMONTHS1947–19481201008060402001949–19531954 –19571958 –19601961 –19691970 –19731975 –19801980–19811982–19901991 –374539241063658129212020012001–34Figure 29.2THE DURATION OF ECONOMIC EXPANSIONSOver the past fifty-seven years, the duration of economic expansions has varied greatly.The average complete expansion has lasted 57 months; the shortest was 12 months, andthe longest completed expansion was 120 months. read more..

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    broken only by two brief recessions lasting only 8 months each: one in 1990–91 andthe other in 2001.Cyclical unemployment reflects unused labor resources. Periods of high unem-ployment also lead to idle factories and underutilized plant and equipment. Thereis a cost to the economy if its labor and capital resources are not fully employed.The output that could have been produced with these resources is the opportunitycost of cyclical unemployment.Because of the potentially high costs, and the read more..

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    Wrap-UpECONOMIC FLUCTUATIONSRecessions: periods of significant decline in real GDP.Expansions: periods of growth in real GDP.Output gap: the deviation (a percentage) of observed real GDP from potential real GDP.Case in PointESTIMATING THE OUTPUT COSTS OF A RECESSIONRecessions are periods when workers suffer from higher than normal levels of unem-ployment. By using the output gap and Okun’s Law, economists have developed away to estimate the opportunity cost of idle workers who are willing and read more..

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    In Chapter 22 we learned that according to Okun’s Law, the unemployment raterises above the natural rate of unemployment level (the unemployment rate at fullemployment) by 1 percentage point for every 2 percentage points that the output gapshrinks. Using Okun’s Law, we can translate an 8 percent output gap such as theUnited States experienced in the 1982 recession into an added 4 percentage points ofunemployment. Since most estimates at the time placed the natural rate of unem-ployment at read more..

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    full-employment model, the real wage—the nominal rate adjusted for the pricelevel—always adjusts to ensure that the labor market clears: that is, labor demandand labor supply are equal. If, for whatever reason, the demand for labor were tofall, the real wage should simply decline to maintain full employment. In the realworld, this rarely seems to happen. In the Great Depression of the 1930s, for exam-ple, when unemployment rose dramatically, real wages in the manufacturing sectorfor those read more..

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    L1 – L0, is the level of cyclical unemployment. People are willing towork at the going real wage, but the work is not there. The same argument holds even if there is a slight adjustment of the real wagethat is too small to align demand and supply. It is the failure of thereal wage to adjust when the labor demand curve shifts to the left thatleads to increases in unemployment. But why don’t real wages adjustquickly? By definition, the real wage is the nominal wage relative tothe prices of read more..

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    contract. Although most workers are not covered by formal contracts, wages orsalaries are commonly adjusted only once a year, again contributing to the sluggishmovement of nominal wages.Efficiency Wages Firms want to pay the efficiency wage: that is, the wage thatminimizes their total labor costs. If paying higher wages leads to greater worker produc-tivity, firms may find that their profits increase when they pay a real wage higher thanthe one at which the labor market would clear. When Henry read more..

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    WHY ECONOMIES EXPERIENCE FLUCTUATIONS∂ 647Thinking Like an EconomistINFORMATION AND MEASURING THE BUSINESS CYCLEDesigning macroeconomic policy requires accurate infor-mation about the economy. Economists’ conclusions about the severity of business cycles and whether the economy has become more stable are affected by the quality of theirinformation.Though some recessions are more severe than others, mosteconomists have accepted the view that recessions since WorldWar II have been, on average, read more..

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    control over the price of the goods they produce. But firms face a great deal of uncer-tainty about the consequences of price changes. The effect of a lower price on afirm’s sales depends on how other firms in the industry as well as its customersrespond. If rivals lower their prices, the firm may fail to gain market share, and theprice decline may simply put its profits into a nosedive. If rivals have no reaction,the firm may gain a competitive advantage. The behavior of customers is also read more..

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    UNDERSTANDING MACROECONOMIC FLUCTUATIONS∂ 649market. Once this has happened, the level of employment, potential output, the realrate of interest, and the price level are determined as the full-employment model ofPart Six explained. Because it takes time for wages and prices to adjust fully, weoften refer to the full-employment model as describing the economy in the longrun—a length of time sufficient to allow wages and prices to adjust to equilibratesupply and demand. When wages or prices read more..

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    650 ∂CHAPTER 29 INTRODUCTION TO MACROECONOMIC FLUCTUATIONSe-InsightCYCLICAL AND STRUCTURAL PRODUCTIVITYProductivity growth is the key to economic growth and risingstandards of living, and the information technologies we asso-ciate with the “new economy” have contributed significantlyto the rapid growth in productivity that the United States hasenjoyed since the mid-1990s. When productivity increasedsharply in 1996, few commentators thought the numbers her-alded a new period of sustained read more..

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    UNDERSTANDING MACROECONOMIC FLUCTUATIONS∂ 651assuming that the firm’s output is proportional to the numberof clients it has.)When the economy comes out of the recession, the firmcan hire new technical staff as it adds new clients. It doesn’tneed to add a new accountant or sales manager or scheduler.As a result, its output will increase more (in percentage terms)than its employment, and its labor productivity rises.Labor productivity falls as the economy goes into a reces-sion; it rises read more..

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    INFLATION ADJUSTMENT The first two fundamental ideas for understanding economic fluctuations—thatwages and prices do not adjust rapidly—set the stage for the model that is devel-oped over the next two chapters. They imply that changes in demand will cause fluc-tuations in employment and production. But in macroeconomics, we are alsointerested in the factors that determine inflation, and our other two fundamentalideas will serve to link fluctuations in unemployment and inflation. The read more..

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    UNDERSTANDING MACROECONOMIC FLUCTUATIONS∂ 653labor markets. Conversely, wages will rise more slowly when cyclical unemploymentrises. For most firms, labor costs are their primary costs of production. If wage hikesoutpace increases in workers’ productivity, firms’ labor costs rise. As labor costs goup, firms will raise their prices; when labor costs fall—as occurs, for instance, iflabor productivity increases faster than wages rise—firms will cut their prices. Thismeans that for a given read more..

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    Federal Reserve in the United States, for example, or the European Central Bank forthe members of the Economic and Monetary Union—are the government institu-tions responsible for achieving this goal through their use of monetary policy. Tokeep inflation under control, central banks in developed and many developingeconomies seek to reduce aggregate spending when inflation rises and to boostspending when inflation falls. They follow such policies as a consequence of our thirdfundamental idea, read more..

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    UNDERSTANDING MACROECONOMIC FLUCTUATIONS∂ 655Fundamentals of Fluctuations 4INFLATION, MONETARY POLICY, ANDSPENDINGIn the short run, central banks act to reduce aggregate spending when inflationincreases and to increase aggregate spending when inflation falls. This relationshipdepends critically on the way in which the central bank reacts to inflation and howmuch importance it places on controlling inflation. Because this relationship dependson monetary policy, it can differ in different read more..

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    2. Sticky prices: When the labor market does not clear, shifts in thedemand for goods and services in the product market lead firmsto adjust production rather than simply change prices (seeChapter 30).3. Short-run inflation–unemployment trade-off: A fall in cyclical unem-ployment leads to an increase in inflation—increases in cyclicalunemployment reduce inflation. This relationship implies thatpolicymakers face a trade-off in the short run between lowerunemployment and higher inflation (see read more..

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    Review and PracticeSUMMARY1. Economies experience recessions and booms in whichoutput fluctuates around its full-employment level.Recessions are periods in which real GDP declines; inbooms, real GDP increases. The fluctuations in outputare called business cycles.2. If wages and prices do not adjust quickly enough toensure that markets are always in equilibrium, so thatdemand and supply are balanced, the economy mayexperience fluctuations in cyclical unemployment.3. To explain cyclical read more..

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    658 ∂CHAPTER 29 INTRODUCTION TO MACROECONOMIC FLUCTUATIONSlabor supply on the product market? Illustrate youranswer diagrammatically.2. Soon after Iraq invaded Kuwait in August 1990, manyfirms feared that a recession would occur. Anticipatinga lack of demand for their goods, they began cuttingback on production. If wages adjust, what will happen to the equilibrium level of wages and employment? Ifwages do not adjust, how does your answer change? In which case will unemployment exist?3. For the read more..

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    Learning GoalsIn this chapter, you will learnHow equilibrium GDP is determined in the short runWhat happens to GDP when the level of aggregateexpenditures changesThe components of aggregateexpendituresHow the real interest rate affects aggregate expenditures4321 read more..

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    Chapter 30AGGREGATEEXPENDITURES ANDINCOME∂In Chapter 29, we learned that recessions and booms can result from shifts inthe demand for the goods and services that the economy produces. Whendemand falls, firms scale back production and need fewer workers—currentemployees are laid off and few new ones are hired. Wages and prices fail to adjustquickly enough to ensure that the economy remains at full employment, and theunemployment rate rises. When demand increases, firms expand production read more..

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    total expenditures in the four parts of the economy: households spending onconsumption, firms on investment goods, the government on public goods, andforeigner buyers on net exports. We have already seen in Chapter 22 thattotal income (output) is equal to the sum of consumption, investment, govern-ment purchases, and net exports. Income depends on spending, but spend-ing also depends on income. When their income rises, for example, householdswill increase their consumption spending. This read more..

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    THE NATIONAL INCOME–OUTPUT IDENTITYNational income is equal to national output (as explained in Chapter 22). Their equal-ity reflects the fact that when a good or service is purchased, the money that is paid musteventually wind up as someone’s income—as wages, in the pockets of the workers inthe firm that produced the good (or of the workers who produced the intermediategoods that were used in the production of the final good); as interest payments, in thepockets of those who lent the firm read more..

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    aggregate expenditures also must be what households, firms, government, and theforeign sector want to spend in total at that level of national income (output), as rep-resented by the aggregate expenditures schedule. Only point E0 is consistent withboth conditions.The second way is to consider what happens at a level of income, Y1, in excess ofY0. At that point, the aggregate expenditures schedule lies below the 45-degree line.What households, firms, government, and the foreign sector would like read more..

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    the final increase in equilibrium output will be smaller. In panel Bof Figure 30.2, theaggregate expenditures schedule shifts up by the same amount as it did in panel A,but the aggregate expenditures schedule is flatter and, as a result, equilibrium outputrises by less.MATHEMATICAL FORMULATIONWe can describe the equilibrium by using simple algebra. The aggregate expendituresequation can be writtenAE= A+ bY,where A is the vertical intercept of the aggregate expenditures schedule (the valueof AE read more..

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    Substituting the second equation into the first equation yieldsY= A+ bY,which can be solved for Y:Y= A/(1 − b).This equation tells us that if A changes by $1, Y will change by 1/(1 − b). For example,if b= .9, a $1 increase in A increases Y by $10. The factor 1/(1 − b) is called the mul-tiplier. It tells us how much total aggregate expenditures and output increase whenthe aggregate expenditures schedule shifts by $1. Wrap-UpINCOME–EXPENDITURE ANALYSIS1. Equilibrium output is the point read more..

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    ical questions. First, why does the aggregate expenditures schedule have a positiveslope and what determines that slope? And second, what factors lead to shifts in theaggregate expenditures schedule?To address these questions, we will take a brief look at each of the four compo-nents of aggregate spending: (1) consumption: purchases by households of goodsand services, such as food, television sets, and clothes; (2) investment: purchases ofcapital goods, machinery, and buildings by firms to help read more..

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    our concern is with the aggregate behavior of the economy, we are most interestedin the change in aggregate consumption as aggregate income changes. The aggregateMPC can be thought of as an average, over the millions of households in the economy,of all the individual marginal propensities to consume. The aggregate MPC is equalto the slope of the aggregate consumption function. The aggregate MPC conveys important information. Since consumption is alarge fraction of total aggregate expenditures, read more..

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    In that case, the aggregate expenditures schedule will be flatter than if the MPSis small.Taxes and the Aggregate Expenditures Schedule Consumption spend-ing by households depends on their disposable income. For a given level of totalincome, an increase in taxes reduces disposable income and leads to a fall in con-sumption. Tax increases therefore shift the aggregate expenditures schedule down.Tax decreases shift it up. Taxes have a second effect on the aggregate expenditures schedule. The read more..

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    in taxes, so disposable income rises by only $0.70. With a marginal propensity toconsume of .9, consumption rises by .9 times the $0.70 increase in disposable income,or by $0.63. A rise in total income leads to a smaller rise in spending. The aggregateexpenditures schedule is therefore flatter if marginal tax rates are high. As we havealready learned, a flatter schedule means the multiplier will be smaller.Taxes that increase with income are an example of an automatic stabilizer.Automatic read more..

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    lion. If any of the components of E changes by $1, equilibrium output changes by 1/(1 − (1 − t)MPC). For example, suppose E increases to $4 trillion. Equilibrium outputrises to $15 trillion. The multiplier is equal to the change in output ($15 trillion −$12.5 trillion = $2.5 trillion) per dollar change in E ($1 trillion), or 2.5. This can alsobe found directly as 1/(1 − (1 − t)MPC) = 1/[1 − (1 − .25) × .8] = 2.5. By contrast, the mul-tiplier without taxes would be 1/(1 − MPC) = read more..

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    For example, the stock market boom of the late 1990s caused many people tofeel wealthier. As a result, they increased their consumption spending at each levelof current income. These increases had the effect of shifting the aggregate expen-ditures schedule upward. When the stock market crashed in 2000, the same individ-uals experienced a drop in their wealth and reduced consumption spending; theaggregate expenditures schedule therefore shifted downward.Wrap-UpCONSUMPTION AND THE read more..

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    INVESTMENT AND THE REAL INTEREST RATETo undertake investment in new plants or equipment, firms must believe that theexpected future returns will be large enough to compensate them for the risks of theinvestment. Moreover, firms are aware that a dollar in the future is worth less than adollar today; if they had the dollar today, they could put it in a bank and get back the dollarwith interest a year later. As the interest rate rises, future dollars are worth less relative totoday’s dollars. As read more..

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    While we have focused our discussion on investment spendingby firms, the same principles are at work when individuals decideto make investment purchases—for example, buying a new car.If someone plans to take out a car loan, the interest rate on theloan is an important factor that will influence whether or not shebuys a car and, if she does, what type of car she buys and howmuch she ends up spending on it. An increase in the interest rateon car loans will increase the cost of buying a car, and read more..

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    without waiting; otherwise, they may seek those goods elsewhere. Finally, becausegearing up a production facility and then closing it down as sales fluctuate can be costly,firms find it profitable to produce at a relatively constant rate, adding to inventorieswhen sales weaken and selling out of inventories when sales strengthen. Inventory investment is the most volatile component of aggregate expenditures.One reason for this variability may again be the impact of the availability of crediton read more..

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    Third, changing perceptions of risk or of future economic conditions affectinvestment expenditures. Their influence helps account for the volatility of investment, and they can be added to our list of factors that shift the aggregate expenditures schedule.Government PurchasesThe third component of aggregate expenditures is government purchases.In later chapters, when we discuss fiscal policy in the United States, we willusually focus on the expenditure and tax policies of the federal read more..

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    The effect of exports and imports on aggregate expenditures is straightforward.Recall that what we are concerned with here is total purchases of domestically pro-duced output. Consequently, exports of U.S.-produced goods to other countries rep-resent another component of aggregate expenditures, just like consumption,investment, and government expenditures. However, some of what households,firms, and the government purchase are goods made abroad. To calculate the totaldemand for domestically read more..

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    EXPORTSWhat foreign consumers buy from the United States depends on their income, notincome in the United States. Exports may also depend on other factors, such as themarketing efforts of American firms and the prices of American goods relative to for-eign goods. To simplify, we will assume that income in other countries does notdepend on what happens in the United States. Exports, like government purchases,will not vary with U.S. income. Exports do depend on the relative cost of goods produced read more..

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    became less expensive, imports rose. Changes in the exchange rate affect importsat each level of income. A rise in the value of the dollar shifts the import functionup; a fall in the value of the dollar shifts the import function down.Changes in the exchange rate affect imports for the same reason that they affectexports. If the dollar rises in value, U.S. goods become relatively more expensive.Foreigners buy fewer American goods and our exports will fall. Since this exchangerate alteration read more..

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    Second, factors such as exchange rates and income developments in other countries can affect net exports and lead to shifts in the AE schedule. A recessionin Europe will reduce U.S. exports and shift the aggregate expenditures schedulefor the United States down. In the absence of any other change, equilibrium outputin the United States will fall. In the late 1990s, the financial crises and subsequentrecessions in many Asian economies raised the concern that the resulting fall inU.S. exports read more..

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    CALCULATING EQUILIBRIUM OUTPUT∂ 681Calculating Equilibrium Output At this point, it may be helpful to work through two simple examples, one illustrat-ing the calculation of equilibrium GDP in a closed economy and the other showingthe same calculation for an open economy. Suppose we have the following informa-tion on a closed economy. Each row in Table 30.1 gives the level of income (Y ) in thefirst column and the levels of taxes (T ), consumption (C ), investment (I ), and gov-ernment read more..

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    682 ∂CHAPTER 30 AGGREGATE EXPENDITURES AND INCOMEY goes from 7,000 to 8,000, disposable income goes from 5,300 (7,000 − 1,700) to6,050 (8,000 − 1,950). Consumption rises from 4,600 to 5,200, an increase of 600.The MPC is the increase in C per dollar increase in disposable income, or 600/750 =.8. Using these values, we can calculate the multiplier to be 1/(1 − (1 − .25) × .8) =1/(1 − .75 × 8) = 1/(1 − .6) = 1/.4 = 2.5, the same value we found directly by finding thenew equilibrium read more..

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    AGGREGATE EXPENDITURES AND THE REAL INTEREST RATE∂ 683Wrap-UpAGGREGATE EXPENDITURES AND OUTPUTAggregate expenditures and output are equal where the aggregate expendituresschedule crosses the 45-degree line.Shifts in the aggregate expenditure schedule have a multiplied impact on the levelof equilibrium output. This multiplier depends on the marginal propensity to consume, the marginal tax rate, and the marginal propensity to import.Factors that can shift the aggregate expenditures schedule up read more..

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    Thinking Like an EconomistINCENTIVES AND THE REAL AFTER-TAX RATE OF INTERESTIn other chapters we have emphasized that real values deter-mine incentives. Thus, decisions to save and invest respondto real interest rates. So far, deriving the real interest ratefrom the nominal interest rate has been straightforward: subtract the rate of inflation from the nominal interest rate.But for the sake of simplicity we have ignored another impor-tant factor, the effect of taxation. In the absence of taxes read more..

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    Review and PracticeSUMMARY1. Income-expenditure analysis shows how the equilibriumlevel of output in the economy is determined when firmsproduce to meet demand. 2. Equilibrium output is determined by the intersection ofthe 45-degree line and the aggregate expendituresschedule. The aggregate expenditures schedule showsthe level of expenditures at each level of national income,while the 45-degree line represents the points whereaggregate expenditures equal output.3. Shifts in the aggregate read more..

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    PROBLEMS1. In the economy of Consumerland, national income andconsumption are related in this way:National income $1,500 $1,600 $1,700 $1,800 $1,900Consumption$1,325 $1,420 $1,515 $1,610 $1,705Calculate national saving at each level of nationalincome. What is the marginal propensity to consume inConsumerland? What is the marginal propensity tosave? If national income rose to $2,000, what do you predict consumption and saving would be?2. To the economy of Consumerland, add the fact thatinvestment read more..

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    Learning GoalsIn this chapter, you will learnWhat a monetary policy ruleis, and how it depends on inflationWhat the aggregate demand–inflation (ADI) curve is, whatdetermines its slope, andwhat causes it to shiftHow the ADI curve can beused to understand importantmacroeconomic eventsHow output and inflation re-spond to aggregate demandshocks and aggregate supplyshocks4321 read more..

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    Chapter 31AGGREGATEDEMAND ANDINFLATION∂Every six weeks, the members of the Federal Open Market Committee(FOMC), the policymaking committee of the Federal Reserve, gather inWashington, D.C. They come from across the nation to discuss the state ofthe economy and to make decisions that can determine the outlook for U.S. infla-tion and unemployment over the next several years. Stock markets can rise or fallin anticipation of FOMC decisions. On April 14, 2000, when the government releasedthe latest read more..

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    United States, monetary policy is the responsibility of the Federal Reserve, our central bank. Keeping inflation low and stable is a primary responsibility of any centralbank, and, particularly during the past twenty-five years, many countries haveundertaken central bank reforms that specify low inflation as the major or evensole objective of monetary policy. To maintain control over inflation, the Fedneeds to keep its eye on the level of aggregate demand relative to the read more..

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    When we discuss interest rates and monetary policy, it is natural tostart with the capital market. We have already seen, in Chapter 24,how the real rate of interest balances saving and investment when theeconomy is at full employment. When the economy is not at full employ-ment, saving and investment must still balance to ensure that the cap-ital market is in equilibrium. Figure 31.1 shows capital market equilibriafor two different levels of output. When the economy is producing atfull read more..

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    THE FED’S POLICY RULEThe Fed is concerned about inflation, and it knows that as unemployment falls, infla-tion tends to rise (our third key concept). As inflation rises, the Fed acts to reduceaggregate demand in order to slow the economy down and lessen any upward pres-sure on inflation. The Fed can affect aggregate demand by influencing the real inter-est rate. An increase in the real interest rate will reduce investment spending, for example. As inflation falls, the Fed acts to lower the read more..

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    Because equilibrium GDP is determined by aggregate expenditures in the short run, we can also say that there is a negative relationship between inflation and the short-run equilibrium level of GDP, given the central bank’s policy rule. Thisrelationship between inflation and GDP is called the aggregate demand–inflation(ADI) curve and is shown in Figure 31.2. Output (GDP) is on the horizontal axis, and inflation is on the vertical axis. The ADI curve in Figure 31.2 shows equi-librium output at read more..

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    To summarize, the negative relationship between inflation and short-run equilibrium GDP represented by the ADI curve is based on the following set of linkages:Finally, although we have emphasized the role of the central bank’s policy rulein producing the negative slope of the ADI curve, other factors are also at work.When the rise in prices outpaces the growth in money, the real value of money heldby households and businesses is reduced. This reduction in real wealth may causeconsumption and read more..

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    THE AGGREGATE DEMAND–INFLATION CURVE∂ 6951The size of the increase in output is determined by the magnitude of the initial increase in spending and themultiplier, as explained in Chapter 30.Fiscal Policy A change in government purchases or taxes altersthe level of aggregate expenditures, and therefore output, for a givenrate of inflation. An increase in government purchases, for example,raises aggregate expenditures at each level of the inflation rate; forevery value of inflation, total read more..

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    International PerspectiveHOW DO OTHER CENTRAL BANKS REACT TO INFLATION?The reaction of the central bank to inflation is a critical factorin determining the slope of the ADI curve. One implication ofthe bank’s role is that ADI curves in different countries mayhave different slopes, because central banks do not all reactto inflation in the same way. Countries whose central bankresponds aggressively to inflation, pushing up interest rates atits slightest hint and cutting interest rates whenever read more..

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    USING THE ADI CURVE∂ 697Wrap-UpFACTORS THAT SHIFT THE AGGREGATEDEMAND–INFLATION (ADI) CURVEFactors that increase aggregate expenditures at each rate of inflation (and shift theADI curve to the right) includeincreases in government purchases,decreases in taxes,an increase in wealth,an increase in business or household optimism, anda cut in interest rates at each rate of inflation.Factors that decrease aggregate expenditures at each rate of inflation (and shift theADI curve to the left) read more..

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    to changes in demand at each level of inflation. That means that the economy’s short-run equilibrium GDP will be determined by the level of aggregate demand. In Figure 31.2,the economy’s equilibrium level of GDP will be Y0 if the inflation rate is equal to π0.If inflation is higher, say, at π1, equilibrium output will be lower, at Y1.Figure 31.2 includes a vertical line at the economy’s full-employment level ofoutput, denoted as Y f. As we know from Chapter 24, full-employment output, read more..

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    USING THE ADI CURVE∂ 699π0π1E1Y1ADI1ADI0IA 0IA 1Y fE0E2OUTPUT (Y )INFLATION (π)Figure 31.5A RECESSION CAUSED BY A SHIFT IN AGGREGATE DEMANDThe full-employment level of output is given by the vertical line at Y f. The initial inflationrate is π0 and the aggregate demand inflation curve is ADI0. The equilibrium is at E0, withoutput equal to Y f. If the ADI curve shifts to the left (to ADI1), equilibrium GDP will fallbelow the full-employment level of output; the new short-run equilibrium read more..

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    is eliminated and the economy is back at full employment, there is no further down-ward pressure on inflation. Eventually the economy reaches a new long-run equilibrium at full employment at the point E 2, with an inflation rate of π1. Case in PointTHE VOLCKER DISINFLATIONIn 1979 and 1980, there was widespread agreement that something should be doneto halt inflation. At the time, inflation was at a postwar high and appeared to bemoving even higher. The economy was at a point such as E0 in read more..

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    AN EXPANSIONARY SHIFT IN THE ADI CURVE∂ 701offsetting amount. But the contractionary impact of monetary policymore than offset the expansionary effect of lower taxes, and the ADIcurve shifted to the left, as shown in Figure 31.5. Figure 31.6 shows the results of this shift in monetary policy. Outputdeclined below potential GDP and the unemployment rate briefly hit a post–World War II high of 11 percent. However, the recession did succeed in curbing inflation, which dropped from around 9 read more..

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    702 ∂CHAPTER 31 AGGREGATE DEMAND AND INFLATIONJohn F. Kennedy’s economic advisers believed that a cut in the individual incometax would cause households to consume more. This increased consumption wouldlead to a rightward shift in the ADI curve. An increase in aggregate expenditures,Kennedy’s advisers believed, would result in increased output and a lower unem-ployment rate, not higher inflation. They argued that inflation would not rise, becausethe economy had excess capacity—productive read more..

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    MACROECONOMIC POLICY AND SHIFTS IN THE ADI CURVEOur examples have illustrated the effects on aggregate demand and output in theshort run. For each example, we assumed the economy started out at full employment.Tracing through the effects of a single disturbance on output and employment in the short run can be useful. More commonly, however, we want to use our macro-economic model not to focus on such effects but to analyze how policy might help maintain the economy at full employment. In Figure read more..

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    in the ADI curve pushed the economy into a recession, with output at E1, below theeconomy’s full-employment output at point E0. If the aggregate demand curveremains at ADI1, inflation will eventually fall and the economy will reach full employ-ment at point E2 with an inflation rate of π2. If inflation adjusts slowly, it may takea long time for full employment to be restored. An expansionary fiscal or monetarypolicy that shifts the aggregate demand curve to the right would push the read more..

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    bank could cut interest rates at each rate of inflation (changing its policy rule).Such cuts would shift the ADI curve to the right. The central bank’s effort to keepoutput equal to potential GDP will prevent unemployment from rising, but at thecost of leaving inflation at the higher level, π1. Alternatively, if the central bankwants to prevent any rise in inflation, it must pursue a tighter policy and higherinterest rates (changing its policy rule, this time toward a higher interest rate at read more..

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    no change in the ADI curve, equilibrium output remains at point E0 atthe initial inflation rate π0. The economy will not remain at E0, however. At an output equal tothe old level of potential GDP, Y0f, firms now have excess capacity—the increase in productivity means they could produce more than beforewith the same resources. The change places downward pressure oninflation. As inflation declines, the real interest rate also falls, leadingto an increase in aggregate expenditures and read more..

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    SHIFTS IN THE INFLATION ADJUSTMENT CURVE∂ 707Case in PointTHE 1990SNow that we have a complete model for understanding how the economy adjusts,we can use it to analyze the U.S. economy at the end of the 1990s. Figure 31.12 showsthe unemployment rate, the output gap, and the inflation rate since 1990. The reces-sion of 1990–1991 shows up clearly in the path of the unemployment rate, which rosefrom 5.6 percent of the labor force in 1990 to 7.5 percent in 1992. This recession wascaused by read more..

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    growth and the growth rate of productivity increased. These developments wereconsistent with a supply shock that lowered the unemployment rate at full employ-ment and shifted the inflation adjustment curve down, as illustrated in Figure 31.11.As our model predicts, this resulted in lower unemployment and lower inflation.The prime candidate for such a favorable supply shock is the new computer andinformation technologies that have transformed so many parts of the Americaneconomy.As the 1990s read more..

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    121086HourlycompensationProductivityUnit laborcosts420–219801985199019952000–4PERCENTLABOR COMPENSATION, PRODUCTIVITY, AND COSTSOURCE:Economic Report of the President (2004).SHIFTS IN THE INFLATION ADJUSTMENT CURVE∂ 709of the stock market and a drop in business investment. By December 2000, economic conditions were weakening much more quickly than had previously been expected. As a consequence, the Fed’s concerns shifted; it now needed to focuson preventing the economy from entering a read more..

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    Internet ConnectionTHE FOMCAfter each meeting of the FOMC, the committee releases a press statement that explains any policy action it has takenand highlights the economic conditions that most concernthe FOMC members. These statements can be found at actionURI(www.federalreserve.gov/fomc/):www.federalreserve.gov/fomc/.710 ∂CHAPTER 31 AGGREGATE DEMAND AND INFLATIONIn the middle of 2004, as economic growth recovered, the Fed’s concerns again turned to preventing inflation from increasing. In read more..

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    Review and PracticeSUMMARY1. Aggregate demand depends negatively on inflation. Asinflation increases, the Fed or other central bank raisesinterest rates, thereby reducing aggregate expendi-tures. This negative relationship is called the aggregatedemand–inflation or ADI curve.2. At a given rate of inflation, the economy’s equilibriumlevel of output is given by the ADI curve. 3. The slope of the ADI curve depends on the centralbank’s behavior. If it increases interest rates sharplywhen read more..

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    712 ∂CHAPTER 31 AGGREGATE DEMAND AND INFLATIONThe relationship between aggregate expenditures and the real interest rate is given by the following table (expenditures are in trillions of 2000 dollars):Real interest rate345678Aggregate expenditures8.387.77.47.16.8Plot the ADI curve. If inflation is 4 percent, what is thelevel of aggregate expenditures? Suppose investmentnow becomes more sensitive to interest rate changes.How would this affect the ADI curve?3. Draw an ADI curve. As we move up read more..

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    Learning GoalsIn this chapter, you will learnAbout the federal funds mar-ket and the federal funds interest rateHow the Federal Reserve usesits policy tools to influencethe federal funds rateThe reasons that centralbanks today focus on inter-est rates rather than on themoney supply321 read more..

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    Chapter 32THE FEDERALRESERVE ANDINTEREST RATES∂In the previous chapter, we assigned a key role to the Federal Reserve’s responseto inflation in the model of short-run fluctuations. The downward slope of theaggregate demand–inflation curve reflected the Fed’s policy reaction as infla-tion varied. What we did not discuss, though, was exactly how the Federal Reserveis able to move interest rates. Chapter 28 did examine the three basic tools of theFederal Reserve—open market operations, read more..

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    A DAY AT THE TRADING DESKThe Fed is able to affect the federal funds rate by controlling the supply of bankreserves in the federal funds market, and it does so by using open market operations.As we saw in Chapter 28, by entering the market directly to buy or sell governmentsecurities, the Fed is able to increase or decrease the supply of bank reserves. Morespecifically, these open market operations are conducted by the Trading Desk locatedat the Federal Reserve Bank of New York. In a typical read more..

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    sale of a government security and an agreement to repurchase it at a future date—perhaps the next day.) The last major activity of the day is a 3:15 P.M. telephone meeting with represen-tatives of the government security market dealer firms. The interchange of infor-mation helps keep the Trading Desk informed of the dealers’ perceptions ofdevelopments in the financial markets.1The Fed’s Target for the Funds Rate The activities of the Trading Deskare designed to affect the level of the read more..

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    then understand how the Fed is able to influence the market to make sure the equilibrium level of the federal funds rate is kept close to the target established bythe FOMC. THE DEMAND FOR RESERVESBanks hold reserves for two reasons. First, they must satisfy the legal reserve require-ment imposed by the Fed. Second, even if reserve requirements were zero (as theyare in some countries), banks need to hold some reserves to meet their daily trans-action needs. Deposits and withdrawals cannot be read more..

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    The position of the demand curve for reserves will depend on banks’ lendingopportunities and on the general volume of transactions. Suppose, for example, thata new technological innovation causes firms to want to invest more money in newequipment. To finance this investment, firms try to borrow more from banks. Asthe quantity of bank loans demanded increases, interest rates on bank loans willrise. Any bank that was holding excess reserves will have a greater incentive tomake additional loans read more..

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    changing. Because the Fed, if it chooses, can always offset any changein borrowed reserves by adjusting nonborrowed reserves, we can sim-plify the situation by treating the supply of total reserves, the sum ofborrowed and nonborrowed reserves, as controlled directly by the Fed.In Figure 32.3, the stock of total reserves set by the Fed is shown as avertical line, labeled TR0. An open market sale decreases total reserves,shifting the supply to TR1.EQUILIBRIUM IN THE FEDERAL FUNDS MARKETWe can now read more..

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    equilibrium funds rate rises. If the Fed wishes to prevent the funds ratefrom changing, it needs to engage in an open market purchase to increasethe total reserve supply.These shifts in the reserve demand curve illustrate another impor-tant consequence of a monetary policy that targets the funds rate. Therightward shift of the reserve demand curve shown in Figure 32.4 ledto an equal shift in reserve supply to keep the funds rate from chang-ing. While the funds rate remained constant, the read more..

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    M1 (the total of currency, traveler’s checks, and checking accounts). Rather thanletting reserve supply adjust automatically to achieve an interest rate target, theFed could decide on a target for the money supply or the quantity of reserves, lettingthe funds rate adjust automatically to clear the federal funds market.Under a money supply procedure, just as under an interest rate procedure, mon-etary policy discussions start with an assessment of the state of the economy and adetermination of read more..

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    tity of money increases. When the monetary authority tries to keep the nominal inter-est rate constant, the quantity of money automatically increases as prices rise. Inflationcauses the money supply to automatically increase, further fueling and sustaining theinflation.In the full-employment model, we assumed that government controlled the supplyof money directly. Because full-employment output is determined by such factorsas labor supply, the capital stock, and the economy’s technology, read more..

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    724 ∂CHAPTER 32 THE FEDERAL RESERVE AND INTEREST RATESReview and PracticeSUMMARY1. The federal funds market is the market in which bankscan borrow or lend reserves.2. The federal funds rate, which is the interest rate onovernight interbank loans, adjusts to balance the supplyand demand for reserves. 3. The Federal Reserve can affect the market for reservesby changing the reserve requirement, by changing thediscount rate, or by open market operations.4. Open market operations are the chief tool read more..

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    Learning GoalsIn this chapter, you will learnModern views of the macro-economic trade-offs that policymakers faceThe roles of automatic stabi-lizers and discretionary policyThe monetary policy rule andwhat it depends onHow monetary and fiscal poli-cies differ in their impacts onthe economy4321 read more..

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    Chapter 33THE ROLE OFMACROECONOMICPOLICY∂Economic policy debates have always been at the core of macroeconomics.After all, macroeconomics began as an attempt to understand the causesof the Great Depression of the 1930s and to formulate government policiesthat might end it. Discussions in the United States in recent years have been dom-inated by the debate over job creation after the 2001 recession, the huge federal gov-ernment deficits and their possible impact on economic growth, and the read more..

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    Inflation–Unemployment Trade-OffsEconomists focus on trade-offs: if we want more of one thing, what do we have togive up? Can we have lower average unemployment if we are willing to accept higheraverage inflation? Does keeping inflation low and stable mean that output and unem-ployment will fluctuate more? Chapter 31 provided the analytical basis for address-ing these questions. Clearly, we would like to have both low (and stable) inflationand low (and stable) unemployment. Economists’ read more..

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    THE NEW TRADE-OFF: OUTPUT STABILITY–INFLATION STABILITYIn recent years, economists such as John Taylor of Stanford University have arguedthat attempts to stabilize fluctuations in output and employment will cause infla-tion to fluctuate more. And attempts to stabilize fluctuations in inflation will causeoutput and employment to fluctuate more.1 Thus policymakers face a different trade-off: one between fluctuations in the real economy (output and unemployment) andfluctuations in inflation. One read more..

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    already seen in Chapter 30 how income-related taxes serve as automatic stabiliz-ers by reducing the multiplier. As incomes rise, individuals and business will have topay more in taxes to local and state governments and to the federal government, anincrease that automatically acts to limit spending increases and to keep overallaggregate spending more stable. For example, suppose the marginal tax rate is 30percent—that is, for each additional dollar you earn, you have to pay 30 cents intaxes. read more..

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    figure, the smaller shift in the light green ADI curve reduces the fall in equilibriumoutput, increasing the economy’s stability. In the face of inflation shocks, automaticstabilizers lead to smaller fluctuations in real output. DISCRETIONARY POLICY ACTIONSFiscal policy has also been used to affect the economy deliberately rather than auto-matically. Discretionary policy actions represent conscious choices by the govern-ment. When we analyzed the impact of an increase in government purchases read more..

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    Internet ConnectionTHE ECONOMIC REPORT OF THE PRESIDENTEvery February, the president’s Council of Economic Advis-ors issues the Economic Report of the President. This reportdiscusses the state of the economy and developments in fiscal policy. As well as providing a wealth of data on the economy, each chapter of the report deals with a current policy debate. The latest report can be found at read more..

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    Figure 33.2 shows the economy in a recession at point E0. Output is below thefull-employment level Y f. The decline in output, with the associated rise in cyclicalunemployment, has resulted from a leftward shift in the ADI curve. An expansionary fiscal policy can end a recession and eliminate the cyclicalunemployment. Increasing government purchases or cutting taxes raises aggre-gate expenditures at each inflation rate, shifting the ADI curve to the right. If thesize of the fiscal policy is read more..

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    734 ∂CHAPTER 33 THE ROLE OF MACROECONOMIC POLICYInternational Perspective FISCAL TRANSFERSThe role of fiscal policy and automatic stabilizers has been atopic of debate within the twelve European countries that alluse the euro as their currency. There, the concern is the lackof automatic fiscal stabilizers that can help mitigate economicfluctuations within the euro zone when the economies of somemembers are in recession while those of others are booming. The members of the European Economic and read more..

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    One way to separate out the effects of automatic stabilizers from these activechanges in policy is to focus on the full-employment deficit—what the deficitwould have been had the economy been operating at full employment. The full-employment deficit adjusts for the stage of the business cycle; it adjusts for thechanges in taxes and spending that vary over the business cycles. For instance, ina recession when incomes fall, the actual deficit increases because tax revenuesdecline with the drop read more..

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    Wrap-UpFISCAL POLICYAutomatic stabilizers increase expenditures and reduce taxes automatically as theeconomy goes into a recession. They act to reduce the impact of economic shocks onGDP by stabilizing aggregate expenditures.The full-employment deficit adjusts for the stage of the business cycle and givesa measure of what the deficit (or surplus) would be if the economy were at fullemployment. It provides a clearer picture of the effects of discretionary fiscal policy actions.Monetary read more..

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    Conducting Monetary Policy The FOMC meets approximately every sixweeks to decide on monetary policy. The central banks in most industrial economiesconduct monetary policy by setting a target for a nominal interest rate; in the caseof the United States, the target is the federal funds rate, the rate on overnight bank-to-bank loans. Chapter 32 explained how the Fed uses its control of bank reservesto achieve that target. At the close of each FOMC meeting, a vote is taken on whetherto raise, lower, read more..

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    rate, borrowing will become more costly: the real cost of auto loans, mortgage inter-est rates, and commercial loans to firms will increase. As credit becomes more costly,households and firms will scale back their spending plans. Because changes in the funds rate affect the entire range of market interestrates, we simplified the discussion in previous chapters by assuming that the Fedsets the level of nominal interest rates. In Chapter 32, we learned that other approachesto implementing monetary read more..

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    The Committee perceives the upside and downside risks to the attainment of bothsustainable growth and price stability for the next few quarters are roughly equal.With underlying inflation still expected to be relatively low, the Committee believesthat policy accommodation can be removed at a pace that is likely to be measured.Nonetheless, the Committee will respond to changes in economic prospects as neededto fulfill its obligation to maintain price stability.REAL INTEREST RATES AND read more..

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    care about the real interest rate, which determines the purchasing power they mustgive up to borrow or the purchasing power they receive by making the loan. If infla-tion rises, lenders demand and borrowers are willing to pay a higher market inter-est rate. And a market interest rate of 10 percent with inflation equal to 6 percentrepresents the same real interest rate as a market rate of 5 percent with inflation of1 percent. The interest rates we hear or read about are nominal; they are not read more..

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    stimulate aggregate expenditures, expand output, and moderatethe recession. We illustrate the connection between inflation and the nominalinterest rate the central bank sets in panel Aof Figure 33.6. The realinterest rate is the nominal rate minus inflation, so the nominal inter-est rate must rise proportionally more than increases in inflation toensure that the real interest rate increases.4 This means that theslope of the line in the figure is greater than 1. If the inflation rateincreases read more..

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    Thinking Like an EconomistREAL VALUES MATTER FOR INCENTIVESEconomists believe that to understand how individuals andfirms behave, we should assume they make rational decisions.In making decisions, individuals and firms respond to incen-tives. But to affect decisions, a change in incentives has to bea real change—it has to reflect an actual alteration in thetrade-offs the decision maker faces. A worker will thus beconcerned with how much her wages can purchase—the realvalue of wages, not read more..

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    Case in PointTHE INTEREST RATE CUT OF JANUARY 3, 2001The effects of the interest rate hikes engineered by the Fed during 1999 and the firstpart of 2000 started to make themselves felt by the end of 2000. And when signs ofa slowdown in economic activity began to appear, they seemed to indicate that theeconomy might be headed toward a recession. On January 3, 2001, new figuresshowed that auto sales by U.S. domestic manufacturers were down almost 8 per-cent from the level of a year earlier. read more..

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    744 ∂CHAPTER 33 THE ROLE OF MACROECONOMIC POLICYe-InsightTHE DOT-COM BUBBLE AND MACROECONOMICSTABILITYJust think if in June 1996 you had invested $20,000 in a little-known and fledgling new company called Yahoo. It would havebeen a risky decision; Yahoo was offering a free service to usersof the Internet—something that most Americans still knewlittle about. A share of stock in Yahoo was selling for $2.09. It would have been a great investment decision. As the year2000 dawned, each share of read more..

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    THE POSITION OF THE POLICY RULEWe can further explore the position of the monetary policy rule by asking what nom-inal interest rate a central bank would want to target if the economy were at fullemployment. Two factors will be important: the equilibrium real rate of interest at full employment and the target inflation rate that the central bank would like to achieve.The Equilibrium Real Interest Rate Recall from Chapter 24 that the full-employment model made an important prediction about the read more..

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    our hypothetical full-employment economy, must then be 5 percent—the full-employment equilibrium real interest rate (3 percent) plus the desired inflation rate(2 percent). Figure 33.7 shows the policy rule for this example (the line labeledAA); when inflation is equal to 2 percent, the policy rule shows that the centralbank sets the nominal interest rate equal to 5 percent.If the equilibrium real rate of interest at full employment changes, the centralbank will need to shift its policy rule. read more..

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    MONETARY POLICY∂ 747The Inflation Target The position of the monetary policy rule also dependson the central bank’s target inflation rate. As we just learned, at full employmentthe central bank will set the nominal interest rate equal to the equilibrium real interest rate plus the target for the rate of inflation. Suppose the central bank de-cides to lower its inflation target from 2 percent to 1 percent. And let’s assume the full-employment equilibrium real interest rate is 3 percent. read more..

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    748 ∂CHAPTER 33 THE ROLE OF MACROECONOMIC POLICYThis shift in the policy rule does succeed in lowering inflation.If the economy initially has 2 percent inflation, the central bankincreases the nominal interest rate in line with the new policy ruleBB. As shown in the figure, the nominal rate rises to 5.5 percent.Since inflation is still equal to 2 percent, this represents a rise in thereal interest rate from 3 percent to 3.5 percent, which dampensaggregate spending and causes output to decline read more..

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    This discussion returns us to the trade-offs that were examined earlier in this chapter. By responding strongly to changes in inflation, the central bank can keep inflation more stable but at the cost of larger fluctuations in real output andunemployment. By responding less aggressively to changes in inflation, real outputand unemployment can be kept more stable but at the cost of greater instabilityin inflation.Wrap-UpTHE MONETARY POLICY RULEA monetary policy rule describes how the central bank read more..

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    investment, they can have different longer-run effects on the economy. A monetaryexpansion lowers real interest rates, stimulating investment. In contrast, a fiscalexpansion reduces national saving and results in a higher real interest rate andlower investment. Using fiscal policy to stimulate the economy, by reducing privateinvestment, may have harmful effects on future potential output. Fiscal and monetary policies differ as well in their impact on exports and imports.A monetary expansion that read more..

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    Wrap-UpDIFFERENCES BETWEEN MONETARY ANDFISCAL POLICYEffects on Aggregate DemandFiscal policy and monetary policy have different effects on the economy. Expansionaryfiscal policy raises the real interest rate and crowds out private investment spend-ing. Expansionary monetary policy lowers the real interest rate and stimulates private investment spending. Policy LagsInside lag: The time required to recognize a need for a change in policy and to implement the policy change. The inside lag is much read more..

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    752 ∂CHAPTER 33 THE ROLE OF MACROECONOMIC POLICYReview and PracticeSUMMARY1. The actual fiscal deficit increases in a recession as taxrevenues decline. This process provides an importantautomatic stabilizer. To measure discretionary shifts infiscal policy, economists look at the full-employmentbudget deficit.2. The aggregate demand–inflation (ADI) curve dependson the monetary policy rule used by the central bank.The slope of the policy rule affects the slope of the ADIcurve, while shifts in read more..

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    3. Assume that the economy is currently at full employ-ment with an inflation rate of 2 percent. The govern-ment embarks on a major new expenditure programthat increases aggregate expenditures (assume that full-employment output is unaffected). (a) If the central bank’s policy rule remains unchanged,what will be the short-run and long-run effects onoutput and inflation of this change in fiscal policy?What will be the long-run effects on the real interestrate at full employment?(b) Suppose the read more..

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    ∂∂755Part 8THE GLOBAL ECONOMY read more..

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    Learning GoalsIn this chapter, you will learnWhat factors determine international exchange ratesHow fixed exchange rate systems differ from flexibleexchange rate systemsHow a fixed exchange ratesystem restricts the use ofmonetary policy321 read more..

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    Chapter 34THEINTERNATIONALFINANCIAL SYSTEM∂After working all year, you have saved enough to buy that new, fuel-efficientToyota Prius. You have located one at a local car dealer, and the price is$20,000. You give the dealer $20,000 and drive away. But is that the end ofthe transaction? No. The car was built in Japan, so Toyota needs yen, the Japanesecurrency, and not U.S. dollars to pay the workers in Japan who manufactured it.The dealer who imported the Prius to the United States therefore read more..

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    Opening a country’s financial markets to foreign investors can have many ben-efits. The most important is that domestic investment is no longer constrained bydomestic saving. There are also potential costs, however, a point driven home in1996 and 1997 when a financial crisis that began in Thailand spread to other coun-tries in Asia and Latin America, and again in 1998 when Russia faced a financialcrisis that led to the largest one-day fall in prices on the London stock exchange ina decade. In read more..

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    SUPPLY AND DEMAND IN THE FOREIGNEXCHANGE MARKETIn competitive markets, prices are determined by demand and supply. Similarly,exchange rates are determined by demand and supply in foreign exchange markets.In our example of just two currencies—dollars and euros—it makes no differencewhether we look at things from the perspective of the demand for and supply of dol-lars or from the perspective of the demand for and supply of euros. The Europeansupply of euros on the foreign exchange market is read more..

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    sell in the foreign exchange market. As they do so, the supply of dollars will increase.The equilibrium exchange rate is the value of dollars in terms of euros that balancesthe demand for dollars and the supply of dollars. In the figure, e0 is the equilibriumexchange rate. At a lower exchange rate such as e1, the demand for dollars exceedsthe supply of dollars. Just as in the market for wheat, if demand exceeds supply, theprice will rise. In this case, the value of the dollar will rise. At an read more..

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    that wants to use the euros to buy European goods and import thosegoods back into the United States. Third, it could lend the euros to aEuropean borrower. To simplify the discussion, we will imagine that noone in Europe would lend to anyone in America, and no one in Americawould lend to anyone in Europe. Foreign borrowing and lending will beconsidered separately. A European firm that sells goods in the United States will find itselfin a similar position. The firm will receive U.S. dollars, and read more..

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    campaign increases output and employment in industries that produce substitutesfor the goods that had been imported, but output and employment decline in U.S.export industries. In contrast, a change that increased the demand by Americans forEuropean goods—perhaps a shift in tastes—would cause the dollar to fall in value;when the dollar falls in value, we say the dollar depreciates. Such a shift in tasteswould increase American imports from Europe and American exports. Foreign Borrowing and read more..

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    States than moving it to Europe or Japan. And this preference becomeseven stronger when they contemplate investing in countries threatenedby political or economic instability. Many countries have defaulted on theirdebts; recent examples include Russia, which in 1998 defaulted on someof the debt it owed and called a moratorium on interest payments toforeign creditors, and Argentina, which in 2002 defaulted on paymentsit owed. The more stable the political and economic environment of theworld, the read more..

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    Thinking Like an EconomistINCENTIVES AND THE REAL EXCHANGE RATEWhether their concern is real GDP, real consumption, realinterest rates, or real exchange rates, economists focus on real variables. In the case of real GDP, they look at a measure of production and correct for changes in the gen-eral level of prices. In the case of the real interest rate, theyfind that saving and investment decisions are based on inter-est rates corrected for changes in price levels. Similarly, whendealing with read more..

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    Expectations about changes in the exchange rate in fact play a role in all over-seas investment. Suppose you have saved up some money for a new car, but youdon’t plan to buy it until the summer you graduate from college, eighteen monthsaway. A savings account, U.S. government bonds, and the stocks of an Americancompany are among the many options you have for investing the funds until youneed them. You also could choose to invest in European assets. If you do, you willfirst need to sell your read more..

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    Exchange Rate ManagementFluctuations in exchange rate can have important effects on an economy. As a coun-try’s currency appreciates, its exports become more expensive for foreign buyers,causing declines in production and employment in export-producing industries.Many developing countries have foreign debts that must be repaid in dollars.Depreciation in their currency will make buying the dollars to repay their debt moreexpensive, increasing its burden. Because of the link between interest read more..

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    expressed in terms of the value of the dollar.) As drawn in Figure 34.5, the marketequilibrium exchange rate (e*) is below the pegged rate (ef). Without some sort of gov-ernment intervention, the peso will depreciate until the exchange rate reaches e*. Atthe pegged rate ef, the supply of pesos exceeds the demand for pesos. To keep the valueof the pesos from falling, the Mexican government would need to shift the demandcurve for pesos to the right, as shown in the figure. The government can do read more..

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    constant. Thus, to maintain a fixed exchange rate, the Bank of Canada (Canada’s cen-tral bank) must ensure that it keeps the Canadian interest rate equal to the U.S. inter-est rate. If the Bank of Canada tries to reduce interest rates slightly, perhaps in anattempt to stimulate Canadian investment spending if Canada is in a recession, foreigninvestors will sell Canadian dollars as they take their capital out of the country to earnhigher yields in the United States. To prevent the exchange rate read more..

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    One of the attractions of the European Monetary System of fixed exchange ratesfor countries like Italy was that it linked their monetary policy with that of Germany,a low-inflation country. Before the creation of the EMU, Italy’s inflation rate washigher than Germany’s. Maintaining a fixed nominal exchange rate with Germanyforced Italy to bring down inflation by reducing its net exports, thereby reducingaggregate expenditures, output, and eventually inflation.Reducing Exchange Rate read more..

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    International PerspectiveGLOBAL FINANCIAL CRISESThe decade of the 1990s witnessed three global financial crises.The first occurred in 1992, forcing the United Kingdom, Italy,and Sweden to abandon pegged exchange rates and leadingseveral other members of the European Monetary System(EMS) to devalue their currencies. The second occurred in1994 with the collapse of the Mexican peso. The collapse raisedconcerns among speculators about the financial health of otherLatin American countries, and their read more..

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    As speculators withdrew capital, the governments of theaffected countries faced difficult choices. One option was tosimply let their currencies depreciate. Unfortunately, in manyof these countries, domestic banks and firms had borrowedheavily from foreign sources; a devaluation would make itmore difficult to repay these loans because it would raise thedomestic currency value that must be repaid. Devaluationwould therefore threaten the solvency of the banking sectorof these countries. The second read more..

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    772 ∂CHAPTER 34 THE INTERNATIONAL FINANCIAL SYSTEMFor example, if the dollar seems to be climbing too high against the yen, a plan mightpropose that the Fed sell dollars and buy yen, thereby pushing up the demand foryen and increasing the supply of dollars. Producers in the United States may bedelighted by this move; demand for exports will increase, as will demand for goods thatcompete closely with imports. But producers in Japan will have just the oppositereaction. If the Japanese read more..

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    Under a currency board, the exchange rate between the local currency and, say, the dollar is fixed by law. The central bank holds enough foreign currency toback all the domestic currency and reserves it has issued. This precaution makes arun on the currency unlikely—the central bank always has enough dollars to pay offanyone who shows up wanting to exchange the domestic currency for dollars. Sincethere is never any fear the country will run out of reserves, investors will have noreason to read more..

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    tary policy from a country’s control—in this case, giving it to the Fed. The poten-tial drawback is that the Fed bases its policy decisions on U.S. economic conditionsand would be unlikely to alter monetary policy in response to a domestic economicor financial crisis in a country that had switched to dollars.At the time it dollarized, Ecuador faced the threat of hyperinflation. By adopt-ing the dollar as its currency, Ecuador has enjoyed low inflation instead. Thanks tohigh oil prices, real read more..

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    Review and PracticeSUMMARY1. In a flexible exchange rate system, exchange rates aredetermined in the foreign exchange market by the forcesof supply and demand.2. The demand for and supply of dollars are determined byexports and imports, by foreigners’ desire to invest inthe United States and Americans’ desire to investabroad, and by speculators who base their demands forvarious currencies on expectations about changes infuture exchange rates. 3. In the absence of foreign borrowing and read more..

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    3. Suppose that at the start of 2001, a U.S. investor put $10,000 into a one-year euro investment. If the exchange rate was 1.5 euros per dollar, how much would $10,000 be in euros? Over the course of the year, the euro investment paid 10 percent interest. But when the investor switched back to dollars at the end of the year, the exchange rate was 2 euros per dollar. Did the change in the exchange rate earn the investor more money or less money? How much? How does your analysischange if the read more..

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    Learning GoalsIn this chapter, you will learnHow open economy factorsaffect the ADI curveHow foreign events can affectthe U.S. economyHow monetary and fiscal poli-cies affect the exchange rateand net exportsHow open economy factorsinfluence the effectiveness ofmonetary and fiscal policies4321 read more..

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    Chapter 35POLICY IN THEOPEN ECONOMY∂The previous chapter focused on the foreign exchange market, and on someof the differences between flexible and fixed exchange rate systems. Theworld’s three major economic blocs—the United States, the EuropeanUnion, and Japan—all have adopted flexible exchange rate systems. The forces ofsupply and demand that were discussed in Chapter 34 operate to determine the rel-ative values of the dollar, the euro, and the yen. The purpose of this chapter is read more..

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    The ADI Curve and the OpenEconomyIn the closed economy, the components of aggregate spending are consumption,investment, and government purchases. In the open economy, net exports must beadded to this list. An increase in net exports, just like an increase in governmentpurchases, leads firms to expand production and employment. If foreigners pur-chase more U.S.–produced goods and services, U.S. exports rise. The firms produc-ing these goods increase production and employment. If U.S. residents read more..

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    While this discussion has focused on the demand for dollars by foreign investors,the supply of dollars in the foreign exchange market will also be affected. With U.S.interest rates higher, U.S. investors will be less likely to buy foreign securities, therebyreducing the supply of dollars in the foreign exchange market. Again, the result is toraise the value of the dollar as demand increases and supply decreases.Our discussion took as its starting point a rise in U.S. interest rates. Though read more..

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    Net Exports and Shifts in the ADI Curve Net exports depend on the realexchange rate, but they also can be affected by other factors. For instance, U.S.exports will be affected by the level of income in other countries. If incomes in Mexicorise, Mexicans will buy more goods and services, including more U.S.-producedgoods. So U.S. exports to Mexico will rise when incomes in Mexico rise. And similarly,if Mexico suffers a recession, U.S. exports to Mexico will fall. Shifts in net exports at a given read more..

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    THE EXCHANGE RATE AND INFLATION∂ 783rises and its appreciation reduces net exports. Second, international developments—booms or recessions abroad or changes in foreign interest rates—can have a directimpact on the U.S. economy by shifting the ADI curve.Wrap-UpINTERNATIONAL FACTORS THAT AFFECT THESLOPE OF THE ADI CURVEWhen monetary policy increases interest rates in response to a rise in inflation, thedollar appreciates. An appreciation reduces net exports, one of the componentsof aggregate read more..

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    Thinking Like an EconomistINTEREST PARITY AND INCENTIVESWhenever expected returns on different assets are unequal (afteradjusting for any differences in risk), an economist sees a profitopportunity. By selling the lower-yielding assets and buying thehigher-yielding one, an investor can increase her total return.Investors have an incentive to adjust their portfolios to take advan-tage of the opportunity offered by the higher-yielding assets. Thisidea—that investors seek out the highest read more..

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    Internet ConnectionFOREIGN EXCHANGE RATESThe Universal Currency Converter aactionURI(www.xe.com/ucc/):t www.xe.com/ucc/ enablesyou to find out how much $1 is worth in any of more than sev-enty other currencies, from the Algerian dinar to the Zambiankwacha. Historical series on U.S. dollar exchange rates withmany countries are provided by the Federal Reserve atactionURI(www.federalreserve.gov/releases/H10/hist/):www.federalreserve.gov/releases/H10/hist/.COMPARING MONETARY AND FISCAL POLICIES IN read more..

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    e-InsightNEW TECHNOLOGY AND THE INTEGRATION OF WORLDFINANCIAL MARKETSNew information technologies are leading to tremendous reduc-tions in the costs of carrying out transactions—particularlyin financial markets. Today, you can search the Web for low-costbrokers and trade in financial stocks and bonds in markets inNew York, London, Frankfurt, or Tokyo, right from your homecomputer.The increased integration of world financial markets altersthe impact that fiscal policy has on the economy. To see read more..

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    COMPARING MONETARY AND FISCAL POLICIES IN THE OPEN ECONOMY∂ 787exports are a large fraction of total spending, these exchange rate effects are themain channel of monetary policy.Although monetary policy may be more effective in the short run in an open economy, one of our key earlier conclusions continues to hold: as wages and prices even-tually adjust, the economy returns to full employment. So even in an open economy, thelong-run effect of monetary policy is on inflation, not on output or read more..

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    International PerspectiveIS A STRONG DOLLAR GOOD FOR THE UNITED STATES?Politicians and news commentators frequently associate the“strength” of a nation’s currency with the underlying healthof its economy. And concerns are often expressed when the value of a currency falls. The experience with the euro pro-vides a case in point. The euro came into existence on January1, 1999, when eleven European countries joined together toform a monetary union. The exchange rate between the euro,its new read more..

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    Central Bank had increased the interest rate to try to pre-vent the weakening of the euro, it would have made Europe’srecovery from recession more difficult.A weak currency will boost exports and reduce imports;a strong currency has the opposite effect. The United Stateshas a huge trade deficit. The fall in the value of the dollar overthe past few years will help reduce this deficit by making for-eign goods more expensive for Americans and makingAmerican goods cheaper for foreigners. Thus, if read more..

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    790 ∂CHAPTER 35 POLICY IN THE OPEN ECONOMYReview and PracticeSUMMARY1. In the open economy, net exports are a component ofaggregate spending. Both imports and exports dependon the real exchange rate. A lower real exchange rateincreases exports and reduces imports.2. Changes in the real interest rate affect investment, theexchange rate, and net exports. A rise in the real inter-est rate reduces domestic investment and net exports,leading to a downward shift in aggregate expenditures. 3. The read more..

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    3. Suppose a fall in net exports due to a recession amongour major trading partners causes a recession in theUnited States. (a) If fiscal policy is used to stimulate the economy andreturn it to full employment, what happens to thereal interest rate, investment, and future output?(b) If monetary policy is used to stimulate the economyand return it to full employment, what happens tothe real interest rate, investment, and futureoutput?4. The United States is a major export market for read more..

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    Learning GoalsIn this chapter, you will learnHow developing economiesdiffer from developedeconomies such as the United States, Japan, andwestern EuropeWhat the impediments to growth in developingeconomies are, and what policies these countries canpursue to improve their standards of livingWhat globalization is and whysome people are skeptical of itHow resources were allocatedunder the old communist sys-tem, and how the transitioneconomies have fared sincethe collapse of communism4321 read more..

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    Chapter 36DEVELOPMENT AND TRANSITION∂Every year, thousands of Mexicans risk their lives to cross into the UnitedStates. The reason is simple: they seek a way out of their poverty. In theUnited States, a family of four is said to be in poverty—to have insufficientincome for a minimal standard of living—if its income is less than $18,811. This incomeis about equal to that of the average family of four in Mexico! The average incomeper capita in Mexico is one-sixth of that in the United read more..

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    This chapter explores the issues of economic development and transition. Wewill see that many of the challenges faced by developing and transitional economiesrelate to the process by which the world has become increasingly integrated eco-nomically. This process, called globalization, has created opportunities for somecountries, but it has also been a source of contention and even conflict.DevelopmentThree-fourths of the world’s population live in less-developed countries, or LDCs.Statistics read more..

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    has been falling. Life is getting worse, not better. The AIDS epidemic has ravagedAfrica and threatens much of the rest of the developing world, making a bad situa-tion even worse. Some countries, like Zambia, have seen life expectancy fall by tenyears in less than a decade. More than one-fourth of the population in southernAfrica is infected with HIV.The United Nations and the World Bank (a bank established by the major indus-trialized countries after World War II that provides loans to LDCs) read more..

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    First, several countries have moved from the circle of LDCs to the ranks ofmiddle-income countries. These are referred to collectively as newly industrial-ized countries, or NICs for short. Those with success stories include the “gang offour”: South Korea, Taiwan, Singapore, and Hong Kong. In the thirty years afterthe devastating Korean War, for instance, South Korea moved from being a back-ward country to a major producer—not just of simple products such as textilesbut of automobiles (the read more..

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    LIFE IN A LESS-DEVELOPED COUNTRYJust as there are large differences between the LDCs and the industrialized coun-tries, so there are large differences among the LDCs. The largest LDC of all, China,has a communist government. The second-largest, India, functions as the world’slargest democracy. Literacy standards in Costa Rica rank with those of the indus-trialized countries, whereas more than half of the adult population in sub-SaharanAfrica is illiterate. One must be careful in generalizing read more..

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    redistributed to the peasants. Such land reforms were a precursor to the remark-able growth in Taiwan and Japan. In other countries, such as the Philippines andPeru, the land reforms have been only partially successful.Over the past fifty years, most LDCs have experienced gradual urbanization.Those who live in the cities have a much higher standard of living, including accessto better education and health facilities. The marked differences between the citiesand rural areas have led some to refer read more..

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    Some of this inequality is simply due to the law of supply and demand. Becauseunskilled labor is abundant and skilled labor and entrepreneurs are scarce, unskilledwages are low and those who have skills prosper. Indeed, earlier theories suggestedthat inequality contributed to economic growth. Sir Arthur Lewis, who received theNobel Prize for his work on development economics, argued that what he called thesurplus of labor kept wages low and profits high. Workers earning subsistencewages could read more..

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    closing this gap, with remarkable success. Some countries, like Singapore,encouraged foreign firms to invest directly, bringing with them access toforeign markets as well as new technology. Other countries, like Korea, focused on licensing new technologies from the more advanced countries.• Political and social stability, which provides an environment conducive toinvestment.So impressive have the outcomes in East Asia been that many refer to them asthe East Asian miracle. Some economists, read more..

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    changes served to level the playing field, enabling American producers such as Intelto draw on America’s comparative advantage in chip production and reassert lead-ership in the industry. The dangers of government intervention are often symbol-ized by the Japanese government’s failed attempt to discourage Honda (originally amanufacturer of motorcycles) from entering the auto market, arguing that therewere already too many producers.Export-Led Growth A second factor that distinguished the read more..

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    Wrap-UpEAST ASIA’S SUCCESSKey ingredients to East Asia’s success include macroeconomic stability, high savingrates to finance investment, investment in education and in technology, and politicaland social stability.Governments pursued market-oriented policies that encouraged saving and investment.Growth strategies emphasized export-led growth.Income equality was fostered.ALTERNATIVE DEVELOPMENT STRATEGIESThe development strategies pursued by East Asia stood in marked contrast to read more..

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    policies, together with macroeconomic stability, were often referred to as theWashington consensus, since they were advocated by the U.S. Treasury and two inter-national institutions located in Washington, the International Monetary Fund (IMF)and the World Bank. In many cases, these policies proved little better than theirpredecessors in promoting growth over an extended period of time. Reducing tariffbarriers led to losses of jobs, and the developing economies were not able to gener-ate new read more..

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    Case in PointA HISTORICAL PERSPECTIVE ONGLOBALIZATIONThere has been much discussion of globalization, the closer integration of theeconomies around the world. The most dramatic aspect of globalization is the growthof trade, of exports and imports. But there are other aspects. Workers migrate fromone country to another, multinational firms do business across borders, billions ofdollars of capital flow from one country to another, and ideas and knowledge areceaselessly communicated via the read more..

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    Trade Giving less-developed economies access to the U.S. markets is a win-winpolicy. American consumers win by having a greater variety of goods at lower prices.The LDCs benefit by having a huge market for their goods. The United States hasa system of preferential treatment for poor countries called the general system ofpreferences, or GSP. Of course, as always with trade, some U.S. producers and theirworkers complain about the loss of jobs to these low-cost competitors. As arguedin Chapter 19, read more..

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    806 ∂CHAPTER 36 DEVELOPMENT AND TRANSITIONe-InsightINDIAN ENGINEERS IN SILICON VALLEY AND SILICONVALLEY’S CAPITAL IN INDIAGlobalization and the increasing integration of the world econ-omy can allow both investment capital and workers to moveacross borders, seeking more profitable opportunities. Nothingbetter illustrates this interchange than the investment by ven-ture capitalists and U.S.-based firms in India’s Silicon Valley andthe immigration of high-tech workers from India to read more..

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    2004 with plans to hire 500 workers. While some American jobs may move to other countries, new jobs are being created by foreign firms that locate in the United States. The movement of jobs is part of the process of globalization. Like free trade, thisprocess can benefit all countries. But also like free trade, its overall benefits do notnecessarily translate into gains for each and every individual. Those workers whosejobs are lost do suffer, just as they would if their jobs moved to another read more..

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    more advanced industrialized countries. But the possibility that Africa can do thesame remains remote. Its current standard of living, already low, is threatened bythe AIDS epidemic and continuing civil strife, conditions that make it difficult toattract foreign capital and that are not conducive even to domestic investment. Asa result, the gap between Africa and the rest of the world is likely to widen.Wrap-UpDEVELOPMENTIn LDCs, per capita income is a fraction of that enjoyed in the developed read more..

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    calculations of this kind allowed it to determine how much of every good should be produced. It then worked backward, figuring out how much each plant in the country should produce. Factory managers were given production quotas—they should produce so many tons of steel, or so many nails. Factory managers alsowere allocated inputs with which to produce the output. This system was called central planning.The Failures of Communism The central planners decided on wage levelsand prices as well. read more..

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    Wrap-UpTHE COMMUNIST SYSTEM IN THE SOVIET UNIONThe government owned the means of production and determined what should beproduced and how it should be produced under a system of central planning.Because wages and prices were set by the government, they could not function to balance supply and demand. Shortages were common and many goods were rationed.By the 1980s, the failures of Soviet agriculture and Soviet industry’s inability to keepup with rapid innovation in the West led first to read more..

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    with ethnic strife or conflicts with their neighbors (such as between Armenia andAzerbaijan). Some countries produced commodities, such as cotton and gold, thathad ready markets in the West; others, accustomed to producing such goods as partsfor Russian tractors or cars, found themselves with limited markets.Gradualism Versus Shock Therapy In the beginning of the transition,many countries faced a problem of extremely high inflation. Under communism,prices were controlled at levels that were too read more..

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    In the end, the shock therapy approach won out in policy circles, especially inthe West. The U.S. Treasury and the IMF pushed for rapid privatization and liber-alization. They argued not only for eliminating trade barriers but also for openingup capital markets. Doing so, they asserted, would demonstrate to outside investorsthat Russia was a business-friendly place in which to invest. To be sure, they saidthat the institutional infrastructure was important, but they believed that this read more..

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    ECONOMIES IN TRANSITION∂ 813the value of existing savings. Mafia-like activity made it increasingly difficult for ordinary individuals to conduct business. Overall, according to a World Bank study, corruption in the region was second only to that in Africa.• Privatization of Russia’s major revenue sources at bargain-basement prices not only lent a sense of unfairness to the whole process but also,since an effective tax collection system had not been put into place, left the government read more..

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    814 ∂CHAPTER 36 DEVELOPMENT AND TRANSITIONReview and PracticeSUMMARY1. In less-developed countries, or LDCs, life expectanciesare usually shorter, infant mortality is higher, and peopleare less educated than in developed countries. Also, alarger fraction of the population lives in rural areas, andpopulation growth rates are higher.2. In recent years, newly industrialized countries (NICs)such as South Korea, Singapore, Hong Kong, andTaiwan have managed to improve their economic read more..

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    REVIEW AND PRACTICE∂ 8156. What are some of the roles that government can play inpromoting economic development and growth?7. How were resources allocated under the former Soviet(communist) system?8. What were some of the problems with the communistsystem, and why was the switch to a market economyexpected to lead to increased incomes?9. What were two of the different strategies for movingfrom communism to a market economy?10. How have different countries fared in the transition?How do you read more..

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    ∂∂817Part 9FURTHER TOPICS INMACROECONOMICS read more..

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    Learning GoalsIn this chapter, you will learnWhat the short-run Phillipscurve is and why it shiftsThe three factors that affectinflationThe short-run inflation–unemployment trade-off andthe role of expectations321 read more..

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    Chapter 37INFLATION ANDUNEMPLOYMENT∂During the 1970s, the most pressing macroeconomic policy issue facing indus-trialized economies was inflation. Despite repeated attempts to reduceit, inflation remained stubbornly high throughout the decade. Figure 37.1shows the inflation rates for the United States, Japan, and western Europe. All dis-play roughly similar patterns. Inflation had remained relatively low during the 1960s,but it jumped to much higher levels in the following decade.To understand read more..

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    full-employment model shows that once real wages have adjusted, the economy willbe at full employment, no matter what the rate of inflation might be.In Chapter 31 we assumed that inflation rises and falls as the economy movesabove or below potential GDP. The adjustment of inflation played a critical role in even-tually moving the economy to full employment. In this chapter, we will examine thefoundations of inflation adjustment in more detail. Three factors are important forexplaining how read more..

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    curve. A. W. Phillips was a New Zealander who taught economics inEngland during the 1950s. He examined data from England on unem-ployment and the rate of increases in nominal or money wages. He founda negative relationship between the two, and this relationship is knownas the Phillips curve. At higher unemployment rates, money wages rosemore slowly. At lower unemployment rates, money wages rose morequickly. The relationship he found is shown in Figure 37.2.The logic behind the Phillips curve is read more..

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    than it was during the high inflation period from 1974 to 1983. In other words, therelationship between inflation and unemployment is not stable. Understanding whythe Phillips curve shifts is a primary objective of this chapter. To explain these shifts,economists draw on the concept of the natural rate of unemployment and the roleof expectations.The Natural Rate of Unemployment There are reasons why unemploy-ment is always positive. Not every worker is qualified to do every job. When thereis read more..

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    tight, and wages rise more rapidly. It is the rate of cyclical unemploy-ment, not the total level of unemployment, that best measures theinflationary pressures in the economy.In Chapter 31, we combined the aggregate demand–inflation (ADI)curve with an inflation adjustment (IA) line. We drew the IA line as ahorizontal line at the economy’s current rate of inflation. If equilib-rium output rose above or fell below full-employment output, we shiftedthe IA line to reflect the changes in read more..

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    Wrap-UpINFLATION AND CYCLICAL UNEMPLOYMENTThe natural rate of unemployment is the unemployment rate when the economy is atpotential GDP and cyclical unemployment is zero.The short-run inflation adjustment (SRIA) curve shows the rate of inflation at eachlevel of output relative to potential GDP, for a given expected rate of inflation.The SRIA curve has a positive slope. If output increases above potential, inflationincreases. If output falls below potential, inflation falls.THE ROLE OF read more..

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    on the rate of inflation. The position of the SRIA curve depends on the level of expected inflation. Because it includes inflationaryexpectations, we refer to it as the expectations-augmented SRIA curve.To better understand the role of the natural rate of unemploy-ment, consider how expectations about inflation are affected both byrecent experience and by anticipated changes in policy and economicconditions. Take the simple case of adaptive expectations1—that is,expectations that respond or read more..

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    Thinking Like an EconomistDISTRIBUTIONAL EFFECTS OF INFLATION ANDUNEMPLOYMENTInflation and cyclical unemployment impose macroeconomiccosts on the economy. Each does so by affecting the lives of mil-lions of individuals. However, not everyone is affected equally.Even when cyclical unemployment reaches very high levels, asit did during the 1982 recession, only a small fraction of thetotal labor force bears the direct hardship of losing a job, andthe burden does not fall evenly on different groups read more..

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    An important implication of this conclusion is a consensus belief about macro-economic policy: governments should not try to use macroeconomic policies to main-tain the unemployment rate below the natural rate or output above potential.Expansionary policies will temporarily lower unemployment and boost income, but eventually unemployment returns to the natural rate. Thus, the policy ques-tion is whether the temporary fall in unemployment is worth the potential cost of higher inflation.A key read more..

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    828 ∂CHAPTER 37 INFLATION AND UNEMPLOYMENTMilton Friedman, Nobel Laureate, 1976Robert Lucas, Nobel Laureate, 1995During the 1960s, most economists believed that a stable Phillips curve allowedlower average unemployment rates to be achieved if one were willing to accept apermanently higher (but stable) rate of inflation. Friedman argued that such a trade-off could not persist. Expanding the economy to lower unemployment would leadto increases in nominal wages as firms attempted to attract read more..

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    Internet ConnectionWINNERS OF THE NOBEL PRIZE IN ECONOMICSYou can learn more about the research contributions of Milton Friedman, Robert Lucas, and other winners of theNobel Prize in Economic Sciences aactionURI(www.almaz.com/nobel/economics/economics.html):t www.almaz.com/nobel/actionURI(www.almaz.com/nobel/economics/economics.html):economics/economics.html.SHIFTS IN THE NATURAL RATEThough the concept of the natural rate of unemployment is well accepted, econo-mists do differ in their judgments read more..

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    old was 11 percent; for teenage males, over 13 percent. In contrast, the unemploymentrates for older workers were much lower.These differences in the unemployment experiences of different age groups haveimportant implications for the total unemployment rate when the age distributionof the population is changing. The total unemployment rate is equal to a weightedaverage of the unemployment rates of different age groups. The weight placed onthe unemployment rate of teenagers, say, will equal the read more..

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    the oil embargo imposed by the Organization of Petroleum Exporting Countries(OPEC) as a result of the 1973 Arab-Israeli War. The sharp increases in inflationcaused by these oil price increases are clearly visible in Figure 37.1. As this expe-rience suggests, other factors besides cyclical unemployment and expectations influence inflation.The basic relationship between output and inflation that we summarized inthe inflation adjustment curve started with the Phillips curve relationship read more..

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    EXPECTATIONSWage and price decisions will be influenced by the expectations about inflation that are held by individuals and firms. If higher inflation is expected, wage growthwill rise, leading to an increase in actual inflation. This happens because workersand firms are concerned with real wages, and nominal wages must increase fasterto maintain real wages when inflation is higher.INFLATION SHOCKSFactors such as oil price changes that affect the cost of production will lead to fluc-tuations in read more..

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    expected inflation rate equal to π0. In the situation depicted, the short-run equilibrium occurs at point E1 with output equal to Y1 and inflationequal to π1. Two aspects of this short-run equilibrium are importantto note. First, the economy is producing at an output level above poten-tial (Y f). Second, the inflation rate π1 is greater than people hadexpected.The economy will not remain at point E1, however, because infla-tion is now higher than people had expected. Inflation read more..

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    834 ∂CHAPTER 37 INFLATION AND UNEMPLOYMENTReview and PracticeSUMMARY1. Other things being equal, in the short run, higher un-employment is associated with lower inflation. This relationship is called the Phillips curve.2. Other things being equal, lower output is associated withlower inflation. This relationship is called the short-runinflation adjustment (SRIA) curve.3. The level of inflation associated with any particular levelof cyclical unemployment or output gap will increase read more..

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    REVIEW AND PRACTICE∂ 835unemployment rate is 5 percent (i.e., U1 = U *= 5 percent).Now suppose in year 2 the unemployment rate falls to 4percent and remains there. Complete the next four rowsof the table. What is the inflation rate in year 7?ExpectedYearUnemploymentInflationInflation15 percent4 percent4 percent24 percent4 percent4.5 percent34 percent4.5 percent5 percent45675. Return to the situation of year 1 in the previous problem.By how much would unemployment need to rise to lowerinflation read more..

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    Learning GoalsIn this chapter, you will learnWhy economists dis-agree about the impact ofgovernment deficitsWhy economists disagreeabout the usefulness ofmacroeconomic stabilizationpolicies What the main debates over the goals of monetarypolicy are321 read more..

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    Chapter 38CONTROVERSIES INMACROECONOMICPOLICY∂Parts Six and Seven provide the tools you can use to analyze many importantmacroeconomic policy debates. You have learned how monetary and fiscalpolicy affect the economy, and how economic disturbances can lead to fluc-tuations in output, employment, and inflation. Much of the analysis representedpositive economics—we asked what the impact of a policy action would be withoutasking whether the policy was good or bad. Now we need to apply the tools read more..

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    Market Committee (FOMC) have supported it. This issue gives us a third question:Should the Fed target inflation? Do Deficits Matter?The budget of the U.S. federal government deteriorated rapidly between 2000 and2004. In 2000, the federal budget had a $236 billion surplus; by 2004, the deficit was$520 billion, equal to about 4.5 percent of GDP. Figure 38.1 shows the big swings in the federal budget picture over the past twenty-five years. By the end of the 1990s,the United States appeared to have read more..

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    ing a large tax cut through Congress in 2001. The September 11, 2001, terroristattacks on the United States led to substantial increases in military expenditures.And the expiration in 2002 of the “pay-as-you-go” rule introduced in the 1990sremoved a significant restraint on government spending. But if we focus just on the current deficit, we will miss the big picture as far asthe federal budget is concerned. Because of the aging of the American population,health care (Medicare and Medicaid) read more..

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    the country must pay some of its national income each year to foreign investors asinterest on its borrowing. A surplus in a small open economy would have the oppo-site effect, leading to a capital outflow. That an increase in the fiscal deficit leaves private investment in the small openeconomy unaffected might suggest that it has no long-term consequences for economicgrowth. After all, since investment has not changed, the economy’s future stock ofcapital is not reduced (as would happen in a read more..

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    rather than raising taxes to finance its expenditures, it has shifted the burden ofreduced consumption to future taxpayers. During World War II, the U.S. govern-ment borrowed money rather than raise taxes by the full amount necessary to financethe war effort. Suppose that the bonds it issued were purchased by forty-year-old work-ers. Then, thirty years later, after those forty-year-olds retire, the government decidesto pay off the bonds by raising taxes on those currently in the labor force. In read more..

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    investment. Barro bases his argument on an analysis originally developed by DavidRicardo, an eighteenth-century English economist. Ricardo noted that when thegovernment cuts taxes and runs a deficit, it must borrow to finance its expendi-tures. The government will need to raise taxes in the future to pay back what it hasborrowed. If households correctly perceive that a tax cut today means higher taxestomorrow, they will save any current windfall in order to ensure that they have theresources read more..

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    ity.” The Humphrey-Hawkins Act set specific “interim” goals for unemployment (4 percent) and inflation (3 percent). These were ambitious targets: in 1978, actualunemployment was 6.1 percent and inflation was 9 percent. Over the next five years,unemployment averaged just under 8 percent, twice the interim goal of 4 percent,and inflation averaged 8.5 percent. Neither of the basic objectives of macroeconomicpolicy—low unemployment and low inflation—was achieved. At other times, theeconomy read more..

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    many economists—should governments even attempt to intervene to stabilize themacroeconomy? Or do such attempts simply worsen economic performance?THE NONINTERVENTIONIST PERSPECTIVEThose who share the view that government should not intervene to stabilize theeconomy differ in their reasons. Some believe that the economy is efficient, leavinglittle for the government to add. Others believe that government actions are inef-fective, while still others argue that they do have significant effects read more..

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    in markets, but they have little confidence in the ability of governments to im-prove macroeconomic performance. Indeed, some believe that intervention is counterproductive, for two reasons.First, they recognize that there are important lags that make policymaking dif-ficult. It takes time for the government to recognize a problem—and the lags in get-ting data, revisions in preliminary data, and the often conflicting information availablecan leave policymakers in great uncertainty as they try read more..

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    years, many countries have attempted to reduce the influence of elected politicianson monetary policy for just this reason.Rules Versus Discretion Critics of intervention claim that historically, whetherbecause of politically motivated decisions or simply because of the lags described ear-lier, government has actually exacerbated the economy’s fluctuations. When thegovernment attempts to dampen a boom, its policies aimed at reducing demandtake effect just as the economy is weakening, read more..

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    THE INTERVENTIONIST PERSPECTIVEThe case for intervention is based on two key beliefs. First, economic fluctuations arenot simply the efficient response of the market to shifts in productivity, as the realbusiness cycle theorists argue. Instead, wages do not adjust quickly enough to main-tain a balance between labor supply and labor demand, and therefore declines inaggregate expenditures lead to cyclical unemployment. Second, the period of exces-sive unemployment can persist for a long time. In read more..

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    InterventionistsNew Keynesian economists generally accept that policies can have no long-run effecton GDP or the natural rate of unemployment because wages, prices, and expectationseventually adjust, but they think markets respond slowly, so periods of cyclical unem-ployment can persist. Discretionary macroeconomic policy can be effective, andgovernments should design built-in stabilizers that can help make the economy less volatile.Should the Federal Reserve Target Inflation?Compared to our read more..

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    ceed in keeping the unemployment rate below its full-employment level, then itsappropriate goals are to contribute to economic stability by ensuring that full employ-ment is maintained and by keeping inflation low. In this way, monetary policy ensuresthat the economy can experience sustainable economic growth.To achieve the goals of full employment and low inflation, the Fed can pursuetwo types of policies. First, it can engage in countercyclical policies—policiesdesigned to keep the economy read more..

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    could be judged would reduce its flexibility to meet unforeseen future economicdevelopments.The Pros Supporters of inflation targeting cite three chief advantages.Inflation targeting focuses on what the Fed can achieve Currently, the Fed has multi-ple goals. A 1977 congressional amendment to the Federal Reserve Act stipulated thatthey include promoting “maximum” sustainable output and employment and “stable”prices. The goal of stable prices is normally translated into a goal of low and read more..

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    they argue that if the Fed is held accountable for achieving its inflation target, itwill inevitably pay less attention to other goals.Inflation targeting reduces flexibility Adopting a formal inflation target would re-duce the Fed’s flexibility in responding to new economic challenges. Supply shocksmay require that the Fed allow inflation to increase temporarily in order to limitthe economic contraction that would be needed to prevent its rise. A formal infla-tion target might limit the read more..

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    background of already-tight domestic labor markets and ongoing strength in demandin excess of productivity gains, the Committee recognizes the need to be alert todevelopments over coming months that might indicate that financial conditions mayno longer be consistent with containing inflation.By the time of their next meeting (on June 30), the FOMC members decided it was time to boost interest rates. After their meeting, they issued the followingstatement:The Federal Open Market Committee today read more..

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    These actions were taken in light of further weakening of the sales and produc-tion, and in the context of lower consumer confidence, tight conditions in some seg-ments of financial markets, and high energy prices sapping household and businesspurchasing power. Moreover, inflation pressures remain contained. . . .CONSEQUENCES OF INFLATION TARGETINGEven a central bank that has adopted a formal inflation target still must make impor-tant policy choices. We can use the ADI framework to understand read more..

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    when using the rule given by B. Panel Bshows the ADI curves under the two differentpolicy rules, ADIA and ADIB. The full-employment equilibrium is at point E0.Suppose the economy is hit by a temporary inflation shock that increases infla-tion, as shown in panel B. An oil price increase or a rise in inflationary expectationswould have this effect. If the central bank’s behavior is described by the policy rule A,the economy moves to a new short-run equilibrium at point EA. If thecentral bank’s read more..

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    The green lines in the figure illustrate what happens under price level target-ing. The inflation shock pushes the price level higher, but now policy acts to returnthe price level to its initial level. This requires deflation—prices must actually fall.Few central banks have adopted price level targeting. The deflation needed toget the price level back on target after a positive inflation shock would require acostly recession and a period of high unemployment.3SHOULD THE FEDERAL RESERVE TARGET read more..

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    Deflation and a Zero Nominal Interest Rate During the 1970s and early1980s, inflation seemed an intractable problem. Most countries succeeded in even-tually reducing inflation, but only at the cost of significant increases in unemploy-ment. Today, the situation is quite different. The average inflation rate in the UnitedStates was just over 3 percent in 2004.In many countries, concern over inflation has been replaced by worries thatprices will fall—deflation. In Japan, prices declined each read more..

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    SHOULD THE FEDERAL RESERVE TARGET INFLATION?∂ 857rate−1 percent expected inflation). The promise to deliver some inflation helps stimulate the economy.Deflations often have been associated with tough times, times of economic stag-nation and high unemployment. When prices fall, the dollars a borrower must repayare worth more than the dollars that were borrowed. Much as unexpected infla-tion redistributes wealth from lenders to borrowers, so conversely, unexpecteddeflation benefits lenders at read more..

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    e-Insighte-TIME AND MACROECONOMIC POLICYAs the U.S. economy boomed during the late 1990s, econo-mists speculated on how the business cycle would be affect-ed. There has been less discussion of the impact the new information-based economy will have on macroeconomic policy.Policymakers will be affected if the economy now respondsmore rapidly to changing conditions.Fluctuations in inventory investment, which have been amajor factor in several previous business cycles, may in thefuture be limited by read more..

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    but doing so leads to bigger swings in output and employment. Even though they would like to keep the economy stable at full employment and low inflation, policymakers must choose which goal to focus on—they cannot achieve both.Policymakers do not face this same fundamental trade-off when the economyexperiences disturbances that shift the ADI curve, such as shifts in fiscal policy,changes in spending decisions by households or firms, or economic fluctuations inother countries that affect net read more..

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    Review and PracticeSUMMARY1. The traditional view of government deficits argues thatdeficits reduce national saving, raise the equilibrium realinterest rate, and crowd out private investment spend-ing. The result is less capital and lower incomes in thefuture. The burden of government deficits falls on futuregenerations. 2. Under Ricardian equivalence, individuals understandthat deficits today mean higher taxes in the future.Those in the private sector increase their saving inanticipation of the read more..

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    REVIEW AND PRACTICE∂ 861between fluctuations in unemployment and fluctuationsin inflation do policymakers face? 10. What is the difference between a policy of inflation targeting and a policy of price level targeting?PROBLEMS1. Suppose the government cuts taxes. Using a supply anddemand analysis of the capital market, explain what theimpact of the tax cut will be on the equilibrium realinterest rate at full employment.2. Suppose the government’s budget is currently in bal-ance but the read more..

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    862 ∂CHAPTER 38 CONTROVERSIES IN MACROECONOMIC POLICYADYfPRICE LEVEL (P)OUTPUT (Y )Figure 38.5THE AGGREGATE DEMANDCURVEIf the central bank adjusts the interestrate whenever the price level deviatesfrom its target level, the ADI curve isreplaced with a relationship between theprice level (P ) and aggregate expendi-tures called the aggregate demand (AD)curve. If P increases, the central bankincreases the interest rate, leading to areduction in aggregate expenditures.Changes in fiscal policy or read more..

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    Learning GoalsIn this chapter, you will learnAbout the principal invest-ment alternatives availablefor your savingsThe important characteristicsof each of these investmentoptionsWhy some assets yieldhigher rates of return thanothersWhether it is possible to“beat the market”Some of the basic rules for intelligent investing54321 read more..

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    Chapter 39A STUDENT’S GUIDETO INVESTING∂The 1990s saw a tremendous rise in the value of the stock market—it seemedas if almost every day some new company was selling shares to the publicand creating new billionaires overnight. This picture all changed abruptlyin 2000 when the stock market collapsed, causing millions to see their paper wealthdisappear. The ups and downs of the stock market are often taken as key signals ofthe economy’s health, and the swings of the financial market that read more..

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    Investment AlternativesSavers wishing to invest are offered a range of possibilities. The choices they makedepend on the amount of money they have to invest, their motivations to save, theirwillingness to bear risk, and such personal characteristics as age and health. Of theseemingly endless array of destinations for one’s money, five are most important:bank deposits, including certificates of deposit (CDs); housing; bonds; stocks; andmutual funds. In making choices among them, investors focus read more..

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    BONDSBonds are a way for corporations and government to borrow. The borrower—whethera company, a state, a school district, or the U.S. government—promises to pay thelender (the purchaser of the bond, or investor) a fixed amount in a specified numberof years. In addition, the borrower agrees to pay the lender each year a fixed returnon the amount borrowed. Thus, if the interest rate on a ten-year bond is 10 percent,a $10,000 bond will pay the lender $1,000 every year, and $10,000 at the end read more..

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    a rate of 7 percent over those ten years, the real value of the $10,000 will be just one-half what it would have been had prices remained stable during that decade.2Because of the higher risk caused by these uncertainties, long-term bonds mustcompensate investors by paying higher returns, on average, than comparable short-term bonds. And because every corporation has at least a slight chance of goingbankrupt, corporate bonds must compensate investors for that higher risk by payinghigher returns read more..

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    regarding the prospects of the economy, the industry, and that particular firm. Lossof faith in any one of these could lead to a drop in the stock price. Thus, an individ-ual who has to sell all his shares because of some medical emergency might findthey have declined significantly in value. Even if the investor believes that the shareswill eventually return to a higher value, he may be unable to wait.Shares of stock are riskier than corporate bonds. When a firm goes bankruptand must pay off its read more..

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    Internet ConnectionINDEX FUNDSMany mutual funds are designed to follow the return of amarket index, such as the Standard and Poor’s (S&P) 500index. Standard and Poor’s Web site aactionURI(www.spglobal.com):t www.spglobal.com pro-vides the latest information on the performance of their indexes.If you follow the links on the left side of the page, you will finda primer on the mathematics of calculating market indexes.too. When stocks go down, bonds often go up, so some mutual funds invest read more..

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    Few assets offer guaranteed returns. If the stock market booms, a stock sharemight yield 20 percent; but if the market drops, the total return might be zero oreven negative. To compare two alternative investment options, we apply the con-cept of expected returns. The expected return on an asset is the single numberthat takes into account both the various possible returns per dollar invested andthe chances that each of those possibilities will occur. If there is a one-in-four chance(a 25 percent read more..

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    a one-in-two chance (a 50 percent probability) the return will be 5 percent, and a one-in-four chance (a 25 percent probability) the return will be zero, the expectedreturn on the stock is 7.5 percent (.25 × 20 percent + .5 × 5 percent + .25 ×0 percent).Case in PointPG&E EMPLOYEES LEARN WHYDIVERSIFICATION IS IMPORTANTIn January 2001, Pacific Gas & Electric Company (PG&E), a major supplier of elec-tricity to northern California, quite suddenly found itself facing bankruptcy. read more..

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    $10.19 in January 2001. The utility’s bonds were downgraded to the lowest echelonsof the junk bond range, indicating that Wall Street thought there was little chancethat bondholders would be repaid or receive interest. PG&E suspended dividendson its stock, laid off workers, and hired bankruptcy lawyers to assess its options.For some PG&E employees, the energy crisis that put at risk the boomingCalifornia economy carried a double threat. Workers were clearly in danger of losingjobs. But read more..

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    (and in some cases, their parents) for most of their lives. The sudden collapse ofPG&E underscores the importance of diversification to minimize (though not avoidentirely) the risk of holding individual stocks.3An important first lesson in investment theory is as follows: If there were no dif-ferences between assets other than the ways in which they produce returns (interest, div-idends, etc.), then the expected returns to all assets would be the same. Why? Supposean asset offered an read more..

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    largest one-day drop occurred on October 27, 1997, when the Dow Jones index lost554 points.The percentage change in the level of stock prices can be seen more clearly byplotting the natural log of the Dow Jones index (panel B). Here, the magnitude ofthe 1929 crash clearly stands out. The 1929 crash was not simply a one-day drop—three of the five biggest percentage daily declines over the 1900–2000 period occurredin late October and early November of 1929. The record for the largest read more..

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    market decline between August 2000 and March 2001 shows upclearly in panel A. While the New York Stock Exchange is by far the largest stockmarket in the world, there are others, and in recent years the Nasdaqmarket has grown in importance. The Nasdaq stock market, createdin 1971, is heavily weighted toward the new technology companies. Thestocks of Microsoft and Intel, for example, are traded on the Nasdaqmarket, not the New York Stock Exchange. The addition of Microsoftand Intel to the Dow read more..

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    Investing in housing, particularly a house to live in, is another tax-favored formof investment enjoyed by most Americans. Most homeowners can deduct their realestate taxes and the interest payments on their mortgage when calculating theirincome for tax purposes. In addition, the capital gain from owning the house is nottaxed until the house is sold. Even then, the capital gain (up to $500,000 for a mar-ried couple) from the sale is not taxed at all. If the tax advantages of home owner-ship were read more..

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    firm can buy or sell as much as it wants at that price; and the transaction is virtu-ally without cost. But these assumptions are not always met: the costs of selling orbuying an asset are often significant. As noted above, for instance, the costs of sell-ing a house can be 5 percent or more of the house’s value. At times, even municipalbonds have been fairly illiquid. The prices at which such bonds could be bought andsold have been known to differ by more than 20 percent.Expectations and the read more..

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    Thus, while changes in tastes or technology or incomes or the prices of othergoods today could not account for some of the sharp changes in asset values describedat the start of this section, changes in expectations concerning any of these vari-ables in the future will have an effect today on the demand. Markets for assets arelinked together over time. An event that is expected to happen in ten or fifteen or evenfifty years can have a direct bearing on today’s market.To evaluate the effects of read more..

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    calculating the present discounted value, we can measure and com-pare returns anticipated in the future. Demand today for an asset willdepend on the present discounted value that it is expected to fetchwhen sold in the future.Present discounted values can change for two reasons. First, theycan change because of a change in the expected price of an asset atthe time one anticipates selling it. This type of change is illustrated inFigure 39.4. That such expectations of future prices can be quite read more..

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    subsides. Thus, if a person knows that economic analysts are predicting lower inflation, she will not expect the gold price increases to continue. Even when individ-uals form their expectations rationally, they will not be right all the time. Sometimesthey will be overly optimistic, sometimes overly pessimistic (although in makingtheir decisions, they are aware of these possibilities). But the assumption of rationalexpectations is that on average they will judge correctly.The 1970s was a decade read more..

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    EFFICIENCY AND THE STOCK MARKETMost people do not think they can wander over to the racetrack and make a for-tune. They are not so skeptical about the stock market. They believe that even ifthey themselves cannot sit down with the Wall Street Journal or browse an onlinebroker’s site and pick out all the best stocks, someone who studies the stock marketfor a living could do so. But economists startled the investment community in the early1960s by pointing out that choosing successful stocks is read more..

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    can expect to earn only a normal level of profit. Of course, the trick is to know whento sell stocks before everyone else also decides it is time to sell. In 2000, the pricesof technology stocks dropped dramatically. Today, shares of Microsoft trade foraround $27 each. The one exception is not really an exception because it involves trading withknowledge that other stock market participants do not have. Inside traders are indi-viduals who buy and sell shares of companies for which they work. read more..

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    believe that their insights, rather than luck, are what has enabled them to beat the market.EFFICIENT MARKETS OR RANDOM NOISE?While most economists agree there is little evidence that individuals can consis-tently beat the market, even when they spend considerable money on information,they disagree over how to interpret this finding. Some see it as evidence of the effi-ciency of the market, as we have seen. But other economists view it as evidence ofnothing more than the market’s randomness. read more..

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    STRATEGIES FOR INTELLIGENT INVESTING∂ 885Strategies for Intelligent InvestingSo far, we have investigated major investment alternatives available to those whosave, some of the important attributes of each, and the ways in which their pricesreflect these attributes. If you are lucky enough (have enough money) to be consid-ering some of these alternatives, keep in mind the following four simple rules. Theserules will not tell you how to make a million by the time you are twenty-five, but read more..

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    886 ∂CHAPTER 39 A STUDENT’S GUIDE TO INVESTINGwell as—no better and no worse than—the S&P 500 index, after a smallcharge for managing the fund is taken into account.Because the index funds have low expenses, particularly in comparisonwith funds that are trying to outguess the market, they yield higher averagereturns to their investors than other funds with comparable risk.3. Look at all the risks you face, not just those in your financial portfolio. Manypeople may be far less read more..

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    Review and PracticeSUMMARY1. Investment options for individuals include putting sav-ings in a bank account of some kind or using them to buyreal estate, bonds, or shares of stock or mutual funds.2. Returns on investment can be received in four ways: asinterest, dividends, rent, and capital gains.3. Assets can differ in four ways: in their average returns,their riskiness, their treatment under tax law, and theirliquidity.4. By holding assets that are widely diversified, individualscan avoid many read more..

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    888 ∂CHAPTER 39 A STUDENT’S GUIDE TO INVESTINGPROBLEMS1. Imagine a lottery in which 1 million tickets are sold at $1 apiece, and the winning ticket receives a prize of$700,000. What is the expected return to buying a ticketin this lottery? Will a risk-averse person buy a ticket inthis lottery?2. Would you expect the rate of return on bonds to changewith their length of maturity? Why or why not?3. Why might a risk-averse investor put some money injunk bonds?4. Would you predict that(a) the read more..

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    absolute advantage: a country has an ab-solute advantage over another country in theproduction of a good if it can produce thatgood more efficiently (with fewer inputs)adaptive expectations: expectations thatrespond or adapt to recent experienceadverse selection: the phenomenon that,as an insurance company raises its price,the best risks (those least likely to make aclaim) drop out, so the mix of applicantschanges adversely; now used more gener-ally to refer to effects on the mix of work-ers, read more..

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    capital goods: the machines and buildingsin which firms invest, with funds obtainedin the capital marketcapital inflows: money from abroad that isused to buy investments, to be deposited inU.S. banks, to buy U.S. government bonds,or to be lent in the United States for anyreasoncapital market: the various institutionsconcerned with raising funds and sharingand insuring risks, including banks, insur-ance markets, bond markets, and the stockmarketcapital outflows: money from the UnitedStates that read more..

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    devaluation: a reduction in the rate of ex-change between one currency and othercurrencies under a fixed exchange-ratesystemdeveloped countries: the wealthiest na-tions in the world, including WesternEurope, the United States, Canada, Japan,Australia, and New Zealanddiminishing marginal utility: the princi-ple that says that as an individual con-sumes more and more of a good, eachsuccessive unit increases her utility, or en-joyment, less and lessdiminishing returns (to scale): the princi-ple read more..

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    Federal Open Market Committee(FOMC): the committee of the FederalReserve System that sets monetary policyfinal goods approach: measuring GDP byadding up all sales of final goodsfinancial investments: investments instocks, bonds, or other financial instru-ments; these investments provide the fundsthat allow investments in capital goodsfiscal deficit: the gap between the govern-ment’s expenditures and its revenues fromsources other than additional borrowingfiscal surplus: the amount by which read more..

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    income effect: the reduced consumption ofa good whose price has increased that isdue to the reduction in a person’s buyingpower, or “real” income; when a person’sreal income is lower, normally she will con-sume less of all goods, including the higher-priced goodincome elasticity of demand: the percent-age change in quantity demanded of a goodas the result of a 1 percent change in in-come (the percentage change in quantitydemanded divided by the percentagechange in income)income per read more..

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    M1, M2, M3: measures of the money sup-ply: M1 includes currency and checking ac-counts; M2 includes M1 plus savingsdeposits, CDs, and money market funds;M3 includes M2 plus large-denominationsavings deposits and institutional money-market mutual funds.macroeconomics: the top-down view ofthe economy, focusing on aggregate charac-teristicsmanagerial slack: the lack of managerialefficiency (for instance, in cutting costs)that occurs when firms are insulated fromcompetitionmarginal benefits: the read more..

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    nominal GDP: the value of gross domesticproduct in a particular year measured inthat year’s pricesnominal rate of interest: the percentagereturn on a deposit, loan, or bond; the nom-inal rate of interest does not take into ac-count the effects of inflationnominal wage: the average wage not ad-justed for changes in the prices of con-sumer goodsnondiscretionary spending: expendituresthat are determined automatically, such asinterest payments and expenditures on entitlementsnonborrowed reserves: read more..

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    price system: the economic system inwhich prices are used to allocate scarce re-sourcesprice taker: firms that take the price forthe good or service they sell as given; the price is unaffected by their level ofproduction.price-level targeting: a rarely adoptedpolicy designed to achieve a stable pricelevelprincipal: the original amount a saver de-posits in a bank (lends) or a borrower bor-rowsprisoner’s dilemma: a situation in whichthe noncooperative pursuit of self-interestby two parties makes read more..

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    rent seeking: the name given to behaviorthat seeks to obtain benefits from favorablegovernment decisions, such as protectionfrom foreign competitionrepeated games: games that are playedmany times over by the same playersrepurchases (RPs): Federal Reserve openmarket transactions that involve a com-bined sale of a government security and anagreement to repurchase it at a futuretime, perhaps the next dayreputation: the “good will” of a firm result-ing from its past performance; read more..

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    substitution effect: the reduced consump-tion of a good whose price has increasedthat is due to the changed trade-off, thefact that one has to give up more of othergoods to get one more unit of the high-priced good; the substitution effect is asso-ciated with a change in the slope of thebudget constraintsunk costs: costs that have been incurredand cannot be recoveredsupply curve: the relationship between thequantity supplied of a good and the price,whether for a single firm or the market read more..

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    velocity: the speed with which money cir-culates in the economy, defined as the ratioof income to the money supplyvertical equity: the principle that peoplewho are better off should pay more taxesvertical merger: a merger between twofirms, one of which is a supplier or distrib-utor for the othervoting paradox: the fact that under somecircumstances there may be no determi-nate outcome with majority voting: choiceA wins a majority over B, B wins over C,and C wins over Awage discrimination: paying read more..

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    CREDITS∂A-13p. 2: Chuck Savage/Corbis; p. 10: (top) Kevin Fleming/Corbis; (bottom)eBay. com; p. 24: David Raymer/Corbis; p. 39: Brooks Kraft/Corbis;p. 52: Chip East/Reuters/Corbis; p. 59: Martyn Goddard/Corbis; p. 74: RF/Corbis; p. 76: Gideon Mendel/Corbis; p. 83: Reuters/Corbis;p. 93: RF/Corbis; p. 100: Keith Dannemiller/Corbis; p. 108: SteveTerrill/Corbis; p. 130: Christie & Cole/Corbis; p. 149: WilliamWebber/Visuals Unlimited; p. 154: Rosenfeld/Zefa/Corbis; p. 165:AP/ Wide World Photos; read more..

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    INDEX∂A-15absolute advantage, 41, 426accounting profits, 166–71acid rain, 414–15acquired endowments, 430, 431acquisitions, see mergersadaptive expectations, 825, 880–81ADI curve, see aggregate demand-inflationcurveADM (Archer Daniel Midland), 275, 411adverse selection:in health care insurance, 340and market for lemons, 333–36advertising, 347– 49competition and, 348informative, 348persuasive, 348profits and, 348– 49AFDC (Aid to Families with DependentChildren), 387affirmative read more..

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    banks:assets of, 621–22, 625balance sheets of, 620–22, 625central, 626–27, 653–55, 696, 722–23,740– 45, 748– 49, 849–59commercial, 613, 614Federal Reserve, 626–28, 654, 716–17history of, 205liabilities of, 621–22, 625money created by, 615–26panics and, 322–24regulation of, 614reserves of, 621–26, 628–30, 715–21barriers to entry, 281–84Barro, Robert, 841– 42barter, 616, 620basic competitive model, 25–29, 206, 226imperfect markets and, 240– 42ingredients in, read more..

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    fiscal expansion and, 732Kyoto agreement and, 149, 408Coase, Ronald, 409Coase’s theorem, 409Coca-Cola Company, 306–7coca leaf production and Colombian GDP,495collusion, 275–77, 314tacit, 275command and control approach, 410Commerce Department, U.S., 6commercial banks, 613, 614commercial policies, 434–35commitment, 327–28communism, 808–10failure of, 793, 808–10see also centrally planned economycomparative advantage, 41, 426–31determinants of, 430–31Internet and, 429marginal rate read more..

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    currency (continued)inflation and, 510–11, 512–13, 773–74curves, interpretation of, 49–50cycles, business, 494–96, 638– 48, 650–51,844– 48see also fluctuations, businesscyclical unemployment, 502–3, 638, 641– 43,646, 648, 656, 821–22, 831deadweight loss, 220, 221debt, federal, 479, 480–81, 557, 560, 561, 840alternative perspectives on, 841“owe it to ourselves” argument and, 841relative to GDP, 555, 559, 560, 561Ricardian equivalence and, 841– 42World War II and, read more..

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    branches of, 17definition of, 6–15information in, 647, 882–84laws of, see specific laws and principlesnormative, 19–20positive, 19as social science, 18economies, modern:creating money in, 615–26financial system in, 612–26economies of scale, 145, 267–70economies of scope, 148economists:disagreement of, 19–20models used by, 18monetarists, 846new classical, see new classical econo-mistsnew Keynesian, see new Keynesian econ-omistson price determination, 70real business-cycle, read more..

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    exchange rates (continued)appreciation and, 577, 761borrowing and, 762–63changes in, 577–80currency and, 770–71, 772–74, 781definition of, 758depreciation and, 577, 579, 762, 770–71determining, 758–65dollar and, 579, 759–65, 772–74, 780–81,783–85equilibrium, 578–80, 760–63, 774expectations and, 765exports and, 579, 760–62fiscal policies and, 787fixed system of, 766flexible, 758, 771–74, 787float, 771foreign borrowing and, 581–82, 762–63imports and, read more..

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    full-employment level of output, 533, 553,554full-employment model, 540– 42business fluctuations in, 643– 44, 648– 49capital markets in, 540, 541government in, 547– 48, 839government purchases in, 549–54inflation and, 843international trade and, 567–68investment in, 554labor markets in, 540, 541monetary policy in, 745– 46, 848– 49money supply in, 609–10, 611–12, 722–23productivity growth in, 585–86product markets in, 540, 541technological change in, 542full-employment read more..

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    horizontal restrictions, oligopolies and, 279hours worked, labor supply decision and,175–81households, decision making in, 534–35housing:incentives and, 343information and, 343real estate agents and, 343subsidies, 388human capital, 203– 4, 592human development, GDP and, 497–98human rights, 447Humphrey-Hawkins Act, 641, 842– 43hyperinflation in Germany, 512–13ideas, production of, 594–95Immigration and Naturalization Service(INS), 806–7imperfect competition:and barriers to entry, read more..

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    industrialized economies and, 819–20interest rates and, 739– 49, 780–81lenders and, 510measurement of, 514–19monetary policy and, 653–56, 691–97,722–23, 848–59overstatement of, 516perceived costs of, 509–11Phillips curve and, 821–23quality improvements and, 517rate of, 509, 652, 700–704, 707–10, 821real costs of, 509–11real rate of interest and, 739– 41sufferers from, 510–11taxpayers and, 510unanticipated, 843uncertainty and, 511, 512–13and unemployment trade-off, read more..

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    investment, investments, 672–76, 696–97attributes of, 870–78bonds, 867–68, 874, 876in capital goods, 537in capital markets, 537–38determinants of, 537–38, 675diversification and, 869, 872–74, 885–86efficient market theory and, 881–84expected returns on, 537–38, 673, 870–74,878–81financial, 537, 865foreign, 762–65, 784in full-employment model, 554government and crowding out, 551, 553India’s Silicon Valley and, 806–7interest rates and, 537–38, 673–74in read more..

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    long-run supply curves, 164–66loss, deadweight, 220, 221loss aversion, 120lotteries, rationing by, 33Lucas, Robert, 827–29, 844Ludd, Ned, 601Luddites, 601luxury tax, 383M1, 617–18, 722M2, 617–18M3, 618machines, as factor of production, 132macroeconomic policies:ADI curve and, 703– 4controversies in, 837–62on economic fluctuations, 637–58goals of, 842– 48history of, 727international, 789interventionist, 847– 48non-interventionist, 844– 46, 847role of, 727–51stabilization read more..

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    monetary policy (continued)trade-offs and, 849–59monetary policy operating procedures,721–23interest rate, 630, 721–23money supply, 721–23monetary policy rule, 692, 695, 700–701,740– 49, 846, 853–54position of, 745– 48and shifts in full-employment real inter-est rate, 746and shifts in inflation target, 747– 48slope of, 748– 49money, 605–32, 715–23counterfeiting of, 619–20creation of, 615–26credit and, 618–19definitions of, 615–17, 619demand for, 607–12electronic read more..

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    open market operations, 628–29, 630,716–17, 719–20, 721–22, 787opportunity costs, 38–39, 40, 140, 166–67,504, 643opportunity sets, 34–37choices and, 34–37costs and, 37– 44Oracle, 5Organization of Petroleum ExportingCountries (OPEC), 59, 275, 478, 705,706, 830–31organizations, see firmsOSHA (Occupational Safety and HealthAdministration), 360output, 15, 844ADI curve and, 698–701aggregate, 493alternative measures of, 496costs of recession, 504, 642– 43equilibrium, 160, read more..

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    price takers, 27, 131, 218price wars, 269prime interest rate, 737–38principal, 193prisoner’s dilemma, 277–79, 312–16, 321, 326private goods, 255private marginal costs, 407private property, rights of, see propertyrightsprivate sector, 12privatization, 802–3, 810, 812–13in centrally planned economy, 12, 296in former Soviet Union, 296movement for, 295producer price index, 517producer surplus, 217–18, 220, 224product, marginal, 133, 136product differentiation:and defining markets, read more..

  • Page - 968

    relative elasticity, 79relative elasticity of demand, 79–80relative inelasticity, 80relative price, 38, 103rent control, 92–93, 218–19, 226rents, economic, 168–69monopoly, 265, 292rent seeking, 292repeated games, 319–20replacement, threat of, 361repurchases (RPs), 716–17reputations, 321reputation solutions, to incentive problem,339research and development (R & D), 291–92capital markets and, 462competition and, 463–64defense, 429as fixed cost, 460–61government support for, read more..

  • Page - 969

    Social Security (continued)as pay-as-you-go program, 396reduction in benefits proposed for, 398as share of expenditures, 375, 376, 377as support program, 389tax increases proposed for, 398social spending on elderly, 562software:economic characteristics of, 491price and quantity of, 518South Africa, 268, 456Soviet-style socialist economies:failure of, 793see also centrally planned economySoviet Union, 7, 296, 327, 408, 808–10see also Russiaspecialization:comparative advantage and, read more..

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    real returns and, 684as redistribution of income, see incomeredistributionrevenue calculations, 108sales, 383sin, 383and supply and demand, 87–88, 220, 221U.S. budget and, 562, 838–39window, 90tax expenditures, 386taxpayers, inflation and, 510tax policy, and law of supply and demand,87–88, 220, 221tax rate:average, 384federal deficits and, 477, 479, 480–81indexing and, 510marginal, 380, 384Tax Reform Act of 1986, 385tax subsidies, 385–86tax system:administrative simplicity of, read more..

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    unions (continued)strikes by, 355substitution principle and, 148union shops, 357unitary elasticity, 79United Auto Workers (UAW), 356, 361United Kingdom, 377United Nations (UN), 795United States:comparative advantage of, 429as debtor nation, 581–82; see also tradedeficitdollar, strength of, 788–89education in, 592equity in, 378expenditures in other countries vs., 377growth in, 485–98job loss and outsourcing, 805–7as mixed economy, 121990s economy of, 707–10as open economy, 549, read more..

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