Frank R.h., Bernanke B.s.-principles Of Economics-mgh (2013)

'

I

of

Principles

Robert

*

/

H. Frank

Ben S. Bernanke

\\

5e

o

Mc

Graw

I

Hill

ECONOMICS

STUDENTS...

HI

Want to get do

to

Prefer

^

better grades?

a better way

Need

you

like

face

it,

(Let's (After

to study before

the

(A little

all,

big

you

are

online

anyway...)

peace of mind is a goodthing...)

students

Connect

McGraw-Hill's

With

STUDENTS GET: \342\200\242

Easy

online

access to

quizzes assigned \342\200\242 Immediate

by

feedback

(No more wishing you at 1 a.m.) \342\200\242

Quick

access

eBook,and

and

tests,

D

on how you're

could call your

doing.

*Available

with select McGraw-Hill

if

wondering

reports

for

required

and

record

Want

to

With

McGraw-Hill's

post

your lectures

or

administration

for students to

outcomes...)

online?

view

instructor Meatw-MCmMci h

As

eirToiHowcoiniKiQ

at your

fingertips.)

TWf t JUft_l\302\243CT Afttl!(>.g. INCECONOMIC). HL\302\243Ct\302\273NY0? BUJWflS CJftEEA)

\342\200\242

Simple

Plus Economics,

time

\342\200\242

work.*

\342\200\242 Detailed

section

titles. MBlgnmentfcUllfer

quizzes, and

Reporting where

Visual

results can

\342\200\242

be viewed

online

Sophisticated

3 Homework

allowing you to

teaching.

assignments,

Auto-graded

Econ

management,

assignment

spend more

Chapter

Connect

INSTRUCTORS GET:

\342\226\240uTtioinOuMO.

and Study tool that assesses your knowledge and recommendsspecific readings, supplemental study materials, practice

more

(No

LESS MANAGING. MORETEACHING. GREATERLEARNING.

Self-Quiz

additional

progress?

The next big thing in digital education DOMQflEHQW*

\342\200\242 A

and

or class performance?

(Say goodbye to manually trackingstudentlearning

accreditation?

M

student

track

and

online

instructor.

to lectures, practice materials, more. (All the material you need to

be successful is right

data and generate

Need to collect

Economics,

and prepared...)

is engaged

if everyone

fun

for class more prepared?

understand...)

ttcomecr

homework,

your

Plus

more

of student

view

instant

an

Want

A\302\260

is much

class

to show up

students

your

Want an easy way to assign homework (Less time gradingmeansmoretime teaching...)

test?

Greater learning.

More teaching.

managing.

INSTRUCTORS... Would

doesn't?)

(who

online?

homework

your

Less

:

testing

^ ^

I

on materials

that

accreditation

outcomes, \342\200\242 An

and

easy-to-use

\342\200\242 The

option

documents

are

standards, Bloom's

for student

Resources

for you to build your

analyzed.

Lffl> youMenttxH*

and

course,

rkz_1_^ bank Ifiomaur banks quHtnn

lectures yMjrktlijrm

mylectures H pre-made assignment collections ut EKtnrttwrcaifciitticiprt-mMtaiiianmMB

capability. that

=

H report

Md*\302\273 c\302\253\302\253t hi*n*iStrictF*m**ittwt pwk*\302\253n bjrlichtsi

to

correlated

Econ S

learning

connect*

101 i1

taxonomy.

lecture capture

to upload

library

tests.

student

and

and reporting function filtering allows you to easily assign and

W

connect

ebook

\342\200\242 A

mttrairnvMi

101

tool.

reports

reports

course access.

mcawc*? trail y*utin

an

Want

version

searchable

online,

of your textbook?

Wish your textbook couldbe availableonline

while

assignments?

your

Plus Economics eBook

Connect

Econ

library

choose

you

reports

library Do Chapter3: Demand

d,Supply,indMirketEquilibrium

omm u punm*ac*wnort una\302\253f asp\302\253flM \302\253nj pernm* p**iaimtg pMM meO\302\253fflaMM\302\253a*aMfejaftH\302\253c1\302\253piMi*iiMrtH0irtiu3\302\253ifii9'Kuieaune k tv*'ivyp\302\253i\302\273 Dfliwrt l\302\253i axmm nai*Kmn IbelateHfj easlj\302\253

eBook offers

Plus Economics

Connect

connect

101 1

to use Connect\302\256 Plus Economics, you have an affordable and searchable online version of your book integrated with your other online tools. If

doing

you're

features like: \342\200\242

Topic

search

\342\200\242 Direct

links from assignments text size

\342\200\242

Adjustable

number

\342\200\242

to page

\342\200\242 Print

by section

Jump

to

Want

get

value

more

from your textbook

Thinklearningeconomics

should

Check out the section Here

you'll

under

STUDENT

the

find a wealth

Connect

Library tab.

of resources designedto help you course. Every student has different

achieve your goals in the so explore the STUDENT needs,

materials best suited

RESOURCES

to you.

RESOURCES

to find the

be

a

purchase?

bit

more

Econ 101 cQ^t\302\253n t my course*

interesting?

\342\200\242 -\302\253 | 4MOMK3 home

library

reports

library Self-Quiz andStudy

CKh mumtnvntrrum* u &tjnj tnapitrertciK* Htr OtkMiiwirran:&\302\253*[\342\226\240 jtuttHttrHuns alUH'ltBttp\342\204\242H*fflS tMingittuoya\302\253 \302\253 basrtonyixjr n\302\2735l ramiaUempT (Resi*s h*lpvDun*lf

B

\302\273 Lik* in Ecnnamiit Chiptar1Thinking

B

t Chiplar1Compimtiv* \302\253 Aduinbgi \302\253 VChipUraSupp^indDumiiid V*aiHow *iiFti-Whoffli' Ctnlfat Ylefj*)Ftannhg Oft

B L B E

\"

3t*fc

h5\302\253c#

B^airtS^h i^5

2

.H.

31u#

F\302\253\302\253(*

rJa*\302\253 Eqvlbbnum andEnrlalnng InPrices antt Changes Prattttlrtj Ouanbbn

2

.1\"

Man \302\273*

2

\342\204\242. Sm*

haaa

I

PRINCIPLES

#

ECONOMICS

Fifth Edition

OF

SERIES

McGRAW-HILL

THE

of Economics

Essentials

and

McConnell,

Brue,

Flynn

Economics

Essentials of

SecondEdition

IN ECONOMICS Money

Economics, Microeconomics,

Cecchetti and Schoenholtz

and Macroeconomics

The Basics

Economics:

Schiller

Sixth

of Economics

Principles

Colander and Economics,Microeconomics, Macroeconomics

Edition

Eighth

Frank and

Principles

Principles of Macroeconomics Edition

Brief Editions: Principlesof Principles

Economics,

of

Principles of

Microeconomics,

Macroeconomics Edition

and

Brue,

Economics,

Microeconomics,

Flynn

and Macroeconomics

McConnell,Brue,and Brief

Editions:

Microeconomics

and Macroeconomics

SecondEdition Principles

of Microeconomics

Samuelsonand Economics,

Microeconomics,

and Macroeconomics

Nineteenth Edition

Schiller The Economy The

Micro

Ninth Edition

Seidman Public Finance

Strategy

Edition Economics

and

Architecture

Organizational

and Maurice

Economics

Intermediate

and

Bernheim

Today,

and The Macro Economy Today

Thirteenth

First

Whinston

Introduction Edition

Fischer, and Startz

Edition

Microeconomics and Behavior

Appleyard,

Economics

Edition

King and King

International Economics, Globalization,

and

Policy:

A Reader Fifth

Edition

International

Economics

Romer

Advanced Macroeconomics Edition

Field, and Cobb

Pugel

Edition

Advanced

Economics

International

Seventh

Frank

Fourth

Edition

Economics:

Environmental

An

International

Edition

Eleventh

Economics

Environmental

Fifth

Edition

Tenth

Edition

First

Field and Field

Edition

Fifth

Eighth

Economy Today,

Gayer

Finance

Business

Macroeconomics Nordhaus

Finance

ManagerialEconomicsand Seventh

Economics

Labor

Rosenand Public

Dornbusch,

First Edition

Brue, and

Edition

Public Economics

Managerial

Microeconomics Miller

Economics

Edition

Contemporary

Managerial Economics Flynn

Economics

Labor

Ninth

Econometrics

Edition

Thomas

Nineteenth Edition

Edition

Macpherson

and Porter

Managerial

McConnell,

Eighth

McConnell,

Edition

Brickley, Smith, and Zimmerman

Second

Economics

Fifth

Baye

and Bernanke

Frank

O'Sullivan

Urban

Labor

BasicEconometrics

Fourth

Third Edition

Borjas

Gujarati and Porter

Essentials of

of Microeconomics,

Principles

Issues

Econometrics

Gujarati

Economics,

Social

Edition

Nineteenth

Fifth

Bernanke of

Today

Edition

Economicsof

Edition

Eighth

Markets

Urban Economics Economics

Sharp, Register, and Grimes

Economics

of

Essentials

Issues

Social

Guell

Issuesin

Fifth

of

and

Banking,

Financial

Economics

Second Edition

and

Money,

Edition

Tenth

Mandel

Banking

Slavin

Economics

Fifteenth Edition

OF

PRINCIPLES

ECONOMICS

Fifth Edition

ROBERT H. FRANK Cornell

BEN

S.

BERNANKE

Princeton

Chairman,

Board of

University

University

[affiliated]

Governors of the

with special

LOUIS

Federal

Reserve

contribution by

D.JOHNSTON

College of Saint BenedictI Saint

John's

craw McGraw-Hill Hiii

Irwin

University

System

The McGraw-Hill

Companies

mc

uraw McGraw-Hill . Irwin

Hiii

PRINCIPLES OF ECONOMICS,FIFTH EDITION Published by McGraw-Hill/Irwin, a businessunit of The McGraw-Hill Companies,Inc., 1221 Avenue of the Americas, New York, NY, 10020. 2013, 2009, 2007, 2004, 2001 by Copyright \302\251 The McGraw-Hill Companies, Inc. All rights reserved. Printed in the United States of America. in any form or by any means, or No part of this publication may be reproduced or distributed stored in a database or retrieval consent of The McGraw-Hill system, without the prior written but not limited to, in any network or other electronic or Companies,Inc., including, storage for distance learning. transmission, or broadcast

Some ancillaries, outside the

This book is printed

on acid-free

and

components,

print

may not

be available

to customers

paper.

DOW/DOW 1098765432

1234567890 ISBN

978-0-07-351140-5

MHID

0-07351140-4

Design of book:The of Frank

electronic

including States.

United

Wright,

Lloyd

images

design of this book are based on elementsof the architecture from the leaded glass windows seen in many of his houses. nature and based on simplicity and harmony. His windows use

in the

specifically

design was rooted in to abstract natural and framing the natural world forms, complementing geometry outside.This concept of seeing the world through an elegantly structured framework ties in nicely to the idea of framing one's view of the world through the window of economics. Wright's elemental

The typeface

used for some of the elements was taken from the Arts and Crafts The typeface, as well as the color palette, brings in the feeling of that movement the geometric elementsof Wright's windows. complements

Vice president and editor-in-chief:Brent Publisher: Douglas Reiner Sponsoringeditor: Scott Smith

movement. in a way

that

Gordon

Ann Torbert Executive director of development: Christina Kouvelis Managing developmenteditor: Editorial coordinator: Emily Kline Vice president and director of marketing: Robin J. Zwettler Senior marketing Melissa Larmon manager:

Brad Marketing director: Marketing manager: Katie Vice president of editing,

Parkins White

design, and Pat Frederickson

Lead

production: Sesha Bolisetty

project manager: Senior buyer: Carol A. Bielski Lead designer: Matthew Baldwin Senior photo research coordinator: ]eremy Cheshareck Photo researcher: PoYee Oster

Lead media Media

manager: Allison manager: Ron Nelms

project

project

Souter

Typeface:10/12Sabon

Aptara\302\256,Inc.

Compositor:

Printer: R.

R. Donnelley Library

Frank, Robert

H.

of Congress

Cataloging-in-Publication

Data

of economics / Robert H. Frank, Ben S. Bernanke; with specialcontribution D. Johnston.\342\200\2245th ed. McGraw-Hill series in economics) p. cm.\342\200\224(The

Principles

by Louis Includes

ISBN-13:

index.

978-0-07-351140-5

(alk. paper)

0-07-351140-4 (alk. paper) 1. Economics. I. Bernanke, Ben.

ISBN-10:

HB171.5.F734 2013

II. Johnston,

Louis

(Louis Dorrance)

III. Title.

330\342\200\224dc23

2011043449

www.mhhe.com

DEDICATION

For Ellen

R.H.I: For Anna

B.5.B.

6

THE

ABOUT

S. BERNANKE

BEN

H.FRANK

ROBERT

Frank

Professor

ProfessorBernanke

the

is

Henrietta Johnson Louis of

Professor

r

Harvard University

Professor of Economicsat the Graduate School of

~

N

at

Management University,

Cornell

he has

where

Georgia Techin years as a Peace

1966,

he taught

math and science for two

in rural Nepal. He received in and his Ph.D. in economics California at Berkeley. During

Volunteer

M.A. in statistics in 1971 1972 from The University of leaves of absence from Cornell, he has servedas chief economistfor the Civil Aeronautics Board (1978-1980),a Fellow in the Behavioral at the Center for Advanced Study Sciences Civilization at l'Ecole des (1992-93), Professorof American Hautes Etudes en Sciences Sociales in Paris (2000-01), and the Peter and Charlotte Schoenfeld Visiting Fellow at Faculty the NYU Stern School of Business in 2008-09. Professor Frank is the author of a best-selling intermediate economics textbook\342\200\224Microeconomics and Behavior, his

2010). His research has in economic and social behavior. His bookson these themes include Choosing the Fond (Oxford, 1995), Passions Within Reason (W. W. Right Norton, 1988), What Price the Moral High Ground? Behind (University of California Press, (Princeton, 2004), Falling Edition

Eighth

focusedon

2007),The The

(Irwin/McGraw-Hill, and cooperation rivalry

Darwin

(Basic Books, 2007), The Guide (Basic Books, 2009),and

Naturalist

Economic

Field

Naturalist's

Economic

Economy

(Princeton, 2011),

translated

into 22

(The Free

Press, 1995), co-authored

languages.

The

which

Winner-Take-All with

Philip

been

have

Society

Cook,

Choice Award, was named a Notable Book New York Times, and was included in BusinessWeek's list of the 10 best booksof 1995. Luxury Fever (The Free Press, 1999)was named to the Knightreceived

a Critic's

of the

Year

by

1979 to

column

to

appears regularly in The New York Times. After his B.S. from receiving

Corps

at

Graduate School

since 1972. His \"Economic

View\"

The

Ridder Best Bookslist for 1999. Professor Frank has been awardedan Andrew W. Mellon a Kenan Award Professorship (1987-1990), Enterprise Scholars (1993), and a Merrill Program Outstanding Educator Citation of the 2004 Leontief (1991). He is a co-recipient Prize for Advancing the Frontiers of Economic Thought. He was awarded the Johnson School'sStephen Russell Award in 2004 and 2010 and the School's Distinguished Teaching in 2005. His Apple Distinguished Teaching Award microeconomics course has graduated more than 7,000 introductory enthusiastic economic naturalists over the years.

Gabrielle

Affairs,

in in 1979. He the Stanford of Business from

1985 and

Princeton

1985,

1975

MIT

taught

taught

from

in

Ph.D.

his

and

economics from

Johnson

received

B.A. in economics

his

and

Management

AUTHO

where

moved

University in he was named

the Howard Harrison and Beck Professor of Economicsand Public Snyder and where he served as Chairman of the

Economics Department.

Professor

Bernanke was sworn in a member of the Board

2006, of the Federal Reserve System\342\200\224his second term expires January 31, 2014. Professor Bernanke also serves as Chairman of the Federal Open Market Committee, the Fed's principal of monetary policymaking body. He was appointed as a member the Board to a full 14-year term, which expires January 31, 2020. Before his appointment as Chairman, Professor Bernanke was Chairman of the President'sCouncil of Economic Advisers, from June 2005 to January 2006. Professor Bernanke's intermediate textbook, with Andrew Abel and Dean Croushore, Macroeconomics, Seventh Edition 2011), is a best sellerin (Addison-Wesley, its field. He has authored more than 50 scholarly publications in macroeconomic macroeconomics, history, and finance.He has done significant research on the causes of the Great the role of financial markets and Depression, in the business institutions cycle, and measurement of the effects of monetary policy on the economy. Professor Bernanke has held a Guggenheim a Sloan Fellowship, and he is a Fellow of the Fellowshipand Econometric of Arts Society and of the American Academy and Sciences. He served as the Director of the Monetary EconomicsProgram of the National Bureau of Economic Research and as a member of the NBER's Business (NBER) he was appointed Cycle Dating Committee. In July 2001, editor of the American Economic Review. Professor Bernanke's work with civic and professional groups includes served two terms as a member of the Montgomery having Township (N.J.) Boardof Education.

as Chairman

and

on

1, February of Governors

PREFACE

year on

are spent each

of dollars

millions

many

lthough

introductory

American colleges and universities,

this investment

has been disturbingly

in

instruction

economics

return

the

Studies

low.

on have

several months after having shown, for example, that taken a principlesof economics former students course, are no better able to answer economic simple questions than others who never even took the course. Most it seems, leave our introductory courses without students, learned even the most important basic economic having

The problem, in our almost always try to teach

is

view,

these courses far too much. In get little more

that

students

the process, really ideas important than minor and ones, coverage everything ends up in a blur. instructors ask themselves, going by Many

\"Howmuch can I cover today?\" when instead they be asking, \"How much can my students

should

absorb?\" that grew out of our conviction students will learn far more if we attempt to cover much less. Our basic premise is that a small number of basic principlesdo most of the heavy lifting in economics, and if we focus narrowly that and repeatedly on those students can principles, actually master them in just a single

textbook

semester.

The enthusiastic reactions of users of previous affirm the validity of this premise. Avoiding excessive reliance on formal mathematical derivations, we present concepts intuitively through drawn from familiar contexts. We rely examples editions

throughout on a well-articulatedlist of seven which we reinforce repeatedlyby Principles, and illustrating contexts.

each applying We ask students

principles

themselves

exercises, and

explain An

that

basic

economic

what

they

infant

airplanes

safety

who

of

interest

while

their

economic

or more

these

about

talk

Students

to as the

students

teaching

landscape

Core Principles. examples with their friends of the

and families. Learning economicsis like learning In each case, there is no substitutefor language. students to speak actually speaking. By inducing naturalist

economic

economics,the

a

serve this

examples

purpose. For those

who would like to learn more about the of examples in learning Bob Frank's economics, lecture on this topic is posted on YouTube's \"Authors\302\251 series Google\" (www.youtube.com/watch?v=QalNVxeIKEE

and principles in the world around them. observe seats

for example,

understands, are required

in

cars

but

not in

cost of spaceto

any curious

seats

posesa

or search \"Authors@Google:

person eager to learn the answer.These

Robert

An Emphasis on As

noted,

Frank\.

FEATURES

AND

KEYTHEMES

Seven Core Principles

do most of the work in almost By focusing exclusively on these the text assures that students leave the course deep mastery of them. In contrast, traditional core principles

a few

economics. principles,

with

a

they often leave the knowledge at all. \342\226\240 The

Cost-Benefit benefit

marginal

Incentive

\342\226\240 The

working

more of one of another.

Take Principle: is at least as

Principle:

are relevant

no action

great as its

good

unless

the

Principle

comparisons

only

of Comparative Advantage: when each concentrates which he or she is relatively

best

does for

activity

Cost-benefit

for identifying the decisions should make, but also for people actual decisions they do make. not

rational

predicting \342\226\240 The

useful

cost.

marginal

that

that

detail

with

little

means

usually

\342\226\240 The its

course with

Principle: Having having less

Scarcity

thing

students

so overwhelm

texts

encyclopedic

Everyone

is typically zero in cars but in airplanes. Scores of such hundreds of dollars the book. Each sprinkled throughout we believe, that should make question these

examplesare one,

students

encourage people

because the marginal

accommodate often

we

to understand

naturalist

economic

Core

principle in numerous to apply these periodically to answer related questions,

problems. Throughout this process, to become \"economicnaturalists,\" employ

stimulate

see each feature reflection of one

role

principles.

Our

examples

on the most

productive. \342\226\240 The

of Increasing

Principle

Use the resourceswith cost before

turning

to

the

those

Opportunity lowest

with

Cost:

opportunity

higher

costs. opportunity \342\226\240 The

Efficiency

Principle:

social goal becausewhen larger, everyone can have

Efficiency is an important the economic pie grows a larger

slice. vii

PREFACE

viii

\342\226\240 The

Equilibrium leaves

equilibrium

individuals

but

the

action.

collective

through

in any other text. for economic argument important social goal. Rather than between and other efficiency than

here

A market in Principle: no for unexploited opportunities not all achievable may exploit gains

economic

maximizing

Naturalism

Economic

Our

ultimate

or explicit

implicit

in

examples:

offer discount

theatres

movie

do

do we

\342\226\240 Why

tickets to

do

\342\226\240 Why

corners?

lines all tend to

checkout supermarket same length?

be

has

\342\226\240 Why

in

much

\342\226\240 Why

does

\342\226\240 Why

do

increased so

in computers investment decades?

of

news

the

hurt

inflation

all countries

almost

market?

stock

provide

free

public

Stressed

Learning to

way

to hit

learn

an overhead

is through repeated practice. economics. learning Accordingly,

introduce new ideas in then

examples and

follow

they work

how

intervals, we

pose the

reinforce

in

familiar

concept understanding

context

the

them

with

we consistently of simple showing

applications

settings.

At frequent

checks that both of these

test and

that apply puzzles

are

Experience

earlier

The

carefully

extend

editions

core

confirms

this approach really does prepare students to basic economic to solve economic principles drawn from the real world.

of

a host

understanding

externalities.

Modern Macroeconomics downturn that began in late 2007 interest in cyclical fluctuations without issues as challenging the importance of such long-run growth, productivity, the evolution of real wages, and of these issues is capital formation. Our treatment economic

The

severe

has

renewed

organized

follows:

as

followed

a modern

by

fluctuations

surplus, repeatedly

introduced

stabilization

and

thereafter,

is more

fully

1 and developed

policy,

of the to

\342\226\240 Designed topics,

these

the

emphasizes

important distinction between short- and

long-run

economy.

allow

chapters

for flexible treatment of are written so that short-run

material (Chapters21-25)can be used long-run material (Chapters 18-20) with

before no

loss

of continuity. \342\226\240 This

the

in Chapter

of long-run issues, treatment of short-term

treatment

\342\226\240 A three-chapter

book

benefits

domestic exchange

a heavy emphasis on an analysis of its effects on real and to such issues as progressing the role of trade, capital flows in

places

with

wage inequality

Modern Microeconomics employed

for

indispensable

globalization, starting

\342\226\240 Economic

no more exciting toolkit for the than a few principles of

naturalist

behavior

ideas.

end-of-chapterquestions problems crafted to help students internalize and with

smash in

The sameis true

and

concepts.

invoked

recent

education?

The only

1 and

in Chapter chapters.

is perhaps

are

In Macro:

for

subsequent

In familiar laws, customs,and social norms. 10 we show how such devices function Chapter to minimize misallocations that result from

the

roughly

goals.

In Chapter 9, we show elementary game theory. how these principlesenablestudents to answer a in of that arise the variety strategic questions and everyday life. We believe that marketplace the insights of the Nobel LaureateRonald Coase

often see conveniencestoreslocatedon

street

adjacent

tennis

early

repeatedlyin

economic

students?

Active

introduced

\342\226\240 There

\342\226\240 Why

the

facilitates

decision Nobel pitfalls identified by 2002 Daniel Kahneman and others\342\200\224such as the tendency to ignore implicit costs, the tendency not to ignore sunk costs, and the tendency to confuse average and marginal costs and benefits\342\200\224are

Somerepresentative

In Micro:

surplus

Laureate

cost-benefitcalculation.The

to understand them.

the attempt

all

\342\226\240 Common

of an

result

mundane details of ordinary and becomes light actively engaged

a new

in

existence

naturalists\342\200\224

sees

naturalist

economic

produce economic human action as the

is to

goal

see each

who

people

achievementof

This conceptunderlies efficiency as an speak of trade-offs goals, we stress that

of

capital formation, and the links rates and monetary policy.

between

ix

PREFACE

ORGANIZATION OF THE FIFTH

EDITION clearer asked

and

\342\226\240 More

we

Principles: If

own

their

provide

emphasis on the Core a thousand economists to versions of the most important

economicprinciples,

we'd

be

to miss to

important

than

principles

of

get

sort.

this

are

now

apply

these

discussion

supports

In Chapter 2, view of production

material:

advantage full-spectrum

the realities economiesface

concepts

\342\226\240 The

simple

simple

Keynesian

comparative

students will see a possibilities and

considering

Chapter 7 makes

market

adjustments,

preventing price

Hand

decisions

and

12

Chapters

uses

and

Health

options.

core concepts: among

policy

institutional

details

effects

the

by

The planned aggregateexpenditure.

is also

of

In

supply:

give

students

to help make policy decisions: 13 feature important policy economics to sort out the best environmental care, regulation,

derivations presented,

run

Run\")

first

trends

unemployment are students

no

with

\"The Economy loss of continuity.

in employment, covered together fully

Run\") in

the

understand

between financial markets and 20 brings together money: Chapter information on financial bond and stock intermediaries, markets,and money so that students can make the

\342\226\240 Strong

connections

connection

among

drawn

stock

commercial banks,and

markets,

money.

bond markets,

emphasis

on

apply the AD-AS modelto we focus on how First, policy.

and

demand

supply.

aggregate

the role of in credibility

of shocks

face

inflation

to aggregate We then examine and

expectations

and

policymaking, inflation

be

should

policy

monetary

the

in

conducted

Short

all three topics.

an

with

25, we

fiscal and

or the

markets: Labor wages, and in Chapter 17 to help the connections between

The model is then

chapters.

previous

macroeconomic

link this to

a

targeting. Finally, we analyze the effects of fiscal on policy long-run growth with an emphasis on how changes in marginal tax rates can affect labor supply and hence discussion of

of labor

discussion

\342\226\240 Thorough market

7,

(Part

Long

of the

focus on the nuts and bolts of model itself. Coherent,intuitive of the AD curve and AS curve are with an emphasis on connecting each the model to concepts the students

applied to businesscycles, the 2007-2009 recession.

and

the

work together to

understanding

24, we

side of learnedin

modular

Economy in

demand and

and 25

the AD-AS

\342\226\240 In Chapter

(Part 6, \"The

easily

model.

\342\226\240 In Chapter

Part 5, presentation: Issues,\" is a self-containedgroup of that covers measurement issues. This chapters allows instructors to proceedto either the long run

short

24 Chapters a thorough

and the

Macroeconomics

\"Macroeconomics: Data

can

students

that

of aggregate

presentation

aggregate

discussed.

\342\226\240 Flexible,

are summarized

policy

monetary

using logic chains

international trade, and income redistributionare all

money

who wishto In addition, do so. easily

can

material

effects

are

but instructors

discussed,

this

skip

the

The

coverage organization: of the Federal Reserve

of Chapter 23, followed beginning of Federal Reserve policy on

the

at

discussed

ADAS

theory.

economics

\342\226\240 Using

are

understand.

efficiency, the cost of economic profit,

and

equilibrium

Invisible

connections

strong

present the

through examples that and numerically. graphically

\342\226\240 Monetary

\342\226\240 The

between

drawn

connection

data.

model

decisions. outsourcing \342\226\240 Strong

to help students

model: We

Keynesian

both

developed

market \342\226\240 Outsourcing

out explicitly to real-world

written

a thousand

on their differenceswould their essential similarities. It is less have exactly the best short list of it is to use some well-thought-outlist to dwell

Yet

different lists.

formulas

The

Microeconomics

In

of output gaps and Okun's Law: for the output gap and Okun's Law

discussion

\342\226\240 Clear

output.

potential \342\226\240 Flexible

exchange

of

coverage

Chapter 26 rates

instructorthinks

subject.This

a

is

balance

sides of the

discussion

of

can be used whenever an best to introduce this important

that it

chapter

also

of trade and capital flows the

economics:

international

self-contained

integrates so

that

the discussion see that

students

and net capital inflows same issue.

of trade

are

two

PREFACE

all

chapters,

Changes

Chapter-by-Chapter made \342\226\240 Chapter edition

and data

1-6: Content as needed.

\342\226\240 Chapters

updates have

7 and 8 from the 7: Chapters have been combined to form this

entitled

Hand in

previous new

is Chapter 9 from the and data updates have

needed.

9: This edition. Content as needed.

\342\226\240 Chapter

been addedas

is Chapter 10 from and data updateshave is Chapter 11 from and data updateshave

11: This edition. Content as needed.

is Chapter 12 from and data updateshave

12: This edition. Content as needed.

is Chapter 13 from and data updateshave

\342\226\240 Chapter

\342\226\240 Chapter

\342\226\240 Chapter

edition.

14:

change

This

edition. Content as needed.

the

previous added

been

care

has

is Chapter

on

the

core

inflation,

commonly

This

previous added

an

previous

prices rose and rise when

on policy choices also been included.

15 from

in the

popular

the

that

fall

they

wealth.

and

20: This is Chapter 21 from the on hyperinflations and their

previous

A section

connection

quantity equation has been added.Box21.1 was

changes

percentage

deleted;

quantity

theory of money at an

Chapter

21: This is

edition.

The entire

intuitive

Chapter 22

from

this

the

keeps level.

the

previous

chapter is now focused on The

recessions.

2007-2009)

and do

Okun's we

business cycles?\" Graphs that show potential output and the output gap have been added to for supply concrete examples. The formulas calculating the output gap and for Okun's law are written

out

explicitly.

22: This is Chapter 23 from the Chapter previous edition and is now entitled \"Spending, and Output,

previous been added

concept

to

measure

is Chapter

increasing

an important saving (causing it

output gap, cyclicalunemployment, the common question,\"How

has provision the Affordable

and data updateshave

discussed

gains/lossesdue to rising

term \"business cycle\"is now an important part of the chapter. This makes it possible to relate the

16 from the previous edition. The Economic Naturalist 16.1 example was removed to help keep focus on the basic definition of GDP. Box 16.1 (chain weighting) was deleted to simplify the presentation of real GDP. \342\226\240 16: This is Chapter 17 from the Chapter previous A new Economic Naturalist example on edition. 15:

\342\226\240 Chapter

prices

recent (2001

been

the

recession.

were

household

both

house

when

on

house of

to the previous added

as in the current

law to

14 from

been revised to include details Care Act of 2010. A new section \342\226\240 Chapter

because capital

falling

determinant

Chapter

been

timely

is featured,

sharply

and

13: This is Chapter The section on health

related to climate

the

has

coverage on the

Chapter 19:This is Chapter 20 from the previous edition. The connectionsbetween saving, capital and wealth have beentightened. This is gains/losses

edition.

10: This edition. Content as needed.

\342\226\240 Chapter

previous added

been

and

19 from the previous Chapter 18: This is Chapter edition. Box 19.1(production has been functions) removed to keep presentation of growth determinantsverbal and intuitive. This chapter has been so that the costs of economic growth and rearranged limits to growth are discussed together as possible there is much overlap (e.g., pollution is both a cost of economicgrowth and a potential limit to growth).

declined)

the

rose

unemployment durations

and

previous

is Chapter 18 from the previous of European unemployment

been removed. Improved duration of unemployment

important

Action.\"

Content

edition.

chapter,

\"Efficiency, Exchange, and the Invisible 8: This

\342\226\240 Chapter

been

discussion

The

edition.

the narrative has been tightened and shortened slightly. of the examples have been updated, Many with a focus on examples that connect to current events such as the financial crisis of 2008 and the Great Recessionof 2007-2009. The Examples and Exercisesfrom the edition have been redesigned to provide more previous has been updated clarity and ease of use.Data throughout. In

This

17:

Chapter

to all Chapters

Common

Changes

EDITION

FIFTH

INTHE

CHANGES

is

media, has beenadded.

Fiscal

focus on recent (2001and can make abstract and current concepts

Policy.\" Examples recessions

2007-2009)

between

connections

events. Box 23.1 (on

so students

J.M.

Keynes)

has

been

on the key

assumption of the model has been integrated into the text. Keynesian New material has been written that place fiscal policy in the larger context of stabilization policyto removed,

help

and

provide

monetary policy,

Box

23.2

in distinguishing among clarity fiscal policy, and stabilization policy.

xi

PREFACE

23: This is Chapter 24 from the previous and is now entitled \"Monetary Policyand the Reserve.\" The discussion of monetary policy

\342\226\240 Chapter

edition Federal

rules has been removed. Payment added as since this is

been

has

reserves

is important

as crucialto keepinginflation

has identified

but

edition, entitled

is Chapter

This

24:

\342\226\240 Chapter

the

regarding

are the

on

focused

and

basis for the

policy but

previous edition

rewritten.

focus

The

curve.

that

are

21-23

Chapters

analysis is

AD-AS

of business cyclesand how fiscal can be used to deal with them.

This is much

25:

\342\226\240 Chapter

of firms

behavior

AS

the causes

monetary

intuitive

Assumptions and examples

price-setting

the Chapter 26 from of the chapter is completely of the chapter is now on

how fiscal and monetary policyare usedas tools.

stabilization

during

policy

monetary

of fiscal and the 2007-2009 recession

Applications

integrated throughout the chapter current concepts can be connectedwith 26:

\342\226\240 Chapter

This is

a combination

of

so

general

27

the previous edition.The more indiscussion of fixed exchange rates has been as has the discussion of speculative The of exchange rates and monetary analysis is now entirely integrated into the text.

depth eliminated, attacks.

policy

McGraw-Hill

member of

and

teaching

Assurance Many

notion some

learning

of Learning

of assurance accreditation

is designedspecifically with

to

support

a simple,

yet

are focused

your assurance powerful,

solution.

of

a

as

only

EDITION the

in on February 1, 2006, as of the Board of Governors of

sworn

was

Bernanke

a member

and

Chairman

Reserve System, a position to which he was in January 2010. From June 2005 until

Federal

he served as chairman of the President's of Economic Advisers. These positions have him to play an active role in making allowed U.S. economic but the rules of service have policy, government restricted his ability to participate in the preparation of 2006,

January

Council

the

edition.

fifth

he

of Saint

lead in

Ben

edition.

fifth

their

creativity

College

to take the

University

created a

the

of

able to enlist the aid of Louis D. Benedict I Saint John's

we were

Fortunately,

great tool for

and Robert

to Louis for the his work on the

students

macro

the

creating

Bernanke

deep gratitude has brought to

and

portion

Frank

energyand book.

He

has

professors.

ACKNOWLEDGMENTS

Our thanks

foremost

and

first

go to

our publisher,

Scott Smith; editor, Douglas Reiner; sponsoring and our managing developmenteditor,Christina our

deeply transform

shepherded

us

the telephone, intelligence,

as well

to

how

our

Scott encouraged us to think the book and helpedus improve into concrete changes. Christina

and

Douglas about

on the of learning, an important element of standards. Principles of Economics,5/e today

It in

standards.

contained

WRITING OF THIS

ON THE

A NOTE

Kouvelis.

Ready

institutions

educational

learninginitiatives

experience.

the

of AACSB

value

skill guidelines found in AACSB is important to note that the statements 5/e are provided Economics, Principles of for the users of this text. guide

express

and professors can be confident that the organization of each surrounds common themes chapter outlined by four to seven learning objectives listed on the first page of each chapter. These objectives, along with AASCB and Bloom's Taxonomy Learning connected to all Test Bank questions and endCategories,are material to offer a comprehensive, thorough of-chapter

proud corporate

Recognizing

knowledge and

of the

Students

is a

accreditation, the authors importance of Principles 5/e have sought to recognize Economics, of in AACSB standards for the curricula detailed guidelines businessaccreditation by connecting questions in the test bank and end-of-chapter material to the general

EDITION Objectives

data simple and easy.

Companies International.

AACSB

and

Johnston

Learning

to

AACSB Statement

ORGANIZED LEARNINGIN THE FIFTH

Chapter

to

Test,

and

collection

the

making

of learning

assurance

presentation of

reappointed

28 from

and

features

similar fashion,

Ben

are

events. Chapters

in a

The

Supply, and 22 Chapters

in

learned

examples discussed in

on the

built

previous

and is now

a coherent,

AD curve.

the

the

from

objectives

reporting

in check.

Aggregate

Demand,

BusinessCycles.\" Concepts and 23 are usedto provide of

25

rewritten

is completely

it

\"Aggregate

derivation

on

interest

of

a monetary policytool; this a tool author Ben Bernanke

EZ

learning objectives that directly relate for your course. You can then use the of EZ Test to aggregate student results

for

query

the

our test bank software,

can use

You easily

ideas through

the revision

through

the

mail,

process and via

in

person,

e-mail

humor. We are to the production team, whoseprofessionalism sound

advice,

and good

on

with

grateful

PREFACE

(and

project

Pat Frederickson,lead

was outstanding:

patience)

Matthew

manager;

lead

Baldwin,

designer;

Carol Bielski,seniorbuyer; senior Cheshareck, Jeremy research and all of those who coordinator; photo worked on the production team to turn our manuscript into the book you hold in your hands. Finally, we also thank Katie White, and Jennifer marketing manager, f or our message Jelinski, marketing specialist, getting into the wider world. our sincere thanks to the following teachers Finally,

and colleagues,whose

innumerable substantive of Economics, 5/e.

led to

thoughtful suggestions improvementsto

and

reviews

thorough

Principles

Mark Abajian,

San

Mesa

Diego

Marshall

Agesa,

Seemi Ahmad,

Dutchess

Ashraf Anna

Almurdaah,

Normandale

Community Wisconsin-River Falls

Antus, of

University

Chris

College and and

Mary

Aroskar, Baton

Rouge Community College University of Central Missouri

Azevedo,

Narine

State

Murray

Badasyan,

University

Rebecca Tuttle Baldwin, Bellevue

Klaus

Christian

Walter

Thomas

College

Chen,

of Tex

Yale

College

as-Austin

Nan-TingChou, University of Louisville Buford Cordle Jr., SouthwestVirginia Community

Beveridge, Durham

Okmyung

Bin,

John Bishop, East Carolina Benjamin

F. Blair,

Elizabeth

Brainerd,

William J. Brennan, Brian C. Brush, Christopher

Burkart,

Dickinson

Fairleigh

B. Fant,

Christopher

San Diego

Roger

Frantz,

Mark

Frascatore,

University

Clarkson

John Gardino, Front

University

D. Gibson, Leroy

Range Community State

College

College

College

Christopher

Gill, Ohio State University

Gootzeit, F. Gummerson,

Gupta,

Carolina-Pembroke

of North

Michigan State University

Seth Gershenson, Amy

University

Tricounty Tech

Garland,

College

Community

University

State

Lydia L. Gan, University

University

University

Spartanburg

Fordham

Francis,

Johanna

Barnali

University

Miami

Florida

Newport

University

University

of Memphis International

University

University

Gail Heyne Hafer, St. Louis

College-

Community

Meramec University

Moonsu Han, North Lasell College

Shore Community

College

Richard Lloyd Hannah,Middle

State

University

Minnesota

Marquette

University

of North Texas

Jr., University

Ellis,

University

Coastal Carolina

S. Edwards,

Community

Mississippi State University Williams

Jr., Purdue

Denison

Diizenli,

Eray

Michael Technical

College

Carolina

East

DeBoer,

Martha F. Evans, FloridaState

Alan

Bibow, Skidmore

Paul

College

State University

Cseh, Valdosta

Harley

University

University

River College

American

GregGeorge,

College

Joerg

Chiuping

State

San Francisco

Macon

Fear Community

University

Benediktsdottir,

Chaudhuri,

University

University

Cape

Beer,

ValerieR. Bencivenga, Sigridur

Community

Tech University

Texas

Becker,

Anoshua

Frank

Bastian, Creighton

Timothy

Illinois State

Carlson,

Fred Englander,

Robert B. Archibald, Collegeof William Nisha

J. Lon

Harry

City College

William Paterson

Andreopoulos,

CampaneUi

Dennis

University

Los Angeles

University

University

Faruk

College

Community

Justine Alessandroni, Fordham

Giuliana

College

Florida State

Joseph Calhoun,

Lawrence

University

Lehman

Cakmak,

Attila

College

Michael Adams, SUNYCollege at OldWestbury Richard

Aslihan

University-Mankato

Michael J.

University

University

of West Florida

Haupert,

Glenn S. Haynes IV,

College

Tennessee

State

Wisconsin-La

University

of

Western

Illinois

and

University

Crosse

PREFACE

Susan

John Hejkal, Andrew

Iowa

of

University

Lora Holcombe,Florida Jack W.

State

Greg Hunter, California Robert Jerome,

Gordon

V. Joshi,

David E.Kalist, Kench,

David

A. Kennett,

Lori G. Kletzer, R. Kolb,

Jaclyn

of

State

Lindo,

Clifford Allen

University

Lipscomb,

Valdosta

Mathews,

Thomas

S. McCaleb,

Michael

A. McPherson,

of

University

Florida State

Ohio

David F. Mitch,

University Cities

Pittsburgh

Kennesaw State University

Timothy

The

State

Minnesota-Twin

of

State

North Texas

Maryland-Baltimore

County

David M.

Mitchell, MissouriState

Shalah

Maryam

Mostashari,

Steven

Nafziger,

Williams

College

Nocetti,

Clarkson

University

University

of

University

Oregon

of

University

Barbara

California-Santa

M. Sandifer,

of

University

Georgia

Naveen

Sarna, Northern

Supriya

Sarnikar, Westfield State College

OusmaneSeek,California Atindra John

Sen, Miami

Shea,

State

Sumati

Stein,

Thomas

Stevens,

Park

of Maryland-College Vermont

of of

University

Srinivas, Radford

Rebecca

University-Fullerton

University

University

K. Smith,

College

Community

Virginia

University

of

University

Michigan-Dearborn

Pennsylvania

University

of Massachusetts

Indiana

Stumph,

and

University

Purdue University-Fort Wayne

University

Texas A&M

University

University

Rutgers

Carolyn Fabian

Michael A. Nelson, Texas A&M University Diego

Mark Ryan,

Patricia

University of

University

Rubin,

University

University

Richard Sicotte,University

University

University of

Jeffrey

Madison

Georgia State

Rouhani,

Caroliniana

University

Svitlana Maksymenko,

Ida Mirzaie,

Claire

Wisconsin-Eau

of Hawaii-Manoa

Donald J. Liu, University

Elyce Rotella, Indiana

Vegas

of California-Davis

James

Rosser,

M.

Nevada-Las Carolina State

North

University

Rosario,

Elham

College

University of

Peter Rupert,

Shippensburg University

Northeastern

Laux,

of Iowa

University

Janet Koscianski, Fritz

Cruz

of California-Santa

University

Mary Kay Knudson, University Fredric

of Wisconsin-

University

Khan,

Chowdhury

University

College

Robinson,

Marina V.

Vassar College

Parkside

State University

Jose

Ratha Ramoo, Diablo Valley

Brian

Tampa

of

Price, Butte

Christina

University

University

San

Bill Robinson,

College

Shippensburg

Brian

Farida

Colorado State University

Florida

Central

of

of Missouri

University

Pereyra,

Steve

College

University

Ed Price, OklahomaState

University-Pomona

Jianakoplos,

Martin

J.M. Pogodzinski,

College

James MadisonUniversity

Jo Ammon

Prathibha

State

Beach

Pacific

Pereira, Tulane University

Claudiney

University

Hsu, Kishwaukee

L. Pennington,

Robert

Hou, California State University-Long

Kuang-Chung

Nancy

Stephanie Owings,Fort Lewis

of Oregon

University

University

Staniec, University of the

Ordovensky

Farley

College

Helms, Washington

Herzog,

Ryan

Thomas A. Odegaard, Baylor

State University

Washington

He,

University

Chetan

Subramanian,

Peggy Sueppel, Albert

SUNY-Buffalo

South Florida Community

J. Sumell,

Vera Alexandrova

Youngstown

State

College

University

Tabakova, East Carolina

University

PREFACE

James

A. Tallant,

Henry

S. Terrell,

Steve Trost, Philip

Cape Fear Community of

University

Tech

Virginia

Sam

Jennifer

A. Vincent,

State

Houston of

Mark

University

Central

Slippery Rock University Champlain

Park

State Nancy Virts, California University-North Joseph P.Wesson, NormandaleCommunity Elizabeth

Maine

Nora Underwood, University Jesus M.Valencia,

Maryland-College

University

Trostel, University of

MarklandTuttle,

College

College

Florida

Wheaton,

Wilson,

Ruhai

St. Bonaventure

C. Wood,

William

Wu,

Southern

Florida

Methodist University

James Madison Atlantic

University

University

Selin Yalcindag,Mercyhurst College Bill

Yang,

Georgia

Southern

University

ridge College

University

AL

IC

PEDAGOG

RES

FEATU

OPENER

CHAPTER

Each

the illustrating

a brief

with

scenario

a realistic

of

narrative

CHAPTER

begins

chapter

learned

to be

concepts

in

the

chapter.

upcoming

X LEARNING

OBJECTIVES

Approximately four to objectives beginning of

are presented at the chapter and are referenced the summary, among the end-

of-chapterreview problems

Comparative learning

Advantage

each

in

again

seven

to

which

to

The learning

they relate.

objectives(LOs)serve introduction

and

questions,

as

a quick

and concepts to to the next moving

the material

be mastered before chapter.

LEARNING OBJECTIVES After reading this chapter,

a cook named Birkhaman, who came from a remote Himalayan village in neighboring Bhutan. employed

Although no formal

you should be able LOI

Birkhaman had virtually education, he was

undertaking n units of an activity divided by n the total

benefit of undertaking n units of an activity divided by n

CHECKS

Theseself-test chapter

enable

students

precedingmaterial reinforce

body of the to determine whether the has been understood and before further. reading

questions

understanding

in the

Detailed Answers to ConceptChecksare found at the end of each chapter.

CONCEPT Should

a

CHECK basketball

L02

Explain and apply the Principle of Increasing Opportunity

Cost (also called the Low-Hanging-Fruit Principle). Use a productionpossibilities curve

L03

to illustrate

opportunity

cost and

comparative

advantage.

Identify factors that shift the menu of pro-

KEYTERMS

Key terms are indicated in bold in the margin the and defined

first time each term are

They

listed

also

is used.

among the

end-of-chapter material. A is

available

book

for

glossary the

CONCEPT

to:

Explain and apply the Principle of Comparative Advantage.

spectacularlyresourceful. His primary food and duties, to prepare maintainthe kitchen, he performed well. But he also had extremely the low-hanging fruit first. other skills. He could thatch a roof, Always pick butcher a goat, and repair shoes. An able tinsmith and a good carpenter, he could sew and fix a broken alarm clock, as well as plaster walls. And he was a local authority on home remedies. Birkhaman's range of skills was broad even in Nepal, where the least-skilled villager could perform a wide range of services that most Americans hire others to perform. Why this difference in skills and employment? One might be tempted to answer that the Nepalese are simply too poor to hire others to perform these services. Nepal is indeed a poor country, whose income per person is less than one one-fortieth that of the United States. Few

To discover whether the advice makes economic sense, we must compare the benefit. The professor's estimates, marginal cost of a launch to its marginal tell us only the average cost and average benefit of the program. These are, however, the total cost of the program divided by the number of launches and respectively, the total benefit divided by the number of launches. Knowing the average benefit and average cost per launch for all shuttles launched thus far is simply not useful for deciding whether to expand the program. Of course, the average cost of the launches undertaken so far might be the same as the cost of adding another launch. But it also might be either higher or lower than the marginal cost of a launch. The same holds true regarding benefits. average and marginal

average cost the total cost of

average benefit

a stint as a Peace Corps rural Nepal, a

volunteer in Huring young economic naturalist

at the

back of

quick reference.

1.5

team's best

player

take all the team's shots?

A professional basketball team has a new assistant coach.The assistant notices that one player scores on a higher percentage of his shots than other players. Based on this information, the assistant suggests to the head coach that the star player should take all the shots.That way, the assistant reasons, the team will score more points and win more games. On hearing this suggestion, the head coach fires his assistant for incompetence. What was wrong with the assistant's idea? xv

PRINCIPLES

CORE

SEVEN

REFERENCES There are seven Core Principles this text focuses on almost student

ensure

to

exclusively

that

mastery.

Throughout the text, these principles

are called out

icon

in

the

are

and

by an the seven

denoted

Again,

margin.

Core Principles are: Scarcity,

Cost\302\251

Comparative

Incentive,

Benefit,

Advantage, Increasing Opportunity and Equilibrium.

Efficiency,

Cost,

of apartments more, the number actually available declines by 1 million units I per month. If the housing market were completely unregulated, the immediate response to such a high level of excess demand would be for rents to rise sharply. But here the law them from rising above $800. Many other ways exist, however, in which prevents market can respond to the pressures of excess demand. For instance, participants owners will quickly learn that they are free to spend less on maintaining their rental units. After all, if there are scores of renters knocking at the door of each vacant a landlord has considerable room to maneuver. Leaking pipes, peeling paint, apartment, broken furnaces, and other problems are less likely to receive prompt attention\342\200\224or, rents are set well below market-clearing levels. indeed, any attention at all\342\200\224when Nor are reduced availability of apartments and poorer maintenance of existing t the difficulties. With an of million apartments only offering only apartments per month, we see in Figure 3.8 that there are renters who'd be willing to pay as much as month for an As the Incentive $2,400 per apartment. Principle suggests, this pressure will almost always find ways, legal or illegal, of expressing itself. In New York City, for example, it is not uncommon to see \"finder's fees\" or \"key deposits\" as high as several

The

Economic Naturalist I. I

ECONOMIC NATURALIST

^

EXAMPLES

manufacturers include more than $1,000 worth of \"free\" Why do many hardware software with a computer selling for only slightly more than that? software industry is different from many others in the sense that its customers care great deal about product compatibility.When you and your classmates are working on a project together, for example, your task will be much simpler if you all use the same word-processing program. Likewise, an executive's life will be easier at tax time if her financial software is the same as her accountant's. The implication is that the benefit of owning and using any given software program increases with the number of other people who use that same product. This unusual of the most popular programs an enormous advantage relationship gives the producers to break into the market. and often makes it hard for new \342\200\242roirams The a

NUMBERED EXAMPLES the

Throughout

text,

numbered

EXAMPLE

ultimate action

is

a result

cost-benefit

RECAP

of

2.5

to of

calculation.

equilibrium

and the

equilibrium

quantity.

Unless prevented by regulation, are driven toward prices and quantities their values by the actions of buyers and sellers. If the price is equilibrium frustrated sellers will cut their initially too high, so that there is excesssupply, too low, so that there is price in order to sell more. If the price is initially excess demand, drives the price upward. This process competition among buyers continues until equilibrium is reached.

xvi

or

of

their

Specialization How costly is failure

to specialize?

2.4 Susan and Tom had divided their time so that each person's output consisted of half nuts and half coffee. How much of each good would Tom and Susan have been able to consume? How much could they have consumed if each had specialized in the activity for which he or she enjoyed a Suppose

that in Example

Since Tom can produce twice as many pounds of nuts in an hour as pounds of coffee, to produce equal quantities of each, he must spend 2 hours picking coffee for every hour he devotes to gathering nuts. And since he works a 6-hour day, that means spending 2 hours gathering nuts and 4 hours picking coffee. Dividing his time in this way, he'll end up with 8 pounds of coffee per day and 8 pounds of nuts.

RECAP

EQUILIBRIUM

price

one

seeeach feature

landscape as the reflection more of the Core Principles.

comparativeadvantage?

Market equilibrium, the situation in which all buyers and sellersare satisfied with their respectivequantities at the market price, occurs at the intersection of the supply and demand curves. The corresponding price and quantity are called the

a question

students to economic

economic concepts, the see that each human of an implicit or explicit

MARKET

with

examples

to apply is to goal

life

everyday

Economic

starts interest in

and titled

examples are referencedand called out further illustrate concepts. With our use engaging questions and examplesfrom

Naturalist example to spark an answer. These learning fuel interest while teaching

Each

Sprinkled throughout chapter

are

Recap

each

boxes

that underscore and summarize

the

importance

the preceding

of

material and

key concepttakeaways.

CHAPTER

OF

END

RES

FEATU

SUMMARY

Each

SUMMARY

chapter

summary

that

objectives

reviews

the

provide

closure

tells

to

the chapter.

3. An

curve is a downward-sloping line that what quantity buyers will demand at any given line price. The supply curve is an upward-sloping that tells what quantity sellers will offer at any given (LOl) price.

\342\200\242 The demand

and learning

key points to

a

with

ends

\342\200\242 Alfred Marshall's

model

between the horizontal and vertical interpretations of the demand curve. (LOl) 2. Why isn't knowing the cost of producing a good Explain

sufficient

\302\273

Incomes,

3.

its market price?

(LOl)

In recent official proposed years, a government that gasoline price controls be imposed to protect the poorfrom rising gasoline prices. What evidence

and the expectations, and complements are among the

tastes,

population,

prices of substitutes

shift demand schedules. Supply governed by such factors the number expectations, of sellers, and, especially for agricultural products, the weather. (L03) that

factors

in turn, are primarily schedules, as technology, input prices,

in allocating resources social concerns about how goods and services are distributed among different people. For example, we often lament the fact many buyers enter the market with too little income to buy even the most basic goodsand services. Concern for the well-being of the poor has motivated many govern-

\302\273 The

efficiency

doesnot

of

markets

eliminate

REVIEW

could

consult

to discover whether

this

enacted? (LOl) 4. Distinguish between the meaning of the expressions and \"change in the \"change in demand\" demanded.\" (L03) quantity 5. Give an example of behavior you have observed that could be described as \"smart for one but dumb proposal was

for all.\" (L04)

QUESTIONS

PROBLEMS

AND you

in

(L03)

quantity.

QUESTIONS

the distinction

to predict

supply will lead to an increase in equilibrium price and a reduction

supply

equilibrium occurs when the quantity buyersdemand at the market price is exactly the same as the quantity that sellers offer. The equilibrium price-quantity pair is the one at which the demand and supply curves intersect. In equilibrium, market price measures both the value of the last unit sold

1.

in will lead to a reduction and an increase in equilibrium

supply

decreasein

equilibrium

\342\200\242 Market

REVIEW

in

price

quantity.

4. A

and demand nor value to explains why neither cost of production the purchaser (as measured by willingness to pay) is, are by itself, sufficient to explain why some goods cheap and others are expensive. To explain variations in price, we must examine the interaction of cost and willingness to pay. As we've seen in this chapter, in their goods differ in price because of differences curves. (LOl) respective supply and demand of

increase

equilibrium

Approximately

at the end appear to test chapter of the logic behind

questions of

review

five

each

understanding

economic

concepts. are

problems

crafted

The

to help

students internalize and extend

concepts.

objectives are

PROBLEMS

at

1. How would each of the following affect the U.S. market corn? (LOl) a. A new and improved crop rotation technique is discovered. b. The price of fertilizer falls. c. The government offers new tax breaks to farmers. d. A tornado sweeps through Iowa.

core

supply

curve

the

end

Learning

also referenced

of each

question

and problemto reiteratethe

for

conned:'

particular (ECONOMICS

goal

that

is being

examined.

xvii

SUPPLEMENTS

FORTHE

SUPPLEMENTS

INSTRUCTOR

ancillaries are available for quick download following and convenient access via the textbook's website at www. mhhe.com/fb5eand are passwordprotected for security.

The

Norander of Missouri State University, manual features general topics such as Economic Education Resources, and Website, Ideas. each chapter will also include: Additionally,

Prepared this Using

Per

by

expanded the

Innovative

Concepts Students ShouldMaster,Teaching Economic Blocks, Additional Stumbling

an Overview, Tips/Student

Naturalist Examples,In-Classand an Annotated Chapter Outline.

Web

and

Activities,

Solutions Manual

Prepared

Per

by

Missouri

Norander,

State University

of (micro), and Sarah Ghosh,University this manual provides detailedanswers (macro),

Scranton to

the

questions.

end-of-chapter

set

lecture

new

prepare

is the

notes and hurdle

this

chapters,

and

to an instructor

hurdles

textbooks

considering changing

microeconomics

Manual

Instructor's

PowerPoints One of the biggest

Notes

Lecture

Micro

Customizable

prospect of

having

to

slides.For the

no longer

exists. A

full

notes for principlesof microeconomics, by Bob Frank for his award-winning microeconomics course at Cornell University,

of lecture

prepared introductory

is available as Microsoft Word files that instructors are welcome to customizeas they see fit. The is to reinforce the lessonsof challenge for any instructor the text in lectures without generating student unrest what's in the book. These lecture by merely repeating

notesaddressthat challenge by constructing examples in that run parallel to those presented the book, yet are different from them in interesting contextual ways. Also available is a complete set of richly illustrated PowerPoint files to accompany theselecturenotes. Instructors are also welcome to customize these files as they

wish.

Test Banks

Prepared by

and

(micro)

4,000 questions objectives,

AACSB

Paul

(macro),

College

Community

of the University of New Fisher of Henry Ford each manual contains nearly

Krause

Kate

Mexico

objectives,and level

categories, of

Test

Computerized

learning Bloom's Taxonomy

by chapter

categorized

learning

difficulty.

Windows

the

from

purchase.

Paul

chapter, and

Prepared Central

Florida,

chapter

notes.

You

xviii

needs

of the University

of

contain a detailed, chapter-byideas presented in the important animated accompanied by graphs and slide can or edit, print, rearrange the slides to fit these

review

textbook, the

by

Underwood

of

of your

slides

the

course.

Solman

MP3 devices.

Exercises

videos

for

downloadable

each

through

Study Econ MobileApp

( I

y^

Study

\"| I

McGraw-Hill

Nora

The

self-grading quizzes,Graphing

Econ

PowerPoints

quizzes.

practice for

available

features as the of study PowerPremium content is also content contains premium

such useful a set textbook, are

there

students

Points, and

environmnents.

Macintosh

and

Online Learning Center Glossary

McGraw-Hill's EZ Test is a flexible and easy-to-use electronic testing program.The program allows you to create tests from book-specificitems.It accommodates a wide can add your range of question types and you own questions. Mulitple versions of the test can be created and course any test can be exported for use with such as Blackboard or WebCT, management systems EZ Test Online is a new serviceand pageOut. gives you EZ Test-created a place to easily administer your exams and quizzes online. The programis available for

STUDENT

www.mhhe.com/fb5e For

Bank

FORTHE

SUPPLEMENTS

McGraw-Hill bile

study

nomics Principles

to offer a new mofor students app learning ecofrom Frank and Bernanke's 5th edition. of Economics

The features

is proud

of the Econ app Study all key terms, a basic math customizable self quizzes, common mistakes, review, and games.For additional information refer to please the back insidecover of this book. Visit your mobile a trial version of the Frank app store and download include:

flashcards

Study Econapp

for

today!

#

SOLUTIONS

DIGITAL

Greater

McGraw-Hill Economics is an online that connects students need to achieve success.

Learning.

|EJJ\342\204\242CS Connect\302\256

assignment and assessmentsolution with the tools and resourcesthey'll McGraw-Hill ConnectEconomics helps prepare students for their future by enabling faster learning, more efficient and higher retention of knowledge. studying, of

number

assignments

faculty can spend more time teaching. Economics, students can engage with and anywhere, making the anytime

more accessible and

coursework

Connect

easier

Economics,

so you

ever,

enables

function

deliver

and

and

classroom

it

and

feedback

where

they need it. When

efficiently material when they

practice

it comes

also is precious.The grading \342\226\240 Have

review

and

or leave

grades

and instant

comments for students to concepts

Library Economics

side-

repositoryfor

additional

to improve

student

reinforcement

as much

only

gives

diagnostics you to assess learned on

fastest

and remediation,

guidance as students need. as part of the learning

which concepts their own, thus

students have freeing

class

more applications and discussion.

time for

Student ProgressTracking

instructors informed about and class is performing, use of lecture and office productive function enables you to: progress-tracking

Economics

keeps

how each student, allowing for more The

\342\226\240 View individualor

section,

immediately and track with assignment performance

work

scored group

and

gradereports. performance

resources

is the

LearnSmart:

to each student, so students the topics they understand and more those they have yet to master. continual

\342\226\240 Access

Library is your

every student concepts.

automatically time on

\342\226\240 Enables

hours.

tests

advance the student's devoted to the concepts

chapter

experience.

it,

time.

study

less

efficiently

review.

with practice

Instructor

of the

\342\226\240 Integrates

quizzes.

Connect

mastered.

\342\226\240 Adapts

by

of their

LearnSmart's intelligent and response

time reducing The result for

path to mastery

practice

need

use

best

that

concepts

\342\226\240 Provides

change

manually

practice,

while

spend

to teaching, your time enables you to:

each response;

classroom

\342\226\240 Reinforce

\342\226\240 The

with

comparisons

by-side

of

but

automatically, giving on their work and correct answers.

and Study

self-study technology within students with a seamless provides and remediation for assessment,

Economics

Connect

feedback

immediate

\342\226\240 Access

function

scored

assignments

students

more

learn

students

providing

Instructor

bank items.

time is precious. Connect

to studying,

comes

study

adaptive

every conceptin the textbook. software adapts to every student

already with

to make the

Students want The LearnSmart

understanding

with the eBook and online of student assignments. grading

Economicshelps

and

to the Self-Quiz

access

students

describedbelow.

delivers automatically

student progress to make grading efficient than ever.

Grading

material practice on the go.

accessible

easily

\342\226\240 Gives

lectures, practice

more.

and

instant

questions,

access to

quick

eBooks,

materials,

paperless

Smart

Center:

students

\342\226\240 Offers

planning,

assignment more

management

submissionand

When

and test

questions

lesson

reporting,

easily

assignments

selectable end-of-chapter \342\226\240 Streamline

and

to:

you

\342\226\240 Create

\342\226\240 Go

is

assignments

can spend more time teaching The managing. assignment management

than

less time

Student Study

Connect\302\256

creating

to

students

combination

Simple Assignment Management With

place for

Student Study Center is the access additional resources. The

Economics

Connect

LearnSmart

learning process

here.

as described

features

With their

Economics

Connect

efficient.

tools so easier, Connect

powerful

and

select

can

your lecture.

Study Center

Student The

Features

Economics

Connect\302\256

Connect Economics offers a and features to make managing

the

any

class. You

enhances

that

asset

\342\226\240 Provides

McGraw-Hill

offers

use

out of

in and

engagement

^ess Managing. More Teaching.

fY^nnPfH\" U^f

H

Economics

Connect\302\256

McGraw-Hill

\342\226\240 Collect

an

instant

relative

data

accreditation

view of

to learning

and generate organizations,

student or class objectives.

reports required by many such as AACSB. xix

Lecture

attention

to lecture

paid

attention

the decreasing

charge

for

Capture

Increase the

discussion

For an

to note-taking.

paid

Capture offers new ways

Lecture

in-classdiscussion, knowing important topics later. LectureCapture and

distribute

and

index

additional

they enables

your lecture

of

a click

with

button. \342\226\240 Record anything

frame

searchable,

iPod,

computer,

intent

\342\226\240 Increase

students'

easing Lecture

your

by

frame.

Capture

anytime and or mobile device.

McGraw-Hill

provides

heads.

textbook

the

experience

learning

for the modern student with A seamless integration of an

following:

access

you

to your

assign

search

\342\226\240 A powerful

key

for anytime,

concepts

or question is covered.

function to in a snap.

students.

pinpoint and

more

information

www.mcgrawhillconnect.com,

McGraw-Hill salesrepresentative. Tegrity

Campus:

Graw automatically

in

class

time

into

study

by

supported

it,

turn

Help

recordings.

learning

need

they

moments

your lecture.

McGraw-Hill's Customer Experience

we understand that getting the most from new technology can be challenging. That's why our services don't stop after you purchase our products. You can e-mail our Product Specialists24 hours a online. Or you can search day to get product-training our knowledge bank of Frequently Asked Questions on our support website. For Customer Support, call

At

McGraw-Hill,

you

visit

One

www.mhhe.com/support.

Technical Support Analysts in a timely fashion.

to

be able

will

egflty capturing

thoroughly for

24/7 Tegrity

CQmpUS every lecture

service

Campus that

makes

is a class

time available 24/7 by in

CourseSmartis

a searchable

format

a new

way for faculty to find

and review eText-

Smart Choose Smart

books.It's

also

for

option

a great

students

who are interestedin accessing their course materials CourseSmart offers thousands of the most digitally. textbooks across hundreds of commonly adopted courses from a wide variety of higher education publishers. It is the only place for faculty to review and the

compare

about Connect, pleasevisit or contact your local

Lectures

CourseSmart CourseSmart

students

preparing

.

Mc

they need, when

semester of

To learn more about Tegrity watch a 2-minute Flash demo at http://tegritycampus.mhhe.com.

Learn

This state-of-the-art,

tested system supports you the world that awaits. For

an entire

all your students'

assist

In short, ConnectEconomics offers and your you students powerful tools and features that optimize your time and energies,enabling you to focus on course and student learning. Connect Economics content, teaching, also offers a wealth of content resources for both and

what

find

efficiently

of our

the problems or questions students and the location in the

that problem

where

eBook

instructors

students

between

links

\342\226\240 Dynamic

easy-to-use

Educators know that the more students can see, hear, and experienceclass resources,the better they learn. In fact, studies prove it. With Tegrity Campus, students quickly recall key moments by using Tegrity Campus's unique search feature. This searchhelps

800-331-5094 or

eBook, allowing to the textbook.

integrated

anywhere

connect

viewing

with

class

any

or Mac.

Team

Plus Economics. and Connect Economics, ConnectPlus Economics all of the Connect Economics features plusthe

\342\226\240 An

of

a PC

on

Support reinvents

McGraw-Hill

complete

one-click start-and-stop process,you screens and corresponding audio.

any part

replay

browser-based

immediately

Economics

Plus

f^

|economics\342\200\224\"^

Connect

tops of their

Connect\302\256

H Mm rnmPTl\" \\HAH/l

eBook

by

anywhere

and class participation by listening concerns about note-taking. will make it more likely you will see

faces, not the

students'

all computer can

across

to lectures

access

\342\226\240 Offer

presentations and computer so it is easily

PowerPoint on

shown

Students

a simple

With

capture

to can revisit you to:

students

for

focus on the \342\226\240 Record

by

when they study and

to review

students

assignments.

Smart,

full

students

text of a textbook online. At can save up to 50% off the

Course-

cost

of a

print book, reduce their impact on the environment, and access to powerful web tools for learning, gain full text search, notes and highlighting, and including email tools for sharing notes between classmates. Your

eBook

also

includes

tech support

in

case

you

ever need

help. Finding your eBook is Smart.com and search by title,

easy.

author,

www.Course or ISBN.

Visit

CONTENTS

BRIEF

PART I

Thinking

2

Comparative Advantage

3

Supply

61

Demand

6

Perfectly

125 151

Supply

Competitive

Efficiency, Exchange, and the

Monopoly,

Oligopoly,

and

9

Gamesand

Strategic

Behavior

10

Externalities and Property

I I

The

Labor

13

The

14

Public

16 17 6

18 19 20

7

21

251 279

Rights

307

of Information

Economics

and Income

Poverty,

Markets,

Environment, and

Goods

Safety 361

Tax Policy

387

Spending,

and GDP

the

Price Level

and

Inflation

Wages

Income,

and

415 439 467

Unemployment

in the LongRun

The Economy Economic

501

Growth

Formation, and Financial Money, Prices, and the Financial System Saving, Capital

Markets

531

561

in the Short Run

The Economy Short-Term

333

Issues

Macroeconomics: Data and

Economic

Fluctuations

24

Aggregate

25

Macroeconomic

26

Distribution

Health, and

23

PART 8

215

Competition

Monopolistic

Spending, Output, and Fiscal Policy Monetary Policy and the Federal Reserve

22

179

Economics of Public Policy

12

15

in Action

Hand

Invisible

Market Imperfections

8

PART 5

Hand

97

5

PART 4

Invisible

Competition and the Elasticity

PART 3

3

35

and Demand

4

7

PART

an Economist

Like

1

PART 2

PART

Introduction

593 613 649

Demand, Aggregate Supply, Policy

and BusinessCycles

681

707

The International Economy Exchange

Rates,

International

Trade,

and Capital

Flows 731

CONTENTS

Introduction

I

PART

Chapter

I

World of 5 Principle in a

Choice

Studying

Cost-Benefit

the

Applying

an Economist

Like

Thinking

Economics:

Comparative

3

THE ECONOMIC NATURALIST

Scarcity 4

Pitfalls

Decision

Important

7

Measuring Costs and Rather Than Absolute Dollar

as Proportions

Benefits

Amounts

8

Normative

Economics:Micro and Macro 15 The Approach of This Text 16

EconomicNaturalism

THE ECONOMIC

\342\200\242 Core

19

Summary

Review

20

Questions

22

Checks

Concept

19

Principles

2

Chapter

Exchange

Working

Appendix:

with

35

of Comparative

THE ECONOMIC NATURALIST Advantage

Comparative

2.2

The Gains from

the

That

Have

Specialize?

Production

49

Some Countries 51

3.3

84

of Supply and

PART

2

86

All

89

\342\200\242Terms

Key

\342\200\242 Problems

Checks

Algebra

Competition

\342\200\242

89

91

Demand

\342\200\242

Appendix:

The

93

Been Slowto

and

Invisible

Hand

Elasticity

97

the

46

Chapter

4

Price Elasticity

47

Shift the Economy's

PossibilitiesCurve Why

Slope

Specializationand Exchange Curve for a

Many-PersonEconomy Factors

81

41

Possibilities

A Production

89

to Concept

3.2

85

Table

Questions

77

3.1

78

85

for One, Dumb for 88 \342\200\242 Core Principles

44

PPC

75

Demand

and Equilibrium

Summary Review

How Individual Productivity Affects the

and Position of

Changes

Explaining

Cashon the

Answers

Curve

\342\200\242

71

73

and Quantities 74

in

Shifts

Smart

and

Production Possibilities 41 The Production Possibilities

and

Efficiency

41

89

68

THE ECONOMIC NATURALIST Shifts in the Supply Curve

37

40

Advantage

61

65

THE ECONOMIC NATURALIST Four Simple Rules 82 THE ECONOMIC NATURALIST

The Principle of Comparative Advantage THE ECONOMIC NATURALIST 2.1 39 Sources

to

36

Cost

Opportunity

\342\200\242

23

Advantage

Comparative

and

\342\200\242 Answers

20

\342\200\242

20

\342\200\242

63

Reconsidered

Controls

in Prices

Key

\342\200\242 Problems

Graphs, and Tables

Equations,

Supply

Predicting

\342\200\242Terms

57

66

Curve

Pizza Price Controls?

18

Key

58

Checks

The DemandCurve

17

NATURALIST 1.3

\342\200\242

\342\200\242 Problems

Central Planning versus the Market and Sellers in Markets 64

Rent

18

57

Questions

Market Equilibrium

1.2

Principles

Buyers

16

THE ECONOMIC NATURALIST

56

for Whom?

and

How,

The

NATURALIST I.I

ECONOMIC

THE

\342\200\242 Review

54

2.4

Chapter 3 Supplyand Demand What,

2: Ignoring Implicit Costs 9 3: Failure to Think at the Margin 10 Economics versus Positive Economics 15

Pitfall

\342\200\242 Core

to Concept

Answers

8

Pitfall 1: Pitfall

56

Terms

of Economic Models

The Role

Three

56

Summary

6

Cost

53

2.3

53

Outsourcing

THE ECONOMICNATURALIST

Economic Surplus 6 Opportunity

Too Much Specialization? 52 and International Trade 53 Advantage

We Have

Can

Price

of Demand

Elasticity

Defined

98

98

Determinants of Price Elasticity

of

Demand

Some Representative Elasticity Estimates Price of Demand 102 Elasticity

100

101

Using

xxiii

CONTENTS

xxiv

A Graphical

Interpretation of

Price Elasticity Changes

The Demand

Total

and

Elasticity

along a Straight-Line

Competitive Some

107

Expenditure

of

and Essential

Unique

A

Inputs: The Ultimate

118

\342\200\242 Terms

Questions

119

\342\200\242 Problems

119

Key

\342\200\242 Answers

120

\342\200\242

to Concept

of Supply Revisited

Input Prices 166 The Number of Suppliers Expectations

The

Changes

126

Demand

of

of Demand 126

The Origins

Needs

128

Demand

into

Wants

Translating

127

NATURALIST 5.1

THE ECONOMIC

Income

135

THE ECONOMIC NATURALIST THE ECONOMIC

of

173

Key

\342\200\242 Problems

\342\200\242 Review \342\200\242 Answers

173

to

176

145

Questions

146

Concept

Checks

\342\200\242

Key

Terms

\342\200\242 Problems

146 146

151

Thinking

about

Hand

180

184

Theory

of Price 184 184

and Losses

Profits

to

Responses

\342\200\242 Answers

148

to

190

and Exit

191

Profit 193

193

NATURALIST 7.1

ECONOMIC

Social

\342\200\242 Review

and

a

195

Optimum

Smart for One,Dumb for All 195 THE ECONOMIC NATURALIST 7.2 196 Market Equilibrium and Efficiency

The Costof Preventing

Chapter 6 PerfectlyCompetitive Supply

Role of EconomicProfit of Profit 180

The Distinction betweenan Equilibrium

142

Surplus

Invisible

the

179

The Importance of Free Entry Economic Rent versus Economic The InvisibleHand in Action THE

Surplus 142

Consumer

Calculating

141

142

Addition

and Consumer

140

Action

in

Two Functions

140

Differences

Income

and

Exchange,

Efficiency,

Types

The Invisible

138

THE ECONOMICNATURALIST 5.5 140 Individual and Market Demand Curves Horizontal

The Central Three

138

5.3

NATURALIST 5.4

The Importance

Price Ceilings

Price

196

Adjustments

200

200

Price Subsidies 204 Supply: The

Opportunity Cost 152 and

Concept

Checks

138

NATURALIST 5.2

ECONOMIC

137

Rule

Spending

Substitution at Work

Individual

173

Hand

Rational

the

Applying

Summary

Questions

Chapter 7

Effects

Substitution

and

Demand

172

Summary

170

Surplus

\342\200\242 Terms

167

Spending Rule 135

Revisited

THE

128

131

Goods

Producer

Calculating

Measuring Wants: The Conceptof Utility a Fixed Income between Two Allocating The Rational

167

of Supply

Theory

167

Products

of Other

Prices

in

the

Applying

167

167

THE ECONOMIC NATURALIST 6.1 and Producer 170 Supply Surplus

127

Wants

versus

166

166

Chapter 5 Demand 125 Law

165

Supply

Technology

123

Formula

The Midpoint

Appendix:

of

Determinants

\342\200\242 Review

161

Maximum-Profit

The

Cost:

163

The \"Law\"

Summary

Maximization

to Profit

Approach Marginal

159

Condition 161

and Average

161

Condition

Supply

158 Profit

Maximize

Cost

Variable

Graphical

157

Run

Firm's Shutdown

on the

Price =

116

4.3

118

Bottleneck

111

114

of Supply Elasticity

Determinants

THE ECONOMIC NATURALIST

Short to

Total Cost

112

Supply

156

Cost Concepts

Important

Average

Elasticity of

a Perfectly

Facing

in the

Note

A

111

The Price

156

Firm

ChoosingOutput

Income Elasticity and Cross-PriceElasticity Demand

Curve

Production

Cases 106

Two Special

Perfectly

155

Profit Maximization

Price

105

Curve

Demand

in

Markets

Competitive

103

Elasticity

Checks

Profit-MaximizingFirms

102

4.2

NATURALIST

ECONOMIC

THE

102

NATURALIST 4.1

THE ECONOMIC

Market

Supply

Importance of Curves

154

Summary

206

Questions

207

Concept

Checks

\342\200\242

Key

Terms

\342\200\242 Problems

210

107 208

\342\200\242 Review \342\200\242 Answers

to

CONTENTS

Market

3

PART

The Prisoner'sDilemma

Imperfections

The

Chapter 8

Monopoly,Oligopoly,

and

The Economicsof

Monopolistic

215

Competition

The EssentialDifference Five

between

Imperfectly Competitive of Market Power over

Control

219

Economies of Scaleand

220

223

8.1

Profit Maximization for the Monopolist Marginal Revenue for the Monopolist The Monopolist's

Why the Invisible under

How

of

Discrimination

235

Is Price Discrimination

Natural

Questions

244

Concept

Checks

237

Thing?

239

Monopoly

247

the

Natural

THE

Using

9 Game

Games Theory

Laws

242

The

Appendix:

Algebra

to

of

Behavior 251

The Three Elements of a Nash Equilibrium 254

294

Ownership

Agreements

Social Norms

302

Questions

303

Concept

Checks

10.4

295

296

297

Arms Races

Agreements

252

Tragedy of

on PayoffsThat Depend THE ECONOMIC NATURALIST

Summary Game

Externalities

Control

Is

289

Subsidies

THE ECONOMIC NATURALIST

to Analyze

Strategic Decisions 252

Externalities

Negative

of UnpricedResources 292 Private

of

Positional

249

and Strategic

of

When Private OwnershipIs Impractical ECONOMIC NATURALIST 10.3 295

Positional

\342\200\242 Review \342\200\242 Answers

244

Monopoly Profit Maximization Chapter

The Effect

288

291

Commons

The Problem 241

Monopolies

\342\200\242

Rights and the

Property

240

10.1

NATURALIST 10.2 289

CompensatoryTaxesand

238

\342\200\242 Problems

Supply

287

The Optimal Amount Not Zero 289

241

Monopoly

Allocation 280

281

Regulations 287 THE ECONOMIC NATURALIST THE ECONOMIC

Vigorous Enforcement of Antitrust 244 243 \342\200\242 Terms Summary Key

Affect

Externalities

for

Remedies

State Ownership and Management 240

State Regulation of Private Exclusive Contracting for

279

Affect Resource

Externalities

The CoaseTheorem 283

Price

NATURALIST 8.3

toward

Property

Laws and

Examples of Price Discrimination ECONOMIC

to

279

and Demand?

231

232

8.2

a Bad

274

HowDo Externalities

Price Discrimination Affects

Output 232 The HurdleMethod

\342\200\242 Review \342\200\242 Answers

277

and Benefits

External Costs

229

Monopoly

Public Policy

Concept

273

Terms

Rights

228

THE ECONOMIC NATURALIST

THE

273

Checks

Hand BreaksDown

Using Discounts to Expandthe Market Price Discrimination Defined 231 How

Questions

Doesn't Guarantee an

Profit

Key

\342\200\242 Problems

Chapter 10 Externalitiesand

227

a Monopolist

Economic

270

225

Profit-Maximizing

Decision Rule Being

224

\342\200\242

273

Summary

with

Problems

Incentives

Economic

267

9.4

268

Problems

SolvingCommitment

of

Importance

NATURALIST

ECONOMIC

THE

THE ECONOMIC NATURALIST

Natural

Economiesof Scale and the Start-Up Costs 221

When

266

Matters

Location Commitment

Economies

Network

and Promises 265

Competition

Monopolistic

220

Monopolies

263

Matters

Timing

Credible Threats

219

261

9.2

NATURALIST 9.3 262

Gamesin Which

or Franchises

Licenses

Prisoner's

Repeated

THE ECONOMIC NATURALIST

219

Inputs

Important

257

260

Dilemma THE ECONOMIC

218

Patents and Copyrights 219 Government

and

Perfectly

Firms

Sources Exclusive

216

Competition

the

and

Tit-for-Tat

of Imperfect

Forms

256

Dilemma

Cartels

NATURALIST 9.1 257

THE ECONOMIC

Imperfect Competition 216 Different

256

Prisoner's

Original

Performance

Relative 10.5

297

and Positional Arms 298

as Positional Arms

Control

299 \342\200\242 Terms

Key

\342\200\242 Problems

306

303 303

\342\200\242 Review \342\200\242 Answers

to

297

CONTENTS

xxvi

of

Economics

The

I I

Chapter

How the Middleman The Optimal Amount

Methods of IncomeRedistribution

310

Test 310

The Cost-Benefit

Welfare

NATURALIST I I.I 311 THE ECONOMIC NATURALIST I 1.2 311 Two Guidelines for Rational Search in Search The Gamble Inherent 313

316

Model

The Lemons

318

in Trading

Problem

NATURALIST

ECONOMIC

Conspicuous of

I

Questions

356

Concept

Checks

THE ECONOMIC NATURALIST Moral Hazard

I

Summary Questions

327

Concepts

Check

Key

\342\200\242 Problems

1.7

324

1.8

325

328

\342\200\242 Answers

The

Economic

The Equilibrium

to

The DemandCurve

for

The Supply Curve Explaining

Shifts

in Earnings

Winner-Take-All

THE ECONOMIC

in the

12.2

342 342

Labor Market

Markets NATURALIST

THE

and CarbonTaxes 372 374

Regulation

Safety

THE ECONOMIC Public Health and

NATURALIST

Security

THE ECONOMIC NATURALIST Summary

381

Questions

382

Concept

Checks

345 12.3

\342\200\242 Terms

Key

\342\200\242 Problems

378

13.3

379

13.4

380

382 382

\342\200\242 Review \342\200\242 Answers

Goods

Demand

The 343

390 14.1

392

Quantity of a

Public Good

to

384

Public

for

The Optimal

393

Curve

Public Good Private

345

13.2 378

NATURALIST

ECONOMIC

Paying

341

through

371

Permits

Pollution

THE ECONOMICNATURALIST

340

THE ECONOMIC NATURALIST Discrimination

339

339

THE ECONOMICNATURALIST 12.1 Compensating Wage Differentials

362 362

Delivery Criterion

Chapter 14 PublicGoodsand Tax Policy Government Provision of Public Goods 388 Public Goods versus Private Goods 388

338

Differences Unions

337

Labor

of Labor 337

Human Capital Theory Labor

333

337

Levels

Employment

Market

Poverty, and

and

Wage

Cost-Benefit

Climate Change

Income Distribution Value of Work 334

Care

369

Auctioning

Markets,

361

Taxing Pollution 369

329

Labor

and

Health,

Health

the

Regulation

\342\200\242 Review

Economics of Public Policy 12

Chapter

to

359

ECONOMIC NATURALIST 13.1 366 The Problem with Health Care Provision Private Insurance 367 The Affordable Care Act of 2010 368 in Environmental Using Price Incentives

Workplace

PART 4

356

\342\200\242 Review \342\200\242 Answers

THE

324

327

\342\200\242 Terms

356

Designing a Solution 364 The HMO Revolution 365

322

1.6

Discourse

THE ECONOMICNATURALIST I THE ECONOMIC NATURALIST I 327

321

323

Political

Disappearing

354

Key

\342\200\242 Problems

Safety

323

Selection

354

Poor

the

\342\200\242 Terms

The Economics of Applying

NATURALIST I 1.5 Discrimination 321

THE ECONOMIC

Adverse

355

320

Ability

Statistical

of Methods

Chapter 13 The Environment,

319

1.3

NATURALIST I 1.4 320 Consumption as a Signal

THE ECONOMIC

for

Combination

319

The Costly-to-FakePrinciple THE

Tax Credit 352

Public Employment Summary

315

351

Wages

The Earned-Income A

Information

The Credibility

Minimum

314

Is Costly Asymmetric

312

349

Programs

Income Tax 350

The Negative

Search

When

Problem

and In-Kind

Payments

Means-TestedBenefit

THE ECONOMIC

The Commitment

349

Transfers 349

311

Problem

a Moral

347

Problem?

308

Information

of

The Free-Rider

Is IncomeInequality

Value

Adds

346

Trends in Inequality

Recent

307

Information

Provision

for a

393

of Public

THE ECONOMIC NATURALIST

Goods 14.2

395 396

387

CONTENTS

399

Centralization

and Property

Externalities

Sourcesof Inefficiency

Rights

in

the

THE ECONOMIC NATURALIST Should

407

Summary Questions

408

Concept

Checks

PART 5 15

Chapter

407

\342\200\242 Terms

Key

\342\200\242 Froblems

\342\200\242 Review \342\200\242 Answers

408

Macroeconomics: Data and

Issues

and GDP

Income,

Spending,

462

Concept

Checks

415

the

a Country

during

Measuring

Increasing Wage

Change 481

425

and Labor

Nominal GDPversus

THE ECONOMIC NATURALIST 15.1 Real GDP and Economic Weil-Being Why Real GDP Isn't the Same as

EconomicWeil-Being THE

GDP

428

The

429

Weil-Being 432

Summary

435

Questions

435

Concept

Checks

435

\342\200\242 Terms

Key

\342\200\242 Froblems

436

Level

439

Indexing to

Maintain

Unemployment

Questions

494

Concept

Checks

Buying

\342\200\242 Froblems

494

\342\200\242 Answers

to

496

The Economy in the

PART 6

Long

Run

The Remarkable Rise in Living

445 Power

447 Think

Differences Why \"Small\" Rates Matter 504

451

Nations

Why

Average

Standards:

503

Record

The

448

501

Growth

Economic

18

Chapter

Does the CPI Measure \"True\" Inflation? The Costs of Inflation: Not What You The True Costs of Inflation 452 456 Hyperinflation

to Full Employment 490 \342\200\242 494 Review Key

\342\200\242 Terms

493

444

16.1

Quantity

489 489

440

Inflation

442

a Nominal

Unemployment

Impediments

to

488

488

Structural

Summary

THE ECONOMICNATURALIST for Inflation 444 Adjusting Deflating

\342\200\242 Review \342\200\242 Answers

Price

and Their Costs

Frictional

CyclicalUnemployment

438

and the Chapter 16 Inflation The ConsumerPriceIndexand

Inflation

434

15.3

Rate versus \"True\"

of Unemployment

Types

486

487

Unemployment

430

486

Unemployment

The Unemployment

Is Related

THE ECONOMIC NATURALIST

of

484

484

of Unemployment

Costs

The Duration

Rate

Unemployment

Measuring Unemployment

429

NATURALIST 15.2 to Economic

ECONOMIC But

Inequality:Technological

the

and

Unemployment

426

GDP

Real

of

479

Globalization

of Capital

Incomes

Inequality: The Effects

Increasing Wage

421

GDP

GDP and the

during

478

1990s

the

in the Though

Was Rapid

Growth

Employment

a

for

Method

to

477

Countries?

Since the 1970s, Real Wage Growth United States Has Slowed,Even

Given Period 420

The Expenditure

462

464

Industrialized

the

417

and Services

Producedwithin

\342\200\242 Review \342\200\242 Answers

467 Chapter 17 Wagesand Unemployment Four Important Labor Market Trends 468 in the Labor Market 469 and Demand Supply and the Demand for Labor 469 Wages in the Demand Shifts for Labor 471 The Supply of Labor 475 Shifts in the Supply of Labor 476 Explaining the Trends in Real Wages and Employment 477 Have Real Wages Increased By So Much in Why

416

Value

Goods

Final

Questions

416

Output

Market

to

410

GrossDomesticProduct:Measuring Nation's

401

405

We Tax?

Key

\342\200\242 Froblems

457

401

14.3

NATURALIST 14.4

THE ECONOMIC

461

\342\200\242 Terms

461

Summary

400

Process

Political

399

399

or Federal?

State,

Local,

What

Inflation and InterestRates 457 Inflation and the Real Interest Rate The Fisher Effect 460

Question of

and the

Regulations,

Laws,

xxvii

Become Labor

in Growth

Rich: The

Productivity

Crucial Role of 506

CONTENTS

xxviii

of Average 509

Determinants

The

Human

Capital

THE ECONOMIC NATURALIST 18.1 The Political and Legal Environment Economic Growth 519 Promoting

Policiesto IncreaseHuman

PoliciesThat

Promote

Moneyand

Countries:

A

Summary

Key

Questions

526

Concept

Checks

Chapter 19

\342\200\242 Froblems

527

\342\200\242 Review \342\200\242 Answers

Markets

and Its

534

National

and the

Public Saving Why Do

People Save?

Government

536

Potential

539

Budget

541

and

Investment

Formation

Capital

Key

Questions

556

Concept

Checks

Chapter 20

\342\200\242 Problems

Productive

Prices,

System Uses

Bondsand

and

and

System

551 to

562

System

562

Fluctuations Occur? A

THE ECONOMIC NATURALIST Summary Questions

610 611

Check

561

\342\200\242 Terms

Key

\342\200\242 Problems

610 611

\342\200\242 Review \342\200\242 Answer

to

Fiscal

and

613

The KeynesianModel'sCrucialAssumption: Meet Demand at Preset Prices 615 Planned

Short-Run

609

21.1

Aggregate

Expenditure

Bonds

564

Stocks

566

Planned

564

Preview

612

Policy

of Saving to

about

Parable

Planned Spending versus Actual Consumer Spending and the

Stocks

and Cyclical

604

Chapter 22 Spending,Output,

the

the Allocation

601

Gap

a Parable 606 Al's Ice CreamStore:A Fluctuations 607

\342\200\242 Review \342\200\242 Answers

Unemployment 600

600

and

Concept

Money,

The Banking

556

594

597

Do Short-Term

Why

559

Financial

The Financial

556

\342\200\242 Terms

555

593

The Natural Rate of Unemployment Unemployment 602

547

THE ECONOMICNATURALIST 19.1 550 and Financial Markets Investment, Saving, Summary

Economic

and Cyclical

Okun'sLaw

Real Interest Rate 543 and Demonstration Self-Control, Saving, Effects 545

Run

about Short-Term Economic

Output

Output

and the

Saving

Gaps

Output

538

Saving

to

Economy in the Short

Fluctuations

536

The Measurementof National Saving Private and Public Componentsof

\342\200\242 Answers

587

Expansions

Some Facts

Components

\342\200\242 Review

589

Short-Term

21

Recessionsand

Flows 533 Gains and Losses Capital Saving

Concept

\342\200\242 Problems

Fluctuations

Stocks and National

586

Checks

584

Run

Long 586

Key

Questions

Chapter

531

532

Wealth

the

in

\342\200\242 Terms

585

and

Formation,

Capital

582

Prices

PART 7 The

Saving,

581

to

529

Financial and

526

\342\200\242 Terms

with

Supply

Operations

Money and Inflation Summary

580

and Prices

Supply,

Money

575

Money

Currency

583

Velocity 521

Case?

Special

of EconomicGrowth 522 Limits to Growth? 523 526

Saving

521

Framework

Creation of Both

Money

Open-Market

521

Development

The Legal and Political The Poorest

and

Research

Support

573

Banks and the

Central Banks,the Controlling the

571

20.1

The Money Supply with and Deposits 578

and

Saving

569

and Aversion

Money

Commercial 519

Capital

569

Sharing

Measuring

520

Investment

PoliciesThat

There

517

NATURALIST 18.2 520

THE ECONOMIC

Are

516

Allocation

Bond and

Role of

THE ECONOMIC NATURALIST and Its Uses 572 Money

515

Management

and the

Markets,

StockMarkets Risk

and

Entrepreneurship

Stock 569

Informational

The

513

Technology 514

The Costs

BondMarkets, of Saving

Resources

Natural

Other

and

508

511

Physical Capital Land

Labor Productivity

Aggregate

Expenditure

Firms

616 Spending

617

Economy 618 and Output

621

xxix

CONTENTS

Short-Run

Short-Run

Finding

Numerical Finding

626

Fiscal

Three Qualifications 640

Summary

639

Key

Questions

642

Concept

Checks

\342\200\242 Froblems

644

\342\200\242

Chapter

23

Reserve

651

Banking Panics

Monetary Policy Can the Fed Controlthe The Role of the Federal

Real

Interest

Funds

Rate

Rate? in

Planned Aggregate Expenditure and Interest Rate 656

Real

Reserve

Respond

to Changes

The MoneyDemand

the Demand

The Supply of

and

Money

How the Fed Controls the OpenMarket Operations Window

Money

Interest Rate

Questions

677

Concept

Checks

\342\200\242 Terms

Key

\342\200\242 Problems

679

Side 719 722

\342\200\242 Problems

723 726 727

\342\200\242 Review \342\200\242 Answer

to

The International Economy

26

Exchange

Rates,

International

and Capital Flows

674 Paid

Exchange

on Reserves 674 676

716

Target

728

Check

672 Chapter

Interest

715

25.3

Policymaking: Art or Science? 725 \342\200\242 Summary Key Terms Concept

672

and

and the Supply

726

714

Credibility

718

NATURALIST

PART 8 Nominal

Lending

Requirements

Policy

713

Inflation

a Numerical

709

Market

670

Equilibrium

and

708

712

25.1

NATURALIST 25.2

Central Bank Reputation

Questions

NATURALIST 23.2 670

THE ECONOMIC

to

Shocks

and Inflation

Expectations

ECONOMIC

668

Curve

Policy

Announcing

Fiscal

665

Affect

That

704

705

Central Bank Independence

664

Prices?

\342\200\242 Review \342\200\242 Answers

707 Chapter 25 MacroeconomicPolicy What Is the Role of Stabilization 708 Policy? Stabilization and Demand Shocks Policy

THE ECONOMIC

for Money 667

Summary

Checks

NATURALIST 23.1 663

Federal

MacroeconomicFactors

Reserve

704

Concept

Inflationary

Reserveand InterestRates Demand for Money 666

Discount

Questions

\342\200\242 Problems

THE ECONOMIC NATURALIST

661

Inflation

The Federal The

the

703

Key

Stabilization

659

a Recession

THE ECONOMIC Asset

654

655

Policy

The Fed Fights The Fed Fights

654

Fluctuations

Economic

and

Markets:

Financial

696 697

700

\342\200\242 Terms

703

Summary

Stabilizing

Policy

693

The Self-Correcting 700 Economy A Role for Stabilization Policy? 702

Federal

the

of

689

and

Economy

Stabilization

650

Reserve

The Fed'sRolein

in

The Self-Correcting

the Federal

649

The History and Structure Reserve System 650

Shouldthe

in

Multiplier

Slope

Demand Shocks:Shifts in the AD Curve Inflation Shocks: Shifts in the AS Curve Using the AD-AS Model to Study Business Cycles 698

to

647

Policy and

Monetary

Monetary

The

Appendix.

KeynesianModel

Federal

\342\200\242 Answers

683

What Factors Shift the AD Curve? 685 The AggregateSupply Curve 688 Why Does the AS Cure SlopeUpward? the AS Curve: Graphical Analysis Deriving What Causes the AS Curve to Shift? 693 Business 696 Understanding Cycles

\342\200\242 Review

642

the Basic

The

641

\342\200\242 Terms

Curve

Model:

684

Downward?

632

Supply

Curve

Demand

Why Does the AD

Purchases and Planned 633 Spending Transfers, and Aggregate Spending 635 and the Recession of 2007-2009 638 Policy as a Stabilization Tool: Policy

Fiscal

Demand-Aggregate

Overview 682

Supply,

681

Cycles

A Brief

The Aggregate

Government Taxes,

Business

The Aggregate 627

Gap

Output

Recessions

and

Output:

Equilibrium

Approach

Graphical

FiscalPolicy

624

Approach

Planned Spendingand the The Multiplier 631

and

Output:

Equilibrium

Short-Run

Chapter 24 AggregateDemand, Aggregate

623

Output

Equilibrium

Rates

Trade,

731

732

Nominal Exchange Rates 733 676 677

Flexibleversus

\342\200\242 Review \342\200\242 Answers

to

Fixed

Exchange

Rates

735

Should Exchange Rates be Fixedor Flexible? 735 The Euro: Common for Europe 736 Currency

CONTENTS

A

Supply

in the Short Run

Determination

Rate

Exchange

Demand

and

Changes in the Changes in the Does a Strong

Supply Demand

Monetary Policy Exchange Rate

Imply

Currency

and

Rate

the

in the

Long

Real Exchange Rate 745 of Exchange Rates: Simple Theory

Run

745

Power Parity Shortcomings

(PPP)

Purchasing

747

of the PPP Theory

750

Questions

761

Concept

Checks

and

\342\200\242 Problems

763

Glossary G-l

Photo Credits Index

1-1

C-0

Inflows

751

754

The Saving Rate and the 760 \342\200\242 Terms Summary Key

The A

Flows

Saving,Investment,

a Strong

742

Determination

The Trade Balanceand Net Capital International Capital Flows 753 The Determinants of International Capital

742

Economy? Exchange

737

738 Analysis of Dollars 740 for Dollars 742

Capital Trade

761 762

Inflows Deficit

756 757

\342\200\242 Review \342\200\242 Answers

to

CORE

SEVEN

PRINCIPLES

I

PRINCIPLE

CORE

The

Principle\ limited. So having

of one

more

Cost-Benefit (or

a firm

extra benefits from

taking

individual

An

Incentive

The A

and lesslikely

does

the

the production of any cost, and only afterward

PRINCIPLE

CORE

good,

turn

is an

social goal

important

larger, everyone can have PRINCIPLE

CORE

The

Equilibrium

a larger

market

may not

extra

costs.

benefit rises,

matter.

a

Cost-Benefit

Incentive

a

on the

concentrates

O

is lowest.

Advantage

Comparative

Cost (also called

in equilibrium

employ those to resources with

first

resources with higher

the

opportunity

lowest

costs.

because when the

economic

leaves no

exploit all gains achievable

pie

grows

slice.

7

Principle

the-TablePrinciple\ A

Scarcity

Increasing

a

Opportunity

6

The Efficiency Principle Efficiency

a

Principle\

\"Low-Hanging-Fruit

opportunity

cost

of Increasing Opportunity

Principle

In expanding

if, and only if, the

an action if its

(or each country)

or her opportunity 5

PRINCIPLE

CORE

another.

Advantage

each person

when

best

activities for which his

The

less of

4

of Comparative

Principle

Everyone

action

as great as the

Principle or a society) is morelikely to take take it if its cost rises. In short, incentives

to

having

us are

to

3

PRINCIPLE

CORE

The

an

are at least

action

a firm

(or

person

means

usually

thing

Principle or a society) shouldtake the

PRINCIPLE

CORE

good

wants, the resourcesavailable

2

PRINCIPLE

CORE

The

needs and

boundless

have

we

Although

called the \"No-Free-Lunch

(also

Principle

Scarcity

(also called the collective

Efficiency

a

Equilibrium

\"No-Cash-on-

unexploited opportunitiesfor through

a

action.

individuals

but

Cost

NATURALIST

ECONOMIC

EXAMPLES

1.1

do many

Why

hardware

more than

include

manufacturers

with a computer selling for only slightly manufacturers make cars without heaters?

software

\"free\"

1.2 Why don't auto 1.3 Why do the keypad

on drive-up automatic

buttons

$1,000 of more than that?

Why

is finding a

11.2

Why

did Rivergate books,

out have

machines

teller

11.1

happened

2.3 If trade between so controversial? 2.4

.400 hitters

nations is so beneficial,

economics reporter Paul

Is PBS

and

TV

why

cars

four-cylinder

in the

Why

insurance? do opponents

Why

do proponents

1970s, only

to shift back

in

the United

Why

7.2

Are

neighborhoods?

poorer

forces, why are many more recycled than glass ones? do supermarket checkout lines all tend to be roughly the same length? there \"too many\" smart people working as corporate earnings recycling

aluminum

7.1

lines longer in to private

are waiting

is left

market

forecasters?

8.1

Why does

used in 8.2

Why

Intel

sell the

overwhelming

majority

of all

movie theaters offer

discount

tickets to

8.3 Why

retailer instruct its clerksto might an appliance the sides of its stoves and refrigerators? 9.1 Why are cartel agreements notoriously unstable?

9.2

How

did Congress

Why

do people

9.4 Why

shout at parties?

do we often

see convenience

10.1

What

10.2

Why

trees

10.3

Why

10.4 Why

is the purpose does

of

free

the government

are shared football

in

advertising

stores located on adjacent laws?

13.1

13.2

property

owners to

get picked too soon?

milkshakes consumedtoo quickly? take anabolic steroids?

players

drugs remain silent? how do they manage

legalized

to pay

more,

from their

competition

nonunionized

to survive

in

counterparts?

of

only

ability?

maintenance

knee more

likely

insurance

health

to receive than

if

MRI

an

he belongs

to a

organization?

government require safety seats for infants who travel in cars in airplanes? but not for infants that travel 13.3 Why do many states have laws requiring students to be vaccinated childhood illnesses? against 13.4 Why do more Secret Serviceagents guard the President than the Vice President, and why do no Secret Serviceagents guard college professors? 14.1 Why don't most married couples contribute equally to joint purchases? 14.2 Why do television networks favor Jerry Springer oyer Masterpiece? 14.3 Why does check-splitting make the total restaurant bill higher? 14.4 Why do legislators often support one another's pork barrel spending Why

does the

programs?

15.1 15.2 15.3

Why

16.1

What

Can

and real GDP ever move

nominal

in

different

directions?

work fewer hours today than their great-grandparents school in poor countries Why do far fewer children complete high in rich countries? do people

did? than

is core inflation?

Why did medieval China stagnate economically? 18.2 Why do almost all countries provide free public education?

dilemma

street

of

with a sore Why is a patient exam if he has conventional health

corners?

in computers

investment

Why

did the U.S.

new

millennium?

stock

Why did Coca-Cola weather is hot?

23.1

Why

23.2

Why does

does

news the

of

Co.

market

test

inflation

average

increased so much in recent decades? in the 1990s, then fall in the

rise sharply

a vending hurt the

machine

How was

25.2 What 25.3

Why

inflation

caused

conquered

in the

1980s?

the Great Moderation?

do Americans

work more than

that

stock market? U.S.dollars

Argentine hold more

U.S.citizen?

plant

25.1 parks

of

penalty often remain silent?

the death

of

firms have

unionized

19.1 Why has

speech

public

If

slightly lesser

21.1

subsidizeprivate

do many

12.2 Why do some ad-copywriters earn more than others? 12.3 Why does Renee Fleming earn millions more than sopranos

20.1

on their hillsides? do blackberries

10.5 Why do

xxxii

television

dents into

hammer

do many

18.1

producers?

cigarette

confronting

9.3

unwittingly solve the

students?

Why

the face

microprocessors

computers?

personal

do many

11.8 12.1

containers

beverage

they

auto

States? 6.1 When

when

Why

to six- and eight-cylinders cars in the 1990s? in England than 5.4 Why are the automobile engines smaller

5.5

TV\"

11.7

Who gets the

wealthy in Seattle? Why did people turn to

on

newspapers?

candidate for

most conveniently located apartments? 3.2 Why do major term papers go through so many more revisions today than in the 1970s? 3.3 Why do the prices of some goods, like airline tickets to Europe, go up during the months of heaviest consumption,while others, like sweet corn, go down? 4.1 Will a higher tax on cigarettes curb teenage smoking? 4.2 Why was the luxury tax on yachts such a disaster? 4.3 Why are gasoline prices so much more volatile than car prices? 5.1 Why does California experience chronic water shortages? in Manhattan live in smaller houses than the 5.2 Why do the wealthy 5.3

and

11.6

outsourcing?

3.1

advertised

\"As

in magazines

products

companies care so much about elite educational credentials? clients seem to prefer lawyers who wear expensivesuits? Why Why do males under 25 years of age pay more than other drivers for

job a likely

Solman's

New Jersey go

11.5

11.4

the

difficult?

Lambertville,

digital video markets? are free-trade agreements

gone?

U.S. lead in

the

to

the phrase

insert

firms

advertise their

all the

have

Where

2.2 What

in

the last bookstore

business?

11.3 Why do

Braille dots?

2.1

of

knowledgeable salesclerkoften

Europeans?

\"knows\"

than

when the

the average

ONE

PART

INTRODUCTION

of economics, perhaps the most to realize is that economics is not a collection important thing of settledfacts, to be copied down and memorized. Mark Twain said that is older than yesterday's newspaper, nothing and the same can be said of yesterday's economic statistics. about the economy that can be Indeed,the only prediction

As

the

begin

you

made

study

there

is that

confidence

with

be

to

continue

will

large,

and largely

unpredictable, changes. If economics is not a set of durable facts,then what is it? it is a way of thinking about the world.Over Fundamentally, economists have developed some simple but many years that are useful for understanding widely applicable principles

almost

economic

any

the

from

situation,

relatively

simple

economic decisionsthat individuals make every day to the of markets such as international workings highly complex financial markets. The principalobjectiveofthis book,and of this is to help you learn these principles and how to course, issues. apply them to a variety of economic questionsand three

The be

will

chapters

used

the book.

throughout

listed among

the Prefaceand

All

the

on

Principles that

the Core

out

I lay

Part

in

seven

Core

back

of the

Principles

reference.

Chapter

I

the first of which

is

fact

our needs

that,

although

resources

to

available

goes on to whether to take of the action,is

action

an

useful

a

that

trade-offs

important decision

Scarcity

satisfy the

that

show

inevitable

the

economic

important

Cost-Benefit

creates. the

deciding and benefit

Principle, the cost

dealing

with

the

After discussing concludes

chapter

and introducing

several

by

the concept of

naturalism.

Chapter consider

Principle

unavoidable

Principle\342\200\224the

comparing for approach

scarcity

Core Principles,

and wants are boundless, the them are limited. The chapter

by

pitfalls,

Incentive

the

describing

three

illustrates

and

introduces

are

book for easy

trade reason

beyond individual decision making to both individuals and countries. An among for trade is the Principle of Comparative Advantage:

2 goes

by specializing

in

services, people

and raise

the and

countries

standards of living.

goods and

of particular

production

enhance Further,

their people

productivity countries

and

2

CHAPTER

I

THINKING

LIKE AN

ECONOMIST

expand Principle resources

their production of the goods or services by applying Cost\342\200\224first those of Increasing Opportunity employing with the lowest cost and only afterward turning opportunity with

resources

higher opportunity costs.

Chapter 3 presents demand,

perhaps

These

tools

the

are

an

most

used

of

overview

basic

to show the

Efficiency Principle (efficiencyis the economics pie grows the Principle (a market but opportunities for collective through action).

an

larger,

Equilibrium

individuals

the

and familiar final

concepts two

by

to

and

economists.

the Principles: because when goal have a larger slice) and Core

social

important everyone

of supply

tools used

the

can

in equilibrium leaves not exploit all may

no unexploited gains achievable

I

f

CHAPTER|

an

Like

Thinking

Economist LEARNINGOBJECTIVES After

you LOI

this chapter,

reading be

should

able

to:

and

apply

Explain

Scarcity \\

says that

which

of any

more

the

Principle, having

good

necessarily

requires

having less

of

thing

something else.

\\

L02

IT

Explain and

Principle,

which says but

People often

make

bad decisions

because they

fail

to

compare

the

relative

costs

only

is at

and benefits.

an

that

be taken

should

action

the

apply

Cost-Benefit

if,

benefit

its

least as great

as

its cost.

ow many

students are

classes have some

schools,

just

economics class? Some your introductory Others average 35, 100,or 200students. At economics classes may have as many as introductory 20

in

L03

or so.

size is best? 2,000 students. What If cost were no object,the best size might be a single student.Think about it: the whole course, all term long, with just you and your professor! Everything could be custom-tailored to your own background and ability. You could cover the material at just the right The tutorial format also would promoteclose pace. communication and trust between you and your professor. And personal your would depend more heavily on what learned than on your grade you actually luck when taking multiple-choice exams.Let's suppose,for the sake of students have been shown to learn best in the tutorial format. discussion, that classes still have hundreds of students? Why, then, do so many introductory The simple reasonis that costs do matter. They matter not just to the university administrators who must build classrooms and pay faculty but also salaries, to you. The directcost of providing you with your own personal introductory economics course might easily top $50,000. Someonehas to pay these costs. In private universities, a large share of the cost would be recovered directly from In state universities,the burden tuition would be split between higher payments.

Discuss three when

occur

that

importantpitfalls

the

applying

Cost-Benefit

Principl

inconsistently.

L04

and

Explain

Incentive you

Principle,

says that

which

want

the

apply

if

to predict

people's behavior, a good

is by

place to start

examining

incentives.

their

if,

4

I

CHAPTER

THINKING

ECONOMIST

LIKE AN

higher tuition

case, the course higher tax payments. But, in either students. the cost per student goes down. For example,an course, course with 300 students might cost as little as $200 per and

payments

would be unaffordable for With larger classes,of economics

introductory

that large

a class

But

student.

environment.

most

would surely

to the

Compared

custom

the

compromise

tutorial

quality of the learning it would be dramatically

however,

format,

more affordable.

what size introductory economics courseto offer, then, university In making confront a classic economictrade-off. the class larger, of instruction\342\200\224a bad At the same time, they reduce they lower the quality thing. costs and hence the tuition students must pay\342\200\224agood thing. In this chapter, we'll introducethree simple that will help you principles understand and of behavior you observe in the world around you. explain patterns These principles alsowill help you avoid three pitfalls that plague decision makers In

choosing

administrators

life.

in everyday

CHOICE

STUDYING

ECONOMICS:

IN A WORLD OF SCARCITY rich

in

Even

Are

small

large

classes \"better\"

than

economics

the

study

of how

people make choicesunder conditions of scarcity and of the results of those choices for

enough time, money,

States, scarcity is a fundamental or

to do everything

energy

of life.

fact

we want to

do or

have. Economics is the study of how people make choicesunder conditionsof scarcity and of the results of those choices for society. In the class-size example just discussed, a motivated economics student might else definitely prefer to be in a class of 20 rather than a class of 100, everything the being equal. But other things, of course, are not equal. Students can enjoy benefits of having smaller classes, but only at the price of having less money for other activities. The student'schoiceinevitably will come down to the relative

have

ones?

like the United

societies

There is never

we'd

everything

importance

of

like to

activities.

competing

trade-offsare widespreadand important is one of the Core Principles of economics. We call it the Scarcity Principle becausethe fact of scarcity simple makes trade-offs necessary. Another name for the Scarcity Principle is the No-FreeThat such

society

Scarcity

O

Lunch

Principle

to you

are

(which

never

really

comes

from the observation

The Scarcity Principle (also calledthe

we have boundless Although more of one good thing having

needs and usually

that are given pay for them).

lunches

has to

available

Principle): to

us are

limited. So

having less of another.

a trade-off is the

that choice involves compromise such trade-offs by using cost-benefit analysis, which is based on the disarmingly simple principle that an action should be taken and its benefits exceed its costs. We call this statement the Costif, only if, a nd is one of the Core of economics: it, too, Benefit Principle, Principles in

Inherent

betweencompeting

Cost-Benefit

O

The if,

and

Cost-Benefit only

if,

the

the

idea of

means

even

No-Free-Lunch

resources

the

wants,

that

always

somehow,

free\342\200\224somebody,

interests.

Principle: extra

benefits

Economists

An

individual

from

taking

fact

resolve

(or a firm action

the

or a society) should are at least as great

take

an action

as the

extra

costs. With the Cost-Benefit Principle in mind, let's think about our class-size that classrooms come in only two sizes\342\200\224100-seat lecture halls again. Imagine and 20-seat classrooms\342\200\224and that your university currently offers introductory economicscoursesto classesof 100 students. Question: Should administrators reduce the class size to 20 students? Answer: Reduceif, and only if, the value of the in instruction improvement outweighs its additional cost. This rule soundssimple.But to apply it we need some way to measure the in practice. If we make a few relevant costs and benefits, a task that's often difficult

question

APPLYING

THE COST-BENEFIT

however, we can seehow the analysis might work. On the 100 to 20 is that we'll reducing class size from of just one. We'll also need five smaller professors classrooms rather than a single big one, and this too may add to the expense slightly of the move. Let's suppose that classes with 20 cost $1,000 per student more than those with 100. Should administrators switch to the smaller class size? If they apply the Cost-Benefit Principle,they will realize that doing so makes senseonly if the value of attending the smaller classis at least $1,000per student than greater the value of attending the larger class. Would you (or your family) be willing to pay an extra $1,000 for a smaller class? If not, and if other students feel the same way, then sticking with the larger class size makes sense.But if you and others would be willing to pay the extra tuition, then the class size makes good economic sense. reducing Noticethat the \"best\" class size, from an economicpointof view, will generally not be the same as the \"best\" size from the point of view of an educational That's because the economic definition of \"best\" takes into account both psychologist. the benefits and the costs of different class sizes. The psychologist ignorescostsand looks class sizes. only at the learning benefits of different In practice, of course, different feel differently about the value of people smaller classes. for example, tend to be willing to pay incomes, People with high more for the advantage. That helpsto explain class size is smaller, and why average tuition at private schools whose students comepredominantly from higher, highincome families. The cost-benefit framework for thinking about the class-size problem also reason for the gradual increase in average class size that has been suggests a possible assumptions,

simplifying

cost side,the now need five

of expense instead

primary

colleges and universities.During the last 30 years, professors' salaries have risen sharply, making smaller classesmore costly. the During same period, median family income\342\200\224and hence the willingness to pay for smaller classes\342\200\224has remained constant. When the cost of offering smaller classes roughly to pay for smaller classes does not, universities shift to goes up but willingness larger class sizes. that result also apply to resourcesother than Scarcityand the trade-offs money. Bill Gates is one of the richest men on Earth. His wealth was onceestimated at over $100 billion. That's more than the combined wealth of the poorest 40 percent taking

of

place

in American

Americans.

goods than he day and a limited pursues\342\200\224whether

to his

tending otherwise

spend

on

could

possibly

amount it be

charitable other

APPLYING

THE

Cost-Benefit

a

If Bill

Gates

saw a $100

on the

sidewalk,would worth his time to pick

bill

lying

it be it up?

and other consumer buy more houses, cars, vacations, use. Yet he, like the rest of us, has only 24 hours each of energy. So even he confronts trade-offs. Any activity he or building his business empire or redecorating his mansion

Gates could

foundation\342\200\224uses

things. Indeed,

Gates's time is so great that pausing wouldn't be worth his while.

to

up

time

and energy

that

he

could

someone once calculatedthat the value of pick up a $100 bill from the sidewalk simply

COST-BENEFIT

PRINCIPLE

In studying choice under the premise that people scarcity, we'll usually begin with are rational, which means they have well-defined goals and try to fulfill them as best they can. The Cost-Benefit Principle is a fundamental tool for the study of how rational people make choices. in the class-size in applying As the costexample, often the only real difficulty benefit rule is to come up with reasonable measures of the relevant benefits and costs.Only in rare instances will exact dollar measures be conveniently available. But the cost-benefit framework can lend structure to your even when no thinking relevant market data are available. To illustrate how we proceed in such cases, the following example asks you to decide whether to perform an action whosecostis described only in vague, qualitative terms.

5

PRINCIPLE

rational well-defined fulfill

she

those can

person

someone

with

goals who tries to goals as best he or

CHAPTER

6

I

THINKING

LIKE AN

ECONOMIST

Comparing Costs and Benefits

EXAMPLE I.I

Should you Imagine a friend

you are about tells you that

to

a $25

buy

same

the

store is a 30-minute

the downtown

$10 on a

to save

downtown

walk

computer

game is on walk

$25 computergame?

game at the nearby

sale at

where

away,

The Cost-Benefit Principle tells us that so exceeds the cost. The benefit doing

campus store when

store for

a downtown

should you

buy

the

If

$15.

only

game?

buy it downtown if the taking any action is the dollar value of it. the benefit of buying downtown is Here, everything you gain by taking since that's the amount save on the of the $10, exactly you'll price game. The cost of action is the dollar value of it. Here, taking any everything you give up by taking the cost of buying downtown is the dollar value you assign to the time and trouble it takes to make the trip. But how do we estimate that value? One is to the auction. way perform following hypothetical Imagine that a has offered to to do an errand that involves the same walk stranger pay you downtown (perhaps to drop off a letter for her at the post office). If she offered you a

Cost-Benefit

O

benefit

should

you

of

of

would you accept? If so, we know that your cost of walking of, say, $1,000, downtown and backmust be less than $1,000. Now imagine her offer being reduced in small increments until refuse the last offer.For example,if you'd you finally agree to walk downtown and backfor $9.00 but not for $8.99, then your cost of making the trip is $9.00. In this case, you should buy the downtown because the game save is than cost of $10 you'll $9.00 benefit) (your greater your making the trip. But cost of the had been suppose your making trip greaterthan $10. In that best bet would have been to the from the nearby campus case, your buy game store.Confronted with this choice, different people may choose differently, on how it is to make the trip downtown. But depending costly they think although there is no uniquely correct most would do choice, people who are askedwhat they in this situation say they would the downtown. buy game payment

ECONOMICSURPLUS Comparedto the

economicsurplus taking

an

action

the

benefit

minus its

cost

of

O

free

time gained

Of course,your

to

$9.

means economic taking all actions that yield a positive total surplus, is just another way of restating the Cost-Benefit Principle. Note that the fact that best choice was to buy the game downtown your doesn't imply that you enjoy making the trip, any more than choosing a large class means that you prefer large classes to small ones.It simply means that the trip is

for example, for a study

an activity

downtown was

This

the

of paying $10 extra for the game. prospect this case, the choice was between a the trip. avoiding

by

Once

again,

cheapergameand

In

COST

OPPORTUNITY

undertake

the trip

which

the

value

making

the game at the

it buying campus store, buying resulted in an economic surplus of $1, the difference between the benefit of making the trip and its cost. In general,your as an economic decision goal maker is to choosethose actions that the generate largest possible economic

less unpleasant than you've faced a trade-off.

opportunity cost the of what must be forgone

of

\"cost\"

of

alternative

downtown

surplus.

Cost-Benefit

1.1 your

in Example

that

Suppose

auction

mental

that the time

could

required

have produced for

the

trip

a different

is the only

outcome.

Suppose,

time you have left

to

one of your day. Or suppose you are watching favorite movies on cable,or that you are tired and would love a short nap. In such we say that the opportunity cost of making the trip\342\200\224that is, the value of cases, what you must sacrificeto walk downtown and back\342\200\224is high and you are more to decide likely against making the trip. difficult

test

the

next

APPLYING

THE

COST-BENEFIT

PRINCIPLE

in an activity is the value your opportunity cost of engaging in if seeing sacrifice to it. For a movie instance, you engage not that a ticket but also that a $10 $20 requires only you buy you give up that you would have been willing to do for free, then the opportunity cost babysitting job of seeing the film is $30.

speaking,

Strictly

of everything

must

Under this We

cost to

all

definition,

warn

must

costs\342\200\224both

stated, we will

otherwise

Unless

costs.

that some

you, however,

refer only to

the

implicit

implicit

value

and

to this

adhere

opportunity

explicit\342\200\224are

strict definition.

economists use the

term

opportunity

forgone. Thus,

of opportunities

in

the

wouldn't include the $10 ticket price when discussed, example just the cost of all economists calculating opportunity seeing the film. But virtually would agree that your opportunity cost of not doing the babysitting job is $20. In the previous example, if watching the last hour of the cable TV movie is the most valuable opportunity that conflicts with the trip downtown, the opportunity cost of making the trip is the dollar value you place on pursuing that opportunity. It is the largest amount be willing to pay to avoid the end of the you'd missing movie. Note that the opportunity cost of making the trip is not the combined value of all possible activities you could have pursued, but only the value of your best alternative\342\200\224the one would have chosen had not made the you you trip. Throughout the text we will pose conceptcheckslikethe one that follows. You'll find that pausing to answer them will help you to master key concepts in economics. Because these checks isn't (indeed, doing concept very costly many students report that they're fun), the Cost-Benefit Principle indicatesthat actually it's well worth while to do them. your economists

these

CONCEPTCHECK I.I You

would

store,

but

would you

THE

again save cost of

your

get from

ROLE OF

$ 10 by buying making the trip

buying

the

the

game downtown rather $ 12, not $9. How much

is now

game downtown?

Where

should

you

than

at

the

economic

campus surplus

buy it?

ECONOMIC MODELS

use the Cost-Benefit Principle as an abstract modelof how an idealized individual would choose among competingalternatives. \"abstract (By model\" we mean a simplified that the essential elements of a description captures in a logical A situation and allows us to analyze them model of a way.) computer like climate which must details and complex phenomenon change, ignore many includes only the major forces at work, is an example of an abstract model. Noneconomistsare sometimes critical of the economist's cost-benefit harshly in modelon the grounds that the real world never conduct people hypothetical mental auctions before deciding whether to make downtown. But this trips criticism betrays a fundamental of how abstract modelscan help to misunderstanding and human behavior. Economists know well that people explain predict perfectly don't conduct hypothetical mental auctions when they make simple decisions.All the Cost-Benefit a rational decision is one that is Principle really says is that or based on a of costs and benefits. explicitly implicitly weighing Most of us make sensibledecisionsmost of the time, without being consciously aware that we are weighing costs and benefits,just as most peopleridea bike without being aware of what keeps them from falling. Through trial and consciously kinds of choices tend to work best in different error, we gradually learn what as bicycle riders internalize the relevant laws of physics, without contexts, just usually conscious of them. being Even the explicit principles of cost-benefit can help us make so, learning analysis better decisions,just as knowing about physics can help in learning to ride a bicycle. For instance,when a young economist was teaching his oldest sonto ride a bike, he Economists

rational

^^ (

^\"^J

Cost-Benefit

7

8

CHAPTER

I

THINKING

ECONOMIST

LIKE AN

followed the time-honored tradition then

his son,

skinned

painfully

the

that

out

of

leaning. Of course!The economist almost

to ride

learned

who

Scarcity is a basicfact almost

thing

always

a

little

can help you

life. Because

economic

of

having less of another

means

along to his

information

second son,

can

physics

make better

help you decisions.

ANALYSIS

COST-BENEFIT

RECAP

economics

a little

year later, someone pointed direction the bike is

it. A

in whichever

as knowing

Just

instantly.

learn to ride a bike,knowing

this

passed

onto

hours and

several

After

best.

and holding

the bike

alongside

running

and hoping for the giving elbows and knees, his son finally got trick to riding a bike is to turn slightly a push

him

of it, having

Cost-Benefit Principle holdsthat

of one

more

Principle).

Scarcity

(the

good The

an individual (or a firm or a society) should the action is at least if, and only if, the extra benefit from taking as great as the extra cost. The benefit of taking action minus the cost of any the action is called the economic from that action. Hence, the taking surplus

action

an

take

Cost-Benefit Principle suggeststhat economic

additional

Rational

will

people

probably

intuitive

an

in

apply the Cost-Benefit Principle most and approximate way, rather than

can

we

example,

others to

predict colleges

classes is the same willing to pay for

for

researchers

Yet

not

higher for situations

strategies

In

these

accurately. But

behavior

predict specific

identifying

it

in

which

situations, helpful

proves

bad decisions.

for avoiding

RATHERTHAN

PROPORTIONS

the what

wealthier families.)

PITFALL I: MEASURINGCOSTSAND AS

although

time,

people

small classes. (Again, while their benefit, as measuredby

Cost-BenefitPrinciple inconsistently. may

the

through explicit and

their likely

that offer all families, tends to be them, have identified

attend

of

tend to compare costs and behavior. As noted earlier, for that students from wealthy families are more likely than rational

that

to predict

economists

enables

create

that

PITFALLS*

DECISION

precisecalculation. Knowing benefits

actions

only those

surplus.

IMPORTANT

THREE

take

we

cost

of small

people

are

tend to apply the people the Cost-Benefit Principle in another way, by

BENEFITS

ABSOLUTE

DOLLAR AMOUNTS As

weigh a

have

EXAMPLE 1.2

makes clear, even people who seem to know they should of the actions are sometimes don't pros they contemplating clear sense of how to measurethe relevant costs and benefits. next

the

example and

the

cons

Comparing Costs and Benefits Should

you are

You

a friend

walk

about tells

downtown

to buy a $2,020 that the same

you

$2,010. If the downtown the

to save

laptop computer

at

the

computer is on sale at

store is

half

an hour's

nearby

campus store when store for only

a downtown

walk away, where

should you

buy

computer?

*The examples

in this

section are inspired

Tversky. Kahneman was awarded the from psychology into economics. insights

Amos

$10 on a $2,020laptop computer?

by the 2002

and the late pioneering researchof Daniel Kahneman Nobel Prize in economics for his efforts to integrate

that the laptop Assuming of this is exactly example difference is that the price of the

is

computergame.

to

enough

light

the sameas that

structure

laptop is

carry

without

DECISION

IMPORTANT

THREE

9

PITFALLS

effort, the

1.1. The only Example than the price of the higher downtown is the dollar amount the same trip, its cost also must

of

dramatically

benefit of buying And since it's exactly $10. you'll save, namely, if you be the same as So are perfectly rational, you shouldmakethe same in both cases. Yet when people are asked what would do in these they the walk downtown to the game situations, overwhelmingmajority say they'd buy but would buy the laptop at the campus store. When asked to explain, most of them say somethinglike \"The trip was worth it for the game becauseyou save As

of

before,

before.

decision

40

the

worth

but not

percent,

for

it

the

laptop

because

you save only

$10 out

$2,020.\"

is faulty reasoning. The benefit of save on the original price. Rather, The benefit of walking downtown to

This

the

proportionyou

it

save.

as for both

cases, means

cases. Yet, as noted,most

reasoning

to which people

pitfalls will identify two that

influenced

they

CHECK

is more

Which

laptop

on a $200

2:

PITFALL

same

in both

decision

differently.

in the

are often

decision just discussed is one of several In the discussion that we follows, prone.

In some additional decisionpitfalls. cases, people ignore costs or to take into account. On other occasionsthey are ought

or benefits

costs

by

CONCEPT

$90

choose

people

of faulty

The pattern decision

benefits

the

computer game. And since the cost of the trip the economic surplus from making both trips that a rational decision maker would make the

the

That

buy

is not the dollar amount you is $10, exactly the same must also be the same in must be exactly the same.

trip downtown is the absolute

that

are

irrelevant.

1.2

valuable: saving $100 on a plane ticket to Chicago?

IMPLICIT

IGNORING

Sherlock Holmes,Arthur

$2,000 plane

ticket

to Tokyo

or

saving

COSTS

detective, was successful Doyle's legendary others overlooked.In Silver Holmes is Blaze, A called on to investigate the theft of an expensive racehorse from its stable. Scotland Yard inspector assigned to the case asks Holmes whether some particular of the crime further Holmes and \"Yes,\" aspect requires study. replies, describes \"the curious incident of the dog in the nighttime.\" \"The dog did nothing in the the puzzled inspector. But, as Holmesrealized, that nighttime,\" responds was the The failure to bark when Silver Blaze was precisely problem! watchdog's stolen meant that the watchdog knew the thief. This clue ultimately the proved to the key unraveling mystery. as we often don't notice when a dog fails to bark, many of us tend to Just overlook the value of activities that fail to As discussed earlier, implicit happen. decisions the value of however, intelligent require taking forgone opportunities properly because

saw

he

details

Conan

that most

into account.

cost of

an activity, once again, is the value of all that must be in that a computer forgone activity. If buying game downtown means not watching the last hour of a movie, then the value to you of watching the end of that movie is an implicit cost of the trip. Many people make bad decisions because tend to ignore the value of such To they forgone opportunities. avoid overlooking implicit economists often translate questions like \"Should costs, I walk downtown?\"into ones like \"Should I walk downtown or watch the end of

The opportunity in

order

the movie?\"

to engage

Implicit fail

to

costs are like dogs bark in the night.

that

10

CHAPTER

I

THINKING

ECONOMIST

LIKE AN

Implicit Cost

EXAMPLE 1.3

Should

you

spring break? With Fort trip

use your

break

spring

frequent-flyer coupon to

fly

to

Fort

Lauderdale

for

about whether to go to only a week away, you are still undecided a group of classmates at the University of Iowa. The roundCedar Rapids is $500, but you have a frequent-flyer coupon you week at the beach trip. All other relevant costs for the vacation

with

Lauderdale

from

airfare

could use for total exactly

the

most you would be willing to pay for the Fort Lauderdale amount is your benefit of taking the vacation. Your only alternative use for your frequent-flyer the coupon is for your trip to Boston weekend after break to attend your brother's wedding.(Your spring coupon expires is $400, should shortly thereafter.) If the Cedar Rapids-Boston round-trip airfare for spring break? you use your frequent-flyercouponto fly to Fort Lauderdale is

vacation

^

Is your flight \"free\" if you

to Fort Lauderdale travel on a

$1,350.

That

The Cost-BenefitPrinciple tells us that

Cost-Benefit

O

The

$1,000.

of the

benefits

trip

should you go to Fort Lauderdale if for the complication of the frequent-flyer

the

matter of comparing coupon, solving this problem would be a straightforward costs. And since your benefit from the week at the beach to the sum of all relevant add your airfare and other costs would up to $1,500, or $150 more than your benefit from the trip, you would not go to Fort Lauderdale. But what about the possibility of using your to make the frequent-flyer coupon to Fort Lauderdale seem free, trip? Using it for that purpose might make the flight the trip. But doing suggestingyou'd reap an economic surplus of $350 by making so also would mean have to fork over $400 for your airfare to Boston. you'd So the implicit cost of using your coupon to go to Fort Lauderdale is really $400. If you use it for that purpose, the trip still ends up being a loser becausethe cost of the vacation, $1,400, exceeds the benefit by $50. In cases like these, you're much I use my frequent-flyer more \"Should likely to decide sensibly if you ask yourself, coupon for this trip or save it for an upcoming trip?\"

cannot

We

emphasize lies in correctly doing. Concept

Principle us from

Example 1.3 slightly.

Refer to

given

expires in Should

those

a cost that is at

the

decision must

moment

be made

beyond a

of

only

chance

1.3, but to

this

use it

will

time be

your frequent-flyer for the

coupon

Fort Lauderdale trip.

coupon?

FAILURE

TO THINKATTHE

MARGIN

are action, the only relevant costs and benefits action. Sometimes people are influenced by costs the wrong costs and they compare benefits. The only costs that should influence a decisionabout whether to take an action are thosewe can avoid by not taking the action. Similarly, the only benefits we should considerare those that would not occur unless the action were taken. As a practical to be influenced matter, however, many decision makersappear by costs or benefits that would have occurred no matter what. Thus, peopleare often influenced by sunk costs\342\200\224costs that are beyond recovery at the moment a decisionis

When

cost

so your

use your

3:

PITFALL

in Example

information

a week,

you

strongly enough that the key to using the Cost-Benefit what taking a given action prevents recognizing precisely Check 1.3 illustrates this point by modifying the details

1.3

CHECK

CONCEPT

recovery

If not

coupon?

frequent-flyer

sunk

its costs.

exceed

deciding

whether

to take an

occur as a result of taking the they ought to ignore. Other times

that would

THREE

For

made.

is a

money spent

example,

on a nontransferable,

airline

nonrefundable

IMPORTANT

following example illustrates,sunk costsmust so they are irrelevant to the decision of

As the

ticket

or not an the action.

whether

borne

be

action is taken,

to take

whether

Sunk Cost

restaurant

an Indian

Sangam,

refill

their

owner of the house. The

guests

remaining

any difference

be

these

two groups?

offers

Philadelphia,

an all-you-can-eat lunch how times they many

as a goodwill gesture, the 20 randomly selected guests that their lunch is on the will pay the usual price. If all diners are

tells

restaurant

there

in

pay $5 at the door, and no matter is no additional charge.One day,

Customers there plates,

$5.

for

1.4

EXAMPLE

at an all-you-can-eatrestaurant?

should you eat

much

buffet

PITFALLS

cost.

sunk

How

DECISION

in

the

of food

quantity

average

consumed

rational, by

people

in

Having eaten their

first diners in each group confront the following helping, back for another helping?\" For rational diners, if the benefit of doing so exceeds the cost, the answer is yes;otherwise it is no. Note that at the moment of decision,the $5 chargefor the lunch is a sunk cost. Those who it have no way to recover it. Thus, for both the (extra) cost of paid groups, another is exactly zero. And since the people who received the free lunch helping were chosen at random, there's no reason their appetites or incomesshould be any different from those of other diners.The benefit of another helping thus should be the on average, for people in both groups. And since their respective costs same, and benefits are the same, the two groups shouldeat the same number of helpings,

I go

\"Should

question:

on average.

Psychologistsand people

in

such

have

economists

do not

groups

eat similar

experimental

evidence, however, that those for whom the

In particular,

amounts.1

luncheon charge is not waived tend to eat substantially more than those for whom the charge is waived. Peoplein the former group seem somehow determinedto \"get their worth.\" Their implicit goal is apparently to minimize the average cost money's cost is not a particularly per bite of the food they eat. Yet minimizing average sensible objective. It brings to mind the man who drove his car on the at highway to boost his average night, even though he had nowhere to go, becausehe wanted fuel economy. The irony is that diners who are determined to get their money's worth usually end up eating too much.

The fact

that

does

criterion failed the

the cost-benefit

test of

in Example

prediction

1.4

about what people should do. If you are letting nothing sunk costs influence your decisions, you can do better by changing your behavior. In addition to paying attention to costs and benefits that should be ignored, peopleoften use incorrect measures of the relevant costs and benefits.This error often occurs when we must choose the extent to which an activity should be pursued (as to whether to pursueit at all). We can apply the Costopposed choosing Benefit

to

invalidate

in such

Principle

increase the level at In benefit

and

attempting cost of

which

its advice

situations I am

to answer an additional

refer to the cost of an additional benefit of an additional unit

^ee, for

example,

Behavior and

by

currently

this

of

activity.

the

To emphasize

of activity the activity is its unit

of

the activity?\" focus should always

pursuing

question,

unit

asking

repeatedly

this

\"Should I

be on the

focus,

ConsumerChoice,\"

Journal

cost

the increase

total

cost that

carrying

out one

in

results from additional

the

in total benefit that the

of Economic

unit

of an activity

marginal benefit

economists

as its marginal cost. Similarly, marginal benefit.

Richard Thaler, \"Toward a Positive Theory of 1, no. 1 (1980).

Organization

the question

marginal

carrying

out one

of an activity

increase

results from

additional

unit

12

THINKING

I

CHAPTER

LIKE AN

ECONOMIST

When the problem is to discoverthe proper level for an activity, to keep increasingthe level as long as the marginal benefit of exceeds its marginal cost. As the following example illustrates, however, fail to apply this rule correctly. rule is

1.5

EXAMPLE

Focusing

on Marginal Costs and

NASA

Should

expand

to five?

the space

ProfessorKosten Banifoot,

Space

Administration's

the

from launch) billion

per

launch).

Congress that

Congressfollow

shuttle program from

his

should

activity people

four

launches

per

cost

undertaking

divided average benefit

by

cost of

the total n units

of an activity

n

benefit

the

of undertaking

of an activity divided

total n

units

by n

year

National Aeronautics and estimated that the gains of $6 billion per (an average per year (an average of $5

space

expand

definitely

Banifoot

the space shuttle

testified

before

program. Should

advice?

whether the advice makeseconomic sense,we must compare the cost of a launch to its benefit. The marginal marginal professor's estimates, us only the average cost and average benefit of the program. These are, however, tell the total cost of the divided the number of launches and respectively, program by the total benefit divided the number of launches. the benefit by Knowing average and average cost per launch for all shuttles launched thus far is simply not useful for decidingwhether to expand the program. Of course, the average cost of the launches undertaken so far might be the same as the cost of adding another launch. But it also might be either higher or lower than the marginal cost of a launch. The same holdstrue regarding and benefits. average marginal Suppose, for the sake of discussion, that the benefit of an additional launch is in fact the same as the average benefit per launch thus far, $6 billion. Should NASA add another launch? Not if the cost of adding the fifth launch would be more than And the fact that the average cost per launch is only $6 billion. $5 billion simply does not tell us anything about the marginal cost of the fifth launch. the between the number of shuttles Suppose, for example, that relationship launched and the total cost of the program is as describedin Table 1.1. The launches would then be (third column) when there are four average cost per launch as Professor Banifoot testified. But note $20 billion/4 = $5 billion launch, per just in the second column of the table that adding a fifth launch would raise costs from to $32 billion, $20 billion making the marginal cost of the fifth launch $12 billion. So if the benefit of an additional launch is $6 billion,increasingthe number of launches from four to five would make no economic sense. absolutely To discover

average

often

of the supporter shuttle program,

are currently $24 billion per year its costs are currently $20 billion On the basis of theseestimates, Professor

NASA

the

Benefits

a prominent (NASA)

program and that

cost-benefit

the

I.I

TABLE

How

Total

Cost Varies with of

Number

launches

the Number of Launches Total cost ($ billions)

Average cost

($ billion/launch)

0

0

0

I

3

3

2

7

3.5

3

12

4

20

5

5

32

6.4

4

THREE

The in

correctly

how to apply the

illustrates

example

following this case.

on Marginal

Focusing How

space shuttles

many

NASA estimated number

should NASA

Cost-Benefit

IMPORTANT

Costs and Benefits

launch?

NASA should continue to launch shuttles as long as the marginal benefit of the In exceeds its cost. this the marginal benefit is constant program marginal example, at $6 billion per launch,regardlessof the number of shuttles launched. NASA should thus keep launching shuttles as long as the marginal cost per launch is less than or equal to $6 billion. the definition of marginal cost to the total cost entries in the second Applying column of Table 1.1 yields the marginal cost values in the third column of Table 1.2. cost is the change in total cost that results when we change the (Because marginal number of launches we each cost between the one, by place marginal entry midway total cost entries.) Thus, for example,the marginal the number of launches from one to two is $4 billion, the and the $3 billion total cost $7 billion total cost of two launches

difference

the

between

launch.

one

of

corresponding

of increasing

cost

TABLE

1.2

How Marginal CostVaries with Number of

the

launches NASA

0

1

3

2

7

3

12

4

20

5

32

see

from

a comparison cost entries in

marginal

($ billion/launch)

3

4

5

8 12

of the the

cost

Marginal

($ billion)

0

we

As with

cost

Total

launches

of Launches

Number

the

third

$6 billion column

marginal

benefit

of Table

1.2,

satisfy the cost-benefit test, but the fourth should thus launch three space shuttles.

and

the

per launch first

launches

fifth

three

do not.

CONCEPTCHECK 1.4 If

the

many

marginal shuttles

benefit should

of each

launch

been

had

not $6

that

$9

billion, how

NASA have launched?

The cost-benefit framework emphasizesthat benefits in deciding whether to pursue an activity benefits\342\200\224measures

but

billion

correspond

to the

the

only

further

increment of activity

are

PITFALLS

Principle

must decide how many shuttles to launch. The benefit of each launch is space to be $6 billion and the total cost of the program again dependson the of launches as shown in Table 1.1. How many shuttles should NASA launch?

rows showing the

DECISION

relevant

costs and costs and

marginal consideration.

under

EXAMPLE

1.6

14

CHAPTERI

THINKING

LIKE AN

ECONOMIST

In many contexts, however, and benefit of the activity.

not be justified,

activity may

than its average

greater

significantly

more inclined to compare the average 1.5 made clear, increasing the level Example even its average benefit at the current though seem

people As

cost of an level

is

cost.

CONCEPTCHECK 1.5 A

professional

that

one

player

this

information,

take win

team's

a basketball

Should

more

scores

on a

the

assistant

shots.That

all the

way,

take all the team's shots? has a new assistant coach.The assistant notices of his shots than other percentage players. Based on

best

player

team

basketball higher

suggests to the

the

head coach

reasons, the

assistant

team

that

the

will

score

star player should more points and

games.

On hearing

What was

this

the

suggestion,

with

wrong

the

assistant's

head coach fires

THREE IMPORTANT

RECAP

makers treat a change in cost only a small proportion of the

not proportions,

2. The pitfall the

including

carry

out

have a

or

original

shouldbe employed

implicit

high

cost,

3. The pitfall

decision

Many

proportionally.

amount. measure

to

value of alternatives implicit A resource (such the action.

alternative use has high implicit cost, however, if

incompetence.

if it constitutes Absolute dollar amounts, costs and benefits.

as insignificant

benefit

of ignoring costs. implicit an action, it is important to

of

analysis

for

PITFALLS

DECISION

of measuring costsor benefits

1. The pitfall

assistant

his

idea?

When performing a

account for that

as a

must

all

relevant

be forgone

cost-benefit costs, in order

coupon)

frequent-flyer

to

may

even if you originally got it \"for free,\" if its best value. The identical resource may have a low it has no good alternative uses.

to think at the margin. When whether to deciding the costs and benefits that are relevant are those that action, only would result from taking the action. It is important to ignore sunk costs\342\200\224 if the action those costs that cannot be avoided even isn't taken. Even a ticket to a concert have cost though may you $100, if you've already it and cannot sell it to the $100 is a sunk cost and else, bought anyone shouldn't influence It's your decision about whether to go to the concert. also important not to confuseaverage costs and benefits with marginal costs and benefits. Decision makers often have ready information about the total cost and benefit of an activity, and from these it's simple to compute the A cost and benefit. common mistake is to conclude that activity's average an activity should be increased if its average benefit exceeds its average cost. The Cost-Benefit Principle tells us that the level of an activity should be perform

increased

of failing

an

if, and

Somecosts and costs,

O

important

benefits,

marginal benefit exceedsits

especially

marginal

for decision making, while

marginal

cost.

benefits and like sunkcosts and others, costs and

implicit

average

are essentiallyirrelevant. This conclusion is implicit in our original statement of the Cost-Benefit Principle (an action shouldbe taken if, and only the extra benefits of it exceed the extra When we encounter if, costs). taking additional of decision examples pitfalls, we will flag them by inserting the icon for the in the margin. Cost-Benefit Principle costs

Cost-Benefit

are

only if, its

and benefits,

ECONOMICS: MICRO

15

MACRO

VERSUS

ECONOMICS

NORMATIVE

AND

ECONOMICS

POSITIVE

in the preceding sectionmake the point that people sometimes stress that our purpose in discussing these examples was make irrational choices. On the contrary, people generally most people appear to choosesensibly most of the time, especially when their decisions are important or familiar ones. The economist'sfocus on rational choice thus offers not useful advice about making better decisions,but also a basis for predicting and only human behavior. We used the cost-benefit approach in this way when explaining salaries have led to larger classsizes.And as we will see, discussing how rising faculty in virtually every other domain. similar reasoninghelps to explain human behavior

The

discussed

examples

choose irrationally. not to suggest that

We

must

The Cost-BenefitPrinciple one that provides guidance to the Cost-Benefit Principle, about the

is an example of a normative economicprinciple, about how we should behave. For example,according we should ignore sunk costs when making decisions As our discussion of the various decisionpitfalls makes clear, Cost-Benefit Principle is not always a positive, or descriptive,

future.

the

however,

economic principle, one that Cost-Benefit Principle can

heedits

we actually will behave. and people

how

describes

be tricky

to

implement,

saw, the

As we

sometimes fail to

prescriptions.

normative economic principle onethat says how people should behave

positive

economic

one

that

predicts

will

behave

principle how people

stress that knowing the relevant costs and benefits does surely enable us to predict how peoplewill behave much of the time. If the benefit of an action reasonable to predict that people will be more likely goes up, it is generally if the cost of an action to take that action. And conversely, goes up, the safest prediction will be that people will be less likely to take that action. This point is so that we designate it as the Incentive Principle. important said, we

That

The Incentive Principle:A an action if incentives matter.

take

that

insist

not

and

costs

of heating

say that Principle

people

oil were to should

people

to

that

predict

likely

to

or a society) is take

it

if

its

cost

more

to

likely

rises.

In

short,

behave rationally

rise sharply,

we

in

each

would

For example, the Cost-Benefit

instance.

invoke

if

the

price

Principle to

MACRO term microeconomicsto describethe AND

the

of group behavior

in

individual

markets.

study

of individual

microeconomics

Macroeconomics, by and of the policies

of the performance of national economies that use to to that Macroeconomics tries to governments try improve performance. understand the determinants of such things as the national unemployment rate, the overall price level, and the total value of national output. Our focus in this chapter is on issues that confront the individual decision whether that individual confronts a personaldecision, a family decision, a maker, business decision, a government policy decision,or indeed other any type of decision. Further of individuals such as on, we'll consider economic models of groups all buyers or all sellersin a specific market. Later still we'll turn to broader contrast,

economic

is the

issues

study

and

Incentive

a

that the positive economicprinciple.It stresses but at the same time does help us predict behavior,

MICRO we use

convention,

choices and

less

turn their thermostats down, and invoke the Incentive average thermostat settings will in fact go down.

ECONOMICS: By

a firm

(or

person

rises, and

benefit

Principle is a benefits usually

Incentive

The relevant

its

measures.

No matter which of these levels is our focus, however, our thinking will the fact economic needs and wants are that, shaped by although effectively material and human resources that can be used to satisfy them are finite. unlimited, the

be

individual

choice

individual

markets

the study

of

under

scarcity and its implications for the behavior of prices and quantities in

macroeconomics

the

study

of

the performance of national economies and the policies that governments

improve

use to try to that performance

16

CHAPTER

I

THINKING

LIKE AN

ECONOMIST

must therefore always take into account problems means having more of one good thing usually less of another. Our and our are to a substantial having economy society shaped degreeby the choices people have made when faced with trade-offs.

Clear

the

about

thinking

idea of

Choosing the course

covered in

of students

to register

in

an

introductory lunch.

all the issues our firm view

take that most introductory reasonthat each of us was drawn to short list of the discipline's core ideas events we see in the world around us. would

to

im-

which

topics to include on of issues that might be in which to cover them.

set

course, but only limited time some inevitably means omitting

are forced to up more than

Another,

which

concerns

inexhaustible

virtually

course.

others.

Covering

authors

textbook

a

one of many

is just

class

each

economics

an introductory

planning

There's

syllabus.

There's no free All

in

Principle applies just as strongly,

the Scarcity the

OFTHISTEXT

number

decisions

that

idea

APPROACH

THE

Oportant

economic

trade-offs\342\200\224the

that covered of your campus library. It is textbooks try to cover far too much. One the of economics was that a relatively study

pick and a whole

A textbook

choose.

floor

can explain a great deal of the behavior and So rather than cover a large number of ideas at a superficial list of core ideas, level, our strategy is to focus on this short each entry again and again, in many different contexts. This strategy will returningto enable you to internalize these ideas remarkably well in the brief span of a single course.And the benefit of learning a small number of important ideas well will far the cost of having to ignore a host of other, lessimportant ones. outweigh So far, we've already encountered three core ideas:the the Scarcity Principle, Cost-Benefit Principle, and the Incentive As these core ideas reemergein Principle. the course of our discussions, we'll call your attention to them. And shortly after a

new coreidea appears,we'llhighlight it by formally restating it. A second important element in our philosophy is a belief in the importance of active learning. In the same way that you can learn Spanish only by speaking and the game, you can learn economics writing it, or tennis only by playing only by And because we want you to learn how to do economics, rather doing economics. than or your instructor does just to read or listen passively as the authors we'll make economics, every effort to encourage you to stay actively involved. For example,instead of just telling you about an idea, we'll usually first motivate the idea by showing of a specific example. Often, you how it works in the context

checks for you to try, as well as by concept the idea to real life. Try working the concept checks are at the back of the corresponding (which beforelookingup the answers chapter). Think critically about the applications:Do you see how they illustrate the point being made? Do they give you new insight into the issue? Work the problems at the end of the chapters and take extra care with those to points that relating you don't economic to the world around you. (We'll fully understand. Apply principles more about this when we discusseconomic naturalism when below.) say Finally, tell a friend about it. you come across an idea or example that you find interesting, You'll be surprised to discover how much the mere act of explaining it helps you understand and remember the underlying The more actively you can principle. in the learning process, the more effective become will be. engaged your learning these

examples show

applicationsthat

will be followed the relevance of

ECONOMIC With

the

a position

NATURALISM

of the cost-benefit framework under to become an \"economic naturalist,\" someone

rudiments

economicsto help make senseof observations studied are able to observe and biology

from marvel

everyday at

many

you are now in uses insights from

belt,

your

who

life. People who have of nature that

details

ECONOMIC

NATURALISM

in the woods in have escaped their notice. For example,on a walk In trees. the student notices the novice see contrast, only biology early April, may in leaf while some are already different of trees and understands why many species the novice may notice that in some animal others still lie dormant. Likewise,

otherwise

would

species

much larger only in species in those males

are

males occurs

pattern favors

larger

often

the

contests

bloody

tend to be roughly is much less fighting

in

but

females,

males

which

student knows that mates. Natural selection size helps them prevail in females. In contrast, males in which there species,

the biology take several

species because their greater among males for access to size as females in monogamous

mates.

for

a few

Learning

same

the

than

simple economicprinciples

way. It enables us to seethe

vision

our

broadens

similar

in a

human existence in

of ordinary

details

mundane

a new

the economic light. Whereas the uninitiated often fail even to notice these details, in the naturalist not only sees them, but becomes actively engaged attempt to a few examples of questions economic naturalists understand them. Let's consider

for themselves.

might pose

The Economic Naturalist I. I software

manufacturers include more than

hardware

do many

Why

a computer

with

The software

selling

The increases

example, your Likewise,

of \"free\"

care

others

on

you

is the same as her accountant's. is that the benefit of owning implication with the number of other peoplewho

same if

her

software

gives the producers makes it hard for new

relationship often

and

many

compatibility.When

word-processingprogram. financial

slightly

that?

in the sense that its customers and your classmates are working task will be much simpler if you all use the an executive's life will be easier at tax time

from

is different

industry

a great deal about product a project together, for

for only

worth

$1,000

than

more

\342\200\242%

and use

any given software program same product.This unusual an enormous programs advantage using that

of the most popular programs to break into

the

market.

offered makers free copies of this pattern, Intuit Corp. computer Recognizing for their part, were its personal financial-management software. Computermakers, Quicken, their new computers more too only happy to include the program, since it made attractiveto

Quicken soon

buyers.

became the standard for personal financial-management

of the program, free copies By giving away and enormous demand for upgrades of Quicken

programs. an

related

TurboTax,

software.Thus,

standard

for tax-preparation

bandwagon. Some

include

their

for

\"primed

more

the pump,\" creating advanced versions of

income-tax software,has

the

become

programs.

have onto jumped by this success story, other software developers with a host of free software Most hardware now comesbundled are even rumored to pay computermakers software developers

Inspired

programs.

Intuit's personal

Intuit

the to

programs!

LOOK,

DOGBERT,

I

G0TTKEFIR5T

VIDEO

TKE

PHONE

CITY

i

IN

NOW WE. WAIT

FOR 50HEBODY EL5E TO BUY A

COMPATIBLE PHONE

VIDEO

AND CAtL

U5.

AfWING THING SOCIETY COULDN'T ADVANCE

I

WITHOUT

I 5AU

THE

15

THAT

LIKE

PEOPLE

THINK

YOU.

. SOMETHING

1

~7j \\

/

Jj&J L.

1

mi*

,/

_M2k

mT\\

ft

18

CHAPTER

I

THINKING

LIKE AN

ECONOMIST

depends

of other

the number

on

EconomicNaturalist

a case in

1.1 illustrates

Naturalist

Economic

The product

people

cost of

the

demonstrates,

number of others who own it.

4T

that

a product

benefit of a As the next product. also on the depend

the

which

own

who

may

The Economic Naturalist 1.2 Why

auto

don't

car sold in

every new

Virtually

has a satellite

One

make cars

manufacturers

States today has a this difference?

United

the

Why

system.

navigation

heaters?

without

heater. But

not

car

every

needs a heater, people can although everyone Yet heaters are of little use in places like Hawaii get along navigation systems. and southern California.What is more, cars producedas recently as the 1950s did not all have heaters. (The classifiedad that led one young economic naturalist to his first car, a 1955 Pontiac, boasted that the vehicle had a radio, heater, and whitewall tires.) in all parts of to manufacture and are not useful Although heaters cost extra money the country, do not cost much and are useful on at least a few each they money days year in most parts of the country. As time passed and people's incomesgrew, manufacturers found that people were orderingfewer and fewer cars without heaters. At some point it in became to heaters all rather than bear the administrative cars, actually cheaper put of some cars with heaters and others without. No doubt a few buyers expense making if they would still order a car without a heater could save some money in the process, to answer

be tempted

might

that,

without

but catering

to these customersis just

no

worth

longer

it.

Similar reasoning explainswhy certain cars today cannot be purchasedwithout a satellite of the 2009 BMW one whether 750i,for navigation system. Buyers example, got wanted it or not. Most buyers of this car, which sells for more than have $75,000, they so the of them would have chosen to order a incomes, high overwhelming majority had it been sold as an Because of the made navigation system option. savings possible when all cars are produced with the same equipment, it would have actually cost BMW more to supply cars for the few who would want them without navigation systems. makes of car have much lower incomeson average Buyers of the least-expensive than BMW 750i buyers. Accordingly, most of them have more pressingalternative uses for their money than to buy navigation for their and this cars, systems explains why some inexpensive makes continueto offer navigation systems only as options. But as incomes continue to grow, new cars without navigation systems will eventually disappear.

afforded

The insights the

4f

The Why

the

keypad

Braille dots on machines enable But even though automobiles on install

Naturalist

Economic do

The

elevator people

blind

people

public roads. dots on

answer

of

producing

to

Economic

The

1.2 suggest an

Naturalist

answer to

1.3

buttons on drive-up

blind

Braille

the cost

by

question:

strange

following

and

buttons

automated teller machines

on

to participate can do many

the

keypads of

more

fully

remarkable

in the

things,

Why, then, do the manufacturers the machines at drive-up locations?

this

riddle buttons

is that with

of

higher

Braille

dots? teller

automated

walk-up

normal flow

of daily

activity.

they cannot drive automated teller machines

once the keypad molds

Braille dots is no

have

have

than

been

the

manufactured,

cost of

producing

CORE

smooth buttons. types of inventory.

for

difficulty

patrons

require separate sets of molds of drive-up machines found buttons a reason to incur these extra costs.

be

users, the best

sighted

and

The preceding concept checkwas to the following assignment: response

observed

have

you

to

with

But since the

dots

is to

only

produce

who do so almost

concepts not stronger. We urge you,

events or

step

can take

you

assignment in

in

Concept

the

keypad

buttons

drive-up

automated

teller

machines have

of economics 1.6. Students

study Check

your

Why do

Braille

<

dots?

of lifelong economic naturalists. Their mastery does not decay with the passage of time, it actually grows strongest possible terms, to make this investment!

only

the

in

pattern of

some

explain

in

become

invariably

economic

to

Bill Tjoa,

student

Cornell

environment.

own

versions of the

several

perform

your

no more useful

There is probably than

in

by

suggested

CONCEPT CHECK 1.6 In 500 words or less, use cost-benefitanalysis behavior

solution

cheapest

different Braille dots

two

and

dots.

with

keypads

the

use,there might

harder to

pose no

If

would

both

Making

19

PRINCIPLES

SUMMARY

of

conditions

under

for

choices

those

behavior

human

rational\342\200\224that

try

to

achieve

their

Becausematerial having more less

with

with the

begins

are

achieve

how peoplemake choices and of the results of scarcity Economic society. analysis of

is the study of

Economics

they

have

assumption

that

people

goals and

well-defined

can. In trying to face trade-offs: goals, people normally them

and of

of some

one

as best they human good

are limited,

resources

making do

means

thing

other good thing.

\342\200\242 In

using

presume

that

Indeed,

we

to treat small proportionalchangesas insignificant, a to and a to tendency ignore implicit costs, tendency decision

order

to

take

this

the action.

The cost of

an

action

is defined

as the dollar value of everything the person must give up in order to take the action. (LOl)

margin\342\200\224for

ignore sunk costs or by failing costs and benefits. (L03)

(LOl)

has been on how rational chapter make choices among alternative courses of people action. Our basic tool for analyzing these decisionsis cost-benefit The Cost-Benefit Principle says analysis. that a person should take an action if, and only if, the benefit of that action is at least as great as its cost. The benefit of an action is defined as the largest dollar amount the person would be willing to pay in in

at the

think

to

fail

rational

the marginal

(the cost of pursuing

is the

\342\200\242 Microeconomics

and

of

group

behavior

macroeconomicsis economics

national governments

use

O

The ScarcityPrinciple (alsocalledthe we have boundless needsand Although available

means

to

limited. So having having less of another. us are

more

marginal

to try

study of individual

to improve

No-Free-Lunch wants,

of one

choices

in individual markets, while the of the performance of study and of the policies that

economic performance.

(ORE PRIHCIPIES Scarcity

to

of the activity (the benefit from unit of it) exceeds its marginal cost an additional unit of it). (L04)

benefit

additional

an

pursuing

by failing

to compare

question

but rather the

example,

is not whether to pursue an activity how many units of it to pursue. In these cases, as long as person pursues additional units

the

\342\200\242 Often

Our focus

the cost-benefit framework, we neednot choose rationally all the time. people identified three common pitfalls that plague in all walks of life: a tendency makers

Principle) the

good

resources thing

usually

CHAPTER

20

Cost-Benefit

The

Cost-Benefit

Principle

(or a firm or a the extra benefits from

An individual

O

if,

only

as the Incentive

ECONOMIST

LIKE AN

THINKING

I

Principle firm or a society) is more likely to take an action if its benefit rises, and lesslikely to take it if its cost rises.In short,

A

(or a

person

matter.

incentives

TERMS

KEY

cost

average

economic

taking

costs.

extra

The Incentive

O

average benefit

should take an action if, and the action are at least as great

society)

(12)

(12)

marginal

benefit

marginal

cost (11)

normative

macroeconomics(15)

principle

economic

positive

microeconomics (15)

surplus (6)

economics (4)

cost (6)

opportunity

(11)

(15)

principle

economic

rational

(15)

sunk cost (10)

person (5)

REVIEW QUESTIONS

1.

A

of yours

friend

on the tennis team

says, \"Private

best choicefor

everyone.

to earn

4. Many peoplethink when

downtown

to drive should

$30 is.

would

offer

someone

might

whether

to see

a movie

is

who be

more

likely to focus

as being free coupons. Explain

air travel

make wasteful

travel

(L03)

your

a

full

droppedout

decide

to

trying

fail

nonrefundable tuition payment you made to this semester a sunk cost?How your university

Explain. (L03) Why

shewould

5. Is the

depend

price

selling

their

of

frequent-flyer are likely to

people

decisions.

or false: Your willingness to save $30 on a new appliance on what fraction of the total

use

they these

why

(L02)

2. True

3.

ticket price than on the $20 by not babysitting? (L03)

$10

the

are definitely better than group lessons.\" what Explain you think he means by this statement. Then use the Cost-Benefit Principleto explainwhy private lessons are not necessarily the lessons

tennis

on

of the

answer

differ if your

tuition of

refund

school

during

to

were

university

to

any student who

the

first

two

months

semester? (L03)

PROBLEMS the most you

1. Suppose

before going out

^-connect

to

willing

washing

earn extra

local farmers'

McGraw-Hill

Visit your mobile app store and download Frank:

Econ

app

Study todayl

How

it? (L02)

tomatoes and sell them at a per pound. By adding compost to your in can increase as shown the table on the next page. If garden, you your yield costs 50 cents and is to make as much profit as compost per pound your goal h ow of should add? (L02) possible, many pounds compost you 3?You and friend Joe have identical tastes.At 2 p.m., you go to the local your Ticketmasteroutlet and buy a $30 ticket to a basketballgame to be played

2. To

the

dirty.

would be willing to pay to have a freshly washed car is $6. The smallest amount for which you would be else's car is $3.50. You are going out this evening and much economic surplus would you receive from

a date

someone

wash

your car is

JECONOMICS

on

*

Denotes

money

in

market for

more difficult problem.

the

summer,

30 cents

you grow

Pounds of tomatoes

Pounds of compost

100

that

night

the

same

buy

his

1

120

2

125

3

128

4

130

5

131

6

131.5

50 miles north of your home in Ithaca. Joe plans to attend but because he cannot to the Ticketmaster outlet, he plans to game, get ticket at the game. Tickets sold at the game cost only $25 because they in Syracuse,

people nonethelesspay the higher price getting good seats.) At 4 p.m., an unexpected snowstorm begins, the of the drive to Syracusemuch less attractive making prospect If than before (but assuring the availability of good both seats). you and Joe are carry

no Ticketmaster

at Ticketmaster,

of you

is one

rational,

surcharge. (Many

to be sure of more

attend

the game

than

the

other?

(L02)

spare cash in additional which on otherwise useless land behind his barn.The mushrooms mushrooms, grow in weight double their first after which time are harvested during year, they and sold at a constant priceper pound.Tom's friend Dick asks Tom for a loan of which he promises to repay after one $200, year. How much interest will Dick have to pay Tom in order for Tom to recover his opportunity cost of

4. Tom is

a mushroom farmer.

to

likely

loan?

the

making

invests

He

all his

Explain briefly. (L03)

seconds you devoted to question 1 on your physics in the last few seconds you devoted to 2 earned 10 extra You earned a total of 48 and 12 points, question you points. o n the two and the total time you spent on each was the respectively, questions If you could take the exam again, how\342\200\224ifat all\342\200\224should you reallocate same. your time between these questions?(L03)

5. Supposethat exam

6.

last few

the

extra points,while

you earned 4

Martha arrived

in

at

and

Sarah

the

theater

have the

same preferences and

to see a play,

she

discovered

incomes.Just as Martha

that she had lost the $10 ticket at the theater planning to buy that she had lost a $10 bill

purchased earlier.Sarah alsojust arrived to see the same play when she discovered If both Martha from her wallet. and Sarah are rational and both still have to for a ticket,is one of them more likely than the other to enough money pay ahead and see the (L03) go play anyway? she had a ticket

7. Residents

of your

are charged a fixed weekly fee of $6 for garbage to put out as many cans as they wish. The average household disposes of three cans of garbage per week under this plan. Now suppose that to a Each can of your city changes \"tag\" system. garbage to be collectedmust have a tag affixed to it. The tags cost $2 each and are not reusable. What effect do you think the introduction of the tag system will have on the total quantity collection. They

city

are allowed

Explain briefly. (L04) of cola and puts it in his refrigerator purchases for his two children. He invariably discovers that all six cans are gone on the first also a of cola once a week for his two day. Jones purchases six-pack but unlike he tells them that each three children, Smith, may drink no more than cans per week. If the children use cost-benefitanalysis each time they decide whether to drink a can of cola, explain at why the cola lasts much longer of

garbage

in your city?

collected

8. Oncea week,Smith

Jones's

house

than

a six-pack

at

Smith's.

(L04)

22

CHAPTER

I

THINKING

ECONOMIST

LIKE AN

in the continental each long-distancecall anywhere United States, a new will service users 30 cents minute for the first 2 minutes and phone charge per 2 cents per minute in each call. Tom's current phone for additional minutes

9* For

and his calls are never shorter calls, to the new phone service, what will to the average length of his calls? (L04) happen 10?The meal plan at university A lets students eat as much as they like for a fixed fee of $500 per semester. The average student there eats 250 pounds of B food per semester. for a book of meal tickets that $500 University charges entitles the student to eat 250 pounds of food per semester. If the student eats more than 250 he or she pays $2 for each additional pounds, pound; if the student If students eats less, he or she gets a $2 per pound refund. are rational, at which will food be (L04) university average consumption higher? Explain briefly. service

\342\200\242

The

is $10

$100

is much

Since

now

have no

to

pay for the from the

you

economic

surplus

should

use your

greater

in

the

($9

than

case

coupon and go to

billion).

but

the

would trip

would

is now

cost

be $10

- $12

be negative,

(L02) $90,

saving

of the

even though

the

Chicago ticket. (L03)

0,

Fort

Lauderdale.

marginal benefit of the fourth launch cost of $8 billion, so the fourth marginal fifth launch should not, since its marginal benefit

$10

buying it downtown from making the

alternative use for your coupon, the opportunity cost Fort Lauderdale trip is zero.That means your - $1,000= $350> so you trip will be $1,350

1.4 The

marginal

is again

downtown

more valuable

saved percentage

of using it

game

from surplus economic your surplus at the campus store. buy

you should

1.3

the

buying

\342\226\240

CHECKS

economic

= -$2. Since

Saving

per minute for all dorm switches

CONCEPT

of

benefit

$12, so your

1.2

If Tom's

TO

ANSWERS

1.1

10 cents

charges

7 minutes.

than

(L03)

is $9 launch cost

($12

billion, which exceedsits should billion)

be added. But exceeds its

the

(L03)

1.5 If the star player takesonemore shot, someother player must take one less. The fact that the star player's average success rate is higher than the other the probability of making his next shot (the players' does not mean that him benefit of shoot once than the probability of more) is higher marginal having another player making his next shot. Indeed,if the best player took all his team's shots,the other team would focus its defensive effort entirely on him, in which case letting others shoot would definitely (L03) pay.

*

Denotes

more difficult problem.

APPENDIX

with

Working

Graphs,

Equations,

and

Tables

examples and most of the end-of-chapter are skills quantitative, none requiresmathematical Although In school and this brief beyond rudimentary high algebra geometry. w e review some of the skills need for with these appendix, you'll dealing many

problems

examples and

One

translate

in

this

of the

book

problems.

important skill is to be able to read simple the information they provide into the relevant

verbal

descriptions

and

or graphs. equations tabular form into an

You'll alsoneedto be able to translate information given in equation or graph, and sometimesyou'llneedto translate graphical into a table or equation.Finally, need to be able to solve you'll with two equations and two unknowns.The following examples the tools you'll need.

information systems illustrate all

simple

CHAPTER

24

WITH EQUATIONS,GRAPHS,

WORKING

APPENDIX

I

EXAMPLE

I

equation

A Verbal

I

A.

an example that from a verbal

with

begin

billing

Your

a mathematical

expression

relationship between variables

or

two

more

variable a quantity to take a

range

that

is free

of different

values

dependent variable a variable in an equation whose value is determined another

by

variable

the

value taken

in the

by

equation

independent variable a variable in an equation whose value determines another

the value taken variable

in the

by

equation

constant (or parameter) a quantity

a long-distance telephone

to construct

plan.

billing

10 cents per minute plan charges you $5 per month plus that describes your monthly bill. equation telephone

telephone

long-distance

an

is a simple mathematical that describes the relationship expression between two or more variables, or quantities that are free to assume different values in some of equation we'll work with contains range. The most common type In two types of variables: dependent variables and variables. this independent the variable is the dollar amount of bill example, dependent your monthly telephone and the independent variable is the variable on which your bill depends, namely, the volume of long-distance calls you make during the month. Your bill also on the fee and the 10 cents minute $5 depends monthly per charge. But, in this A those amounts are not variables. also called a constants, constant, example, in in is a an that is fixed not free to value, parameter, quantity equation vary. As the terms the variable describes an outcome that on suggest, dependent depends the value taken by the independent variable. Once you've identified the dependent variable and the independent variable, choosesimple symbols to represent them. In algebra courses, X is typically used to Y the variable and the variable. represent independent dependent Many people find if they choose symbols it easier to remember what the variables stand for, however, that are linked in some straightforward way to the quantities that the variables in this we bill in represent.Thus, example, might use B to representyour monthly dollars and T to representthe total time in minutes you spent during the month on An equation

the

describes

that

how

shows

description of the

Description

for long-distancecalls.Write equation

TO

AN EQUATION

CONSTRUCT We

TABLES

DESCRIPTION

A VERBAL

USING

AND

that is fixed in value

calls.

long-distance

Having you

now in a

are

the

identified

and chosen symbols to that links them: equation

variables

relevant

position to write

the

B= 5

representthem,

+ 0.10T,

(1A.1)

and T is your monthly total long-distance bill in dollars in minutes. The fixed fee (5) and the charge per long-distancecalling monthly in this equation. Note the importance minute are parameters of being clear (0.10) about the units of measure. Because B represents the monthly bill in dollars, we must also expressthe fixed monthly fee and the per-minute charge in dollars, which is why the latter number appears in Equation 1A.1 as 0.10 rather than 10. Equation 1A.1 follows the normal convention in which the dependent variable appears by itself on the left-hand side while the independent variable or variables and constants appear B

where

is your

monthly time

on the

side.

right-hand

Once we

much you'll

have the equation for

owe as a function

example, you

make

if

simply

substituting

of

32 minutes

32 minutes

monthly

bill when you

your

5 +

can use it

monthly

bill, we

monthly

volume of

of calls, you

for Tin

B =

Your

the

can

to

long-distance calls.For

calculate

your

monthly

bill

1A.1:

Equation

0.10(32) = 8.20.

make 32 minutes

how

calculate

of

calls

is thus

(1A.2)

equal to

$8.20.

by

GRAPHING

Under the

monthly

for a month

during

billing

plan described

in

which

you made 45

minutes

THE

GRAPHING

EQUATION

you

owe

OF A STRAIGHTLINE

25

IA.I

CHECK

CONCEPT

THE

Example of

how much would calls? long-distance I A. I,

OF A

EQUATION

STRAIGHT LINE The

next

shows

example

how to

as a graph.

portray the

billing

plan

described

in Example

1A.1

Graphing an Equation that portrays

a graph

Construct

described

in

Example

on the vertical axis horizontal axis.

The first translate

and

I,

the monthly your

putting

your

total volume

charges,

of calls,in

billing plan

telephone

long-distance

telephone

in dollars

minutes

per

per month, on the

month,

this instruction is the one we just took, namely, to of the billing plan into an equation. When graphing the normal conventionis to use the vertical axis to represent the In and the horizontal axis to representthe independent variable. therefore axis and T on the horizontal axis.One put B on the vertical

in responding to step the verbal description

an equation, dependent variable Figure

I A.

we

1A.1,

shown

the figure is to begin by plotting the monthly different total amounts of long-distancecalls. For example,someonewho makes 10 minutes of calls during the month would in Figure have a bill of B = 5 + 0.10(10) = $6.Thus, 1A.1 the value of 10 minutes on the horizontal axis correspondsto a bill of $6 per month on the per month verticalaxis of long-distance calls during the A). Someone who makes 30 minutes (point month will have a monthly bill of E = 5 + 0.10(30)= $8,sothe value of 30 minutes per month on the horizontal axis correspondsto $8 per month on the vertical axis (point C). Similarly, someone who makes 70 minutes of long-distancecalls month will have a monthly bill of B = 5 + 0.10(70)= $12,so the value of during the 70 minutes on the horizontal axiscorresponds to $12 on the vertical axis (point D).

way

to

the graph

construct

bill values

The

IA.2

EXAMPLE

that

correspond

line joining As shown in

these points is the Figure

in

to several

1A.1,

graph

the graph

of the

monthly

billing

of the equation B =

5+

1A.1.

Equation 0.10T

is a

straight

line. The parameter 5 is the vertical of the line\342\200\224the value of B when intercept T = 0, or the point at which the line intersects the verticalaxis.The parameter 0.10 is the slope of the line, which is the ratio of the rise of the line to the correspondingrun.

0

**^

vertical line,

dependent

variable

independent

variable

slope

in

straight

bill

the

the equals zero

line, the vertical distance the line travels between a straight

two

(rise) to

points

the

horizontal

corresponding

distance (run)

FIGURE Monthly

by

when

of the

ratio

any

in a straight

intercept

value taken

the

The Bill

I A. I

Monthly in Example

Telephone IA.I.

The graph of the equation 8 = 5 + 0.107is the straight line shown. Its vertical intercept is

30

40

T (minutes/month)

50

0.10.

is 5 and its

slope

CHAPTER

26

I

APPENDIX

WITH EQUATIONS,GRAPHS,

WORKING

rise/run is simply

The ratio

TABLES

AND

distance between any two points on the line i f between those For by points. example, we choose \342\200\224 = 2 and the A in and C the rise is 8 6 1A.1, points Figure corresponding run is 30 \342\200\224 10 = 20, so rise/run = 2/20 = 0.10.Moregenerally, for the graph of any = a + Y the a is the vertical and the foX, equation parameter intercept parameter b

divided

the

vertical

the

distance

horizontal

is the slope.

ITS

FROM

LINE

GRAPH

The next exampleshows graph of the line.

plan.

IA.2 shows is

What

the

IA.2

Monthly

Distance Plan.

equation

points A

and

and

the slope 4/20= vertical

shown

points

- 20 = 20,

intercept

line

from

a

for a

plan

is the

new long-distance fixed monthly fee

^Monthly bill

for the

= 4

billing

(

12

Rise

so

= 4

t^^

CO

Run

($/mont

= 20

CQ

(the value

T = 0) is 4.

is 8

billing

for this graph? How much is the charge per minute?

A

of the line is 1/5 = 0.20.The

of 8 when equation

5s

horizontal

between

C is 40

straight

Graph

16

Long-

between C is 12 \342\200\224 8 = 4

units, and the distance

much

for a

the equation

distance

vertical

The

derive

the graph of the monthly

under this plan?How

FIGURE

a

from

Figure

Another

to

how

Derivingan Equation

EXAMPLEIA.3

STRAIGHT

THE EQUATION OF A

DERIVING

4

So the plan

+ 0.20T.

I

l

0

10

I

30

20

50

40

60

T (minutes/month)

of the line shown is the rise between any two points divided by the \342\200\224 = = 40 \342\200\224 = A 12 run. For and rise 8 = 4 and run 20 C, corresponding points = = = so the slope equals rise/run 4/20 1/5 0.20. And since the horizontal of the line is its must be 4, intercept equation given by

The slope

B = Under is $4.

this

plan,

The charge

minute.

the fixed

monthly

per minute is the

fee

4 + 0.20T. is the

slope of

value of the

billing

20,

(1A.3)

the bill when T = 0, which line, 0.20, or 20 cents per

27

SLOPE

IA.2

CHECK

CONCEPT

AND

IN THE VERTICAL INTERCEPT

CHANGES

Write the equation for the billing is its fixed monthly fee? Its charge

in the

shown

plan

accompanyinggraph. How much

per minute?

\302\243-Mnnthlv

30 /

24

hill

2^\342\200\224

00

($/month) CQ

1

0

i

5

15

10

i

i

20

25

30

T (minutes/month)

INTERCEPT

VERTICAL

IN THE

CHANGES

AND SLOPE two

next

The

and concept checks provide practicein examples in its vertical intercept or slope.

Change Show how

the

fixed

monthly

seeing

a line

how

a change

with

shifts

billing

fee

were

whose

plan

is

graph

from $4 to

increased

in

Figure

IA.2

in

Vertical

would

$8.

Intercept

change

IA.4

EXAMPLE

if the

$4 to $8 would increase the vertical monthly fixed fee from in but would leave its slope unchanged. An increase $4 billing plan by in the billing plan by $4, as shown the fixed fee thus leads to a parallel upward shift in Figure 1A.3. For any given number of minutes of long-distancecalls,the monthly

An

in the

increase

intercept of

the

FIGURE

^^

20

New

monthly

in

C^^

16

^ D

A^^

8

P

*A

4

i

0

10

i

30

20 T

Original

monthly

bill

(minutes/month)

40

50

Vertical

60

in

Increase

Intercept. the

vertical

intercept of a straight an upward

produces in the line.

shift

E

CQ

the

An increase

k

^^

IA.3

The Effect of an

bill

line parallel

28

I

CHAPTER

APPENDIX

WORKING

WITH EQUATIONS,GRAPHS,

TABLES

AND

on the new bill will be $4 higher than on the old bill.Thus 20 minutes of calls per month cost $8 under the original plan (point A) but $12 under the new plan (point A'). And 40 minutes cost $12 under the original plan (point C), $16 under the new plan (point C); and 60 minutes cost $16 under the original plan under the new $20 D), (point plan (point D'). charge

how

Show

chargeper the

Because

the

or twice the increase

an

IA.2

Figure

would change

Effect of an

the

Charge

Becausethe

fixed

graph is in

Figure

from 20 cents

increased

were

would

IA.2

the

monthly

change

to 40 cents.

if the

unchanged, the vertical intercept of the new billing 1 A.4, is 0.40, of the new plan, shown in Figure in the equation Y = a + foX, of the original plan. More generally, slope in b makes the slope of the graph of the equation steeper. monthly

fixed fee is

to be 4. But

the

slope

Increase

Q,y

New

monthly

bill

per Minute. monthly fee

continues to be $4,the vertical plan

if

IA.4

FIGURE

in

in

$4 to $2.

plan whose

billing

minute

plan continues

The

graph is

whose

plan

billing

reducedfrom

Change in Slope

IA.5

EXAMPLE

IA.3

CHECK

CONCEPT

Show how the fixed fee were

intercept is the same

original

plan.

With

Original

bill

monthly

of the new

as that

of the

the new

charge per minute of 40 cents, the slope of the billing plan rises from 0.20 to 0.40.

T

CONCEPT

50

40

30

20

10

60

(minutes/month)

IA.4

CHECK

Show how the billing plan whose graph is in Figure IA.2 would change 20 cents to 10 cents. per minute were reducedfrom

Concept Check1A.4illustrates foX,

a reduction

in b

CONSTRUCTING

GRAPHS

FROM

the

makes the slope of

charge

a +

EQUATIONS AND TABLES

example and conceptcheckshow into an equation or graph.

The next

the

Y = rule that in an equation of the less graph equation steep.

general the

if

how

to transform

tabular

information

CONSTRUCTING

a Table

Transforming I A. I

shows four

points from equation. If all points on this billing Table

vertical intercept

the

charge

a

monthly

equation

equation and graph it. What minute? Calculate the total bill per

long-distance lie on a straight

of the

is the for

EQUATIONS

to a Graph

telephone

line, find

29

TABLES

FROM

EXAMPLE

I

A.6

billing the

fixed fee? What with I hour of

monthly

a month

AND GRAPHS

is

calls.

longdistance

TABLE

I A.

I

on a

Points

Long-Distance

Long-distance

Billing Plan Total long-distance

bill

($/month)

calls

(minutes/month)

10.50

10

11.00

20

11.50

30

12.00

40

One to this problem is simply to plot any two points from the table on approach a graph.Sincewe are told that the billing is a equation straight line, that line must be the one that passes through two of its 1A.5 we use any points. Thus, in Figure A to denote the point from Table 1A.1 for which a monthly bill of $11 to 20 minutes and C to denote the point row) corresponds per month of calls (second for which a monthly bill of $12 corresponds to 40 minutes month of calls per The line these is the (fourth row). straight passing through points graph of the

billing

equation.

a steady hand, however, or use extremely large graph paper, a line between two points on the billing plan is unlikely to be very alternative is to calculate the for the approach equation Since the is a we know that it takes the billing plan directly. equation straight line, = + B form sT where is the fixed fee and s is the Our general f f monthly slope. goal is to calculate the vertical intercept f and the slope s. From the same two we plotted earlier, A and C, we can calculate the slope of the billing plan as points s = rise/run = 1/20 = 0.05. Unless you have

the

method

of extending An accurate.

IA.5

FIGURE Monthly

bill

the

Plotting Billing

Monthly

from a

Equation

Sample of Points. A is taken

Point

I, and

Table

I A.

row

4. The

from row

monthly

plan is the straight passes 20

30

T (minutes/month)

40

50

2,

point C from billing line

through these

that points.

30

CHAPTER

I

APPENDIX

WITH EQUATIONS,GRAPHS,

WORKING

B=

plan,

billing

total

the

12,s = 0.05,and

T

=

TABLES

calculate/\",

remains is to

So all that

the

AND

fixed

the

12 =

fee.

monthly

monthly bill is $12 for 40 minutes, 40 into the general equation B =

so

f+

At

sT

C on

point

substitute

we can

to obtain

f + 0.05(40),

(1A.4)

or

=

12

which solves for

10. So the monthly

f=

B = For

this

($0.05/minute),

= 10

is B

calls

longdistance

10 + 0.05T.

the total

and

be

must

equation

billing

feeis $10 per month,

equation, the fixed

billing

per minute

(1A.5)

/\"+2,

bill for

+ 0.05(60)= $13,just

as

(1A.6)

the

a

calling with

month

shown

charge is 5 1 hour of

cents

1A.5.

in Figure

CONCEPT CHECK IA.5 The billing

four points from a

shows

table

following

bill

Long-distance

Total

20.00

If all

points

30.00

20

40.00

30

50.00

40

on

this

is the charge per minute? calls per month?

without How

The next exampleand concept to solve two equations with

I

A.7

Simultaneous

Solving

Suppose you are telephone

to the

trying

vertical intercept

find the

line,

straight

graphing it. What is the monthly would the charges be for I hour

much

SIMULTANEOUS

SOLVING

EXAMPLE

lie on a

plan

billing

equation

corresponding

calls

long-distance

(minutes/month) 10

($/month)

the

telephone

long-distance

monthly

plan.

fixed

of long-distance

EQUATIONS how to

demonstrate

check two

proceed when

need

you

unknowns.

Equations to

service. If you

between

choose

choose Plan

two rate

I, your

plans for

charges

will

be

your

computed

long-distance

according

equation

B= I0 + 0.04T, where

of

What

fee?

B is

long-distance

computed

again your monthly calls in minutes.

according to

in dollars

bill

If you

the equation B

=

20

choose

and T

(I

A.7)

is your

Plan 2, your

+ 0.02T.

monthly

monthly

volume bill

will

of

be

(IA.8)

SOLVING

SIMULTANEOUS

31

EQUATIONS

How many minutes of long-distancecallswould have to make each month, on you average, to make Plan 2 cheaper? Plan 1 has the attractive feature of a relatively low monthly fixed fee, but also the unattractive feature of a relatively rate high per minute. In contrast, Plan 2 has a fixed fee but a low rate who made relatively high relatively per minute.Someone an extremely low volume of calls (for example, 10 minutes would do per month) 1 (monthly bill = $10.40) than better under Plan under Plan 2 (monthly bill = for its $20.20) becausethe low fixed fee of Plan 1 would more than compensate rate minute. someone who made an volume higher per Conversely, extremely high of calls (say, 10,000 minutes per month) would do better under Plan 2 (monthly = = bill bill $220) than under Plan 1 (monthly $410) because Plan 2's lower rate minute would more than for its per compensate higher fixed fee. Our task here is to find the break-even calling volume, which is the monthly volume for which the bill is the same under the two plans. One way to calling monthly

to graph the two billing and see where they cross. At that plans the two are satisfied which means that the crossing point, equations simultaneously, call volumes will be the same under both as will the bills. monthly plans, monthly In Figure 1A.6, we seethat the graphs of the two plans crossat A, where both bill of $30 for 500 minutes of calls per month. The break-even yield a monthly volume for these is thus 500 minutes calling plans per month. If your calling volume is than on will save that, higher average, you money by choosing Plan 2. For example, if you 700 bill under Plan 2 ($34)will be $4 cheaper minutes, your monthly average if you than under Plan 1 ($38).Conversely, 500 minutes each average fewer than i f will do better under Plan 1. For 200 month, you example, you average only bill under Plan 1 ($18)will be $6 cheaper than under Plan 2 minutes, your monthly A t 500 minutes the two cost the same ($30). ($24). per month, plans exactly The question posed here also may be answered As in the algebraically. graphical our is to find the that satisfies both (T, B) approach just discussed, goal point As a first we rewrite the two billing equations simultaneously. step, billing on top of the other, as follows: equations, one answer

this question is

B

=

B = As you'll recall from high of one equation from the

school

10

+ 0.04T.

20 +

0.02T.

algebra,

(Planl) (Plan

if we

corresponding terms of

2)

subtract the terms the

other

equation,

from

each

side

the resulting

IA.6

FIGURE

The

Volume

Break-Even

of Long-DistanceCalls. When

volume

your

longdistance

calls

is 500

of

minutes

per

month,

your

monthly

will

be the

same

under

bill

both

plans. For higher calling Plan 2 is cheaper;

volumes, Plan

I

is cheaper

volumes.

for lower

32

CHAPTER

I

APPENDIX

WITH EQUATIONS,GRAPHS,

WORKING

AND

TABLES

must be equal. So if we subtract from the corresponding terms in equation differences

B= -B

0

Plan

l's

- 0.02T (-Plan2)

=

+ 0.02T

(Plan 1 1 \342\200\224 Plan 2)

(Plan

Plan

2

(Planl)

= -20 -10

the

-

Plan

to get

2).

T=

500.

into either plan's equation, we then find B = 30. For example, = + 0.04(500) 30,as does Plan 2's: 20 + 0.2(500) = 30. yields 10 = (500, 30) lies on the equations for both (T, B) point plans the algebraic approach just describedis often called the method of

equation the

Because

0.04T

the terms on each side of Plan 1 equation, we get

= 500

T

Plugging

+

last equation

we solve the

Finally,

10

the

simultaneously,

simultaneous equations.

CONCEPT

IA.6

CHECK

you are

Suppose to according

the

to

trying

telephone service.

If

you

choose

choose

between Plan I, your

8 is

again

calls

longdistance

according to

+ 0.107

bill in dollars your monthly in minutes. If you choose Plan

the

for

your

long-distance

be computed

(Plan

and

7 is

2, your

I),

your monthly monthly

bill

volume of

will

be computed

equation

8 = Use

monthly

plans

bill will

equation

8=10 where

two rate

100 +

0.017

(Plan

the algebraic approach described in the preceding of monthly call volume for these plans.

2).

example

to

find

the

breakeven level

KEY TERMS constant

dependent

parameter

(24)

variable

(24)

equation (24)

independentvariable

variable (24)

(24)

vertical intercept (25)

rise (25) run

slope

(24)

ANSWERS

TO

(25)

(25)

APPENDIX

CONCEPT

(HECKS

1A.1 To calculate your monthly bill for 45 minutes of calls,substitute 45 minutes = $9.50. for Tin equation 1A.1 to get B = 5 + 0.10(45) 24 = 6 and 1A.2 Calculating the slope using pointsA and C, we have rise = 30 \342\200\224 \342\200\224= = = = = run 30 15 6/15 2/5 0.40.And since the 15, so rise/run horizontal of the line is its 18, intercept equation is B = 18 + 0.40T. Under this fee is $18 and the charge per minute is the slope of plan, the fixed monthly the billing or 40 cents minute. line, 0.40, per

ANSWERS

1A.3 A

reduction

$2

in the

shift

billing

in the monthly plan by $2.

fixed fee would producea downward

^

16

14 (

^12

llO 0

New

bill

monthly

bill

C

1 8 OQ

^ D'

parallel

monthly

Original

TO APPENDIX

^^^^^^

6

4

2 i

i

i

10

20

30 T

1 A.4

i

40

50

60

(minutes/month)

With an unchanged monthly fixed fee, the vertical intercept of the continues to be 4.The of plan slope the new plan is 0.10, half the original

billing

slope of

the

plan. Original monthly

bill

New

T

monthly

bill

50

40

30

20

1A.5

new

(minutes/month)

be B = f + sT, where the fixed monthly fee and fis in the first two the calculate the slope table, slope. points = 10/10 = 1.0. To calculate in s = rise/run we can use the information /!, = + row 1 of the table to write the billing as 20 a nd solve equation f 1.0(10) for f = 10. So the monthly must be B = 10 + LOT. For this billing equation billing equation, the fixed fee is $10 per month, the calling charge is $1 per 1 hour of long-distance calls is and the total bill for a month with minute,

Let the

s

is

billing

B = 10 +

equation

From

the

= $70.

1.0(60)

1A.6 Subtracting the

Plan 2 equation 0 =

-90

from

+ 0.09T

the

(Plan

Plan 1 1

equation yields the

- Plan

equation

2),

which solves for T = 1,000. So if you average more than do better on Plan 2. long-distance calls each month, you'll

1,000

minutes

of

CONCEPTCHECKS

33

CHAPTER

2

Comparative

Advantage as a PeaceCorps

a stint

uring

rural

in

volunteer

a

Nepal,

LEARNING

young economic naturalist

employeda cooknamed from a

came

who

in

village

formal

duties,

Bhutan.

resourceful.

His

to prepare

food and

spectacularly

the

maintain

remote Himalayan

LOI

Birkhaman had virtually he was education,

Although no

After reading this chapter, you should be able to:

Birkhaman,

neighboring

he

kitchen,

tinsmith

able

and

clock, as well

alarm

L02

performed

remedies.

a good

the low-hanging

pick

Always

fruit

and

the

this

exchange with

little

Cost

carpenter, he could sew and

as plaster walls.And

of goods specialization.

he

was

fix

a

Our

task

in

this

chapter

more

is to

broken

productive

than

investigate

why

As this chapter will show, the is comparative advantage. Roughly,

reason that a person

has

at producing a particulargoodor service (say, relatively more efficient at producinghaircuts goods or services.We will see that we can all have service if each of us specializes in the activities advantage.

is so productive a comparative advantage if that person is haircuts) than at producing other

specialization

more

at which

of every

good and

we have a

Opportunity

(also

called the Use

Principle). production

and servicesare generally far

of

Low-Hanging-Fruit

on home

a local authority

is so.

comparative

the

apply

Principle

Increasing

first.

was broad even in Nepal, where the least-skilled range could a wide of services that most Americans hire others villager perform range in skills and employment? to perform. Why this difference One might be tempted to answer that the Nepalese are simply too poor to hire others to perform these services. Nepalis indeed a poor country, whose income per person is less than one one-fortieth that of the United States.Few have spare cash to spend on outsideservices. But as reasonable as this Nepalese the reverse is the case.The poverty explanation may seem, actually Nepalesedo not perform their own services because they are poor; rather, are poor they because their own services. largely they perform The alternative to a system in which is a jack of all trades is one everyone in which people specialize in particular and services, then satisfy their goods needsby trading among themselves. Economic systems based on specialization those

Explain and the

L03

possibilities

and

opportunity

cost

comparative

advantage. that

factors

Identify

shift the menu production

L04

a

to illustrate

curve

of skills

Birkhaman's

apply

Comparative Advantage.

primary

other skills.Hecould thatch a roof, butcher a goat, and repair shoes.

An

and

Explain

Principle of

well. But he also had

extremely

OBJECTIVES

possibilities.

Explain the

role of advantage

comparative

trade

in international and

describe

jobs are vulnerableto

of

why some

more

outsourcing

than others.

36

2

CHAPTER

COMPARATIVE ADVANTAGE

This

will introduce the is a graphical

also

chapter

possibilities describingthe

production method of and services

which

curve,

of goods

combinations

$*:;$\302\243$&.

This tool will allow us economy more clearlyhow specialization enhances the of even the productive capacity simplest economy. can produce.

an

that

to see

EXCHANGEAND

COST

OPPORTUNITY Scarcity

O

The

the

that

on

any

opportunity

one activity is having

spendon others.As

the

clear, this principle do better

can

at which he

EXAMPLE 2.1

II

Joe

1

everyone

own

his own

activities to others.

those

relative

best

the

write his own

Jamail

Joe

services?

will?

in the legal profession as \"The King in American history. And at number lawyer richest he is also one of the wealthiest, Americans, known

Jamail,

of Torts,\"

400

more than

is the most

269 on the Forbes list of with net assets totaling

trial

renowned

1111 1 t

1

on

his

makes

example

following

helps explain why

or sheperforms

this man perform most of services because he was poor, or was he poor becausehe performed most of Did

less time availableto

concentrating

by

Z-

Scarcity Principle

cltUn b i\302\253orin\302\273^>wcijM iHiimiKdenhri Should

lit

(see Chapter 1) reminds us cost of spending more time

Principle

Scarcity

billion.

$1.5

But although Jamail devotes virtually all of his working hours to high-profile he is also to a much broader litigation, competent perform range of legal services. in f or that he could his own will two hours, only half as Suppose, example, prepare

long as it prepare

On the year,

\302\253Jt* \"80 JCVINAII \302\247JtQ

Joe Jamail prepare his

Should

own

which

would typically

absolute advantage one has an

over fewer than

another

hours

absolute advantage if he or she takes to perform a task

other

the

person

comparative advantage has

person

over advantage

one

a comparative another if his or her

opportunity cost of performing a task

is lower

person's

strength

of his

means

that the

be several earn

attorney. Does that

any other

than

the

other

opportunity cost

that

mean

Jamail

should

will?

far

talent

as a

opportunity

litigator,

cost

earns

Jamail

of any

thousand dollars per hour. Attorneys less than that amount. would Jamail

than another

attorney,

it would

not be

in

his

many millions

time he

competent property lawyer who could preparehis will even though Jamail's considerableskillswould enable

will?

quickly

person

take

would

own

his

spendspreparing his will

who

specialize

have

little

for him him

interest

of dollarsa

in property

difficulty

for less than

engaging $800.

law a So

to perform this task more to prepare his own will.

In Example 2.1, economistswould Jamail has an absolute advantage say that his will but a at trial work. He has an absolute preparing comparative advantage in less time than at his will because he can that task advantage preparing perform a property could. Even the has a so, lawyer property lawyer comparative wills because her opportunity cost of performing that task is advantage at preparing lower than Jamail's. 2.1 made the implicit assumption that would have been Jamail Example will to an hour his or for a trial. But equally happy spend preparing preparing he was tired of trial and felt it be to refresh his suppose preparation might enjoyable of law. his own will then have made knowledge property Preparing might perfect sense! But unless he expected to gain extra satisfaction from that task, performing he'd almost certainly do better to hire a property lawyer. The property lawyer would also benefit, or else she wouldn'thave offered to prepare wills for the stated at

price.

AND

EXCHANGE

(or two

nations) have

with

two people

when

of performing various and services by goods

costs

opportunity

the total value of available The following example

increase always one another.

can

they

different

COST

ADVANTAGE

of moderneconomics is that

most important insights

of the

One

trading

OF COMPARATIVE

PRINCIPLE

THE

OPPORTUNITY

tasks,

captures the logicbehind

this

insight.

ShouldBeth

own web

her

update

Consider a small community

EXAMPLE 2.2

Advantage

Comparative

page?

is the only professional bicycle HTML professional programmer. Beth also happens If the amount of time each of to be an even better HTML programmer than Paula. them takes to perform these tasks is as shown in Table 2.1, and if each regards the two tasks as equally pleasant (or unpleasant), does the fact that Beth can program faster than Paula that Beth should update her own web page? imply

The entries

Beth

which

in

is the only

Paula

and

mechanic

the table show that Beth has an absolute advantage over Paula While Beth, the mechanic, needsonly 20 minutes to update a web the needs 30 minutes. Beth's page,Paula, programmer, advantage over Paula is even greater when the task is fixing bikes: She can complete a repair in only in

in

activities.

both

10 minutes,

to Paula's 30 minutes.

compared 2.1

TABLE

Information

Productivity

Timeto a web

Paula

30 minutes

30 minutes

Beth is a better programmer than

fact that

the

update own

web page.As Paula has a comparative will, her own

his

programming:She

is relatively

more productive at

comparative advantage

comparative

at a

advantage

in

30

to

minutes

opportunity the taking

to opportunity the

time

do

update

each

cost of updating a web time to update a web

repair. Beth, in

(Remember

Paula

contrast,

in terms

two

bicycle

of bicycle

repairs.

Beth

Similarly,

a person

that

instead of

has a

of performing

that

a web page? Since she takes of time she takesto fix a bicycle\342\200\224

updating

amount

page is

Beth.

that

cost

one

bicycle

is effectively

can

repair. giving

complete

update a single web page.For her,

updating a web page is programming,measured

lawyer

or her opportunity

not imply

who litigates over Beth at

programming than

page,

one bicycle she takes to

does

Paula

advantage

cost of

page\342\200\224the same

the

with

repair.

bicycle

given task if his

task is lower than another person's.) What is Paula's opportunity

by

repair

10 minutes

preparing

her

a bicycle

20 minutes

should

has a

to complete

Time

update

page

Beth

But Beth

and Beth

for Paula

the

In other up the

words,

two bicycle

repairs in

opportunity

cost

Beth's opportunity

of

cost of

repairs forgone, is twice as high

as

Paula's.

at programming. Thus, Paula has a comparative advantage The interesting and important of the opportunity cost comparison implication in Table summarized 2.2 is that the total number of bicycle repairs and web if Paula and Beth both spendpart updates of their time at each activity accomplished if will be smaller than the number each always accomplished specializes in the in which she has a for activity comparative advantage. Suppose, example, that people

COMPARATIVE

ADVANTAGE

TABLE

2.2

Opportunity

Costs for Paula

2 bicycle

Paula

I

cost of a bicycle repair 0.5 web page update

cost of a web page

Opportunity updating Beth

and Beth

bicycle

Opportunity

repairs

I

repair

web

page update

community demand a total of 16 web page updates per day. If Beth spent time updating web pagesand the other half repairing bicycles, an eighthour would workday yield 12 web page updatesand 24 bicycle repairs. To complete the remaining 4 updates, Paula would have to spend two hours programming, which would leave her six hours to repair bicycles. And since she takes 30 minutes to do each repair, she would have time to complete 12 of them. So when the two women try to be jacks-of-all-trades, end a total of 16 web page they up completing and 36 updates bicycle repairs. in her Consider what would have happened had each woman specialized of Paula could have 16 web on her own activity comparative advantage. updated pages and Beth could have performed 48 bicycle repairs. Specialization would have 12 bicycle repairs out of thin created an additional air. in their

half her

1

i

\302\251

\"Were

a natural^

property,

When

computing

pay close attention In Example2.2,we

to

and

Rachel I handle intellec ual \" you re a content-provider

the opportunity cost of one goodin the form in which the productivity

of another, we must information is presented.

terms

told how many minutes each person neededto perform we units of each task each person Alternatively, might be told how many in an hour. Work through can perform the following concept check to see how to in when information is this alternative format. proceed presented each

task.

were

AND

EXCHANGE

OPPORTUNITY

39

COST

CONCEPT CHECK 2.1 Barb

Should

small

Pat is

and

mechanic

that Barb

should

HTML

if

does the fact that Barb her own web page?

update

2 web

page

Barb

3 web

page updates

The principle illustrated it formally as one of the

Productivity

per

the

by

core

I

preceding

principles

(or

country)

repair

is so examples of the course:

The Principleof ComparativeAdvantage:

does

Everyone

on the activities for

concentrates

in

his

which

per

the

does not devote growing

food,

surgery,

and

most

hour

important

we

that

each person opportunity cost

best when or her

possible from specialization based on comparative rationale for market exchange. They explain why each 10 of his or her time to producing cars, 5

O

Comparative

made

gains

advantage constitute

imply

repair

bicycle

is lowest.

Indeed,the

Pat

than

per hour

3 repairs

hour

tasks as equally

faster

program

rates

productivity

the two

per hour

updates

their

If

regards

can

in programming

Pat

each

each

bicycle

professional

only

programmer.

table, and

in the

Productivity

state

in which Barb is the

professional

only

unpleasant),

(or

web page?

community

the

are as shown

at the two tasks pleasant

her own

update

Considera

person

percentto

percent

0.0001 percentto performing brain tasks at which we are By concentrating relatively if we all tried to be we can produce vastly more than together to building housing,

25 percent

so on.

productive,

on

those

self-sufficient.

This versatility

insight was

brings

us back he was

marvelous,

to

Birkhaman

cook.

the

Though

Birkhaman's

neither as good a doctoras someone who

has

been

as someone who spends each school, nor as gooda repairman If a number of with Birkhaman's native talents had joined day fixing things. people in each of them one or two would have tasks,togetherthey together, specializing more and better and services than each could have enjoyed goods possibly produced there is much to admire in the resourcefulness of independently. Although who have learned to on their own that is skills, people through necessity rely path no route to economic prosperity. and its effects provide ample grist for the economic naturalist. Specialization Here's an example from the world of sports.

trained

in medical

The

2.1

Naturalist

Economic

\342\200\242%

Where have all the a .400

In baseball,

comesto

bat.

Though

.400 hitters

hitter

gone?

player who averages common in professional

is a

never

at least four

hits

every

10 times

he

used to appear for example, a player known

baseball,

.400 hitters

as Early in the twentieth century, Willie Keeler batted .432, meaning that he got a hit in over 43 percent of his times at bat. But since TedWilliams of the Boston Red Sox batted .406 in 1941, there hasn't been a single .400 hitter in the major leagues.Why not? relatively

frequently.

Wee

Some

baseball

buffs argue

that

the

of the

disappearance

players are not as good as yesterday's.But examination. For example, today's players are bigger, baseball

that

claim

stronger,

.400

hitter

means

does not withstand and faster than

today's close

those of

Advantage

CHAPTER 2

40

COMPARATIVEADVANTAGE

Keeler's

Willie

4 inches, Bill

.400

day. (Wee

disappeared not improved,

leagueshas

N

~

' . \"'

.\"/\"--

-\"

^

) \"

' ^

.

'

7

*

^

-_ y r

has no major league baseball did it more than since TedWilliams

Why

player

half

over 5

a little

just

feet,

play in better

including

the In

that the in the major and fielding pitching argues

of

quality

particular,

play

.400 more difficult. baseball improved?Although there nutrition, training, and equipment, batting

has played an important role.1At one for the entire game. Now pitching pitch

time, pitchers were expected to staffs include who specialize in starting the game (\"starters\,") others who spepitchers in pitching two or three innings in the middle of the game (\"middle cialize and still others who specializein pitching relievers\,") only the last inning different skills and tactics. Pitchers (\"closers\.") Each of these rolesrequires specialization

\\

-K

of

quality

many reasons, also

makes

which

higher,

has the

Why

are

was

himself

because declined.

has

hitter

standards are

*

Willie

weighed only 140 pounds.) a leading analyst of baseball history, James, and

-,

\"

'

g

also may

8

batters

specialize

out, or

in

in facing left-handed or right-handed batters to hit balls on the

getting

batters,

ground.

in striking Similarly,

few

defensive positions; most specializein only in defense (to the detriment of their one. Some players specialize hitting | @ in late in the game to skills); these \"defensive specialists\" can be brought batted .400 has increased protect a lead. Even in managing and coaching, specialization a century ago? marked|y Relief pitchers now have their own coaches, and statistical specialists use computers to discover the weaknesses of opposing hitters. in specialization The net result of these increases is that even the weakestof today's teams With no \"weaklings\" to pick on, hitting .400 over play highly competent defensive baseball. an entire season has become a near-impossible task.

fielders

|

play

today

multiple

OF COMPARATIVE ADVANTAGE

SOURCES

the individual to be the result of level, comparative advantage often appears inborn talent. For instance,somepeopleseemto be naturally at gifted while others seem to have a knack for bikes. But programmingcomputers special fixing is more often the result of or education, training, comparative advantage experience. Thus, we usually leave the design of kitchens to people with architectural the of contracts to who have studied law, and the teaching training, drafting people in of physicsto peoplewith advanced that field. degrees

At

national

the

At

natural resources

which

Canada,

farm and

in

has

forest land, has

may

derive

or culture.

from

differences

in

The United States,which

world's leadingresearchuniversities, has of electronic hardware and design computing one of the world's highest endowments per-capita in a comparative the advantage production of

share of the

advantage

comparative software.

in society

differences

a disproportionate

has

advantage

level, comparative

or from

a

the

of

in the explain why Colorado specializes as an ocean resort. skiing industry specializes noneconomic factors also can give rise to comparative Seemingly advantage. For instance, the emergence of English as the de facto world language gives Englishin countries a comparative advantage over non-English-speaking nations speaking the production of books,movies, and music. Even a institutions popular country's affect the likelihood that it will achieve may comparative advantage in a particular will tend to have a pursuit. For example, cultures that encourage entrepreneurship in the introduction of new whereas those that comparative advantage products, standards of care and will tend to have a promote high craftsmanship comparative agricultural products.

Topography Hawaii

and climate

while

advantage aFor

in the

an interesting

evolutionary

production

of

high-quality

discussion of specialization

biologist, see StephenJay

Gould,

and the

variants

of established

decline of the .400 hitter

Full House (New

York:Three

products.

from the perspective of an Rivers Press, 1996), Part 3.

COMPARATIVE ADVANTAGEAND

What

Televisions

and

the United

States,

but

digital video

TV and

the

these

research,

in

part

ifc

in

first-produced

share of the by this country's

a minuscule

was supported

in turn

which

41

markets?

(DVRs) were developedand

U.S. accounts for only This is explained products. the

today

in technological

advantage

in

recorders

video

digital

world production of comparative

U.S. lead

to the

happened

2.2

Naturalist

Economic

The

PRODUCTIONPOSSIBILITIES

by

total

country's

education. Other factors were high system of higher contributing expenditureson the of electronic componentsfor the military and a culture that development As for the production of these the actively encourages entrepreneurship. products, United States enjoyed an early advantage partly because the product designswere themselves favored facilities located in close evolving rapidly at first, which production to the product designers.Early production also relied intensively proximity techniques in the United on skilled States. In time, however, product labor, which is abundant

outstanding

Both

automated.

production

more complex manufacturing

of these

to greater factories located

changes gradually workers. And at that point, no longer

could

States

United

many of the

and

stabilized

designs

led

compete

with

in

less-skilled

relatively

like the

countries

high-wage

in low-wage

located

those

were

operations

reliance on

areas overseas. Why unable

was to

the United States remain competitive of televisions

a manufacturer and other electronic

EXCHANGEAND

RECAP

from exchange

Gains

in

advantages

advantage

a web

producing in

producing,

page\342\200\224measured

is smaller

than

COST

OPPORTUNITY

are possibleif

have comparative trading partners different and services. You have a comparative goods if web cost of producing say, pages your opportunity in terms of other production opportunities forgone\342\200\224

the corresponding

opportunity costsof

your

partners.

trading

production is achieved if each person specializes in producing the in which or service he or she has the lowest opportunity cost (the good of makes Principle Comparative Advantage). Comparative advantage specialization worthwhile even if one trading partner is more productive than others, in absolute terms, in every activity. Maximum

COMPARATIVE

ADVANTAGE

PRODUCTION

POSSIBILITIES

AND

and specialization allow an economy to produce more In this section, we gain tries to a little of person produce everything. into the of a graph that insight advantages specializationby introducing usedto describethe various combinations of goods and services that an advantage

Comparative

if each

than

further

can be

economy can produce.

POSSIBILITIES

PRODUCTION

THE We

begin

coffee

and

with pine

a hypothetical economy in which nuts. It's a small islandeconomy

picking or of gathering pine valley. The more time coffee

available

for

with a

gathering

beans

nuts

smaller amount

workers

So of

if

spend people

nuts.

two goods

only and

grow on small bushes on that fall from trees on the

that

nuts.

CURVE \"production\" the

steep

island's

are produced:

either of valley floor the overlooking

consists central

hillsides

picking coffee, the less time want to drink more coffee, they

they

must

have

make

do

equipment?

as

CHAPTER2

42

COMPARATIVE

possibilities curve a the maximum of one good that can be

production

describes

that

graph

amount

produced for every of production

level

possible

of the

other

good

ADVANTAGE

If we know how productive workersare at each we can summarize the activity, various combinations of coffee and nuts they can produce each day. This menu of is known as the production possibilities curve. possibilities in which the economy has To keep matters simple, we begin with an example a worker who can divide her time between the two activities. only single

Production PossibilitiesCurve

EXAMPLE 2.3

What

is the

possibilities

production

only worker?

curve for an

economyin

which

Susan

is the

Consider a societyconsistingonly of Susan, who allocates her production time coffee and nuts. She has nimble fingers, a quality that makes her more 2 at coffee than at nuts. She can productive picking gathering gather pounds of in an hour. If she works a total nuts or pick 4 pounds of coffee of 6 hours per day, describe her productionpossibilities curve\342\200\224the graph that displays, for each level of nut the maximum amount of coffee that she can pick. production, The vertical axisin Figure 2.1 shows Susan's daily production of coffee and the horizontal axis shows her daily of nuts. Let's at two production begin by looking extreme allocations of her time. First, supposeshe employs her entire workday 4 coffee.In that since she can of (6 hours) picking case, pick pounds coffee per hour, she would pick 24 pounds That per day of coffee and gather zero pounds of nuts. A in combination of coffee and nut production is represented 2.1. by point Figure It is the vertical intercept of Susan's curve. production possibilities Now suppose, instead,that Susan devotes all her time to gathering nuts. Since she can gather 2 pounds of nuts her total would be per hour, daily production 12 pounds of nuts. That combination is represented by point D in Figure 2.1, the horizontal intercept of Susan's production curve. Because Susan's possibilities production of each is to the amount of time she devotes to good exactly proportional that the her curve will lie on good, remaining points along productionpossibilities between

the straight line

that

D.

A and

joins

FIGURE 2.1

Susan's Production

24
Possibilities.

For the

production

relationships

production curve

is a

given,

the

possibilities straight line.

s/day)

Production

\\

/

\\

c

and

nuts

nod)

offee

____\\c

CO

U

\\d

4

0 Nuts

8 (pounds/day)

12

possibilities curve:

that can

be produced

All with

of coffee

combinations Susan's

labor

COMPARATIVE ADVANTAGEAND

PRODUCTIONPOSSIBILITIES

43

coffee example, suppose that Susan devotes 4 hours eachday to picking X hours to gathering nuts. She will then end up with (4 hours/day) (4 pounds/ = of coffee hour) = 16 pounds per day and (2 hours/day) X (2 pounds/hour) 4 pounds of nuts. This if she is the point labeled B in Figure 2.1. Alternatively, 4 to nuts, she will get (2 hours/day) X (4 pounds/ devotes 2 hours to coffee and = 8 pounds of coffee per day and (4 hours/day) X (2 pounds/hour) = 8 hour) pounds of nuts. This alternative combination is represented 2.1. by point C in Figure Since Susan's production possibilities curve is a straight line, its slope is (PPC) constant.The absolute value of the slope of Susan's PPC is the ratio of its vertical to its horizontal of (24 pounds intercept intercept: coffee/day)/(12 pounds of nuts/ = of of (2 pounds coffee)/(1pound nuts). (Be sure to keep track of the units day) of measure on each axis when this Susan's ratio.) This ratio means that computing 2 cost an additional nuts is opportunity of poundof pounds of coffee. Note that Susan's opportunity cost (OC) of nuts can also be expressed as the formula: following simple For

and 2

in coffee

loss OC

gain where \"loss in

by this

is expressed

coffee

increasein

nuts.

lossin

Vi

pound

cost of an opportunity to equivalent saying that her

Susan's

The downward slope of the production the Scarcity Principle\342\200\224the idea

more

of one

good

thing

generally

cost of

nuts

(2.2)

additional pound

of

opportunity cost of

nuts

is 2

pounds of of coffee is

a pound

she has to pay she has to pay point

said to be an

for

an additional

for

an additional

that

lies either

attainable

point,

curve shown in Figure possibilities because our resources are limited,

that

(see having to settle for less of another pound of coffee if she wishes, but only if she If Susan is the only in the economy, person

becomes,

in

effect,

pound of coffeeis half a pound of nuts is 2 pounds

Thus, the price of nuts, or the price

its price.

pound

of coffee. the along production possibilitiescurve meaning

2.1

means

1). Susan can have an additional to give up half a pound of nuts. her opportunity cost of producing a good Chapter

is willing

Any

\"gain in nuts\"

of nuts.

illustrates having

and

opportunity

-n coffee*

gam

coffeeis thus

up

Susan's

Likewise,

formula:

OCcoffee To say that

(2.1)

'

nuts

of coffee given

the amount

means

coffee\"

means the corresponding

in

that

it

can

be produced

or

within

with currently

it is

2.2, for example, pointsA, B, C, D, and E are attainable Points that lie outside the production possibilities curve are said to be points. that cannot be available resources. unattainable, meaning they produced using currently In Figure 2.2, F is an unattainable point becauseSusan cannot 16 pick pounds of coffee per day and gather 8 pounds of nuts. Points that lie within the curve are said in the sense that existing resourceswould allow for to be inefficient, of production more of at least one goodwithout the of other At sacrificing production any good. 8 pounds of coffee per day and gathering E, for example, Susanis picking only 4 pounds of nuts. This means that she could increase her coffee harvest by 8 pounds without nuts Susan per day giving up any (by moving from E to B).Alternatively, 4 could as as additional of nuts each without gather many pounds day giving up to C). An efficient point is one that lies the any coffee (by moving from \302\243 along production possibilities curve. At any such point, more of one good can be produced less of the other. only by producing available

resources.

In Figure

a

Scarcity

attainable

point

any

combination of goods that

can

be produced using currently available resources

unattainable

any

point

of goods that

combination

cannot be produced available

currently

inefficient combination of currently an

any

point

for which

goods

resources

available

increase

using

resources

in the

one good without

enable

production of in

a reduction

the production of the

other

efficient point any combination of goods for which currently available resources do not allow an increase

in

the

production

one good without a reduction the production of the other

of in

CHAPTER 2

44

ADVANTAGE

COMPARATIVE

2.2

FIGURE

Attainable

and

24
Efficient

on Susan's

Points

Possibilities

Production

Curve. that

Points production (for

lie either along the curve possibilities

example, it (for

within

A, 8, C, and D)

example,

be attainable. lie outside the

said to that

-1

are \302\243) (pounds/day)

Points production

00

curve (for example, F) are unattainable. Points that lie along the curve are said to be efficient, while those that lie within the curve possibilities

are said

\302\243-Y

or

Coffee

--if-^jp

\\D

! 0

to be inefficient.

12

8

4

Nuts (pounds/day)

2.2

CHECK

CONCEPT

For the PPC shown

in

Figure

2.2, state

whether the

following

points

are

attainable

and/or efficient:

a.

20 pounds

per

day of

b.

12 pounds

per

day

c.

4 pounds per

day

6 pounds

of coffee, of coffee,

8 pounds

AND POSITIONOF an

2.4

How do

of

nuts.

per

day

day

of

nuts.

AFFECTS THE SLOPE

the production curve depend on possibilities let's compare Susan's PPC to that of Tom, who is less but more productive at gathering nuts.

productivity, coffee

picking

changes in

is short

that

the opportunity

keen eyesight,qualities that beneath

fall

pounds

describe

affect

productivity

and has

for gathering nuts of nuts or pick 2 economy,

per

Changes

Productivity

Tom

nuts.

how the slope and positionof

individual's

productive at EXAMPLE

of

PPC

THE

To see

per day

PRODUCTIVITY

INDIVIDUAL

HOW

coffee, 4 pounds

of

coffee

the economy's

trees on the per

hour.

make

cost of nuts? him

especially

hillsides. He can gather

If Tom

well-suited 4 pounds

were the only person

in

the

production possibilitiescurve.

Tom's PPC the same way we did Susan's. Notefirst that if an entire workday (6 hours) to coffee he ends up with picking, = X 12 of coffee and zero (6 hours/day) (2 pounds/hour) pounds per day poundsof nuts. So the vertical intercept of Tom's PPC is A in Figure 2.3. If instead he devotes = 24 pounds X (4 pounds/hour) all his time to gathering nuts, he gets (6 hours/day) of nuts means the horizontal per day and no coffee.That intercept of his PPCis D in 2.3. Because Tom's of each is to the amount of Figure production good proportional time he devotes to it, the remaining points on his PPC will lie along the straight line that these two extreme points. joins We

Tom

can

devotes

construct

ADVANTAGE

COMPARATIVE

AND PRODUCTION POSSIBILITIES

FIGURE N)

^

y

^^^

Tom's production and

coffee

curve:

possibilities

nuts that can

All combinations of

be produced

with

Tom's

labor

PossibilitiesCurve. Tom's

opportunity

cost of

of nuts producing one pound is only half a pound of coffee.

>S6

00

2.3

Tom's Production

(pounds/day) -^

h

^|^^

8

16

Coffee

0

Nuts

24

(pounds/day)

he devotes 4 hourseach day

hours to = 8 nuts, (4 hours/day) gathering pounds/hour) pounds of = 8 X coffee and of nuts (2 hours/day) (4 pounds/hour) per day pounds per day. if he devotes 2 hours to This is the point labeled B in Figure 2.3. Alternatively, = 4 4 to nuts, he'll get (2 hours/day) X (2 pounds/hour) coffee and pounds of coffee = 16 X and of nuts. This alternative (4 hours/day) (4 pounds/hour) per day pounds combination is represented by point C in Figure 2.3. How does Tom's PPC comparewith Susan's? Note in Figure 2.4 that because Tom is absolutely less productive than Susan at picking coffee, the vertical intercept of his PPC lies closer to the origin than Susan's. By the same token, becauseSusanis less than Tom at the horizontal nuts, absolutely productive gathering intercept of her PPC lies closerto the origin than Tom's. For Tom, the opportunity cost of an additional of nuts is of which is one-fourth Susan's cost of Vi coffee, pound pound opportunity in the slopes of their nuts. This difference in opportunity costs shows up as a difference PPCs: The absolute value of the slope of Tom's PPC is %, whereas Susan'sis 2. For example, if he'll

end up

to

coffee

picking

and 2

X (2

with

2.4

FIGURE 24

Individual

\\

^

PPC

Susan's

Compared.

\\>r

X ri

Tom

\"D
C

productive

3

12 \302\247.

s^

a

\302\243

o

^

^**^^^

0

Tom's

PPC

24

12

Nuts (pounds/day)

In this advantage

over

is less

coffee

U

example, Tom has both an absolute advantage in gathering nuts. Susan, for her part, Susan

advantage and a comparative

Production

Possibilities Curves

advantage

over

and a comparative has both an absolute

Tom in picking

coffee.

productive

than Susan, but in nuts.

in

more

45

46

CHAPTER

2

COMPARATIVE ADVANTAGE

We cannot is a

Advantage

or more

two

emphasize strongly

relative

concept\342\200\224one

people (or

CONCEPT Suppose

hour; Tom can pick is Susan's

What

makes

countries) are being compared.

pick 2 pounds I

pound

of

of coffee

coffee

per

or gather 4 pounds

per hour hour

opportunity cost of gathering a pound of nuts? Where

of gathering

opportunity cost

of Comparative the productivities of

2.3

CHECK

Susan can

the Principle sense only when

that

enough that

and

gather

a pound

does

I

pound

of

of nuts

nuts

per

per hour.

of nuts? What is Tom's Susan's comparative advantage

now lie?

THE GAINS

FROM SPECIALIZATIONAND EXCHANGE

in individual that a comparative advantage arising from disparities costs creates for 2.1 and (see Examples 2.2). The opportunity gains everyone shows how the same can be illustrated following example point using production saw

we

Earlier

curves.

possibility

EXAMPLE 2.5

Specialization How

is failure

costly

Suppose that

in

to specialize?

Example

2.4 Susan

and Tom had divided their time so that each and half coffee. How much of each good to consume? How much could they have for which he or she a activity enjoyed

person's output consisted of half nuts would Tom and Susanhave been able if each had specializedin the consumed advantage?

comparative

of nuts in an hour as poundsof produce twice as many pounds 2 hours picking coffee of he must each, quantities spend for every to gathering nuts. And since he works a 6-hour day, that 2 hours gathering nuts 4 hours picking coffee. Dividing his means and spending in this way, he'll end up with time 8 pounds of coffee per day and 8 poundsof nuts. since Susan can produce twice as many of coffee in an hour as Similarly, pounds 2 hours gathering of to of she must nuts, each, pounds pick equal quantities spend nuts for every hour she devotes to pickingcoffee.And since she too works a 6-hour 2 hours picking coffee 4 hours gathering nuts. So, that means and day, spending like Tom, she'll end up with 8 pounds of coffee per day and 8 pounds of nuts. (See thus be 16 pounds of each Figure 2.5.) Their combined daily production will in had each their activities contrast, good. By they specialized respective of comparative their combined daily production would have been advantage, 24 pounds of each good. If they coffee and nuts with one another, each can consume a exchange if exchange combination of the two goods that would have been unattainable had not 12 in been possible. For example,Susan can Tom of coffee give pounds exchange for 12 pounds of nuts, each to consume 4 pounds per day more of each good enabling E in Figure 2.5, than when each produced and consumed alone. Note that point which has 12 pounds of each lies each per day good, beyond person'sPPC,yet is attainable with and easily specialization exchange. Since

coffee,

Tom can

to produce equal hour he devotes

ADVANTAGE

COMPARATIVE

AND PRODUCTION POSSIBILITIES

FIGURE

24 \\

^

When

Tom and Susan divide time so that

produces (pounds/day)

U

B

!

^^^

|

12

8

0

Nuts

the

As

larger as the

concept check

following

24

(pounds/day)

illustrates, the

from

gains

specialization

grow

costs increases.

in opportunity

difference

Tom'sPPC

^

CONCEPT CHECK2.4 do

How

in opportunity

differences

Susan can

pick 5 pounds

cost affect the

from

gains

specialization? of nuts in an hour.

Tom can or gather 5 pounds of nuts in an hour. Assuming they again work 6-hour days and want to consume coffee and nuts in equal quantities, by how much will specialization increase their consumption to the alternative in compared which each produced only for his or her own consumption?

pick

I

pound

of coffee

or gather

I

pound

of coffee

in and exchange grow with increases these differences alone among trading partners, in living standards account for the enormous differences in between rich and poor countries. income the 20 richest countries in the Average for was over to $400 $47,000 year 2008, example, per person, compared only per in the 20 countries.2 we will more later about person poorest Although say in explaining specialization's role these differences, we first discuss how to construct the PPC for an entire economy and examinehow factors other than specialization cause it to shift outward over time. might the

Although

from

gains

the differences in opportunity still seem insufficient to

A PRODUCTION MANY-PERSON

Although

most actual

constructing

a production

specialization

costs

POSSIBILITIES CURVE FOR A ECONOMY

economiesconsistof possibilities

millions

curve for an

of workers,

economy of

the process of size is really no

that

different from the process for a one-person Consider again an economy economy. which the only two goods are coffee and nuts, with coffee again on the vertical axis and nuts on the horizontal axis.The vertical of the economy's PPC is intercept

in

countries: Australia, Austria, Belgium, Brunei Darussalam, Canada, Denmark, Hong Netherlands, Norway, Qatar, Singapore, Sweden, Kong, Iceland, Ireland, Kuwait, Luxembourg, United Arab Emirates, United and United States. Low-income countries: Switzerland, Kingdom, Afghanistan, Comoros Congo, The Democratic Republic Burundi, Central African Republic, Of Eritrea, Ethiopia, Guinea, Guinea-Bissau,Haiti, Liberia, Madagascar, Malawi, Mali, Mozambique,Niger, Rwanda, Sierra Leone, Togo, and Zimbabwe. (Source: IMF 2010 www.gfmag.com/tools/global-database/economic-

2High-income

data/10299-the-worlds-richest-and-poorest-countries.html#axzzlUkVpJon2)

the

same

each number

of coffeeand nuts, they can consume a total of 16 pounds of coffeeand 16 pounds of nuts each day. of pounds

^

^^V

00

without

Specialization.

PPC

Susan's

their

offee

2.5

Production

47

CHAPTER 2

48

FIGURE

ADVANTAGE

COMPARATIVE

2.6

Possibilities

Production

Curve for

Economy. For an economy

of workers, has a gentle

1^

a Large

the

:::::::^!!^^^c

OOlO

with millions PPC typically

outward

bow

pounds/day) of

shape.

(1,000s

Coffee

1

OlO

1_

^

75!80 77

30

20

0

L^1\342\200\224

Nuts

(1,000s

of pounds/day)

the total amount of coffee that could be picked if all available workers worked full time picking coffee.Thus, the maximum attainable amount of coffee production in Figure 2.6 as 100,000pounds is shown for the hypothetical economy per day amount chosen for illustrative The horizontal (an arbitrarily, purposes). intercept of the PPC is the amount of nuts that could be gatheredif all available workers worked full time gathering shown for this same as nuts, 80,000 pounds economy chosen But note that the PPC shown in the per day (alsoan amount arbitrarily). is not a straight line\342\200\224asin the earlier examples involving only a single diagram worker\342\200\224but rather a curve that is bowed out from the origin. in We'll more a moment about the reasons for this shape. But first note that a say PPC means that the cost of nuts increases as the bow-shaped opportunity producing more of them. for that when the moves Notice, economy produces example, economy

from

A,

where

by giving up still

further,

it is only

producing

per

pounds

5,000

however\342\200\224for

5,000 pounds

of

coffee,

increasing

note that

per day

to B, it

gets 20,000

day of coffee.When

nut

pounds of production

nuts

per day is increased

from B to C\342\200\224theeconomy again this time gets only 10,000 additional yet cost persists over the entire opportunity in moving from D to E, the economy again but now gains only 2,000 pounds a day

by moving

example,

gives up 5,000 pounds per day pounds of nuts. This pattern of of the PPC. For example, length gives up

coffee,

only

of

coffee

same pattern of increasingopportunity cost to Note, finally, applies coffee. Thus, as more coffee is produced, the opportunity cost of producing additional coffee\342\200\224as measured that must be sacrificed\342\200\224also rises. by the amount of nuts is the PPC for the The answer lies in Why multiperson economy bow-shaped? the fact that some resources are relatively well-suited for gathering nuts while others are relatively well-suited for picking coffee. If the economy is initially producing only coffee and wants to begin producingsome nuts, which workers will it reassign? Recall Susanand Tom, the two workers discussed in the preceding example, in which of

nuts.

that

Tom's comparative advantage

the

nuts and Susan's comparative gathering workers were coffee and you picking currently picking wanted to reassignone of them to gather nuts instead, whom would you send? Tom would be the clear choice, becausehis departure would cost the economy only half as much coffee as Susan's and would augment nut production by twice as much. The principleis the same in any large multiperson economy, exceptthat the of opportunity cost differencesacrossworkers is even greater than in the range earlier two-worker As we workers from coffee example. keep reassigning production advantage was

coffee.

was

If both

FACTORS THATSHIFT

sooner or later we

nut production,

to

Susan from

coffee

opportunity

cost

The

shape

the general

shouldalways

this the the most The

principle

accessible

resources

with the lowest

resource

A Note should

opportunity costs, we

opportunity cost first. fruit picker's rule of

We

call

picking

Opportunity Cost (alsocalledthe\"Low-Hangingproduction of any good, first employ those

In expanding the lowest opportunity

the

2.6 illustrates

of the

honor

in

like

first:

fruit

of Increasing

with

cost, and

only

turn

afterward

to resources

costs.

opportunity

higher

Why

the

in Figure

shown

different

have

resources

Low-Hanging-Fruit Principle,

Principle\:")

with

possibilities curve

when

that

exploit

Principle

Fruit

of the production

specialists

on the Logic of the Fruit Picker's Rule a fruit picker harvest the low-hanging fruit

first? This

rule makes sense

(and hence cheaper) to low-hanging if and he on a limited amount of fruit to begin with, he pick, planned picking only would come out ahead the less-accessible fruit on the clearly by avoiding higher branches.But even if he planned on picking all the fruit on the tree, he woulddo better to start with the lower branches first because this would enable him to enjoy the revenue from the sale of the fruit sooner. The fruit picker's job can be likened to the task confronting a new CEOwho has been hired to reform an inefficient,ailing The CEO has limited time and company. so it makes sense to focus first on problems that are relatively easy to attention, correct and whose elimination will provide the biggest improvementsin performance\342\200\224 the fruit. Later smaller on, the CEO can worry about the many low-hanging needed to raise the from to excellent. improvements company very good for

For one, the

reasons.

several

Again, the important

to take

the

opportunities

an

that

economy

two goods, the

produces

is to

be sure

first.

ADVANTAGE AND

POSSIBILITIES For

Principle

Low-Hanging-Fruit

most favorable

COMPARATIVE

RECAP

is easier

fruit

message of

of your

advantage

PRODUCTION

production possibilitiescurve

of one good that can be produced for every level of of the other good. Attainable are those possible production points that lie on or within the curve and efficient points are thosethat lie along the curve. The slope of the production curve tells us the possibilities opportunity cost of producing an additional unit of the good measuredalongthe horizontal axis. The Principle of Increasing Opportunity Cost,or the Low-HangingFruit tells us that the slope of the production curve Principle, possibilities becomes steeper as we move downward to the right. The greater the differences among individual costs, the more bow-shaped the opportunity productionpossibilities curve will be; and the more bow-shaped the production the the from will be. curve, possibilities greater potential gains specialization describes

FACTORS

the

maximum

amount

THAT

SHIFT

PRODUCTION As

its

name

implies,

is to

with

the production

a trade-off.

THE ECONOMY'S

POSSIBILITIES CURVE

production options open to any society

49

reassign others whose

Indeed, we must eventually nuts is far higher than hers.

production. of producing

PRODUCTION POSSIBILITIESCURVE

ECONOMY'S

coffee

even

withdraw

must

THE

possibilities curve

society.

At any

provides

The only way people can produceand

produce and consumelesscoffee.In the

long

a summary

of the

given moment, the PPC confronts run,

however,

consume

it is

more

nuts

often possible

Increasing

a

Opportunity

Cost

CHAPTER

50

FIGURE

Economic Outward

2

COMPARATIVEADVANTAGE

2.7

Growth: An in the

New

Shift

PPC

Economy's PPC. Increases

in productive

resources (such as labor capital equipment) or improvements

and

in knowledge

and technology causethe PPC to shift outward. They are the main factors that drive economic growth.

Nuts (1,000s

to increaseproduction economic

the

growth.

when peoplespeak of Figure growth is an outward shift in in the curve. It can result from increases possibilities This is what is meant

all goods.

production

economy's

amount

of

As shown

in

2.7,

of productive resourcesavailable

technology

render

that

existing

the

causes

What

factor is investment

quantity in

of pounds/day)

economic

or

resources

from

improvements

or

in knowledge

more productive.

of productive resourcesto grow in an economy? One and equipment. When workers have more and their often This increases, productivity dramatically. behind the differences in living standards between rich to one study, for example, the value of capital

factories

new

equipment to work with, is surely an important factor and poor countries.According better

30 times as great as in Nepal.3 worker don't occur all at once. They are a capital per in of even of differences rates of savings and decades, centuries, consequence investment. Over of investment can translate into time, even small differences in rates in the amount of capital equipment available to each extremely large differences worker. Differences of this sort are often self-reinforcing: Not only do higher rates of saving and investment cause incomesto grow, but the resulting income higher levels also make it easier to devote additional resources to savings and investment. investment

per

worker

in the

United Statesis about

Such large differences

Over

time, then,

translate into

very

in

even small initial large

productivity

income

advantages

from

specialization

can

gaps.

PPC curve to shift outward and Population growth also causesan economy's thus is often listed as one of the sources of economic growth. But because populationgrowth also generates more mouths to feed, it cannot by itself raise a country's standard of living. Indeed it may even cause a declinein the standard of living if densities have to on available land, existing population already begun put pressure and other resources. water, in sources of economic growth are improvements Perhaps the most important and As economists have s uch knowledge technology. long recognized, improvementsoften lead to higher output through increased specialization. Improvements in technology often occur spontaneously. More frequently are directly or they indirectly

the

Earlier

opportunity 3Alan

Heston

Comparisons,

of increases we discussed a

result

in

education.

two-person examplein

cost led to a tripling and Robert

of

Summers,\"The

1950-1988,\"

Quarterly

output

Penn

Journal

which

individual

from specialization

differences

in

(Concept Check 2.4).

World Table (Mark 5): An Expanded Set of Economics, May 1991, pp. 327-68.

of

International

FACTORSTHAT

PRODUCTIONPOSSIBILITIES

THE ECONOMY'S

SHIFT

are far more gains from specialization often spectacular than those in One reason is that not example. specialization only capitalizes on preexisting in individual differences skills but also deepens those skills and through practice it eliminates of the and costs experience. Moreover, many switching start-up people incur when they move back and forth among numerous tasks.Thesegains apply not only to people but also to the tools and equipment they use. Breaking a task down into machine, simple steps, each of which can be performed by a different

Real-world

the

workers. greatly multiplies the productivity of individual in simple settings, these factors can combineto increaseproductivity Even hundredsor even thousands-fold. Adam Smith, the Scottish philosopherwho is remembered as the founder of modern economics,was the first to recognize today the enormity of the gains made possible by the division and specialization of labor. for instance, his description of work in an eighteenth-century Scottish Consider, pin factory:

One man fourth

it, a

the head

make

a small

seen

fifth

requires two

three kind

they

pins of

cuts head;

it,

distinct

operations only ten

where

exerted

of pins in

pounds

thousand

four

of

or

a third

receivingthe

straightens

the top for

of this

when

could,

them about twelve upwards

it at

grinds

manufactory

. . . [who]

employed

another

the wire,

out

draws

points

are in

have

make among a pound

ten persons,

Those

size.

middling

to

men were

themselves,

a day. There

... I

a

it,

thousand therefore, could make among them upwards of forty-eight a tenth part of fortypins in a day. Each person, therefore, making thousand four thousand eight pins, might be consideredas making eight hundred pins in a day. But if they had all wrought separately and independently, and without been educated to any of them having this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day.4

The gains

in

They

prodigious.

the single

don't rely heavily

that

that

productivity

constitute

from specialization are indeedoften most important explanationfor why societies

result

on specialization and exchangehave

to keep

failed

pace.

HAVE SOME COUNTRIES BEENSLOWTO SPECIALIZE?

WHY

be asking yourself, \"If specialization is such a great thing, don't why in If in countries like people poor Nepal just specialize?\" so, you're good company. Adam Smith spent many years attempting to answer preciselythe same question. In the end, his explanation was that is an important population density You

may

precondition for

century

Smith,

specialization.

to be far

tended

than In

the

in

lone

the

in so

rural

Highlands

butcher,

In contrast, each of

4Adam Smith, 5IbicL,

chapter

and

3.

the

in

work

eighteenth

maker.5

had

these

Scottish they

been

same tasks was cities of Smith's able

too small and fragmented.

The Wealth

large

of Scotland:

of England

and very small villages which are scattered about as the Highlands of Scotland, every farmer ... A country baker, and brewer for his own family. not a joiner, a cabinet maker, only a carpenter, but in wood, as well as a wheelwright, a ploughwright,

a cart and waggon

were simply

naturalist, observedthat

cities

country

carpenter ... is and even a carver

the large English have specialized

the

houses

desert a be

must

ever the economic

more specialized in

of Nations

performed by a different

to, but the Of

course,

(New York: Everyman's

markets

in

which

high population Library,

in

specialist

day. ScottishHighlanders

would

also

they

participated

density

1910 [1776]),

by

book 1.

itself

CURVE

51

CHAPTER2

52

COMPARATIVE

ADVANTAGE

that specialization will result in rapid economic growth. But arrival of modern shippingand electronic communications especially low was a definite obstacleto technology, population density gains from specialization. remains one of the most remote and isolated countries on the planet. As Nepal as the its was less than 30 people mid-1960s, recently average population density per in mile f or to more than mile (as compared, example, 1,000 people per square square no guarantee before the

provides

1\342\200\224r l* \342\226\240*'.'*

Specialization was further

New Jersey).

goods and services

rugged terrain. Exchanging

by Nepal's

villages was difficult,

the

because

nearest

be reached only after trekking several hours, or even days, village over treacherous trails. More than other factor, this extreme isolation Himalayan any accounts for Nepal's failure to benefit from long-standing widespread specialization. the Population density is by no means the only important factor that influences of be for degree specialization. Specialization may severely impeded, example, by laws and customsthat limit people's freedom to transact freely with one another. The communist governments of North Korea and the former East Germany restricted which helps explain why those countries achieved far exchange severely, less specializationthan South Korea and the former West Germany, whose

taw

VCl^3Sp*

i

***^.

CAN WE Can specialization

too far?

proceed

specialization

For example,most tends to be one of

that

fact

better than

to casualties

appear

people

first

boosts productivity does not mean that for also entails costs. less, specialization enjoy variety in the work they do, yet variety as workplace tasks becomeever more

specialization

is always the

SPECIALIZATION?

MUCH

TOO

mere

of exchange.

supportive

HAVE

Of course, the more

could

more

far

were

governments

cases

most

in

h

limited

of other

residents

with

specialized.

narrowly

-fit

III

a/Eft to

JqvV

-fttW irt

e^

COVERS1>te-

l>\\

iAEGE

tasks

IN

THE

\\

\\

Indeed,

on ,

LATEST

T\302\243U_YouAH

v/\302\243Am\302\243R

A#0UT

workplace

fo T^E

To

one of Karl Marx's central themes was that the fragmentation of exacts a heavy psychologicaltoll on workers.Thus, he wrote,

often

All means for the development of production ... mutilate the laborer into a fragment of a man, degradehim to the level of an appendage of a machine, of charm in his work and turn it destroy every remnant into hated toil.6

Charlie Chaplin's psychological

6Karl

Marx,

costs

1936 film

of repetitive

Das Kapital (New

Modern

Times

factory work.

York: Modern

Library),

As

paints an

a vivid portrait of the worker, Chaplin's

assembly

pp. 708,

709.

only

task, all

every

day

on the assembly

to

day, is

tighten

line. Finally,

he

the

snaps

nuts on two and staggers

53

AND INTERNATIONAL TRADE

ADVANTAGE

COMPARATIVE

bolts as they pass before him from the factory, wrenchesin

every nutlike protuberance he encounters. Do the extra goods made possible by specialization come at too high simply We must at least the for price? certainly acknowledge potential specialization to proceed too far. Yet specialization need not entail rigidly segmented, mind-numbingly tightening

hand,

repetitive work.

And

as well.Thosewho

it is

important

don't

specialize

a

to recognize that failure to specialize entails costs must accept low wages or work extremely long

hours.

said and

done,we

can

expect

up more

shortest

we

concentrate

a comparative

have

we

which

to meet life's financial obligationsin time to do whatever else we wish\342\200\224if time\342\200\224thereby freeing at least a significant proportion of our efforts on those tasks for

all is

When the

advantage.

AND

ADVANTAGE

COMPARATIVE

INTERNATIONALTRADE same

The

themselves.

one

one

with

As

be

may

individuals in an economy to specialize and exchange leads nations to specializeand trade among each nation can benefit from even though exchange, in absolute terms. the other productive than

that leads the another also

logic

goods with

individuals, more

generally

The Economic Naturalist

If

is so

nations

between

trade

beneficial,

why

are

2.3

agreements

free-trade

%>m

so

controversial?

One of the most heated issues in the 1996 presidential campaign was President Clinton's a treaty to sharply support for the North American Free Trade Agreement (NAFTA), reduce trade barriers between the United States and its immediate neighbors north and south. The treaty attracted fierce oppositionfrom candidate Ross Perot, who third-party insisted that it would is so beneficial, why

mean unemployment for does anyone oppose it?

millions

of American

workers.

If

r\\5

n

n ^

^

A

exchange

to international trade increasesthe total each nation, it does not guarantee that goods produced NAFTA individual citizen will do better. One specific concern regarding was that it would in the production of goodsmade help Mexico to exploit a comparative advantage by The

of

value

is that, while and services

answer

all

labor. Although

unskilled

goods, many their jobs to workersin Americans

barriers in

each

U.S. consumers would that unskilled

feared

from

benefit

workers

in

the

reduced United

prices for such would lose

States

Mexico.

over the vociferous oppositionof American labor have failed to detect overall losses far, however, significant job among in the United States, although workers there have been some losses in specific

In the

end,

NAFTA

unions. So unskilled

reducing

was

enacted

studies

industries.

If free

so

trade is so

many

why

great,

oppose

people

do

it?

OUTSOURCING in the news in recent has been the outsourcing of U.S. years the term once meant services performed by jobs. Although primarily having subcontractors outside the confines of the it connotes firm, anywhere increasingly the act of replacing American service workers with much relatively expensive in service workers overseas locations. cheaper A case in point is the transcription of medical records.In an effort to maintain accurate records, many dictate their case notes for later transcription after physicians In their the was often examining patients. past, transcription performed by the

An

service

issue

very

much

a term

outsourcing

used to connote performed

by

having

low-wage

increasingly services

workers

54

CHAPTER2

ADVANTAGE

COMPARATIVE

But secretaries also must attend to a variety of concentration. They must answer serve as phones, and so on. As insurance and malpractice receptionists, prepare correspondence, disputes in medical litigation became more the 1980s and errors records 1990s, frequent during In response,many turned to independent became much more costly to physicians. services by full-time, dedicated specialists. companies that offered transcription Thesecompaniestypically served whose practices were located in physicians the same community. But while many of the companies that manage transcription servicesare still located in the United States, an increasing fraction of the actual work itself is now performed outsidethe United States. For example, Eight in northern California, enables physiciansto Crossings, a company headquartered upload voice dictation files securely to the Internet, whereuponthey are transmitted to transcribers who perform the work in India. The finished documents are then in electronic form, to physicians,who transmitted edit and even sign back, may them online.The advantage for physicians, of course, is that the fee for this service is much lower than for the same service performed domesticallybecausewage rates in India are much lower than in the United States. In China, Korea, Indonesia,India, and elsewhere, even highly skilled in the United professionals still earn a small fraction of what their just counterparts States are paid.Accordingly, face companies powerful competitive pressure to not low-cost from overseas b import just goods suppliers,ut also a growing array of

spare moments.

physician's secretary in other tasks that disrupt

professional services. As

As a

Bill Gates put

Chairman

Microsoft

business manager,

involved in can technologies

those

over the management

communicationtechnology

responsibilitiesfor work

to

a hard look at

that

closely

core

directly

Web

whether

another

work,

take

company

modern

and use

with the

Web

your

aren't

that

people\342\200\224now

are doing the work. In the

can push the freedomthe

style, employees

interview,

company

those tasks. Let

of employees

instead

partners

of your

and consider

competencies,

you to spin off

enable

a 1999

in

to take

need

you

Revisit the areas

competencies.

it

provides

Web

to its

work

limits.

In economic terms,the outsourcing of services to low-wage foreign workersis to the of exactly analogous importation goodsmanufactured by low-wage foreign workers. In both cases, the resulting cost savings benefit consumers in the United States. And in both cases, jobs in the United States may be put in jeopardy, at least An American worker's is at risk if it is possible to temporarily. manufacturing job the he from another at lower cost. By the same import good produces country if an American service worker's is at risk a can token, job lower-paidworker perform that same service somewhere else.

^WS

The EconomicNaturalist2.4 Is

economics

PBS

Paul

analysis with Jim

Hour

reporter from In the attempt outsourcing.7

Paul Solman's

job a

his associate Lee Koromvokis of current economic issuesfor Lehrer. Is it likely that his job will

and

Solman

depth

reporter

identify

In their

the

view,

7Frank Levy and Richard

Next Job Market

produce

video

for

segments

outsourcing?

that provide

PBS evening news program be outsourced to a someday

the

in-

The News low-wage

Hyderabad?

book, The New

to

candidate

likely

(Princeton,

Division

of

economists

Labor,

characteristics

of a job

that

is amenable

any

job

Murnane, The

NJ: Princeton

New

Division

University

that

Levy and

Frank make

it a likely

Richard

Murnane

candidate for

to computerization is also vulnerable of Labor:

Press,

2004).

How

Computers

to

Are Creating the

COMPARATIVEADVANTAGE

AND

INTERNATIONAL

55

TRADE

task means to break it down into units that can be rules. ATM machines, for example,were able to replace many of the tasks that bank tellers once performed because it was straightforward to reduce these tasks to a simple series of questions that a machine could answer. By the same token, the workers in offshore call centers who increasingly book our airline and hotel

outsourcing.To computerizea with

managed

simple

like computer basically following simple scripts much programs. So the less rules-baseda job is, the less vulnerable to outsourcing it is. Safest of all are those that Levy and Murnane describe as \"face-to-face\" jobs. Unlike most rules-based jobs, these jobstend to involve complex face-to-face communication with other people, kind of communication that dominates Solman's economics reporting. precisely the In an interview for the NewsHour, Solman asked Levy what he meant, exactly, by \"complex communication.\" reservationsare

I

\"Suppose

question currency?

word

say the

Am

I

b/7/,\"

does

is what

about

talking

Levy mean?...

that

you hear

responded,\"and Am I talking

a piece of to answer

about front

the

legislation,

of end of a duck?

Levy and

For example,

addition to someone's

is

it

someone'shouse Corvette

Chevrolet

of tasks that

category

for one reason or another difficult to see how someone

that

those

outsourcing\342\200\224namely, physicallypresent.

a second

describe

Murnane

to be

the worker

require

in China

Chicago suburb or repair a blown in Atlanta or fill a cavity in someone's tooth in a

or in

build an

could

India

head

to

vulnerable

less

are

Solman?

break

to

on

gasket

Los Angeles.

job appears safe for the time being. Because it and because many of his interviews can be face-to-face, communication, complex conductedonly in the United States, it is difficult to see how a reporter from Hyderabad could displace him. So on

both

Paul Solman's

counts,

involves

fact that

safe does not mean that it is most dentists continue to think themselves completely example, although immune from outsourcing, it is now possible for someone requiring extensive dental work to have the work done in New Delhi and still save enough to cover his Of course, the

and

airfare

is relatively

a job

For

sheltered.

a two-week vacation in India. are more than 135 million Americans in

force. Every three and 7 million find new jobs ones. At various points in your life, you are likely to be among this group in transition. In the long run, the greatest is the ability security available to you or any other worker to adapt to new circumstances. a education quickly Having good provides no guarantee but it should enable to a against losing your job, you develop comparative of tasks that require more than just executing a simpleset of rules. advantageat the kinds There

or

months

7 million

so, approximately

labor

the

their

lose

AND INTERNATIONAL

ADVANTAGE

COMPARATIVE

RECAP

of them

TRADE

like

Nations,

can benefit from

individuals,

partner may be more productive the

costs, expansions

the

domestic

between

difference

more of

a nation

exchange

than

exchange, even

though

in absolute

other

opportunity

benefits from

do not

the

costs and

exchange

nations.

But

citizen

will

do

hurt

in

guarantee that each individual

better. In particular, unskilled workersin high-wage the short run by the reduction of barriersto trade

countries with

8www.pbs.org/newshour/bb/economy/july-dec04/jobs_8-16.html.

trading

terms. The greater

world opportunity

other

with

one

low-wage

may be

low-wage foreign economics

reporter likely

whole

the

\\T/c

Is a

a piece

that is to think about only way you're going context of the conversation. But that's very complicated work down into some kind of software.\"8

The

It

the

And

that.

K

nations.

to

replace

Paul

56

COMPARATIVE ADVANTAGE

2

CHAPTER

SUMMARY

\342\200\242 One

production

of that good

a

absolute advantage over another of a good if she can produce more the other person. One person has

has an

person

in the

than

production

becauseof

is relatively more efficient than the other person at producing that good, her opportunity cost of producing it is lower meaningthat than her counterpart's. Specialization basedon is the basis for economic comparative advantage a good

of

production

exchange.

slicefor

person

or she is relatively

which he economic

if she

each

When

most

the

efficient,

that

resources

good,

only

efficient.

individual level, comparative advantage in talent or ability from differences or from

\342\200\242 At the

spring

in

differences

national those

include

and experience.

training,

education,

level, sources of comparative advantage innate and learned differences, as in

differences

language,

natural resources, and a host

other

of

a country's PPC to shift outward investment in new factories and in equipment, population growth, and improvements and technology. (L03) knowledge

\342\200\242 Factors

over

the

At

well as

factors.

for that

summarizing a society

efficiently. In a coffee and of coffee

simple economy that the

nuts,

production

PPC

shows

(vertical axis) possibleat

quantity

level

each

of nut production (horizontal axis).The slopeof the PPC at any point represents the opportunity cost of nuts in pounds of coffee.(LOl) at that point, expressed

The Advantage

O

(L04)

Advantage

of IncreasingOpportunity Cost (also called the \"Low-Hanging-Fruit Principle\ In expandingthe production of any good, first those employ resources with the lowest opportunity and afterward cost, only

Cost

D

with

higher

KEY

absolute advantage comparative

costs.

The Principle

resources

attainable

specialize

each (or each country) concentrates Everyone does best when person on the activities for which his or her opportunity cost is lowest.

Increasing

Opportunity

opportunity

of Comparative

Principle

prompts individuals to

PRIHCIPIES

(ORE

Comparative

logic that

their

more productive than the other, in absolute terms, for each good. For both individuals and the nations, benefits of exchange tend to be larger the larger the differences are between the trading partners'

only

produces

the maximum

cause

include

and exchange goods with one production another also leads nations to specialize and trade with one another. On both levels, each trading can partner benefit from an exchange, even though one may be

curve is a simpledevice possibilities the possible combinations of output can produce if it employs its resources

production

that

time

\342\200\242 The same

(LOl)

in \342\200\242 The

(LOl)

may

climate,

institutions,

culture,

(or the Low-Hanging-Fruit that in expanding the production of a society should first employ those are relatively efficient at producing that afterward to those that are less turning Cost

good,

any

(LOl)

everyone.

downward

states

Principle),which

making possible the largest

is maximized,

pie

specializes

the

Opportunity

at

task

the

in

curves slope possibilities which Scarcity Principle,

states that the only way a consumercan get more of one good is In economies to settle for less of another. whose workers have different costs of opportunity each the slope of the PPC becomessteeper producing good, as consumersmove downward the curve. This along in illustrates the change slope Principle of Increasing

in the

another

over

advantage

comparative

\342\200\242 All

efficient

(36)

(43) advantage

point

opportunity

(36)

to

TERMS (43)

inefficient point

point

turn

costs.

(43) outsourcing (53)

production possibilitiescurve unattainable

point

(43)

(42)

57

PROBLEMS

REVIEW

1. Explain what

a comparative

\"having

QUESTIONS

2. Why do

does

are poor

that people

saying

specialize

people

5.

the

become

that

and

economy's

boost

production

helped the United States to leading exporter of movies,books, music? (L03) have

factors

What

that

innovations

technological

labor productivity affect an curve? (L03) possibilities

becausethey

make more sense than saying their own servicesbecausethey perform

not

4. How will

at

advantage\"

means. producing a particular good or service What does \"having an absolute advantage\"at a good or service mean? (LOl) producing

world's

popular

are

(LOl)

poor?

a reduction in

3. How will

of hours

number

the

worked each day affect an curve? (L03) possibilities

production

economy's

PROBLEMS

1. Ted can wax a car in

car in

in

a car in

minutes.

30

60

What

a comparative

has

Tom can

minutes.

is each

wax a

man's

advantage

in

Mc

Graw

connect

|ECONOMICS

washing

(LOl)

and Bill are

2. Nancy

to replace

2 hours

at

advantage

either

mechanics.

auto

to replace

2 hours

and

or wash

minutes

a car a car? Who

of washing

opportunitycost

cars?

20

or wash

minutes

15

a set of

a set of

brakes. brakes.

State

and, for each

task

4 hours to replacea clutch hours to replacea clutch and whether has an absolute anyone

takes Nancy Bill takes 6

task, identify

has

who

a comparative

advantage. (LOl)

3. Considera society

between only of Helen, who allocates her time bread. Each hour she devotes to dresses sewing sewing 4 dresses and each hour she devotes to bread 8 loaves of yields baking yields bread.

consisting

and baking

dresses

(LOl)

a. If Helen

works a total

of

8 hours

per day, graph

her productionpossibilities

curve.

b. Using

your graph,

which

of

the

points

listed

below are

attainable and/or

efficient?

28

dresses

16

dresses

18

dresses

per day, per day, per day,

16 loaves per day. 32 loaves per day. 24 loaves per day.

that in Problem 3 a sewing machine is introduced that enables Helen Suppose to sew8 dressesper hour rather than 4. (L03) only a. Show how this development shifts her production possibilities curve. b. Indicateif the following are attainable and/or efficient before and points after the introduction of the sewing machine. 16 dresses per day, 48 loaves per day. 24 dresses per day, 16 loaves per day. \"An increase in c. Explain what is meant by the following statement: with to one increasesour productivity respect any good options for producing and consuming all other goods.\" 5. Susan can pick 4 pounds of coffee in an hour or gather 2 pounds of nuts. Tom in an hour or gather 4 poundsof nuts. can pick 2 pounds of coffee Each works 6 hours per day. (LOl, L03) a. What is the maximum number of pounds of coffee the two can pick in a day?

4.

b. What is the

maximum

number

of pounds

of nuts the two

can gather

in

a day?

fe?

Econ

McGraw-Hill

Visit your mobile app store and download

the

Frank:

Econ

app

Study todayl

58

CHAPTER 2

ADVANTAGE

COMPARATIVE

and Tom

c. If Susan

when they

d.

were pickingthe

per day, who would gather they still be able to pick? Now

of

pounds 8 pounds pounds

e. Would and

and

Susan

suppose

when

nuts

4 pounds to begin gathering and how many pounds of coffee

they

the

nuts,

Tom were gathering the maximum decided that they would like

of

20 pounds

pick each

of nuts would of

number

to begin picking coffee, and how many

of coffee per day. Who would the pick of nuts would they still be able to gather? it be possible for Susan and Tom in total to gather

should

of coffee

of pounds

number

maximum

they would like

that

decided

each

coffee

If so,

day?

26 pounds of

how much

nuts

of each good

pick?

person

point at 30 pounds of coffee per day, 12 pounds of nuts per day an attainable point? Is it an efficient point? of coffee per day, 24 pounds of nuts per day an g. Is the point at 24 pounds attainable point? Is it an efficient point? h. On a graph with of coffee per day on the vertical axis and pounds pounds of nuts per day on the horizontal axis, show all the points you identified in f. Is the

a-g.

parts

6? Refer

to the two-person economy

a. Supposethat

at a

If each

person specialized

price

$2

of

pound

per

advantage,

in Problem

described

Tom could

market

a comparative

b.

and

Susan

or

buy

for coffee

completely

in

how much

5. (L04) and nuts

sell coffee

the

could

in

good they

earn

by

for

he or

for which

world

the

and $2 per pound

selling

nuts.

she had all their

produce?

prices just described, what is the maximum amount of in the world Tom could buy market? What is the maximum of nuts? Would it be possible for them to consume 40 pounds

At

the

8 pounds c. In light of possible

each

day?

ability to buy and sell in world the same graph all combinations of the them to consume.

on

show

of coffee

for

\342\226\240

their

amount of

nuts

and

markets at the stated prices, two it would be goods

\342\226\240

CHECKS

CONCEPT

TO

ANSWERS

Susan

coffee

and

2.1

in programming

Productivity Pat

2 web

page updates

Barb

3 web

page

updates

per

in bicycle

Productivity I

hour

per hour

repair

3 repairs

repair

per hour per

hour

tell us that Barb has an absolute advantage over Pat While Barb, the mechanic, can update 3 web pages per 2. Barb's absolute advantage over hour, Pat, the programmer, can update only Pat is even greater in the task of fixing bikes\342\200\2243repairs per hour versus Pat's 1.

The entries in the in both activities.

But

as

in the

table

second example

programmer than Pat opportunity

Pat must

comparative comparative advantage

*

Denotes

this that

chapter, Barb

the fact that Barb is a better should update her own web

cost of updating a web page is 1 bicycle repair, a web give up only half a repair to update page. Pat has a over Barb at programming and Barb has a advantage over Pat at bicycle repair. (LOl)

page.Barb's whereas

in

doesnot imply

more difficult problem.

ANSWERSTO CONCEPT CHECKS

2.2

In the day

of

accompanying graph, is unattainable; is both attainable

nuts)

day of nuts) coffee,

per day

8 pounds

of

nuts)

(20 pounds per day of coffee, 4 poundsper B (12 poundsper day of coffee, 6 pounds per and efficient; and C (4 pounds per day of is attainable and inefficient. (L02)

A

24

1? 20 \"D

C

o

Q. 12

d

2.3

4

0

46 8 12

Nuts

(pounds/day)

cost of gathering

a pound of nuts is now Vi pound of cost of a of nuts is now opportunity gathering pound only 1 pound of coffee. So Tom has a comparative advantage at picking coffee and Susan has a comparative at gathering nuts. (L02) advantage

Susan's coffee

opportunity

and

Tom's

2.4 SinceTom

can

five produce to produce

times as

many

pounds

of nuts

in an

hour as

5 hours equal quantities of each,he must spend hour he devotes to gathering nuts. And since he picking coffee for every works a 6-hour day, that means 5 hours picking coffee and 1 hour spending nuts. his time in this way, he will end up with 5 pounds of gathering Dividing if she is to produce equal quantities each good. Similarly, of each good, Susan must spend 5 hours gathering nuts and 1 hour picking coffee. Soshetoo produces 5 pounds of each good if she dividesher 6-hour day in this way. Their

poundsof

coffee,

combined daily production will thus be 10 pounds of each good.By working and specializing, however, they can and consume a total together produce 30 pounds per day of each good. (L02)

of

59

CHAPTER

Demand

and

Supply

3

I

LEARNING

After reading this chapter, you should be able to:

'\342\200\242 \342\200\242

r

i.

OBJECTIVES

LOI Describehow

i

:

l

curves summarize

.

behavior

I

'

1

the

and suppl

demand

and

sellers

the

of buyers in the

marketplace.

L02 I1'

ii,

}

curves interact to

'*.'

determine

l

excess demand

there's

for

its price tends

a product,

L03 to

rise.

equilibrium

and quantity.

price

1.1 When

how

Illustrate

The

grocery

10 million residents for have

residents

within

of food

pounds

No doubt or

adequate

nutritionally

is produced

markets

restaurants,

stores,

eating

the

city

and drink many

and private kitchens at most a week or

and

Yorkers,

foods

buying

of

to

so. Sincemost and since

diets,

requires

of

to change.

millions

city each

the

people

least

a small

of

day.

Yet the entire process is astonishingly must somehow ensure that not system

transporting a fixed collectionof it

be quite an

would

(and well-managed)

army

to

carry

impressive out.

For example,the New only enough food is delivered to satisfy Yorkers' can't be too discriminating palates, but also the right kinds of food. There much pheasant and not enough smoked eel; or too much bacon and not enough canned tuna; and so on. Similar eggs; or too much caviarand not enough judgments more

complex

than that.

and

Explain

and

almost no food that

L04

apply

the

Principle

Efficiency

these

groceries at their favorite local little or no thought to the and resources required to feed city it is, nevertheless. Even if the

daily basis. But near-miraculous New York City consisted only of a given list of destinations each day,

operation, requiring at

York City's to feed the area's

favorite Italian restaurants, give

on a

residents

varied

is sufficient

proper,

nearly miraculous coordinationof supplying

highly

in New

moment

any

New York provisioning be delivered to locations throughout

New

at their

at

on hand

foodstuffs

shifts

in supply and demand curves cause prices and quantities

stock of

the

and demand

supply

P

-!'

!

Discusshow

the Equilibrium

Principle (also called \"The

No-Cash-on-

the-Table

Principle\.

62

SUPPLY AND

3

CHAPTER

DEMAND

within each categoryof food and drink: There must be the right amount cheese and the right amounts of provolone, gorgonzola, and feta. But even this doesn't begin to describethe of the decisions and actions complexity to our nation's with its bread. Someone has to decide required provide largest city daily where each of food a nd and particular type gets produced, how, by whom. Someone must decide how much of each type of food delivered to each of the tens of gets thousands of restaurants and grocery stores in the city. Someone must determine whether the in big trucks or small ones, arrange deliveriesshould be made that the trucks be in the at the and ensure that and drivers be available. time, right place right gasoline qualified Thousands of individuals must decide what role, if any, they will play in this be made

must

of Swiss

effort.

collective

Some

delivery trucks rather build houses.

\\ 1

1

i

\342\200\242 J1

~

\342\200\236 ' \342\226\240

A

\342\200\224 * .\"

^

*

-

^

\"

\\

r

^

w

' :

=^

% s

-- I ~~~

|

\"

\\ 7*

'

,

According

20,000 and 40,000 new

\" \" \342\226\240 * \342\226\240 :

'

shortage.

housing

houses

apartment

I

behind,peoplefrom

Uj'

\342\226\240

__ \342\200\236 #<

q

I

|

..,\342\200\236-,

|

j

|

\342\200\242l^ 1

I

s

f

| g.

J system

work

New

York

so much

City's food

better

neighborhoods

not

also

are planting only

shortage

relations between

strained

chronically

flower gardens!

a growing

of

land-

recalled, \"and [the landlord] photographer pulled it out, out the wires to his doorbell.\"1 T he for his landlord, pulled accused the of his efforts to renovate part, photographer obstructing the apartment. According to the landlord, the tenant preferred for in substandard the apartment to remain condition since that gave him an excuse to withhold rent payments.

Same city,

-\302\247 goods

Why does

the

the

selves,\"

-

*7

Yet, paradoxically, in the midst of this shortage, are being demolished; and in the vacant lots left

\302\253 sowe

I

.

between

needs

city

each year

and tenants.

lords

>\342\226\240

units

In one all-too-typical case,for example, a in a loft on the Lower East Side an photographer living waged eight-year court battle with his landlord that generated literally thousands of of legal documents. \"Once we put up a doorbell for ourpages

'

!

i

to one estimate, the

City is experiencing

York

New

rental housing, but i

or electricians.

housing merely to keep up with and to population growth replace existinghousing that is detein the riorated The actual rate of new construction beyond repair. is units As a America's result, city, however, only 6,000 per year. most densely populated city has been experiencing a protracted

t @

i

burgers at

or flip

restaurants,

upscale

plumbers

becoming

market.

housing

^. .:

in

almost

the

despite

involved,

'

chefs

choose to drive food right number\342\200\224must deliver lumber. Others\342\200\224again, the right just who fix these trucks rather than carpenters farmers rather than architects or

number and complexity of the tasks incomprehensible somehow the supplying of New York to get done City manages a store will run out of flank Oh, remarkablysmoothly. grocery occasionally steak or a diner will sometimes be told that someone else has just if episodes ordered the last serving of roast duck. But like these stick in memory, it is only because they are rare. For the most part, New York's food delivery system\342\200\224like that of every other city in the so seamlessly that it attracts no notice. country\342\200\224functions virtually in New York City's rental The situation is strikingly different

Yet

VSv

become

become

McDonald's, insteadof

*

trucks

Others must

must

others

bricklayers. Still

that the mechanics

become

number\342\200\224must

who

the

people\342\200\224just

than

than

those

two

services adequate

receive and the

different

strikingly

are available

patterns:

In the food

variety

and people

wide

in

income) are generally satisfied with

choices available

to

them.

In contrast,

industry,

(at least

what in

the

they rental

chronic and chronic dissatisfaction are shortages both buyers and sellers.Why this difference? The brief answeris that New York City relies on a complexsystem administrative rent regulations to allocate housing units but leaves industry,

n& among

its housing

market? of

Times

with

housing

distribution

aQuoted by

and

John

Magazine,

Tierney,

\"The Rentocracy: At the

May 4,1997,

p. 39.

Intersection of Supply

and

Demand,\"

New

York

HOW,

WHAT,

the allocation of food and demand. Although

hands of market

in the

essentially

AND FOR WHOM? CENTRAL

forces\342\200\224the

forces

PLANNINGVERSUSTHE

of supply

might suggest otherwise, both theory and experience in most that the chaotic and forces, suggest seemingly unplanned outcomes of market can do a better of economic resources than can a cases, (for example) job allocating if even the has the best of intentions. government agency, agency In this chapter we'll explore how markets allocate food, housing, and other goods and services,usually with remarkable efficiency despite the complexity of the tasks. To be sure, markets are by no means perfect, and our stress on their virtues is to some extent an attempt to counteract what most economists view as an underappreciation remarkable But, in the course of our by the general public of their strengths. we'll see markets function so most of the time and why discussion, why smoothly in bureaucraticrules and regulations work as well rarely solving complex economic problems. To convey an understanding of how markets work is a major of this course, goal and in this chapter we provide only a brief introduction and overview. As the course in considerably we'll discuss the economic role of markets more detail, proceeds, attention to some of the of markets as well as their paying problems strengths. intuition

FOR WHOM?

AND

HOW,

WHAT,

MARKET

PLANNINGVERSUSTHE No

city,

state,

or

of

society\342\200\224regardless

answer certain basiceconomicquestions. and other resources should we devote productionof food, and how much to providing

should we useto produce

And

how should the

In the

thousands

each

resulting

good? goods

of different

how For

to

it is

organized\342\200\224can

example,

building other

escape

the

need to

of our limited time how much to the services? What techniques

how much

housing, and

goods

Who should be assignedto each specific task? services be distributed among people?

and

societies for which records are available, issues one of two ways. One approachis for all or small number of by an individual

these have been decided in essentially economic decisions to be made centrally, individuals on behalf of a larger group. like

CENTRAL

For example, in

many

agrarian

societies

those throughout history, families or other small groupsconsumed only goods and services that they produced for themselves and a single clan or family leader made most important and distribution decisions.On an production immensely larger Soviet Union (and other communist scale, the economic organization of the former was also largely centralized. In so-called centrally communist countries) planned a central bureaucratic committee established nations, production targets for the farms and a master for how to achieve the factories, developed country's plan detailed instructions who was to targets (including concerning producewhat), and set for the distribution and use of the and services up guidelines goods produced. Neither form of centralized economic organization is much in evidence today. When implemented on a small scale,as in a self-sufficient family enterprise, in the centralized decision is certainly feasible. For the reasons discussed making the was doomed once it however, preceding chapter, jack-of-all-trades approach became clear how dramatically could their standards people improve living by each individual focus his or her efforts on a is, by having specialization\342\200\224that of tasks. And with the fall of the Soviet Union and its satellite relatively narrow range in the late 1980s, there are now only nations three communist economies left in the world: North and China.The first two of these to be on their Cuba, Korea, appear last and China has abandoned to legs, economically speaking, largely any attempt control production and distribution decisionsfrom the center. The major of centralized allocation and control now residein the bureaucratic remaining examples that administer agencies programs like New York City's rent controls\342\200\224programs that are themselves becoming increasingly rare. At the of the twenty-first we are therefore left, for the most beginning century, with the second form of economic part, major system,one in which production in private markets. In and distribution decisions are left to individuals interacting

MARKET

63

64

CHAPTER

3

SUPPLY AND

DEMAND

so-called

the

pure

to pursue

markets, to refer to

for the most part broad

limits,

to

free

start

that

they

industrial

businesses,

the distribution

themselves

are no fact, buy. countries are more properly or

there

In

shut them

of goods and the

down, or sellthem.And

purchasing power, labor market.

which

in

comes

cases

most

centralizedcontrol

for

benefits

consumption

within

by individual

is determined

services

country,

tend

a

Still, it people are

because

economies

markets have replaced to assign production tasks and

after

country

Modern

such systemsas free-market

preferences backed by individual from the income people earn in In reason

products

to produce

Their goods and servicesare allocatedby of collective control. regulation, and other forms

free

of

sense

makes

today.

economies, people decidefor

economies.\"

\"mixed

as

combination

and which

economies

free-market

described

or free-market,

capitalist,

careers

which

the simple much more

wisdom often assert that economists effectively.The popular pressand conventional \"If about issues. someone once all the (As disagree important quipped, you lay economists in the world end to end, they still wouldn't reach a conclusion.\") The fact is, that there is overwhelming agreementamong economists about a broad range however, of issues.A substantial believes that markets are the most effective means for majority scarce resources. For a recent found that more than allocating society's example, survey 90 percent of American professionaleconomistsbelieve that rent regulations like the ones implemented by New York City do more harm than good. That the stated aim of these regulations\342\200\224to make rental housing more affordable for middle-and low-income families\342\200\224is clearly was not enough to prevent them from wreaking havoc on benign New York City's housing market. To see why, we must explore how goods and services in private are allocated nonmarket means of allocating goods and markets, and why services often do not produce the expected results.

with

Beginning

the

market

market

good consists of all sellers of that good

for any buyers

interactions

and

various

good

some

%

Pablo Picasso's paintings than Jackson Pollock's?

sell for

so

much

who

definitions, we will

than

determine

buy\342\200\224or might

parts of the country, $10. Where does the

In most less

do

simple concepts and and sellers in markets

individuals

H

more

IN MARKETS explore

how

the

and quantities of the among buyers and services traded. We a market: The market for any goods begin by defining consists of all the buyers and sellersof that good. So, for example, the market for pizza on a given day in a given place is just the set of people (or other economic actors such as firms) potentially able to buy or sell at that time and location. pizza In the market for pizza, sellers the individuals and comprise t hat either do sell\342\200\224or under the right circum^ companies might, in this market include all sell\342\200\224pizza. Similarly, buyers | stances, z.

Why

SELLERS

AND

BUYERS

the prices

buy\342\200\224pizza.

a decent

pizza

market price of

can still be pizza

come

had for from?

of other Looking beyond pizza to the vast array goods that are and sold we are some bought every day, may ask, \"Why goods and others Aristotle had no idea. Nor did Plato, cheap expensive?\" or Copernicus,or Newton.On reflection,it is astonishing that, for almost the entire span of human not even the most history, creative minds on Earth had any real inkling of how to intelligent and answer that seemingly simple question. Even Adam the Smith, Scottish moral philosopher whoseWealth Nations launched the of in of economics suffered confusion on this issue. 1776, discipline Smith and other early economists Karl Marx) (including that the market of a was determined thought price good by its cost of production. But although costs do affect surely prices, they cannot sells for so explain why one of Pablo Picasso'spaintings much more than one of Jackson Pollock's.

BUYERS AND

65

IN MARKETS

SELLERS

economists Stanley Jevons and other nineteenth-century Z to explain price by focusing on the value derived -y*\"v\"\", \302\253-:: ^ people \"\" \342\226\240 ' \":. \342\226\240 .''\"sir\" --.'-. \" ^ *z from consuming different goods and services.It certainly seems - ' A%V \342\200\242\342\226\240**\342\226\240 * 1 ^ Mt? V o al J \"\" Q-< that will a lot for a value * ^. v ^ plausible people pay good they highly. >.:>\\^ -C >v ^ \342\226\240 ' * > w.*\342\226\240 1- S *w^ \\~*. . Yet willingness to pay cannot be the whole story, either. Deprive \\ S a person in the desert of water, for example, and he will be dead *. J1J' ^5 Rig in a matter of hours, and yet water sells for less than a penny a V. -3 *'. human gallon. By contrast, beings can get along perfectly well Mayer/C . Artist \\~r \" m\"* o -\" \302\253 without and sells for more than $1,000 an ounce. gold, yet gold \342\226\240 ncilati \" -n T ,fc,^!!1 - - *\342\226\240 , -A Cost of production? Value to the user? Which is it? The \302\243 \302\247 * \\ which seems obvious to is that both answer, today's economists, A Jackson Pollock 3aint ] M arsri all in the late nineteenth century, the British economist Alfredfred Marshall matter. Writing was among the first to show how costs and value interact to determine both clearly the prevailing market pricefor a good and the amount of it that is bought and sold. Our task in the pages ahead will be to explore Marshall'sinsights and gain some in them. As a first we introduce the two main practice applying step, components of Marshall's curve. pathbreaking analysis: the demand curve and the supply

tried

CURVE

DEMAND

THE

In the market for pizza, the demand curve that tells us how many slices peoplewould convention,

and quantity

usually put the horizontal axis.

A fundamental

property

of

is a

for pizza be

willing

price on the

economists on

- 4.

vertical

simplescheduleor graph

to buy at different prices. By axis of the demand curve

demand curve

a schedule

or

of a graph showing the quantity good that buyers wish to buy at

each price curve

demand

the

is that

it

is

downward-sloping

curve for pizza tells us that as the respect to price. For example,the demand of will more slices. the demand curve for Thus, price pizza falls, buyers buy daily in in on a look like the curve seen 3.1. pizza Chicago given day might Figure economists refer to demand and supply\"curves,\" we often draw (Although usually them as straight lines in examples.) The demand curve in Figure 3.1 tells us that when the price of pizza is low\342\200\224say to buy 16,000 slicesper day, whereas $2 per slice\342\200\224buyers will want they will want to slices at a of and at a of $3 12,000 buy only price only 8,000 price $4. The demand curve for pizza\342\200\224as for any other good\342\200\224slopes downward for multiple reasons. Some have to do with the individual consumer's reactions to price changes.Thus, as pizza becomes more expensive, a consumermay switch to chicken sandwiches, hamburgers, or other foods that substitute for pizza. This is called the substitution effect of a price In a increase reduces the demanded because it reduces change. addition, price quantity A consumer can't afford to as slices of purchasing power: simply buy many pizza at as at lower This is called the income effect of a higher prices prices. price change.

with

quantity

that

results

price of the income

the

4

i

^^

Price

0

i i i

i i i

! 1 1

! 1 1

! 1 1

12

16

8

x. ^^ ^^

N

Demand

Quantity (1,000s of slices/day)

power

3.1

Daily Demand Chicago.

The demand

curve for

function

i\\.

i i i

purchasing

a change

changes the

for Pizza in good

($/sl

because

price of a good

buyer's

the

good changes

the change in demanded of a good

results

that

switch

effect

quantity

FIGURE

8 3

because buyers substitutes when

to or from

The

4

the change in effect demanded of a good

substitution

the

Curve any

is a downward-sloping of its price.

the

in

66

3

CHAPTER

SUPPLY AND

Cost-Benefit

O buyer's

largest

reservation dollar

price the the buyer to pay for a good

amount

would be willing

DEMAND

Another reason the demand curve downward is that consumers differ in slopes of how much they're willing to pay for the good. The Cost-BenefitPrinciple tells us that a given person will buy the good if the benefithe expectsto receive from it exceeds its cost. The benefit is the buyer's reservation price, the highest dollar amount he'd be willing to pay for the good. The cost of the good is the actual amount that the buyer actually must for which is the market it, pay price of the In most different have different reservation markets, good. buyers prices. So, when the good sells for a high price, it will satisfy the cost-benefit test for fewer buyers than when it sells for a lower price. To put this same point another way, the fact that the demand curve for a good is downward-slopingreflects the fact that the reservation price of the marginal declines as the of the good bought increases. Here the buyer quantity marginal is the who buyer person purchasesthe last unit of the good sold. If buyers are slices of pizza a day in Figure 3.1, for example, the 12,000 currently purchasing reservation for the be $3. (If someone had been price buyer of the 12,000th slicemust to more than the demanded at a of would have $3 that, willing pay quantity price been more than 12,000 to beginwith.) By similar when the sold reasoning, quantity is 16,000 slices per day, the marginal buyer's reservation must be $2. price only We defined the demand curve for any good as a schedule telling how much of it consumers wish to purchase at various prices. This is calledthe horizontal of the demand curve. Using the horizontal interpretation, we start with interpretation on the vertical axis and read the demanded on the price corresponding quantity horizontal axis. Thus, at a price of $4 per slice,the demand curve in Figure 3.1 tells us that the quantity of pizza demanded will be 8,000 slices per day. The demandcurve also can be interpreted in a second way, which is to start with on the horizontal axis and then read the marginal quantity buyer's reservation on the vertical axis. when the of sold is 8,000 slices per Thus, price quantity pizza in the demand curve 3.1 tells us that the day, Figure marginal buyer's reservation is slice. T his second of the demand curve is calledthe $4 price per way reading terms

vertical

interpretation.

CONCEPT In

Figure

CHECK 3.1, what is the

3.1

THE SUPPLY supply curve a graph or schedule showing the quantity of a good that sellers wish to sell at each price

In the

buyer's

marginal

10,000 slicesper day? demanded at a price of pizza

sold is

For $2.50

the

reservation

same demand per slice?

price when the

curve,

what

will

of pizza quantity be the quantity of

CURVE

market for pizza, the supply curve is a simple schedule or graph that tells us, for each possibleprice,the total number of slices that all pizza vendors would be willing to sell at that price. What does the supply curve of pizzalooklike? The answer to this question is based on the logical assumption that suppliers should be willing to sell additional slicesas long as the price they receive is sufficient to cover their opportunity cost of if them. what someone could earn a slice of is Thus, supplying by selling pizza insufficient to compensate her for what she could have earned if she had spent her time and invested her money in some other way, she will not sell that slice. Otherwise, shewill. differ with to pay for Just as buyers respect to the amounts they are willing sellers also differ with to their cost of pizza, respect opportunity supplying pizza. For those with limited education and work experience, the opportunity cost of is relatively low (because such individuals do not have a lot selling pizza typically of For the cost of is of alternatives). others, high-paying opportunity selling pizza moderate value, and for still others\342\200\224like rock stars and professional athletes\342\200\224it is in opportunity differences cost among prohibitively high. In part because of these t he curve of will be with people, daily supply pizza upward-sloping respect to price. As an illustration, see Figure 3.2, which showsa hypothetical curve for supply in the market on a pizza Chicago given day.

BUYERS

AND

SELLERS

/

4

Daily Supply

of Pizza

Supply

67

MARKETS

3.2

FIGURE

The

IN

Curve

in Chicago.

At higher prices, sellers offer more units generally

8 3

for sale.

2 V U 0.

0

16

12

8

Quantity (1,000s of slices/day)

The fact the

that

Low-Hanging-Fruit

as

that

us

tells

cost

opportunity

be seen as a consequence of preceding chapter. This principle we expand the production of pizza, we turn first to those whose of producing pizza is lowest, and only then to others with a higher

the

supply

curve slopes

upward may in the

discussed

Principle,

Increasing

a

Opportunity

Cost

opportunity cost. the

Like

curve, the supply curve can be interpreted Under the horizontal interpretation, we begin with

demand

or vertically.

over to

the

to read the

curve

supply

that

quantity

on the horizontal axis. For instance,at wish to sell 8,000 slicesper day. Under the vertical interpretation, we curve to read the corresponding marginal

of $2

a price

wish

sellers

either

horizontally

then

a price,

to sell at

per slice, sellersin

that

go

price

3.2

Figure

a quantity, then go up to the supply in on the vertical axis. Thus, if sellers

begin with cost

slices per day, the opportunity cost of the 12,000 Figure 3.2 are currently supplying marginal selleris $3 per slice.In other words, the supply curve tells us that the marginal cost of producing the 12,000thsliceof pizza is $3. (If someone could producea 12,001st slice for less than $3, she would have an incentive to supply of pizza it, so the quantity with.) supplied at $3 per slicewould not have been 12,000 slices per day to begin By similar reasoning, when the quantity of pizza supplied is 16,000 slicesper day, the of producing another slice must be $4. The seller's reservation price for selling marginal cost an additional unit of a goodis her marginal cost of producing that good. It is the smallest dollar amount for which she would not be worseoff if she sold an additional unit.

CHECK

CONCEPT In

Figure

3.2

is the

3.2, what

cost

marginal

of a slice

of pizza

when

sold is 10,000slicesper day? For the same supply curve, what pizza supplied at a price of $3.50per slice?

The market for of

that

good.

a good

For

demanders would that

to

buy

of pizza quantity be the quantity of

CURVES

of the actual and potential and sellers buyers shows the quantity that price, the demand curve to buy and the supply curve shows the quantity

consists

any given

be willing

would be willing to sell. Suppliers are at higher prices (supply curves slopeupward) and demanders less at higher prices (demand curves slopedownward).

suppliers

more

AND SUPPLY

DEMAND

RECAP

the will

of the good

willing

to

sell

are willing

seller's reservation price the smallest dollar amount for which a seller would be willing to sell an additional unit, generally cost equal to marginal

CHAPTER

68

3

AND

SUPPLY

DEMAND

MARKET

a balanced or in which unchanging forces at work within a system are canceled by others equilibrium

situation

equilibrium

price and

equilibrium

quantity

and

at the

quantity

of the supply curves for the

the

all

price

intersection and demand good

EQUILIBRIUM

in both the physical and socialsciences, The concept of equilibrium is employed In general, a system is in and it is of central importance in economic analysis. equilibrium when all forces at work within the system are canceled by others, resulting in a balanced or unchanging In physics, for example, a ball hanging situation. from a spring is said to be in equilibrium when the spring has stretched sufficiently that the upward force it exerts on the ball is exactly counterbalanced by the downward force of gravity. In economics, a market is said to be in equilibrium when no in the market has reason to alter his or her so that there is no behavior, participant any in for or that market to tendency production prices change. If we want to determine the final of a ball hanging from a spring,we position need to find the point at which the forces of gravity and spring tension are if balanced and the system is in equilibrium. we want to find the price at Similarly, which a good will sell (which we will call the equilibrium price) and the quantity of in it that will be sold the (the equilibrium quantity), we need to find equilibrium in the market for that good. The basic tools for finding the a market equilibrium for a good are the supply and demand curves for that good. For reasonswe will the equilibrium price at which the supply

explain, quantity

hypothetical supply and

equilibrium price of pizza sold will be 12,000

Chicago,

equilibrium occurs in

when all sellers are satisfied

a market

and

buyers

It

equilibrium.

their

respective quantities at the

wish

to

market

equilibrium price

Rather, they

than that

FIGURE and in

it

wish

mean

that sellers

it

Note alsothat

if the price of pizza in our slice, either buyers or sellerswould price of pizza were $4 perslice,as shown

$3 per the

wish to one can

The

wouldn't be pleasedto receivea price higher means only that they're able to sellall they to say that buyers are satisfied at the doesn't mean that they wouldn't be happy to pay less than that price. means only that they're able to buy exactly as many units of the good as to at the equilibrium price. doesn't

equilibrium price. Rather, sell at that price. Similarly,

the

price

for the pizza market in and the equilibrium slice, per in as shown 3.3. per day, Figure be $3

slices Note that at the equilibrium price of $3 perslice,both sellers and buyers are \"satisfied\"in the following sense: Buyers are buying the exactly quantity of pizza they wish to buy at that slices and sellers a re the quantity of (12,000 price per day) selling exactly in wish to sell slices And since are satisfied this (also 12,000 pizza they per day). they to change their behavior. sense, neither buyers nor sellersface any incentives in the definition of market Note the limited sense of the term \"satisfied\" than

with

therefore

will

good are the price and good intersect. For the

of a the

earlier

shown

curves

demand

the

quantity

market

and equilibrium quantity and demand curves for

buy

only

8,000

slices per day,

force someone to

buy

a slice

market were anything Chicago be frustrated. Suppose, for in

Figure wish to

sellers

but

of pizza

3.4. At

sell 16,000.

against her wishes,this

3.3

Equilibrium

Quantity

Supply

Price

of Pizza

Chicago.

The equilibrium quantity price of a product are

and the

that correspond of the

values the

intersection

and

demand

curves for

to supply that

Demand

product.

8 Quantity

12 (1,000s

that

16 of slices/day)

other

example,

price, And

buyers no

since

means

that

MARKET

Excess

= 8,000

supply

slices/day

y

/ 4

3.4

Excess

Supply. there

price,

equilibrium

excess

or

supply,

and

supplied

is

the

surplus,

difference between

3

I

FIGURE

When price exceeds

Supply

/

S

\\

69

EQUILIBRIUM

quantity

quantity

demanded.

V2 U

f

0.

i

0

Demand

16

12

8

^

|

\\

Quantity (1,000s of slices/day)

buyers equilibrium

will buy only the 8,000 slices they it is sellers who end up price, they are left

example, the

than

to

buy

equilibrium slices 16,000

price\342\200\224say,

per day at

being

supply

the price

that

suppose

Conversely,

excess

an

with

$2

per

that

At

frustrated.

of 8,000 in

slice. As

shown

price,

a price

of $4

slicesper day.

of pizza

our

in

3.5,

Figure

want to

this

in

were less

market

Chicago

sellers

whereas

exceeds the

So when price

to buy.

wish

buyers

sell only

want 8,000.

cannot be forced to sellpizza their wishes, this time it is against the buyers who end up being frustrated. At a price of $2 per slicein this example, slices per day. they experience an excess demand of 8,000 An feature of private markets for goods and services is their extraordinary automatic tendency to gravitate toward their respective and equilibrium prices quantities. This tendency is a simple consequence of the IncentivePrinciple.The mechanisms by in our definitions which the adjustment happens are implicit of excess supply and And

excess

since sellers

demand.

was $4

for example,

per slice,leading

frustrated have

Suppose, sense

the

in

an incentive

strategy available

price from been paying

$4

of wanting

to take whatever

to them

to, say,

$4

excess

to

is to

the

that

supply

of pizza

price

as shown

in

to sellmore pizza they

steps

cut their

3.4.

Figure

than

buyers

can to

increase

slightly.

Thus,

price

slice,he would attract pizza supplied by other

$3.95 per

per slice for

our

in

many

sellers.

their

sales.

by exceeds

supplied

quantity demanded when price of a good exceeds price

equilibrium

excess demand by which quantity exceeds

the the

amount

the

demanded

quantity supplied when

the

price of a good lies

the

equilibrium

below

price

sellers are buy,

The

sellers

simplest

Incentive

a

seller reduced his

if one

buyers who sellers, in order

of the

Those

amount

the

market

hypothetical

Because wish to

excess supply which quantity

had to

FIGURE 3.5

ExcessDemand.

Supply

y

When

4

?

3

\\

_

yf

/

Excess demand

= 8,000slices/day

($/sl

/ ^ 1

8

0 Quantity

12 (1,000s

16 of slices/day)

Demand

lies below price,

equilibrium

there

excess demand, the between and

Price

price

is

difference

quantity demanded

quantity

supplied.

70

CHAPTER3

SUPPLY

AND

DEMAND

their lost business,would then have an incentive to match the price cut. But if all sellers lowered their to $3.95 per slice, there would still be prices considerable excess So sellers would face incentives to cut their prices. supply. continuing This pressureto cut prices won't go away until prices fall all the way to $3 per slice. that price starts out less than the equilibrium price\342\200\224say, Conversely, suppose who are frustrated. A person who can't get all the $2 per slice. This time it is buyers he wants at a of slice has an incentive to offer a higher price, $2 pizza price per to obtain that would otherwise have been sold to other hoping pizza buyers.And for their will be too to as sellers, part, only happy post higher prices long as queues recover

that

notice

of frustrated

remain.

buyers

to its equilibrium level upshot is that price has a tendency to gravitate under conditions of either excess supply or excess demand. And when price reaches in the technical its equilibrium level, both buyers and sellersare satisfied sense of ableto or sell the amounts of their being buy precisely choosing.

The

EXAMPLE

3.1

Market

Equilibrium

and Samples of points on the demand supply in Table provided 3. /. Graph the demandand supply its

curves

pizza market are

for

and

this market

find

and quantity.

price

equilibrium

of a

curves

TABLE 3.1

Points alongthe Demandand for

Demand

(1,000sof

($/slice)

Supply of Pizza

Price

Quantity

($/slice)

slices/day)

(1,000s

supplied

of slices/day)

8

1

2

2

6

2

4

3

4

3

6

4

2

4

8

table

the

are plotted

in

of

price

and then joined to indicate curves intersect to yield an of 5,000 slices per quantity

3.6

Figure

curves for this market. These $2.50 per slice and an equilibrium

and demand

3.6

FIGURE

Graphing

Supply and

Demand and

and

plot the

relevant points given table and then join with a line.

and

demand

curves,

Supply

Finding

Price

Equilibrium

Quantity. To graph the supply

Pizza Market

1

The points in equilibrium

of a

Curves

Pizza

Quantity demanded

Price

supply

Supply

Equilibrium

in the them price

and quantity occur at the intersection of these curves.

Demand

2 Quantity

4

\"

o

(1,000s

6

8

of slices/day)

10

the

day.

MARKET

We

EQUILIBRIUM

that market equilibrium doesn't necessarily an ideal produce market participants.Thus, in Example 3.1, market participants are the amount of pizza they buy and sell at a price of $2.50 per slice, this little more than that he can't buy additional buyer may signify other more valued sacrificing highly purchases.

emphasize

outcome for all

satisfied with but

for

pizza

a poor without

low incomes Indeed, buyers with extremely basic goods and services, which has prompted to ease the burdens of the society to attempt

often have

even

poor. Yet

purchasing

difficulty

in almost

governments the

every

of supply

laws

and

demand cannot simply be repealedby an act of the legislature. In the next we'll see that when legislators attempt to prevent markets from section, reaching their equilibrium prices and quantities, they often do more harm than good. more effective, Fortunately, there are other, ways of providing assistance to

needyfamilies.

RENT CONTROLS

RECONSIDERED

in New the market for rental housing units York City and suppose in and supply curves for one-bedroomapartments are as shown 3.7. This left would reach an rent of market, alone, Figure equilibrium monthly would be rented. Both $1,600, at which 2 million one-bedroom apartments landlords and tenants would be satisfied, in the sense that they would not wish to rent either more or fewer units at that price. This wouldn't necessarily mean, of course, that all is well and good. Many for be unable to afford a rent of $1,600 tenants, potential example, might simply month and thus be forced to remain homeless to move out of the (or per city to a Consider

that

the

again demand

cheaperlocation).Suppose made

it unlawful

that,

acting

for landlords to

purely

out of

charge more

benign motives, $800

than

per

month

legislators

for one-

in enacting bedroom apartments.Their stated aim this law was that no person should have to remain homelessbecausedecenthousing was unaffordable. But note in Figure 3.8 that when rents for one-bedroomapartments are prevented from above landlordsare to $800 rising per month, willing supply only 1 million apartments per month, 1 million fewer than at the equilibrium monthly rent of $1,600. Note also that at the controlledrent of $800 per month, tenants want to rent 3 million one-bedroom apartments per month. (For example, many in who would have decided to live New people Jersey rather than pay $1,600 a in New month York will now choose to live in the city.) So when rents are prevented from above $800 per month, we see an excessdemand for onerising 2 bedroom of million units each month. Put another the rent apartments way, controls result in a housing shortageof 2 million units each month. What is

FIGURE 3.7

y

o

\\

o

Supply

/

An

Unregulated

2 million

($/apartment)

/

rent

rented

V

Monthly

o Quantity

2

(millions

of apartments/month)

Housing

Market. For the supply and demand curves shown, the equilibrium monthly rent is $ 1,600and apartments at that price.

will

be

CHAPTER

3

SUPPLY AND

DEMAND

3.8

FIGURE

Rent Controls. When

from

2,400

are prohibited

rents rising

Supply

to the

c c

equilibrium

level, the result is excess demand in the housing market.

r thly artm

c

Q.

Z

W-

o

Controlled

Excess

1,600

demand

= 2

million

apartments/month

ftf

rent

= 800 Demand

12

0 Quantity

more,

the

per

number

of apartments

(millions

actually

3 of apartments/month)

available declines by

1 million units

month.

If the housing market were completely the immediate unregulated, response to sucha high level of excess demand would be for rents to rise sharply. But here the law prevents them from rising above $800. Many other ways exist, however, in which market participants can respondto the pressures of excess demand. For instance, owners will quickly learn that they are free to spendless on maintaining their rental if units. After there are scores of renters at the door of each vacant all, knocking has considerable room to maneuver. apartment, a landlord Leaking pipes, peeling paint, broken furnaces, and other problems are less likely to receiveprompt attention\342\200\224or, at all\342\200\224when rents are set well below market-clearinglevels. indeed, any attention Nor are reduced of apartments and poorer maintenance of existing availability

an offering of only 1 million apartments per are renters who'dbe to pay as much as month, Figure willing for an apartment. As the Incentive Principlesuggests, this $2,400 per month pressure In will almost always find or of itself. New York ways, legal illegal, expressing City, for it is not uncommon to see \"finder's fees\" or as as several example, \"key deposits\" high thousand dollars. Owners who cannot charge a market-clearing rent for their apartments also have the option of converting them to condominiums or co-ops, which enables them to sell their assets for prices much closer to their true economic value. Even when rent-controlled owners don't hike their prices in these apartment various serious misallocations result. For instance,ill-suited roommates ways, often remain their constant becauseeachis reluctant to together despite bickering in reenter the housing market. Or a widow might remain her sevensteadfastly room apartment even after her children have left home becauseit is much cheaper than alternative dwellingsnot covered by rent control. It would be much better for if she relinquished that all concerned to a larger family that valued it more space But under rent she has no economic incentive to do so. controls, highly. In markets without There's also another more insidiouscostof rent controls. rent landlords cannot discriminate tenants on the basis controls, against potential of race, religion,sexualorientation, or national physical disability, origin without an economic Refusal to rent to members of suffering penalty. specific groups would reducethe demand for their apartments, which would mean having to accept lower rents. When rents are artificially below their equilibrium level, however,the pegged excess demand for enables landlordsto engagein resulting apartments discrimination with no further economic penalty. Rent controlsare not the only instance in which governments have attempted to repeal the law of supply and demand in the interest of helping the poor. During the late for the federal tried to hold the price of 1970s, example, government

apartments

the only

we see in

Incentive

O

difficulties. With 3.8

that there

MARKET

below

gasoline

level out

its equilibrium

of

that

concern

high

EQUILIBRIUM

73

prices

gasoline

in the As with controls imposed unacceptablehardships in the gasoline rental housing market, unintended consequencesof price controls market made the policy an extremely to aid the poor. For costly way of trying in resulted lines at the example, gasolineshortages long pumps, a waste not only of valuable but also of as cars sat for extended time, gasoline idling periods. In their opposition to rent controls and similar are economists measures, a total lack of concern for the poor? this claim is sometimes revealing Although in some made by those who don't understand the issues, or who stand to benefit from there is little for it. Economists way government regulations, justification simply realize that there are much more effective ways to help poor peoplethan to low try to give them apartments and othergoodsat artificially prices. One straightforward would be to the additional income approach give poor and let them decide for themselves how to spend it. True, there are also practical in transferring difficulties involved additional purchasing power into the hands of the poor\342\200\224most importantly, the difficulty of targeting cash to the genuinely needy without weakening others' incentivesto fend for themselves. But there are practical this For example, for far less than the waste caused by ways to overcome difficulty. the could afford subsidies to the price controls, government generous wages of the and could for those who are working poor sponsor public-serviceemployment in unable to find the sector. jobs private that effects on Regulations peg prices below equilibrium levelshave far-reaching market outcomes. The following check asks to consider what concept you happens when a price control is establishedat a level above the equilibrium price. on

drivers.

low-income

CONCEPTCHECK3.3 In

whose

housing market

rental

the

will be the

effect of a

rent

Controlled

that

law

and

demand

prevents

supply

rents from

curves are

shown

$ 1,200

above

rising

what

below,

per

month?

= 1,200

\302\247 \302\247 800

5 is C Q. O rt

12

0

(millions

Quantity

PRICE CONTROLS?

PIZZA

The sourcesof largely to imagine price

what

would

controls

happen

on pizza.

curves for pizza are as shown in it unlawful $2 per slice, making buyers

want

to

buy

16,000

the rent-controlled housing market York City can be seenmore vividly concern for the poor led the city's leaders

between

contrast

the

unregulated food markets

implement

3 of apartments/month)

in

if

New

Suppose, for Figure

3.9

example,that

and that the

to charge

slices per day, but

more sellers

than

city

that

want

and supply a imposes price amount. At $2 the

to sell

only

8,000.

and by

the

trying

to

demand ceiling of

price ceiling

per slice,

allowable

a maximum price,

specified

by law

CHAPTER 3

74

SUPPLY

AND

DEMAND

3.9

FIGURE

Price Controls in

y

the

Supply

Market.

Pizza

A price

ceiling

below

4

the

equilibrium price of pizza result in excess

would

demand for

J _\\/

3

=

demand

Excess

= 8,000

slices/day

pizza. Price


= 2

ceiling

0.

^

0

12

8

(1,000s

Quantity

At a

price

queues

of

behave

rudely

buyers

$2

of

per

trying to clerks,

Demand

16 of slices/day)

every pizza restaurant in the city will have long to purchase pizza. Frustrated buyers will unsuccessfully in kind. Friends of restaurant managers who will respond slice,

treatment. Devious pricing strategies will to begin in sold combination with a of $2 $5 cup Coke). Pizza will be made from poorer-quality ingredients. Rumors will begin to circulate about sources of black-market pizza. And so on. The very idea of not being able to buy a pizza seems absurd, yet precisely such in markets in which are held below the equilibrium things happen routinely prices

will

to

begin

get preferential

emerge (such as the

of pizza

slice

levels.For example,prior to the other

and

goods

that

countries

in those

considerednormal

MARKET

RECAP

Market equilibrium,

excess

demand,

governments, in

line

for

it

hours first

was

to

bread

buy

of those

choice

available.

were

their

of communist

while the politically connectedhad

basic goods,

with

collapse

for people to stand

the

EQUILIBRIUM situation

in which all buyers and sellersare satisfied at the market price, occursat the intersection

respective quantities of the supply and demand curves.The correspondingprice and are quantity called the equilibrium price and the equilibrium quantity. Unless prevented by regulation, prices and quantities are driven toward their equilibrium values by the actions of buyers and sellers.If the price is too so that there is excess supply, frustrated sellers will cut their initially high, in If order to sell more. the is too so that there is low, price price initially continues

competition

until equilibrium

AND

PREDICTING

changein

the

demanded the

demand

response

price upward.This

EXPLAINING

CHANGES

process

IN

PRICES AND QUANTITIES

quantity

a movement along curve that occurs

to a change

buyers drives the is reached.

among

in

price

in demand a shift change the entire demand curve

of

how the factors that govern and demand curves are changing, we supply informed predictions about how pricesand the corresponding quantities will change. But when describing changing circumstancesin the marketplace, we must If

in

we

can

know

make

take care to recognizesomeimportant must

the

distinguish quantity

between demanded

distinctions. For example, we terminological in the meanings of the seemingly similar expressions change in the and change in demand. When we speakof a \"change

CHANGES

EXPLAINING

AND

PREDICTING

IN

PRICES

75

AND QUANTITIES

FIGURE 3.10

6

5

An

_ ^w

v

^^,

-c 4

Increase

in

quantity

demanded

6

Increase in

V

demand

^V

w

versus an

(a)An increase in quantity demanded describesa

3 U

2

0. !

1

0

i

i

2

4

i

i

6

8

\\d

\\

10 12

0

of cans/day)

(1,000s

Quantity

\\d TV I

movement

downward

\342\200\242S

d'

12

(b)

means the change in the quantity that people wish to buy to a change in price. For instance, Figure 3.10(a) depicts an increase demanded that occurs in response to a reduction in the price of tuna. When the price falls from $2 to $1 per can, the quantity demanded rises from 8,000 to 10,000cans per day. By contrast, when we speak of a \"change in demand,\" this means a shift in the entire demand curve. For example, Figure 3.10(b) depicts an increasein demand, that at every price the quantity demanded is higher than meaning In summary, before. a \"change in the quantity demanded\" refers to a movement along in demand\" the demand curve and a \"change means a shift of the entire curve. A similar terminological distinction A on the supply side of the market. applies in the entire change in supply means a shift supply curve, whereas a change in the refers to a movement along the supply curve. quantity supplied Alfred Marshall's supply and demand modelis one of the most useful tools of the economic naturalist. Once we understand the forces that the placements govern in a position of supply and demand curves, we're suddenly to make sense of a host of interesting observations in the world around us. this

demanded,\"

in response in the quantity

occurs

that

change in entire supply change supplied

the

supply

a better

explain

price

examples.

The

the

particular

feel for how the supply and demand and quantity movements, it's helpful in demand first one illustrates a shift market itself.

will

the

to

happen

rental fees decline? Let

the

initial

supply

ballsare what used

in

economists

combination

equilibrium

price and

of

quantity

balls

tennis

and demand curves for tennis balls be as shown where the resulting equilibrium price and

D in Figure 3.11, per ball and 40 million

S and $1

value

in

in

price

than

balls

call

when

per

month,

complements,

used alone.

by

the

quantity

if there

3.2

EXAMPLE

if court curves are

respectively. Tennis courts and tennis goods

that

are

Tennis balls,for

more example,

valuable would

when be of

were no tennis courts on which to play. (Tennis balls would still have some value even without courts\342\200\224for example, to the parents who pitch them to their children for batting As tennis courts become cheaper to use, practice.) will more their demand for tennis, and this will increase people respond by playing in court-rental tennis balls. A decline fees will thus shift the demand curve for tennis little

to a change

model enables us to predictand to begin with a few simple that results from events outside

Complements

What

curve

IN DEMAND

SHIFTS get

a shift of the

supply

in the quantity a movement along curve that occurs

response

To

along

the demand curve as price falls, (b) An increase in demand describes an outward shift of the demand curve.

of cans/day)

(1,000s

Quantity

(a)

quantity

in

Increase

Demand.

u

^

in the

Increase

Quantity Demanded

two goods

complements

complements

in

an increase

in

causes a leftward demand curve (or

if

rightward

a decrease shift)

are

consumption

the

for

price of one shift in the the other causes a

if

CHAPTER 3

76

SUPPLY

AND

DEMAND

FIGURE3.il

The Effect on the

Market for Tennis Decline

of a

Balls

in

l

When the price of a ($/ball)

shifts right,

causing

XV

ce

equilibrium

/

Pri

and quantity

price


X

1.00

complementfalls, demand

L\\V'

1.40

Fees.

Court-Rental

]\\\302\260x

to rise. 0

(millions of balls/month)

Quantity

balls rightward as

to D'. (A \"rightward shift\" shift.\" These distinctions

an \"upward

and vertical Note in

interpretations

the

58

equilibriumquantity,

that, for the

will happen

What

the

Suppose shown

and goods

substitutes

in

consumption

an increase

in

the

causes a rightward demand curve for (or

if

leftward

a decrease shift).

the

horizontal

curve.)

the new and the new original price than the original quantity. shift

demand

illustrative

balls, $1.40, is higher million balls per month,

to the

the

than

is higher

are if

the other causes a

supply

curves are

quantity

shown,

access

and

denoted

P and

delivery

falls?

curves for overnight letter deliveriesare as and that the resulting equilibrium price

demand

D in

S and

of overnight letter

quantity

3.12

Figure

Q. E-mail messagesand

letters

overnight

are

in many call substitutes, meaning that, at applications functions for people. (Many noneconomistswould call least, the two serve similar them too. Economists don't always choose obscureterms for important substitutes, in the concepts!) When two goods or servicesare substitutes,a decrease price of one will cause a leftward shift in the demand curve for the other. (A \"leftward shift\" in a

economists

what

of

examples

price of one shift in the

initial

the

by

and

price

equilibrium

serviceas the priceof Internet

two

to

Substitutes

3.3

substitutes

correspond, respectively,

demand

can be described

curve also

a demand

of

of tennis

equilibriumprice

EXAMPLE

3.11

Figure

of

58

40

demand curve can alsobe described

demand curve

for

Effect on

the

Decline of Internet

of a

Delivery

Price

falls,

^\342\226\240N &.

8 +J 0 \\mS

price of a substitute demand shifts left, causing

equilibrium

to

from

shifts

shift.\") Diagrammatically, the in Figure 3.12. DtoD'

the

price

/S

v

^

Access. When

service

the Market

for Overnight Letter in

a \"downward

as

delivery

3.12

FIGURE

The

overnight

,

p

V

-<

^v

f

^V

^ f r->. D'

Q U

^r

^^

S^^. '

^V ^^

^W^r

f^^.

^W

X.

^V'

&.

0.

x

and quantity

X.

^V

\\o

1

fall.

0

Q'

Quantity

Q

(letters/month)

CHANGES

EXPLAINING

AND

PREDICTING

PRICES

IN

AND QUANTITIES

As the figure shows, both the new equilibrium price, P', and the new P and Q. Cheaper Internet are lower than the initial values, Q', won't Federal and UPSout of but it will business, probably put Express

equilibrium quantity, access

definitely cost them

customers.

many

The

concepts

like the one

CONCEPT

shift an other.

and complementsenableyou

of substitutes

posed in

the

concept

following

questions

in

airfares

affect

intercity

bus fares and

the

price

of hotel

rooms

in

communities?

resort

Demand

curves are shifted not just by also by other factors that

complementsbut pay

answer

to

check.

CHECK 3.4

a decline

will

How

if an increase in the price define goods as substitutes in the demand curve for the other. By contrast, in the price of one causesa leftward in increase shift

economists

To summarize,

of one causesa rightward goods are complements if the demand curve for the

for a

given good or service.One of

most

the

in the

changes change

the

prices of substitutes and to people are willing such factors is income.

amounts

important

The Economic Naturalist3.1 \342\226\240%

relative

federal government implements a large pay increasefor its rents for apartments locatednearWashington Metro stations rents located far away Metro stations? for apartments from

the

When

why do to

For the citizens of Washington, employees, it's more convenient than to live in subway station thus command relatively high

one

proportion of whom apartment located one block

a substantial

D.C.,

live in an

to

that

is 20

blocks away.

are from

employees,

go up

government the nearest

located

Conveniently

apartments

and supply curves for such Suppose the initial demand in are as shown 3.13. a federal some government raise, apartments Figure Following pay in who live less convenient will be and able to use employees apartments willing of their extra income to bid for more located part conveniently apartments, and those who already live in such apartments will be willing and able to pay more to them. The effect of the raise is thus to shift the demand curve for keep pay to the right, as indicated conveniently located apartments by the demand curve labeled

D'.Asa Q',will

result,

both

rents.

the equilibrium

be higher than

price

and

quantity

of such

apartments, P'

and

before.

FIGURE 3.13

The Effect

of a

Federal

the Rent for Conveniently Pay Raise on

---S^---

LocatedApartments

$/month) D

> N.

X. Rent(

\\d

n

1

0

c3

Q'

Conveniei ritly located (units/month)

D.C. An increase in income shifts demand for a normal good to the right, causing equilibrium price and in Washington,

quantity

apartments

to

rise.

Who located

gets to

live

apartments?

in the

most

conveniently

77

CHAPTER3

78

SUPPLY

AND

DEMAND

to ask how there could be an increase in the number of located to be fixed by the conveniently apartments, which might appear constraints of geography. But the Incentive Principle remindsus never to underestimate the of sellers when confront an to make money ingenuity they opportunity if more of that want. For rents rose by supplying something people example, some landlords warehouse to sufficiently, might respond by converting space residential use. Or perhaps people with cars who do not place high value on living near a sell their to landlords, thereby freeing them for subway station might apartments to rent them. that these constitute movements (Note people eager responses along in that the supply curve of conveniently located apartments, as opposed to shifts

O

curve.)

supply

whose

normal

good

a good

demand

curve

shifts rightward

when the increase

seem natural

It might

Incentive

incomesof buyers

and leftward when

incomesof buyers

the

When incomes increase,the demand curves for most goods will behave like the in demand curve for conveniently located and of that fact, apartments, recognition economists have chosen to call such goodsnormal goods. In fact, the demand curves for some Not all goods are normal goods,however. shift leftward when income goodsactually goes up. Such goodsare calledinferior goods.

would

When

decrease

having

something? In general,this inferior

good

demand

curve

when the increase

and

a good whose shifts leftward

incomesof buyers rightward

incomesof buyers

when the

inconveniently located

that an

are an

goods prices.

Apartments

cause

would

income

buy

in unsafe,

the demand

to

choose

to, which means

afford

could

less of

there exist attractive

example. Most residentswould

such neighborhoodsas soonas they

increasein

to

want

for which

higher

slightly

neighborhoods

out of

move

tend to make you

with

happens

sell for only

that

substitutes

more money

for such apartments

shift

to

leftward.

decrease

CHECK 3.5

CONCEPT

How will located far

pay increase for from Washington

a large away

federal employeesaffect

the

for apartments

rents

Metro stations?

Ground beef with high fat content is another exampleof an inferior good. For health reasons, most peopleprefer of meat with low fat content, and when grades do buy high-fat meats it's usually a sign of budgetary When people they pressure. in this situation receive higher incomes, they switch usually quickly to leaner grades of

Cost-Benefit

meat.

are another important factor that determines whether the will satisfy the Cost-Benefit Principle. Steven Spielberg's film Jurassic if previously Park appeared to kindlea powerful, latent, preference When this film was first released, the demand for among children for toy dinosaurs. such toys shifted to the right. And the same children who couldn't find sharply in toy designs involving horses dinosaur enough toys suddenly seemed to loseinterest and other present-dayanimals, whose demand curves shifted sharply to respective or tastes,

Preferences,

O

purchase of a

the

good

given

left.

about

Expectations

curves to shift. If Apple cheaper or significantly demand

curve

preceding

upgraded

the current

IN THE

SHIFTS The

for

the future Macintosh

are another users hear model

will be

model is likely

to

factor

shift

examples

price.

is based

for

introduced next

example,

demand that

a

the

month,

leftward.

involved what

changes happens

that gave rise to supply curves

when

of production,anything costs will shift the supply curve, resulting in a new curve

cause

may

SUPPLY CURVE

curves.Next,we'lllookat supply

that

a crediblerumor,

on costs

that

shifts in demand shift. Becausethe

changes

equilibrium

production and

quantity

PREDICTING

AND

EXPLAINING

Increasing will happen

What

priceof

to the

fiberglass,

Suppose

the

initial

curves

S and

D

in

price

equilibrium

used for

a substance

supply

and demand

Figure

3.14,

and

quantity

CHANGES

Opportunity

Cost

of skateboards

if the

making skateboards, rises?

curves for

resulting

in an

IN

as shown

are

skateboards

equilibrium price and

by

PRICES

79

AND QUANTITIES

EXAMPLE

3.4

the of

quantity

FIGURE 3.14

The Effect

on

Increase in

the

Market of an

Skateboard

the

Price

of

Fiberglass. [80

60

^r

($/skateboard)

r

5^

I I I I I I I

Price

0

800

-<

Quantity

When

input

supply

shifts

prices

rise,

equilibrium

left, causing price to rise and

equilibrium

quantity

to

fall.

1,000

(skateboards/month)

skateboard and 1,000 skateboards per month, Since fiberglass respectively. in its of the materials used to produce skateboards, the effect of an increase is to raise the cost of skateboards. How will this affect price marginal producing the supply curve of skateboards?Recallthat the curve is upward-sloping supply because when the price of skateboards is low, only those potential sellerswhose cost of making skateboards is low can sellboards whereas at marginal profitably, those with costs also can enter the market higher prices, higher marginal profitably (again, the Low-Hanging-Fruit Principle).Soif the cost of one of the materials used to produceskateboards the number of potential sellers who can profitably rises, sell skateboards at any given price will fall. And this, in turn, implies a leftward in the supply curve for skateboards.Note that shift a \"leftward shift\" in a supply curve also can be viewed as an \"upward shift\" in the same curve. The first to the horizontal of the supply curve, while the second corresponds interpretation to the vertical We will use these corresponds interpretation. expressionsto mean the same The new curve the (after exactly thing. supply price of fiberglass rises) is $60

per

is one

S' in Figure 3.14. in the cost of fiberglass have effect on the demand curve any for skateboards? The demand curve tells us how many skateboards wish to buyers if his at each is to a skateboard purchase price.Any given buyer willing purchase reservation for it exceeds its market And since each reservation price price. buyer's of owning a skateboard, does not depend on the price, which is based on the benefits in of there should be no shift the demand curve for skateboards. price fiberglass, In Figure 3.14, we can now see what when the supply curve shifts happens leftward and the demand curve remains For the illustrative supply unchanged. curve the new of than the shown, skateboards, equilibrium price higher the

curve

labeled

Does an

increase

$80,is

800 per month, is lower than the original price, and the new equilibrium quantity, new values are illustrative. There is (These original quantity. equilibrium merely insufficient information provided in the example to determine their exact values.) will choose a skateboard Peoplewho don't place a value of at least $80 on owning to spend their money on something else.

Increasing

a

Opportunity

Cost

80

CHAPTER3

SUPPLY

AND

DEMAND

on equilibrium

effects

The

whenever

direction

marginal

price and

in the

run

quantity

decline, as illustrated

of production

costs

opposite next

the

in

example.

EXAMPLE 3.5

Reduction of MarginalCost will

What

to the

happen

rate of carpentersfalls? Suppose

the

initial

curves

S and

D

supply and

in

houses

new

if the

wage

new houses are as shown by equilibrium price of $120,000

for

in an

resulting

of

the

per

3.15

FIGURE New

demand curves

3.15,

Figure

The Effect on the for

equilibrium price and quantity

Declinein

/s

Market

of a

Houses

/s1

3

Carpenters'

Rates.

Wage

When

00s/hc \302\251

input prices fall, supply shifts right, causing equilibrium price to fall and equilibrium

| 90

^

>^_\\\302\243^

u

rise.

quantity to

0

X\\SD

50

40

0

Quantity (houses/month)

houseand

an

quantity

equilibrium

wage rate

of 40

houses per month,

respectively.

A decline

cost of making new houses, and this means more builders can profitably that, for any given price of houses, in the serve the market than before. Diagrammatically, this means a rightward shift in the supply curve also S to S'. (A \"rightward shift\" supply curve of houses,from in the

of

carpenters

reduces

the marginal

can be described as a \"downward shift.\ Does a decreasein the wage rate of carpenters have any effect on the demand curve for houses?The demand curve tells us how many houses buyers wish to at each price. Because carpentersare now less than before, the purchase earning maximum amount that they are willing to pay for housesmay fall, which would in the demand curve for houses. But because imply a leftward shift carpenters make up only a tiny fraction of all potential home buyers, we may assume that this shift is negligible. Thus, a reductionin carpenters' a wages produces significant rightward shift in the supply curve of houses,but no appreciable shift in the demand curve. We see from the new equilibrium Figure 3.15 that price, $90,000 per house,is lower than the original price and the new equilibrium quantity, 50 houses per month, is higher

Examples the

production

skateboards

and

exampleillustrates,

than

the

original

3.4 and 3.5 involved of the good in

carpenters' supply

quantity.

changes

in the

cost of

question\342\200\224fiberglass

labor in the curves also shift

a material, or

in the

production of houses.As when

technology

production the

changes.

following

input,

of

in

PREDICTING AND

The Economic Naturalist term

do major 1970s?

Why

the

Students

make even

minor

manuscript

from changed

radically

changes need In

curves depicts

not

only

than

today

m

in

use could not days before word processors were in widespread in their term papers without to retype their entire having scratch. The availability of word-processing has, of course, technology the picture. Instead of having to retype the entire draft, now only the revisions

be entered.

D depict the supply and demand 3.16, the curves labeled S and for revisions in the days before word processing, and the curve S' the supply curve for revisions today. As the diagram shows, the result is a sharp decline in the price per revision, but also a corresponding

revisions.

number of

equilibrium

Why

does

written

more revisions now

FIGURE 3.16

The Effect ofTechnical Term-Paper Revisions. When

a new

right, causing

Note purchased own term hands, opportunity radically

that typing

on the

Change

technology reduces the price

equilibrium

in The

to

fall

cost reduced

of the that

of production,

cost and

Market for

equilibrium

supply

shifts

quantity to rise.

Naturalist 3.2 we implicitly assumed that market. In fact, however, many students make a difference? Even if no money actually

Economic

services

in a

papers. Doesthat students pay a price when they

of term-paper

time

it

takes

cost, we

revisions even if

to

revise

perform

their

that task.

would expect to most

students

term

students type their changes the

papers\342\200\224namely,

Because technology has

seea largeincreasein

type their own

the

number

work.

Changesin input prices and technology are two of the most important factors in supply that give rise to shifts curves. In the case of agricultural commodities, weather be another with favorable conditions shifting the factor, may important curves of such to the and unfavorable conditions supply products right shifting them to the left. (Weather also may affect the supply curves of nonagricultural its effects on the national transportation system.)Expectations productsthrough changes also may shift current supply curves, as when the from a current causes to withhold poor crops drought suppliers supplies from existing stocks in the hope of selling at higher prices in the future. Changes in the number of sellersin the market also can cause supply curves to shift. of

future

expectationof

81

Figure

in the

increase

revisions

more

many

3.2

AND QUANTITIES

dark

the

in

go through so

papers

IN PRICES

CHANGES

EXPLAINING

price

work go through so many than in the 1970s?

CHAPTER

82

3

SUPPLY

AND

DEMAND

RULES

SIMPLE

FOUR

For supply and demand curves for

the four basic

illustrate

rules that

shifts

how

govern

and demand affect

in supply

These rules are summarized

and quantities.

prices

equilibrium

the conventional slopes (upward-sloping for demand curves), the preceding examples

have

that

downward-sloping

curves,

supply

in

Figure

3.17.

FIGURE 3.17

Four Rules Governingthe Effects

of Supply

and

Demand Shifts.

Quantity An

Quantity

in demand

increase

to an increase

equilibrium price

and

in

demand

to a decrease in both equilibrium price and

the

both

in

A decrease

lead

will

quantity.

will lead the quantity.

Quantity An increase

in

a decrease in price and

increase

an

that cause

1.

A

2.

An

increase

in

3.

An

increase

in

An

increased

An

increase

An

expectation

When

an

in the

price

decrease

or

price of

preference in the

these factors

by demanders

population

of higher

move in

DEMAND

shift) in

demand:

good

or service.

good

or service.

for the good or

service.

of potential buyers.

prices the

to

equilibrium in the

quantity.

AND

upward

complements to the the price of substitutes for the income (for a normal good).

in the

will lead

supply

and a decrease

equilibrium

an increase(rightward

in

in the

increase

FACTORS THAT SHIFT SUPPLY

RECAP

4. 5. 6.

to

quantity.

equilibrium

Factors

supply will lead the equilibrium

A decrease

in

opposite

the

future.

direction,

demand

will

shift

left.

PREDICTING AND

Factors that 1. A

decrease

An

the

in

of the

production

2.

an increase

cause

cost

in

supply:

labor, or other inputs

of materials,

good or

service.

that reduces the

in technology

improvement

or downward shift)

(rightward

cost

of

AND QUANTITIES

IN PRICES

CHANGES

EXPLAINING

used in

the

the

producing

good or service.

3.

4. 5.

An

improvement

An

increase

An

expectation

When

The shifts

of

the next same depend

in the in the

move in

prices the

products).

suppliers. in

the

opposite

future.

supply

direction,

rules summarized in Figure 3.17 provided the curves have their

qualitative any

number of

of lower

these factors

weather (especially for agricultural

hold

both

time, the direction in which equilibrium on the relative magnitudes of the shifts.

for supply

and demand

supply

price

or

left.

shift

conventional

magnitude,

example demonstrates,when

will

or demand

curves

at

shift

the

will

changes

quantity

But as

slopes.

Shifts in Supply and Demand How

do shifts

in

both

demand

and supply

affect

quantities

equilibrium

and

3.6

EXAMPLE

prices?

in the corn tortilla the equilibrium price and quantity chip that the oils in following events occur: (1) researchers prove which tortilla chips are fried are harmful to human health and (2) the price of corn harvesting equipment falls?

What

will

market if

happen

both

to

of the

The conclusionregarding the health effects of the oils will shift the demand for tortilla chips to the left because many people who once bought chipsin the belief that they were healthful will now switch to other foods. The declinein the price of additional harvesting equipment will shift the supply of chips to the right because In Figures 3.18(a) and farmers will now find it profitable to enter the corn market. 3.18(b),the original supply and demand curves are denotedby S and D, while the new curves are denotedby S' and D'. Note that in both panels the shifts lead to a declinein the equilibrium price of chips. FIGURE 3.18

The Effects

of

Simultaneous and

Supply

When

demand

supply

shifts

price falls, quantity (b)

0 Quantity

Q'+Q (a)

Q+Q'

0 of bags/month)

(millions

Quantity

of bags/month)

(millions

(b)

but may

or fall (a).

Shifts Demand. shifts

in

left and

right, equilibrium equilibrium rise

either

83

CHAPTER3

84

SUPPLY

AND

DEMAND

But note also that the effect of the shifts on equilibrium cannot be quantity determined without knowing their relative magnitudes.Taken the separately, demand shift causes a decline in equilibrium whereas the supply shift causes quantity, in equilibrium quantity. an increase The net effect of the two shifts thus on depends which of the individual effects is larger. In Figure 3.18(a), the demand shift declines. In Figure 3.18(b), the supply shift dominates, so equilibrium quantity so dominates, equilibrium quantity goes up.

The following posed

problem

previous

happen to the equilibrium price of the following events occur:

and quantity

will

What

both

corn

to consider a

simplevariation

the

on

CHECK 3.6

CONCEPT if

the

asks you example.

check

concept in

protect

helps

destroys part

of the

The

Economic

Why

do

against cancer corn crop?

(I)

in

heart

and

tortilla chip market a vitamin found in

corn

the

that

discover

researchers

swarm of locusts

and (2) a

disease

3.3

Naturalist

\302\243W

months Seasonal

prices of some goods, like airiine ticketsto Europe,go up during heaviest of consumption, while others, like sweet corn, go down? the

for airline tickets

movements

price

prices to for tickets is highest

Thus, ticket

in demand.

the

demand

the

w

s subscripts

and

denote

Europe

during

winter

are

the

primarily

of seasonal

result

the

variations

because during the summer months in Figure 3.19(a), where those months, as shown and summer values, respectively. are

highest

{Sw

\\ .S

Ps

5

XV

>~j

Pw

/s 3 SI

f

Ps i

8 p,w f^r

' 0

dJ\\

\\

0

Qw Qs Quantity (1,000sof tickets)

,SS

1 ^w

^r

i i i i i

D

Qw Qs

Quantity

of bushels)

(millions

(b)

(a)

FIGURE 3.19

SeasonalVariation Prices

heaviest

some goods cheapest during of heaviest consumption,

Why

are

the

months

while

others

those

months?

are most

expensiveduring

consumption

By contrast,

Air Travel and Corn Markets. period of heaviest consumption when of high demand, (b) Prices are lowest during

in the

are highest during is the result consumption (a)

when

seasonal

of seasonalvariations months because its

the

heavy consumption

is

the

result

of high

heavy

the period

of

supply.

price movements for sweet corn are primarily the result in the summer price of sweet corn is lowest

in supply.The supply

is highest

during those

months,

as seen

in Figure

3.19(b).

AND

EFFICIENCY

AND

EFFICIENCY

Marketsrepresenta highly for a

good is

to potential

in

85

EQUILIBRIUM

EQUILIBRIUM effective

equilibrium,

system

the

equilibrium the value that

resources. When a market information price conveys important

of allocating

demanders potential place on that good. same time, the equilibrium price informs demanders about the potential cost of supplying the good. This rapid,two-way transmission of opportunity information is the reason that markets can coordinatean activity as complex as supplying New York City with food and drink, even though no one person or organization about

suppliers

At the

overseesthe But

optimal,

in

process.

are the prices and quantities the sense of maximizing

determined

in market

total economicsurplus?

equilibrium That

is, does

socially equilibrium

markets benefits always maximize the difference between the total costs experienced by market As we'll the answer is \"it see, participants? A market that is out of such as the rent-controlled New depends\": equilibrium, York housing market, always createsopportunities for individuals to arrange transactions that will increase their individual economic As we'll also see,however, surplus. a market for a good that is in equilibrium makes the largest possible contribution to total economic when its and demand curves reflect all surplus only supply fully costs and benefits associatedwith the production and consumption of that good. in

unregulated

and total

THE

ON

CASH

In economics we transaction

cannot

TABLE

assumethat

all

take place

exceeds the seller's reservation

exchange

is purely

voluntary. This means that

unless the buyer's reservation price.

When

that condition

price

is met

for

a

the good

and a transaction

from the place, parties receive an economic surplus.The buyer's surplus transaction is the difference between his reservation and the he price price actually is the difference between the price she receivesand her pays.The seller'ssurplus reservation the transaction is the sum of the buyer's price. The total surplus from and the seller's It is also to the difference between the buyer's surplus surplus. equal

both

takes

reservation priceand the seller's reservation price. whose reservation Suppose there is a potential buyer price for an additional slice of pizza is $4 and a potential sellerwhose reservation price is only $2. If this a slice of from this seller for the total $3, buyer purchases pizza surplus generated \342\200\224= = this is $4 \342\200\224 $2 $3 $1 is the buyer's surplus $2, of which $4 by exchange and $3 \342\200\224 $2 = $1 is the seller's surplus. A regulation that prevents the price of a goodfrom reaching its equilibrium level in of this sort from and the unnecessarily prevents exchanges taking place, process reduces total economic surplus. Consideragain the effect of price controls imposed in the in Figure if a price market for pizza. The demand curve 3.20 tells us that of slice were slices of would be sold.At $2 8,000 ceiling per imposed,only pizza per day that the vertical of the and demand curves tell us that quantity, interpretations supply a buyer would be willing to pay as much as $4 for an additional slice and that a seller to sell one for as little as $2. The difference\342\200\224$2 slice\342\200\224isthe per if economic that would result an additional slicewere surplus produced and sold. As noted earlier, an extra slice sold at a price of $3 would result in an additional $1 of economic surplus for both buyer and seller. When a market is out of equilibrium, it's always to identify possible mutually beneficial exchanges of this sort. When people have failed to take advantage of all beneficial we often that there's \"cash on the table\"\342\200\224the mutually exchanges, say in a market is economist's for unexploited opportunities. When the price metaphor

would

be

buyer's surplus the difference between the buyer's reservation price and the price he or she actually

pays

seller's

surplus

between

the

the

seller and

reservation

total

the difference price received by his

or

her

price

surplus

between

price and price

the

difference

the buyer's reservation the seller's reservation

willing

additional

cash on the table becausethe reservation price of sellers (marginal cost) will always be lower than the reservation price of buyers. In the absence of a law preventing from paying more than $2 per slice, buyers restaurant owners would raise their and their until quickly prices expand production

below the

equilibrium

price,

there's

cash on the table metaphor

an

economic

for unexploited gains

from exchange

86

3

CHAPTER

DEMAND

3.20

FIGURE

Price Controls Pizza Market.

A price

SUPPLY AND

in

equilibrium price of pizza result in excess

would

demand for

'

\\-Sf


0.

^

the

of $3

price

equilibrium

able to get preciselythe mutually beneficial

O

slices

table.

It is

almost as

if

optimal economic surplus that

the in that results quantity good the maximum economic possible from producing and surplus quantity

efficiency

good

(or economic

efficiency) a condition occurs

when

all

goods

that

and

services are produced and consumed at their respective socially

optimal

Efficiency

levels

Cost-Benefit

ability

no

be no surprise that and buyers to detect the presence of cashon

opportunities

quantity

ALL

that maximizes the total any good is the quantity from and the From the producing consuming good. know that we should keep expanding production of the of

results

we as its marginal

Principle,

FOR

least as great as its marginal cost. This is that level for which the marginal cost socially optimal quantity and marginal benefit of the good are the same. When the quantity of a good is less than the socially optimal quantity, boosting its production will increase total economic surplus. By the same token, when the of a good exceeds the socially optimal its production quantity quantity, reducing will increase total economicsurplus. Economic or occurs efficiency, efficiency, when all goods and servicesin the economy are produced and consumed at their respective socially optimal levels. social means that Efficiencyis an important goal. Failure to achieve efficiency total economic surplus is smaller than it could have been. Movements toward make the total economic pie larger, making it possible for everyone to have efficiency a larger slice.The importance of efficiency will be a recurring theme as we move forward, and we state it here as one of the core principles: good

as long

means that

The O

should

be

in the

The socially

of a

it

uncanny

unexploited

SMART FOR ONE,DUMB

O

price, buyers would to buy each day. All

that

give off some exotic scent centers of their brains. The desire to triggering explosions olfactory in cash off the table and into their is what drives sellers each of New scrape pockets York City's thousands of individual food markets to work diligently to meet their in customers' demands. That they succeed to a far higher degree than the participants rent-controlled market is evident. Whatever flaws it city's housing plainly might than have, the market system moves with considerably greater speed and agility any centralized allocation mechanisms yet devised.But as we emphasize in the following section, this does not mean that markets always lead to the greatest good for all. the

neurochemical

Cost-Benefit

in mind,

Principle

they

want

would have been exploited, leaving

for exchange

marketplace have an

sellers in the

of pizza

table.

Incentive

the

With

Incentive

At per slice were reached.

12,000

opportunities

cash on the

more

of slices/day)

(1,000s

Quantity

Demand

16

12

8

0

consuming the

= 8,000

2

U

optimal

demand

Excess slices/day

^>

pizza.

v

socially

Supply

4

the

below

ceiling

y

the

Efficiency

economic

benefit is at

the

Principle:

pie grows

larger,

Efficiency everyone

social goal because when slice. larger

is an important can have a

the

AND

EFFICIENCY

EQUILIBRIUM

Is the market equilibrium quantity of a good efficient? That is, does it the total economic received for that surplus by participants in the market in When the market for a is we can good? private given good equilibrium, say that the cost to the seller of producingan additional unit of the good is the same as the benefit to the buyer of having an additional unit. If all costs of producing the good if are borne and all benefits from the good accrue directly to directly by sellers, it follows that the market of the good will equate the buyers, equilibrium quantity cost and benefit of the And this means that the marginal marginal good. equilibrium quantity also maximizes total economic surplus. But sometimes the production of a good entails costs that fall on people other than those who sell the good. This will be true, for instance, for goods whose production levels of environmental pollution. As extra units of these goods generates significant are produced,the extra pollution harms other people besides sellers.In the market for such goods, the benefit to buyers of the last good produced is, as equilibrium to the cost incurred sellers to that But since before, equal by produce good. producing that good also imposespollution costs on others, we know that the full marginal cost of the last unit produced\342\200\224the seller's private marginal cost plus the marginal pollution cost borne by others\342\200\224must be higher than the benefit of the last unit produced. So in this case the market equilibrium of the will be than the quantity good larger socially if output Total economic of the good were optimal quantity. surplus would be higher lower.Yet neither sellers nor buyers have any incentive to alter their behavior. Another possibility is that people other than those who buy a good may receive benefits from it. For when someone a instance, significant purchases vaccination measles from her doctor, she not only but also makes herself, against protects it less that others will catch this disease. From the likely perspective of society as a we should the number of vaccinations until their marginal whole, keep increasing cost equals their marginal benefit. The marginal benefit of a vaccination is the value of the protection it provides the person vaccinated plus the value of the protection it provides all others. Private consumers, however, will choose to be if the marginal benefit to them vaccinated only exceeds the price of the vaccination. In this of vaccinations will be smaller than case, then, the market equilibrium quantity the that maximizes total economic individuals quantity surplus.Again, however, would have no incentiveto alter their behavior. Situations like the ones just discussed provide examplesof behaviors that we In call \"smart for one but dumb for all.\" each the individual actors are case, may are their as best and there can, behaving rationally. They pursuing goals they yet maximize

remain unexploited opportunities for gain from the point of view of the whole The is that these opportunities cannot be exploitedby individuals society. difficulty In alone. can often organize acting subsequent chapters, we will see how people to such For we summarize this now, collectively exploit opportunities. simply in the form of the following core principle: discussion

The A

Principle

Equilibrium

exploit

all

MARKETS

RECAP

When

called

(also

leaves no achievable gains through in equilibrium

market

the

supply

and benefits the

market

But

if people

and

curves for a

production in the result

economic

surplus.

it,

but

may

not

action.

the

equilibrium will other than buyers

Principle\:

individuals

SOCIAL WELFARE

demand

sellers bearcostsbecauseof largest possible

collective

for

opportunities

unexploited

AND

associated with

the \"No-Cash-on-the-Table

benefit from market

good reflect

all

largest possible the

equilibrium

good,

costs

significant

and consumption

of

that

good,

economic surplus.

or if people

need not

other than

result in

the

a

Equilibrium

87

88

SUPPLY AND

3

CHAPTER

DEMAND

-

is a downward-sloping line that buyers will demand at any given is an upward-sloping line price. The supply curve that tells what quantity sellers will offer at any given

\342\200\242 The

curve

demand

what

tells

-

SUMMARY

3.

quantity

neither

why

explains

the

model of supply and demand cost of production nor value

(as measured

purchaser

to pay)

willingness

by

some by itself, sufficient to explain why To cheap and others are expensive. explain in price, we must examine the interaction

willingnessto goods

is,

are goods variations

of cost

in this

seen

we've

of differences

because

price

and

chapter, in

their

curves. (LOl)

and demand

supply

respective

As

pay.

in

differ

decrease

4. A

in

a reductionin in

equilibrium

factors schedules,

and population, expectations, and complements are among demand schedules. Supply

tastes,

Incomes,

prices

substitutes shift

that

in

and

are primarily

turn,

as technology, input prices, of sellers,and, especially

the weather.

demand

buyers

equilibrium at the

as the quantity

when the

occurs sellers

that

quantity

price is exactlythe same offer. The equilibrium

market

price-quantity pair is the oneat which and supply curves intersect.In equilibrium, value

both the

measures

price

to buyers and the produce it. (LOl)

cost of

for

sold to required unit

last

the

of

For

most

well-being governments

to

outcomes interventions

price of a good lies above there is an excess supply of value, motivates sellers to cut their supply continues to fall until equilibrium the

\342\200\242 When

When price lies below excess demand. With upward

on

pressure

price

and price is reached.

value, frustrated

higher prices and until

there is

products,

agricultural

resources

or excess supply

demand

is

equilibrium

small and prevent

brief, exceptin

full

adjustment

markets

of prices.

occurs, where

it

of the

supply

tends

to be

of a

marketplace,

in its rules demand

curve

1. An

increase

equilibrium

2.

A

model is a primary

reduction

equilibrium

any

and

demandcurves.The following good

with

even

buy

almost

invariably

to

and

a

tenants.

and

(L04)

difficulty is that best solution is to incomes directly. The

the

tool

four

a downward-sloping

an upward-sloping supply curve: in demand will lead to an increase in price and quantity. in demand will lead to a reduction in and price quantity.

the

poor

have too

discover ways of law of supply and

repealed by the legislature. But the capacity to alter the underlying govern the shape and positionof supply schedules. (L04) cannot

be

have

\342\200\242 When

naturalist. Changes in the of it traded in good, and in the amount can be predicted on the basis of shifts

supply or

hold for

to

if unintended, consequences. rent-control laws, for example, lead

regulations

(LOl)

economic

equilibriumprice

the

and demand

levels. Suchlaws

\342\200\242 If the

the

the all

reflect \342\200\242 The basic

buyers

many

severe housing shortages,black marketeering, between rapid deterioration of the relationship landlords

feature of the market system is that, relying only on the tendency of people to in self-interested to market respond ways price signals, it somehow to coordinate the actions of manages billions of buyers and sellers worldwide. When literally excess

fact

income

little

goods people.

basic goods and services.Concernfor the of the poor has motivated many in a variety of ways to alter the intervene of market forces. Sometimes these take the form of laws that below peg prices

like

Programs

lament the

too

with

how

the

A remarkable

reached.

market

their equilibrium harmful, generate

equilibrium Excess good.

prices

demand,

persists

prices

that

equilibrium

excess

to offer

motivated

are

buyers

its

its

we often

example,

enter the

the

(L03)

in of markets efficiency allocating does not eliminate social concernsabout and services are distributed among different

the

market

resources

the

demand

the

the

governed by such factors the number expectations,

\342\200\242 The \342\200\242 Market

in

(L03)

\342\200\242

of

lead to an increase a reduction in equilibrium

will

supply

price

quantity. to

will lead to an increase

quantity.

equilibrium

Marshall's

and

price

equilibrium

price. (LOl) \342\200\242 Alfred

in supply

increase

An

money,

their

demand do

legislatures

that demand

forces and

and demand curves for a good costs and benefits associated with

supply

significant

and

production

little

boosting

consumption

of that good,

the

people to produce the good that in the largest possible economic surplus.This results does not apply if others, besides conclusion, however, benefit from the good (as when someone buyers, benefits from his neighbor's purchase of a vaccination or if others besides sellers bearcosts measles) against market

becauseof generates

price will guide the quantity of

equilibrium and consume

pollution).

the

doesnot result

when its production cases, market equilibrium greatest gain for all. (L04)

(as good In such in

the

89

PROBLEMS

PRINCIPLES

(ORE

The Efficiency

Efficiency

O

Equilibrium

Principle

is an

Efficiency

important social goal becausewhen

economic

the

pie

a larger slice. grows larger, everyone can have The Equilibrium Principle (alsocalledthe \"No-Cash-on-the-Table

O

Principle\

A market

in

individuals

but

leaves

equilibrium

not exploit

may

no unexploited opportunities for all gains achievable through collective

action.

TERMS

KEY

buyer's reservation price (66)

demand

in the

change demanded

(74)

quantity

in supply

change

(75)

curve

equilibrium

quantity

Explain the distinctionbetween curve.

(LOl)

interpretations the cost

isn't

substitutes

substitution

(66)

inferior

(78)

total

(85)

In

recent

that the

gasoline

the

QUESTIONS

horizontal

could

of the demand

proposal

a good

poor

of

rising

expressions

enacted?

5. Give that

for

(LOl)

between the meaning

\"change

in

demand\"

demanded.\"

quantity

official proposed imposed to protect evidence gasoline prices. What

to discover whether this

consult

you was

4. Distinguish

a government years, controls be price

from

surplus

(68)

equilibrium

knowing producing sufficient to predict its market price?(LOl)

Why

effect (65)

supply curve

good

(86)

quantity

(76)

(65)

REVIEW

vertical

socially optimal

(68)

(69)

(67)

price

surplus (85)

income effect

market

(65)

and

seller's

(68)

market (64)

complements (75) demand

reservation

price

excess supply (69)

quantity

(75)

supplied

seller's

(68)

equilibrium

demand

good (78)

price ceiling (73)

equilibrium

excess

(74)

in the

change

normal

efficiency (86)

efficiency(86)

table (85)

cash on the

change in

economic

(85)

surplus

buyer's

an example could

of

the

and \"change in

the

(L03) of

be described

behavior

you

have

as \"smart for

observed

one but

dumb

all.\" (L04)

PROBLEMS

How would eachof corn?

the

following

affect

the U.S.

(LOl)

a. A new

and improved

b. The priceof

fertilizer

crop

rotation

technique

falls.

c. The government offers new tax breaksto A tornado sweeps through Iowa.

d.

market supply curve

farmers.

is discovered.

for

conned:

|economics

3

SUPPLY AND

DEMAND

2. Indicate

/^Study

b. Buyers

store and

Econ

disease.

Study

3. An

4. State

stores?

Tucson

in

whether the

a.

diapers

and

will an increasein land? (L03)

What

7.

How

will

to the

happen

automobiles?

the

birth

affect

rate

equilibrium price and

price

equilibrium

increase in

a.

b.

The

of grapefruit

price

good

Exceptionally

harvest. the

Suppose

gains

10.

levels market

the

in

if the

price of price of

of automobile for new

Nebraska,

weather

sold in the

quantity

of oranges if

the risk

reduces

The New York

as well

developments

a much

provides

Times

of heart

breeds that

affect the

United States? (L03)

greater than expected

reports

as the discovery

more weight than existing these

and

falls drastically.

issue of

current

food. How will chickens

beef

of

juice

disease.

cow diseasein that

of

substitutes,or

the equilibrium

required

price

c. The wage paid to orangepickersrises.

9.

supplied)

quantity

of

(L03)

what will happen to the equilibrium events take place. (L03) following A finds that a daily glass of orange study

d.

outside

quantity

and quantity

8. Predict the

desert

the

diapers.

law mandating an

a new

will

CDs.

are complements, or

chickenfeedincreases?(L03) insurance affect the

price of

balls.

disposable

5. How

6.

in the

dryers.

b. Tennis rackets and tennis c. Ice cream and chocolate.

d. Cloth

of goods

pairs

and

machines

Washing

price of

(LOl)

following

both. (L03)

in the

the supply

affect

claim

his

will

consumption

pepperoni

linking

spotted a UFO over (not the

to have

claims

student

Arizona

Tucson. How binoculars

read a study

market for CDs learn of an increase for CDs). (a substitute the market for CDs learn of an increase

d. Buyers in

vacations increases.

for Adirondack

market

the

in

downloadable MP3s

app todayl

the

for pizza

market

the

in

c. Buyers

download

the Frank:

in the

demand

shift

(LOl)

to heart

your mobile app

following would

of the

each

think

incomes of buyers in

a. The

McGraw-Hill

Visit

how you

market:

indicated

consume

of mad

an outbreak

of a new breed of the

chicken

same amount

equilibrium price and quantity

of of

available only from small businessesoperating of large cities.Today tofu has become popular predominantly as a high-protein health food and is widely available in supermarkets throughout the United States. At the same time, tofu production has evolved to become modern D raw a factory-based using food-processing technologies. diagram with demand and supply curves depictingthe market for tofu 25 years ago and the market for tofu today. Given the information above, what does the in in model about the volume of tofu sold the demand-supply predict changes United States between then and now? What does it predict about changes in the price of tofu? (L03) Twenty-five in

years

ago, tofu was Asian sections

ANSWERSTO CONCEPT CHECKS

3.1

At

of 10,000

a quantity

is $3.50 per slice.At 14,000 slicesper day.

slices per day, of $2.50

a price

the

(HECKS

CONCEPT

TO

ANSWERS

reservation

buyer's

marginal

per slice,the

price will be

demanded

quantity

(LOl)

^3.50

1.2.50 V \302\243L

Demand

14

10

Quantity

3.2

At

a quantity

slice.

a price

per day.

(LOl)

At

of 10,000 of $3.50

(1,000s of slices/day)

slices per day, per slice, the

the

cost of pizza is $2.50 per will be 14,000 slices

marginal

supplied

quantity

Supply

'12-16

8

14

10

of slices/day)

(1,000s

Quantity

landlords are permitted to chargeless than

3.3 Since established

by

rent-control

a law

laws,

no effect on the rents at the equilibrium value of

actually chargedin

have

3.4 Travel by air and shift

will

airfares

fares and

travel

$800

intercity

by

month.

per

to

travel

fewer bus trips taken.Travel

by

this

market,

rooms

3.5

located

Apartments

A pay

increase for

apartments

rent.

rented.

(L03)

rent at $1,200 will which will settle

substitutes, so a the

left, resulting

and the use of shift the demand

air

complements,so a declinein airfares will roomsto the right, resulting in higher hotel rates and an number of

rent

maximum

(LOl)

bus are

for bus

the demand

the

maximum

the

sets

that

declinein in

bus

lower

resorthotelsare for resort hotel

increase

in the

(L03) far from federal

downward,

Washington

workers

will

Metro stations are an inferior shift the demand curve for

thus

which will lead

to a reductionin

their

good. such

equilibrium

91

92

CHAPTER

3

SUPPLY AND

DEMAND

3.6

The

vitamin

losses

shift

discovery the

supply

the

equilibrium price the equilibrium shifts, panel).

(right

shifts the demand of chips

for chipsto the

to the left. Both shifts

of chips. But depending quantity of chips

on the either

may

right

the crop increase in

and

in an

result

relative magnitude of the rise (left panel) or fall

(L03)

S' s

S'

V 'So

P' H

/

S

P

k

8P

SI

g

0.

f

P

/\302\243/

\\}'

\\l :

d

Quantity

(millions

of bags/month)

Q

p \302\243

y\\\\^D X\" !

Quantity

(millions of bags/month)

D

||

APPENDIX I

The Algebra of Supply and Demand In

in a chapter, we developedsupply and demand analysis framework. The advantage of this framework is that many in either easier one within which to visualize how shifts curve

of this

text

the

geometric it an

find

affect equilibrium price and quantity. It is a straightforward extension to translate supplyand demand analysis into algebraic terms. In this brief appendix,we show how this is done. The of the algebraic framework is that it greatly the advantage simplifies computing

numerical values of equilibrium Consider, for example,the P denotes the price of the good equations

of

prices

and quantities. demand curves

and

supply

and Q

denotes its

in

Figure What

quantity.

3A.1, where are the

curves?

these

appendix to Chapter 1 that the equation of a straight-line take the general form P = a + bQd, where P is the price of the on the vertical axis), Qd is the quantity demanded at that (as measured product measuredon the horizontal a is the vertical of the demand axis), price (as intercept For the demand curve shown in Figure curve, and b is its slope. 3A.1, the vertical is 16 and the is \342\200\2242. So the for this demand curve is intercept slope equation Recall from the must

curve

demand

P = Similarly,

form P

=c+

supplied

slope

equation

dQ%

at that

slope.For the the

the

curve

4. So the

straight-line supply curve must again the price of the product,

of a P is

price, c is the

supply

is also

where

(3A.1)

16-2Qd.

vertical intercept of

shown

in Figure

equation for

this

P =4

the

supply

the general is the Qs quantity curve, and d is its take

3A.1, the vertical intercept is 4 and

supply

+ 4QS.

curve

is (3A.2)

know the equations for the supply and demand curves in any market, a simple matter to solve them for the equilibrium price and quantity using the method of simultaneous equations describedin the appendix to Chapter 1. The following illustrates how to apply this method. example If we

it is

CHAPTER 3 APPENDIX

94

FIGURE Supply

THE

ALGEBRA OF

3A. I and

DEMAND

AND

SUPPLY

D 1

Demand

S

Curves.

16

12

4 N.0

0

EXAMPLE3A. I

Simultaneous

-Q

8

2

Equations

a market are given by If the supply and demandcurves for P = 16 \342\200\224 the 2Qd, find respectively, equilibrium price and quantity

we know that

In equilibrium, may

which

then

equate

yields

equation gives

Q*

= 2.

the

Equations

3A.1

4 + 4Q* = 16-

2Q*,

= price P*

equilibrium

already

have identified at 3A.1. is (That glance Figure

with

begun

we could

in hand,

the

why

ANSWER

Find

the

are

given

equilibrium price and quantity it seems natural to say that the following

finding

having

graphical

check

concept

the

equilibrium to produce

price

accurate

on both

of the supply

the

supply

and

Since the equilibrium

quantity.

equilibrium

the supply and

whose

demand curves, we equate the

and demand equationsto obtain 2Q*

which solves for Q* = demand equation gives

= 8

2. Substituting the

equilibrium

demand

curves

(HECK

CONCEPT

APPENDIX

3A.1 Let Q* denote quantity lie

the

by

3A.2

a simple

CHECK 3A.I

in a market equilibrium price and quantity = = 8 P P and 2QS 2Qd, by respectively.

TO

or demand

of Equations 3A.1 and

the graphs

helps

CONCEPT

(3A.3)

12.

us visualize the equilibrium outcome.) As the illustrates, advantage of the algebraic approach to and quantity is that it is much less painstakingthan of the and demand schedules. drawings supply

approach

and market.

4QS

this

back into either the supply

=2

Q*

+

4

for

this common value as Q*, we and 3A.2 and solve

Qd. Denoting

sides of

Substituting

Of course,having

=

Qs

the right-hand

P=

-

price and right-hand

sides

2Q*,

Q* =2

back into

price P* =4.

either

the

supply

or

TWO

PART

COMPETITION

THE

AND

HAND

INVISIBLE

in a

now

core principles of economics, you to position sharpen your understandingof how

and

how

work

things market

has

in

an

perfectly

are perfectly

be

will

on

competitive

informed and no firm

power.

We begin

in

4 by

Chapter

the concept of of demand and supply

exploring

which elasticity,

describes

the

variations

in prices,

incomes, and

sensitivity

of supply

discussion

our

focus

2 our

Part

In

idealized,

consumers

which

in

behave.

firms

consumers

economy

basic

the

grasped

Having

are

other economic factors.In

and demand

simply to assumethe law

of

to

demand,

I, we

Part

in

which

asked

you

says that demand 5 we will see that

In curves are downward-sloping. Chapter this law is a simple consequence of the fact that people spend

their

to

shift

will

see

to

be

consequence

in rational

incomes

limited

fully

the

and

to

decisions

production

in

agenda

by

see

concept investigate

firms,

how even

focus

6 our

taken

by firms

will

whose goal is

7 is to develop more carefully and I of economic surplus introduced in Part the conditions under which unregulated

Chapter

marketsgeneratethe will

Chapter

the market,whereourtask upward-sloping supply curves are a

to maximizeprofit.

Our

In

side of

seller's

the

why

of

ways.

market though

largest

forces the

possible

economic

surplus.

encourage aggressive cost resulting gains will eventually

We

cutting take

form of lower prices rather than We will higher profits. also explore why attempts to interferewith market outcomes often lead to unintended and undesiredconsequences.

the

CHAPTER

4

Elasticity

^..

.\"

i

LEARNINGOBJECTIVES

..-

\" \342\200\242 ^^

11

.

x\">

S r _ -\"

After reading

this

you should be

able to:

LOI

the

'*'*

^

Define

chapter,

price

of demand

elasticity

and explain what

J_~\342\200\224-

determines

whether

demand

is elastic

or

L02

inelastic.

the

Calculate

price

elasticity of demand .

i

curve.

a demand \342\226\240\342\226\240***

^s If

the

total

demand expenditures

L03

r

for illegal drugs is inelastic, increased on illegal drugs.

arrests of illegal

drug

sellers

Understand how

changesin

expenditure

more

The

vigorous

such efforts

price

of

likelihood

L04

drugs

drug users

will

will respond

increase.

by consuming

of crime drug userscommit but

depends

total expenditure demand curve for illicit

on their

rather

characteristics

Given

of

the

expenditure on drugs,but

that

demand

curves

a smaller quantity not on the quantity

on drugs.Depending drugs,

a price

are downward-sloping, of drugs. But the amount of on

drugs they consume, the specific

increase might reduce

total

total expenditure. f or that Suppose, example, patrols shift the supply curve in the market for illicit drugs to the left, as shown in Figure 4.1. As a result, the equilibriumquantity of drugs would fall from 50,000 to 40,000ouncesper day and the of would rise from to ounce. The total amount on $50 $80 price drugs per spent X which was would $2,500,000 per day (50,000 $50/ounce), drugs, ounces/day it also

could raise extra border

of income

the

and

demand

good.

cross-

the

Explain

price elasticity

that your

of

elasticity

for the

demand

iPod or laptop computer will be stolen? If attempts to reduce the supply of illicit are successful, our basic supply and demand drugs tells us that the curve for will shift to the left and the market analysis supply drugs the

reduce

on

depending

the price addiction.

of

price total

total

and

revenue

their any illicit drug users commit crimesto finance connection between drugs and crime has ledto callsfor efforts to stop the smuggling of illicit drugs. But can

the

a good affect

will increase

from

information

using

elasticity of demand.

L05

the

Discuss

of

elasticity explain determines

what whether

is elastic and

price supply,

supply

or inelastic,

calculate

the

price

elasticity of supply using

information

from a supply

curve.

98

ELASTICITY

4

CHAPTER

4.1

FIGURE

The Effect of Extra on the

Patrols

Border

Market for Illicit Extra patrols

shift

supply

leftward

and reduce

quantity

demanded,

may

actually

total

amount

\\^\\S

COo

Drugs.

^^^\\^S

Ol o

the

($/ounce)

P

but they increase the spent on drugs.

D

i

i

0

50

40

Q (1,000s of ounces/day)

rise to

$3,200,000per day the supply

stem

to

efforts

laptop being stolen.

ounces/day

(40,000

of drugs would actually

In

X $80/ounce). increase

the

this

case,

likelihood

then,

of your

Other benefits from stemming the flow of illicit still outweigh the drugs might But knowing that the policy might increase resulting increase in crime. drug-related crime would clearly be useful to law-enforcement authorities. Our task in this chapter will be to introduce the concept of elasticity, a measure of the extent to which quantity demanded and quantity to variations in supplied respond and other factors. In the precedingchapter, we saw how shifts in supply income, price, and demand curves enabled us to predictthe direction of change in the equilibrium values of price and quantity. An understanding of price elasticity will enable us to make even more precisestatements about the effects of such changes. In the illicitled to an increase in total drug example just considered, the decreasein supply other cases, a decreasein supply will lead to a reduction in total spending.In many spending. that explains this pattern, as we'll Why this difference? The underlying phenomenon see,is price elasticity of demand. We'll explore why some goods have higher price than others and the implications of that fact for how total elasticity of demand spending responds to changes in prices. We'll also discuss price elasticity of supply and examine the factors that explain why it takes different values for different goods.

Could

reducing

the

of

supply

illegal drugs cause an increase in drug-related burglaries?

PRICE the

When

the

predict

how much

price of a good or service effect of the price increase on

rises,the

by

For

half,

example,

purchases

PRICE percentage

quantity

or servicethat I

percent

the

change demanded of a good in

change

results

in its

yachts

from a

price

The quantity price.

quantity expenditure,

demanded we

falls. But to also must know by such as salt is not

Indeed,

sharply.

plummeted

ELASTICITY

The priceelasticity

price elasticity of demand the

of

falls.

to changesin

goods, however,

total

demanded of somegoods even if the price of salt wereto double,or most people would hardly alter their of it. For other consumption the quantity demanded is extremely responsiveto changesin price. when a luxury tax was imposed on yachts in the early 1990s,

quantity

very sensitive

to fall

OF DEMAND

ELASTICITY

DEFINED

of the good is a measureof the responsiveness in to its the quantity good changes price. Formally, price in the quantity of demand for a good is defined as the percentage elasticity change demanded that results from a 1 percent change in its price. For example, if the price of beef falls by 1 percent and the quantity demanded rises by 2 percent, then the of demand for beef has a value of \342\200\2242. price elasticity the definition of quantity demanded Although just given refers to the response in price, to a 1 percentchangein price, it also can be adapted to other variations demanded

of

demand

of that

for a

PRICE

they're relatively small.In such cases, we calculate the price elasticity of demanded divided by the corresponding percentage change in quantity in if 2 in the a reduction percentagechange price. Thus, percent price of pork led to a 6 percent increasein the quantity of pork demanded, the price elasticity of demand for pork would be

99

OF DEMAND

ELASTICITY

provided

as the

demand

Percentagechange quantity Percentage change in in

zero) becausepricechangesare always

in

the

opposite

convenience, we drop the negative sign and speak of price elasticitiesin terms of absolute value. The demand for a good is said to be elasticwith respect to price if the absolute value of its price elasticity is greater than 1. It is said to be inelastic if the absolute value of its price elasticity is lessthan 1. if the absolute value of its priceelasticity demand is said to be unit elastic Finally, is equal to 1. (See Figure 4.2.)

the demand

is less

demand

Mastic

unit

demand

equals

for

I

1

I

2

Price

3

inelastic

of demand

elasticity

price

if

lessthan

of Demand

Elasticity

but

the

when

per day.

falls to

the

elastic

wish quantity

to purchase demanded

price, what is the price elasticity of with respect to price?

demand

400 slices per day, rises to 404 slices for pizza? Is the

demand

from $1 to $0.97 is a decreaseof 3 percent. The rise in 400 slices to 404 slicesis an increase of 1 percent. The price = 1/3. So when the for pizza is thus (1 percent)/(3 percent)

of pizza

is $1, the

The fall

in

price from

quantity demanded

of

original

for pizza?

$1 per slice,buyers $0.97 per slice,the

of pizza is

price At

elasticity

of demand

price

demand for pizza

initial

price

it is

inelastic.

demand

for

pizza

is not

elastic with

respect

to price;

CONCEPT CHECK4.1 What

is the When

per year, but

elasticity the

price

when

I

4.2

greater

When

for

and Inelastic

elastic, unit

Elastic

Inelastic

elasticity

I

Demand.

1

is the

than

the demand

elastic

Demand

What

for a

of demand for

seasonski passes?

of a season ski pass is $400, buyers wish demanded price falls to $380, the quantity

per year. At the original price, what is the price elasticity the demand for ski passes elasticwith to price? respect

to

purchase rises to

of demand for

10,000 passes 12,000 passes ski

passes?

Is

a

good is unit elastic with respect to price if its price elasticity of

Elastic

0

is

good is inelastic with respect to price if its price elasticity of

FIGURE

Unite

for a good to price if

elasticity of demand than I

inelastic

be negative

always

So for

demanded.

quantity

its price

respect

(4.1)

(or direction from changes in

will

demand

is elastic with greater

\342\200\2242 percent

price

the price elasticity of

speaking,

Strictly

6 percent

demanded

demand

the

elastic

a good is called or

elastic,

with

to

respect

price elasticity is

the than

I, equal

to I, or

I, respectively.

EXAMPLE 4.1

ELASTICITY

OF PRICE ELASTICITYOF DEMAND

DETERMINANTS

the price elasticityof demand for a good or service?To that before a rational consumer buys any product, the purchase satisfy the Cost-Benefit Principle. For instance, considera good(such as a dorm refrigerator) that you buy only one unit of (if you buy it at all). to buy it. Now imagine that the Suppose that, at the current price, you have decided a price increase of this magnitude be likely to price goes up by 10 percent. Will make you change your mind? The answer will depend on factors like the following. determine

factors

What

recall question, decision must first

this

answer

Possibilities

Substitution

product you want to buy goes up significantly, you're likely to some other good that can do roughly the same job, but for If the answer is yes, then less money?\" can the effect of the price you escape if increase to the substitute But the answer is no, you by simply switching product. are more likely to stick with your current purchase. Theseobservations that demand will tend to be more elasticwith suggest to for for which close substitutes are readily available. for Salt, respect price products has no close w hich is one reason that the demand for it is substitutes, example, inelastic. that while the of salt demand is Note, however, highly quantity people insensitive to the same cannot be said of the demand for highly price, any specific brand of salt. After all, despite what salt manufacturers say about the special of their own labels, consumers tend to regardone brand of salt as a advantages if substitute for another. Morton wereto raise the of its salt Thus, virtually perfect price would switch to someotherbrand. significantly, many people simply The vaccine rabies is another product for which there are essentiallyno against A person attractive substitutes. who is bitten by a rabid animal and does not take the vaccine faces a certain and painful death. Most peoplein that would position could afford rather than do without the vaccine. pay any price they the

When

price

ask yourself,

\"Is

of a

there

Share

Budget

were to double.How would that affect the like most people,it would have no effect at all. Think about it\342\200\224a of the price of a $1 item that doubling you buy only every few years is simply to worry about. By contrast, if the price of the new car nothing doubled, you were about to buy suddenly you would definitely want to check out substitutes such as a used car or a smaller new model. You also might possible consider holding on to your current car a little longer. The larger the share of your is your incentive to look for substitutes budget an item accounts for, the greater when the price of the item rises. items, therefore, tend to have Big-ticket higher

Supposethe

of key rings suddenly price number of key rings you buy? If you're

elasticities

price

of demand.

Time

Home appliances

than models, somemore energy-efficient an the its general rule, appliance is, higher price. that a new air conditioner and electric rates Suppose you were about to buy rose It would probably be in your interest to buy a more efficient suddenly sharply. if machine than you'd what originally planned. However, you'd already bought a new air conditionerbefore learned of the rate increase? You wouldn't think it you worthwhile to discard the machine and it with a more efficient right away replace model. Rather, you'd wait until the machine wore out, or until you moved, before

As a

others.

come

in a the

making the switch. this

As

but

many

elasticity

more

efficient

substitution of one product or service for another occur in the immediate aftermath of a price increase, others take place years or even decades later. For this reason, the price in the long run than in of demand for any good or service will be higher example

illustrates,

time. Some substitutions

takes

variety of

the short run.

PRICE

FACTORS THAT

RECAP The

INFLUENCEPRICE

ELASTICITY

elasticity of demand for a good or service tends to be largerwhen for the good are more readily available, when the good's share in consumer's consumers have more time to adjust budget is larger, and when price

substitutes the

to a change in SOME

price.

ELASTICITY

REPRESENTATIVE

ESTIMATES

The entries in

Table 4.1 show that the price elasticities of demand for different this of 3.5 for products often differ substantially\342\200\224in sample, ranging from a high public transportation to a low of 0.1 for food. This variability is explained in part of elasticity just discussed.Note, for example, that the price by the determinants elasticity of demand for green peas is more than nine times that for coffee, reflecting the fact that there are many more closesubstitutes for green peas than for coffee.

4.1

TABLE

Price

Historical

Elasticity

Estimates for SelectedProducts Estimated

Service

or

Product

of Demand

Price

Food

0.1

Coffee

0.3 and

Magazines

0.3

newspapers

Housing

0.6

Tobacco

0.6

Clothing

0.6

Medical care

0.8

Oil

0.9

Motor

I.

vehicles

I

Beer

1.2

Furniture

1.3 1.6

meals

Restaurant

Elasticity

Household electricity

1.9

Boats, pleasure

2.4

aircraft

Green peas

2.8

Public

transportation

3.5

K. Elzinga,

\"The

in The Structure of American Industry, ed. Walter State and Local Public Finance (Chicago: Irwin, and Lester Taylor, Consumer Demand in the United States: Analyses 1996); H. S.Houthakker and Projections, 2nd ed. (Cambridge, MA: Harvard University Press, 1970);Ashan Mansur and \"Numerical of Applied General Equilibrium Models: Estimation, John Whalley, Specification eds. Herbert Scarf and John Calibration, and Data,\" in Applied General Equilibrium Analysis, Shoven (NY: Cambridge University and Price Elasticities Press, 1984); Joachim Moller,\"Income in Different Sectors of the Economy\342\200\224An Analysis of Structural Change for Germany, the U.K., A and the U.S.A.\"(University of Regensburg, \"The Demand for Electricity: 1998); L. Taylor, Bell Journal and Henri Theil, Ching-Fan and 1975); Survey,\" of Economics (Spring Chung, in Econometrics,\" Evidence on James Seale, \"Advances Supplement I, 1989, International CT: JAI Press, 1989). (Greenwich, Consumption Patterns Sources:

Adams

(NY: Macmillan,

Note alsothe the

high

price

contrast

elasticity

Beer Industry,\"

1977); Ronald

between

of demand

a substantial share of most family spending categories like food.

Fisher,

the low price elasticity of for green peas.Unlike green budgets and there are few

demand

peas, substitutes

for food and food occupies for broad

ELASTICITY

OF DEMAND

102

CHAPTER

4

ELASTICITY

An

of the factors that sense of consumer

understanding

not

to

only

make

Consider, for

policy.

DEMAND

OF

ELASTICITY

PRICE

USING

example, the

of demand is necessary

elasticity

price

govern

behavior, but alsoto design

effective

taxes affect

how

about

debate

public

smoking among

teenagers.

aif

The Economic

4.1

Naturalist

Will

tax on cigarettescurb

a higher

hired

Consultants main reason Does

tobacco

important

have testified

industry

teenagers smokeis that

The consultants

the most

the

friends higher

are almost certainly

a higher tax on cigarettes would have rates. Because most teenagers smoking

adolescent

little

influence is

peer

smoking.

that

imply

The

sense?

that

right

of teen

determinant

Congress

smoke, these taxes would have

economic

make

in

smoking.

teenage

curbing

their

and they concluded that the consultants' testimony

consultants testified,

effect.

by

cigarette taxes aimed at

higher

against

smoking?

teenage

not

does

that

But

little

impact

have

little

on money

to

a significant share spend at their own discretion, cigarettes constitute of a typical smoker's teenage budget.The price elasticity of demand is thus to be far from negligible. For at least some teenage likely tax would make smoking unaffordable.And even among smokers,a higher those who could afford the higher prices, at least some others would choose to spend their money on other things rather than pay the prices.

higher

Given

that the tax

would

at least

affect

not

Do high

cigarette

prices

mr

discourage teen

The Economic Why

was

may

the

the

tax

smokers,the

deters

may be extremely large.The mere fact that peer therefore does primary determinant of teen smoking higher cigarette taxes will have no significant impact on the

imply

be the that

number of teens who

smoking?

If

unravel.

effects

cumulative pressure

argument

begins to

some teenage

even a small number of smokers directly its effect on the price of cigarettes, through it will also deter others indirectly, the number of peer role by reducing modelswho smoke. And those who refrain because of these indirect effects will in turn no longer influence others to smoke, and so on. Soeven if the direct effect of higher taxes on teen smoking is small, the cigarette consultants'

smoke.

Naturalist 4.2

luxury

tax on

yachts sucha disaster?

In 1990, Congress tax on yachts costing more than $ 100,000, imposed a luxury along with similar taxes on a handful of other luxury goods. Before these taxeswere the Joint Committee on Taxation estimated that they would yield more than imposed, in revenue in 1991. However, million the tax actually a bit more than $31 generated half

aFor Luxury

that

amount,

an alternative Boats,\"

$16.6 million.1 Several

years later,

\"The view, see Dennis Zimmerman, Research Service,February

Congressional

the

of the 10, 1992.

Effect

Joint

Economic

Luxury ExciseTax

Committee on the

Sale of

A

Why did

the

estimated

tax

luxury

that

the

on yachts backfire?

tax

on yachts

led

had

industry.Taking account of lost income

the U.S.government of

its

went

came

actually taxes\342\200\224almost

luxury

INTERPRETATION

GRAPHICAL

$39

to

a loss

taxes

and

of 7,600 increased

jobs in

U.S. boating

the

unemployment

in fiscal 1991 out $7.6 million behind million worse than the initial projection.

benefits, as a result What

wrong?

The 1990 law

imposed

no

luxury

the United States. What Congress are almost perfect substitutes for And, no surprise, when prices on

taxes on yachts built to consider was

failed

and that

purchased foreign-built

outside yachts

and purchased in the United States. domestic went because of the tax, yachts up yacht in droves switched to foreign models. A tax imposed on a good with a high buyers of consumption but price elasticity of demand stimulates large rearrangements little revenue. Had done the economic it would yields Congress analysis properly, have predicted that this particular tax would be a big loser. Facing angry protests

from unemployed New England

yachts

A

in

For

built

shipbuilders,

Congress

repealed

the

luxury

tax

on

1993.

GRAPHICAL

PRICE

yachts

INTERPRETATION

OF

ELASTICITY

in price, price elasticity of demand is the proportion changes by which demanded divided the quantity changes by corresponding proportion by which This formulation enables us to construct a price changes. simple expressionfor the of demand for a minimal information about its price elasticity good using only demand curve. Lookat Figure 4.3. P represents the current price of a good and Q the quantity in the current price and the demanded at that price. AP represents a small change in demanded is AP/P will resulting change quantity given by AQ. The expression then stand for the proportion by which and will stand for the price changes AQ/Q which These two corresponding proportion by quantity changes. expressions, small

OF PRICE

ELASTICITY

103

104

ELASTICITY

4

CHAPTER

FIGURE 4.3 A Graphical

Interpretation of Price elasticity any

point

Price

Price

of demand

at A =

elasticity

of Demand.

Elasticity

x

|^

^

at

along a straight-line curve is the ratio of

demand at price to quantity times the reciprocal slope of the demand

that point of the curve.

0

AQ

Q +

Q

Quantity

along

of the

definition

our

with

for priceelasticity:

the formula

Price

Suppose, for when

that

price

=

AP/P One

to 105,

of the

sign

negative

that

example,

rose

4.1),

(Equation

give us

(4.2)

AP/P'

were sold at

20 units quantity

e = (5/20)/(5/100)= 5. it has

price of 100 and units. Neglecting the

original

to 15

then have

would

we

the

fell

demanded

of this formula is that to calculate the

feature

attractive

demand

AQ/Q elasticity

change,

quantity

which yields

5/100,

price elasticity of

AQ/Q = 5/20 and

a straightforward

graphical

at point A interpretation.Thus, price elasticityof demand on the demand curve shown in Figure 4.3, we can begin by rewriting the right-hand side of Equation 4.2 as (P/Q) X (AQ/AP). And since the slope of the demand curve is equal to AP/AQ, AQ/AP is the reciprocal of that slope: AQ/AP = 1/slope. if

The price elasticity

of

want

we

denoted

at point A,

demand

simple formula:

eA,

therefore

has

the following

1

(4.3)

X

slope*

Q

To demonstrate how convenient this of elasticity can be, interpretation supposewe want to find the price elasticity in of demand at point A on the demand curve 4.4. The slope of this demand curve is Figure the ratio of its vertical to its intercept = 4. So horizontal 20/5 intercept: 1/slope = 1/4.

FIGURE 4.4

graphical

CalculatingPrice Elasticity

of

20

Demand.

The price elasticity of demand at A is given by (P/Q) X(l/slope)

(8/3) X

(1/4)

=

16

=

u

2/3.

*

\\P

12

ignore

4 i

0

i

12

the

(Actually,

_^W\\

8

i

i

3

4

5

Quantity

the

minus

slope

is

of price elasticity same sign.)The ratio so the price elasticity

What

is the

CHECK

we

again

at point A is equal to = = 2/3. (8/3) X (1/4) (P/Q) X (1/slope) This means that when the price of the good is 8, a 3 percent reduction in price will lead to

a 2 percentincreasein

CONCEPT

but \342\200\2244,

for convenience, since demand has the always at point A is 8/3, P/Q

sign

quantity

demanded.

4.2

price elasticity

of demand

when

P =

4 on the demand curve

in

Figure

4.4?

A

The

of

when

P =

easily

e = (P/Q) vertical

X

price

4.5, calculate of elasticity

the price demand on

FIGURE

Price

= 2.

So the of D2 curves,

to its

intercept

= 1/2.

6/12

intercept:

reciprocalof

the

curves.

slope

is 2. For both demand = 4 when P = 4, so Q

(P/Q)= 4/4 = 1

the price

Thus

each.

for

demand

elasticity of

whenP = 4is(l)X(l/2) = l/2

forD1and(l)X(2) = = =

(P/Q) elasticityof

1/5

2forD2.

1, Q 10on D2, = 1/10. Thus price

P

When

=

demand

(1/10)

X

so =

(2)

when P = 1 on D2.

rule: If two demand curves have a point in less price elastic of the two with respect to this does not mean that the steeper curve is less elastic price at that point. However, at at P = 1, price elasticity of demand on D2 was Thus, we saw that every point. half the corresponding only 1/5, or lessthan elasticity on the steeper Dx at P = 4. This

common,

PRICE

a general

illustrates

example

curve must

the steeper

be

the

CHANGES ALONG

ELASTICITY

A

STRAIGHT-LINE

CURVE

DEMAND

As a glance at at every point

makes clear, price elasticity has a different value curve. The slope of a straight-line demand curve is constant, which means that is also constant. But the price-quantity 1/slope ratio P/Q declines as we move down the demand curve.The of demand thus elasticity our

formula

elasticity

along a straight-line

declines steadilyas we move

Sincepriceelasticity

demand

downward

along

a straight-line

demand curve.

demanded divided by percentage change quantity the corresponding percentagechange in price, this pattern makes sense. After all, a in movement of a absolute size is small terms when it occurs price given percentage near the top of the demand curve, where price is high, but large in percentage terms when it occurs near the bottom of the demand curve, where price is low. Likewise, a

occurs near the percentage

terms

is the

of a

movement

quantity

top

when

of

at the

Figure

value is large in

curve, where

demand

it occurs

example,

in

given absolute

the

The graphical interpretation

elasticityof demand be 1. Consider, for in curve D shown

of

the

Demand

When price and quantity are the same, price elasticity of demand is always greater for the less steep of two demand

So

(1/slope)is 1/2 for Dr Similarly, of D2 is the ratio of vertical

and the

Elasticity

Curve.

to its 12/6

4.5

Steepness

its

of

the slope its

4.2

EXAMPLE

D2

The

is the ratio

intercept:

horizontal

105

ELASTICITY

be

(1/slope).

intercept

horizontal

the

is

and Slope

the formula

using

of D1

slope

in Figure

shown

4. What

Elasticity

OF PRICE

I?

These elasticitiescan calculated

P =

when

demand

elasticity

and D2

curves D,

demand

the

For

between

Relationship

INTERPRETATION

GRAPHICAL

near the bottom of of

elasticity

percentage is low,

quantity

the

curve,

also makes

it

where easy

when

terms

and small

it

in

quantity is high. the price curve must always A on the demand

to see why

demand midpoint of any straight-line the price elasticity of demand at point 4.6. At that point, the ratio P/Q is equal to

6/3 = 2.

CHAPTER4

106

ELASTICITY

The slope 4.6

FIGURE

Elasticity at the of a Straight-Line

the

at the

u

I

A

6

alonga

\\d

point

below elasticity

0

3

6

Quantity

above

these and

of any straight-line

half,

unit

bottom

that elasticity

the

half of a

curve in Figure 4.8(a) has a

f < 1

slope of zero,

that

of its slope

the reciprocal

is infinite. Priceelasticity

b

b/2

0

every

point

demand curve. curves

are

Such demand

said to

elastic.

respect

is perfectly

to price

of demand is

if

elastic

Second,

price

the

with

elasticity

infinite

slope is infinite.

respect

is perfectly

to price

of demand is

if

inelastic price

curve

in Figure

4.8(b) is vertical,

of its slope is thus reciprocal demand is thus exactly zero at every point along vertical demand curves are said to be perfectly inelastic.

perfectly inelastic demand demand

demand

RECAP

with

The

equal

OF

be perfectly

means

which

to zero.

that

Price elasticity

the curve.For this

CALCULATING PRICEELASTICITY

of

is thus infinite at a horizontal along

demand

Quantity

perfectly elastic demand

means

which

straight-line

demand curve.

demand

curves.

demand

horizontal

the

First,

a/2 \302\243

on the

inelastic

straight-line

y

rule

general

declines along

demand

the

elastic at

and

midpoint,

the

to

exceptions

a

Demand is elastic on top

There are two important

Regions

Curve.

Demand

CASES

SPECIAL

TWO

along a Straight-Line

any

the elastic, inelastic,

findings by denoting elastic portions

unit

4.7

Elasticity

1 at

the midpoint. By the same token, must be greater than 1 for any the midpoint. Figure 4.7 summarizes

demand curve.

Price

price

curve,

be less than

must

demand

of

point

demand

straight-line

elasticity

price

FIGURE

= 1.

(1/2)

but

I.

value

neglect

Inserting these formula yields

This result holds not just for Figure 4.6, also for any other straight-line demand curve.2A glance at the formula also tells us that since declines as we move downward P/Q

of

midpoint

(again, we

1/2

= (2) X

X (Vslope)

(P/Q)

*A

=

(1/slope)

sign for simplicity). the graphical elasticity

into

=

curve is the ratio of to its horizontal intercept,

demand

this

intercept

negative

values

of

any straight-line demand curve always takes the

of

12/6 = 2. So

12

Midpoint

Demand Curve. The price elasticity demand

vertical

its

its

of

reason,

DEMAND

elasticity

elasticity of demand for a good is the percentage change in the that results from a 1 percentchange in its price. Mathematically, the elasticity of demand at a point along a demand curve is equal to (P/Q) X P and Q represent priceand quantity where and (1/slope) is the (1/slope), of the slope of the demand curve at that Demand is elastic with reciprocal point. to price if the absolute value of its priceelasticity exceeds 1; inelastic if respect is less than 1; and unit elastic if price elasticityis equal to 1. price elasticity

zero

The price

quantity demanded

see why, note that at the midpoint of any such curve, P is exactly half the vertical intercept of the curve and Q is exactly half the horizontal intercept. Since the ratio of the vertical to the intercept horizontal intercept is the slope of the demand curve, the ratio {P/Q) must also be equal to the slope of the demand curve. And this means that (1/slope) will always be equal to the product {P/Q) X Thus, = {P/Q) X {Q/P) will always be exactly 1 at the midpoint of any straight-line demand curve. (1/slope) 2To

demand

{Q/P).

AND ELASTICITY

TOTAL

107

EXPENDITURE

4.8

FIGURE

Perfectly Elasticand Perfectly

Inelastic

Demand

Curves.

The Perfectly elastic demand

QJ

Perfectly inelastic

=

(elasticity

(a)

\302\260\302\260)

U

demand


==

(elasticity

u

&.

0)

&.

0.

Quantity

slightest price leads

desert the

substitutes.The

(b)

(a)

at every

the

in favor of

product

0

Quantity

point. Even

increase in consumers to

0.

0

elastic, or

elastic,

infinitely

curve

demand

horizontal

is perfectly

demand

vertical (b) is perfectly

curve

inelastic at every point.

Consumersdo not,

or

switch to substitutes in the face of large

cannot, even

increases

Sellersof price or

and services have a strong consumers spend more on my

goods

\"Will

like

questions

EXPENDITURE

TOTAL

AND

ELASTICITY

fewer units

at

a higher

price?\" As

interest in

it

able to answer more units at a lower the answer to this question

being

if I sell

product turns

on the price elasticity of demand. depends critically how the total amount spent on a varies with

good

The total

in price.

out, To see the

price

why, let's first of the good. number of units

examine

on a good is simply the daily daily expenditure bought the price for which it sells. The market demand curve for a good tells us the quantity that will be sold at each price. We can thus use the information on the demand curve to show how the total amount spent on a goodwill with its price. vary will spend on tickets each To illustrate, let'scalculatehow much moviegoers times

day

The

be sold, for

at the

so total for

but

$2

as shown in

and the price is $2 per ticket (a). per ticket,500tickets per day will at that price will be $1,000 expenditure per day. If tickets sell not $4 apiece, 400 ticketswill be sold each day (b), so total expenditure

demand curve is demand curve tells us

if the

higher price

will

be

that

4.9

Figure

a price

at

of $2

per day.

$1,600

FIGURE 4.9 12

>P

10

Total

8

u

Expenditure

= $l,0007day

2

2

The Demand

0

Movie Tickets.

6

4

4

0 Quantity

I

12 (100s

I

I

3

4

6

of tickets/day)

(a)

An

0

B

I

Quantity

I

4

3

12 (100s

5

X

6

of tickets/day)

(b)

increase

for

in price from

$2 to $4 per ticket total

I

5

Expenditure

= $l,6007day

2

^A I

Total

8

6

2

sP

Curve

increases

expenditure on tickets.

108

CHAPTER

4

ELASTICITY

that the total amount

Note

the total

and total

expenditure Total

revenue

=

Expenditure

consumers

spend

consumers spendon a product each day receive. That is to the product say, are simply two sides of the same coin:

must equal total

of the

sellers

amount

on a

Total

Revenue: The

product (P

X

Q)

is equal

dollar amount to

the

terms

that

that

amount

dollar

sellers receive. seem that an increase in the market price of a product shouldalways increase in the total revenue received by sellers. Although that in the case we it needn't be so. The law of demand tells us happened just saw, always that when the price of a good rises, people will buy less of it. The two factors that in total and thus move govern revenue\342\200\224price quantity\342\200\224will always opposite directions as we move along a demand curve. When price goes up and quantity goes the product of the two may down, go either up or down. that for the demand curve shown in Figure 4.10 Note, for example, (which is the same as the one in Figure 4.9), a rise in price from $8 per ticket (a) to $10 per ticket Thus will spend (b) will cause total expenditure on tickets to go down. people on tickets at a of but at a $1,600 per day $1,000 price $8, only per day price of $10.

It

result

in

to $ 10per ticket fall

12

Curve for

Tickets.

An increase in total

tickets.

in an

4.10

FIGURE

The Demand Movie

might

price

-\\p

from $8

results

expenditure

in a

on

12

Total

/=

8 \302\253

S

au

10

Expenditure

$l,6007day

^

8

6

Total

Expenditure

$l,000/day

\\S=

6

($/ticket)

\342\200\242C 4

0.

Price

4 \\d

2

2 I

12

0

CQuantity

(100s

1

1

3

4

IX

5

I

6

of tickets/day)

(a)

0 Quantity

12 (100s

I

I

I

3

4

5

X

6

of tickets/day)

(b)

The general rule illustrated 4.9 and 4.10 is that a price increase will by Figures in in an increase total revenue whenever it is terms, produce greater, percentage than the corresponding percentage reduction in quantity demanded. the Although two price increases(from same absolute $2 to $4 and from $8 to $10) were of the much different when expressed as a percentageof value\342\200\224$2 in each case\342\200\224they are An in the increase from to $4 representsa 100percent increase $2 original price. in whereas an increase from to a 25 increase $8 $10 price, represents only percent And the reductions caused the two increases were price. although quantity by price alsoequal in absolute terms, they too are very different when as expressed in of the sold. the decline Thus, although percentages quantities originally quantity in demanded was 100 tickets per day in each case, it was just a 20 percentreduction in Figure 4.9) but a 50 percent reduction in the first case (from 500 units to 400 the second to 100 in Figure 4.10). In the second case,the (from 200 units negative effect on total expenditure of the 50 percent reduction outweighed the quantity positive effect of the 25 percent price increase. The reverse happenedin the first case: the 100 percent increasein price $2 to $4) outweighed the 20 percent (from in quantity (from 5 units reduction to 4 units). The following example providesfurther into the relationship between insight

total revenue

and

price.

ELASTICITY

and Total Expenditure

Elasticity For 4.11,

total

how

each record

in

graph

Table

than

the one

shown

6

S rice

next step is to plot total expenditureat each of the price points on a graph, as in Figure 4.12. Finally, sketch the curve these by joining points.(If greater is required, accuracy you can use a larger points

for

Tickets.

i__^.

8 \302\253

calculate total expenditure for shown in the graph and price the as in Table 4.2. The results,

sampleof

Movie

^ 10

constructing

4.3

EXAMPLE

FIGURE4.il

with the

this

109

TOTAL EXPENDITURE

The Demand Curve

12

tickets.

first step

is to

varies

expenditure

price of movie The

shown in Figure graph showing

the demand curve draw a separate

AND

i^w

0.

2

_!

i

i 1

i 1

12

0

_L : 1

X

3

4

5

1

X

6

of tickets/day)

(100s

Quantity

X.

! 1

in

4.2.)

TABLE 4.2

Total Expenditure as a Function

of

Price

Total expenditure ($/day)

Price ($/ticket)

0

12

10

1,000

8

1,600

6

1,800

4 2

1,600

0

0

1,000

FIGURE 00O CT> O

o o

1

Function

_l

curve

1

expenditure

L

L

OOo

reaches

midpoint of the expenditure

curve.

Total

f

1

I

2

i

4

I

6

I

8

I

10

\\

12

Price($/ticket)

Note

increases.

expenditure decreases.

4.12 that as the price per ticket increases from $0 to $6, total But as the price rises from $6 to $12, total expenditure reaches a maximum of $1,800per day at a price of $6. expenditure

in Figure Total

a

maximum at the price

j

corresponding

c)

as a

of Price.

For a good whose demand is a straight line, total

1 ($/day)

4.12

Total Expenditure

to the demand

The pattern observedin the preceding holds true in general. For a example demand total is at the that lies on the curve, straight-line expenditure highest price of the demand curve. midpoint about how expenditure varies with Bearing in mind these observations price, let's return to the question of how the effect of a price change on total expenditure on the price elasticity of demand. for example, that the business depends Suppose, of a rock band knowshe can sell tickets to the band's 5,000 manager weekly if he sets the price at $20 per ticket.If the elasticity summer concerts of demand for tickets is equal to 3, will total ticket revenue go up or down in response to a 10 percent increase in the price of tickets? Total revenue from tickets sold is currently tickets/ ($20/ticket) X (5,000 = week.The fact that the of demand for tickets week) $100,000 per price elasticity is 3 implies that a 10 percent increase in price will produce a 30 percent reduction in will the number of tickets sold, which means that fall to 3,500 quantity tickets per week.Total expenditure on tickets will therefore fall to (3,500 tickets/ = X ($22/ticket) is significantly less than the week) $77,000 per week, which current

total.

spending

have happened to total expenditureif the band manager had reduced ticket pricesby 10 percent, from $20 to $18? Again a price assuming in of the result would have beena 30 increase tickets sold\342\200\224from 3, elasticity percent week to week.The total would have 5,000 6,500 per per resulting expenditure = been ($18/ticket) X (6,500 tickets/week) more week, $117,000 per significantly than the current total. These examples illustrate the rule about how price following important affect total for an demanded changes expenditure elastically good: would

What

When

I:

Rule

in total

price elasticity

expenditure

Let's look at and quantity.

always

intuition

the

of demand is greater than

and

changes

in opposite

behind

this rule. Total expenditureis the product of price demanded product, the percentagechange in

an elastically

For

in price

I, changes

directions.

move

than the corresponding percentage change in price. Thus the in will more than offset the revenue unit sold. change quantity change per Now let's see how total spending to a price increasewhen demand responds is inelastic with respect to price. Considera caselike the one just considered for tickets is not 3 but 0.5. How will total except that the elasticity of demand in to a 10 increase ticket This time the expenditure respond percent prices? number of tickets sold will fall by only 5 percent to 4,750 ticketsper week, quantity

be

will

larger

in

expenditure on tickets will riseto (4,750tickets/week) the $104,500 per week, or $4,500 per week morethan level. total

that

means

which

X

=

($22/ticket)

expenditure

current

a 10 percentprice reduction (from to $18 per ticket) when $20 0.5 would cause the number of ticketssold to grow by only 5 price elasticity in from weekto total 5,000 per 5,250perweek, resulting percent, expenditure of = X less than week, ($18/ticket) (5,250 tickets/week) $94,500 per significantly In contrast,

is

total.

the current these

As

when

examples

demand

was elastic: Rule

2:

When

price elasticity

total expenditure

Again, the is

demand

change

always

in

move

intuition

behind

inelastic

with

smaller revenue per unit will be

demanded

number of units

the effect of pricechangeson total expenditure is preciselythe oppositeof what it was when demand

illustrate,

is inelastic

sold.

of demand is less than in the same direction. this

respect than

sold

the

I, changes

in price

and

changes

in

is straightforward. For a product whose to price, the percentage changein quantity

rule

corresponding

(price)

will thus

percentage

more

than

change offset

the

in

price.

change

The

in the

INCOME

The relationship is summarized

revenue

between elasticity and the in Figure 4.13, where the

AND

ELASTICITY

CROSS-PRICE

OF DEMAND

ELASTICITY

price change on total used to denote elasticity.

of a

effect

e is

symbol

FIGURE 4.13 If demands

is...

increase will...

A price

A price

reducetotal

reduction will...

increase

and

Elasticity

of a

total

Effect

the

Price Change on

Total

Expenditure.

expenditure

expenditure

elastic

(6>l) x

p

= pQ

Q

x

p

total

increase

= M

Q

reduce

expenditure

total

expenditure

inelastic

(6
P

X

Q

=

P

ffl

X

Q

=

PQ

Recall that in the example with which we began this chapter, an increase in the in the total amount spent on drugs.That will happen price of drugs ledto an increase in that whenever the demand for drugs is inelastic with to price, as it was respect instead been elastic with to price, the example. Had the demand for drugs respect in total would have led to a reduction on drugs. drug supply interruption expenditure

ELASTICITY

INCOME

ELASTICITY OF

AND CROSS-PRICE

DEMAND

for a goodcanbe defined not only with respect to its own to the prices of substitutes or complements,or even to income. For example, the elasticity of demand for peanuts with respect to the price of cashews\342\200\224also known as the cross-price elasticity of demandfor peanuts with of peanuts respect to cashew prices\342\200\224is the percentage by which the quantity in response demanded to a 1 percentchangein the price of cashews. The changes income elasticity of demand for peanuts is the percentage by which the quantity demanded of peanuts changes in response to a 1 percent change in income. Unlike the elasticity of demand for a good with respect to its own price,these other elasticities be either positive or negative, so it is important to note their may The income of demand for inferior for algebraic signs carefully. elasticity goods, is negative, whereas the income of demand for normal goodsis example, elasticity When the cross-price elasticity of demand for two goods is positive\342\200\224as in positive. the peanuts/cashews two are substitutes. When it is negative, example\342\200\224the goods the two goods are complements. The elasticity of demand for tennis racquets with to court rental fees, for example,is lessthan zero. respect

The

of demand

elasticity

price but

with

also

CHECK 4.3

CONCEPT If

a

demand

increase in private universities

10 percent

attend

respect

for

private

income

to go up

universities?

causes by

the number 5 percent,

of students who

choose

what is the income elasticity

to

of

elasticity of demand by which the demanded of the first quantity in response to a good changes I percent change in the price of cross-price

the

percentage

the

second

income the

elasticity

percentage

demanded

to a

I

of demand

by which quantity changes in response

percent

change

in income

CHAPTER4

ELASTICITY

the

When

normal

has negative

good

On the

income

percentage

the

change in quantity that occurs in response

supplied to a I percent

change

in price

the

OF SUPPLY

market, we use priceelasticity

of the

side

of

to measure

demand

the

On the seller's sideof the the analogous measure is price elasticity of supply. It is defined as the market, in quantity in response to a 1 percentchange percentage change supplied that occurs in if a 1 percent increasein the price of peanuts leads to a 2 For example, price. percentincreasein the quantity supplied, the price elasticity of supply of peanuts would be 2. The mathematical formula for price elasticity of supply at any is the point same as the corresponding for price elasticity of demand: expression responsiveness of quantity

price elasticity of supply

when

of demand.

elasticity

ELASTICITY

buyer's

to the

respect

are substitutes;

goods

A negative, the two goodsare complements. has positive income elasticity of demand and an inferior good

PRICE

THE

two

the

of demand is

elasticity

cross-price

for one good with

of demand

elasticity

cross-price

another good is positive,

price of

ELASTICITIES

INCOME

AND

CROSS-PRICE

RECAP

in price.

to changes

demanded

Priceelasticity

of

AQ/Q supply

(4.4)

AP/P'

where P and Q are the

AP is a small change in and quantity at that point, price in and the price, AQ resulting change quantity. As with the corresponding expression for price of demand, elasticity Equation 4.4 can be rewritten as (P/Q) X (AQ/AP). And since (AQ/AP) is the reciprocal of the slope of the supply curve, the right-hand side of Equation 4.4

the

initial

equal to (P/Q)

Curve

Supply

Which Price

quantity

10

supply curve shown, (I /slope)is the same at every

u

{P/Q) X

declines as quantity

0.

4

(I/slope)

0

increases.

positive

3

2

will

supply

so

curve, be a

point.

slightly

B is

smaller

(10/3)

X

(1/2)

=

5/3,

value.

CHECK 4.4

CONCEPT P =

of

at every

number

expressionat a

the

supply

typical

Consider the supply curve shown in Figure 4.14. The slope of this supply curve is 2, so the reciprocal of this slope is 1/2. Usingthe formula, this means that the price elasticity of supply at A is (8/2) X (1/2) = 2. The corresponding

Quantity

For

the

price elasticity ! i i i i i i i i i i

AQ

point, but the ratio P/Q declines as Q increases. So =

slope of

/

8


the

elasticity

price

Elasticity

Rises. For

S

for

as Quantity

Declines

we saw in Equation 4.3 for of demand. Price and elasticity are as is the always positive,

expression

FIGURE 4.14 A

is

(1/slope)\342\200\224the same

X

supply

curve

shown

in

Figure

calculate

4.14,

the elasticity of

supply

when

6.

Not all supply curves, however,

as quantity

rises.

Consider,

have

for example,

the

property

the supply

that price elasticity declines curve shown in Figure 4.15.

THE

this

along

point

every

same at

P/Q is the

ratio

the

Because

PRICE

supply

supply

value At

take

will at

A,

point

every

for

example,

supply = (P/Q) X

Calculatingthe Price

=

(12/14) of

elasticity

at B

1. Similarly, =

(5/15)

supply

S

X

(4/12)

price (12/4)

X


Graphically.

Price elasticity

E

5

price elasticity of =

A

4

AP

AQ

0.

= 1

supply will

point that reason

price elasticity be equal

always

of

to 1

at

any

0

along a straight-line supply curve the origin. The passes through is that for movements along any

such line, both change

always

and

price

in

15

12

of supply

is

at (P/Q) X (I/slope),which = I, A is (4/12) X (12/4) exactly the sameas at 8. The price elasticity of supply is equal to I at any point along a straight-line supply curve that passes through

again.

Indeed, the

of Supply

Elasticity

the same exactly this curve. along

(1/slope)

I

FIGURE 4.15

curve,

and because the slope of the supply curve is also constant, price elasticity

of

OF SUPPLY

ELASTICITY

the

origin.

Quantity

quantity

the same

exactly

proportion.

the

On

curves

with

examples

market.

buyer's infinite

side of price

illustrate,

the market, two elasticity

polar

important

and zero

cases

price elasticity.

As

analogous polar cases exist

on

the

Perfectly

were demand the

seller's

Inelastic

next

side

two

of the

Supply

the limits of Manhattan? of land within borough Land in Manhattan sells in the market for a price,just like aluminum or corn or automobiles or any other product. And the demand for land in Manhattan is a function of its For all its downward-sloping price. practical purposes,however, is fixed. No matter whether its is or the same low, supply completely price high in the market. The supply curve amount of it is available of such a good is vertical, and its price elasticity is zero at every price. Supply curves like the one shown in 4.16 are said to be inelastic. Figure perfectly What

is the

FIGURE

elasticity

of supply

4.16

A Perfectly

InelasticSupply

Price elasticity

of supply

EXAMPLE 4.4

is zero

Curve.

at every point

along

a vertical

supply curve.

perfectly supply

respect

inelastic to price

supply inelastic

is perfectly if

elasticity

with

is

13

I

CHAPTER 4

14

ELASTICITY

4.5

EXAMPLE

Elastic

Perfectly is the

What

Supply of supply

elasticity

Supposethat

the

their respective

of lemonade?

required

ingredients

costs are as follows:

to bring a

cup

of

2.0cents

cup

Paper

Lemon

3.8cents

Sugar Water

2.0 cents

0.2 cent

Ice

1.0cent

Labor

and

to market

lemonade

seconds

(30

5.0cents

@ $6/hour)

remain the same no matter how many cups of lemonade are can be purchased in any quantities at the stated prices, draw the curve of lemonade and compute its priceelasticity. supply Since each cup of lemonade costs exactly to make, no matter how many 14^ cups are made, the marginal cost of lemonade is constant at 140 per cup.And since each curve is equal to marginal cost (seeChapter 3), this means that the point on a supply curve of lemonade is not upward-sloping but is instead a horizontal line at 14^ supply The price elasticity of supply of lemonade is infinite. 4.17). per cup (Figure If these

proportions

made,and

the

inputs

FIGURE 4.17 A

Elastic

Perfectly

Curve. The elasticity

Supply r>

of supply

is

infinite at every point along horizontal supply curve.

a

(cents/cup)

Price

0

of lemonade

Quantity

(cups/day)

Whenever additional

perfectly elasticsupply is perfectly

to price

infinite

if

elastic elasticity

with

supply

combination of

inputs,

of that

good

purchased will

be

units

of a

horizontal.

Such

be produced by using the same as prices, have been used so far, the supply elastic. supply curves are saidto be perfectly

good can

at the same

curve

respect

of supply is

OF

DETERMINANTS

SUPPLY

ELASTICITY

The two precedingexamplessuggest some of the factors that the elasticity govern of supply of a good or service.Thelemonadecasewas one whose production process was like a cooking recipe. For such cases,we can exactly double our essentially I f each the of each remains fixed, output by doubling ingredient. price ingredient the cost of production for such goodswill be constant\342\200\224and hence their marginal horizontal

supply curves.

The Manhattan

to produce be duplicated at used

land

land any

in

price.

example

is a

contrast

Manhattan\342\200\224even

in

if we

the

extreme.

knew what

The inputs they

that

were\342\200\224could

were not

THE PRICE

The key to predictinghow elastic the is to know the terms on which additional the more good can be acquired.In general,

acquired, the others)govern

be with respect to price in producing involved that inputs additional units of these can be easily inputs of will be. The factors price elasticity supply following (among ease with which additional inputs can be acquired by a producer.

higher the

Flexibility of Inputs production

other

of

good

will

of the

of a goodrequiresinputs that are also useful for the to lure additional relatively easy inputs away from

that production

extent

the

To

of a

supply

units

it is

goods,

elastic with uses, making supply of that good relatively respect Thus the fact that lemonade labor with minimal price. productionrequires only skills means that a large pool of workers could shift from other activities to current

their

lemonade

if a

production

requireselaborately

price increase

arose. Brain surgery, by contrast, labor, which means that even a large in the very long run. supplies, except

opportunity

profitable and

trained

to

specialized

would not increaseavailable

Mobility of Inputs

in the price of an increase transported from one siteto another, will enable a producer in that market to summon inputs from other markets. For example, the supply of agricultural is made more products elastic with respect to price by the fact that thousands of farm workers are willing to northward the season. The of entertainment is migrate during growing supply more elastic by the willingness of entertainersto hit the road. Circus similarly made and even exotic dancers often a substantial performers, comedians, lounge singers, spend fraction of their time away from home. For instance, to a 1996 New York according Times the exotic dancers follow the so the same article, action, top \"basically entertainers who worked the Indianapolis 500 now headto Atlanta for the Olympics.\" For most goods,the price elasticity of supply increases each time a new highway is or when the telecommunications network improves,or indeedwhen other built, any makes it easier to find and from one to another. development transport inputs place If

can

inputs

a productin

be easily one

market

Ability to Produce

Substitute Inputs

finished diamond gemstones include raw diamond required In skilled and elaborate and labor, time, the crystal, cutting polishing machinery. number of people with the requisite skills can be increased, as can the amount of specialized The number of raw diamond crystals buried in the earth is probably machinery. fixed in the same way that Manhattan land is fixed,but unlike Manhattan land, rising miners to spend the effort required to find a larger proportion of prices will encourage

The

to produce

inputs

those crystals.Still, the

The day produce

is

there are already synthetic introduction of a perfect

increasethe of elasticity

price

elasticity

of gemstones

supply

of

tends to be relatively diamond crystals.

however, when gemstonemakers crystals that are indistinguishable from

diamond

synthetic

gemstone diamonds the number of augmenting

of natural

supply

of the difficulty close at hand,

because

inelastic

that

crystals

substitute

synthetic

for

highly

look

ones.

real

natural

diamond

Indeed, The

jewelers.

experienced

of diamonds (or, at any rate, and feel just like diamonds).

of supply that

fool even

to

be able

will

crystals would the price

Time

Because it

takes

time

because it

takes

time

skilled long augment

the price

workers, run than existing

in

the

stocks

to switch from one activity machines and factoriesand

for producers to build new short

elasticity of

supply

will

of equipment

be higher

short run, a manufacturer's and skilled labor may

run. In the

expand output beyond a certainlimit.But if a bottleneck,new MBAs can be trained in only two staff is the problem, new lawyers can be trained

to another, train

for most goodsin inability

and

additional the

to

it impossible to of was the shortage managers years. Or if a shortage of legal in three years. In the long run, make

ELASTICITY

OF SUPPLY

4

ELASTICITY

can

firms

always

new

buy

build

equipment,

new factories,

and hire additional

workers.

skilled

that gave rise to the perfectly elastic supply curve for we discussed earlier are satisfied for other example many products in the long run. If a product can be copied (in the sensethat can any company the and other information to it), acquire design technological required produce and if the inputs neededfor its production are used in roughly fixed proportions and are available at fixed market prices, then the long-runsupply curve for that product will be horizontal. But do not these many products satisfy and their in the very conditions, supply curves remain steeply upward-sloping,even conditions

The

the

in

lemonade

long run.

ar

The EconomicNaturalist4.3 are

Why

prices so

gasoline

much more volatile

Automobile price changes in the manufacturers announce an increase gasoline prices

the

highest

than

the

in

often daily

fluctuate

lowest

daily

prices

in

car prices?

a year, when usually occur just once few percentage points.In contrast, to day. As shown in Figure 4.18, for example, two largest cities were three times higher

States

of only a

from

wildly

prices

gasoline

United

than

day

California's

in 2001

and early 2002.

Why

this

enormous

difference

volatility?

*

^/^#VVV

aV#////

V

O\"

*?

$>

* *

2001-2002 FIGURE 4.18

GasolinePricesin Source: Oil Price

Two

Information

California

Cities.

Service, www.opisnet.com.

to price volatility, at least two important features distinguish the the market for cars. One is that the short-run price elasticity of demand for gasoline is much smaller than the corresponding elasticity for cars.The other in the gasoline market than is that supply shifts are much more pronouncedand frequent in the car market. (See Figure 4.19.) With respect

gasoline market

from

THE PRICE

^

&. ftf

^^^^^^

u

^^^^^

(A \302\251

o

o

s,>^

^^^^^

^^^^^

^^^^^^^r

\302\253*16.4

^^

/

the

two markets

the

sharply,

change

of gasoline

quantity

the

in the

gasoline

market (a) than in the car market (b),and also because supply and demand are less in the short elastic gasoline market.

the

In

completely fixed, so we demand would not

run

in the

in

difference

depends largely

short

on

the

run, car ownership price of gasoline In contrast, much. by

the

if

even

the

first

we demand

we drive them.

amounts

quantity

ways? Consider

in these

different

are almost

patterns

commuting

were to

frequent

(b)

price elasticities of demand.The kinds of cars we own and and

in

Prices.

Cars

(a)

are

D

(1,000s of cars/day)

Gasoline

Why

^_. ^^^^^

11 12

(millions of gallons/day)

in

Prices Than

volatile

Quantity

Quantity

I

Gasoline prices are more prices because supply shifts are larger and more

^r

I

6 7.2

0

'

4.19 Volatility

Car

/ /s

^^'Jr_ri i

^^//' ^^

&.

0.

^r

FIGURE

Greater Gasoline

^r

17

OF SUPPLY

ELASTICITY

change

dramatic changein the price of cars, we could always postpone our next car purchases. To see why the supply curve in the gasoline market experiences larger and more in shifts than the curve the car examine the market, we need only frequent supply in relative stability of the inputs sellers these two markets. Most of the employed by in used electronic cars\342\200\224steel, rubber, inputs producing glass, plastics, components, the key input labor, and others\342\200\224are reliably available to car makers. In contrast, used in making gasoline\342\200\224crude oil\342\200\224is to profound and unpredictable supply subject a sudden

were or accelerate if there

interruptions.

is so

This

in

however,

whenever

large

world's

much of the

because

countries that

States on several previous

the United action,

part

of oil-exporting

a group

OPEC,

often

fear that political producers Middle East. in Figure 4.18 the sharp

of

supply

sharply Even in

occasions.

curtailments

supply

has

occur

in

crude

curtailed

the absence the

oil

oil

controlled

of formal

by

to

shipments

market\342\200\224for

might engulf the

instability

oil is

its

OPEC

Note

terrorist attacks on the World 2001. Because many believed that scale war between Muslim societies

the

spike

in

gasoline

Center

Trade

major oil-producing

that occurred just after prices and Pentagon on September I

I,

attacks was to provoke largeand the West, fears of an impending oil supply Similar oil price spikes occurred in the early interruption were perfectly rational. in months of 201 I, when several Middle Eastern countries political upheaval threatened to oil Such fears alone can a temporary disrupt supplies. trigger supply if even war is avoided.The of war creates the expectation of oil interruption, prospect that

cutbacks

supply

later).

prices with

we

see

But

once

for

the

oil

in this

market.

current

in the future, which markets (in order

recedes, the

position. Given it takes

of these

prices

higher

from

fear of war

to its earlier that's all gasoline,

speed

equal

demand

cause

would

some of their

to withdraw

aim

the

the

to generate

supply

curve

leads

to sell it

producers

of gasoline

at

higher

reverts

short-run price elasticity of the considerable price volatility

low

less

are gasoline stable than

prices?

example,

of the

countries

Why

prices so much automobile

17

I

18

CHAPTER 4

ELASTICITY

Price

common

is also

volatility

sharply and supplycurves

unregulatedmarket for electrical

of

supply

air

because

And

are

in

highly

wholesale

electricity

was essentially fixed in the short run. for a large shareof demand,several

capacity accounts

generating conditioning

in which demand curves fluctuate One such market was California's the summer of 2000. The during

markets

inelastic.

of unusually warm weather caused spells Price at one point reachedmorethan four

demandto shift times

its highest

sharply

to

the right.

level from the

previous summer.

INPUTS:THE

ESSENTIAL

AND

UNIQUE

ULTIMATE

SUPPLY BOTTLENECK basketball are an enthusiastic bunch. Directly through their and indirectly through their of television advertisers, support billions of dollars each year on the sport. But these dollars are they spend literally not distributedevenly across all teams. A disproportionate share of all revenues and product endorsement fees accrueto the peopleassociated with consistently stands the National teams, and at the top of this pyramid winning generally of

Fans

professional

of tickets

purchases

Basketball

Association's

team.

championship

Consider the task of trying to produce a championship team in the NBA. What are the inputs would need? Talented players, a shrewdand dedicated coach and you assistants, trainers, physicians, an arena, facilities, means for transporting practice some of these players to away games, a marketing staff, and so on. And whereas can be acquired at reasonable prices in the marketplace, inputs many others cannot. Indeed, the most important input of all\342\200\224highly talented players\342\200\224is in extremely limited supply. This is so becausethe very definition of talented player is inescapably such a player is one who is better than most others. relative\342\200\224simply put, Given the huge payoff that accrues to the NBA championship team, it is no that the bidding for the most talented surprise players has become so intense.If there were a long list of players with the to boost a team's winning potential the Miami Heat wouldn't have agreedto pay LeBron James percentage substantially, a salary of $15 million a year. is But, of course, the supply of such players limited. There are many hungry that would like nothing extremely organizations better than to claim the NBA championship each year, how much each yet no matter is willing to spend, teams only one can succeed.The supply of NBA championship is perfectly inelastic with to price even in the very long run. respect

important product whosesupply unique and essential inputs. In the movie for example, although the supply of movies starring Jim industry, Carrey is not perfectly inelastic, there are only so many films he can make each year. Because his films scores of film revenues, consistently generate huge box office producers want to sign him for their projects. But because there isn't enough of him to his salary per film is more than $20 million. go around, In the long run, unique and essential inputs are the only truly significant If it were not for the inability to duplicate the services of such supply bottleneck. most and services would have extremely of supply inputs, goods high price elasticities Sports champions are is constrained

elasticity

in

the

long

to

inability

reproduce

-

SUMMARY

of demand is a measureof how elasticity It is the strongly buyers respond to changes in price. in demanded that occurs percentage change quantity in 1 in to a The response percent change price. price

the only

means

no

run.

\342\200\242 The

by

by the

demand if

the

for

1, inelastic

elastic

if

is called elastic with respect to price value of its price elasticityis more than if its price elasticity is less than 1, and unit

a good

absolute

its

price

elasticity

is equal

to 1. (LOl)

REVIEW

as salt, which

such

\342\200\242 Goods

occupy

prices of

share of

a small

only

consumer's budget and have few or no good substitutes, tend to have low price elasticity of demand. Goods likenew carsof a particular make and which shares and have model, occupy large budget attractive tend to have substitutes, many high price of demand. Price elasticity of demand is elasticity the typical

higher

the

in

run than

long

people often need time \342\200\242 The

to

adjust

\342\200\242 Price

for the price elasticity of supply at any is point where P and Q are the price and (AQ/Q)/(AP/P), at that point, AP is a small change in the initial quantity

changes. (LOl)

formula

expressed as the formula e = (AQ/Q)/(AP/P). Here, P and Q representprice and at that point and AQ and AP represent quantity in price and quantity. small changes For straight-line demand curves, this formula can also be expressed as

e = (P/Q)X price down

tell us

formulations

These

(l/slope).

declines in absolute terms as elasticity a straight-line demand curve. (LOl)

price, and AQ is the resulting change in formula also can be expressedas where

\342\200\242 The

that

we move

in price will increase total spending on a good if is elastic but reduce it if demand is inelastic. An in price will increase total spending on a good increase if demand is inelastic but reduce it if demand is elastic. Total expenditureon a goodreaches a maximum when

elasticity difficult or

units

of

if

1. (L03)

Analogous

formulas

of demand

for a

are used

good with

to define the

and the

KEY

cross-priceelasticity demand

perfectly

elastic

perfectly

inelastic

REVIEW 1.

Why

on the

depend

income

spent on

2. Why

that

fraction

good?

does the price elasticity

decline as we

demand

price elasticity of demand for

a consumer's

does

a good

curve?

3. Under what

move

down

of

of

existing

greater

(106)

along

conditions

will

supply

an

4.

total

price

spending

the

demand, the

price

run than

long

in

elasticity short

the

of demand (98)

priceelasticity

of

revenue

unit elastic

economists

do

Why

attention

for a

in the

good.

price elasticity

total

(113)

algebraic

good a straight-line

increase

that

supply

(112)

(108)

(108)

(99)

QUESTIONS

consumer's

(LOl)

in

total expenditure

supply (114)

sign

of the

with respect

demand

acquire

producing

TERMS

(LOl)

of a product lead to a reductionin product? (L03)

for that

the

in

on

additional

mobile, or if an acceptable inputs can be developed. And

elasticity of

price

perfectly inelastic demand (106)

of

(111)

of the

slope

of a good depends to

is

it

involved

relatively

for

the

perfectly elasticdemand

elastic (99) demand

are

inputs

inelastic (99)

of

(111)

income elasticity

costly

inputs

of supply is run. (LOS)

elasticity

to income

respect

of supply

price

substitute

like \342\200\242

(l/slope)

In general, the more easily additionalunits of these can be the of inputs acquired, higher price elasticity will be. It is easierto of a supply expandproduction if the used to that product inputs produce product are similar to inputs used to produceother products,

demand

to

of the

X

(L05)

how

the

This

quantity.

(P/Q)

is the reciprocal

(l/slope)

supply curve.

\342\200\242 A cut

price elasticity of demandis equal

of supply is defined as the percentage in quantity supplied that occurs in response percent change in price. The mathematical

elasticity

change to a 1

can be

also

curve

demand

percentage

corresponding

price. (L04)

a point along a

of demand at

elasticity

price

to price

the

case, elasticity is the demanded divided by in income or change

In each in quantity

goods.

change

percentage

because

run

short

the

in

other

119

QUESTIONS

demand

to

the for

a

attention to of demand for

pay little

elasticity

the

a good

to its own price,yet pay careful algebraic sign of the elasticity of good with respect to another good's

price?(L04)

5.

is supply

Why in

the

short

elasticity higher run? (LOS)

in

the

long

run than

120

4

CHAPTER

ELASTICITY

PROBLEMS

the demand for a particular or less price-elasticthan the

1. Is

ir

corned:

|

2. Among

ECONOMICS

of car, like a Chevrolet, likely for all cars? Explain. (LOl)

brand

demand

be more

to

the following executives, and students\342\200\224 executives, groups\342\200\224senior junior is likely to have the most and which is likely to have the least price-elastic

which

for

demand

3. Calculate

D, and

in the

membership

Association of Business Professionals?

the price elasticity of E on the demand curve

value) at points

(in absolute

demand

below.

(LOl) A,

B,

C,

(LOl)

McGraw-Hill

00

Visit your mobile app store and download

the

Frank:

Econ

app

A

75

Study todayl

50 25

I^^S^ 1

1

25

50

^^^^

100

75

Quantity

4. Suppose,while

your uncle's closet, you found the original a valuable painting Dogs Playing Poker, pieceof art. You decide to set up a in uncle's The demand curve to seethis valuable display your garage. piece of art is as shown in the diagram. What price should you charge if your goal is to maximize your revenues from tickets sold? On a graph, show the inelastic and elastic regions of the demand curve. (LOl, L03) rummaging

through

of

Quantity

(visitors/day)

5. The

schedule

California, Price

below shows the number of packs of bagels bought a variety of prices.(LOl, L03)

in

Davis,

each day at of bagels

($/pack)

Number

of packs

purchased per day

6

0

5

3,000

4

6,000

3

9,000

2

12,000

I

15,000

0

18,000

a. Graph the daily demand curve for packs of bagels in Davis. b. Calculate the price elasticity of demand at the point on the demand which the price of bagelsis $3 per pack.

curve

at

c.

all

If

pack, d. Calculatethe e. If bagel

$2

the demand curve shown, by price of the product affect total

in the

to $4

pack demand

the

per

curve

per packto $3 perpack,

from $2

of bagels

per

a point on

revenues?

to total

happen

$3

pack.

per

price

A on

point

increase

of bagelsis

shops increasedthe

would

what

6.*At

price

the price

of bagelsfrom

the price

to total revenues? happen of demand at elasticity

would

what

where

increased

shops

bagel

will a 1 percent percentage on the expenditure product? (L03)

what

0 (units/week) 7* Supposethat,

to induce

attempt

of electricity.

government officials were then more

this increase

8.

A

2

in the

increase

percent

price of milk causesa 4 syrup. What is the

for chocolate syrup

demand

price

L04)

goodscomplements

with

substitutes?

or

are the respective price curve shown in the accompanying

9. What

cross-price

of milk? Are the two

the price

to

respect

in the of elasticity

reduction

percent

of chocolate

demanded

quantity

concept of

(LOl,

was implemented, that people used even elasticity, explain how

regulation

discover

to

surprised

occurred.

have

might

this

After

before. Using the

than

electricity

citizens to conserveenergy, the air conditionersbe more

that all

requiring

regulations

use

their

in

efficient

an

in

enacted

government

(L04)

of supply at figure? (LOS)

elasticities

A

B on

and

the supply

B

1

fs

AP 4 \302\253

\"/

u

AO

/ 9 12

0 Quantity

10.

that the ingredients required to bring Suppose in the table: their respective costs are as listed

a sliceof

8 cents

Flour

20 cents

sauce

Tomato

Cheese

If these supply * Denotes

30 cents

(3 minutes

proportions remain

the inputs can curve

more

difficult

and

2 cents

Paper plate

Labor

to market

pizza

the

be purchasedin

of pizza problem.

60 cents

@ $l2/hour) same any

no matter quantities

how

many

at the

slices and compute its priceelasticity.

slices

are

made,

stated prices, draw (LOS)

and the

122

CHAPTER 4

ELASTICITY

4.1 In responseto a 5 percent is thus

(20

4.2

At

percent)/(5

the demand

$400,

A in

point

curve

demand

in the price of ski passes, the quantity reduction of demand for ski passes percent. The price elasticity = 4, and that means that at the initial of percent) price

by 20

increased

demanded

(HECKS

CONCEPT

TO

ANSWERS

for ski passes

with respect

is elastic

the accompanying is 20/5 = 4, so e

diagram, P/Q

= 1X

=

4/4 =

(1/slope)

to price. (LOl) = 1. The slope of

1/4.

this

(LOl)

20

16

\\P

8 12 \302\260-

8

4 I

I

12

0

X

I

I

3

4

5

Quantity

4.3

Income

change

4.4

For

elasticity in income

the

(P/Q)

supply X

(1/slope)

= percentage change in quantity demanded/percentage = 5 percent/10percent= 0.5.(L04)

curve =

below, Q (6)

0

X

(1/2)

= 1 when = 3.

12 Quantity

P

=

(LOS)

3

6, so

elasticity of

supply =

APPENDIX

|

I

The

Midpoint

Formula you

uppose

in

test

At a

price of 3, quantity

of 4, quantity for

this

Let's attempt

a question

encounter

like the following on a

standardized

economics: of a good is 6, while at a price What is the price elasticity of demand

demanded

is 4.

demanded

good?

to answer this

question

the formula

by using

e = (AQ/Q)(AP/P).

in the question 4A.1 we first plot the two price-quantitypairs Figure given and then draw the straight-line demand curve that connects them. From the AP = 1 and AQ = 2. But it is clear that what values do we use for P and graph, Q? If we use P = 4 and Q = 4 (point A), we get an elasticity of 2. But if we use P = 3 and Q = 6 (point if we reckon P), we get an elasticity of 1. Thus, price and quantity as proportions of their values at point A we get one changes if we compute them as proportionsof their but values at point B we get answer, another. Neither of these answers is incorrect. The fact that they differ is merely a reflection of the fact that the elasticity of demand differs at every point along a straight-line demand curve. the original of Strictly speaking, question (\"What is the price elasticity demand for this good?\") was not well posed.To have elicited a uniquely correct at point A?\" answer, it should have been \"What is the price elasticity of demand B ?\" Economists or \"What is the price elasticity of demand at point have nonetheless a convention, which we call the midpointformula, for developed like the one originally posed. If the two points in answering ambiguous questions question are (QA, PA) and (QB, PB), this formula is given by In

e =

AQ/[(Qa

;

AP/[(PA

The midpoint

to use by

using

formula averages

thus

sidesteps

the

new and

of the

e_ 6

+ Qb)/2] +

;-.

4A.1)

PB)/2]

question

old values.

AQ/(Qa +

of which price-quantity The formula reduces to

pair

Qb)

AP/(PA + PB)

\342\226\240

(4A2)

124

CHAPTER 4

APPENDIX

THE

MIDPOINT

FORMULA

FIGURE 4A. I Two

For the two points

[2/(4

at

+

and

A

6)]/[l/(4 B.

+

Points

shown

on a

in

Demand Curve.

Figure

3)] = 1.4, which

4A.1,

the midpoint

liesbetweenthe values

employ the midpoint formula again in will employ the measure elasticity chapter, which is called point elasticity. We will not

questions

concerning

this

text.

formula yields e = for

elasticity

price

Hereafter,

discussedin

the

text

all of this

CHAPTER

5

Demand northern border of

n the a

in the

university

large

East, a creek widens a picturesque

form

remembered

alumni

spot.

the

Over

of

popular recreation

as a

the lake

years,

LOI

had

become

had

A

impossible.

generous alumnus then sponsored an effort to restore the lake. Heavy

L03

the occasion,the university

price to pay.

or service is

a good

When

scarce, it

must

competing users.In most markets,monetary the case of a stand offering free ice cream, rationing

device.

with some

Having

to stand

in

a ceremony.

held

is a

line

Bands played,

prices

to part

that although the demand curve is between the demanded of a usually relationship quantity and its the is a much more good monetary price, relationship really general one. At bottom, the demand curve is a relationship between the quantity and

demanded

acquiring greater

all

a good.

Our task

in

depth

in

home

the

point

as a

described

this

than

costs\342\200\224monetary

will be was possible in

chapter

and

nonmonetary\342\200\224associated

to explorethe demand Chapter

3. There

side

we merely

of the

with

market

asked you

to

Cost2).

individual

are translated demand.

Explain the

reasoning rational

the

it

apply

rule and to consumer

decision making related and

L04

to

how the

show

rule

effects.

income

Discuss the the

individual demand

curve and demand

the

market

curve.

Defineand consumer

is

to substitution

between relationship

L05

effective

money.

This exampledrives

Discusshow

spending

be rationed among that task. But in perform

time becomes the no less so than having cost,

Principle

behind

somehow

waiting

Principle

(Core

into

the a chorus and visitors the donor's presidentspoke, sang, distinguished applauded and students turned out for the festivities. generosity.Hundreds of faculty to promote their product, the proprietors of a local Spotting a good opportunity icecreamstore set up a temporary stand at the water'sedge,with a large sign: \"Free Ice Cream.\" Word Soon scores of people were lined up waiting to try Vanilla spread. Almond Delight, Hazelnut Cream,and Fudge Faire. The ice cream was because it was free, everyone could obviously afford it\342\200\224or so it plentiful, and seemed. In fact, many who wanted ice cream that never people day got any. in a long line too steep a The reason, of course, was that found they waiting To mark

Benefit

wants

silt-free.

was

lake

L02

Because of changes in the distribution of income, demand for premium wines has surged, while demand for low-priced wines has declined.

dredging equipment hauled out load after load of mud, and months later the

law of

the

Relate

demand to the

gradually siltedin, and by the late 1980s, even paddling a canoe

acrossit

OBJECTIVES

After reading this chapter, you should be able to:

lake, fondly generations

by

LEARNING

to

calculate

surplus.

126

CHAPTER

5

DEMAND

as an

accept

claim that the quantity demanded of a good or This is known as the law of demand, price relationship as a of the that emerges simple consequence assumption In limited incomes in rational the we'll see ways. process, plausible

intuitively

service declinesas its and we'll see how it people

their

spend

rises.

more

and substitution as factors that account for the law clearly of demand. to generate market demandcurves the by adding demand curves for individual we'll see how to use the buyers horizontally. Finally, demand curve to generate a measure of the total benefit that buyers reap from their roles of income We'll also see how

dual

the

in a

participation

LAW OF DEMAND

THE

of the

discussion

our

With

market.

free ice cream

demand

as follows:

Law of

Demand: Peopledo less of

in

offer

what

want

they

let us

mind,

to do

restate the law

as the cost of

of

doing

it rises.

Cost-Benefit

O

this way, we can see it as a direct consequence of By stating the law of demand if the Cost-Benefit Principle,which that an should be says activity pursued (and Recall that we measure the only if) its benefits are at least as great as its costs. benefit of an activity to pay to pursue it\342\200\224 by the highest price we'dbe willing our reservation for the When the cost of an namely, price activity. activity rises, it's more likely to exceedour reservation and we're therefore less likely to price,

pursuethat not to

activity.

law of

The

mention

explicit\342\200\224we

ORIGINS

THE

is the sum

a \"cost\"

implicit and

How much

must

medical

manicures,

discs,

compact

that

stresses

demand applies to BMWs, cheap key

of all the

in

an

\"free\" ice

and

cream,

care, and acid-freerain.It

sacrifices\342\200\224monetary

to engage

make

rings,

and

nonmonetary,

activity.

OF DEMAND

latest you willing to pay for the Lady Gaga CD? The answer will on how feel about her music. To her diehard fans, buying the clearly depend you new release might seem a But essential; absolutely they'd pay steepprice those who don't like her music may be unwilling to buy it at any price. Wants (also called \"preferences\" or \"tastes\") are clearly an important determinantof a consumer's reservation price for a good. But that raises the question of where wants come from. Many tastes\342\200\224such as the taste for water on a hot day or in origin. But many for a comfortable place to sleepat night\342\200\224are largely biological are

indeed.

others are

while

dishes,

Tastes for

by

shaped

heavily

molded. For

culture,

example, peopleraisedin those raised

in

France

and even

southern

generally

basic

India

prefer

may

cravings

develop

a taste

be

for hot

socially curry

milder foods.

stable for many but tastes for others years, books about the Titanic disaster have been may highly Although in available since the vessel sank not until the 1912, continuously spring appearance of film in Cameron's blockbuster did these books to sell James begin large quantities. In spring 1998, five of the 15 books on the New York Times bestseller paperback list were about the Titanic itself or one of the actors in the film. Yet none of these list in the years books, or any other book about the Titanic, made the bestseller In since then. Still, echoesof the film continued to reverberate in the marketplace. the years sinceits release,for example, demand for ocean cruises has grown sharply and several television networks have introduced showsseton cruiseships. Peer influence another of how social forces often influence provides example demand. it is often the most determinant of demand. For Indeed, important single be

some

items

volatile.

may remain

if our man will purchase an illegal goal is to predict whether a young recreational drug, knowing how much income he has is not very helpful. Knowing the prices of whiskey and other legal substitutes for illicit also tells us little. drugs these factors do influence purchase decisions, by themselves they are Although if weak But we know that most of the man's best friends are predictors. young there's a chance that he'll use as well. users, heavy drug reasonably good drugs instance,

Another important way in which social forces shape demand is in the relatively desire to consume goods and services that are recognized as the best of their kind. For instance, many people want to hear Placido Domingo sing, not just becauseof the quality of his voice, but because he is widely regarded as the world's best\342\200\224or at least the world's best known\342\200\224living tenor. the decision of how much to on an interview suit. Consider, too, spend counselors never tire of us that a good first Employment reminding making impressionis extremely when for a interview. At the very least, that important you go job in means a suit that looks But is showing up good. looking good a relative concept. If everyone else shows up in a $200 suit, you'll look good if you show up in a $300 suit. But you won't look as good in that same $300 suit if everyone else shows up in suits The amount chooseto on an interview $1,000. suit, then, costing you'll spend in your circle are spending. others clearly depends on how much common

NEEDS VERSUSWANTS we distinguish between goods and services need people want. For w e that someone wants a ski merely example, might say in Utah, vacation but what he really needsis a few days off from his daily or that someone wants a house with a view, but what she really needs is routine; shelter from the elements. since we Likewise, people need protein to survive, that a malnourished needs more But it would might say severely person protein. strike us as odd to say that anyone\342\200\224even a malnourished more person\342\200\224needs filet of since health can be restored far less beef, prime by consuming expensive In

language,

everyday

and those they

sources

of

protein.

emphasize that once we

like to

Economists

have

achieved

subsistence

bare

shelter, and clothing requiredto consumption\342\200\224the in terms maintain our health\342\200\224we can abandon all reference to needs and speakonly wants. This linguistic distinction helpsus to think more clearly about the true levels of

of

choices.

our

of

nature

of food,

amount

someone who says, \"Californians

don't have nearly as much tend to think about water differently shortages than someone who \"Californians don't have as much water as they want when says, nearly the price of water is low.\" The first person is likely to focus on regulations to prevent from their or on to additional runoff from lawns, people watering projects capture the Sierra Nevada mountains.The to focus on the likely in low of water California. Whereas remedies of the first sort are artificially price

For instance,

water as they

need\"

will

secondpersonis more

and extremely and effective. simple often costly

to implement,

difficult

raising the price

The

Why

does

Somemight relatively low

person

that

respond

average

annual

and do not

problem existsbecause Californians encourages

chronic water

experience

California

the state

must

serve

other

rainfall.Yet

states,

experience water shortages

to use

local

governments

water

in

ways

that

Economic

of water is both

Naturalist

5.1

shortages?

needs of a large population with a like New Mexico,have even less rainfall per as often as California. California's nearly

the

sell water at extremely low prices, make no sense for a state with

which low

rainfall.

For

128

DEMAND

CHAPTERS

in high-rainfall for conditions states like instance, rice, which is well suited in California. But because South Carolina, requires extensive irrigation California farmers can obtain water so cheaply, they plant and flood hundreds of thousands of acres of rice paddies each spring in the Central Valley. Two thousand tons of water are neededto produce one ton of rice, but other grains can be producedwith many only half that amount. If the price of California water were higher, farmers would simply switch to other grains.

Likewise,

San Diego to common

cheap

encourages homeowners lawns and shrubs,

water

water-intensive

plant

in like

Los the

Angeles ones

and

East and Midwest. By contrast, residents of cities like Santa native plantings Mexico, where water pricesare high, choose

in the

Fe, New

that require

or

little

no watering.

INTO

WANTS

TRANSLATING

DEMAND It's a simple fact

of life that although our resources are finite, our for good things are boundless. Even if we had unlimited bank we'd quickly run out of the time and energy needed accounts, to do all the things we wanted to do. Our challengeis to use our limited resources to fulfill our desires to the greatest possible degree. That leaves us with a practical question: How should we allocate our incomes among the various goodsand services that are available? To appetites

Why

rice

'%

\\

%l

do fanners grow in an arid state like

water-intensive crops like

answer this question,it's helpful

California?

goods and serviceswe buy our desires.

WANTS:

MEASURING

from

their

Early

'I

THE CONCEPT OF

utility

imagined

rather

UTILITY

that the

utility

associated

a device by different

provided

with

different The

Jeremy Bentham, for example, wrote of be used to measure the amount of no such device consumption activities. Although

economist

British

a \"utilometer,\" - 1

but

might someday be subjectto precisemeasurement.

nineteenth-century

*v

by recognizing that the means for satisfying

begin

maximization.

economists

activities

-,

to

ends in themselves,

the

to as utility

^\342\226\240*s(\\

not

of utility to represent the satisfaction concept people derive activities. The is that consumption assumption people try to allocate their incomes so as to maximize their a goal that is referred satisfaction, use

Economists

are

that

could

have shown that higher levels of electrical activity on the brain's left side are strongly

now have neuropsychologists crude measures of satisfaction. equipment generate Figure 5.1, for example, showsa subjectwho is connectedto an apparatus that measures the intensity of electricalwaves from different emanating of his brain. of Wisconsin Richard Davidson parts University psychologist and his colleaguesdocumented that with subjects relatively heavy brainwave measures from the left prefrontal cortex tend to be happier emanating with (as assessedby a variety of other measures) than subjects relatively brain-wave measures from the heavy emanating right prefrontal cortex. would have been thrilled to learn that a device like Jeremy Bentham the one pictured in Figure 5.1 might exist some day. His ideal utilometer would measure utility in utils, much as a thermometer measures in Fahrenheit or Celsius. It would assign a numerical temperature degrees

associated

utility

existed

'I.;

\342\226\240!

1

FIGURE

\\

5.1

Can Utility

Be Measured

Electronically? Scientists

satisfaction.

with

higher

levels of

in

Bentham's that

can

to every

value

and so on.Unfortunately,

in

Figure

5.1

are far

day,

contemporary

at least

even

sophisticated

from capable

of

eating a cheeseburger, devices like the one shown assessments. fine-grained

a movie,

activity\342\200\224watching

such

TRANSLATING WANTS

intellectual enterprise,however,

For Bentham's

was of

Even without practical significance. the consumer as someone whose

no

to envision

of a

absence

the

goal wasto maximize

she obtained from the goods she consumed.Bentham's about model,\" as we'll see, affords important insights to her income. ought spend

the

\"utility

how a

129

DEMAND

real utilometer

he could

a machine,

such

INTO

continue

total

utility

maximization

rational consumer

To explore how the model we begin with a very works, simple problem, the one facing a consumerwho reaches the front of the line at a free ice cream stand. How many cones of ice cream should this person, whom we'll call Sarah, ask for? Table 5.1 shows the between the total number of ice cream cones relationship in utils per hour, she derives Sarah eats per hour and the total measured utility, from them. Note that the measurements in the table are stated in terms of cones hour and utils hour. hour\"? Because without an time per per Why \"per explicit we would have no idea whether a was a lot or a little. Five dimension, given quantity ice cream cones in a lifetime isn't much, but five in an hour would be more than most of us would care to eat.

5.1

TABLE

Utility from

Total

Sarah's

Cone

Ice Cream Consumption Total

(cones/hour)

quantity

(utils/hour)

utility

0

50

90

120

140 150

140

total utility increases with each cone she hour makes her per happier than eating and so on. But five cones four, which makes her happier than three, eating beyond more icecream makes Sarah less the sixth Thus, hour, per consuming actually happy. cone reducesher total utility from 150 utils per hour to 140 utils per hour. in Table 5.1 graphically, as in Figure We can display the utility information 5.2. Note in the graph that the more cones per hour Sarah eats,the more utils she to the fifth gets\342\200\224but again only up cone. Once she moves beyond five, her entries

As the

eats, up to the

total

in

show, Sarah's Eating five cones 5.1

happiness reaches a maximum utils when she eats five cones At

that

she

point

has no

the sixth cone, even absolutely

free.

Eating

Sarah's

decline.

to

begins

utility

Table

cone.

fifth

of

per

though

make her worseoff. another

important

between relationship namely,

additional

and

5.1

Table

utility

3

actually

Figure 5.2 illustrate of the aspect and

consumption\342\200\224

from

declines

as total consumptionincreases.Thus,

yF-

Sarah's Total

~--^

For

_

at

-f

50

/

I

1

I

2

most

3

4

Cones/hour

I5

6

Consumption. goods, utility rises

a diminishing

additional

+J

0

from

Utility

Ice Cream

120

90 ;= l/> D

the additional utility units of consumption

that

&.

o

it's

it would

140

hour.

incentive to eat

5.2

FIGURE 150

150

rate

with

consumption.

CHAPTER5

130

TABLE

Sarah's

DEMAND

5.2

Marginal Utility from Ice Cream Consumption

Total and Cone

Total

quantity

(cones/hour)

utility

Marginal

utility

(utils/cone)

(utils/hour)

50

utility

Marginal

change in

50

40 90

30

utility

change

in consumption

90 utils

-

50

utils

\342\200\224 I cone

2 cones

40 utils/cone

120 20

140 10

150 -10 140

one

whereas

per hour

cone

hour is just a little marginal

The term

additional

the

utility

utility gained from consuming an additional unit of a good

utility

marginal

cone

that

indicate

to

per hour

Because

marginal

one quantity

to

Thus, we'd say is 40

another,

value

of 40 utils

cones per hour, downward-sloping

be the case.)

increases beyond

unit of a

as consumption

some point

utility

column

cones

per

changes shows the

marginal

We

to

this

do

one

consumption

of moving from

utility

one

cone.

in

change

we graph

marginal

each specificmarginal

per cone midway

and so on. (In this straight line for

utility

Thus,

corresponds.

occurs we

utility,

value

in Figure

as we

halfway

region

the

move from adopt

the

between

the

normally

5.3, we plot the marginal

between one coneper

example, the

that

utility

hour

marginal utility but this need shown,

and graph

two is a

not always

for marginal utility to decline as consumption increasesbeyond is called the law of It holds not just for point diminishing marginal utility. in this illustration, but also for most other goods Sarah'sconsumption of ice cream for most consumers.If we have one brownie or one Ferrari, we're happier than we are with none; if we have we'll be even not twice as two, happier\342\200\224but happy\342\200\224and The

additional

the

that

per

is the

when

two quantities to which it utility

utils

utility

convention of plotting

consuming an good to diminish

total

preceding columns. to the movement from

of the

rows

corresponds

utility

marginal cones

two

five

zero,

second

between the

to the next.

quantity

marginal

utils\342\200\224than

to changes in Sarah's level of ice cream in that column entry represents the increase in utils when Sarah's utility (measured per cone) consumption rises from in the hour to two. Note that the entries third column per marginal utility

consumption. For example,the are placed midway

diminishing

50

consumption changes by values that marginal utility correspond

one

utility the tendency for the additional utility gained from

better\342\200\224by

four (just 10 utils' worth). denotes the amount by which one unit. In Table 5.2, the third

when

in total

law of

is a lot

than

better

tendency

some

on.

Though

this pattern is

called a law,

there are exceptions. Indeed, some exhibit For example, consumption increasing marginal utility. an unfamiliar song may seem the first time hear then it, irritating you gradually become more tolerable the next few times you hear it. Before long, you may discover that even find yourself you like the song, and you may singing it in the so

activities

even

seem to

TRANSLATING WANTS INTO

5.3

FIGURE

50

40

The more conesSarah

/marginal

smaller

u

utility

\"55 I

20

1

L

r

her will

i

T

^w

satisfies

diminishing

the

law

marginal

-\"/ i

!

;I

4

:

:

4.5

3.5

2.5

1.5

0.5

*3

!

Cones/hour

shower.

is a

such exceptions,

Notwithstanding

plausible characterization of

for many goods. Unless goods we discuss.

the law

of diminishing

between

relationship

assume that

stated, we'll

she gets to the

do when

Sarah

will

What

otherwise

the

of

front

the

utility

marginal

and consumption holds for the various

utility it

line? At that

point, the

sunk costand is hence irrelevant to her decision about how many cones to order. And since there is no for the the cost of an additional oneis zero. cones, monetary charge ordering to the Cost-Benefit Sarah should therefore continueto According Principle, a ordercones as long as the marginal benefit (here, the marginal utility she gets from an additional cone) is greaterthan or equal to zero. As we can see from the opportunity cost of

time

she spent waiting

is a

is positive 5.2, marginal utility up to and including the fifth after five cones. as Thus, noted earlier,Sarah should negative

in Table

entries but

the

becomes

cone

order

five cones.

INCOME

A FIXED

ALLOCATING

BETWEEN TWO GOODS

time we face considerably more complexpurchase decisions than the faced. For one thing, we must make decisions about many generally not just a single one like icecream. Another is that the cost of goods, complication consuming additional units of each good will rarely be zero. To see how to proceedin more complex cases, let's suppose Sarah must decidehow to spend a fixed sum of money on two different goods, each with a positive price. Should she spend all of it on one of the goods or part of it on each? The law of diminishing marginal utility that it all on suggests spending a singlegoodisn't a goodstrategy. Rather than devote more and more money in large quantities (and whose to the purchase of a goodwe already consume is therefore low), we generally do better to spend marginalutility relatively that on other goods we don't have much will of, whose money marginal utility of

Most

the

one Sarah

be higher.

likely

The simplest way decisions

of

beginning

to

illustrate

a utility-maximizing with

the

following.

how

consumer

economists

is to

the

marginal be. For Sarah,

consumption of ice cream

J

cones

10 h

each hour,

consumes

utility

I 1

_.

30 \302\247

Utility.

Sarah's

/

5

Marginal

Diminishing \342\200\224 \342\200\224I

131

DEMAND

think

work through

about

the a series

spending of examples,

Cost-Benefit

of utility.

132

CHAPTER5

EXAMPLE

5.1

DEMAND

Rational

The

Is

Sarah

Rule (Part I)

Spending her

maximizing

utility

from consuming

chocolate and vanilla

ice

cream?

sells for $2 per pint and vanilla sells for $1. Sarah has a per year to spend on icecreamand her marginal utility from in Figure each 5.4. If she is consuming type varies with the amount consumed, as shown 200 of vanilla and 100 pints of chocolate each year, is she currently buying pints ice cream

Chocolate

budget

of

$400

maximizing her utility?

OE \302\243\302\243\302\243 w .E *\302\243

3 o

a.

\342\226\2403-S3

12

fit

0 Pints/yr

(a) 5.4

FIGURE

At

Curves for Two Flavors of IceCream(Part I). consumption levels, her marginal utility of chocolate ice cream is higher than her marginal utility of vanilla. But chocolate is twice as expensive

Utility

Marginal

current

Sarah's

25 percent as vanilla.

Note first that with 200 pints per year of vanilla and 100 pints of chocolate, Sarah is spending $200per year on each type of ice cream, for a total expenditure of $400 per year on ice cream, exactly the amount in her budget. By spending her money in this is she getting as much fashion, 5.4(b) that her utility as possible? Note in Figure

ice cream is 16 utils per pint. Since chocolate costs additional spending on chocolate is yielding utility at the rate of = 8 utils in Figure 5.4(a) that note Sarah's (16utils/pint)/($2/pint) per dollar. Similarly, marginal utility for vanilla is 12 utils per pint. And since vanilla costs only $1 per pint, = 12 utils per her current spending on vanilla is yielding (12 utils/pint)/($l/pint) In other words, at her current dollar. rates of consumption of the two flavors, her

marginal

$2 per pint,

from

utility

her

chocolate

current

than for chocolate. And marginal utility per dollar for vanilla cannot possibly be maximizing her total utility. To see why, note that if she spent $2 lesson chocolate (that is, if she bought one less than but with the same $2, she before), she would lose about 16 utils;1 pint could buy two additional pints of vanilla, which would boosther utility by about 24 utils,2 for a net gain of about 8 utils. Under Sarah's current she allocation, budget is thus spending too little on vanilla and too much on chocolate.

spendingyields

this

means

that

higher

Sarah

In the next example, we'llseewhat chocolate and $100 per year more

aThe actual rises slightly

happens

if Sarah

spends $100

would be slightly larger than 16 utils because her marginal consumes less of it. 24 utils because her marginal 2The actual increase will be slightly smaller than slightly as she buys more of it. reduction as she

per year

less

on

on vanilla.

utility utility

of chocolate of vanilla

falls

TRANSLATING

Spending Rule (Part 2)

The Rational Is Sarah

Sarah'stotal the

her

maximizing

earlier

amount

budget and the If her marginal utility

cream

ice

example. consumed,

as shown

of vanilla and 50 pints

of

in

prices of the from

5.5, and each year, is

if

ice cream?

are the same as in each type varies with the currently buying 300 pints flavors

two

consuming

Figure

chocolate

and vanilla

chocolate

consuming

from

utility

she's

she maximizing

of

of

cream utility

utility ice

her

utility?

cream

ice

vanilla Marginal

I I I I I I I

'utils/pint) ginaldlate

(utils/pint)N> -\"=

, i i 1

CO

O

Mar choc<

H

200

>-

0

300

50

Pints/yr

^

100

Pints/yr

(a)

(b)

FIGURE 5.5 Utility

Marginal When

Sarah

Conversely,

when

for Two Flavors of IceCream(Part her consumption of vanilla (a), her marginal utility

2).

Curves

increases

she reduces her

of chocolate

consumption

(b),

her

of chocolaterises.

Note first

that

the

direction

of Sarah's

rearrangement of

her

of vanilla falls.

marginal

utility

spending

makes

she was spendingtoo light original example, much on chocolate and too little on vanilla. less on chocolateice $100 Spending creamcauses her marginal utility from that flavor to rise from 16 to 24 utils per ice cream 5.5(b)]. pint [Figure By the same token, spending$100moreon vanilla causes her marginal utility from that flavor to fall from 12 to 8 utils per pint [Figure 5.5(a)]. Both movements are a simple consequenceof the law of diminishing marginal utility. Since chocolate still costs $2 per pint, her spendingon chocolate now yields = 12 utils additional at the rate of dollar. (24 utils/pint)/($2/pint) utility per vanilla still costs $1 per pint, her spendingon vanilla now Similarly, since yields additional utility at the rate of only (8 utils/pint)/($l/pint)= 8 utils So at her per dollar. new rates of consumption of the two flavors, her spendingyields higher marginal for of the utility per dollar for chocolate than vanilla\342\200\224precisely the opposite in we saw the ordering original example. Sarah has thus made too big an adjustment in her effort to remedy her original from the new combination of flavors (300 pints consumption imbalance.Starting of vanilla and 50 of for chocolate), per year pints per year example, if she then two fewer of vanilla would reduce her 16 utils) (which bought pints utility by about and used the $2 she saved to buy an additional of chocolate (which would pint boosther utility by about 24 utils), she would experiencea net gain of about 8 utils. So again, her current combination of the two flavors fails to maximize her total utility. This time, she is spendingtoo little on chocolate and too much on vanilla. sense

in

of the

in

which

we

saw that

WANTS

EXAMPLE

INTO DEMAND

5.2

133

CHAPTER

134

5

DEMAND

CHECK 5.1

CONCEPT In

the

combination

optimal

affordable

the yields

the

of goods combination that

highest

total

EXAMPLE 5.3

utility

examples,

preceding

the amount

that

verify

has budgeted

Sarah

that

the stated combination of flavors for ice cream.

costs

exactly

is Sarah's optimal combinationof the two flavors? In other words, all the combinationsof vanilla and chocolate ice cream that Sarah can among which one the maximum total The afford, provides possible utility? following illustrates the condition that this combination must example optimal satisfy. What

The RationalSpending

Rule

her utility

Is Sarah maximizing

Sarah'stotal the the

pints

cream

ice

examples. consumed,

previous amounts

3)

(Part

budget and the If her marginal

prices of the from

utility

and vanilla

chocolate

consuming

from

two

flavors

consuming

of

same as in varies with

are the each type

as shown in Figure 5.6, and if she is currently and 75 pints of chocolate each year, is she maximizing

of vanilla

ice cream?

250

buying

her

utility?

of cream

cream utility

utility ice

_>

O

ice 'utils/pint) ginaldlate

(utils/pint) o vanilla Marginal

75

0

250

0

Pints/yr

Pints/yr

(b)

(a)

FIGURE 5.6

each

her

current

for Two

Curves

Utility

Marginal At

consumption

per dollar is exactly

the same for

5.6(b)], and

now yieldsadditional Sarah's marginal

again

still

costs

sincechocolate still utility

utility

for

of 250 pints per year of vanilla a total of $400, exactly the amount from chocolate is now 20 utils per

combination

the

Sarah's ice cream budget.Her marginal

vanilla

utility

flavor.

As you can easily verify, 75 pints per year of chocolate [Figure

Flavors of IceCream(Part 3).

levels,marginal

costs utility

$2 per

costs

pint, her

rate of (20 utils/pint)/($2/pint) vanilla is now 10 utils per

=

pint

spent on vanilla

of pint

spending on chocolate

at the

her last dollar $1 per pint, = 10 utils per dollar. So at

and

[Figure now

10 utils

per dollar.

5.6(a)], and yields (10

also

since utils/

of consumption of the two pint)/($l/pint) her the same flavors, spending yields precisely marginal utility per dollar for each if flavor. she a little less on chocolate and a little more on vanilla (or vice Thus, spent i f her total would not at all. For she two more versa), utility change example, bought of vanilla would increase her 20 and one fewer of (which utils) pints utility by pint chocolate would reduce her 20 both her total on (which utils), utility by expenditure icecream and her total utility would remain the same as before.When her marginal her

new

rates

utility per dollar is the same for each flavor, its impossible for Sarah to rearrange to increase total utility. 250 pints of vanilla and 75 pints Therefore, spending chocolate form the combination of the two flavors. per year optimal

her of

THE

SPENDING

RULE

RULE

SPENDING

RATIONAL

THE

RATIONAL

illustrate the rational spendingrule for through to allocate a fixed The problem budget acrossdifferent goods. or utility-maximizing, combination must this rule. satisfy

The exampleswe solving

optimal,

worked

have

of how

the

Spending Rule: Spending

The Rational marginal

across goods

be allocated

should

utility per dollar is the same for

each good.

so that

the

The rational

rule can be expressed in the form of a simple formula. If we spending to denote from chocolate ice cream consumption (again marginal utility MUC measuredin utils per pint) and Pc to denotethe price of chocolate (measured in dollars the marginal per pint), then the ratio MUC/PCwill represent utility per dollar spent on chocolate, measured in utils per dollar. Similarly, if we use MUV to denote the marginal utility from vanilla ice cream consumption and Py to denote the price of vanilla, then MUV/PV will represent the marginal utility per dollar on vanilla. The dollar will be the same for the spent marginal utility per exactly two types\342\200\224and hence total utility will be maximized\342\200\224when the following simple equation for the rational spendingrule for two goods is satisfied: use

=

MUC/PC

MUV/PV.

generalized to apply to spendingdecisions most general form, it says that the ratio of regarding large to must be the same for each the consumer buys. If the marginal utility price good ratio were higher for one good than for another, the consumer could always increase her total more of the first and less of the second. utility by buying good the rational spending rule applies to goodsthat are perfectly Strictly speaking, as milk or gasoline. Many other goods,such as bus rides and television sets, divisible, such can be consumedonly in whole-number amounts. In such cases,it may not be possible to satisfy the rational rule spending exactly. For example,when you buy one television dollar be somewhat set, your marginal utility per spent on televisions may higher than the corresponding ratio for other goods, yet if you bought a second set, the reverse in such cases is to allocate each additional well be true. Your best alternative might rational

The

rule is easily

spending

of goods. In its

numbers

dollar

you

good for which

spend to the

Notice that

we

not chosen

have

dollar is highest. rule as one of the spending list not because the rule is utility per

marginal

your

to classifythe

rational

of economics. We omit it from this it follows directly from the Cost-BenefitPrinciple. in keeping is considerableadvantage the list of Core Principles

Core

Principles because

we noted

but unimportant,

As

there

as small

AND SUBSTITUTION EFFECTS REVISITED

INCOME In

saw

3, we

Chapter

the

that

depends on its own price,on the We also

incomes.

consumer

it demanded

The substitution substitutes for consumers to

the

poorer

that

good

the good

prices

of a

good

consumers

that

of substitutes

wish

and complements,

to purchase

and on

a good changes,the quantity of effect and the income effect. the fact that when the price of a good goes up, relatively more attractive, causing some

when

the

price of

substitution

for its substitutes.

refers

in real

or richer

of one

to become

refers

effect that

abandon

price

saw

quantity

changes for two reasons:the

The income effect either

earlier,

as possible.

to the

fact

that

a price

terms. Consider,for

of the ice cream flavors

in

the

change

instance,

preceding

makes the consumer effect of a change in

the

examples.

At

the

original

for vanilla), Sarah's $400 annual ice $1 per pint chocolate, prices ($2 per pint cream budget her to buy at most 200 pints per year of chocolate or If the price of vanilla rose to $2 per pint, 400 pints per year of vanilla. that would reduce not only the maximum amount of vanilla she could afford (from 400 to 200 pints per year) but also the maximum amount of chocolateshecouldafford in combination with any given amount of vanilla. For at the original price example, for

enabled

a

Cost-Benefit

135

136

CHAPTER

5

DEMAND

afford to buy 150 pints of chocolate while pints price of vanilla rises to $2, shecan buy only 100 pints of chocolate while buying 100 of vanilla. As noted in Chapter 3, a pints reduction in real income shifts the demand curves for normal to the left. goods The rational rule helps us see more clearly a change in the price of spending why one good affects demands for other goods. The rule requires that the ratio of if to be the same for all This means that the marginal utility price goods. price of one the ratio of its current to its new will be lower good goes up, marginal utility price than for other goods. Consumerscan then increase their total utility by devoting smaller proportions of their incomesto that good and larger proportions to others. of $1

per pint

for

EXAMPLE5.4

Sarah could

vanilla,

of vanilla;

buying 100

the

when

but

Responseto a Price

Reduction

Supposethat marginal

shown

utility

in

5.7.

Figure

showed

in

$400

still

the

year and the

per

and $1

varies

ice cream?

of chocolate

price

chocolate

for

each type

consuming

As we

the

budget is

$2 per pint

are again from

a reductionin

ice cream

total

Sarah's

flavors

two

the

respond to

Sarah

should

How

per

pint

250

pints

Her

as consumed, she is examples, currently each year, which is the optimal

previous

amounts

the

with

and 75 pints of chocolate combination for her at these prices. How should shereallocateher spending the two flavors if the price of chocolateicecreamfalls to $1 per pint? buying

prices of

vanilla.

for

of vanilla

of

of

cream utility

utility ice

among

cream

20

ice (utils/pint) o

i i i

vanilla Marginal

/

(utils/pint) Marginal chocolate

i

o

75

0

250

Pints/yr

Pints/yr

(b)

(a) 5.7

FIGURE

for Two Flavors of IceCream(Part 4). of flavors, marginal utility per dollar is the same for each flavor.When the price of chocolatefalls, marginal utility per dollar becomeshigher for chocolate than for vanilla.To redress this imbalance, Sarah should buy more chocolate and less vanilla.

Marginal Utility Curves At the current combination

the

Because of

the

rational

two

spending

shown in Figure 5.7 constitute for Sarah at the original prices,they

the

price

= (20 =

exactly

combination satisfy

the

utils/pint)/($2/pint) = 10utils/dollar

MUV/PV

=

(10 utils/pint)/($l/pint).

falls to $1 per pint, spendingrulebecausethe

of chocolate

longer satisfy the rational

chocolate will

must

rule:

MUC/PC

When

the optimal

quantities

flavors

suddenly

MUC/PC

be twice

= (20 >

what

it

was

the

original

marginal

before:

utils/pint)/($l/pint) = 20 utils/dollar

MUV/PV

= 10

utils/dollar.

will no quantities per dollar for

utility

RATIONAL

THE

SPENDING

RULE

this imbalance, Sarahmust rearrange her spending on the two flavors in such as to increasethe marginal dollar for vanilla relative to the marginal utility per in if she buys dollar for chocolate. And as we see that will utility per Figure 5.7, happen a larger quantity than before of chocolate and a smaller quantity than before of vanilla.

To redress a way

CHECK 5.2

CONCEPT pound

income on

all of his

spends

John

the

and

his marginal

price

utilities

respectively. Is John

two

food

goods:

of shelter is $ 10per square for the two goods are 20 utils his utility?

maximizing

If

not,

1 we saw that people often the distinction between average

appreciate

this

of utility

model

economist's

the

illustrates,

example

and

Eric consume

the

As

to apply

when people attempt

maximization.

vs. Average

Marginal Should

to

fail

and benefits.

costs

marginal

arises

also

pitfall

because they

bad decisions

make

In Chapter following

and shelter.The price of food is $5 per At his current consumption levels, and 30 utils per square yard, per pound how should he reallocate his spending? yard.

EXAMPLE

Utility

5.5

more apples?

of applesand a total of oranges.The price of apples is $2 50 apples and 50 oranges each, the price of orangesis $1 each,and he consumes eachweek.True or false: Eric should consume more applesand fewer oranges. Eric

of 1,000

a total

gets

of 400

utils

week

per

utils

from

per

week

Eric spends $100 per weekon apples = 10 utils utils/week)/($100/week) = 8 and (400 utils/week)/($50/week)

(1,000 apples

oranges.Many might dollar for applesis only

knowing

be tempted to than for higher

his average

his consumption

from

his consumption

utility

per

and

$50

per

dollar

utils

respond

per that

oranges, he dollar

on oranges. He thus averages from his consumption of dollar from his consumption Eric's

because

average

should consumemore apples.But good doesn't enableus to say

for each

his current combination is optimal. To make that determination, to compareEric'smarginal utility per dollar for each good. The information doesn't permit us to make that simply comparison.

whether

TRANSLATING

RECAP

WANTS

of per

utility

we need given

INTO DEMAND

the various challenges us to allocate our incomes among so as to fulfill our desires to the greatest possibledegree. The combination of goods is the affordable combinationthat yields the optimal For that are perfectly divisible, the rational spending highest total utility. goods rule tells us that the optimal combinationis one for which the marginal utility per dollar is the same for each good.If this condition were not satisfied, the consumer The

Scarcity

goods

that

are

Principle available

couldincreaseher per

dollar

APPLYING

utility

was lower and

THE

The real payoff

by spending less on goods for more on goodsfor which her

RATIONAL

SPENDING

which

marginal

the marginal

in

from

these

utility

higher.

RULE

the law of demand and the rational learning abstract using concepts to make senseof the world in efforts to become an economic naturalist, encourage you your in this vein. of Economic Naturalist sequence examples

lies

was

utility

a

spending

around we

turn

rule

you. To now to

a

Scarcity

137

138

5

CHAPTER

DEMAND

at Work

Substitution

In the

these

of

first

up, rational

goes

Can't meet the

substitutes.

on the role of substitution. When the price consumers generally turn to less expensive on a new car? Then buy a used one, or rent an French restaurants too pricey? Then go out for

we focus

examples,

of a good or service

payments

line. apartment on a busor subway or eat at home more often. National Football Leaguetickets too Chinese, high? Watch the game on television, or read a book. Can't afford a book?Checkone out of the library, or download some reading matter from the Internet. Once you begin to see substitution at work, be amazed the number and richness of the you'll by

examples that

'

''

*

--

'\" '-\342\226\240'.''\342\226\240 _ it -

Why

do the wealthy

wealthy

in Seattle?

live in

Manhattan

in

smaller houses than

the

Bill cofounder Gates lives in a 45,000-square-foot house in Washington. His house is large even by the standards of Seattle, of whose wealthy residents live in houses with more than 10,000 many of similar wealth in Manhatsquare feet of floor space.By contrast, persons tan rarely live in houses larger than 5,000 square feet.Why this difference?

Microsoft

w

Seattle,

;

'

1

5.2

Naturalist

^1 m

every day.

you

The Economic

^p

- .

confront

.

!

* %

For people trying to decide how large a house to buy, the most obvious difference between Manhattan and Seattle is the huge differin cost of land alone is several times higher | ence in housing prices.The ? Manhattan than in Seattle, and construction costs are also much of New Yorkers could afford to build a ^ higher. Although plenty Manhattan housing prices are so high | 45,000-square-footmansion, houses and spend what \302\251that they simply choose to live in smaller they

\"\"w

o

J

.'-*

-iJl*:

Would

he

lived

Bill

Gates

build a 45,000-square-foot

house

in other save for instance.

if

in Manhattan?

than

often

ways\342\200\224on

lavish

their

wealthy

of

ways\342\200\224some

changed

their

switched

to

behavior

windows,

and

to economize

transportation;

public

work; took fewer

straightforward,

trips;

turned

solar heaters;

down

others

on the

use

in eastern Long Island, go to the theater more other U.S. cities.

and

out

counterparts

An especially vivid illustration of substitution when fuel shortages brought on by interruptions Middle East led to sharp increasesin the price variety

homes

summer

New Yorkers also eat

in

occurred in

late

the

during

of oil

the supply

from

1970s, the

of gasoline and other fuels.In a remarkably ingenious\342\200\224consumers of energy. They formed car pools;

closer to

bought four-cylinder cars; moved their thermostats; installed insulation,

and bought more efficient

storm

people

Many

appliances.

even moved farther south to escapehigh winter bills. heating As the next example pointsout, consumersnot only abandon a good in favor of substitutes when it gets more expensive, but they also return to that good when pricesreturn to their original levels.

w

Naturalist 5.3

The Economic did

Why

people

turn

and eight-cylinder In 1973, up

to

disruption

to four-cylinder

cars in

the

cars in

the

1970s,

only to

the price of gasoline was 38 cents per gallon.The following in the wake of a major disruption of per gallon in 1979 drove the 1980 price to $ 1.19per gallon.These

52 cents

shift

back

to six-

1990s? year

the

price shot

oil supplies. A increases sharp

second in the

RATIONAL

THE

led to

of gasoline

price

delivered

which

people

gasoline, the

$1.40

The

key

to

switch

of cars sold with

six-

to

increases

in the

fuel

economy

per

all, for

gasoline, the could

slowly

in

faced

a consumer

with the

engines, cars most

supplies

focus on

an automobile

big

in the

changes

engine to

of

real price

choose,what

matters

to all other goods. price of gasolinerelative of whether to spend $ 1.40for a gallon of how much utility she could get from other things she

but the

is

same money. terms

or dollar,

nominal,

four-cylinder

eight-cylinder

the price of gasolinecontinued to though the 1980s and 1990s, it declined sharply

Even through

rise

other goods.Indeed,in terms of real purchasing power, the 1999price was is, in 1999 $1.40 bought actually slightly lower than the 1973 price. (That slightly fewer goods and services than 38 cents bought in 1973.) It is this decline in the real price of gasoline that accounts for the reversal of the trend toward smaller engines. relative

price of

to

the

A

sharp

in

the

States

United

the

Ford

in the

decline in sport

explosivegrowth

real price of vehicles

utility in 2001, up

thesewould have hottest sellersin

been the

less than dismal

cheap-energy

\"We

SUVs,

long

in

motored

lists

received

seldom

Here's another decisions.

of vehicle

7,500

miles

over

to say hi!v

began

$4 per

to rise sharply

gallon

purchases began

in

some

to shift

and by the terms, of the parts country. Just almost immediately. Large discounts. And with deep in

real

just months earlier, began sellingat for fuel-efficient Prius, buyers not only hybrids such as the Toyota even more than the sticker price. discounts, they frequently paid related of the influence of closely example price on spending

demand

high

waiting

patterns

also

1990s.

as a pounds (three times as much on streets. Vehicles like per gallon city failures during the but were far the 1970s, they by environment of 2001.

than

10

In 2004, gasoline pricesyet again summer of 2008 had reached almost

as expected,the

helps account for the Almost 4 million SUVs were sold 750,000 in 1990. Some of them\342\200\224like

gasoline

the

in

from only

more

Excursion\342\200\224weigh

Civic) and get

Honda

real

price

the dollar

price of

a good relative to the average dollar price of all other goods

a decision

with

question

important

purchase

with

despite

patterns is to

these

explaining

fuel

1999.Yet

by

gallon

gasoline.When someone decideshow is not the nominal price of gasoline, After

demand for cars than the six- and

139

RULE

and prices rose only stabilized, the continued rise in the price of smaller engines did not continue. By the late 1980s, the proportion and eight-cylinder this reversal? engines began rising again.Why 1980, however,

After

owned.

had

reaching

slowly,

big

better

much

SPENDING

price the absolute price of a good in dollar terms

nominal

CHAPTER 5

140

DEMAND

automobile enginessmallerin England the most popular model of BMW's 5-series

Why are J

Uu

In England,

States

United the

5.4

Naturalist

Economic

The

mr

530i.The engine in the this difference? 530i.Why

is the

the

in

engine

it

5l6i

than

United States?

in the

car is the 516i, whereas in the is almost 50 percent smaller than

In both BMWs appeal to professionalswith similar countries, incomes, roughly in purchasing so the differencecannot be explained Rather, it by differences power. is the direct result of the heavy tax the British of tax, a gallon levy on gasoline.With sells for more than two times the price in the United $8 in England\342\200\224about gasoline States.This difference encourages the British to choose smaller, more fuel-efficient

engines.

The Importance of IncomeDifferences

between the rich and the poor is that the rich have houses than the why the wealthy generally buy larger that the wealthy feel more strongly about housing than poor, we neednot assume A much simpler explanation is that the the total poor. utility from housing, as with most other the amount that one consumes. goods, increases with As the next example not only for illustrates, income influences the demand housing and other goods,but also for quality of service.

Doesthe

quantity

demanded depend

of horsepower on gasoline prices?

To explain

incomes.

higher

difference

obvious

most

The

The Economic Naturalist

ar

are

Why

5.5

lines longer

waiting

in

neighborhoods?

poorer

a Baskin-Robbins retailer offered free ice campaign, of its franchise stores.The first was located in a high-income in a low-income neighborhood. Why the second was the queue for free ice neighborhood, in cream the low-income neighborhood? longer

As part

of a recent promotional

at two

cream

Residentsof both neighborhoods must decide whether to stand ice cream or go to someotherstore and avoid the line by paying the

^Kieisf

aw

make

we

others

than

the

the plausible assumption that to pay to avoid standing in

high-income

RECAP lines

longer

neighborhoods?

in low-income

which

clerks,

aremorelikely

Why are

others

than

lines

income

expect to

in

and

lines

are shorter in grocery short at any grocery

stores

that

store means

means charging higher prices.High-incomeconsumers to be willing to pay for shorter lines.

APPLYINGTHE RATIONAL

Application of the of

why

high-incomeconsumers.Keeping

more

hiring

are more willing see shorterlines

higher incomes

we should

neighborhood.

Similar reasoning helpsexplain

cater to

with

people line,

for free usual price. If

in line

rational

substitution

rule highlights the in explaining differences

spending

RULE

SPENDING

important roles in

consumption

communities, and acrosstime.The rule also as opposed to nominal, and prices income are what matter. The demand for a good falls when the real price of a substitute falls or the real price of a complement rises. patterns\342\200\224amongindividuals, among the fact that real, highlights

If

information

add

individual

the

each individual's

what

know

we

usethat

to construct

curves

demand

requires care.

Supposethat

only two their demand

are

there

that

and

tuna

demand curve for a good looks like, how can we demand curve for the good? We must a but together, process that is straightforward

the market

ADDITION

HORIZONTAL canned

141

CURVES

DEMAND CURVES

MARKET

AND

INDIVIDUAL

DEMAND

MARKET

INDIVIDUALAND

buyers\342\200\224Smith

and

curves are as shown

Figure

for

market

the

Jones\342\200\224in

in

5.8(a)

and (b). To

construct the market demand curve for canned tuna, we simply announce a of and then add the demanded sequence prices quantity by each buyer at each For a t a of 40 cents Smith demands six cans per week price. example, price per can, and demands two cans week for a market demand of cans (a) (b), Jones per eight per week

(c).

FIGURE 5.8

c

1.60

Individual

1.40

Demand

1.20

6 8

2 4

0

2 4

0

L_\\

0.20

, ,

Jones'squantity

(cans/week)

(cans/week)

(a)

The

demand

curve

Vi i

^k

I

2 4

6 8

Total

quantity

l\\

1012

(cans/week)

(c)

(b)

individual demandcurves to get the market demand a term used to emphasizethat we are addition, which are measured on the horizontalaxesof individual

horizontal

as

quantities, curves.

CONCEPT

5.3

CHECK

The buyers' sideof demands are as shown

market

the

in the

for movie tickets consists of two consumers curve diagram below Graph the market demand

market.

18 /~s

+J V

^ \\\\

^^ +j V

\\

^

-* .~

\\

u

12 .\302\253 +j

\\\\

+J

\\

V*

V*

\\

\\

Q

V

\\

u

u

\\

&.

&.

\\

0.

0.

\\ 0

24

Tickets/yr

0

48

Tickets/yr

The any

quantity demanded at on the market

price

demand I I

of adding

process

curve is known adding

demand

i

6

Smith'squantity

Market

0.80

0.60 0.40

u

Market

CannedTuna.

1.00

u

and

Curves for

whose for this

of the

curve individual

(c) is the quantities

demanded at that price,

(a) and

(b).

sum

142

5

CHAPTER

5.9

FIGURE

The

Curves

Demand

Market

All

Identical

6

and

Individual

When

DEMAND

5

Have

Buyers

crt

Demand

Curves. demand

individual

When

curves are identical, the market demand (b)

get

^^

a

rt

5

\342\200\224

a

_

^3 u

I 2

I 2

curve

quantity on the individual demand curve (a) by the number of consumers in

\342\200\224

^3 u

1

each

multiplying

by

we

6

__

-^N

1

0

2

I

I

I

4

6

8

I

X

10 12

(cans/month)

Quantity

the

^^

I

0 Quantity

4

2

I

IX

8 10 12 of cans/month)

(1,000s

(b)

(a)

market.

6

Figure 5.9 illustrates the special case in which each of 1,000consumersin the has the same demand curve (a). To get the market demand curve (b) in this each on the representative individual demand case, we simply multiply quantity market

curve

by

1,000.

CONSUMER

AND

DEMAND

SURPLUS

In Chapter 1 we

consumer between

price for actually

surplus a buyer's a product

paid

the

difference

reservation and the price

in a first encountered the concept of economic surplus,which she would have been willing to pay buyer's case is the difference between the most for a product and the amount she actually pays for it. The economicsurplus received is often referred to as consumersurplus. by buyers The term consumer received surplus sometimes refers to the surplus by a single On other occasions, it's usedto denotethe total buyer in a transaction. surplus in a market or collectionof markets. received by all buyers

CALCULATING

CONSUMER

SURPLUS

For performing cost-benefit analysis, it's often important to be able to measure the consumer received all who surplus by buyers participatein a given market. For example, a road linking a mountain and a village port city would create a new market for fresh fish in the mountain village; in deciding whether the road should be built, analysts would want to count as one of its benefits the gains that would be in this new market. reaped by buyers To illustrate how economistsactually measure consumer we'll surplus, 11 potential consider a hypothetical market for a good with each of whom can buyers, a maximum of one unit of the each The first buy good day. potential buyer's reservation for the product is $11; the second buyer'sreservation is $10; the price price third reservation is and so on. The demand curve for this market $9; buyer's price in will have the staircase shown 5.10. We can think of this curve as shape Figure the digital counterpart of traditional demand curves. the units shown on (If analog the horizontal axis were fine enough, this digital curve would be visually total

indistinguishable

from

its analog

counterparts.)

in Figure 5.10 were curve is shown Suppose the good whose demand available at a price of $6 per unit. How much total consumersurplus would

DEMAND AND

CONSUMERSURPLUS

5.10

FIGURE

A Market with a Demand Curve. a product

When

sold only

\"Digital\"

can be

in whole-number

amounts, its demand has the

in this

buyers

market The

market.

this

reap?

buyer

a price

At

of the

sixth

of $6,

143

curve

stair-step shape shown.

six units per day would be sold in receive no economic surplus exactly $6, the same as its selling

would

unit

since his reservationpricefor that unit was But the first five buyers would reap a surplus for their The purchases. buyer of the first unit, for example, would have been willing to pay as muchas of exactly $11 for it, but since she'd pay only $6, she'dreceivea surplus $5. The buyer of the second unit, who would have been willing to pay as much as would receive a surplus of $4. The surplus would be $3 for the buyer of $10, the third unit, $2 for the buyer of the fourth unit, and $1 for the buyer of the price.

fifth

unit. If we

add all the

consumer

surplus

Figure

5.11.

each

buyers' surplusestogether,we

day. That

a total

get

surplus corresponds to the

of $15

of

shaded area shown

in

FIGURE5.il

12

Consumer

11

10 9 8 7 6 5 4 3 2 1

Consumer

'=

Consumer surplus

region)

$l5/day

is the

difference that

for they

t

J

L

_L

5

J

6 Units/day

L

7

_L

8

_L

_L

Demand

_L

9 10 11

J

12

Surplus. surplus

buyers

between

the most

to pay the price

are willing

each unit and actually

(shaded

cumulative

pay.

144

CHAPTER5

DEMAND

5.4

CHECK

CONCEPT

Calculate consumer the

that

buyers'

curve

a demand

for

surplus

prices for each

reservation

one

the

like

are

unit

$2 higher

just described except than before, as shown

graph below.

in the

13

12

^ 10

1 8 (u

u

6

I

^~

~

4

Demand

2 0

7

6

5

4

3

2

1

9 10 11

8

12

Units/day

Now

is a

EXAMPLE5.6

we want

suppose

conventional

demand

straight-line

simple extension

of the

in a market to calculate consumersurplus with a curve. As the following example illustrates, this method used for digital demand curves.

Measuring

Consumer

How much

do buyers benefit from

the

Consider

5.12,

which

4,000 gallons In

Surplus

first that,

note

generates no

consumer surplus at

gallons

buyers

per

day,

their

market for milk?

in the

participation

market for milk whose demand and curves are shown in Figure supply has an equilibrium price of $2 per gallon and an equilibrium quantity of in this market reap? per day. How much consumer surplus do the buyers 5.12,

Figure

as in all.

5.11, the last unit also that for all milk

Figure

Note

receive consumer surplus,

3.00

as in

just

Figure

each

exchanged

J\302\273 2.00

l

1.50

1-00

.50 0

S

i

i

i

1

2

3 Quantity

r^sj

4

5

6

7

8

9 10 11

12

of gallons/day)

(1,000s

FIGURE 5.12 Supply

and

Demand

in the

Market for Milk.

the supply and demand curves shown, and the equilibrium quantity $2 per gallon For

the

equilibrium

is 4,000

day

sold up to 4,000 5.11. For these buyers,

Ss

^ 2.50_ >v T

task

price of milk

gallons per

day.

is

SUMMARY

145

consumer the most to surplus is the cumulative differencebetween they'd be willing milk for measuredon the demand and the (as curve) pay price they actually pay. Total consumer is thus the surplus received by buyers in the milk market shaded triangle between the demand curve and the market price in Figure 5.13. = b Note that this area is a right whose vertical arm is triangle $l/gallon and whose horizontal arm is b = 4,000 gallons/day.And since the area of any triangle is equal to (l/2)bh, consumer surplusin this market is equal to

= $2,000/day. (l/2)(4,000 gallons/day)($l/gallon)

consumer surplus

3.00

^2.50 c

I

2.00

S

1.50

1.00 \342\200\242C

.50

10 11 12

123456789

0

of gallons/day)

(1,000s

Quantity

FIGURE 5.13

Consumer Surplusin Consumersurplus

the

Market

area of the

is the

for Milk. shaded

triangle

($2,0007day).

A useful way of thinking about consumer surplus is to in consumers would the for the right to price pay, aggregate, in this milk market. The answeris $2,000per day, since which their combined benefits exceedtheir combined costs.

ask what

is the

highest participating

continue that's

the amount

by

demand curve for a good can be interpreted horizontal interpretation tells us, for each the total quantity that consumers wish to buy at that price, price. The vertical the most a buyer would be willing to interpretation tells us, for each quantity, consumer pay for the good at that quantity. For the purpose of computing we curve. The value on surplus, rely on the vertical interpretation of the demand the vertical axis that to each point along the demand curve corresponds As discussed

in

or

the

marginal

corresponds

to

is the cumulative market

below by

price. the

vertically.

It is

The

buyer's reservation price for the good. Consumer surplus differences between these reservation pricesand the area bounded above curve and bounded by the demand

of the

sum

market

3, the

Chapter

either horizontally

the

price.

-

\342\200\242 The

rational

consumer

different goods so that from the last dollar spent

allocates the on

SUMMARY

income among

marginal utility gained each good is the same.

-

This rational spendingrule gives demand, which states that people they

want

to

do as

the cost

of

rise

doing

do

the law of less of what it rises. Here, to

CHAPTER

146

to the sum

\"cost\" refers

of

all

sacrifices\342\200\224explicit

nonmonetary

in order

made

be

must

DEMAND

5

and monetary and implicit\342\200\224that

to engage in the

\342\200\242 The

\342\200\242 The

to substitute

ability

important Because

virtually

the price-quantity is an

another

for

summarize

substitutes,

terms

of wants

and

describing

economists

rather

to

prefer

than needs.

speak

face

We

At

choices,

from

that

the consumer and

power, demanded.

too,

augments the

consumer

surplus (142)

demand

price. (LOS)

TERMS

marginal

Why

goods(134)

(130)

economists

do out

arising

2. Explain utility it

real price (139) of

combination

optimal

spending rule (135)

rational

(130)

utility

nominal price (139)

RHItW

1.

is a quantitative measure of the of their buyers benefit as a result ability to purchase goods at the market price. It is the area betweenthe demand curve and the market surplus

by which

amount

quantity

marginal

(126)

law of diminishing utility

For

product.

(L03)

KEY

law of

the

of

the demand curve is sometimes of the benefit side of the summary

a

\342\200\242 Consumer

also acquires more realpurchasing

this,

as

benefit

would

unit

market.(L04)

goods,

reason

having

described

consumers)

an additional

this reason,

the income effect is a second demand curves slope downward. important When the of such a good falls, not only does it price become more attractive relative to its substitutes, but

\342\200\242 For normal

price

corresponding

our demands as needsis misleading we have no options. (LOl) suggests

it

a demand curve, the the amount represents by which along

the consumer (or

in

buy

for a single we employ them to for an entire market.

relationship

quantity

any

at various

can be used to summarize

commonly

that

the

shows

that

to

want

relationship

more

individual, but

factor behind the law of demand. every good or service has at least

some because

one good

good people

prices. Demand curves

activity.

L03)

(LOl,

of a

schedule

is a

curve

demand

amounts

economists

why

even

useful,

rather

\"needs\"?

than

consider

if psychologists

4.

of demands

to speak

prefer

of \"wants\"

QUESTIONS

(LOl)

5. Give

does the law of diminishing marginal encourage people to spread their spending many different types of goods?(L03)

3. Why

\"free\"

good

zerois

is offered at to

unlikely

from

an economic

of a

good that you

your

marginal

be

a

perspective.

(L03)

(LOl)

precisely.

or service that

a good

a monetary price of

truly

the concept of cannot measure

why

Explain

consumed

utility

with

across

an for

example which

the amount

of

it

you

utility

consumed.

have

increased

(L03)

PROBIEMS

Any

s-connect

consumer

base the

|

ECONOMICS

When What

on his this

making

does

to decide whether to buy a or her reservation priceand what does the buyer's decision,

trying

decision

the

market

price measure?

(LOl)

given

good

the

existing

or service will market

price.

reservation pricemeasure?

2. Which

the

given good or service:socialinfluence, item?

the

producing

3. You are

be

should

what

swallow? (LOl)

4.

current

Martha's

the

price

for

price

a

good, or the cost of

of the

(LOl) marginal

your

buffet. If you

an all-you-can-eat

at

lunch

having

a buyer's reservation

would impact

factors

following

from consuming

utility

marginal

morsel

last

the

from

utility

are rational, of food you

orange juice is 75 utils

per

If from coffee is 50 utils ounce. marginal utility consuming per costs 25 cents ounce and coffee costs 20 cents orange juice per per ounce, is If Martha maximizing her total from the two utility beverages? so, explain how If know. how shouldshe her not, (L03) you rearrange spending?

and her

ounce

current marginal

5. Toby's

and his

marginal

from

utility

from

utility

is 100

peanuts

consuming

cashews

consuming

is 200

utils

utils

per

ounce.

per

ounce If

cost 10 cents per ounce and cashewscost 25 cents is Toby ounce, per from the kinds of nuts? If so, explain how maximizing his total utility you If not, how should he rearrange his spending?(L03) know. peanuts

6.

week from her consumption of pizza and a total her of The of per consumption yogurt. price pizza is $1 the of is and sheconsumes 10slicesof pizza $1 per slice, price yogurt per cup, and 20 cups of yogurt each week.True or false: Sue is consuming the optimal Sue

of

pizza

whose

rentals,

assumethat amounts.

b? Tom's

(L03)

prices pizza

his

total

which $3

are

he spends on pizza and movie rental, respectively. We can in whole-number available only per

rentals should

slices

amounts, Tom

Pizza slices/week

Tom

can

purchase

each

sum of the utility he derives from pizza and movie in the vary with the amounts consumed as shown and movie rentals are again consumable only in how many pizza slicesand how many movie

is the

utilities

and pizza

whole-number

two goods that

allowance.

utility

these

of the

combinations

possible with

rentals.If table,

and yogurt.

(L03)

a. List all week

per

allowance of $24, all of are $6 per sliceand slices and movie rentals

a weekly

has

Tom

utils

from

week

utils

combination

7.

of 20

a total

gets

of 40

each week?

consume

Utils/week from

pizza

Movie rentals/

week 0

Utils/week from

rentals

0

0

1

20

1

40

2

36

2

46

0

3

48

3

50

4

58

4

54

5

66

5

56

6

72

6

57

7

76

7

57

8

78

8

57

Ann lives in Princeton, New Jersey, and commutes by train each day to her job in New York City (20 round trips per month).When the price of a round trip goes up from $10 to $20, sheresponds by consuming exactly the same number *

Denotes

more difficult problem.

McGraw-Hill

Visit

your mobile

store and

download

the Frank:

Study

Econ

app todayl

app

148

CHAPTER

5

DEMAND

of trips

(L03, L04)

a. Doesthe the

that

fact

increase

price

b. Explain why on restaurant

an

a. Graph the

for

market

curve

demand

for

the

diagram

below.

(L04,

two

LOS)

market.

this

the

amusement

Tickets/yr

park

market if

48

0

10.

consists of

park tickets

amusement

are as shown in

the total consumer surplusin $12 each.

for

tickets sell

the

demands

market

b. Calculate

meals.

restaurant

meals.

whose

consumers

on

less

her quantity of train travel is completelyunresponsive to is not a rational consumer? imply that Ann in train travel might increase affect the amount she spends

buyers' side of

?? The

spending$200per month

as before, while

Tickets/yr

the demand curve shown, find the total amount of consumer surplus that in the gasoline market if gasoline sellsfor $2 per gallon. (L05)

For results

80100

1,000s

of

* Denotes

more

difficult

problem.

5.1 The combinationof chocolate

cream

($100)

budget.

5.2

The

rational

(HECKS

CONCEPT

TO

ANSWERS

gallons/yr

300

costs a

per year

pints

total

of

$400,

of vanilla ($300) and 50 pints of is exactly equal to Sarah'sice

which

(L03)

spending rule

requires MUF/PF

=

MUS/PS

where

MUF and

utilities from food and shelter and PF and Ps are the MUSare John'smarginal of food and At shelter,respectively. combination, John's prices original = 4 utils per dollar and = 3 utils per dollar. John should MUF/PF MUS/PS thus more of his income on food and lesson shelter. (L03) spend

ANSWERS TO

5.3

two

the

market

demand curve

0 8

demand curves,

individual

Adding

(c): (L04)

Consumer

surplus

is now the

13

Tickets/yr

new shadedarea,$28per Consumer

12

yields

8

Tickets/yr

Tickets/yr

5.4

0

48

0

24

(a) and (b),horizontally

=

day.

(L05)

surplus

$28/day

\302\24310

E

3

J

L

_L

8 Units/day

J

9

I

10

I

L

11 12

the

CONCEPTCHECKS

149

CHAPTER

6

Competitive

Perfectly

Supply LEARNING

OBJECTIVES

After reading this chapter, you should be able to:

LOI

L02

how

Explain nity

cost

the

supply

is related

to

curve.

Discuss the the

between relationship \\

tu-

oppo

supply curve for ar

\342\226\240 \342\226\240\302\273.

market

\342\200\242\342\226\240.jf

for an

L03

=

A'

and the

firm

individual

curve

supply

industry.

Determinea

perfectly

competitive

firm's

profit-maximizing Competitive markets

ars built

many

productivity

leave

never

today than

it

barbers

pursuing

why

why are

century, An

have

answer

given

any

they

jobs

roughly

as

would not

as it

just

growth

always has.

in manufacturing

now

is suggested

occupation

more productive than they paid five times as much? by the observation that the is the most one could have become

barbers

in manufacturing. If workers in as they could have earnedin have been to work in service willing much

were

during much?

at the

the last

turn

service

of

the

cost of

opportunity

in some

other

could instead have industries were not paid occupations, many of them

or musicians other

If

industries

in the

first

place.

profit

run.

short

the

Connect the determinantsof

supply that

with affect

individual

firms' costs

and

the

of L05

and

level

the factors

about half an

as

earned

L04

fewer

no

with

workers' productivity, it's

fivefold wages have risen more than real wages for serviceworkersrisenjust

occupation. Most peoplewho chosen

in

Beethoven's Fifth Symphony performs in 1850. And it still takes a barber

are no

musicians

and

long.

did

hour to cut someone'shair, Given the spectacular no surprisethat their real century.

for

took more than 50 hours to assemblein the 1970s are now in less than 8 hours. Similar productivity growth has occurredin other industries. Yet in many service industries, manufacturing if at all. For example, the London has grown only slowly, Orchestra

But

exploited

that

Philharmonic

musicians

profit opportunities

output

apply

theory

supply.

Define

and calculate

producer surplus.

152

6

CHAPTER

PERFECTLY COMPETITIVE

between

link

intimate

the

and

manufacturing

prices at which

industries

service

illustrate

goods and servicesare offered

market and the opportunity cost of the resources to required them. produce In the previous chapter, we saw that the demand curve is a schedule that tells how many units buyers wish to purchaseat different Our task here is to prices. into the factors that the the schedule that tells how curve, gain insight shape supply many units suppliers wish to sellat different prices. in the demand side and the supply side of the market are different Although several of these differences are the behavior of both Indeed, ways, many superficial. the same. After sense, fundamentally all, the buyers and sellersis, in an important I two groups confront essentially similar questions\342\200\224in the \"Should case, buyer's in I another unit?\" and the \"Should sell another unit?\" What is seller's, more, buy these Thus, a buyers and sellersuse the samecriterion for answering questions. rational consumerwill buy another unit if its benefit exceedsits cost and a rational if the cost of making it is less than the extra revenue he seller will sell another unit can get from selling it (the familiar Cost-Benefit Principle again). for

O

of wages in

The trajectories

the

Cost-Benefit

SUPPLY

in the

sale

ABOUT SUPPLY: THE

THINKING

COST

OPPORTUNITY

OF

Do you you've

live

in a

probably

IMPORTANCE

state that noticed

soft drink

refundable

requires

that some

container deposits? If

people always redeemtheir

so,

containers

own

their used containers to be is a service and its productionobeys recycled by Recycling the same logic that applies to the production of other goods and services.The of recycling curve for a good or following sequence examples shows how the supply serviceis rooted in the individual's choice of whether to produceit.

while

other people

pass up this

EXAMPLE

6.1

Cost

Opportunity

leaving

opportunity,

used containers

others.

and Supply

soft drink containers? is trying to decide how to divide his time between his job as a dishwasherin the Harry which an hour for as hours as he choosesto work, and $6 hall, dining pays many in soft drink containers to redeem for which case his gathering deposit, pay depends on both the deposit per container and the number of containers he finds. Earnings is indifferent between the two tasks, and the number of containers he'll aside, Harry in find as shown the table on the number of hours he searches: below, depends, per day How much

should

time

Searchtime (hours/day)

Harry

spend recycling

Total number of

containers found

0

0

1

600

2

1,000

3

1,300

4

1,500

5

1,600

number

Additional

containers

600

400 300

200

100

found

of

ABOUT

THINKING

containers may be redeemed spend searching for containers?

If the Harry

For each additional

loses

hour

he could

$6

the

cost of

searching searchingfor containers

column redeem

yield

searching

as a dishwasher.This

THE IMPORTANCE OF OPPORTUNITY

COST

should

hours

many

for soft drink containers,he is his

hourly

His benefit from

containers.

drink

soft

for

cents each, how

for 2

spends

Harry

have earned

SUPPLY:

opportunity

each hour spent

additional containershe finds (shown in deposit per container. Sincehe can each container for 2 cents, his first hour spent collecting containers will = of or more than he could have earned as a $6 600($0.02) $12, earnings 3 of the

number of

is the

table) times the

he collects

dishwasher.

the Cost-Benefit then, Harry should spendhis first hour of work By Principle, each day searching for soft drink containers rather than washing dishes. A second hour for containers will yield 400 additional containers, for additional searching A of so it too satisfies the cost-benefit test. third hour earnings $8, spent searching = $6 of additional 300 additional f or containers, 300($0.02) yields earnings. Sincethis is exactly what Harry could have earnedwashing he's indifferent dishes, between spending his third hour of work each day on one task or the other. For the sake of discussion, however, we'll assume that he resolves ties in favor of in for which case he'll three hours each containers, searching spend day searching

for

containers.

What is the lowest redemptionpricethat would induce Harry to spend at least one hour per day recycling? Since he'll find 600 containers in his first hour of on each container would enable him to match his $6 per search, a 1 cent deposit if hour opportunity cost. More the generally, redemption price is p, and the next hour spent searching yields AQ additional then Harry's additional containers, from the additional hour will be earnings searching p(AQ). This means that the will smallest that lead to search another hour must satisfy redemption price Harry the

equation

= $6.

P(AQ)

How high would Harry to searchfor

the a second

for a

searches

containers

if he

him to

do so must

second hour, =

p(400)

satisfy

CONCEPT

redemption price hour? Since he

example above, calculatethe and fourth, Harry to search a third, In the

for soft

drink

horizontal axis, is shown

at various in

Chapter

goodswill

offer

to induce

be

additional

price

redemption

that

for p = 1.5cents.

shown

3. There

higher

becomes,

Harry

of container

these reservation

will

lead

that

will

lead

in effect,

prices,

Harry's

a supplier of reservation

search are 2, 3, and 6 cents, we can now plot his supply

plots the redemption price number of containersrecycled each day in Figure 6.1. Harry's individual supply curve of us the number of containers he is willing to recycle This curve, which

and the

in Figure

6.1 is

are exceptionsto

quantities

prices

redemption

Check 6.1, we sawthat

hours

redemption prices.

The supplycurve saw

tells

services

container-recycling

AQ

to

have

= 400

hour.

fifth

fifth

axis

vertical

container

lowest

services.

container-recycling

per containeron the on the

find

$6, which solves

containers,

prices for his third, fourth, and respectively. Having calculated

curve of

can

smallest

the

In Concept

services.

container-recycling

of containers

6.1

CHECK

By searching

(6.1)

this

upward-sloping, just like those we but sellers of most rule, general

at higher prices.

a

Cost-Benefit

153

CHAPTER

154

PERFECTLY

COMPETITIVE

SUPPLY

6.1

FIGURE

Individual

An

6

curve

Harry's supply

Supply

for Recycling

Curve

Services. the

When

deposit

increases, it

\342\200\242a g

c

\302\243 Q) Q

to abandon

attractive alternative

more

price

becomes

pursuits time

searching

u

to spend for soft

1.5-

drink containers.

10 13 16 15 cans

Recycled

(100s

MARKET SUPPLY CURVES

AND

INDIVIDUAL

of cans/day)

and market supply curves for a product is and market demand curves. The quantity that to a given price on the market demand curve is the corresponds in the market. sum of the quantities demanded at that price by all individual buyers that to any given price on the market Likewise, the quantity corresponds supply curve is the sum of the quantities at that price by all individual sellers in supplied the market. that the supply side of the recycling-services market Suppose,for example, consists only of Harry and his identical twin, whose individual Barry, supply curve is the same as Harry's. To generate the market supply curve, we first put the individual a supply curves side by side, as shown in Figure 6.2(a) and (b).We then announce price, and for that price add the individual quantities supplied to obtain the total in the market. Thus, at a price of 3 cents per container, both quantity supplied Harry and Barry wish to recycle 1,500 cans per day, so the total market supply at in like that is 3,000 cans per day. Proceeding manner for a sequence of prices, price in Figure 6.2(c). we the market services shown generate supply curve for recycling This is the same process of horizontal summation by which we generated market demand curves from individual demand curves in the previous chapter. The

between

relationship

analogous to

Supply Curve

Market

for Recycling Services. To

between

the individual

Harry's

Barry's

Market

supply

supply

supply

curve

curve

curve

the market

generate

supply

(c) from the curves supply

curve

individual (a)

the individual

relationship

6.2

FIGURE

The

the

and

individual

(b), we

add the

supply curves

horizontally.

10 13

10 13

|16

Recycledcans

(100sof

cans/day)

(a)

12 20

|16

15

15

cans

Recycled

(100s

of cans/day)

(b)

30

cans

Recycled

(100s

26|32

of cans/day)

(c)

FIRMS

PROFIT-MAXIMIZING

IN PERFECTLY COMPETITIVE

6.3

FIGURE

supply curve

Market

The Market with

Curve

O)

Supply

1,000

Identical Sellers. Togenerate the market supply curve

(cents/can) co

with

f\\

ro

we

1 Deposit

155

MARKETS

i i '

-\302\273\342\226\240 \302\253, i 1

0

10

6

i '

13

for a market sellers,

1,000 identical simply

16

each

multiply

quantity value individual supply

\342\226\240

on the curve

by 1,000.

15

Recycledcans

(100,000sof

cans/day)

if there were many with individual suppliers supply curves we could the market curve Harry's, generate supply by simply multiplying each quantity value on the individual supply curve by the number of suppliers. For 6.3 shows the supply curve for a market in which there are 1,000 instance, Figure with individual curves like suppliers supply Harry's. Alternatively,

identical

to

Why

do

is suggested Fruit

Principle.

individual

curves tend to be upward-sloping? of IncreasingOpportunity Cost, recyclers should always look first

One

supply

by the Principle Container

explanation

or the for

Low-Hangingthe containers that locations. As the

are easiestto find\342\200\224such as those in plain view in readily accessible it will to incur the additional cost of searching farther redemption price rises, pay from the beaten path. If all individuals have identical upward-sloping supply curves, the market curve will be as well. But there is an important additional supply upward-sloping reason for the positive of market slope supply curves:Individual suppliers generally differ with respect to their costs of supplying the product. (The opportunity of Increasing Cost applies not only to each individual searcher, but Principle Opportunity also across unattractive individuals.) Thus, whereas people facing employment in other be to soft drink containers even opportunities occupations may willing recycle when the redemption more attractive price is low, those with options will recycle if the is only redemption price relatively high. In summary, then, the upward slope of the supply curve reflects the fact that costs tend to rise at the margin when producersexpandproduction,partly because each individual her most attractive but also because first, exploits opportunities different potential sellersface different costs. opportunity FIRMS

PROFIT-MAXIMIZING

COMPETITIVE

IN PERFECTLY

MARKETS

the nature of the supply curve of a product more fully, we must explore say more about the goals of the organizations that supply the product and the kind of In virtually economic environment in which they operate. every economy, goods and services are producedby a variety of organizations that pursue a host of differentmotives. The Red Cross supplies blood becauseits organizers and donors want

To

to help peoplein need; the local government fixes potholes becausethe mayor was elected on a promise to do so; karaokesingers because like perform they public are driven attention; and car-washemployees primarily by the hope of making

enough money

to

pay

their

rent.

Increasing

a

Opportunity

a

Opportunity

Cost

Increasing

Cost

156

PERFECTLY COMPETITIVE

6

CHAPTER

SUPPLY

MAXIMIZATION

PROFIT

rich variety of motives, most goodsand services that are offered firms whose main reason for existing economy are sold by private is to earn profit for their owners. A firm's profit is the differencebetween the total in producing revenue it receives from the sale of its product and all costs it incurs it. A profit-maximizing firm is one whose primary goal is to maximize the amount of use in standard supply and demand profit it earns. The supply curves that economists that goods are sold by profit-maximizing firms in theory are based on the assumption in which individual are markets firms have no perfectly competitive markets, which this

Notwithstanding

for sale in

profit the total revenue a firm receives from the sale of its minus all

product and

costs\342\200\224explicit

in

implicit\342\200\224incurred

it

producing

profit-maximizing whose

maximizethe

total

goal

primary

difference and

revenues

firm

a firm

is to

between its costs

total

perfectly competitive market a market in which no individual supplier on the

price influence

it sells

influence over the market prices of the influence market price, perfectlycompetitive

The following

1.

over

a

firm

that

has no

the price at

to they sell. Because of their inability are often described as price takers.

of markets that

are

perfectly

sell the same standardized product. Although this condition is almost firms never literally it holds as a for markets. satisfied, Thus, rough approximation many the markets for concrete building blocks of a given size, or for apples of a given be described in this way. This conditionimplies that are willing variety, may buyers if by so doing they to switch from one sellerto another can obtain a lower price.

All

2. The market has many taker

firms

are characteristic

conditions

four

products

competitive:

has significant influence market price of the

product

a market

small

which

individual

farmer's

impact

and

buyers

as a

the product

its product

fixed

to

decision

on the market

to becomea vegetarian 3. Productive

and

buyers

of the total

fraction

sellers will be number

plant

each of which buys

sellers,

This

exchanged.

quantity

price takers, regarding their

beyond

fewer acres

price of

wheat,

would

have

resourcesare mobile.This

control.

condition the

of wheat would have

just as an individual no perceptible effect

a profitable

condition

business

in

implies a market,

resources elsewhere.

4. Buyers

a

implies that market price of

For example, a no

single

appreciable

consumer's decision

on the

price

of beef.

that if a potential seller he or she will be able to to enter that necessary

opportunity obtain the labor, capital, and other productive resources market. the same sellerswho are dissatisfied with token, By in confront a market are free to leave that market they given identifies

or sells only

the

opportunities

and employ their

sellers are well informed. This conditionimplies that and buyers aware of the relevant opportunities available to them. If that were not so, buyers would be unable to seek out sellers who charge the lowest prices, in the markets in and sellers would have no means of deploying their resources which they would earn the most profit. The market for wheat a perfectlycompetitive market. The closely approximates market for operating systemsfor desktop does not. More than however, computers, 80 percent of desktop operating systems are sold by Microsoft, the company giving in influence that market to have control over the it charges. enough significant price For example, if it were to raise the price of its latest edition of Windows by, say, 20 percent, some consumersmight switch to Macintosh or Linux, and others might and

sellers are

their next upgrade; but many\342\200\224perhaps even most\342\200\224would continue with their plans to buy Windows. if an individual wheat farmer were to charge even a few cents By contrast, more than the current market price for a bushelof wheat, he wouldn't be able to sellany of his wheat at all. And since he can sell as much wheat as he wishes at the market price, he has no motive to charge less. postpone

THE

DEMAND

COMPETITIVE

CURVE FACING A

PERFECTLY

FIRM

firm in a perfectly competitivemarket, what From the perspective of an individual does the demand curve for its product look like?Sinceit can sell as much or

as

S

^

^S.

*E

\302\243P0

demand

firm

Individual

The

*E

^

^^^^^^^^^\342\200\224^^^^^^^^^\342\200\224 ^^^^^^\342\200\224^^^^^^\342\200\224D

The market demand and supply curves intersect to

ty,

of the firm's

Individual

quantity

(b)

(a)

it wishes

as

little

at the prevailing

perfectly elasticat

the

quantity

curve,

(units/month)

(units/month)

market

market price,the

price.

demand

curve

Figure 6.4(a) shows the

for its

product is and

demand

market

supply curves intersecting to determine a market price of PQ. Figure 6.4(b) shows in this the product demand curve, as seen by any individual firm a D., market, horizontal line at the market pricelevel PQ. of the conclusions of the standard and demand model also hold Many supply for firms\342\200\224those like that have at least firms, Microsoft, imperfectly competitive someability to vary their own prices. But certain other conclusions do not, as we shall seewhen we examine the behavior of such firms more closely in Chapter 8. firm has no control over the market Since a perfectly of its competitive price it needn't about the level at which to set that As product, worry choosing price. we've seen, the equilibrium market price in a competitive market comes from the intersection of the industry supply and demand curves.The challenge confronting firm is to choose its output the perfectly level so that it makes as much competitive firm responds as it can at that As we how the profit price. investigate competitive to this challenge, we'll see that some costs are more important than others.

a deeper

gain

consider a perfectly

chargefrom wages

it

understanding

of the origins of firm

its employees and and the machine

pays

The employees

the

supply

the decision

curve,

it is helpful

of how much

an input of a good

to

to produce goods and services.In more factors of inputs also include and land, structures, others, production might entrepreneurship, possibly but for the moment we consider only labor and capital. When we refer to the short run, we mean a period of time during which at least some of the firm's factors of production cannot be varied. For our bottle maker, we will assume that the number of employees can be varied on short notice but that the capacity of its bottle-making machine can be altered only with significant delay. For this firm, then, the short run is simply that period of time which the during firm cannot alter the capacity of its bottle-making machine. By contrast, when we of the we refer to a time of sufficient that all the run, speak long period length

complexexamples,

firm's factors 6.1

of hours its relationship

factor of

market

to

the lease payment on its bottle-making machine. are the firm's only two factors of production\342\200\224

used

Table

least

a firm

competitive confronting in question is a small company that makes bottles. To keep glass that the silica for bottles is available free of suppose required making a nearby desert and that the only costs incurred by the firm are the

simple,

things

competitive

that has at some control over the price of its product

firm

firm

The

produce.

imperfectly

IN THE SHORT RUN

PRODUCTION To

price

(a).The

product

individual firm's demand D. (b), is a horizontal line at the market price.

0

Qo

market

the

determine i

Market

Firm.

Competitive

P

\"^^

0

Curve

Demand

Facing a Perfectly

^

^/^

157

MARKETS

6.4

FIGURE

demand

supply and

Market

IN PERFECTLY COMPETITIVE

FIRMS

PROFIT-MAXIMIZING

of productionare variable. shows

described

in Table

production

short run

a period

sufficiently

short

someof the

firm's

production are

of time

that at

least

factors

a period of time length that all the firm's factors of production long

run

of

fixed

of

sufficient

how the company's

employees spend on the

production

used in the or service

job

6.1 exhibits

bottle productiondepends a

on

the

number

day. The output-employment to many such pattern that is common

each

variable

are

CHAPTER6

158

PERFECTLY

SUPPLY

COMPETITIVE

TABLE 6.1

Employment

and Output for a GlassBottleMaker

number

Total

of employees

per

Total

day

of bottles

number

per day

0 80

200

260

300

330

350

362

returns of diminishing a property of the relationship between the amount of a good law

or serviceproduced

the

and

of the

production

ever-larger the variable factor requires

fixed factor

good eventually increases

of production

input whose quantity altered in the short

variable factor whose

an input

altered

the

in

some

beyond labor

begins

to diminish

begin

amount of a variable factor to required produce it; the law that when some factors of says are increased fixed, production in

an

be

cannot

run

law of

be

can

quantity

run

short

factors

firm's

the

of all firm's

the

of

marginal cost as output changes

from one

the change in

change

in

output

in

pattern

which

at least

bottle-making

gains as the

some

machine,

level

to total

corresponding

CONCEPTS

bottle-making

cost

firm

described machine

in Table is $40

3.

payment to its employeesis called variable cost because, unlike fixed cost,it varies with the number of bottles the company The variable produces. in 4 cost of producing 200 bottles for is shown column of Table 6.2 per day, example, as $24 per day. Column 5 shows the firm's total cost,which is the sum of its fixed and variable costs. Column 6, finally, shows the firm's marginal cost, a measureof defined

by the

refers to situations fixed factor is the

this

The company's

how

production

another,

COST

IMPORTANT

SOME

column

firm's

factors

variable

divided

refer to

for 6.1, suppose the lease payment which must be whether bottle-making per day, paid the company makes any bottles or not. This payment is both a fixed cost (since it does not depend on the number of bottles per day the firm makes) and, for the duration of the lease, a sunk cost. The first two columns of Table 6.2 reproduce the and output entries from Table 6.1, and the firm's fixed cost appears in employment

of production

total cost the sum payments made to fixed and

and it always fixed. Here, the

Economists

variable factor is labor.In the context of this example, the law of in the returns that successive increases labor diminishing says simply input eventually yield in bottle smallerand smaller increments to output. (Strictly speaking, the law ought be called the law of eventually returns because diminishing output may initially at an increasing rate with additional units of the variable factor.) grow returns from additional units of the variable input Typically, eventually diminish because of some form of congestion. For instance, in an office with three secretaries and only a single desktop computer, we would not expectto get three times as many letters typed per hour as in an office with only one secretary becauseonly one can use a computer at a time. person

the company's

all

the sum of all

made to

payments variable

production

are

employee.

of

and the

For the

cost

returns,

diminishing

factors of

third

the

with

but

of production

fixed cost the sum of payments made to the fixed factors of production variable

Each time we add an additional unit of labor, output grows, the additional that results from each additional unit point output to diminish. Note in the right column, for example, that output

relationships.

its total as

the

cost changes when its output changes. change in total cost divided by the

Specifically, corresponding

marginal change

cost is in output.

Note, for example,that when the firm expands production from 80 to 200 bottles which of per day, its total cost goes up by $12, gives rise to the marginal cost entry = bottle. To that cost $0.10 ($12/day)/(120 bottles/day) per emphasize marginal in total cost when quantity refers to the change we place the marginal cost changes, entries between the corresponding rows of the table. quantity

and Total

Fixed,Variable,

per

day

per

Costs of BottleProduction cost

Fixed

Bottles

Employees

0

1

80

0

cost

Marginal

($/bottle)

($/day)

($/day)

40

0

Total cost

Variable cost

($/day)

day

40

0.15 40

12

52

0.10

2

200

40

24

64

3

260

40

36

76

4

300

40

48

88

5

330

40

60

100

6

350

40

72

112

7

362

40

84

124

CHOOSING OUTPUT TO MAXIMIZE

0.20

0.30

0.40

0.60 1.00

PROFIT

how the company's following examples and exercises,we'llexplore to produce on the of depends price bottles, the

In the

about how many bottles the cost of capital.Again,

maximize the where

profit

amount

our

is the difference

assumption it earns from the

starting

of profit

between its total

Profit = Total = Total

35 cents each,how

If bottles

sell for

Table

6.2 produce

is

production and sale of and

revenue

\342\200\224

cost

revenue

\342\200\224

many

Total

Variable

its total

cost

should

bottles,

cost.

\342\200\224

Profit Maximizing bottles

decision

wage, and basic goal is to

firm's

the

that

revenue

The

Fixed

cost

(6.2)

Output Level

the company

marginal

answer

to this

we

need

expand

simply apply the its level

of

output?\"

Cost-Benefit Principle to the If its goal is to maximize its as long as the marginal benefit

benefit.

that the Cost-Benefit Principle thus identifies the profitapplied number of bottlesto we can calculate levels maximizing produce, profit directly, as in Table 6.3. Column 3 of this table reports the firm's revenue from the sale of is calculated as the product of the number of bottles produced per day bottles, which and the price of $0.35 per bottle. Note, for example, that in the third row of that = $70 total revenue is Column 5 column, (200 bottles/day)($0.35/bottle) per day. the firm's total which is the difference between its total reports daily profit, just in revenue that the largest profit entry (column 3) and its total cost (column 4). Note column occurs at an of 300 bottles as $17 5, per day, output per day, just suggested by our earlier application of the Cost-Benefit Principle. To

confirm

6.2

described

question will be to expand from expanding is at least as great as the marginal cost. Since the perfectly firm can sell as bottles as it wishes at the market price of $0.35 per competitive many its benefit from an additional bottle is $0.35.If we compare bottle, marginal selling this marginal benefit with the marginal cost entries shown in column 6 of Table 6.2, we see that the firm should keep expanding until it reaches 300 bottles per day it would have to hire a fifth (four level, employees per day). To expand beyond that and the cost ($0.40per bottle) would exceed the employee, resulting marginal the

EXAMPLE

each day?

To answer this question, question \"Shouldthe firm profit,

MARKETS

6.2

TABLE

in

IN PERFECTLY COMPETITIVE

FIRMS

PROFIT-MAXIMIZING

a

Cost-Benefit

159

160

CHAPTER

6

PERFECTLY

SUPPLY

COMPETITIVE

TABLE 6.3

Output, Revenue, Costs, and Profit Output

Employees

0

the

As

Total

(bottles/day) 0

day

per

revenue

($/day)

0

28

1

80

2

200

3

260

70 91

4

300

105

cost

Total

($/day)

Profit ($/day)

40

-40

52

-24

64

6

76

15

88

17

5

330

115.50

100

15.50

6

350

122.50

112

10.50

7

362

126.70

124

2.70

concept

following

product gives riseto an

increase

check demonstrates, an in the profit-maximizing

increase in the price level of output.

of the

CONCEPTCHECK6.2 would

How

the

sell for

bottles

profit-maximizing

62 cents

The following

declinein level of

check

concept

which

cost,

marginal

level of

each?

bottle production changein

Example

6.2

if

illustrates that a fall in the wage rate leads to also causes an increase in the profit-maximizing

a

output.

CONCEPT CHECK6.3 would

How

bottles

profit-maximizing

35 cents

each,but

level of wages

bottle production changein $6 per day?

Example

6.2

if

fall to

example the firm's fixed cost had been not $40 per day but would that have affectedthe firm's profit-maximizing level per day. How, of output? The answer is \"not at all.\" Each entry in the profit column of Table 6.3 would have been $5 per day smaller than before, but the maximum profit entry still would have been 300 bottles per day. The observation that the profit-maximizing quantity does not dependon fixed costs is not an idiosyncrasy of this example. That it holds true in general is an immediate of the Cost-Benefit which consequence Principle, says that a firm should increase its output if, and only if, the marginal benefit exceeds the marginal cost. Neither the marginal benefit of expanding is the market of (which price bottles) nor the marginal cost of expandingis affected fixed cost. by a change in the firm's When the law of diminishing returns when some factors of applies (that is, firm are cost as the fixed), marginal production goes up expands production some Under these circumstances, the firm's best option is to keep beyond point. as long as marginal cost is lessthan expanding output price. Note that if the bottle company's fixed cost had been any more than $57 per it would have made a loss at level of day, every possible output. As long as it still had to pay its fixed cost, however, its best bet would have been to continue producing 300 bottles after a larger all, to experience a smaller loss than per day. It's better, one. If a firm in that situation conditions to remain the it same, expected though, would want to get out of the bottle businessas soonas its equipment lease expired. Suppose

$45

O

the

sell for that

in the if

at all,

It

a firm that

that

seem

might

market price would output level for which rule.

do

always

can sell as much best in the short

equals

price

for example,

Suppose,

161

MARKETS

FIRM'S SHUTDOWN CONDITION

ON THE

NOTE

A

IN PERFECTLY COMPETITIVE

FIRMS

PROFIT-MAXIMIZING

that

the

by

producing

cost. But there

marginal

constant

wishes at a

as it

output run

and selling the

are exceptionsto this

price of the firm's product falls its variable cost at all possible

market

so

low

its revenue from sales is smaller than levels of The firm should then cease production for the time output. being. By shutting down, it will suffer a loss equal to its fixed costs.But by remaining open, it would suffer an even larger loss. if P denotes More formally, the market price of the product and Q denotes the number of units produced and sold, then P X Q is the firm's total revenue from firm and if we use VC to denotethe firm's variable the sales, cost, the rule is that should shut down in the short run if P X Q is less than VC for every level of Q: that

Short-run

bottle

the

Using

Calculate the that

the firm's

AVERAGE

example, suppose

company

corresponding

profit

(6.3)

Q.

6.4

CHECK

CONCEPT

for all levelsof

Q < VC

P X

condition:

shutdown

best option is to

bottlessold not level of

to each

ceaseoperations

in the

for as

output,

short

VARIABLE COST AND AVERAGE

$0.35 in Table

but only $0.10.

6.3,

and

verify

run.

TOTAL

COST

firm is unable to cover its variable cost at any level of output\342\200\224 X < P that VC for all levels of It must then also be true that is, suppose Q Q. P < VC/Q for all levels of Q, sincewe obtain the second inequality by simply both sides of the first one cost\342\200\224 dividing by Q. VC/Q is the firm's average variable its variable cost divided its The firm's short-run shutdown condition by output. may in the short run if the prodthus be restated a secondway: Discontinue operations uct price is less than the minimum value of its average variable cost (AVC). Thus,

Suppose

that

the

that

condition

shutdown

Short-run

P<

(alternate version):

minimum

value

average

variable

variable cost

cost (AVC)

divided

by total

output

of AVC.

(6.4) As we'll see in the next section, this version of the shutdown condition often enables us to tell at a glance whether the firm should continue operations. A related cost concept that facilitates assessmentof the firm's profitability is aver= total cost which is total cost divided ATC (ATC), (TC) age by output (Q): TC/Q. The firm's profit, again, is the difference between its total revenue (P X Q) and its total cost. And since total cost is equal to average total cost times quantity, the firm's \342\200\224 X X A firm if its is also to is said to be profitable (P (ATC profit equal Q) Q). revenue (P X Q) exceeds its total cost (ATC X Q). A firm can thus be profitable its ATC for some level of output. only if the price of its product price(P) exceeds

Keeping track

all

of

we'll see that

however,

cost concepts may seem tedious.In the next from doing so is that enable us to payoff they

these the

profit-maximization decisionin A GRAPHICAL the

For

in this marginal

curves

framework.

firm we've are shown in the

in Figure

firm's

been discussing,average

average

total

6.5. (Becausemarginal

variable

cost

cost

as we

and

Table 6.4. Using the cost, average variable cost, and

4 and

columns

6 of

cost

corresponds

to the

move betweentwo output levels, each marginal cost value in at an rows.) plotted output level midway between those in the adjacent

total

is

table, we plot

cost

graphical

APPROACH TO PROFITMAXIMIZATION

bottle-making cost values

average total

a simple

section,

recast the

entries

change Table

in

6.4

averagetotal costdivided

cost by total

(ATC)

total

output

profitable firm a firm whose total revenue exceeds its total

cost

162

PERFECTLY COMPETITIVE

6

CHAPTER

SUPPLY

TABLE 6.4

Average Variable

Cost and AverageTotal

Production

of Bottle

Cost

Average

variable

Bottles

Employees

per day

cost

Variable

cost

per day

($/unit

($/day)

Average

Total

cost

of

0

1

80

0 12

0.15

52

0.65

2

200

24

0.12

64

0.32

3

260

36

0.138

76

0.292

4

300

48

0.16

88

0.293

5

330

60

0.182

100

0.303

6

350

72

0.206

112

0.32

7

362

84

0.232

124

0.343

We

call

example,

cost

output)

0

for

Marginal

of

($/unit

($/day)

output)

cost

total

($/bottle)

40

to several your attention that the upward-sloping

features of

the

curves

cost

portion of the

0.15

0.10

0.20

0.30 0.40 0.60 1.00

in Figure

marginal

cost

6.5. Note,

curve

(MC)

to the region of diminishing returns discussed earlier. Thus, as the firm moves two bottles beyond employees per day (200 per day), the increments to total become smaller with each additional output employee,which means that the cost of producing additional bottles(MC) must be increasing in this region. Note also that the definition of marginal cost implies that the cost marginal curve must intersectboth the average variable cost curve (AVC) and the average total cost curve To see why, consider the (ATC) at their respective minimum points. that what to the of children in a third-grade logic explains happens average weight If the new (marginal) student is lighter class when a new student joins the class. than the previous will fall, but if the average weight for the class, average weight new student is heavier than the previous average, average weight will rise. By the same token, when marginal cost is below average total cost or average variable the cost must be and vice versa. And this cost, corresponding average falling, corresponds

FIGURE 6.5

The Marginal, Variable,

0.65

Average

Total Cost Curves for Bottle

and

minimum

a

Manufacturer.

The MCcurve AVC

0.60

and Average

cuts

both the

ATC curves at points.

their

The

upward-sloping portion of the cost curve marginal

corresponds to the region of diminishing returns.

0.55

^0.50 Jj

0.45

2

0.40 0.35

\302\243 \302\260-30

*

o

0.25

AVC

0.20

0.15

0.10

0.05 0

260

300

330 350

Output (bottles/day)

PROFIT-MAXIMIZING

both

the marginal cost curves.

that

ensures

average

cost

Seeing the bottle maker'sAVC

posed

in

Concept

6.4

Check

must

curve

curve

pass displayed

much easier to in the short down

through

FIRMS

IN PERFECTLY COMPETITIVE

the minimum

graphically

points

163

MARKETS

of

makes the question

answer.The question, recall,was

if the price per bottle was only shut run at Figure 6.5 reveals that the firm should indeed shut down because this lies below the minimum value of its AVC curve, making it price impossible for the firm to cover its variable costsat any output level.

the

whether

firm should

A glance

$0.10.

= MARGINAL

PRICE

COST: THE MAXIMUM-PROFIT

CONDITION So

implicitly assumed amounts. Under

we've

far,

whole-number

in that the bottle maker could employ workers only these conditions, we saw that the profit-maximizing cost was somewhat less than (because marginal price

output level was one for which cost higher than adding yet another employeewould have pushed marginal price). the next example, we'll seethat when and employment can be varied output condition is that price be equal to marginal cost. continuously,the maximum-profit

In

The GraphicalApproachto ProfitMaximization For the

6.3

EXAMPLE

in Figure 6.6, find bottle maker whosecostcurves are shown the profiteach. How much profit will this output level if bottles sellfor $0.20 What is the lowest price at which this firm would continue to operate

maximizing firm earn? in

the

run?

short

6.6

FIGURE

Price = The

Cost:

Marginal

Perfectly

Firm's

Competitive

Supply

Profit-Maximizing

Rule. If

price

marginal

is greater cost,

can increase

than

the firm its

profit

by

expanding production and sales. If price is less than cost, the firm can marginal increase its profit by

160 200 Output

260 300

(bottles/day)

firm should continue to expand as long this Principle tells us that as great as marginal cost. In Figure 6.6 we see that if the firm follows this it will 260 bottles the at which price and rule, produce per day, quantity cost are To further confidence that 260 must be the profitmarginal equal. gain when the is first that the firm $0.20 maximizing quantity price per bottle, suppose had sold someamount less than 200 bottles Its benefit from that\342\200\224say, only per day. one bottle would then be the bottle's market expanding output by price, here 20 cents.Thecost of expanding one bottle is to the output by equal (by definition) firm's marginal cost, which at 200 bottles per day is only 10 cents (seeFigure 6.6). So by selling the 201st bottle for 20 cents and producing it for an extra cost of only 10 cents,the firm will increase its profit by 20 \342\200\224 10 = 10 cents per day. In a similar

The

Cost-Benefit

as priceis

at

least

producing

and selling

output.

a

Cost-Benefit

less

CHAPTER

164

6

PERFECTLY

SUPPLY

COMPETITIVE

way, we

can show that cost,

marginal

for

the seller

Conversely, suppose

the

that

day\342\200\224say, 300\342\200\224ata

per

price of 300 is 30 output bottle per day, it would

cost at

less than the level at

quantity

any

can boost profit

an

firm

of 20

production.

expanding

by

selling more than

was currently

cents each. In Figure

cents per bottle.If

the

which price equals

6.6

we

bottles

260

see that

marginal

then contracted its output while losing only 20 cents

firm

cut its costs by 30 cents its result, profit would grow by 10 cents per day. The same argument can be made regarding than is 260, so if the firm any quantity larger an at which is less than it can cost, currently selling output price marginal always do better by producing and selling fewer bottles. We've thus established that if the firm sold fewer than 260 bottles per day, it could earn more profit by expanding; and if it sold more than 260, it could earn one

by in

As a

revenue.

by contracting. It follows that at a market price of 20 cents per bottle, the its profit by selling 260 units per day, the quantity for which price and marginal cost are exactly the same. At that the firm will collect total revenue of P X Q = ($0.20/bottle) quantity = $52 per day. Note in Figure 6.6 that at 260 bottles per day the (260 bottles/day) firm's average total cost is ATC = $0.12 per bottle, which means that its total cost

more

maximizes

seller

is ATC X Q = ($0.12/bottle)(260 bottles/day) = $31.20 per day. The firm's profit is the difference between its total revenue and its total cost, or $20.80 per day. that the minimum value of the firm's AVC curve is $0.07. So if the Note, finally, firm of bottles fell below 7 cents the would shut down in the short run. each, price

Another graphically.

attractive feature of the level is that it permits

graphical method of finding

output

maximizing

for

Thus,

price

in

the

in Figure

preceding

and ATC times = $20.80

bottles/day)

$0.12/bottle)(260

rectangle

firm

the

between

difference

6.7.

us to

calculate

example,

the

profit-

the firm's

profit daily profit is simply the

the number of units sold: ($0.20/bottle per day, which is the area of the shaded

\342\200\224

6.7

FIGURE

Measuring

MC

Profit

Graphically.

to (P - ATC) Q, which is equal to the area of the shaded rectangle. Profit

is equal

X

Profit

= $20.807day

| 0.20

Price

d 0.12

260

Output (bottles/day)

Not

as the one shown in Figure 6.7. Suppose, for of bottles had beennot 20 cents but only 8 cents. Since that example, price is than the minimum value of AVC (see Figure 6.8), the firm should price greater continue to operate in the short run by producing the level of output for which cost bottles But because is less than ATC (180 price equals marginal per day). price at that level of output, the firm will now experience a loss, or negative on profit, all

that

firms

the

are

as fortunate

PROFIT-MAXIMIZING

IN PERFECTLY COMPETITIVE

FIRMS

6.8

FIGURE

Profit.

A Negative When at

the

is less

price

o

=

Profit

O

U

0.10

0.08

Price

180

Output (bottles/day)

This profit is calculated as (P -

its operations. X

bottle)

bottles/day)

(180

=

\342\200\224$3.60per

shaded rectangle in Figure 6.8. In Chapter 7, we'll seehow firms in response to the incentives implicit occur

the

in

long run,

and our

\"LAW\" OF

THE

The law rises.If

ATC)

day,

X Q

which

=

- $0.10/

($0.08/bottle

is equal

to

the

area

of the

resources from one market to another and losses. But such movements profits focus here is on productiondecisionsin the short run. move

in

SUPPLY

consumers buy less of a product when its price law of supply, it would offer say that producers more of a product its price rises.Is there such a law? We know that curves are essentially marginal cost curves and that because of the law of supply in cost curves are the short run. And returns, diminishing marginal upward-sloping so there is indeeda law of supply that applies as stated in the short run. In the long run, however,the law of diminishing returns does not apply. (Recall that it holds only if at least some factors of production are fixed.) Because firms can vary the amounts of all factors of productionthey use in the long run, they can often double their production by simply the amount of each input doubling they use. In such cases, costs would be exactly to output and the firm's proportional not So marginal cost curve in the long run would be horizontal, upward-sloping. for now we'll say only that the \"law\" of supply holds as stated in the short run but not necessarily in the long run. For both the long run and the short run, however, the perfectly competitive curve is its marginal cost curve.1 firm's supply of the market supply curve representsthe Every quantity output along summationof all the quantities individual sellers offer at the corresponding price. So the between and cost exists for the market correspondence price marginal supply curve as well as for the individual supply curves that lie behind it. That is, for every be equal to each seller's price-quantity pair along the market supply curve,pricewill of

demand

there

were

tells us that an analogous for sale when

marginal cost ofproduction.

we sometimes say that the curve represents the cost side of supply whereas the demand curve representsthe benefit side of the market. At a market demand what curve, every point along price represents buyers would be in to for an additional unit of the this, turn, is how we willing pay product\342\200\224and measurethe amount which benefit an additional unit of the by they'd by having is why

This

the

1

market,

Again,

output

this rule level

holds subject

for which

to the provision that cost. price equals marginal

total

which

area of the

-$3.60/day

revenue exceed

variable

production

cost at the

than ATC

profit-maximizing

quantity, the a loss,

165

MARKETS

firm

experiences

is equal shaded

to the

rectangle.

PERFECTLY COMPETITIVE

SUPPLY

Likewise, at every point along a market supply curve, product. it would cost producers to expandproduction by one unit.

measures

price

what

PROFIT-MAXIMIZING FIRMSIN PERFECTLY

RECAP

COMPETITIVEMARKETS The

perfectly

product,

meaning

short

sell any firm's goal is to

the

run,

profits. It will exceeds

this

accomplish

a horizontal

choosethe

by choosing

average

curve for its at the market price. In the output that maximizes its

demand

it wishes

quantity

the market price of cost. The perfectly

is equal to variable

cost

marginal

firm faces

competitive it can

that

level

of

the output level for which its its product, that price provided

competitive firm's

curve

supply

is

the portion of its marginal cost curve that lies above its average variable cost curve. At the profit-maximizing quantity, the firm's profit is the product of that and the difference between price and average total cost. quantity

factors

What

supply\"

rise to

give

to a

refers

SUPPLY

OF

DETERMINANTS

changes

in

shift

the

in

entire

supply?

REVISITED remember

(Again,

that a

supply curve, as opposedto a movement

\"changein along

in the quantity curve, which we call a \"change supplied.\") A seller will offer more units if the benefit of selling extra output to the cost of goes up relative in it. And since the benefit of a producing selling output perfectly competitive market is a fixed market pricethat is beyond the seller's control, our searchfor factors that influence supply naturally focuses on the cost side of the calculation. The preceding

the

suggest

examples likelihood

the

why

following

will satisfy the

a product

that

factors,

among others, will

cost-benefit test for

a given

affect the

supplier.

TECHNOLOGY

Perhaps the most in

Improvements

make

lower cost. This shifts each right) and hence shifts

the

the introduction the

in

increases

more

of

of production cost is technology. it possible to produce additional units of output at individual to supply curve downward (or, equivalently, the market supply curve downward as well. Over time, determinant

important

technology

sophisticated

of goods

number

machinery

produced per hour of

has resulted effort

in

expended.

dramatic

Every

such

in the market supply curve. shift development gives riseto a rightward But how do we know technological changewill reduce the cost of producing goods and services?Might not new equipment be so expensivethat producers who used it If so, then rational would have higher costs than those who relied on earlier designs? producers simply would not use the new equipment.The only technological changes that rational producers will adopt are those that will reduce their cost of production.

INPUT PRICES Whereas

supply

change

technological

in supply,

shifts

shifts

changes

literally

crude oil,which fluctuates

sharply,

always) leadsto gradual can give rise to large

rates rise, the marginal cost of any business that employs curves to the left (or, equivalently, upward). When supply rates fall, the opportunity cost of capital also falls, causing equipment shift to the right.

Similarly,

to

generally (although not of prices important inputs

As discussed in Chapter 4, for example, the price of overnight. in the production most important input of gasoline, often in supply and the resulting shifts cause gasoline prices to exhibit

when

labor also rises,shifting supply

the

is the

correspondingfluctuations. interest

in

wage

DETERMINANTS

OF SUPPLIERS

NUMBER

THE

Just as demand

OF SUPPLY REVISITED

grows, supply curves also shift For example, if container recyclers die or retire at a higher rate than new recyclers enter the industry, the supply curve for recycling serviceswill shift to the left. Conversely, if a rise in the unemployment rate leadsmorepeople to recycle soft drink containers (by reducing the opportunity cost of time the supply curve of recycling services will shift to the right. spent recycling), to

shift

curves

as the number

the right

to the

when

right

of individual

population

grows.

suppliers

EXPECTATIONS future movements can affect how much sellers chooseto price market. Suppose, for example,that recyclers the future expect to be much higher than the current price becauseof growing use components in cars. The rational recycler would then have an aluminum from the market at today's lower price,thereby to have

about

Expectations

current

the

in

offer

price of aluminum of aluminum withhold

incentiveto

more

next year's to

to sell at

available

aluminum

more

offer

higher

OF OTHER PRODUCTS

IN PRICES

CHANGES from

Apart

future price. Conversely, if recyclers expected to be lower than this year's, their incentive would be for sale in today's market. the

of aluminum

price

prices of other goodsand

in the

determinant of

perhaps the most important

change,

technological

supply is variation

services

that

sellers

might produce.

search for those precious metals for which the surplus of Prospectors, for example, benefits over costsis greatest. When the price of silver rises,many for stop looking when the price of platinum falls, gold and start looking for silver. Conversely, many

prospectors

platinum

to gold.

attention

their

THE DETERMINANTS OF SUPPLY

RECAP

relevant

the

Among

in input

technologies, changes future

shift

changes,

price

factors causing supply curves to shift are new of sellers, expectations prices, changes in the number and changes in the prices of other products that firms

of

produce.

might

OF SUPPLY

APPLYINGTHETHEORY the

Whether

or indeed

is producing

activity

any other production

decisionsin

new soft drink containers or recycling used at the same all, activity logic governs all

ones,

supply

markets (and in any other setting in which sellers wish to at a constant until they price):Keepexpanding output cost is equal to the price of the product. This logic helps us understand competitive

perfectly

can sellas much marginal recycling

why

as

efforts are

more intensive

for

some

than others.

products

The Economic Naturalist 6.1 When

recycling

is left

beverage containers In both containers'

to private

recycledthan

cases, recyclers gather respective

redemption price

for

redemption a container

market forces,why glass

are

many

more

aluminum

ones?

containersuntil

their

marginal

prices. When recycling is is based on what companies

costs are equal left

to

can sell it

to the

forces, the the materials (or

market

ife

167

168

6

CHAPTER

PERFECTLY COMPETITIVE

SUPPLY

in it) for. Aluminum which commands a a high

aluminum

are made has

to

raw materials required

resale

limited

only

value,

into

aluminum,

scrap

primarily

are so

glass containers

new

make

processed

leads profit-seeking companies to offer cans. By contrast, the glass from which

and this

price,

price for

redemption containers

glass

be easily

can

containers high

the

because

cheap.This

difference leads lower profit-seeking companies to offer much redemption prices for glass containersthan for aluminum ones. The high redemption to prices for aluminum cans induce many people track these cans down, whereasthe low redemption prices for glass containers leads most people to ignore them. If recycling is left completely to drink containers market forces, soft then, we would expect to see aluminum would litter the quickly recycled, whereas glasscontainers increasingly is in fact the pattern we do see in states without landscape. This recycling laws. is a simple (More on how these laws work in a moment.) This pattern of the fact that the supply curves of container-recycling services consequence

are

In

states

that don't

The have

beverage

container

deposit laws, why are aluminum cans more recycled than glass bottles?

important likely

6.4

Suppose

raw materials is only

of valuable

The second

recycling.

makes the

more

environment

next example suggests,this second recycling substantial numbers of

is

by

that,

might

removing

for everyone.

pleasant

benefit

of two

one

easily

justify

the

litter,

As the cost

of

containers.

glass

Isn'tZero Optimal Amount of Pollution

Why the What

acquisition from

benefits

recycling

to be

EXAMPLE

upward-sloping.

is the

optimal

socially

that

be willing to environment.

services is as

container

amount of recyclingof glasscontainers?

citizens of Burlington, Vermont, would collectively for each glass container removed from their local If the local market supply curve of glass container recycling shown in Figure 6.9, what is the socially optimal level of glass the

60,000

cents

6

pay

recycling?

supply curve of

Market

container recycling

glass

services

price

(cents/container) Redemption

^^^^^^ i

i

0

1

(1,000s FIGURE

i

10

6

Number of

The

i

i

containers

i

!

i

13 15

16

recycled

of containers/day)

6.9

Supply Curve

of Container Recycling

for Burlington,Vermont.

Services

DETERMINANTS OF SUPPLY

the citizens

Suppose

tax money

to

litter

finance

of Burlington

authorize

REVISITED

169

their city government to collect of each glasscontainerremoved, to pay, is 6 cents, the willing container recycled. To maximize the

removal. If the benefit

by what residents are collectively offer to pay 6 cents for each glass total economic that number of containers surplus from recycling, we shouldrecycle for which the marginal cost of recycling is equal to the 6-cent benefit. marginal Given the market supply curve the is containers shown, 16,000 optimal quantity offers per day, and that is how many will be redeemedwhen the government as

measured

government should

6 cents

per container.

containers

16,000

Although

the

others

enough

of

be

will

After

remain.

example, and a redemption price to induce people to track them

preceding

locations,

per day will

6 all

cents

from the environment in some are discarded in remote all, container is simply not high per removed

down.

So why not offer an even higher price and get For the example the reason is that the marginal given, container each is than the benefit glass day greater

rid of all glasscontainerlitter? cost of removing the 16,001st

of removing

it. Total

economic

litter the marginal surplus is largest when we remove only up to the point that benefit of litter removal is equal to its marginal which occurs when cost, 16,000 containers is actually wasteful. per day are recycled. To proceed past that point when Many people becomeupset they hear economists say that the socially In amount of litter is than zero. the minds of these people, the optimal greater amount of litter is zero. But this optimal exactly position completely ignores the t here would be benefits from litter but further, Scarcity Principle.Granted, reducing there also would be costs.Spending more on litter removal therefore means on other useful things. No one would insist that the spendingless optimal amount of dirt in his own home is zero. (If someone does make this him ask he doesn't home all the dust claim, why stay day vacuuming in his absence.) If it doesn't that is accumulating pay to remove all the dust from your house, it doesn't to remove all the bottles from the pay environment. Preciselythe same logic applies in each case. If 16,000 containersper day is the optimal amount of litter can we expect the individual spending decisions of private removal, in that amount of litter citizens to result removal? we Unfortunately _'\342\200\242\"\"\"' -^ ^V cannot. The problem is that anyone who paid for litter removal indiwould bear the full cost of those services while reaping only a vidually In fraction of the benefit. the citizens of 60,000 tiny Example6.4, ,A\" benefit of 6 cents per container removed, Burlington reaped a total which means a benefit of only (6/60,000) = 0.0001cent per person! Someone who 6 cents for someone elseto remove a container paid would thus be incurring a cost times than his share of 60,000 greater the

benefit.

resulting

Note

that

in Chapter

the

incentive

problem

here is similar

3 for the person decidingwhether

illness. The

problem

was

that

the

incentive

to

to the

one

be vaccinated

to be

because,

even

-.

;:>\302\243*>\302\273\342\226\240

a

V*

discussed

against an

vaccinated was too

the patient bears the full cost of the benefits accrueto others.Thus, an important vaccination, many resulting Is the socially of the extra benefit from one person being vaccinated is that part any others also become less likely to contract the illness. in which private market forces do The case of glass container litter is an example not producethe best attainable outcome for society as a whole.Even who people toss containers on the rather than are often them, carelessly ground, recycle offended by the unsightly landscape to which their own actions contribute.Indeed, this is why they often support laws mandating adequate redemption prices for containers. glass

weak

Scarcity

a

though

of the

optimal

quantity

of litter

zero?

170

CHAPTER

6

PERFECTLY COMPETITIVE

SUPPLY

that

Activities

Equilibrium

O

litter are

generate

described in Chapter 3. People who the environment, but because their

attractive.

container deposit laws vast

The

of container

majority

these laws.

that enacted

in states

CONCEPT

If the supply curve and each of the city's

of glass container

Principle care

don't

about

littering misleadingly

no individual's recycling

the environment. The soft-drinkstates were a simpleway to bring with the interests of society as a

of

quality

balance

almost literally

litter disappeared

overnight

from

be willing the landscape, at what

price for

redemption

is as shown in the diagram, pay 0.00005 cent for each level should the city

services

recycling

would

citizens

60,000

removed

the

governmentset

make

Equilibrium they

6.5

CHECK

glass container

incentives

by numerous

enacted

more closely into

interests

individual

whole.

because

after all, yet

effort,

effect on the

a noticeable

have

efforts

private

the

of

so not

do

litter

some

requires

Recycling

a good illustration

glasscontainers,

to

how

and

many

be

will

recycled

each day?

supply curve of

Market

container recycling

glass

services

price

(cents/container) Redemption

^m^^^^^

i i i

1

1

1 1

1

0

(1,000s

containers

i i !

1

13 15

16

recycled

of containers/day)

SURPLUS

PRODUCER

AND

1

10

6

Number of

SUPPLY

1

The economicsurplus producersurplus by

which

the

price exceeds

seller'sreservation

price

amount

the

analogous construct

seller actually have been

received by a buyer is called consumer surplus.The a seller is producer surplus, the difference between the price a receives for the product and the lowest price for which she would in to sell it reservation which will be her (her willing price, general

for

cost). As in the case

marginal refers

to

the

occasions it collection

of

surplus describes

of

consumer

received the

total

markets.

PRODUCER

CALCULATING

In the preceding chapter, we

boundedabove Producer

the term producer surplus sometimes a while on other by single seller in a transaction, in received all sellers a market or surplus by surplus,

by the demand in a market is

surplus

exampleillustrates, below by the

market

saw that

SURPLUS consumer

curve and

calculated

the area bounded curve. supply

it is

surplus

in a

bounded belowby in

an

analogous

above by

the

the

market is the area market

way. As market price

price.

the following and bounded

SUPPLY

Produce Surplus

Measuring do sellers

much

How

the

Consider

6.10,

Figure

of

quantity

their

demand and

price of per day. How much

gallons

$2

market for milk?

in the

participation

market for milk, whose which has an equilibrium

4,000

market

this

benefit from

supply

are shown in and an equilibrium do the sellers in surplus curves

gallon

per

producer

reap?

3.00

^ 2.50

,0 73

2.00

&

1.50

.g 1.00

.50

10 11

123456789

0

12

of gallons/day)

(1,000s

Quantity

FIGURE 6.10 Supply

in the

Demand

and

Market for Milk.

the supply and demand curves shown, and the equilibrium quantity $2 per gallon For

In

Figure

surplus equal to the

$2 per gallon and producer

surplus

their

reservation

received

by buyers curve and the

the

as given by milk

to

market

is

gallons

4,000

market

the

between

difference

price in

price of milk gallons per day.

equilibrium

is 4,000

all milk sold up

note first that for

6.10,

sellers receive a

the

the supplycurve.Total is thus the shaded triangle

betweenthe supply market price in Figure is a right triangle whose vertical arm is h = $2/gallon

that this area whose horizontal

Note

6.11.

and

3.00

^ 2.50 73

2.00

Producer

S

1.50

=

surplus

$4,0007day

.g 1.00

.50 0

10

123456789 Quantity

(1,000s of gallons/day)

FIGURE6.il

ProducerSurplus Producer

surplus

Market area of the

in the is the

for Milk. shaded

triangle

per day,

price of

($4,0007day).

11

12

AND

PRODUCER

EXAMPLE

SURPLUS

6.5

171

CHAPTER6

172

SUPPLY

COMPETITIVE

PERFECTLY

is b =

arm

(1/2)

bh,

4,000 gallons/day.And surplus

producer

the

since

of any triangle

area

market is equal to

in this

is equal to

= (l/2)(4,000gallons/day)($2/gallon)

$4,000/day.

in this surplus in the aggregate,

Producer would market.

pay, It is

example may for the right per day, since that's the

$4,000

exceedtheir

be

thought continue

to

amount

by

highest price sellers in the milk participating which their combined benefits of as the

costs.

combined

supply curve for a good can be interpreted The horizontal interpretation tells us, for each horizontally vertically. the total that wish to sell at that price. The vertical price, quantity producers tells for each the smallest amount a seller would be willing us, interpretation quantity, to accept for the good. For the purpose of computing producer surplus, we rely on the vertical of the curve. The value on the vertical axis that interpretation supply to each the curve to the corresponds point along supply corresponds marginal seller's reservation cost of producing it. price for the good, which is the marginal Producer surplus is the cumulative sum of the differences between the market price and these reservation prices. It is the area bounded above by market price and bounded below by the supply curve. As discussed

in

-

3, the

perfectly competitive is a horizontal line at the price for which supply and demand intersect. (LOl)

-

SUMMARY

facing a

curve

\342\200\242 The demand

Chapter

or

either

firm

industry

whatever

at a

constant

price\342\200\224

sell that quantity option which price equals marginal cost, is to

best

for

output

wish

they

quantity

seller's

the

of

exceeds the minimum value of average price variable cost. The supply curve for the seller thus coincides with the portion of his marginalcost curve that exceeds variable cost. This is average we sometimes the why say supply curve represents the costsideof the market (in contrast to the demand which the benefit side of the curve, represents provided

\342\200\242 The

supply for

that,

goods

depend, resources

in

on

turn,

cost of

the opportunity

the

them. (LOl)

to produce

required

to be

upward-sloping, at least in short run, in part because of the Principle of curves

\342\200\242

the

any

to supply at that price. The prices at which and services are offered for sale in the market

wish

Supply

for a good or serviceis a schedule that sellers price, tells us the quantity

curve

tend

Increasing

Cost.

Opportunity

In

general,

rational

of their best producers will always take advantage or first, moving on to more difficult opportunities costly opportunities only after their best oneshave been exhausted. this tendency is the Reinforcing

law of diminishingreturns,which that when says some factors of production are held the fixed, amount of additional variable factors requiredto

produce

successive

increments

larger. The industry supply curve summation of the supplycurves in the industry. (LOl)

in

output grows horizontal individual firms

is of

the

perfectly competitive in which markets

generally, for

markets\342\200\224or,

more

individual sellers can

sell

relevant

the

\342\200\242

Among

are

shift

changes

new

factors causing supply changes in input

curves to

technologies,

in the

number of

sellers,expectations

prices, of

and changes in the prices of other products that firms might produce. You are now ready to apply the theory of supply. The logic that governs all supply decisions in perfectly markets is competitive as follows:Keepexpanding output until cost marginal is equal to the price of the product. (L04) future

price

\342\200\242 Producer surplus

changes,

is a a seller by

surplus

reaped

cumulative sum of the market

\342\200\242 For

(L03)

market).

price

and

area bounded belowby the

measure of or sellers in differences

the

between

It is the the

prices, which is the and bounded

their

reservation

above

by market price curve. (LOS)

supply

economic

a market.

173

PROBLEMS

TERMS

KEY

average total of

factor

cost (ATC)

fixed factor

(158) of

long run

(157)

profit-maximizing

marginal

cost (158)

profitable

perfectly competitive

(157)

production

fixed cost

(161)

cost (AVC) (161)

variable

average

market

(158)

production

price

taker

profit

(161)

run (157)

short

total cost (158)

(156)

(156)

producer surplus (170)

imperfectly competitive firm (157) law of diminishing returns (158)

firm (156)

firm

variable

cost

variable

factor of

(158)

production (158)

(156)

REVIEW QUESTIONS

1.

would expect supply curves basis of the Principle of

you

why

Explain

slope upward

Cost.

Opportunity

Increasing

to

single

seed,

the

on

or false:The perfectly competitive the output level equals marginal cost. (L03)

always produce

3. Economists

firm for

which

should

4.

price

do

Which factor

the

congestion helps account for the law of diminishing returns. With in mind, this be impossible to explain why it would feed all the people on Earth with food grown in a

you

of

production next two

workerswho

that

stress

often

and

sunlight,

water, labor,

other

5.

Why

supply

do

we

curve

think is more for an ice

months: operate

use the

be a

to

likely

fixed

cream producerduring its factory building or its

the machines?

Explain. (L04)

vertical interpretation

when we

were

inputs

available. (L04)

(LOl)

2. True

even if unlimited

flowerpot, fertilizer,

of

measure producersurplus?

(LOS)

PROBLEMS

to divide her time between her job as a wedding hours as she chooses to per hour for as many in which her pay depends on both the price of collector, fossils and the number of fossilsshe finds. Zoe is indifferent aside, Earnings between the two tasks, and the number of fossilsshecan find depends on the number of hours a day she searches, as shown in the table below: (LOl) Zoe

is

to

trying

how

decide

photographer,which work, and as a fossil

$27

pays

connect\"

| ECONOMICS

fe? Econ

Total fossilsper day

Hours per day

h

McGraw-Hill

5

1

a. Using

the

9

3

12

4

14

5

15

information

acceptper

b.

2

fossil

above, in

order

Visit

the lowest price that Zoe her spending more time collecting

and less time working as a weddingphotographer. Plot these points in a graph with price on the vertical axis and on the horizontal. What is this curve called? day

quantity

would fossils

per

two firms in a competitive industry are P = 2 + Q2, where Q1 is the output of and given by, respectively, 2Q1 firm 1 and Q2 is the output of firm 2. What is the market supply curve for this industry? the two curves side then add their (Hint: Graph side, by at a sample of different prices.) (LOl) respective quantities

The supply

curves for

the

P =

only

download

the Frank:

Study

Econ

compute

to justify

your mobile

store and

app todayl

app

the

PERFECTLY

SUPPLY

COMPETITIVE

3. A

price-taking

new air

conditioners.

air

makes

firm

conditioners is $120.The

total

firm's

The market price of one of their cost information is given in the

below:

table

Air conditioners

per day

Total

cost

How many

air

2

150

3

220

4

310

5

405

6

510

7

650

8

800 should

conditioners

maximize its profit? (L03)

4. For

the

curves

pizza

level of

output

pizza is $2.50

whose

seller

are shown

($ per

day)

100

1

in

and

the

how

marginal,

accompanying

the firm produce

per day if

average variable, and diagram,

much profit will this

per slice?(L03)

its

average

goal

is to

total

cost

what is the profit-maximizing

producer earn

if

the

price

of

MC

ATC

AVC

570

Quantity (slices/day)

5* For the pizza seller whose marginal, average variable, and total average cost curves are shown in the accompanying what is the profitdiagram, level of output and how much profit will this producer earn if the maximizing price of pizza is $0.50 per slice? (L03)

0

260 Quantity

*Denotes more

difficult

problem.

(slices/day)

the

Tor total

cost

seller whose

pizza

are shown in Problem 5), what

curves

seller as in how much

marginal, averagevariable,and the accompanying diagram (who is the

average

the

is

same and

profit-maximizing output profit will this producer earn if the price of pizza is $1.18 per of

level

slice?(L03)

MC

u

0.68

435

260

0

(slices/day)

Quantity

Paducah

makes baseball

Company

Slugger

by Acme Sporting

Paducah's

Goods, which of

factors

only

pays

production

bats out of

of bats

Number

produces

as

shown

5

1

10

2

15

4

20

7

25

II

30

16

35

22

$15 per hour and

would be the

Paducah's

but

only

fixed cost

daily

is the profit-maximizing

of

quantity

of bats if the

number

profit-maximizing

werenot $60perday

7, how would Paducah'sprofit-maximizing if the government imposed a tax of $10 per day this tax as equivalent to a $10 increasein fixed

cost.)

a.

level of output

Paducah's

would

a tax

government imposed

increasein

b. ^Denotes

Why

more

do

the

these

difficult

profit-maximizing

of $2

level on

for the lathe and bats?

firm's fixed cost

of output

effects?

(L03, of

this

be affected

(Hint: Think

the company?

per bat? (Hint:Think

firm's cost.) marginal two taxes have such different

problem.

table below.

$30?

8. In Problem

What

depends

day

per

Number of employee-hoursper day

day

what

to it

finished bat.

in the

0

is $60,

building

it

0

a. If the wage is b. What

per

number

supplied

operators and a small

are lathe

of bats

building on the number of employee-hours per day, (L03, L04) The

lathe.

a

with

lumber

for each

$10

Paducah

of

L04)

be if

tax as

the

a $2-per-bat

176

CHAPTER 6

PERFECTLY

SUPPLY

COMPETITIVE

The demand and supply curves below. Calculate daily producer

for

the

market

pizza

are shown

in

the

graph

surplus. (LOS)

Quantity

(1,000s

6.1

Since will find 300 containers if he searchesa third we find his hour, Harry reservation price for searching a third hour by solving p(300) = $6 for p = 2 cents. His reservation pricesfor additional hours of search are calculated in

an

way. (LOl)

analogous

Fourth hour: hour:

Fifth

6.2

If

sell for

bottles

the

including

6.3

The

relevant

and

marginal

should

per

Employees

day

Bottles per day

(HECKS

CONCEPT

TO

ANSWERS

of slices/day)

costs

are now as shown half what it entry

cost

($/day)

employees and

Variable cost ($/day)

continue

should

firm

(350 bottles

employee

hire six

now

each, the

sixth

cost

Fixed

62 cents

p(200) = $6,sop = 3 cents. = $6, so p = 6 cents. p(100)

in

was

to expand up

to and

per day).(L03)

the

below.

table in the

original

With each

produce 350bottlesper day.

cost

Total

($/day)

0

0

40

0

40

1

80

40

6

46

2

200

40

12

52

3

260

40

18

58

4

300

40

24

64

5

330

40

30

70

6

350

40

36

76

7

362

40

42

82

variable

example, the (L03)

Marginal cost

($/bottle) 0.075

0.05

0.10

0.167

0.20

0.30

0.50

firm

ANSWERS

6.4 Because the should

shut

firm

down

Employees

per day

makes

in the

Output

its smallest loss when short run. (L03)

revenue

Total

it

zero

hires

Total cost

employees,

it

Profit

0

(bottles/day) 0

0

40

-40

1

80

8

52

-44

2

200

20

64

-44

3

260

26

76

-50

4

300

30

88

-58

5

330

33

100

-67

6

350

35

112

-77

7

362

36.20

124

-87.80

6.5

The

fact

redemption price

day

will

($/day)

($/day)

to pay 0.00005 cent city's 60,000 residentsis willing means that the collective benefit of each bottle is (60,000)(0.00005) = 3 cents.So the city should set the at 3 cents, and from the supply curve we seethat bottles 15,000 per be recycled at that price. (L04) that

for each bottle

removed

($/day)

each of the removed

TO

CONCEPT

CHECKS

177

I

CHAPTER

Exchange,

Efficiency,

Invisible

the

and

7

I

in Action

Hand

LEARNINGOBJECTIVES After

this

reading

LOI

chapter,

able to:

you should be

explain the

and

Define

differences between profit,

accounting -

profit, and

economic

v

L02

normal

profit.

Explain

the Invisible

Hand

and

Theory

economic

show how

economic

and

profit

loss affect the

Early suppliers

that

ability

faded

of more fuel-efficient cars were able to charge as other suppliers adopted similar technologies.

premium

prices

for them, but

L03

allocationof

resources

across

industries. economic

why

Explain

profit, unlike economic

rent, tends toward

The

in

market for ethnic cuisine the early 1970s: The city

in Ithaca, New had one Japanese,

York, offered few choices two Greek, four Italian, 40 years later and with

and three Chineserestaurants.Today, some the same population, Ithaca has one Sri Lankan, two one Indian, essentially two Vietnamese, four Mexican, three French, one Spanish, sixThai,two Korean, Greek,seven Italian, two Caribbean, two Japanese, and nine Chinese restaurants. In some of the city's other markets,however, the range of available choices has narrowed.For example,several companies provided telephone answering services in 1972, but only one does so today. Rare indeedis the marketplacein which the identities of the buyers and sellersremain static for extended New businesses enter, established periods. in Ithaca onesleave.Thereare morebody-piercing studios now and fewer

watch-repairshops;moremarketing companies;

and

more

or coppertone.

Driving these

migrate

to

industries

changesis and

the

business

locations

in

fewer

steel or blackfinishes,

in stainless

appliances

and

consultants

which

owner's profit

quest for

intercity fewer

bus in avocado

abound

the

and

run.

long

the

Identify

whether

market

equilibrium is

socially

efficient,

and

why no opportunities

for to

gain

remain

market is in L05

a

equilibrium.

total

Calculate

economic and

open when

individuals

explain

affected

profit. Businesses

opportunities

L04

zero in

surplus

how

it

is

that

by policies

prevent markets from reaching

equilibrium.

CHAPTER7

180

EFFICIENCY,

AND THE

EXCHANGE,

HAND

INVISIBLE

INACTION

desertthose whose

prospects

bleak.

appear

most widely quotedpassagefrom Wealth of Nations, Adam Smith

It is not from the benevolence or the baker that brewer,

of their

of the we

expect

O

even though

THE CENTRAL ROLE OF The

economic

goal is to maximize profit means. THREE

theory its

TYPES

payments a

the actual makes

firm

factors of production

to its and

other

suppliers profit

the

between a firm's total and its explicit costs implicit

costs

costs of the by

the

difference revenue

the opportunity resources

firm's owners

entrepreneur

intention.\"

hand to As

self-interest

Smith

is the

ECONOMICPROFIT that the firm's what, exactly,

OF PROFIT

between

of

profit

is different

the two is

Accounting

accounting

the

an invisible

from the accountant's, and the for hand important understanding how the invisible works. Accountants define the annual profit of a businessas the difference between in and its explicit costs for the year, which are the actual the revenue it takes firm makes to its factors of productionand payments the other Profit thus suppliers. defined is called accounting profit. distinction

costs

of our

them

to

We to

advantage.

of business behavior is built on the assumption So we must be clearat the outset about profit.

The economist's understanding

explicit

but

humanity,

prime mover of economic the end result is an allocation of goods and services have more tattoo activity, parlors in 1972? If that serves society's collective interestsremarkably well. producers are \"too much\" of one and \"not offering product All of stimulate into action. the another, profit opportunities enough\" entrepreneurs the exerts relentless on to hold the of each while, system pressure producers price goodcloseto its cost of production, and indeed to reducethat cost in any ways possible. The invisible that can happen because hand, in short, is about all the good things of the IncentivePrinciple. Our task in this chapter is to gain deeper insight into the nature of the forces that guide the invisible hand. What exactly does \"profit\" mean? How is it if and how does the for it serve ends? And measured, quest society's competition holds close to the cost of do so become price production, why many entrepreneurs in We will also discuss cases which of Smith's fabulously wealthy? misunderstanding in in in results both decision and the realm errors, theory costly everyday making of government policy. saw it,

Incentive

butcher, the our dinner, interest.

own

Smith went on to argue that although \"intends only his own gain,\" he is \"led by promote an end which was no part of his

cities now Why do most American and fewer watch-repair shops than

In perhaps the treatise, The

wrote,

but from their regard of their address ourselves not to their their self-love, and never talk

necessities,but

landmark

his

profit

= Total

revenue \342\200\224 Explicit

costs.

discourse. It is the profit is the most familiar profit concept in everyday one that companies use, for example, when statements about their they provide in releases or annual profits press reports.1 define total Economists,by contrast, profit as the difference between the firm's revenue and not just its explicit costs, but also its implicit costs, which are the

Accounting

supplied

this discussionignores of the firm's capital any costs associated with depreciation the buildings and machines owned by a firm tend to wear out over time, the government allows the firm to consider a fraction of their value each year as a current cost of doing business. For a firm that employs a $1,000machine with a 10-year life span might be allowed to record example, business each year. $100 as a current cost of doing aFor simplicity,

equipment.Because

THE CENTRALROLE

181

PROFIT

OF ECONOMIC

FIGURE 7.1

The Difference

between

Profit and

Accounting

Economic Profit. Explicit

costs

between

difference

v Normal

of firm

by owners

costs of all the resources supplied by defined is called economicprofit, or excess profit.

Economic profit

= Total

revenue

the

\342\200\224

firm's

costs.

the difference betweenaccounting and economic profit profit, in total annual revenue whose only consider a firm with $400,000 costs explicit firm are workers' The owners of this have salaries, totaling $250,000per year. machines and other with a total resale value of supplied capital equipment This firm's accounting profit then is $150,000,or the difference $1 million. between its total revenue of $400,000per year and its explicit costs of $250,000 To illustrate

per year. To

economic profit,

the firm's

sometimescalledits

the opportunity cost of the resources owners. Supposethe current annual interest rate on savings accounts is 10 percent.Had owners not | invested in capital equipment,they could have earned an additional $100,000 per year interest by

must first calculate

their $1 million in a savings depositing the firm's economicprofit is $400,000 $250,000 $100,000

per year =

profit,

by the

profit).

of its

explicit and

normal

we

implicit

costs

the opportunity resources supplied

profit

of the

a firm's owners,

firm's

between a and the sum

difference revenue

total

equal

by

to

minus economic profit

accounting profit

U

So

account.

per year

year

per

excess

supplied

explicit

profit (or excess

the

firm's

cost

calculate

costs,

and normal

profit)

Implicit

all

is

thus

Profit

owners.

\342\200\224

a firm's

(also equal to the difference between accounting

economic costs

Explicit

by

and implicit profit

opportunity

and

revenue

(c)

(b)

supplied

owners. Economicprofit (c) the difference between total

profit

resourcessupplied

(a)

resources

Economic

cost of

Opportunity

revenue and explicit costs. Normal profit (c) is the cost of all opportunity

\\

=

profit

(b) is the total

profit

Accounting

\342\200\224 <

$50,000

per year.

Note that this economic profit

the accounting

firm's implicit

opportunity

of the

cost

owners. This

exactly $100,000

and

per

than

smaller

amount

of the V

year

y

supplied by the firm's

between

its economic

a business's

profit is calledits

profit. profit is simply the of the resources supplied to a businessby

Normal

normal cost opportunity

owners.

and

accounting

economic

represented

show how various

differencebetween profit. A firm's total revenue in Figure 7.1 (a), while (b) and (c) revenue is apportioned among the

7.1 illustrates the

Figure is

by

resources

difference

profit

accounting

its

profit

costs\342\200\224the

is

the

cost

this

and

profit

categories.

'All

I know,

Harrison,

years and have

is yet

that

Vve

to see

been

on the

an excess

board forty

profit\"

182

7

CHAPTER

EFFICIENCY, EXCHANGE, AND

THE INVISIBLE

examples illustrate why

The following

economic profit EXAMPLE

INACTION

HAND

is so

Should

stay

Buffet

Pudge

and

accounting

important.

Accounting versus Economic Profit,Part

7.1

between

distinction

the

in

the

I

business?

farming

who lives near Lincoln, Nebraska. His payments for Pudge Buffet is a corn farmer land and equipment rental and for other supplies come to $10,000 per year. The he supplies is his own labor, and he considersfarming as attractive only input just as his only other employment opportunity, a retail store at a salary of managing is indifferent between $11,000 per year. Apart from the matter of pay, Pudge farming and international

a manager. large to

being

too

market

Pudge'srevenue

corn

from

His economic profit?

His

Corn sells for a constant price per bushel in an in one farmer's corn production. be affected by changes sales is $22,000 per year.What is his accounting profit? normal profit? Should he remain a corn farmer?

7.1

TABLE

Revenue,

Cost, and

Profit Summary Accounting

Economic

( =

profit

Total

Implicit

costs

costs

($/year)

($/year)

revenue

($/year)

( = total

Explicit

As

-

explicit costs)

($/year)

( =

implicit costs)

costs)

($/year)

1,000

11,000

per year, the

his $22,000

difference between

and supplies. His economic profit

equipment,

cost of his labor.Sincethe store manager, he is making

profit

implicit

($/year)

is $12,000 7.1, Pudge's accounting profit annual revenue and his $10,000yearly

in Table

shown

Normal

costs

explicit

12,000

11,000

10,000

22,000

-

-

revenue

profit

total revenue

is that

amount

payment

for

land,

less the opportunity

as a per year he couldhave earned of $1,000 per year. Finally, his normal profit is the $11,000 opportunity cost of the only resource he supplies, namely, his labor. SincePudge likes the two jobs equally well, he will be better off by $1,000 per year if he remains in farming.

CONCEPT CHECK In

7.1, how

Example

latter an

is the

$11,000

economic

profit

7.1

will

Pudge's

economic

corn production is not $22,000,but

When economic

loss

an economic

profit that is less than

zero

revenue

\342\200\224$1,000 per

abandon

farming

You the the

A negative

expects to sustain

Pudge

own

year.

falls from

might

$22,000 to $20,000,Pudge has an economic profit is also calledan economic

loss

indefinitely,

economic

profit of

economic

his best

loss.

If

bet would be to

store.

just save enough money to

and equipment, his best option would be to remain that is based on a following example illustrates, impression difference between and economic accounting profit profit. land

from

profit change if his annual revenue Should he continue to farm?

of managing a retail that if Pudge could

in favor

think

an

$20,000?

a farmer.

buy But

his as

failure to perceive

THE

Does

Let'sbuild

on

7.1 and

Example

who owns the

farmland

land. If the land couldbe rented

Uncle Concept Check 7.1. Suppose Pudge's been renting, dies and leaves that Pudge to some other farmer for $6,000 per year,

Warren, parcel

of

should

in farming?

remain

Pudge

ECONOMICPROFIT

EXAMPLE 7.2

Profit, Part 2

has

Pudge

ROLE OF

a difference?

land make

own

one's

owning

Economic

versus

Accounting

CENTRAL

TABLE 7.2

Revenue,Cost,and

Profit

Summary

Accounting (

profit

Total

Implicit

Explicit

(

revenue

costs

costs

($/year)

($/year)

($/year)

20,000

= total \342\200\224

\342\200\224

explicit

\342\200\224

costs)

explicit

implicit

will

in

7.2,

for

the

Pudge rents his farmland option

that

yields

of all

or

highest

it. He should stay economic profit.

accounting profit

explicit costs

it

incurs.

OF

ROLE

is the

For a

firm

greater

to

remain than

in business or equal

in

to zero.

PROFIT

between its revenue is the difference

profit

firm's revenue and all costs it incurs\342\200\224both profit is the opportunity cost of the resources firm. When a firm's accounting profit is exactly of the inputs supplied by the firm's owners, the

profit

in

the

long

was as a renter.But

the same way whether farming only if that is the

ECONOMIC

difference

Economic

than he

answered

owns

THE CENTRAL

RECAP A firm's

the

is

costs) 17,000

an owner

as farmer

profit

implicit

-1,000

job.

Pudge obviously would be wealthier of whether to remain a question

=

16,000

if Pudge

managerial

(

($/year)

be $16,000

abandonfarming

the

Table

costs)

Normal

($/year)

continues to farm his own land, his or Check 7.1. accounting profit per year, $6,000 morethan in Concept But his economic profit will still be the same as before\342\200\224that is, \342\200\224$1,000 per must deduct the $6,000 per year opportunity cost of year\342\200\224because Pudge his own even he no must make an land, farming though longer explicit payment to his uncle for it. The normal profit from owning and operating his farm will be cost of the land and labor he provides.But $17,000 per year\342\200\224the opportunity since earns an he will again do better to Pudge accounting profit of only $16,000, As shown

costs

($/year)

17,000

4,000

revenue

Economic profit = total revenue

and the sum between the

Normal implicit. by the owners of the to the opportunity cost equal firm's economic profit is zero. run, it must earn an economic explicit

supplied

and

183

184

EFFICIENCY, EXCHANGE, AND

7

CHAPTER

THE INVISIBLE

INACTION

HANDTHEORY

INVISIBLE

THE

HAND

TWO FUNCTIONS OF PRICE In

rationing in

changes

function of price prices distribute scarce

goodsto those consumers most

value them

of price direct resources overcrowded markets

allocative

function

in prices

changes away

who

highly

from

and toward underserved

that

markets

invisible hand theory Smith's theory that the

are

Adam actions

of

self-interested

independent,

buyers and sellers will often result in the most efficient allocation of resources

the

free enterprise system, market first, the rationing function

pricesserve

two

and distinct

important

of price, is to distribute scarcegoodsamong are the ones who value them claimants, potential ensuring that those who get them most. Thus, if three people want the only antique clock for sale at an auction, the clock goes home with the person who bids the most for it. The secondfunction, the allocative function of price, is to direct productive resources to different sectors of in which price cannot cover the cost of the economy.Resourcesleave markets in production and enter those which price exceeds the cost of production. Both the allocative and rationing functions of price underlie Adam Smith's celebrated of the invisible hand of the market. Recall that Smith thought the theory market and sellers so as to system channeled the selfish interests of individual buyers and the stick of promote the greatest good for society. The carrot of economic profit economicloss,he argued, were the only forces necessary to ensure that existing market would be allocated efficiently and that resources would be supplies in any allocated across markets to produce the most efficient possiblemix of goods and services. functions.

The

TO PROFITS

RESPONSES

AND LOSSES

invisiblehand works,we begin by looking at how firms in the long respond profits and losses.If a firm is to remain in business A it must cover all its both and firm's normal run, costs, explicit implicit. profit is firm a cost of business. the owner of a that earns no more than a Thus, just doing normal has to recover the cost of the resources profit managed only opportunity invested in the firm. By contrast, the owner of a firm that makes a positive economic earns more than the opportunity cost of the invested she resources; profit earns a normal and then some. profit would be delighted to earn more than a normal Naturally, everyone profit, and in which firms are earning no one wants to earn less. The result is that those markets in which an economic markets profit tend to attract additional resources,whereas firms are experiencing economiclossestend to lose resources. To see how this happens,we'llexamine the of the market for corn, workings in whose short-run and demand curves are shown 7.2(a). supply Figure Figure 7.2(b) total cost curves for a representative farm. The depicts the marginal and average of bushelis determined the intersection $2 equilibrium price per by supply-demand To

get

for how the

a feel

to economic

FIGURE 7.2

EconomicProfit

in the

Short Run Market.

Corn

At an

bushel

earns

the

(b).

profit

= $l04,000/year //

price of (a), the typical

b o

an economic

profit of $104,000per year

ATC.

Economic

equilibrium

$2 per farm

in

-

3 ^

\342\200\224 \342\200\224 \342\200\224 _ *r

\\ \\

($/bushel)

Price

!|

f^

!

// Price

1.20

/ 0

Qua

(millions

130

0

65 ntity

of bushels/year)

(a)

Quantity (1,000s of bushels/year)

(b)

THE

in

(a).

The

farm whose

representative

maximizes its profit by

MC and ATC

producingthe quantity

of corn cost, 130,000bushels Recall from Chapter 6 that

for

in (b) then

shown

curves

are

which

price

HAND THEORY

INVISIBLE

equals marginal

per year.

total cost at any level is the sum of average output divided The difference between costs, explicit by output. price and ATC is thus to the amount of economic earned unit sold. equal average profit per In Figure 7.2(b), that difference is $0.80 per unit. With 130,000 bushels per year the representative farm earns an economic profit of $104,000 sold, per year. in The existence of positive economic the corn market means that profit in that producers market are earning more than their cost of farming. For opportunity we assume that the to enter the corn market\342\200\224land, labor, simplicity, inputs required and the like\342\200\224are available at constant is free to equipment, prices and that anyone if he or she chooses.The key point is that enter this market since price exceeds the cost of the resources to enter the others will want to market, opportunity required enter. And as they add their corn production to the amount already on offer, supply shifts to the right, the market causing equilibrium price to fall, as shown in Figure At the new of farm now earns $1.50 7.3(a). price per bushel,the representative much less economicprofit than before, 7.3(b)]. only $50,400 per year [Figure

and implicit,

all

FIGURE

7.3

The Effect of Entry Price and Economic

on

Profit. At

the

original

per bushel,

price of $2

existing

farmers

earned economic profit, new farmers to prompting enter.

With

entry, supply shifts (a)] and

right [from S to S' in equilibrium price falls, economic profit (b).

For method,

we

so that

their ATC

to the

all the way profit

curves are identical. of ATC.

value

minimum

still be

would

employ the same standard production

all farms

that

assume

simplicity,

positive, and

entry

farm

will

would

Entry

(At

any

will then price

continue,

continue than

higher

driving price

still

until

price

falls

that, economic lower.)

Recall

6 that the short-run marginal cost curve intersectsthe ATC curve at the minimum point of the ATC curve. This means that once price reaches the minimum value of ATC, the profit-maximizing rule of setting price equal to marginal cost results in a quantity for which price and ATCare the same. And when that happens, economic from Chapter

profit

for

the representative

In the

adjustment process just

above the Suppose

instead

average

in variable

2This

zero, as shown

giving rise

initial

in

Figure

equilibrium

7.4(b).

price

was

to positive economicprofits.

that

qualification

the market

at

a price

at

that

equals marginal however,

exactly

considered,the

demand curve for corn had intersected the short-run below the minimum value of each firm's ATC curve, as is above the minimum value of 7.5(a). As long as this price Figure each farm will supply that quantity of corn for which price cost,2 that

supply curve shown

of ATC,

value

minimum

be

cost,

shown

quantity,

refers to the

firm's

as 70,000

the farm's shutdown

bushels per year

average total

condition,

discussed

cost

in

in

Figure

is $1.05 Chapter

6.

7.5(b).

Note,

per bushel,

or

as does

185

CHAPTER7

186

EFFICIENCY,

AND THE

EXCHANGE,

INACTION

HAND

INVISIBLE

7.4

FIGURE

when

Equilibrium

*MC

Entry

Ceases. Further entry ceases once price falls to the minimum value of ATC. At that point, all firms earn a normal

economic

profit.

each earns

an

/

s/ 2

\\

\\

($/bushel)

Equivalently, economic

<

\342\200\242C 1.00

0.

profit of zero.

/ 0

\302\260\"

X

/1

Price

^f\\ v\342\200\224

D

\\

i

90

0

115

65

/y /

\\

ice

ATC

Quantity (millions of bushels/year) (a)

(1,000s

Quantity

of bushels/year)

(b)

$0.30 more than the price for which it sells each bushel. As shown in (b), the farm thus sustains an economic loss of $21,000 per year. If the demand curve that in led to the low price and resulting economic losses will to abandon farming for other Figure 7.5 is expectedto persist,farmers begin activities that better returns. This means that the curve for corn promise supply will shift to the left, resulting in higher and smaller losses. Exit from corn prices in fact, until will has again risen to $1 per bushel, at which continue, farming price exit. Once point there will be no incentive for further again we see a stable in Figure equilibrium in which 7.6. price is $1 per bushel,as shown Given our simplifying that all corn farms employ a standardized assumptions and that at fixed productionmethod inputs can be purchased in any quantities on prices, the price of corn cannot remain above $1 per bushel (the minimum point the ATC curve) in the long run. Any higher price would stimulate additional entry price again fell

until $1 the

per bushel in price of corn

The fact

in the

goal

minimum

is

level.

again rose to firms

Further,

run because

are free

any

the price lower

$1 per bushel.

to enter or leave

long run, all firms in the industry is not to earn zero profit. Rather,

of corn cannot

price

would

below

remain

stimulate

exit

the

value

loss

MC

the

of ATC (a),

(b).

an

3

-Q

0.75

60

0

Quantity (millions of bushels/year)

(a)

until

at any time ensures that, industry to earn zero economicprofit. Their is a consequence of zero-profit tendency an

will tend

Market.

below

farm sustains

economic

that

long

Economic Corn

the

When price each

to

7.5

FIGURE

A Short-Run

Lossin

that

the

0 Quantity

7090 (1,000s

of bushels/year)

(b)

THE

HAND THEORY

INVISIBLE

FIGURE 7.6

price

rises

value

of

all

firms

Exit

when

Equilibrium

Ceases. Further exit

ceasesonce

to the

ATC.

minimum

At that

point,

earn a normal

economic

profit.

each earns

an

Equivalently, economic

profit of zero.

40 60

0

90

0

of bushels/year)

(millions

Quantity

Quantity

(a)

the price

of bushels/year)

(1,000s

(b)

movements associatedwith

and exit. As the Equilibrium Principle\342\200\224 entry the No-Cash-On-the-Table Principle (see Chapter 3)\342\200\224predicts, when confront an for people opportunity gain, they are almost always quick to exploit it. What does the long-run curve look like in the corn market just discussed? supply This question is equivalent to asking, \"What is the marginal cost of producing In general, in the long run may additional bushels of corn in the long run?\" adjustment also

called

not just entry and exit of standardized firms, but also the ability of firms to mix of capital equipment and other fixed inputs they employ. Explicit consideration of this additional but step would complicate the analysis considerably would not alter the basic logic of the simpler account we present which mix of fixed inputs in the short assumes that all firms operate with the same standard entail alter

the

here,

of adjustment process consists exclusively standardized method. single production The fact that a new firm could enter or leave this corn market at any time means that corn production can always be augmented or reducedin the long run at a cost of $1 per bushel. And this, in turn, means that the long-run supply curve of corn will be a horizontal line at a price equal to the minimum value of the ATC bushel. Since the cost (LMC) of producing corn is $1 curve, per long-run marginal so is the cost as constant, (LAC) and it, too, is $1 per bushel, long-run average in Figure 7.7(a). Figure 7.7(b) showsthe MC and ATC curves of a shown representativecorn farm. At a price of $1 per bushel, this corn market is said to be in longrun equilibrium. The representative farm produces 90,000 bushels of corn each the for which its cost. And since is year, quantity price equals marginal price exactly this farm also earns an economic profit of zero. equal to ATC, These observations call attention to two attractive features of the invisible hand theory. One is that the market outcome is efficient in the long run. Note, for the value to buyers example, that when the corn market is in long-run equilibrium, of the last unit of corn sold is $1 per bushel, which is exactly the same as the longrun marginal cost of producing it. Thus, thereis no possiblerearrangement of resources that would make some participants in this market better off without

run. Under this assumption, the entry and exit of firms

contract

added

costs

production,

others.

attractive feature outcome can be described as A second

higher

than

the

long-run

use a

If farmers some were to expand production, for example, incurred would exceed the added benefits; and if they were to the cost savings would be lessthan the benefits forgone.

causing harm to the

the

that

cost

opportunity cost of

of

long-run

competitive

is the market

equilibrium

sense that the price incurred by suppliers. That cost includes the resources supplied by owners of the fair, in the

buyers

must pay is

a normal firm.

profit,

no the

a

Equilibrium

187

CHAPTER

188

Equilibrium

Long-Run

a Corn

AND THE

EXCHANGE,

INACTION

HAND

INVISIBLE

in

Market with

Constant

Long-Run

Average each

sameATC can

EFFICIENCY,

7.7

FIGURE

When

7

supply

Cost. has the producer the industry as much or as

curve,

as buyers wish at a buy price equal to the minimum value of ATC (a). At little

output

1.00

to

that price, producer

the

representative

(b) earns

0

115

0

zero

Quantity (millions

economicprofit.

of bushels/year)

90 of bushels/year)

(1,000s

Quantity

(a)

(b)

Smith's invisible hand theory doesnot mean that is optimal in every way. It simply means that markets in the limited are efficient technical sense. Thus, if the current allocation differs from the market-equilibriumallocation,the invisible hand theory implies that in we can reallocateresources a way that makes some people better off without

We must

market

of resources

others.

harming

The following

EXAMPLE

7.3

example affords

additional

insight

into

invisible

how Smith's

in practice.

works

hand

that

emphasize

allocation

Movement toward Equilibrium What

a city

in

happens

\"too

with

many\"

hair

stylists and

\"too few\"

aerobics

instructors?

and prices in the markets for haircuts and aerobics all are zero economic 7.8, Figure suppliers currently earning profit. Now supposethat styles suddenly change in favor of longerhair and increased physical fitness. If the long-run marginal cost of altering current levels is constant production in both in describe how and will each markets, market, in both prices quantities change At the

initial

equilibrium

classesshown

the short

quantities

in

run and the long run.

the

Are

new

equilibrium

quantities socially optimal?

ATCU ATCA

MCH

Price

$/haircut)

I

0

0H

500

0

Haircuts/

Haircuts/ day

day

(a)

0

>^

Price ($/class)

200

0

Classes/

0A

Classes/

day

day

(b)

Markets for (a) Haircuts and (b) Aerobics Classes. cost and average total cost curves for a representative total cost curves for a MCA and ATCA are the marginal cost and average aerobics instructor. Both markets are initially in long-run equilibrium, with market earning zero economicprofit.

Equilibrium

MCH and hair stylist

ATCH

and

representative

sellers

Price o ($/class)

7.8

FIGURE Initial

I I

Price

/\302\243\"'

$/haircut)

MCA

in

each

are

in the

the marginal

THE

in the demand for haircuts, shift longer hair stylesmeans a leftward in the on fitness shift emphasis physical implies a rightward demand curve for aerobicsclasses, as seen in Figure 7.9. As a result of these demand For the sake of illustration, shifts, the new short-run equilibrium prices change. these new prices are shown as $12 per haircut and $15 per aerobics class.

shift to

The

while the

increased

s \\-<

S

^ ^^w

\"^^ ($/class)

($/haircut)

X

V

X

X

X

X

XX 'i

Price

X

Price

i W^

200

500

350

i 1 1 1 1

300

Haircuts/day

Classes/day

(a)

(b)

7.9

FIGURE

in Two Markets. The Short-Run Effect of Demand Shifts (a) The decline in demand for haircuts causes the price of haircuts to fall from $15 to $ 12 in the short run. (b)The increasein demand for aerobics classes causesthe price of classes to rise from to $ 15 in the short run.

Because each equilibrium

will

D'

prices,

$10

producer was earning

zero economic profit at the original will economic lossesand aerobicsinstructors stylists experience economic profits at the new prices, as seenin Figure 7.10.

hair

experience

ATCA Economic

/

loss

/

I

MCA

I Economic J2

profit

u

($/haircut)

8

o

12

/

/

Pri

u

/

t

Q'hQh

Haircuts/day

15

11

\\

QaO'a Classes/day

(a) FIGURE

(b)

7.10

Economic Profit and Loss in the Short Run. The assumed demand shifts result in an economic loss for the representative and an economic profit for the representative aerobics instructor (b).

hair

stylist

(a)

INVISIBLE HAND

THEORY

189

190

CHAPTER

7

EFFICIENCY, EXCHANGE, AND

THE INVISIBLE

INACTION

HAND

in economic losses the short-run equilibrium price of haircuts results will in search some hair to leave that market of more stylists, stylists begin favorable opportunities elsewhere.As a result, the short-run supply curve of haircuts will shift leftward, resulting in a higher equilibrium price. Exit of hair stylists Because

for hair

will

of providing

cost

opportunity

the price

until

continue

By the

of haircuts risessufficiently

them, which

same token, becausethe

classes results in

economic

by

to

assumption

price of aerobics outsiders will begin to enter

short-run

equilibrium

for instructors,

profits

the long-run

cover

is $15.

to shift rightward. supply curve of classes New instructors will continue to enter until the price of classes falls to the longrun cost of providing them. By assumption, that cost is $10. Once opportunity all adjustmentshave taken place, there will be fewer haircuts and more aerobics classesthan before. But because marginal costs in both marketswere assumed constant in the long run, the prices of the two goods will again be at their that

the

causing

market,

short-run

original levels.

that those stylists who leave the market won't hair-cutting who enter the aerobics market. Indeed, people teaching the sheer number of occupations a former hair given stylist might choose to pursue, the likelihood of such a switch is low. Movements of resources will typically involve several indirect a former hair become a secretary, steps. Thus, stylist might and a former worker become an aerobics instructor. postal might We also note that the invisible hand theory about how long these says nothing mention

It bears

necessarily be the

same

In some markets, especially labor markets,the take. required take months or even years. But if the supply and demand curves might remain the markets will eventually reach stable, equilibrium prices and quantities. in the same And the new prices and quantities will be sociallyoptimal sense as before. Becausethe value to buyers of the last unit sold will be the same as the cost of producing it, no additional transactions will be possible that benefit marginal

adjustments might

movements

without

some

harming

others.

THE IMPORTANCE OF FREE ENTRY function of

The allocative

and leave

existing

firms

existing

any force

entry

prevents new market

firms

from

entering

that a

price cannot operateunless

at will. If

new

firms

could

economic profit, making over time, and price would not tend

were

to fall to zero cost of production.

barrier to

ones

AND

a large

EXIT firms

not

enter

economic

to gravitate

can

enter

a market

new markets in

which

not tend toward the marginal

profit

would

that inhibit firms from entering new markets are calledbarriers to entry. book publishing market, for example, the publisher of a book enjoys copyright protection granted by the government. Copyright law forbids other publishers from and works. This barrier producing selling their own editions of protected allows the price of a popular book to remain significantly above its cost of productionfor an extended for its period, all the while generating an economic profit no of a and indeed most new publisher. (A copyright provides guarantee profit, books an economic loss for their actually generate publishers.) Barriers to entry may result from as well as legal constraints. Some practical for have argued that the compelling advantages of product economists, example, in the computer have created barriers to software market. compatibility entry Since more than 90 percent of new desktop computers come with Microsoft's Windows software already installed, rival companies have difficulty selling other files with operating systems that may prevent users from exchanging friends and colleagues. This fact, more than any other, explains Microsoft's Forces

In the

spectacular

profit

No less leave. When

history.

important than the the airline industry

freedomto entera marketis the freedom was regulatedby the federal government,

to

air

RENT ECONOMIC

carriers were money

losing difficult

or

Barriersto

exit

serve

to

required

PROFIT

191

were specific markets, even though they that a market, once entered, is

discover

firms

When

ECONOMIC

to leave, they become reluctant to enter new markets. become barriers to entry. Without free entry and exit, reasonably of Adam Smith's invisible hand cannot be expected implications theory

impossible

thus

then, the

to hold. in

often

in them.

VERSUS

All

things

most

U.S.

considered,

markets.

producers enjoy a high Because free entry is one

competitivemarkets,unless

of perfectly

THE INVISIBLE

RECAP

otherwise

freedom of entry characteristics defining we'll assume its existence. of

degree of

the

stated,

HANDTHEORY

functions of prices guide economies, the allocative and rationing resources to their most highly valued uses. Prices influencehow much of each in of allocative Firms enter industries function). type good gets produced(the which are to sustain an economic and leavethose prices sufficiently high profit in which low prices result in an economic loss. Prices also direct existing to the buyers who value them most (the rationing function). supplies of goods Industries in which firms earn a positive economic profit tend to attract new firms, shifting to the Firms tend to leave industries industry supply right. in which they sustain an economic loss,shifting curves to the left. In supply each case,the supply movements continue until economic profit reacheszero. In long-run the value of the last unit produced to buyers is equal equilibrium, to its marginal cost of production, no for leaving possibility additional

In market

transactions.

mutually beneficial

because the

conspicuous

can

zero, how

many

that

happen?

and

to a landlordor the supplier

has a different that

input

markets

year.

meaning.

of

a

Economic

is,

rather leave

$100 but $900 per

the

suppliers

planet,

largely

from competing

dominated by his

Yet

company.

the distinction between economic of rent as the payment they make economic rent that part of the dorm refrigerator, but the term economicrent for a factor of payment rent is that portion of the payment for an production that exceeds the owner's

the supplier'sreservationpricefor landowner'sreservation pricefor an he would be willing to lease it suppose

is above

receivedan annual

would

on

no fabulously rich even in markets with market forcespush economic toward profit

example, that a That

rival

\342\200\224

to this question hinges on economic rent. Most people think

answer

The

wealthiest man prevents

compatibility

software have become people barriers to entry. If the

in

effectively

numerous

profit

problem

of

is the

Gates

Bill

chairman

Microsoft

PROFIT

ECONOMIC

VERSUS

RENT

ECONOMIC

of

$1,000,

least $100, but for If a farmer gives him it fallow. an annual the landowner's economic rent from that

payment

of at

year.

Economicprofit

for input. Suppose, of land is $100 per to a farmer as long as he less than that amount he that

acre

payment payment

not of will

be

in that it, too, may be seen as the business owner'stotal revenue) and her in business reservation price for remaining sum of all her (the costs,explicitand But whereas economic toward zero, it has no implicit). competition pushes profit such effect on the economic rent for inputs that cannot be replicatedeasily. For the lease for land remain above the example, although payments may substantially in landowner's reservation and new land cannot come onto the price, year year out, difference

between

what

is like

someone

rent is paid (the

economic

reservation below supply

price,

which the

the price

the owner would factor

not

192

CHAPTER7

EFFICIENCY,

AND THE

EXCHANGE,

to reduce or eliminate only so much land

market after

all,

the

As

EXAMPLE

7.4

competition. There

through

economic rent can

illustrates,

example

following

rent

economic

the

to be had.

is,

accrueto peopleas

land.

as

well

INACTION

HAND

INVISIBLE

Rent

Economic

Howmuch

rent

economic

talented chef get?

will a

99 of which

of normal ability at a in earn other salary per year, they that are equally attractive to them. But the 100th restaurant has an occupations talented chef. Because of her dinersare to unusually reputation, willing pay 50 percent more for the meals she cooks than for those preparedby ordinary chefs. Owners of in the 99 restaurants with chefs each collects $300,000 per year revenue, ordinary which is just enough to ensurethat each earns exactly a normal profit. If the talented chef's outside the restaurant industry are the same as those of opportunities how much will she be her at equilibrium? How chefs, ordinary paid by employer much of her pay will be rent? How much economic profit will her A

100 restaurants,

has

community

of $30,000

as the

same

the

employ

chefs

amount

could

economic

employer earn?

Becausediners

are

talented chef, the

owner

per year that

the

in total

take

for

cooked

meals

by the

receipts not of $300,000

In the long run, competition shouldassurethat the each pay year will be $180,000 per year, the sum of the $30,000 in extra revenues for which she is solely chefs get and the $150,000

ordinary

industry\342\200\224by

chefs\342\200\224her

who hires

owner

assumption,

per year. The

is $150,000 zero. exactly

rent

economic

her will

Since the talented

price is the amount she couldearn $30,000 per year, the same as for

reservation

chef's

talented

restaurant

the

ordinary

will

total

responsible.Sincethe outside

50 percent more

of $450,000.

but chef's

talented

to pay hires her

willing who

be

economicprofit

of

chef's opportunitiesoutside

the restaurant are no industry is it to the talented chef so much? chef's, why ordinary necessary pay her employer were to pay her only $60,000, which Suppose they both would consider a generous since it is twice what chefs earn. The employer salary ordinary would then earn an economic profit of $120,000 per year since his annual revenue would be $150,000more than that of ordinary restaurants, but his costs would be only $30,000 more. But this economic of some profit would create an opportunity for the owner if other restaurant to bid the talented chef For the owner of a away. example, restaurant were to hire the talented chef at a of the $70,000, competing salary chef wouldbe $10,000peryear better off and the rival owner wouldearn an

better than

economic

an

of $110,000 per year, rather than if the talented chef is the sole

profit

Furthermore, positive

economic

economic

$90,000, has been example, This

the remains.

profit, profit

his current economic profit of zero. reason that a restaurant earns a for that chef should continueas bidding long as any Some other owner will pay her $80,000, still another will be reached only when the talented chef's salary

and so on. Equilibrium bid up to the point that at an annual paycheck of bidding

process

superior performanceis that

copied.If France,

then

instead

it

were

her privileged

similar training.

no

further

the

profit

remains\342\200\224in

our

$180,000.

assumes, of she

economic

possesses

result

course, that some

of, say, training

the

personal

position would erode over

for the chef's talent that cannot be

reason

a culinary as other time, at

institute in chefs sought

RENT

ECONOMIC

RENT VERSUS

ECONOMIC

RECAP

VERSUS ECONOMIC

PROFIT

ECONOMIC PROFIT

the payment to a factor of production which is driven price. Unlike economic profit, toward zero by competition, economic rent may persist for extendedperiods, in the case of factors with talents that cannot easily be duplicated. especially special rent

Economic

exceeds

the

amount

is the

by

which

reservation

supplier's

THE INVISIBLEHAND INACTION To

help

examinehow different

contexts.

opportunities more than known as

any

the

like

\"thinking

an economist.\"

Hand at the

Invisible

The As

hand works, we will your intuition about how the invisible us gain insight into we observe in a wide variety of patterns In each to focus on is that case, the key idea we want you for remain unexploited for very long. Perhaps private gain seldom this idea encapsulates the essence of that distinctive mindset other,

develop it helps

Supermarket and on the

example illustrates, the

following

just to opportunitiesto earn economic profits a more desirable outcome. opportunity to achieve

in

but also

cash,

do

checkout

supermarket

lines all

tend to be roughly

careful attention the next few times you go grocery Pay the lines at all the checkout stations tend to be roughly one line that was significantly shorter than the others

the checkout most shoppers

area.Which would

do you seldom than all the others? Why

line

do

the

checkout

any

other

7.1

Naturalist same

the

length?

notice that shopping and you'll same length. Suppose you saw as you wheeled your cart toward the

would you choose? The same, the short line seldom

see one supermarket

to

Economic

The

Why

Freeway

No-Cash-on-the-TablePrinciple refers not

shorter one,of remains

line that is

shorter

substantially

course;

for

shorter

because long.

a

Equilibrium

m

193

194

7

CHAPTER

EFFICIENCY, EXCHANGE, AND

CHECK

CONCEPT

HAND

multilane

to explain

Principle

at about

move

freeway

INACTION

7.2

No-Cash-on-the-Table

the

OUse

THE INVISIBLE

all

why

lanes

on a crowded,

the same speed.

The InvisibleHandand Cost-Saving

Innovations

economists

When

of perfectly

speak

whose contribution to total

businesses

perceptibleimpact on market price.As called

often

and then

They take

takers:

price

produce

that

quantity

of

competitive firms, they

market output

explained

is

too

in Chapter

have

small

in

mind

to have

a

6, such firms are

the market priceof their product as given for which cost output marginal equals that

price.

This characterization of the competitive firm gives the impression that the firm is essentially a passive actor in the marketplace. Yet for most firms, that is anything but the case. As the next example even those firms that cannot illustrates, hope to influence the market pricesof their products have very powerful incentives to

develop and introduce cost-saving innovations.

EXAMPLE

7.5

The

Impact

How

do

of Cost-Saving innovations

cost-saving

Innovations on EconomicProfit affect

long run? Forty merchant

economic profit

in

the

short

run? In the

that carry oil from the operate supertankers States. The cost per trip, including a normal profit, is at one of these companies developsa moreefficient $500,000. An engineer propeller that results in fuel savings of $20,000per trip. How will this innovation design affect the company's accounting and economicprofits? Will these changes persist in

the

long

marine

companies

to the United

East

Middle

run?

In the short run, the reductionin a singlefirm's costs will have no impact on the market priceof transoceanic services. The firm with the more shipping efficient of $20,000 propeller will thus earn an economicprofit per trip (since its total revenue will be the same as before,while its total cost will now be $20,000per trip lower). As other firms learn about the new design,however, will they begin to adopt it, causing their individual supply curves to shift downward the marginal cost per trip at these firms will drop by $20,000). (since The shift in these individual curve supply curves will cause the market supply in a lower market price for to shift, which in turn will result and shipping a decline in economic profit at the firm where the innovation originated. When all firms have the new, efficient design, the long-run supply adopted curve for the industry will have shifted downward by $20,000 per trip and each company will again be earningonly a normal At that point, any profit. firm that did not adopt the new propeller design would suffer an economic loss of $20,000 per trip.

The incentive economic

profit in

beauty,

terms

ensures that the long

run.

come to reap up with cost-saving innovations in order of the most powerful forceson the economic Its landscape. of the invisible hand theory, is that firms competition among to

is one

resulting cost savings

will

be passed

along to

consumers in

the

THE DISTINCTION

A SOCIAL OPTIMUM

AND

EQUILIBRIUM

AN EQUILIBRIUM

BETWEEN

DISTINCTION

THE

AN

BETWEEN

AND A SOCIAL

OPTIMUM

The

This

no further

cannot be said

$100

economists on

bill

people own will chapters, the same as fish in

misunderstood to mean

colleague restrains him, younger colleague.\"If

the older economist replies. The No-Cash-on-the-Table Principle

equilibrium. Occasionally a $100 bill first it and picks it up gains spots

earningsprospects quickly. Still, the

No-Cash-on-the-Table

are only three

someunusual

bill on the

perform

better

Principle

ways to earn a big payoff:

sidewalk is

than

or

or training;

talent,

skill,

a big

a lot

can make

person

as

lucky,

of

It tells

us, in

that

effect,

have

hard; to especially be lucky. The person who work

to to

of the investors

many

the stock

whose stocksdo well

finds

whose stocks

achieve

their

gains

the investor Warren through hard work or specialtalent.For example, legendary Buffett, whose portfolio has grown in value at almost three times the stock market for the last 40 years, spends long hours studying annual financial average reports and has a remarkably keeneye for the telling detail. Thousands of others work just as hard yet fail to beat the market averages. It is important to stress, that a market beingin equilibrium however, implies to individuals. It does not imply only that no additional opportunities are available that the resulting allocation is necessarily best from the point of view of society as

a whole.

FOR

SMART

Smith's

interests

no illusion that on his description end which was no

under

was

elaboration an

promote

insight

profound

promotes

Nor

is

it

pursuing

FOR ALL

DUMB

ONE,

broader

the

was that the individual pursuit of self-interest often of society. But unlike some of his modern disciples, this is always the case. Note, for example, Smith's of the entrepreneur led by the invisible hand \"to

part

the

interest he when

he

of

his

intention\":

for society

worse

always

his own

effectivelythan

really

it was

that

Smith

was

well

aware

that the individual

that

promotes

frequently

no part of of society

it. By more

promote it. [Emphasis

intends to

added.]

pursuit of

self-interestoften

does

not

interest. In Chapter 3 we citedactivities that society's generate environmental pollution as an example of conflicting economicinterests,noting that in those circumstances behavior for one but dumb for may be describedas smart in all. As the following levels of investment example suggests, extremely high coincide

earnings

Equilibrium

un-

is in

market

the

by purchasing

money

is important.

simply

are

Other investors

average.

are any

there never

lie on the sidewalk, and the person a windfall. Likewise, when a company's must be the first to recognize the

somebody

improve,

that

and

opportunity,

that

are none when

does

who

Smith

a

be a $100 bill.\" would have picked it

someone not

means

is told

can't

\"That

saying, it were,

that there

but

opportunities,

exploited

Adam

Equilibrium

to be a economiststoops to pick

When the younger

sidewalk.

by now,\"

there

a

that

to exploit. For example, the story opportunities to lunch when they spot what appears way

their

the

on

lying

bill, his older not?\" asks the

the

\"Why up

such

anyone,

Principle is sometimes

No-Cash-on-the-Table are never any valuable

of two up

in later

see

owned by

are not

that

that

resources

will

a market individuals.

waters.)

The there

prices of (As we

value.

economic

resources

of

opportunities

that the market

implies

principle

eventually reflect their

international

Principle tells us that when for gain are available to

or No-Cash-on-the-Table,

Equilibrium,

reaches equilibrium,

with

forecasts

also

can be

smart for one, dumb

for

all.

195

CHAPTER7

196

EFFICIENCY,

Are

many\" smart

\"too

there

Stock analysts

use

INACTION

HAND

INVISIBLE

7.2

Naturalist

Economic

The

4T

AND THE

EXCHANGE,

people

forecasters?

earnings

corporate

models to

mathematical

complex

as

working

forecastcorporate

more

earnings.The

the models become. models,the more accurate reliable forecast sooner than others can reap a Thus, the analyst windfall to rise. Given the speed with which stock by buying stocks whose prices are about the results of even the second-fastest however, prices respond to new information, model use. Individual stock analysts forecasting may come too late to be of much thus face a powerful incentive to invest more and more money in their the fastest forecast. Does this incentive models, in the hope of generating

analysts invest

of these development whose model produces a

the

in

in the

result

to

analysts spent

someone's

model that

proper

on

their

the

produce

forecast

forecasting

models?

models, and

forecast,

winning

be devoted

otherwise

might

in

is of little speed of forecasting interests suffer little when the price If all level a few hours more slowly.

less money still

would

to

fine-tuning

the

the

models

valued uses. Yet if any one individual spends the winning forecast will not be his. The invisible hand went awry in the situation just described because the benefit of an investment to the individual who made it was larger In later than the benefit of that investment to society as a whole. In chapters we will discuss a broad class of investments with this property. the efficacy of the invisible hand on the extent to general, depends in the which the individual costs and benefits of actions taken with the respective costs and benefits of those actions marketplacecoincide to society.Theseexceptionsnotwithstanding, some of the most powerful forces at work in competitive markets clearly promote society's

(D^ffltwr Investment great

after

banking allP

more

to

put

less, he can

that

its

to

moves

stock

resources could be

Dad.

of investment

society

of a stock

{
level

some point, increased as a whole, whose

Beyond benefit

socially optimal

be

sure

interests.

wasnH

MARKET EQUILIBRIUMAND EFFICIENCY as fair. Nor

regard

people

by themselves

cannot

markets

Private

neighborhoodsfor

can they

guarantee an income distribution that

ensure

clean

most

highways, or safe

air, uncongested

all.

all successful societies, markets are supplementedby active in at least some instances. We will almost always achieve our if more we know what tasks markets can do well, and then goals effectively private allow them to perform those the that markets Unfortunately, discovery cannot solve every problem seems to have led some criticsto that In virtually

politicalcoordination

tasks.

markets

has they

cannot

solve

any attempts suited. ideally

prompted are

Our task

in

the market. We

generate

the

attempts

sired

to

this

section

will

explore possible

largest

interfere

will be to explore why tasks are best left to many the conditions under which unregulated markets economic surplus. We also will discuss why

market

with

consequences. As noted in Chapter

conclude

problems. This misperception is a dangerousone becauseit to prevent markets from even those tasks for which doing

lead to

unintended

and

unde-

mere fact that markets coordinate the production of and services is reason to at them. goods enough marvel and other externalities like the ones discussedin the

3, the

a large and complexlist of But in the absence of pollution

outcomes often

THE DISTINCTION

make an even stronger claim\342\200\224namely,

economists

section,

preceding

produce these goods,but

not only

The term

also

produce

use

as economists

efficient,

AN

BETWEEN

it,

has

them as efficiently a narrow technical

EQUILIBRIUM AND A

that

say that market

197

markets

as possible. meaning. When price and

this: If equilibrium is efficient,we mean simply take other than their a transaction that will make values, quantity anything equilibrium at least some peoplebetter without others can be This off harming always found. of is also known as Pareto after Vilfredo Pareto, conception efficiency efficiency, the nineteenth-century Italian economistwho introduced it. in this sense? The answer is that efficient it is always Why is market equilibrium to construct an that some without others possible exchange helps harming whenever a market is out of equilibrium. Suppose,for example, that the supply and demand curves for milk are as shown in Figure 7.11 and that the current price of milk is $1 per gallon. At that sellers offer price, only 2,000 gallons of milk a day. At that the values an extra quantity, marginal buyer gallon of milk at $2. This is the price that to a on the demand which represents 2,000 gallons curve, corresponds day what the marginal buyer is willing to pay for an additional gallon (another applicationof the vertical interpretation of the demand curve).We also know that the cost of producingan extra gallon of milk is only $1. This is the price that corresponds to 2,000 gallons a day on the supply curve, which equals marginal cost (another of the vertical interpretation of the supply curve). application we

SOCIALOPTIMUM

efficient

(or Pareto

a situation

is efficient

is possible that

people

will

without

efficient) if

help

harming

no change

some others

FIGURE7.il 2.50

A

| 2.00h -M

8

In this

loo

h

12

3 (1,000s

Quantity

per 4

5

of gallons/day)

a price of $1 per gallon leadsto excess demand of 2,000 gallons milk as they which means that frustrated cannot as much per day, many buyers buy want at the going price. Now supposea supplier sells an extra gallon of milk to the most eager of these buyers for $1.25, as in Figure 7.12. Since the extra cost gallon to the seller is better off than before. And since the most $0.25 only $1 produce, eager buyer values the extra gallon at $2, that buyer is $0.75 better off than before. In sum, the transaction creates an extra air! $1 of economic surplus out of thin Note that none of the other buyers or sellersis harmed this transaction. by Thus, milk selling for only $1 per gallon cannot be efficient.As the following Concept Check 7.3 illustrates, there was nothing about the price of $1 per gallon. special Furthermore,

price),

price below $1.50 per gallon (the a similar transaction, which means that design $1.50 per gallon cannot be efficient. sells

milk

if

price less than

for any

market selling

equilibrium milk for any

CONCEPTCHECK7.3 In

7.1 I, suppose

Figure

transaction

without

that

causing

will

harm

that

create

milk

initially

additional

to anyone

Price

Equilibrium

market, milk is selling for $ I per gallon, $0.50 below the equilibrium price of $ 1.50 currently

0

we can

in Which

Level.

1.50

0.50

Indeed,

Market

Is Below the

else.

sells

economic

for 50

cents per

surplus for

both

gallon.

buyer

a

Describe

and

seller

gallon.

198

7

CHAPTER

EFFICIENCY, EXCHANGE, AND

THE INVISIBLE

INACTION

HAND

7.12 How Excess Demand FIGURE

Createsan for a

Opportunity

Surplus-Enhancing

Transaction. At

price of $ I

a market

most

gallon, the

is willing to additional gallon, a seller can produce

dissatisfied

buyer

$2 for an

pay

which at

per

intensely

a cost

of only

$ I. If

this

buyer pays the seller $ 1.25for the extra gallon, the buyer gains an economic surplus of

$0.75and

the

economic

surplus

seller gains an of $0.25.

Furthermore, surplus

additional

it

is

to describe

possible

always

for both buyer and

market equilibrium level. Suppose,for

seller whenever

a transaction that

that

example,

the

price

the current

will

create

lies above

the

price is $2 per

7.13. At that price, we have excess the most dissatisfied sells a supply 2,000 gallons per day. Suppose producer milk of for to the who values it most This $1.75 gallon buyer highly. buyer, who would have been willing to pay $2, will be $0.25 better off than before. Likewise the producer, who would have been willing to sell milk for as little as $1 per will gallon (the cost of production at 2,000 gallonsper day), be $0.75 marginal better off than before. As when the price was the new transaction $1 per gallon, creates $1 of additional economic without other surplus harming any buyer or seller.Sincewe could design a similar surplus-enhancing transaction at any price above the equilibrium level, sellingmilk for more than $1.50 per gallon cannot

gallon

in

the

milk

in Figure

shown

market

of

be efficient. The

clear

why

vertical only

the

supply and demand curves

of the

interpretations equilibrium

price

can be

a market

in

efficient. When

FIGURE 7.13

How ExcessSupply an Opportunity

Creates

for a Surplus-Enhancing

Transaction.

At

price of $2 per sellers can

a market

gallon,

dissatisfied

produce an

additional

of milk at a

cost of only

gallon $ I,

which is $ I less than a buyer would be willing to pay for it. If the buyer pays the seller $ 1.75 for an extra gallon, the buyer gains an economic surplus of

$0.25and

the

seller gains an

economic surplus of $0.75.

2.50

\\-

? 2.00 c*

\\

\\^_T^\" _/ X

l\\X

1-75

-M 1.50 g

1.00

s\302\260-

/

0.50

0

X

:

< xX

s> \\X

<& \\mS

/ X1 i

12 Quantity

/l

i

/s

i :

xIX

i

3 (1,000s

i

%

4

5

of gallons/day)

thus the

make price

it is

BETWEEN AN

DISTINCTION

THE

EQUILIBRIUM

AND

in the either higher or lower than the equilibrium price, the quantity exchanged will always be lower than If the the is below equilibrium quantity. price If the price is the sold will be the amount that sellers offer. equilibrium, quantity above equilibrium, the quantity sold will be the amount that wish to buy. In buyers either case, the vertical value on the demand curve at the quantity exchanged, which is the value of an extra unit to buyers, must be larger than the vertical value on the supply curve, which is the marginal cost of producing that unit. So the market equilibrium price is the only price at which buyers and sellers

market

cannot design a surplus-enhancingtransaction.The leads,

limited

specific,

market

to the largest possible total economic words, free markets are said to produce and sense,

other

in

price

equilibrium

In this

surplus. distribute

goods

and

services efficiently.

in this to claim that market equilibrium is always efficient even is an overstatement. The claim holds only if buyers and sellers are well informed, if markets are perfectly competitive, and if the demand and supply curves certain other restrictions. For example, market equilibrium will not satisfy if the individual be efficient cost curves that add up to the market marginal curve fail to include all relevant costs of the product. Thus, as we supply producing saw in Chapter the true cost of will be than indicated 3, expandingoutput higher if the market curve that harms others. by supply production generates pollution The equilibrium output will then be inefficiently large and the equilibrium price Actually,

limited sense

low.

inefficiently

Likewise, market equilibrium will not be efficient if the individual demand that make do not capture all the relevant up the market demand curve benefits of buying additional units of the product. For instance,if a homeowner's to pay for ornamental shrubs is based only on the enjoyment she herself willingness from and not on benefits that accrue to her them, gains any may neighbors,the market demand curve for shrubs will understate their value to the neighborhood. curves

The equilibrium market price for We

relevant

limited

be inefficiently

will

and the

in later chapters. market imperfections in greater detail attention to perfectly competitive markets whose curves all relevant benefits and whosesupply curves all capture capture in the costs. For such goods, market equilibrium will always be efficient sense described earlier.

that market

fact

to be

feature,

samething

as

a price of

$1.50

for

small

inefficiently

our

confine

Efficiency Is Not the Only The

be

will

low.

up such

take

will

For now, we will demand

shrubs

of ornamental

quantity shrubs

per

children

their

equilibrium maximizes economicsurplus

sure. Bear in \"good.\"

Goal

mind,

that

however,

For example, the market gallon, yet many poor families

at that price. Still

childrento sleep.

others

may

attractive

an

is

\"efficient\" does

not mean the

may be in be unable

equilibrium at to afford milk

milk

for

may not

have

even

a place

for their

on predeterminedattributes of buyers and and so on. the incomes, tastes, abilities, knowledge, Through combined effects of individual cost-benefit decisions, these attributes rise to the give in If and demand curves for each an we are supply good produced economy. in concerned about the distribution of attributes like w e should not income, inequality be surprised to discover that markets do not always yield outcomes we like. Most of us could agree, for example, that the world would be a better one if all had income to feed their families The claim that people enough adequately. equilibrium in the market for milk is efficientmeans simply that taking people's incomes as given, the resulting allocation of milk cannot be altered so as to help some Efficiency

is a

concept

that is based

sellers\342\200\224their

people

without

To this

rightly

point

at the same time harming a critic of the market

others.

system

might

out, imposing costson others may

respond: be

So what? As

justified

if doing

such

critics

so will help

A SOCIAL OPTIMUM

199

200

CHAPTER

7

EFFICIENCY,

AND THE

EXCHANGE,

with sufficiently

those

would prefer to

controlson home heating been

of social

oil.

no action at

to take

in

the

these

of oil

price

Why Efficiency Should

market

Efficiency

possibleto generateadditional gain things

price had

alternative

in

name

the

transactions

it

is a

economic

end

desirable fullest

in equilibrium

remain available

for gain

on-the-Table

surplus is to gain

reaching that would

a market

more

of the

no

additional

buyers or forces powerful

is out

It is

it

always

of

resources we

need

EFFICIENCY

AND

individual

because

extent.

opportunities

sellers. The No-Cashthat help push

But even if all markets are in equilibrium, the of resources neednot be socially optimal. to socially optimal when the costs or benefits in the market differ from those experiencedby

equilibrium.

allocation

resulting

be

not

Equilibrium will individual

participants

society

as a

A market

whole.

in

is said to be is possible that

equilibrium

no reallocation

meaningthat

is one in which to

describes

Principle

toward

from

but

itself,

possible

when

surplus

in

SOCIALOPTIMUM, EQUILIBRIUM,

A market

be a

must

there

that

market

the

Goal

additional economic we want to do.

RECAP

markets

clear

makes

efficiency

other goals to the

all our

achieve

to

equilibrium. To

policymakers

by imposing

Be the First

not because

is important

to do the

the

let

than

justice.

The economist'sconceptof

us

1970s

agree that if the have been justified

better alternative policy.Pricecontrolson oil prevent equilibrium, and as we've seen,that means forgoing benefit some without people harming others.

enables

American

late

the

most people

example,

dollars rather

terms, in

of us might controls might

Many price

all,

their tax

with

Arguing

in responded to rapid increases

For

demands.

unmet

shelters

to death.

freeze

homeless

important

homeless

fund

INACTION

HAND

INVISIBLE

efficient, or Pareto efficient, will

some people

benefit

without

others.

harming

a market is not in equilibrium\342\200\224because price equilibrium levelor belowit\342\200\224thequantity exchanged

When

the equilibrium level. At in

made

unit

additional

both

which

such

buyer and

a quantity,

seller benefit

is either above the is always less than

a transaction from

the

can always

exchange

be

of an

of output.

when surplus in a market is maximized exchange is \"efficient\" price. But the fact that equilibrium in this sense does not mean that it is \"good.\" All markets can be in equilibrium, yet many people may lack sufficient income to buy even basic markets to reach equilibrium is goods and services. Still, permitting when economic to because, important surplus is maximized, it is possible pursue every goal more fully.

Total economic at

occurs

THE

COST

PRICE

the

equilibrium

OF

PREVENTING

ADJUSTMENTS

PRICECEILINGS During

1979,

of home heating this sudden

in oil supplies from the Middle East caused the price more than 100 percent. Concernabout the hardship in increase would on families northern states led price impose poor an interruption oil to rise by

COST

THE

to imposea priceceilingin

the government

price ceilingprohibited

sellers

from

market for home heating oil. This more than a specified amount for

the

charging

The following example illustrates why well intended, was a bad idea. though

imposing

A

waste

much the

Suppose

7.14,

Figure

does a

ceiling on heating

a price

Price

Ceiling

on

oil,

Oil

Heating

price ceiling on heating oil cause?

demand and supply curves for home heating oil are in which the equilibrium price is $1.40pergallon.Suppose

as shown that,

in

at that

price, many poor families cannot heat their homes adequately. Out of concern for the at $1 per gallon. How much poor, legislators pass a law setting the maximum price lost economic cost society? surplus does this policy

Consumer

0

=

$9007day

12

3

surplus _S

4

(1,000s

Quantity

5

8

of gallons/day)

FIGURE 7.14

EconomicSurplus in Home Heating Oil. For

the

supply and

price of home

an

Unregulated

demand curves

shown,

Market the

for

equilibrium

1.40 per gallon and the heating is 3,000 equilibrium quantity gallons per day. Consumer is the area of the shaded triangle ($900 per surplus upper Producer is the area of the lower shaded day). surplus oil is $

triangle (also $900 per day).

If this total economic surplus without controls. price will be sold at a of $1.40 3,000 regulated, gallons per day price per is the area of the 7.14, the economic surplus receivedby buyers Figure shaded triangle.Since the height of this triangle is $0.60 per gallonand

First, market gallon.

let's

calculate

is not In

upper its

PRICE ADJUSTMENTS

oil.

heating

How

OF PREVENTING

base

($0.60/gallon)

is 3,000

gallons per day, its area is equal to (1/2)(3,000gallons/day) received is the per day. The economicsurplus by producers

= $900

EXAMPLE 7.6

201

202

CHAPTER

7

THE INVISIBLE

EFFICIENCY, EXCHANGE, AND

INACTION

HAND

2.00

/

c

^c 1.80

/S

/X

5 1-60 re

Lost ecomomic = $8007day

/TyQ^^jf

1.40

S

/ Consumer surplus = $9007day

surplus

1/A/2JS^\342\200\224-

V

1.20

T

0.

Producer 1-00

^^D

=

surplus

$IOO/day

0.80

I

I

I

4

3

12

0

8

of gallons/day)

(1,000s

Quantity

5

FIGURE 7.15

The Waste By

limiting

Caused

output

by Price in the home

Controls. heating

to 1,000gallons

oil market

per day, price controls causea lossin economic $800 per day (area of the lined triangle).

surplus

of

lower shaded triangle. Sincethis triangle also has an area of $900 per in this market will be $1,800 day, surplus per day. If the price of heating oil is prevented from rising above $1 per gallon,only 1,000 gallons per day will be sold and the total economic surpluswill be reduced the area of the lined triangle shown in Figure 7.15. Since the height of this by is and its base is 2,000 gallons per day, its area is $0.80 triangle per gallon = Producer falls from $800 (l/2)(2,000 gallons/day)($0.80/gallon) per day. surplus market to the area of the lower shaded $900 per day in the unregulated triangle, or (1/2)(1,000 gallons/day)($0.20/gallon) = $100 per day, which is a loss of $800 per day. Thus, the loss in total economic surplus is equal to the loss in which means that the new consumer surplusmust be the same producersurplus, as the original consumer surplus.To verify note that consumer this, surplus with the price is the area of the shaded which is $900 ceiling upper figure, again per day. To compute this area, first split the figure into a rectangle and a triangle.) (Hint: the home heating oil market from By preventing reaching equilibrium, price controls waste of producer $800 surplus per day without creating any additional surplus for consumers! of the

area

economic

total

CONCEPTCHECK7.4 In

Example

price

For

is a

ceiling had been

several

reasons,

much

set not

that

level.

For

are

sold

total

would

at

$

I

but

the reduction

conservative estimateof

equilibrium day

7.6, by how

in

economic at $

total

surplus

1.20 per economic

have been

reduced if

the

gallon?

surplus

shown

in

Figure

7.15

by attempts to hold price below its one thing, the analysis assumes that each of the 1,000 gallons per in this market will end up in the hands of the consumers who value the

waste

caused

THE COSTOF PREVENTING

PRICE

203

ADJUSTMENTS

them most\342\200\224inthe diagram, those whose reservation pricesare above $1.80 per gallon. will want But since any buyer whose reservation price is above $1 per gallon to buy at the ceiling price, much of the oil actually sold is likely to go to buyers whose reservationprices are below $1.80. Suppose, for example, that a buyer whose reservation was made it into the line outside a oil $1.50 price pergallon heating supplier just ahead If of a buyer whose reservation was each had a $1.90 price per gallon. buyer 20-gallon tank to fill, and if the first buyer got the last of the available oil, then total surplus day's if the oil had gone to the would be smaller second by $8 that day than buyer. A second reason that in surplus shown in Figure the reduction 7.15 is likely to

be an underestimate is that shortages typically prompt buyers to take costly actions to enhance their chances of being served. For example, if the heating oil distributor its available at 6:00 several a.m., many buyers may arrive begins selling supplies hours early to ensure a placenear the front of the line. Yet when all buyers incur the cost of arriving no one gets any more oil than before. earlier, the fact that reducetotal economicsurplus, Notwithstanding price ceilings

defenders controls are justified because they enable at least might argue that some low-income familiesto buy heating oil at affordable prices. Yes,but the same could have been accomplishedin a much less costly way\342\200\224namely, objective by the to buy heating oil. giving poor more income with which It may seem natural to wonder whether the poor, who have limited political can to receive income transfers that would enable them to heat power, really hope their homes. On reflection, the answer to this question would seem to be yes,if the alternative is to impose price controls that would be even more costly than the income After the as ends all, transfers. price ceiling implemented up costing heating oil their

sellers $800 per day

someamount

less

in

than

The additional more beneficial to the

of controls.

economic

lost

$800

a day

tax

in

revenue

surplus. So

they

additional

taxes

could

finance

to be willing ought in order to escape the income transfers that

to pay

burden would

poor price controls. This point is so important, and so often misunderstood by voters and will Think that we it it another of the economic policymakers, emphasize by putting way. from a market as a to be divided the various market surplus pie among the of total economic 7.16(a) $1,000 per day participants. Figure represents surplus in the home heating oil market when the government available to participants limits the R of oil to We divided this into two labeled and $1 P, to slices, price per gallon. pie denote the surpluses received by rich and poor participants. 7.16(b) Figure

be far

represents

the

$1,800

home heating rich and

oil

than

per day of total economicsurplus is free to reach its equilibrium

poor participants in

the

same

proportion

when

available

level.This pie is as the pie

in

the

the price

divided

left

of

among

panel.

7.16

FIGURE

the Pie Is

When

Larger,

EveryoneCan Have Bigger Any

policy

that reduces

economicsurplus

is a

opportunity to make everyone

Surplus

with

price

(a)

controls

Surplus

with

and no

income

transfers

price controls

(b)

a

Slice.

better

off.

total

missed

CHAPTER 7

204

EFFICIENCY,

AND THE

EXCHANGE,

The important both

Incentive

O

poor

is this:

to notice

point

and

rich

INACTION

HAND

INVISIBLE

participants

Because the

on the

pie

home heating

in the

oil market

right side is larger, can get a bigger

slice of the pie than they would have had under price controls.Rather than tinker with the market price of oil, it is in everyone's interest to simply transfer additional income to the poor. in mind, supporters of price controlsmay With the Incentive Principle object that income transfers to the poor might weaken incentive to work, and thus people's might prove extremely costly in the long run. Difficult issues do indeedarisein the of for design programs transferring income to the poor\342\200\224issues we will consider in some detail in later chapters. But for now, suffice it to say that ways exist to transfer income without work incentives significantly. One such method is the undermining Earned Income Tax Credit,a program that the of low-income supplements wages workers.Given such programs, transferring income to the poor will always be more efficient

than

their

to boost

trying

standard

living

price controls.

through

PRICE SUBSIDIES

Sometimesgovernments prices of \"essential\"

try

goods

this approach at

taken

total economic

low-income services. France

assist

various points by

A

much

Surplus

per month. The shaded surplus

for

the

in

market

in the

buyers

in

triangle

of

bread

quantity

market would be 4,000,000

in this

would

market.The height

domestic bread

Bread

of

a

Market Without

Subsidy. For

the

demand

since

X.

-a

X

3.00

\302\243

Consumersurplus / .X

=

$4,000,000/month

.Q

**-

v

in the

domestic bread market, no bread is produced

4.00

,0

shown, consumer surplus (area of the shaded triangle) is $4,000,000 per month. This amount is equal to total

economicsurplus

5.00 o rt

curve

World

price

==

_^^^^^^^.^^_ ^^^^^^^^n^^^^^^^^^^~o

$2.00

Q

*E

0.

1.00 ^V

domestically. i

0 Quantity

I

4

2 (millions

6

be the loaves

consumer economic

7.17 represents

Figure

FIGURE 7.17

EconomicSurplus in

for bread?

subsidy?

no subsidy, the equilibrium price price of $2 per loaf and the equilibrium

With world

reduce

imports bread for its population at the world price of $2 per in Figure curve for bread is as shown 7.17, by how in if economic decline this market the surplus government provides

total

will

a $1 per loaf

they

the

demand

domestic

the

that

As

nation

island

small

loaf. If

Economic

subsidies reducetotal economic surplus

much do

By how

are like price ceilingsin

have

example,

price of bread.

the

surplus.

The ImpactofSubsidies on

EXAMPLE7.7

consumers by subsidizing the

and Russia, for

subsidizing

such subsidies

illustrates,

example

following

to

and

D X

8

of loaves/month)

this

triangle

is

THE COSTOF PREVENTING

PRICE

205

ADJUSTMENTS

FIGURE 7.18

The Reduction Economic

5.00 Consumer

c -Q

/

^W

World

u

price

= $2.00

economic maximized

at 4,000,000

loaves

=$l,000,000/month

per

the

for

=

0.

i

0

i

D x

with subsidy

consumingan

of loaves/month)

(millions

triangle.

$2

per loaf,

and its base is 4,000,000 loaves

(l/2)(4,000,000 loaves/month)($2/loaf) can import is perfectly

country

supply

per

month,

area is equal to

so its

$4,000,000 per month. Because the wishes at the world price of $2 per loaf, Because the marginal cost of each loaf of =

as much bread as elastic in this market.

it

sellersis exactly the same as the price buyers pay, producer surplusin this So total economicsurplus is exactly equal to consumer surplus, is month. which, again, $4,000,000per Now that the government administers its $1 per loaf subsidy suppose in bread the world market at $2 per loaf and reselling it in the program by purchasing domestic market for only $1 per loaf. At the new lower price, buyers will now consumenot 4,000,000loaves per month but 6,000,000. Consumer surplus for in the bread market is now the area of the larger shaded triangle in buyers = Figure 7.18: or (l/2)($3/loaf)(6,000,000 loaves/month) $9,000,000 per month, month more than before.The catch is that the wasn't free. $5,000,000 per subsidy = Its cost, which must be borne by taxpayers, is ($l/loaf)(6,000,000 loaves/month) bread to

is zero.

market

$6,000,000per

month. So even market is though consumer surplus in the bread than the net effect of the is to reduce total before, larger subsidy program actually economic surplus by $1,000,000 per month. Another to see why the subsidy reducestotal economic way surplus by that amount is to note that total economic is maximized at 4,000,000 loaves surplus the for which the reservation per month, quantity marginal buyer's price is equal to marginalcost,and that the subsidy induces additional consumption of cost of $2 but 2,000,000 loaves per month. Each additional loaf has a marginal is worth less than that to the buyer (as indicated by the fact that the vertical coordinate of the demand curve lies below $2 for consumption 4,000,000). beyond As monthly consumption expands from to 6,000,000 loaves per 4,000,000 the cumulative difference between the cost of bread and its month, marginal value to buyers is the area of the smaller shaded triangle in Figure which is 7.18, month. $1,000,000 per

This reductionin

from

the

siphoned into

perspective that much

a bonfire.

economic

constitutes

surplus

of participants in

cash out

of

their

bank

pure

waste\342\200\224no

this market, than accounts

buyer's

additional

loaves per month is $1,000,000 per month, the area of the smaller shaded 2,000,000

8

6

4

2

Quantity

X^

marginal

price is equal to marginal cost. The reduction in economic surplus from

i i !

quantity

reservation

/\\

i

month,

which the

S

i

1.00

of

per loaf, total surplus is

economicsurplus

**-


marginal cost

is $2

bread

in total

Reduction

\\^

the

Since

surplus

= $9,000,000/month

XX

o

from

a Subsidy.

4.00 ^

3.00 -

in

Surplus

if

each month

different,

someone

had

and thrown

it

206

7

CHAPTER

THE INVISIBLE

EFFICIENCY, EXCHANGE, AND

How much illustrated

7.5

CHECK

CONCEPT

people

surplus 7.7, had been

market. Subsidy

advocates

give low-income would be willing Logically,

if voters

set at

better

much

a

who

let

transfers

to tolerate subsidies,which are more are willing to support subsidies,they

to supportincometransfers This is not to say that Since they get to buy bread

low-income

to

of $ 1.00?

would be unwilling

to explain

asked

be

must

subsidy, as

bread

the

policy would be to give them buy bread on the

that taxpayers

complain

people income

if

per loaf instead

$0.50

income and then

some additional

lost

would have been

economic

total

in Example

Comparedto a bread subsidy, income

INACTION

HAND

costly should

why

low-

open to

people

than income transfers. be even more eager

persons.

all from bread subsidies. since the subsidy is program financed collected primarily from middle- and upper-income families, by taxes poor families come out ahead on balance.The point is that for the same probably we could do much more to help the poor. Their is that they have expense, problem too little income. The simplest and best solution is not to try to peg the prices of the goods they and others buy below equilibrium levels, but rather to give them some additional money.

profit

Accounting

and

revenue

its

owners.

for economic profit is the invisible hand quest that drives resource allocation in market economies. in which businesses earn an economic Markets profit tend to attract additional resources,whereas markets in which businesses experience an economic losstend If new firms enter a market with to lose resources. economic

the

profits,

right,

that market's

causing a reduction in

supply curve shifts the price of the

to

Prices will continue to fall until economic profits are eliminated. By contrast, the departure of firms from markets with economic losses causesthe supply in such markets to shift curve the left, increasing of the Prices will continue to rise until price product. product.

economic losses are eliminated.In the long run, market forces drive economic profits and losses toward

zero. (LOl, L03) \342\200\242 Economic

input input.

for an portion of the payment that exceeds the reservation price for that If a professional baseball player who is

rent

to

willing

is the

as $100,000 per year he earns an economic rent

for as little

play

$15

paid

million,

$14,900,000per

the

Whereas

year.

is

of

hand

invisible

drives economic profit toward zero over the long because run, economic rent can persist indefinitely the services of players like DerekJeteris replicating individuals

Talented

impossible.

tend \342\200\242 The

prices and

at lower

the

responsible for

(LOl)

no benefit at

reap

poor

SUMMARY

is the difference between a firm's its explicit expenses. It differs from economic which is the difference between profit, revenue and the sum of the firm's explicit and implicit costs. Normal between profit is the difference and economic accounting profit profit. It is the of the resources supplied to a businessby opportunity cost

\342\200\242

the

superior to capture the

economic

rents.

\342\200\242 The

benefit

who

performance

of a

resulting financial

are

businesswill gains as

(L03)

an investment

of

sometimes

its

from

differs

benefit

to an individual to society as a

whole.Suchconflictingincentives may give rise to behavior that is smart for one but dumb for all. hand of the Despite such exceptions,the invisible market works remarkably well much of the time. One

of

the

market social

to

contributions

system's most important is the pressure well-being

innovations. that the resulting to consumers in the

to adopt cost-saving Competitionamong firms ensures creates

get

savings

passed

run. (L04) the

\342\200\242 When

capture producing that

price

supply

all the that

product

and

along

and demand curves for relevant costs and benefits

it

cost long

a product

of

market equilibrium for product, will be efficient. In such a market, if do not equal their equilibrium quantity then

REVIEW

some

least

at

others. (L04) market

\342\200\242 When

underlying of

production

people

or service, the quest for economic not only that existing supplies

than

the

rearranged to others. (L04) harming could be

\342\200\242 The

allocated acrossmarkets

way possible. In any one generated by the market, benefit

results

are

some

equilibrium, the

larger

implies that if

price

economic

is a

surplus

measure

of

(180)

profit

function to

of price (184)

entry

(190)

economic loss

(182)

barrier

(181)

How

per

can

year

a business from his

zero economicprofit? 2. Why did

in 1960?

the

radio

States

repair

shops

now have than

they

(LOl)

3. Why do market not economicrent

forces toward

drive economic zero?

(L03)

the

seek their

that the

the are

have poor far more

poor

income

such

obtain

hand

invisible

the power costly than

(184)

theory

(181) of price

function

rationing

4.

profit but

economists

do

Why

goal

important

5. United

buy,

raise

to

could incomes

(184)

QUESIIOHS

(LOl)

fewer

trying

we

complain

normal profit

(197)

(180)

owner who earns $10 million business credibly claim to earn

cities in

do most

more radiosbut

than

implicit costs (180)

efficient (or Pareto efficient)

REVIEW

1.

why

to imposeregulationsthat income transfers. (LOS)

(191)

costs

who

must explain

transfers

rent

explicit

Those

lack the politicalpower to

economicprofit economic

rich and poor would be of the poor is that difficulty

TERMS

KEY

allocative

levels.

reduce find

both

main

too little income. Rather the prices of the goods they

equilibrium

from

ceilings and grounds

can

we

do better by enacting policiesthat of the poor and then letting prices

surplus.(L05)

markets

schemes

such that

have

control

participants in a market benefit by in it. It is the sum of total consumer participating total surplus and producer surplus in the market. One of the attractive of market equilibrium is properties that it maximizes the value of total economic

accounting

The

a

with

on the

defended

often

which

under

better off.

by which

fullest

slice. (LOS)

policies

subsidies\342\200\224are

alternatives

amount

the

goalsto the

a larger

that they help the poor. But economic surplus, meaning

they

efficiencybecause

that prevent equilibrium\342\200\224such as price or

reaching

someone owns a valuable resource,the market of that resource will fully reflect its economic price value. The implication of this principle is not that lucrative opportunities never but rather that exist, such opportunities cannot existwhen markets are in equilibrium. (L04) \342\200\242 Total

pie, everyone can have

Regulations

Principle

like the

won't

Whenever a market is out of economic pie can be made larger.And

\342\200\242

No-Cash-on-the-Table

we

extent.

possible

resources without people

justice.

of income

enables

in

allocation

social

with

distribution

the

that

so, we should always strive for us to achieve all our other

\342\200\242 Even it

equated

among results produced intersection of the supply and demand curves on that income distribution, even though those are efficient. (LOS)

based

but

buyers,

efficient

most

other

individual

among

also that resources are the

believe

the

by

the

a good

allocated efficiently

Efficiency

If we

not be

should

\342\200\242

people is unjust,

supply and demand curves reflect costs and benefits to societyof the

ensures

profit

can be found that will make better off without harming

a transaction

values,

207

QUESTIONS

efficiency as an policy? (LOS)

emphasize

of public

a senator considering that would increase the policy workers by $100 million per economic of retirees by surplus You

how to

are

economic

outcome

for

everyone?

surplus

of

year but reduce the $1

What additional measuremight you the policy to ensurethat the overall better

a

on

vote

(LOS)

million

per year. with

combine

result

is a

208

CHAPTER

7

EFFICIENCY,

AND THE

EXCHANGE,

INACTION

HAND

INVISIBLE

PROBIEMS

or false:Explain

1. True

Mc

Graw

a.

connect

|economics

never any b. Firms

your mobile

store and

app

an economic

make

can

Jones owns and manages are $5,000.Annual expenses

a cafe in CoUegetown as follows: (LOl, LOl)

whose annual revenue is

download

the Frank: Econ

cost-savinginnovations

2. John

McGraw-Hill

accounting profit when the

run.

short

the

in

there are

that

means

table\"

the

equilibrium.

long-run

can introduce

c. Firms that

or false:(LOl, L04)

statements are true

cash on

opportunities. make no

environments

competitive

market is in

Visit

economic

unexploited

in

profit

the following \"There's no

why

maxim

economic

The

Study

app todayl

$2,000

Labor

500

and drink

Food

100

Electricity

lease

Vehicle

150

Rent

500

Interest

for equipment

loan

on

1,000

John's annual accounting profit.

a. Calculate

b. John couldearn $1,000peryear he prefers to run

as a recycler of aluminum cans. However, he would be willing to pay up to $275 per

In fact,

rather than to

the cafe

run

to

year

cafe.

the

profit? Should John

stay

in

the

recycle.Is the

cafe business?

Refer to Problem 2. (LOl, L03)

a.

the

Suppose

Explain.

b.

Suppose rate of his

of

$1,100per year.

earn

can

John

well as running city of

of normal

salary, each revenue.

of

However,

talented

cafe,

New Orleans

designers

employ

$1,000 the

designer.

much

How

an

won't economic

5. Unskilled working

but

same,

recyclers'

making an economic profit?

199

will

he likes

recycling just as have

cafe

profit?

has 200 advertising

the

earn? What

Jacobs

199

companies,

of which

a year.

$100,000

Paying this

advertising

company

proportion

of

his

annual

salary

will be

for which Jacobs worksbeableto earn

profit?

workers in a in a

and

additional revenuewould the

profit on $500,000 in the 200th company employs Janus Jacobs, an unusually This collects $1,000,000 in revenues becauseof company the

economic rent?

b. Why

as a recycler,

ability at a salary of firms makes a normal

Jacobs'stalent.(L03)

a.

a year

how much

each year to earn a normal

to collect The

remain the

cafe still

Is the

an economic

making

interest John had not had to get a $10,000loanat an annual 10 percent to buy equipment, but instead had invested $10,000 own answer to 2a and 2b money in equipment. How would your

change?

c. If

and expenses

revenues

cafe's

earnings rise to

cafe

Explain.

factory

for

poor cotton-growing regionmust $6,000

a year

and being

a

tenant

choose cotton

between farmer.

can work a

farmer

One

Such farms

cost

of

politician

$20,000 and marketing

yield

motto

elected, his administration

scheme

will

that

a.

market

the

If

long run?

b. Who would would

they

are as

a. The weekly

to tenant

charge

this

policy

and no

industry, how would the short run? In the

long run? How

much

and

demand

shown

in

consumer

the

curves for used DVDs in Lincoln, the following: (L05)

supply

Calculate

diagram.

surplus.

weekly producer surplus.

b. The

c.

by

in the

scheme

the

is

gain each year?

6. Supposethe weekly Nebraska,

of

no

at

farms

in the cotton-growing incomes of tenant farmers in

reap the benefit

if he

irrigation, and marketing

created

the

that

promised

would be unaffected

of cotton

be

the projectaffect

tenant

yields on

cotton

has

a fertilizer,

fund

will

price

new jobs would

people come first\"

is \"working

triple

farmers. (L03)

rents for $10,000 a year. each year. The total nonlabor is $4,000 a year. A local

which

of cotton the cotton

worth

producing

whose

120-acre farm,

maximum

The

weekly

be willing to pay

that producers and consumersin Lincoln would and sell used DVDs in any given week (total

amount

to be ableto buy

economic surplus).

12

10.50 Q

7.50

|

6

Q)

u

*E

0.

2

0

48

18

6

(DVDs/week)

Quantity

succeedsin on

the

persuading

DVDs, on

used

teenagersby policy.

the

Calculate

exorbitant

local

prices.

weekly shortageof

total

from Lincoln High School to impose a priceceilingof $7.50 are taking advantage of suppliers

students

local government

the grounds that

charging

a. Calculate the

b.

6. Supposea coalitionof

to Problem

7. Refer

(LOS)

surplus lost

economic

DVDs

used

that

from this

will result

every weekas a result

of

the

price

ceiling.

8.* The

of

government

price of gallon. where

If Islandians' P is the price

gallons per government's

island nation, imports heating oil at a to citizens at a price of $1 per demand curve for heating oil is given by P = 6 \342\200\224 Q,

Islandia,

$2 per gallon and

a small

makes

it available

per gallon in dollars and year, how much economic surplus

policy?

Denotes more difficult

(LOS)

problem.

Q is the quantity is lost as a result

in of

millions the

of

210

CHAPTER 7

EFFICIENCY,

AND THE

EXCHANGE,

INACTION

HAND

INVISIBLE

to Problem 8. Suppose each of the 1 million Islandian householdshas the curve for heating oil. (LOS) a. What is the household demand curve? b. How much consumer would each household lose if it had to pay surplus $2 per gallon insteadof $1 per gallon for heating oil, assuming there were

9.* Refer

demand

same

no other changesin

household

the

budget?

money saved by not subsidizingoil, by how much could Islandian government afford to cut each family's annual taxes? d. If the government abandoned its oil subsidy and implemented the tax how much would each be better off? by family c. With the

*Denotesmore difficult -

7.1

-

CHECKS

CONCEPT

in the table below, Pudge's accounting shown is now $10,000, the profit difference betweenhis $20,000annual revenue and his $10,000-per-year payment for and supplies. His economicprofit is that amount land, equipment, minus the opportunity cost of his labor\342\200\224again, the $11,000 he could per year have earned as a store manager. So Pudge is now earning a negative economic profit, \342\200\224$1,000per year. As before, his normal profit is the $ll,000-per-year cost of his labor. Although an accountant would say Pudge is opportunity an annual of that amount is less than a normal profit for $10,000, making profit his activity. An economist would therefore that he is an economic say making lossof $1,000 per year. Since Pudge likes the two jobs equally well, he will be better off by $1,000 per year if he leaves farming to become a manager. (LOl) As

Economic profit ( = total

Accounting

revenue

profit

(

= total

\342\200\224

explicit

revenue

Total

($/year)

20,000

explicit

costs

costs

($/year)

($/year) 11,000

10,000

7.2 If

each lane did not move at could reduce his travel time

these

exploit At

a price

Suppose and

sells

Normal (

=

profit

implicit

costs)

costs)

costs)

($/year)

($/year)

10,000

-1,000

about the

same

pace,

switching

simply

by

lane moves at

11,000

lane any driver in a slower to a faster one. Peoplewill about the same pace. (L03)

of 50 cents per gallon, there is excess demand of 4,000 gallons per day. a seller produces an extra gallon of milk (marginal cost = 50 cents) = $2.50) for it to the buyer who values it most (reservation price

$1.50.Both no other

implicit

($/year)

until each

opportunities

\342\200\224

costs

\342\200\224

Implicit

Explicit

revenue

7.3

cut,

problem.

TO

ANSWERS

the

and

buyer

buyers or

additional economic surplusof by the transaction. (L04)

seller will gain

sellerswill

be

hurt

2.50

J 2.00 -M

1.50

^

1.00

\302\260-

0.50

12

0 Quantity

3 (1,000s

4

5

of gallons/day)

$1,

and

ANSWERSTO CONCEPT CHECKS

7.4

As shown surplus

in

the

the new

diagram,

accompanying

per day.

is $200

economic

sur plus = $l,200/day

Consumer

^c 1.80

Ss

16\302\260

=5

Lost ecomomic

-5\302\260

1.40

S

Ar

Q)

surplus

=

$2007day

1.20

T

0.

Producer

\\d

1-\302\260\302\260

^/i

surplus

$400^0.80^

/

i

i

i

I

1

)

1

2

3

4

5

(1,000s


7.5

total

(LOS)

2.00 c

=

loss in

of gallons/day)

$1.50perloaf.

per loaf subsidy, the new domesticpricebecomes shaded surplus is the area of the small triangle in the = (l/2)($0.50/loaf)( 1,000,000loaves/month) $250,000 per month.

With The

a $0.50

new

lost

5.00h o

4.00 in total

Reduction

3.00h World

price

economic surplus

=

$250,0007month

= $2.00

1.50

Domestic

1.00 h

with subsidy

0 Quantity

2 (millions

4 5 6

8

of loaves/month)

price

diagram: (LOS)

21 I

THREE

PART

MARKET

IMPERFECTIONS Smith's frictionless

Adam

abandon

now

We

what happenswhen and firms interact people by a variety of imperfections.Not surprisingly, that served society so well in the perfectly often goes astray in this new environment. focus

Our

or

one

only

in

be on

8 will

Chapter

number of firms

a small

perfectly competitive firms.We

by

often

monopolies

their

of

In

escape

Chapters

differ

see

will

cases

discuss

served

from

those

that,

although

the

that constrain

profits

the two types of

decision

makers confronted

an environmentthat was essentiallyfixed.In however, we

hand

world

competitive

counterparts,

7, economic

I to

plagued

invisible

the

similarities.

important

many

markets

in

how markets served by

will

pressures

competitive

perfectly have

firms

the

world to investigate

in

which

people

9,

Chapter

actions

their

expect

to alter the behaviorof others,as when a firm's decision to advertise or launch a new product inducesa rival to follow suit. Interdependences of this sort are the rule rather than the exception, and we will explore how to take them into account using simple theories of games. In how the allocation of 10, we will investigate Chapter

resourcesis

benefits that

We

accrue

will see

to people

that

activities

when

affected

if

not directly cannot

parties

generate in

involved

easily

another, the self-servingactionsof individuals

costs

or

those

activities.

with

negotiate

lead

one to

will

not

that

buyers and

efficient outcomes.

Although the

invisible

hand

theory

assumes

sellers are perfectlyinformedabout all relevant this options, in In I I is almost never satisfied assumption practice. Chapter we will how basic economic principles can help explore informed individuals and firms make the best use imperfectly

of the

limited

information

they

possess.

CHAPTER

8

Oligopoly,

Monopoly,

LEARNING

and

Monopolistic

After you

Competition

OBJECTIVES

this chapter, to:

reading

be able

should

LOI

among

Distinguish

types of

three

e

imperfectly competiti

>VT_

industries

(monopoly,

oligopoly,

and

monopolistic competition)

competition

imperfect

from perfect

differs

competition.

so

L02

D

five sources

the

Identify

of market

power

describe

and

why

of scale

economies

\\

1

how

describe

and

are the

^v.

most

enduring

of monopoly L03

power.

Apply the

concepts

of marginal Monopoly

almost

sellers

rebate coupon

or endure

to buyers who always offer discount prices some other type of inconvenience.

years

with

the

playing

enormous

economic

In a

perfectly competitive

from

only

cards, which can

two, a deck of Magic Cards cost no more to manufacture profit as cashon the lower prices, so that

The Gathering. To

of Magic:

game

MagicCards,

an

to

marginal revenue to the output level

mail in a

find

be bought

sells for than

upward of

ordinary

play,

the creators of in most stores playing

$10. And

you need a deck of the game. But unlike for only a dollar or since

Magic

cards, their producer

L04

level

Cards

market,

It would

eventually

the

entrepreneurs

entice them to offer cards would sell

would

see this economic

Magic

for

roughly

at slightly their cost of

Cards

cards do. But Magic Cards have beenon production, just as ordinary playing the market for years now, and that hasn't The reason is that the cards happened. are copyrighted, which means the government has granted the creators of the an exclusive license to sell them. game The holderof a copyright is an example of an imperfectly firm, competitive or price setter\342\200\224that is, a firm with at least some latitude to set its own price. The competitive is a price taker, a firm with no influence over firm, by contrast, the price of its product.

from

small

perspective.

society's

L05

Discuss why often

profit-

output

for a monopolist

is too

earns

profit. the

why

Explain

maximizing

profit. table.

maximize

a monopolist's

becameobsessed

around the country

schoolchildren

ago,

available

ordinary

are willing

and

cost

and price that

ome

sources

of the various

firms

offer discounts

to buyers who are to

willing

some

jump

form of hurdle.

L06 Discusspublic that

to

policies

are often applied natural

monopolies.

CHAPTER 8

216

COMPETITION

AND MONOPOLISTIC

OLIGOPOLY,

MONOPOLY,

Our focus in

this

served

by imperfectly

perfectly

competitive

more than could

Cards

markets

which

in

those

served

competitive by salient differenceis the imperfectly to charge ability, under certain circumstances, of production. But if the producer of Magic

cost

its

on the ways from

differ

firms

firms. One

firm's

competitive

will be

chapter

any price or even $100,

charge

it

does

why

wished,

it charge

only

$1,000? We'll see that even though Why such a company may be the only seller of its product, its pricing freedom is far from absolute. We'll also seehow some imperfectly firms to earn an economic even in the competitive manage profit, and even without like long run, government protections copyright. And we'll explore why Adam Smith's invisible hand is lessin $10?

evidence

not

in

served

a world

COMPETITION

IMPERFECT

competitive market is an ideal; the life differ from the ideal

The perfectly

encounter

in

arbitrary,

everyday

texts

Economics

but

structures. are quite

they

markets

actual in

we

degrees.

varying

three types of imperfectly among The classifications are somewhat in analyzing real-world markets.

distinguish

usually

market

competitive

firms.

competitive

imperfectly

by

useful

FORMS OF IMPERFECT

DIFFERENT

COMPETITION perfectly competitive ideal is the pure monopoly, a single firm is the lone seller of a unique product. The of Magic Cards is a pure monopolist,as are producer of electric many providers power. If the residents of Miami don't their from Florida Power and Light Company, buy electricity they Farthest

to

rarget a^acking Oi blowing

an oho AvenantJS a*\302\243hen

\\rpirud

the

from

a market in

which

do without. In different types of imperfect simply

as

gwded tiy ft i0 thai eock crrmt\302\253 fragmwl of vine

Magic

ordinary

playing

to produce?

sell for 10 times as much as cost no more cards, even though they

structure

price setter a firm least some latitude own price pure monopoly

with at to

the

set its

only

supplier of a unique product with no close substitutes

Convenience

an

industry structure in which a large number of firms produce slightly differentiated products that are reasonably close

substitutes

for

one

another

which

oligopoly.

that

are

competitive

perfectly

number

a large

perfect

essentially

another. In contrast,monopolisticcompetition a large

number of

rival

firms

sell products

that in a supply of firms typically substitutes for one is

that are

an

industry

close, but

not

be highly similar in many respects, quite perfect, substitutes. Rival products may but there are always at least some features that differentiate one product from in the eyes of some consumers. Monopolisticcompetition in common another has with perfect competition the feature that there are no significant barriers firms from entering or leaving the market. preventing Localgasolineretailing is an example of a monopolistically competitive The sold different stations be identical in chemical terms, but industry. gas by may nearly a station's location is a feature that matters for many consumers. particular

different

while location

are another most of the products found on any example. Although shelves are also carried by most other the stores, product lists of stores are not identical. Some offer small stocksof rental for example, DVDs, others do And even more so than in the case of gasoline retailing, stores

store's

given

competition

monopolistic

in

Recall from the chapter on perfectly competitive industry,

sell products

many

on two of them

Competition

Monopolistic

Cards

and

are

extremes

We focus

competition.

here: monopolisticcompetition

poeti,

Why do

between these two

not.

important differentiating feature that if a perfectly competitive than the prevailing market price for

is an

Recall more output

at

all. Things

are different

for the

of convenience were

firm

its

product,

monopolistically

stores.

to

charge even just slightly it would not sell any firm. The fact competitive

217

COMPETITION

IMPERFECT

its offering is not a perfect substitute for those of its rivals means that it can a than do and not lose all its customers. charge slightly higher price they But that does not mean that firms can expect to monopolistically competitive in earn positive economic the run. On the because new firms profits long contrary, are able to enter freely, a monopolistically is competitive industry essentially the in If same as a perfectly this competitive industry respect. existing monopolistically firms were earning positive economic profits at prevailing competitive prices, new firms would have an incentive to enter the industry. Downward on prices pressure would then result as the larger number of firms competed for a limited of pool customers.1 As as economic would remained, potential long positive profits entry in a continue and priceswould be driven ever lower. Conversely, if firms that

were

industry

monopolistically competitive

would

the

leaving industry. on pressure

begin

initially

suffering

long

as economic

As

economic losses, some firms losses remained, exit and the

prices would continue.So in long-run equilibrium, firms are in this respect essentially like perfectly monopolistically competitive All expect to earn zero economicprofit. firms: competitive firms have some latitude to vary the prices Although monopolistically competitive in the short run, of their product is not the most decision pricing important strategic A confront. far more issue is how to differentiate their from they important products those of existing rivals. Should a product be made to resemblea rival's as product as Or should the aim be to make it as different as Or should closely possible? possible? firm the strive for something in between? We'll consider these questions in the next chapter, where we'll focuson this type of strategic decision making. upward

resulting

Oligopoly

between perfect competition and pure monopoly lies market is a small number of oligopoly, supplied by large firms. Cost advantages associatedwith size are one of the primary reasons for large as we will discuss is also a pure monopoly, presently. Oligopoly typically consequence of cost advantages that prevent small firms from being able to competeeffectively. In some cases,oligopolistssell undifferentiated In the market for products. wireless for the of service, phone example, offerings AT&T, Verizon, and Sprint are similar. The cement is another of an oligopoly sellingan very industry example undifferentiated The most essentially product. important strategic decisionsfacing in such cases are more likely firms to involve pricing and advertising than specific the continuum a structure in which

Further

along

of

features

their

decisions until In other

product. the

next

Here, too,

in

discussion

of such

and

automobile than

pure

tobacco

industries, oligopolists in the sense that monopolists,

are

features have significant effectson consumerdemand.Many product Ford buyers, for example, would not even consider a Chevrolet, buying few smokers ever switch from Camelsto Marlboros.As with oligopolists

their

long-time

and

we postponemore detailed

chapter.

cases, such as the

more like monopolisticcompetitors differences

the entire

very

undifferentiated products, pricing and advertising are important for firms in these industries, but are those related to so, too,

who produce strategic decisions

specific

features.

product

so important in economic oligopolies, entry profit to zero. Consider,for example, an oligopoly served by two firms, each of which firm earns an economic profit. Shoulda new enter this market? Possibly, currently firm large enough to achieve but it also might be that a third the cost advantages of the two incumbents would effectively flood the market, so low that driving price all three firms would suffer economic losses.There is no guarantee,however, that an oligopolist will earn a positive economicprofit. Because

cost advantages associated is no presumption that

there

(London:

large

and

are usually exit will push

size

Chamberlin, The Theory of Monopolistic Competition (Cambridge,MA: Harvard 1st ed. 1933, 8th ed. 1962), and Joan Robinson, The Economics of Imperfect Competition Macmillan, 1st ed. 1933,2nd ed. 1969).

aSee Edward Press, University

with

oligopoly an in which a

large that

firms

small

substitutes

number

produce

are either

structure

industry

of

products

close or perfect

CHAPTER8

218

MONOPOLY,

see in

As we'll

next

the

to

of the

any

we'll consider the competitive

perfectly competitive

chapter, we'll usethe of types imperfectly competitivefirms. In

three

decisions

strategic

is the competition offer products that the eyes of at least

Monopolistic of small firms

substitutes in

resemble

competitive industries

perfectly

cause economic profits

each

in

monopolist the next chapter,

detail.

MONOPOLISTIC COMPETITIONAND

RECAP

same

term

and monopolistically

oligopolists

confronting

differentiates

is the

firms

of this

duration

the

in greater

firms

characteristic that

the essential

section,

firms from

imperfectly competitive of the three cases. So for

to refer

COMPETITION

AND MONOPOLISTIC

OLIGOPOLY,

to

are

a large

number

entry

and exit

respects, yet not perfect

in many

similar

some consumers.Monopolistically competitive zero

toward

tend

in which

structure

industry

OLIGOPOLY

industries, the

in

that

in

run.

long

in which a small number of large firms is the industry structure entire market. Cost advantages associatedwith large-scale

Oligopoly the

supply

to

tend

operations

or

products

products.

DIFFERENCE

ESSENTIAL

THE

standardized

Oligopolists may produce either

be important.

differentiated

BETWEEN PERFECTLY

AND IMPERFECTLY COMPETITIVE

FIRMS

In

economics

advanced

analysis of subtle differences competitive

more

Far

firms.

the single, common from

their

courses, professors

perfectly

in

the

for our

important

feature

of imperfectly

purposes,however,

be to

will

all imperfectly

focus on

competitive

firms

the perfectly the product,

whereas

that

counterparts\342\200\224namely,

to the

attention

much

of different types

differentiates

that

competitive

generally devote

behavior

elastic demand curve for its a imperfectly competitive firm faces downward-sloping demand curve. In the perfectly competitive industry, the supply and demand curves intersect to determine an equilibrium market price. At that price, the perfectly firm can sell as units as it wishes. It has no incentive to charge competitive many more than the market price because it won't sell anything if it does so. Nor does it have to charge less than the market any incentive price because it can sell as units as it wants to at the market many

competitive

firm

faces

a perfectly

price. The perfectly competitive firm's demand curve is thus a horizontal line at the market price, as we saw in the previous chapters.

By contrast, an

imperfect

a local

if

gasoline

retailer\342\200\224

a

competitor\342\200\224charges

more than its rivals for a pennies of some of its customers may gas,

it. But

others

will

remain,

few

gallon desert

perhaps because

to pay a little extra to they are willing continue stopping at their most convenient

location.

An

firm thus faces a demand

curve.

imperfectly

Figure

contrast between the If

the

station at State and Meadow per gallon, would all its customers

Sunoco

3 cents

Streets

raised its gasoline prices by

shop elsewhere?

facing

perfectly

competitive

competitive firms.

competitive sloped

negatively

8.1 summarizes demand

and

this

curves

imperfectly

FIVE

OF

SOURCES

POWER

MARKET

219

FIGURE 8.1

The Demand Perfi ectly

competitive

Imperfectly competitive

firm

firm

and Imperfectly

3

Q.

3 o **-

Curves

Perfectly

Facing

Competitive Firms.

D

Market

\302\256

(a)

The

demand

curve

confronting a perfectly

price

*E

competitive

^3

0

0

Quantity

elastic at the (b) The demand

Quantity

(a)

(b)

confronting

firm is perfectly market price, curve

an imperfectly

competitive firm

is

downward-sloping.

FIVE

OF

SOURCES

MARKET

POWER

demand curves are said to enjoy market downward-sloping to their ability to set the prices of their products. A common misconception is that a firm with market can sell any quantity at any power All it can do is pick a price-quantity combination It cannot. on its price it wishes. demand curve. If the firm chooses to raiseits price, it must settle for reduced sales. do some firms have market power while others don't? Since market power Why often carrieswith it the ability to charge a priceabove the cost of production, such power tends to arise from factors that limit competition. In practice, the following five factors often confer such power: exclusivecontrol over inputs, patents and copyrights, confront

that

Firms

power,

a term

refers

that

government licensesor franchises, CONTROL

EXCLUSIVE

economies

of scale,

and network

OVER IMPORTANT

economies.

INPUTS

firm controls an input a single essential to the production of a given product, that firm will have market power. For example,to the extent that some U.S. tenants are to pay a premium for office spacein the country's tallest building, the Willis willing Tower (formerly the Sears Tower), the owner of that building has market power. If

PATENTS

AND COPYRIGHTS

the inventors or developers of new productsthe exclusive give right to sell those products for a specified period of time. By insulating sellers from competition for an interval, patents enableinnovators to charge higher prices to recoup their costs. Pharmaceutical product's development companies, for example,spend millions of dollars on research in the hope of discovering new drug therapies for serious illnesses. The for an drugs they discover are insulated from competition in the United States\342\200\224by government 20 years For the interval\342\200\224currently patents. life of the patent, only the patent holder may legally sell the drug. This protection enables the patent holder to set a price above the cost of production to marginal recoupthe cost of the research on the drug. In the same way, copyrights protect the authors of movies,software, music,books,and other published works. Patents

LICENSES

GOVERNMENT Yosemite

government

Concession

Park. One of the

wilderness

to

run

the

OR FRANCHISES

has an exclusive license from the U.S. Corporation and concession at YosemiteNational lodging operations government's goals in granting this monopoly was to preserve Services

the

character

of the

area to the

And greatest degreepossible.

indeed,

market

raise the losing all

a firm's ability to of a good without its sales

power

price

CHAPTER 8

220

MONOPOLY,

AND MONOPOLISTIC

OLIGOPOLY,

the

cabins

inns and

nicely

the

with

they do

in

ECONOMIES OF When a constant

scale

to

returns

production process have constant returns

is

a to

said

scale

to

all inputs are changed given proportion, output changes by the same proportion if,

when

by a

returns

increasing

to scale (or

economies of scale)a production process increasing

is said

returns

to

if,

when

are changed by a given proportion, output changes by more than that proportion

natural a monopoly monopoly that results from economies of scale (increasing returns

scale)

MONOPOLIES

NATURAL

AND

SCALE

factors of

production, what

to its

happens

If

output?

to exhibit constant returns to scale.If output more than doubles, the production process is saidto exhibit returns to scale, or economies of scale. When production is subject increasing to economiesof scale, the average cost of production declinesas the number of units increases. For example, in the generation of electricity, the use of produced the unit cost of production. The markets for such larger generatorslowers products tend to be served by a single seller, or perhaps only a few sellers, because having a in significantly result that large number of sellerswould higher costs. A monopoly results from economies of scaleis called a natural monopoly. exactly doubles, the

output

firm's

production

process

is said

have

to scale

all inputs

to

by

all its

doubles

firm

Yosemite Concession Services Company blend No neon mar the national as scenery. garish signs park rivals compete for the tourist's dollars.

offered

valley's where

places

COMPETITION

NETWORK

ECONOMIES

brand of dental floss others use, many to us as more peopleusethem.In the case of home videotape recorders, for instance, the VHS format's defeat of the competing Beta format was not its on most explained by superior picture quality\342\200\224indeed, technical Beta was as dimensions, important regardedby experts superior to VHS. VHS won because it to a sales Rather, simply managed gain slight edge on the initial version of Beta, which could not record programs longerthan one hour. Beta later corrected this the VHS lead Although deficiency, proved insuperable. Once the fraction of consumers owning VHS passed a critical threshold,the most

of us

become

much

Although products

reasons

do

for

don't care what more valuable

it became

choosing

and

compelling\342\200\224variety

of tape

availability

rental,

accessto repair facilities, the capability to exchange tapes with and so on. friends, The VHS victory since have now been however, proved fleeting, videotape players all but completely displaced by DVD players and DVRs. A similar network economy helps to account for the dominant of position Microsoft's Windows operating system,which, as noted is installed earlier, currently in more than 80 percent of all personal Because Microsoft's initial sales computers. software a incentive to write for the Windows advantage gave developers strong of available software in the Windows format is now vastly format, the inventory larger

than

that for

any

software such as word multiple

operating

appear

first\342\200\224and

desire

to

achieve

competing processors

operating system. and spreadsheets

systems, specialized often

only\342\200\224in the

compatibility

choosing believed a competing need not be permanent,

if, as

And although general-purpose continues to be available for

professional software

Windows

format.

for file sharing gave in the case of many

and

games

This software

a good people Macintosh Apple

usually

gap and reason

the

for

users, they superior. But, again, network dominance as witnessed by Apple's dramatic resurgence in recent years. far the most and of these sources of market power are By important enduring economiesof scale and network economies. Lured by economic firms almost profit, If find substitutes for exclusive there's to be had always inputs. enough profit by renting out space in this country's tallest building, some real estate will eventually developer build one taller than the Willis Tower in Chicago. Likewise, firms can often evade patent laws by making is only slight changes in design of products. Patent protection in case. few franchises each But temporary, any Finally, governments grant very year. if not completely insurmountable. economiesof scale are both widespread and enduring, even entrenched network economies can be as persistenta sourceof natural Firmly as economies of scale. n etwork economies are essentially similar Indeed, monopoly to economies of scale. When network economies are of value to the consumer, a increases as the number of users s o we can that increases, product's quality say any level can be produced at lower cost as salesvolume increases. Thus given quality Windows,

even

system

was

otherwise

FIVE

economies may be viewed and that's how we'll treat production, network

just

form of

another

economies of

OF

221

POWER

MARKET

in

scale

here.

them

OF

FIVE SOURCES

RECAP

as

SOURCES

POWER

MARKET

power to raise its pricewithout exclusive control of important inputs,

its entire market stems from and patents copyrights, government of or network economies. By far the most licenses,economies scale, important and of these are economies of scale and network economies. enduring A firm's

OF SCALE AND

ECONOMIES

saw in Chapter produced, while fixed fixed costs in the long

As we

costs of this

costs are 6, variable costs are independent run because all

often loom large for in the production

costs start-up costs involved

sort,

marginal cost. A good costs and low variable fixed

definition

production

such

for

equation

OF

IMPORTANCE

in

costs,

= F

this

those that

inputs

in

of the

and

be producedat

as software, whose production entails will be subject to significant economies increases,

+ M*Q, where F is fixed and

illustration), with this

cost,

Q is the level

of

the

a very

fixed

large

of scale.

average

low

start-up

Because

total cost

of

increases.

output

production processfor

are start-up the software. Once

example,

testing

software can

as

are no

But as

for

software,

writing

costs don't increase as output will decline sharply goods

there

a practical matter, a product's useful life.Most of the

of

duration

of output

the level

speaking,

Strictly

be varied.

can

with

vary

of output.

of computer

copies

consider a

To illustrate,

TC

such

the

incurred

costs

one-time

those tasksare done,additional

constant

THE

COSTS

START-UP

by

losing

total cost is given by the is marginal cost (assumed For the output produced. variable cost is simply M*Q, which

M

process simple total cost function, the product of marginal cost and quantity. Average total cost (ATC), is TC/Q, + to M. As cost declines becausethe equal F/Q Q increases, average steadily fixed costs are spread out over more and more units of output. total cost (b) for a Figure 8.2 shows the total productioncost (a) and average firm with the total cost curve TC = F + M*Q and the corresponding average total cost curve ATC = F/Q + M. The average total cost curve (b) shows the decline in cost as output grows. Though average total cost is always higher than per-unit production

FIGURE 8.2 TC= F+ M*Q

^^ sX

0 u

\"c5

For a

u flj

p

\\S^>!\\7C

rag

V

,0

<$

0

M

0

Qo

Total

Economies

firm

total cost

whose

curve of producing

0

\342\200\224^r

a Production

of Scale.



F+M*Q0

Average

Costs for

Processwith

3

ifr

X

/***, \342\200\242V

c

rt V

Total and

0

0

(a)

(b)

=\342\226\240-FIQ+M

Q units of

= F + output per year total cost rises at a M*Q, (a) constant rate as output grows, while average total cost is TC

(b) declines.Average

total

cost is always higher than cost for this firm, marginal the difference significant

but

becomes less

at high

output levels.

222

CHAPTER

8

MONOPOLY,

OLIGOPOLY, AND MONOPOLISTICCOMPETITION

grows.

At

firm, the difference betweenthe high levels of output, average total

for this

cost

marginal

extremely

Because the

cost (M).

marginal

As the following

EXAMPLE 8.1

examples illustrate, cost is in

large fixed

how

on

depends

fixed cost per unit

of output,

volume

large

extremely

Economies of Scale\342\200\224Small

the

becomes

importance to marginal

relation

diminishes

cost

out its fixed

is spreading

firm

two

costbecomesvery

as output to

close

over

an

almost insignificant. of economies of scale

cost.

Cost

Fixed

Two video game producers, Nintendoand Playstation, each have fixed costs of costs Nintendo $0.80 $200,000 and marginal of per game. If produces I million units and 1.2 how much lower will million, per year Playstation produces total

PlayStation's average

Table 8.1 summarizes Nintendo.

Even

for the two firms. Note in the cost advantage over of its video game produces 20 percent fewer copies suffer a significant cost disadvantage becausefixed cost categories

relevant

the

row that

bottom

cost be?

production

Playstation enjoys only Nintendo

though

than Playstation, it does not cost is a relatively small part

of

total

a 3-cent

average

production

cost.

Producers

(a)

TABLE 8.1

Costs for Two

Game

Computer

Nintendo Annual

production

Fixed cost Variable

cost

Average

In

the to

relative

EXAMPLE

8.2

1,200,000

$200,000

$200,000

$960,000 $1,160,000

$800,000

Total cost total

Playstation

1,000,000

$1,000,000 cost

next example, cost. marginal

$1.00

per game

note how the

Economies of Scale\342\200\224Large

$0.97

when

changes

picture

fixed cost

looms large

Cost

Fixed

Two video game producers, Nintendoand Playstation, each have fixed costs of costs $10,000,000 and marginal of $0.20 per video game. If Nintendoproduces I million units per year and Playstation produces 1.2million, how much lower will PlayStation's

average

total

The relevant cost categories The bottom row shows that advantage over

Nintendo,

If the video

cost be? for the

two

Playstation

substantially

larger

are

firms

enjoys than

in

now

a $1.67 the

summarized

average

previous

total

in Table

8.2.

cost

example.

the fact that games the two firms produce are essentially similar, can lower and still cover its costs should enable Playstation charge significantly prices it to attract customers away from Nintendo. As more and more of the market goes to its cost will become self-reinforcing. Table 8.3 shows how a Playstation, advantage shift of 500,000 units from Nintendo to Playstation would cause Nintendo'saverage total cost to rise to $20.20 per unit, while PlayStation's average total cost would fall to firm unit. The fact that a cannot survive at such a severe $6.08 per long disadvantage the video market is served now explains why game by only a small number of firms.

FIVE SOURCES

OF

TABLE 8.2

Costs for Two

Game

Computer

Producers

(b)

Nintendo Annual

1,000,000

production

cost

Average total

8.3

Costs for

$10,000,000

$240,000

$200,000

Total cost

TABLE

1,200,000

$10,000,000

Fixed cost Variable

Playstation

cost

|per

$10,200,000

$10,240,000

$10.20

$8.53

game

Two Computer Game Producers (c) Nintendo

Annual

500,000

production

cost

Average total

big

while

Nintendo

An

will

share

$10,340,000

$20.20

$6.08

8.1

be

unit cost advantage

if

it sells

units per year,

2,000,000

200,000?

trend

economic

worldwide

value embodied

of the

in

the

recent

during

goods

is that an

decades

and services

we

from

stems

buy

For example, in 1984 some 80 development. percent of the cost of a computer was in its hardware (which has relatively high in the 20 was its software. But by 1990 those cost); marginal remaining percent werereversed. F ixedcost now accounts for about 85 percent of total proportions in the computer software industry, in a growing costs whose are included products share of ordinary manufactured goods. fixed

investment

$340,000

$10,100,000

per game

PlayStation's sells only

important

increasing

cost

CHECK

How

$10,000,000

$100,000

Total cost

CONCEPT

1,700,000

$10,000,000

Fixed cost Variable

Playstation

in

and

research

The Economic

8.1

Naturalist

does

Why personal

The

fixed investment

the

Intel

But

once

cost

Intel sell

the

of all

majority

overwhelming

microprocessors

used

in

computers?

Core

required to produce a

chip has of producing each the

sells more than

80

new

Mobile microprocessor

\\7 Extreme

been designedand chip

percent

is only

of

all

the

leading-edge runs

pennies. This cost

microprocessors.

upward

manufacturing pattern

such as microprocessor of several billion dollars. facility built, the marginal explains why Intel currently

m

MARKET

POWER

223

CHAPTER

224

8

MONOPOLY,

AND

OLIGOPOLY,

COMPETITION

MONOPOLISTIC

As fixed cost becomes moreand

of many

small

firms,

the important, a small share

more

each producing

only

perfectly competitive pattern of its industry's total output,

becomes less common.For this reason, we must develop a clear senseof how the of firms with market power differs from that of the perfectly competitive firm.

behavior

\342\200\224

I-.

}

/-= -'

i-^Sr

5?

n

OF SCALE

ECONOMIES

RECAP

design,

LLj-

ANDTHE IMPORTANCE OF

COSTS

START-UP

Research,

r*

engineering,

and other fixed costsaccountfor

an

to bring productssuccessfully to market. For costs, marginal cost is lower, often products than total cost declines, often substantially, average total cost, and average sharply, as output grows. This cost pattern explains why many industries are dominated by either a single firm or a small number of firms. share

increasinglylarge

MONOPOLIST

THE

whether

of

Regardless

O

a firm is

basic goal is to maximize as the benefit of doing so cost is also the same for the

that its as long marginal

perfectly

profit-maximizing firm competitive

the perfectly marginal in

results in

total revenue that from a one-unit change

a firm's

output

unit

of

output.

revenue. For the the

market

benefit of

when

competitive firm

is the

expanding output

the change

price selling

a price taker or a its

for a the

revenue the firm cases, this marginal

perfectly

competitive

of the product. an extra unit is

differs

monopolist,

firm,

If that price exactly $6.

will benefit

firm

expands

calculation

the perfectly

monopolist benefits of expanding

additional In both

the

Further,

as for

monopolist

economists

cases, the

the cost.

we look at the and

price setter,

In both

profit.

exceeds

decision

The

revenue

FOR

MAXIMIZATION

PROFIT

Cost-Benefit

of all costs required with large fixed

assume output

of

competitive firm.

from

that output.

of a For both

the marginal benefit of if it sells one additional receive is called the firm's marginal

marginal revenue is exactly equal to is $6, for example, then the marginal

PROFIT

MAXIMIZATION

225

MONOPOLIST

FORTHE

REVENUE FORTHE MONOPOLIST

MARGINAL

for a

is different

monopolist. To

a monopolist, the marginal benefit less than the market price. As the following while the perfectly clear, the reason is that competitive firm as it wishes at the market price, the monopolist can sell an additional unit only if it cuts the price\342\200\224and it must do so not just for the additional unit but for the units it is currently selling. with the demand curve shown in Suppose, for example,that a monopolist 8.3 is currently of output at a price of $6 per unit. What Figure selling 2 units situation

The

of sellingan additional discussion will make can sell as many units

be its

would

is strictly

unit

revenue from selling an

marginal

unit?

additional

8.3

FIGURE

The Monopolist's from

Benefit

Unit. The monopolist shown receives $ 12 per week in

8^ ^^w ^^ +j

^^^

lib\" w \302\260r \\mS

revenue

total

o

u

per week at

^^^D

0.

2

0

This

3

8

In

that

$15 selling

case, the

This monopolist's total revenue from the sale of 2 units week is ($6 per per = week. Its total revenue from the sale of 3 units $12 (2 units week) per per per week would be $15 per week.The difference\342\200\224$3 week\342\200\224is the revenue per marginal from the sale of the third unit each week. Note that this amount is not only smaller than the original price ($6) but smaller than the new price ($5) as well. unit)

CHECK

from 3

marginal

to 4 units

8.2

revenue for per

the

monopolist

week,

in

4 to 5 units

and then from

8.3 as

Figure

it

expands

output

week.

per

in Figure 8.3, a sequenceof is shown monopolist whose demand curve 2 4 to 5\342\200\224willyield to from 3 to and from 3, 4, output\342\200\224from marginal revenue of $3, $1, and \342\200\224 We these results in tabular form $1, respectively. display in Table 8.4. For the

increases

TABLE

Marginal

in

8.4

Revenue

for a

Monopolist ($ per unit) Marginal

Quantity .

,

revenue

2

1

3

3 I

4

-I 5

-

1

third

of $5

benefit

unit

- $12= $3, price

2 units

$6 each. could earn selling 3 units

monopolist

selling the

Calculate

selling

by

a price of

$ 15 per week by per week at a price

(units/week)

Quantity

CONCEPT

Selling

an Additional

of $5.

each.

from

would be

less than

its

CHAPTER 8

226

MONOPOLY,

AND MONOPOLISTIC

OLIGOPOLY,

Note in the table that two

quantity its

expanded

the

Likewise,

of

3 and

$1

marginal

to which they figures 2 units per from output

unit. Strictly speaking,this but to the movement between revenue

COMPETITION

displayed betweenthe For correspond. example,when the firm week to 3, its marginal revenue was $3 per revenue

values are

to neither quantity hence its quantities, placement in the table. in moving firm from 3 to 4 units the earned marginal week, per so that is between the quantities of unit, per figure placedmidway

4, and

so

revenue

marginal

corresponds

those

on.

of quantity, we would plot the marginal revenue as a function 2 for the movement from to 3 units of marginal output per week ($3) at a 2 value of because 2.5 lies between and 3. Similarly, we 2.5, quantity midway would plot the marginal revenue for the movement from 3 to 4 units ($1) per week at a quantity of 3.5 units per week, and the revenue for the movement marginal from 4 to 5 units per week ( \342\200\224 at a quantity of 4.5. The resulting $1) marginal

To graph revenue

revenue

MR,

is shown

in

Figure

8.4.

8.4

FIGURE

in

Revenue

Marginal

Form.

Graphical

Becausea monopolist cut price

to

not

for the

only

curve,

must

an extra

sell

extra

unit,

unit

for all existing units, marginal revenue from the sale of the extra unit is but also

sold

less than its

-1 |-

'MR

price.

selling

8

2-3-.4V5 Quantity

(units/week)

More consider a monopolist with generally, whose vertical intercept is a and whose horizontal 8.5. This monopolist's Figure marginal revenue curve it will be twice as steep as the demand intercept of a, and

intercept will

FIGURE

The

Revenue

Marginal

for a

Curve

Monopolist

a Straight-Line

with

Demand For

8.5

Curve. with the

a monopolist

demand

curve

corresponding revenue vertical

demand

curve intercept curve,

shown, the marginal

has the same as the and

a

horizontal intercept only as large as that of the demand curve.

half

be

not

Q0, but

Q0/2, as shown in

Figure

a

also

will

curve. 8.5.

curve as shown in

demand

straight-line intercept

is Q0,

have a

vertical

Thus,

its horizontal

MAXIMIZATION

PROFIT

Marginal revenue curves

FORTHE

MONOPOLIST

algebraically. If the formula for the formula for its marginal monopolist's bQ, If revenue curve will be MR = a \342\200\224 have had is calculus, this relationship 2bQ. you to but even without calculus can it derive,2 easy you verify by working through a few numerical translate the formula for the demand curve into a First, examples. and then construct the revenue curve diagram, corresponding marginal graphically. from the graph, write the formula for that revenue curve. Reading marginal

the

derived

Having

describe how the case of the

is P

be expressed

=a

\342\200\224

then

DECISION RULE revenue curve, we'renow in a position to

PROFIT-MAXIMIZING

MONOPOLIST'S

THE

can

also

curve

demand

the

marginal

monopolist's

the output level that maximizes As in profit. the Cost-Benefit that the firm, perfectly competitive Principle says should continue to as as the from so monopolist expand output long gain doing exceeds the cost. At the current level of output, the benefit from expanding output is the revenue value that to that level. The cost of marginal corresponds output expanding is the marginal cost at that level of output. Whenever marginal revenue exceeds output firm the should whenever revenue falls marginal cost, expand. Conversely, marginal firm short of marginal the should reduce its is at the maximized cost, output. Profit the

chooses

monopolist

a

Cost-Benefit

cost. for which marginal revenue precisely equals marginal the monopolist's profit-maximizing rule is stated in this way, we can see that the perfectly firm's rule is actually a specialcaseof the monopolist's competitive rule. When the perfectly competitive firm its marginal expands output by one unit, revenue exactly equals the product's market price(becausethe perfectly competitive firm can expand sales by a unit without having to cut the price of existing So units). when the perfectly competitive firm with it is also equates price marginal cost,

level of

output

When

cost. marginal revenue with marginal the two cases concerns the calculation

equating between

is the

What

profit-maximizing

monopolist's

Considera monopolist with 8.6.

Figure

If this

demand

the

the

is the

revenue.

Marginal

Revenue

cost curves

shown in

output level? and

marginal

level of

profit-maximizing

S 6 V ^w 0

**-

0

I3

0.

^s

^V

+J

^v

^ ^^

w Q u

output?

^ ^_

^s^ i i

i

12

MC

At

the

of 12 equals

^v

greater

_N*

24

marginal

marginal revenue than

TR = PQ

who have had an introductory course in calculus, of total revenue with respect to output. If P = a = aQ bQ2, which means that MR = dTR/dQ

-

is always

price than

marginal

means this

revenue,

must be less

cost, which monopolist

should produce

those derivative

for

current output level units per week, price cost. Since the marginal

monopolist's

\\D \\

Quantity (units/week)

2For

Curves

Cost

a Monopolist.

.^^X.^v.^V

v^

0

v^

v^ v\"^

and

Demand

Marginal

^w

it expand

8.6

FIGURE

+J

should

week,

per

The

3 Q. ^

difference

significant

only

of marginal

producing 12 units

firm is currently

or contract production?What

Thus,

less.

marginal revenue can be expressed as the bQ, then total revenue will be given by

\342\200\224

= a - 2bQ.

EXAMPLE 8.3

227

228

CHAPTER

8

MONOPOLY,

OLIGOPOLY, AND MONOPOLISTICCOMPETITION

8.7

FIGURE

The Monopolist's

Profit-

Maximizing Output This

profit which

8 units

selling

by

week, the

Level.

maximizes

monopolist

per

level at

output

revenue

marginal

cost. The equals marginal profit-maximizing price is $4 per unit, the price that to the profitcorresponds on the maximizing quantity

demand curve.

8.7, we begin by

In Figure corresponds

to

the

monopolist's

demand curve, and its horizontal marginal

cost of

$3 per

an

firm

per

This

unit.

production until level of 8 units output will charge $4 per unit,

contracting at

units

per

week.

the

price

demand curve.

week

monopolist revenue

marginal

marginal

has the

revenue curve

that

as the intercept as large. Note that the is zero, which is clearly less than its will therefore earn a higher profit by same

vertical

is half

intercept

at 12

revenue

monopolist's marginal

the

constructing

demand curve. It

equals marginal cost, which occurs At this profit-maximizing output level, the that corresponds to 8 units week on the per

CONCEPTCHECK8.3 For

the

with the

monopolist

maximizing

price

and

level

demand and

cost

marginal

curves

shown,

find

the

profit-

of output.

8 E

6

2

4

2

0

0

A

BEING

MONOPOLIST

6

8

(units/week)

DOESN'T

GUARANTEE

AN ECONOMIC PROFIT be greater price for a monopolistwill always cost providesno assurancethat the monopolist will earn an economic for example, the long-distance telephone service provider Consider, profit. whosedemand, cost curves are revenue, cost, and average total marginal marginal shown in Figure This maximizes its 8.8(a). monopolist daily profit by selling 20 million minutes per day of calls at a price of $0.10 per minute.At that = less than the company's MC, yet price is $0.02 per minute quantity, MR average The

fact

that

than marginal

the profit-maximizing

INVISIBLE HAND

THE

WHY

BREAKS

DOWN

229

UNDER MONOPOLY

FIGURE 8.8 Even

loss

Economic

= $400,000/day

Economic

^ 1

ATC

= $400,000/day

maximizes

^
\\

i

20

(millions/day)

(a)

(b)

$0.12 per minute.As a result, the company sustains an economic loss minute on all calls provided,or a total loss of ($0.02 per minute) = (20,000,000 minutes per day) $400,000 per day. The monopolist in Figure suffered a loss because its profit-maximizing 8.8(a) was lower than its ATC. If the monopolist's profit-maximizingprice price exceedsits average total cost, however, the company will, of course, earn an economic profit. Consider, for example, the long-distance provider shown in Figure 8.8(b).This firm has the same demand, marginal revenue, and marginal in Figure 8.8(a). But because cost curves as the firm shown the firm in (b) has lower fixed costs, its ATC curve is lower at every level of output than the ATC in (a). At the profit-maximizing curve price of $0.10 per minute, the firm in Figure 8.8(b) earns an economic profit of $0.02 per minute, for a total economic profit of $400,000 per day. of

$0.02

per

Both the

perfectly

choosing

the output

FORTHE

MAXIMIZATION

PROFIT

RECAP

firm

competitive

level at which

MONOPOLIST

and the monopolist revenue

marginal

maximize profit marginal

equals

But whereas marginal revenue equalsthe market price for the perfectly it is always less than the market price for the firm, monopolist. if price exceeds average monopolist will earn an economic profit only cost at the profit-maximizing level of output.

by

cost. A

competitive

THE INVISIBLE HAND

WHY In our

we saw

discussion of equilibriumin were

explore

whether

competitive

under

conditions

firms

consistent the

BREAKS DOWN

output

which

in Chapter 7, of consumers and pursuits markets

competitive

perfectly

the self-serving

with the broader interests of same conclusion holds true for

as a

society the

case

whole. Let's

of imperfectly

firms.

the monopolist level efficient from

Consider

the

total

MONOPOLY

UNDER

corresponding

price

on

in

Figures

8.6

and 8.7.

Is this

firm's

profit-maximizing

society's point any given level of output, the demand curve indicatesthe amount would buyers of

view?

For

per day process. Because the

this

economic

cost of

total

the

ATC,

(millions/day)

economic

loss of $400,000

monopolist

\\MR

Minutes

its profit by selling per day of

in

in

price of the

profit-maximizing

\\d

\\

20

\\MR

^v

\\

:

Minutes

MC

X

Loss.

(a)

minutes

calls but suffers an

ATC

\\

May

in

monopolist

20 million

0.05 \302\243

MC

The

0.10

I 0.08 0.05 \302\243

a Monopolist

Suffer an Economic

profit

(b) exceeds

monopolist profit.

earns

an

230

8

CHAPTER

MONOPOLY,

OLIGOPOLY, AND MONOPOLISTICCOMPETITION

to pay for an additional unit of output. When the monopolist is the benefitto unit of output week, per marginal society of an additional is thus $4 (see Figure 8.7). And since the marginal cost of an additional unit at that would gain a net benefit of 8.7), output level is only $2 (again, see Figure society unit above the $2 per unit if the monopolist were to expand production by one level. Because this economic is not realized, the profitprofit-maximizing surplus be

willing 8 units producing

Recall

be. If that is so, answer is that the

it might

than

production? The

some way to

units. As

the

maintain

a practical

matter,

Now, let's look at

this

means

of inefficiency

existence

the

that

inefficient.

is socially

monopolist

maximizing

doesn't

why

the

the

that

price

however,

that

from

situation

units

is not

always

a different

only

there

were

of only the extra

the price

cut

and

smaller

simply expand

monopolist

monopolist would gladly do so, if of existing

pie is

economic

possible.

angle. For the

served

market

level of output? by this monopolist, what is the socially efficient At any output level, the cost to societyof an additional unit of output is the same as the cost to the monopolist, namely, the amount shown on the monopolist's cost curve. The marginal benefit to society(not to the monopolist) of an marginal extra unit of output is simply the amount people are willing to pay for it, which is the amount shown on the monopolist's demand curve. To achieve social efficiency, the should until the benefit to society monopolist expand production marginal in 12 the which this case occurs at a level of units week. cost, equals marginal per Social efficiency is thus achieved at the output level at which the market demand

the

intersects

curve

The fact

monopolist's marginal revenue is less marginal

cost curve.

for the monopolist results in a price loss. For the the size of this discussed, deadweight monopolist just deadweight loss is equal to the area of the pale blue triangle in Figure 8.9, which is (%)($2 per unit) = $4 per That is the amount (4 units per week) by which total economic is reduced because the too little. surplus monopolist produces that

than

week.

FIGURE

The

8.9

Deadweight

Loss

from Monopoly. A

loss

results

in economic because

surplus

the profit-

maximizing level of output (8 units per week) is less than the socially optimal level of output week). is

the

(12 units

per

8 12

This deadweight loss area of the pale blue

triangle, $4 per

24

(units/week)

Quantity

week.

a monopolist,

For

marginal

price, the occurs

when

markets. monopoly

perfect against

level.

output

level

is

efficiency.

is less evident competition the law?

This in

difference

monopoly

markets

explains

always

is always

Under

social

cost

marginal

revenue

perfect competition, by contrast, cost marginal equals the market price\342\200\224the same

be satisfied for of the market If

monopolist'smarginal

monopolist'sprofit-maximizing

efficient

socially

profit maximization occurs when

revenue. Since the

why

profit

below the maximization

criterion the

equals less than

that

invisible

than in perfectly

must hand

competitive

efficient and monopoly is not, why isn't in fact, tried to limit the extent of monopoly has, Congress is socially

USING

TO EXPAND THE MARKET

DISCOUNTS

231

laws. But even the most enthusiastic proponentsof those laws the limited usefulness of the since the alternatives to recognize legislative approach often entail of their own. monopoly problems antitrust

through

Suppose, for

that

example,

a monopoly

from manufacturing

somehighly

results from a patent

that

prevents

all

product. society be not because such patents? Probably eliminating protection would innovation. all successful industrial nations grant discourage Virtually some form of patent protection, which gives firms a chanceto recoverthe research and costs without which new productswould seldom reach development the market. Or suppose that the market in question is a natural monopoly\342\200\224one that, because of economies of scale, is most cheaply served by a single firm. Would society do better to require this market to be served small firms, each with by many costs of production? Such a requirement would merely significantly higher average one form of replace inefficiency with another. In short, we live in an imperfect world.Monopoly is socially inefficient, and that, needless to say, is bad.But the alternatives to monopoly aren't perfect

but one firm

better

valued

Would

without

off

either.

INVISIBLE

WHYTHE

RECAP

HAND

BREAKS DOWN

UNDER MONOPOLY

The monopolist revenue

equals

at the output level for which marginal profit cost. Because its profit-maximizing price exceedsmarginal

maximizes

marginal and hence

also marginal cost, the benefit to society of the last unit must be than the cost of the last unit produced price) greater produced level for an industry served by a profit(the marginal cost). So the output maximizing monopolist is smaller than the socially optimal level of output. revenue,

(the

USING

market

DISCOUNTS

TO EXPAND THE

MARKET

\342\200\224

fact that the benefit to the benefit to society. monopolist corresponding From the monopolist's point of view, the price reduction the firm must grant to expand existing buyers output is a loss. But from the point of view of those buyers, in their pockets. each dollar of price reduction is a gain\342\200\224one dollar more in this situation, which is similar to the tension Note the tension that exists in all other situations in which the economic is smaller than it otherwise be. pie might As the Efficiency Principle reminds us, when the economic pie grows larger, everyone can have a larger slice. To say that is inefficient means that steps monopoly If people could be taken to make some people better off without others. harming have a healthy regard for their own self-interest, doesn't someone take those why for doesn't the from the earlier sell steps? Why, example, monopolist examples 8 units of output at a price of $4, and then once those buyers are out the door, cut the for more price-sensitive price buyers? The

PRICE

source

of inefficiency in monopoly of expanding output is

DISCRIMINATION

markets

less than

is the

the

DEFINED

Sometimes the monopolist does preciselythat. Charging different different buyers for the same or service is a known as discrimination. prices good practice price of price discrimination include senior citizens' and children'sdiscounts Examples on movie and rebate on retail tickets, supersaver discounts on air travel, coupons

merchandise.

Efficiency

a

price discrimination

the

practice of charging different different prices for buyers essentially

the

or service

same good

232

CHAPTER

8

MONOPOLY,

OLIGOPOLY, AND MONOPOLISTICCOMPETITION

in some seem to work effectively but markets, if after the offered all; Buyers stupid, monopolist periodically a 50 percentdiscount on the $8 list price, those who were paying $8 might the next cut and their to take anticipate price postpone purchases advantage of it. In somemarkets, not or not take the trouble however, know, buyers may simply may to find out, how the price they pay compares to the prices paid by other buyers. the to prevent some groups from Alternatively, monopolist may be in a position In such cases, the at the discount made available to others. buying prices

at price

Attempts

not

monopolist can

~^i< \342\200\224^

price-discriminate

The Economic Why

do many

Whenever

would lower

discrimination

are not

others.

in

effectively.

Naturalist 8.2 offer discountticketsto students? offers a discount, the goal is to target that discount to

movie theaters

a firm

not purchase the reservation prices

buyers

who

it. People with low incomes generally have product without for movie tickets than with high incomes. Because people

students generally have lower disposable incomes than working theater owners adults, can expand their audiencesby charging lower prices to students than to adults. Student discounts are one practical no way of doing so. Offering student discounts also entails risk of some people buying the at a low price and then reselling it to others at product a higher price.

Why do theaters?

HOW

In the

PRICE following

students

pay

lower

we'll

prices at

many

see how the

ability

to

price-discriminate

First we'll

monopolist's profit-maximizing output. in which the monopolist must charge the same priceto every level

movie

AFFECTS OUTPUT

DISCRIMINATION examples,

ticket

of

affects

the

consider a baselinecase buyer.

USING DISCOUNTS

How

Carla supplements a reservation

with

income

her

for teaching assistant by editing term papers students per week for whom she might edit, each

as a

There are eight price as given

undergraduates.

Cost

should Carla edit?

manuscripts

many

and Opportunity

Maximization

Profit

TO EXPAND

in

the

table.

following

Reservation Student

Carla is a profit $29 and she must she edit?

price

A

$40

8

38

C

36

D

34

\302\243

32

F

30

G

28

H

26 If the

maximizer. charge

the

cost of her time to edit each paper is to each student, how many should papers she make? How much accounting profit?

opportunity

same price

How much economicprofit

will

summarizes Carla's total and marginal revenue at various output in the amounts the total revenue we the column, generate simply multiplied reservation the number of students whose reservation corresponding price by prices were at least that high. For example, to edit 4 papersper week (for students A, B, C, and D), Carlamust charge a price no higher than D's reservation price ($34). So = $136 her total revenue when she edits 4 week is week. 8.5

Table

levels.

To

Carlashould marginal

expanding exceeds the

keep

revenue

(4)($34) papers per per of students she serves as long as her or opportunity cost of her time. Marginal revenue,

the number

TABLE 8.5

Total and Marginal Revenue from Reservation

Student

price

($ per paper)

Editing Total

revenue

($perweek)

revenue

Marginal

paper)

($ per

40 A

40

40

8

38

76

C

36

108

D

34

136

\302\243

32

160

F

30

180

G

28

196

H

26

208

36 32

28

24

20

16 12

the

EXAMPLE

THE

MARKET

8.4

234

CHAPTER

8

MONOPOLY,

OLIGOPOLY, AND MONOPOLISTICCOMPETITION

revenue of Table 8.5.

in total

difference

column

last

Note that

from

results

that

another student, is shown in

adding

the

revenue from editing 2 papers per week,her marginal be Since that amount exceedsher $32. $29 editing paper she should take on the third But since the marginal revenue opportunity cost, paper. of on a fourth would be Carla should stop at 3 papers $28, taking paper only week. T he total cost of the time per opportunity required to edit the 3 papers is

a

were

if Carla

would

third

\342\200\224 = $87, so Carla'seconomic is $108 $87 profit Carla incurs no explicit costs, her accounting profit will be

= $21

(3)($29)

EXAMPLE 8.5

Social

per week. per week.

Since

Efficiency

is the

What

$108

number of papers for

socially efficient

Again, suppose that she could edit as many are again as listed in

Carla's opportunity the

cost of editing is $29 per paper and week for students whosereservation per

8 papers

as

to edit?

Carla

that prices

table.

following

Reservation Student

is the

What

same

price

she

edits

the socially

38

C

36

D

34

\302\243

32

F

30

G

28

H

26

students

to

willing

is socially

than

profit

will

Carla

economic

that

to edit? If she and accounting

than Carla's opportunity G and H are unwilling

must charge profits be if

cost, so

students

But

for Carla'sservices.The socially

efficient

outcome,

number, will

be

therefore,

to

is for

pay

at

Carla

she must charge a priceno higher = $180 per week,slightly

(6)($30)

her total opportunity cost of (6)($29)= thus be only $6 per week.Again, because Carla will be the same as her total revenue, profit

her accounting EXAMPLE 8.6

her

more

pay

efficient.

to edit 6 papersper week.To attract than $30 per paper. Her total revenue more

of papersfor will

efficient number of papers?

F are

A to

Students

least $29

$40

8

socially efficient number to each student, what

the

serving these

price

A

$174perweek.Her

economic

incurs $180

no explicit per week.

costs,

Price Discrimination

If Carla

can

price-discriminate,

how

many

papers

should she edit?

of human nature. After a moment's conversation discern that student's reservation student, price.The reservation in of her customers are as the prices potential again given following table. If Carla confronts the same market as before,but can charge students their respective reservation how many papers should she edit, and how much economic and prices, Carla

Suppose

with

accounting

is a

shrewd judge

she can

a

profit

will

she make?

DISCOUNTS

USING

TO EXPAND THE MARKET

235

Reservation

price

Student

Carla will reservation

Carla

edit

$40

8

38

C

36

D

34

\302\243

32

F

30

G

28

H

26 for students students G

papers Because

price. not

will

A

their

edit

A

to

F and

and H

papers. Carla's total

have

revenue

charge each

exactly his or her

reservation

prices

be $40

= $210 per week,which is also her cost of 6 is opportunity editing papers (6)($29)= $174perweek, \342\200\224 = more $174 $36 per week, $30 per week profit will be $210 edited six papersbut was constrained to charge each customer the + $32

$34

+ $30

A monopolist

calleda perfectly

who can charge each buyer discriminating

monopolist.

exactly

Notice

below

$29,

+ $36 + Her total accounting profit.

will

+ $38 her

so

than same

economic when she

price.

her reservation when Carla was that, his or

price is

her profit-maximizing level of output was discriminating among the same as the efficient level of output: 6 papersper week.With a exactly socially All there is no loss of who are perfectly discriminating monopoly, efficiency. buyers to pay a price high to cover marginal cost will be served. willing enough Note that although total economicsurplus is maximized by a perfectly consumers would have little reason to celebrateif they discriminating monopolist, found themselves with such a firm. After consumer all, dealing surplusis exactly zero for the perfectly discriminating monopolist.In this total economic instance, and are one and the same. surplus producer surplus In practice, of course, perfect discrimination can never occur because no price sellerknowseachand every buyer's precise reservation price. But even if some sellers in the way of their charging a separate did know, practical difficulties would stand in to each For markets the sellercould not prevent price buyer. example, many buyers who bought at low prices from to other reselling buyers at higher prices, capturing some of the seller's business in the process. Despitethese difficulties, price discrimination is widespread. But it is generally imperfectpricediscrimination, that is, price in which discrimination at least some buyers are chargedlessthan their reservation prices. customers

HURDLE

THE

in this way,

perfectly discriminating a firm that

monopolist

each

buyer

reservation

charges her

his or

exactly price

METHOD OF PRICE DISCRIMINATION

seller's the goal is to charge each buyer highest price that is to Two obstacles sellers from this buyer willing pay. primary prevent achieving sellers don't know how much each is to And goal. First, exactly buyer willing pay. those who are willing to pay a high second, they need some means of excluding from at a low These are formidable which no seller price buying price. problems,

The

profit-maximizing

can hope to

solve

completely.

which sellers achieve a crude solution to both by to overcome someobstacleto be eligible for a discount buyers This method is called the hurdle method of discrimination. For price. price example, the seller sell a product at a standard list price and offer a rebate to any buyer might in a rebate who takes the trouble to mail coupon.

One

problems

is

common

to require

method

hurdle

method

discrimination

of price the

practice

which a seller offers a discount to all buyers who overcome

some obstacle

by

236

8

CHAPTER

MONOPOLY,

Cost-Benefit

O

a threshold

hurdle

perfect

that

completely segregatesbuyers reservation

whose

reservation

prices

imposing no jump

prices

it from others

above

the

EXAMPLE

cost

lie

whose

lie below it, on those

hurdle

8.7

who

OLIGOPOLY, AND MONOPOLISTICCOMPETITION

The hurdle method solvesboth of the seller's problems, provided that with buyers low reservation prices are more than others to the hurdle. Becausea willing jump decision to jump the hurdle must satisfy the Cost-Benefit to Principle, such a link seems exist. As noted earlier,buyers with low incomes are more likely than others to have low reservationprices(at least in the case of normal goods). Becauseof the low cost of their time, they are more to send in opportunity likely than others to take the trouble rebate coupons. Rebate couponsthus target a discount toward those buyers whose reservation are low and who therefore might not prices buy the product otherwise. A perfect hurdle is one that separates buyers precisely according to their in reservation and the no cost on those who jump the hurdle. prices, process imposes

reservation the highest price among buyers who jump lower than the lowest reservation who choose price among buyers not to jump the hurdle. In practice, perfect hurdles do not exist.Some buyers will their reservation hurdles always jump the hurdle, even though prices are high. And will always exclude at least some buyers with low reservation Even so, prices. used hurdles do a remarkably goodjob of targeting discounts to many commonly In with low reservation the that we will assume for follows, buyers prices. example conveniencethat the seller is using a perfect hurdle.

With a hurdle

perfect hurdle,the

will be

Perfect

Hurdle

How much

should Carta chargefor

editing

if she

uses a

perfect

hurdle?

has the opportunity to edit as many as 8 papers per week for in are as the table. This time prices given following she can offer a rebate coupon that gives a discountto any student who takes the trouble to mail it back to her. Suppose further that students whose reservation in are at least never mail the rebate while those whose $36 prices coupons, reservationprices are below $36 always do so. Suppose

the

Carla

again

whose

students

reservation

Reservation

price

Student

If

Carla's

be larger

or

$40

8

38

C

36

D

34

\302\243

32

F

30

G

28

H

26

cost of editing each paper is again $29, what should should she offer as a rebate?Will her economic smaller than when she lacked the discount option?

opportunity

price be, and

A

what

amount

her list profit

allows Carla to divide her original market into two submarkets coupon she can charge two different The first submarket consists of students A, prices. $36 and who therefore will not bother B, and C, whose reservation prices are at least D through to mail in a rebate coupon. The second submarket consists of students H, whose lower reservation indicate a to userebate prices willingness coupons. In eachsubmarket, Carla must charge the same price to every buyer, just like an in Sheshould therefore each submarket ordinary monopolist. keep expanding output in that market exceeds her marginal as long as marginal revenue cost. The relevant data for the two submarkets are displayedin Table 8.6. The

in which

rebate

USING DISCOUNTSTO EXPAND

TABLE 8.6

Price Discriminationwith

Hurdle

a Perfect

Reservation price Total revenue ($ per week) ($ per paper) List Price Submarket

Student

revenue

Marginal

paper)

($ per

40 A

40

40

8

38

76

C

36

108

36

32

Price Submarket

Discount

34 D

34

34

\302\243

32

64

F

30

90

G

28

112

H

26

130

30

26 22

18

On

marginal

the basis

we see

market,

revenue

of the entries in

for

$29 only

exceeds

exceeds $29.

each

submarket is $36, the servicesto students A,

B,

and

C.

Her

price

profit-maximizing

list

charge in that market For the discount price submarket, marginal

for the first two

students (D and

E).

So the

price

sub-

C) since in the list price and still sell her

and

B,

she can

price

highest

for the

revenue column marginal serve all three students (A,

the

should

Carla

that

revenue

profit-maximizing

is $32, the highest price Carla can charge and still sell her discount students who mail in the price of $32 means that coupon will receive a rebate of $4 on the $36 list price.) Note that the rebate offer enablesCarla to serve a total of five students per week,comparedto only three without the offer. Carla's combined total revenue for the two markets is (3)($36) + week. Since her opportunity cost per is $29 per paper, or a total of (5)($29) = $145 per week,her is profit \342\200\224 = $27 per week, than when she edited $172 $145 per week per week

price

in

services

this

to D

submarket

and E. (A

2($32)= $172

three papers

CONCEPT

and didnot offer

CHECK

Example

the

economic

rebate.

8.4

8.7, how much those students whose only In

$6 more

should

Carla

charge

in each

reservationpricesare below

IS PRICE DISCRIMINATIONA

BAD

submarket $34

will use

if

she

knows

that

rebate coupons?

THING?

so conditionedto think of discrimination as bad that we may be tempted to In the conclude that price discrimination must run counter to the public interest. both consumer and were enhanced example above,however, producer surplus actually use of the hurdle method of price discrimination. To show this, by the monopolist's

We are

THE

MARKET

237

238

CHAPTER

8

MONOPOLY,

AND

OLIGOPOLY,

let's compare

to the

COMPETITION

MONOPOLISTIC

consumerand producersurplus

corresponding

Carla

when

she charges the

when

values

employs

same priceto all

the hurdle method buyers.

to charge the same price to every customer, she edited only the papers A, B, and C, each of whom paid a price of $36. We can tell at a glance that the total must be under the hurdle method because surplus larger not only are students A, B, and C served at the same price ($36),but also students D and E are now served at a price of $32. To confirm this intuition, we can calculate the exact amount of the surplus. For student who hires Carla to edit her consumer is the difference any paper, surplus In both the single price and between her reservation and the price actually price paid. Carla had of students

When

\342\200\224 = discountprice examples, student A's consumer $36 $4; student surplus is thus $40 \342\200\224 = E's consumer surplus is $38 $36 and student C's consumer is $2; surplus

Total consumer surplus in the list price submarket is thus $4 + $2 = is the same as total consumer surplus in the original situation. But $6 per week,which now the discountprice submarket additional consumer generates surplus. Specifically, student D receives student's reservation $2 per week of consumer surplus since this of is more than the discount of So total consumer is $34 $2 $32. price price surplus now $6 + $2 = $8 per week, or $2 per week more than before. Carla's method. For each producer surplus also increasesunder the hurdle she her is the she minus her reservation edits, paper producer surplus price charges \342\200\224 = I n the Carla's was $21 per case, (3)($36 $29) price ($29). single-price surplus week. When she offers a rebate coupon, she earns the same producer surplus as = $6 before from students A, B, and C and an additional (2)($32 \342\200\224 $29) per week from students D and E. Total producer surplus with the discount is thus $21 + $6 = that amount to the total consumer surplusof $8 per week, $27perweek.Adding we get a total economic of $35 surplus per week with the rebate coupons, $8 per \342\200\224

$36

$36

= 0.

week more than

rebate. the rebate, the final student F, even though

the

without

Note, however, because Carla doesnot serve

with

even

that

perfectly efficient,

her opportunity it's still more

EXAMPLES

OF

of

$30

exceeds

Once you

grasp

the

cost of $29. But

is not

outcome

this student's

though

efficient than charging

the

socially efficient

reservation price is not

method

hurdle

a single priceto all

buyers.

DISCRIMINATION

PRICE

behind the hurdle

principle

you'll begin to see examplesof or appliance store, for hardware,

it

all

around

instance,

method

of

price

you. Next time you

notice

discrimination, visit

how many different

a grocery,

product

illustration of the hurdle Temporary sales are another method. Most of the time, stores sell most of their merchandise at the \"regular\" offer special sales at a significant discount.The hurdle in this price but periodically instance is taking the trouble to find out when and where the sales occur and then to the store that This going during period. technique works because buyers who caremost about price (mainly, those with low reservation to prices) are more likely

rebates.

cash

include

promotions

advertisements carefully and buy only To give another example,book publishers hardcover at a price from $20 to $30, and a year edition priced between $5 and $15. In this instance, the extra year and accepting a slight reduction monitor

People who are strongly edition, while those with Or take the example different

producing a Chevrolet's.

thosewith

typically

sale periods. launch a new

book

in

later they bring out a paperback the hurdle involves having to wait in the of the finished product. quality

end up waiting for the paperback for the hardback. prices usually spring of automobile who producers, typically offer several with different trim and accessories. Although GM's actual cost of Cadillac may be only $2,000 more than its cost of producing a

models

Chevrolet,

during

Cadillac's

the

Buyers high

with

reservation

about

concerned

price

high reservation

selling low

be $10,000to $15,000higher than the the while Chevrolet, prices purchase are more likely to choosethe Cadillac.

price may reservation

prices

USING DISCOUNTS

TO EXPAND

THE

Commercial air carriers have perfected the hurdle method to an extent matched no other seller. Their by supersaver fares are often less than half their regular coach fares. To be eligible for these discounts,travelers must their purchase in advance tickets 7 to 21 days and their journey must include a Saturday night almost

stayover. Vacation travelers

involve

more

can

schedules often

whose

travelers,

stay overs.

Saturday

to be much sellers Many employ

price tends

easily

change

at

the

satisfy these last

not

than just

the vacation traveler's. one hurdle but several

business

and whose trips traveler's

business

And\342\200\224no surprise\342\200\224the

higher

restrictions than

moment

by

offering

seldom

reservation deeper

hurdles. For example, movie successively more difficult release their films to first-run theaters at producers major premium prices, then several months later to neighborhood theaters at a few dollars less. Still later they make the films available on pay-per-view cable channels,then release them on and them to be shown on network television.Each successive DVD, finally permit hurdle involves a little longer and, in the case of the televised versions, waiting in segregating lower These hurdles are remarkably effective accepting quality. to their reservation moviegoers according prices. Recall that the efficiency loss from single-price monopoly occursbecause,to the the benefit of expanding output is smaller than the benefit to monopolist, as a whole. The hurdle method of discrimination reduces this loss society price by a practical means of cutting for price-sensitive giving the monopolist prices buyers the can partition a market using the only. In general, the more finely monopolist hurdle the smaller the efficiency loss. Hurdlesare not perfect,however, method, and some degree of efficiency will be lost. inevitably to

discounts

who jump

buyers

The Why

an

might

of its stoves The

Sears

differentials

an

annual

to

retailer instruct its clerks

appliance

Economic

Naturalist

to hammer dents into

the

8.3 sides

and refrigerators?

\"Scratch

YT

Dent

Sale\" is

another example

of how

retailers

use quality

Sears stores hold segregate buyers according to their reservation Many in the sale in which they display with minor scratches and blemishes appliances

prices.

to parking lot at deep discounts.Peoplewho don't care much about price are unlikely turn out for these events,but those with very low reservation prices often get up early to be first in line. Indeed, these sales have proven so popular that it might even be in a in some of its sale items deliberately. retailer's interest to put dents

Would a profit-maximizing

appliance

retailer

ever deliberately damage its

own

merchandise?

M^4r

MARKET

239

240

CHAPTER

8

MONOPOLY,

MONOPOLISTIC

AND

OLIGOPOLY,

DISCOUNTS TO

USING

RECAP

COMPETITION

EXPANDTHEMARKET

to monopolist is one who chargesdifferent prices the same good or service.A common method of involves a discount price discrimination is the hurdle method, which granting in a rebate to buyers who jump over a hurdle such as mailing coupon. An effective hurdle is one that is more easily clearedby buyers with low reservationprices than by buyers with reservation high prices. Such a hurdle enables the to expand loss monopolist output and thereby reduce the deadweight

A price-discriminating different

from

for

buyers

essentially

pricing.

monopoly

but also

output

because of the loss in efficiency associated because the monopolist earns an economic profit

not only

is problematic

Monopoly

restricted

NATURAL MONOPOLY

POLICYTOWARD

PUBLIC

with

at the

uncomfortable about buyer's expense.Many peopleare understandably having to in from the sole of or service. For this voters reason, purchase provider any good societies have to aimed at many empowered government adoptpolicies controlling

natural

monopolists.

There are several ownership and

prices it

firms to

attempt

to achieve this aim. A government ways may assume of a natural monopoly, or it may merely to regulate the attempt In some solicits bids from private cases, charges. government competitive In natural services. still other cases, produce monopoly governments control

monopolies into smaller entities that of thesepoliciescreateeconomic of problems

natural

dissolve

to

another. But many

with

compete

one

each the yields greatest

their

own. In

is to come up with the solution that case, the practical challenge of benefits over costs. Natural be inefficient and unfair, but, surplus monopoly may as noted earlier, the alternatives to natural are far from monopoly perfect.

STATE OWNERSHIP AND

MANAGEMENT

is inefficient because the monopolist's profit-maximizing price than its marginal cost. But even if the natural monopolist wanted to set in business. it could not do so and hope to remain cost, priceequal to marginal in After all, the defining feature of a natural is economies of scale monopoly which means that marginal cost will be less than production, always average total cost. Setting to cost would fail to cover price equal marginal average total cost, Natural

monopoly

is greater

which implies an Consider

wired for very low.

economic

the case

loss.

of a localcabletelevision

company.

Once

an area

the marginal cost of an additional television, For the sake of efficiency, all subscribers should pay a cost. Yet a cable company that priced in this manner would

adding

cable

has been is

subscriber

priceequal

to

that

never be able network. This same problemapplies not if to cable television but to all other natural Even such just companies monopolies. firms wanted to set price equal to marginal cost of course, they do not (which, sincethey will earn more by setting marginal revenue equal to marginal cost), they cannot do so without an economic loss. suffering One way to attack the efficiency and fairness problems is for the government to take over the industry, set price equal to marginal and then absorb the cost, losses out of tax revenues. T his has been followed with resulting general approach in in results the state-owned electric whose efficient France, good utility industry methods have set the standard for worldwide. pricing electricity pricing in hand. But state and efficient management do not always ownership go hand is free to while Granted, the state-owned natural cost, monopoly charge marginal marginal

to recover the

fixed

cost

of setting up the

POLICY TOWARD

PUBLIC

the private natural monopoly to the fact that private natural

cut costs than figures

their

the government

when

the

production,

the

cost

marginal

costsis

the

Department

empirical

organization?

OF

REGULATION

STATE

monopoly

goes up by $1. But cuts $1 from the cost of

cuts the monopoly'sbudget of Motor Vehicles.Did it

that is gained the inefficiency that question.

being

by

PRIVATE

$1.

by strike

you

Think as an

to set price equal to a weakened incentive to

able from

results

cut

MONOPOLIES

In the United States,the most common method of curbing monopoly profits is for to the natural rather than own it. Most states, for government regulate monopoly take this with electric natural utilities, example, approach gas providers,local and cable television The standard telephone companies, companies. procedurein these cases is called cost-plus regulation: Government data on the regulators gather costs of and then the monopolist's explicit production permit monopolist to set that cover those a to assurea normal return on the firm's costs, plus prices markup investment. While it may sound reasonable, cost-plus regulation has several First, it pitfalls. in administrative which and firms generates costly proceedings regulators quarrel in the costs it is over which of the firm's expenditures can properly be included allowed to recover. This question is difficult to answer even in theory. Consider a firm like whose local service is but AT&T, telephone subjectto cost-plusregulation whose other products and servicesare unregulated. Many AT&T from employees, in both the president on down, are involved and unregulated activities. regulated How should their salaries be allocated between the two? The company has a strong incentive to argue for greater allocation to the regulated activities, which allows it in to capture more revenue from customers the local market. captive telephone A second with cost-plus regulation is that it blunts the firm's incentive problem to adopt cost-saving for when it innovations, does, regulators require the firm to cut its rates. The firm to its cost gets keep savings in the current period, which is a incentive to cut costs than the one stronger facing a government-owned monopoly. But the incentive to cut costs would be stronger still if the firm could retain its cost Furthermore,

indefinitely.

savings

in cases

in

which

regulators

set rates

by

allowing

a fixed markup to costsincurred,the regulated monopolist monopolist have an incentive to increasecosts rather than reduce them. may actually the thought Outrageous though may be, the monopolist may earn a higher profit by in the company restrooms. faucets installing gold-plated does not solve the natural basic Finally, cost-plus regulation monopolist's the to set to cost without problem: inability price equal marginal losing money. these are all seriousproblems,governments seem to be in no hurry to Although to add

the

abandon

regulation.

cost-plus

EXCLUSIVE

CONTRACTING

FOR NATURAL MONOPOLY

methods for dealing with natural is for the monopoly firms to bid for the natural market.The private monopolist's in detail the service it wants\342\200\224cable fire protection, television, government specifies collection\342\200\224and firms submit bids how much will garbage describing they charge for the service. The low bidderwins the contract. The incentive to cut costs under such an arrangement is every bit as powerful as that firms. bidders should also facing ordinary competitive Competition among One

of

the

most

government to

promising

invite

Incentive

a

its profit

production,

a state-owned

efficiency

outweighs

an

to

cost of

typically

government

back to your last visit efficiently managed Whether

manager

of

directs our attention incentive to stronger When the private monopolist a much

241

MONOPOLY

Principle

counterparts.

government-owned

to cut $1 from the

a way

out

is not. Yet the Incentive monopolies often face

NATURAL

cost-plus regulation

a method

of regulation under which the firm is regulated permitted to

charge prices that cover explicit costs of production plus a markup to cover the opportunity

provided

cost of resources by the

firm's owners

242

CHAPTER

8

MONOPOLY,

OLIGOPOLY, AND MONOPOLISTICCOMPETITION

concerns about the fairness of monopoly profits.And if the to exclusive bidder, willing provide a cash subsidyto the winning even allows the to set to cost. contracting monopolist priceequal marginal in municipal fire protection results Contracting has been employedwith good

eliminate

any

government is

and garbagecollection. Communities these services often spend only and

fire

municipal

sanitation

Despite these attractive

that

private companies to provide as adjacent communities served by

employ

half as much

departments. features,

however,

exclusive

is not

contracting

without

to be provided is complex or requires a large problems, especially in capital equipment. In such cases, contract specificationsmay fixed investment be so detailed and complicated that they become tantamount to regulating the firm directly. And in cases involving a large fixed investment\342\200\224electric power generation and distribution, for example\342\200\224officials face the question of how to transfer the when

if a new firm assets the assets as cheaply them.

What,

in

such

the service

contract. The winning but the possible, retiring cases, is a fair price?

wins

the

as

firm

Fire protection and garbagecollection aresimple out these functions are not contracting prohibitive. But in made easily outweigh any savings possible by exclusive VIGOROUS

The nineteenth

ENFORCEMENT

naturally

firm is entitled enough

other

wants

to a fair

to acquire price

for

the costs of such costs might cases, that

contracting.

OF ANTITRUST

LAWS

witnessed the accumulation of massiveprivate the fortunes, century had never beenseenin the industrialized world. Public sentiment ran the so-called robber barons of the period\342\200\224the Carnegies, Rockefellers, high against In and others. which declared Mellons, 1890, Congresspassedthe Sherman Act, \"to or to . . . of illegal any conspiracy monopolize, attempt monopolize any part the trade or commerce among the several States.\" And in 1914, Congress passed the from acquiring shares in a Act, whose aim was to prevent Clayton corporations if the transaction would lessen or create competitor \"substantially competition a monopoly.\" Antitrust laws have helped to prevent the formation of cartels, or coalitions of firms that collude to raise prices above competitivelevels.But they also have caused some harm. For example,federal antitrust officials a decade spent more than trying to break up IBM Corporation in the belief that it had achieved an unhealthy dominance in the computer industry. That view was proved comically wrong by IBM'ssubsequent failure to foresee and profit from the rise of the personal computer. By breaking up large companies and discouraging mergersbetween companiesin the same industry, antitrust laws to may help promote competition, but they also may prevent companies from achievingeconomies of scale. A final possibility is simply to ignore the problem of natural monopoly: to let the choose the to and sell it at whatever monopolist quantity produce price the market will bear. The obvious objections to this policy are the two we began with, namely, that a natural monopoly is not only inefficient but also unfair. But just as the hurdle method of price discrimination mitigates efficiency losses, it also lessens the concern about taking unfair of advantage buyers. Consider first the source of the natural monopolist's economicprofit. This firm, is one with economies of scale,which means that its average production cost recall, declinesas output increases. that cost, Efficiency requires price be set at marginal but because the natural monopolist's marginal cost is lower than its average cost, it cannot charge all buyers the marginal cost without suffering an economic loss. The depth and prevalence of discount pricing suggest that whatever economic a natural earns will not come out of the discount buyer's profit monopolist generally discount are than the cost of pocket.Although prices higher monopolist's marginal in most cases are lower than the cost. the Thus, production, they average monopolist's if any, must come from buyers who pay economic profit, list price. And since those

likes of which

SUMMARY

243

have the option, in most of jumping a hurdle and paying a discount cases, if their not is at least not coerced. contribution, price, completely voluntary, strongly So much for the source of the economic What about its monopolist's profit. buyers

disposition?Who

gets

it? A

large

chunk\342\200\224some

35

percent,

in many

cases\342\200\224goes

to

is paid out to government via the corporate income tax.The remainder some of whom are and some of whom are not. These shareholders, wealthy shareholder profits are also taxed by state and even local governments. In the end, twothirds or more of a monopolist's economic services profit may fund provided by of various levels. governments Both the source of the monopolist's economic profit (the list-price buyer) and the disposition of that profit (largely, to fund cast doubt services) public on the claim that monopoly constitutes a social on profit injustice any grand scale. the hurdle method of differential cannot Nevertheless, pricing completely eliminate the fairness and efficiency that result from monopoly pricing. problems In the end, then, we are left with a choice among imperfect alternatives. As the Cost-Benefit Principle emphasizes, the best choiceis the one for which the balance of benefits over costs is largest. But which choice that is will depend on the

federal

the

hand.

at

circumstances

The natural

monopolist

output from

society'spoint of

also

monopolist

sets

earn

may

problem). Policies for state

and

ownership

price

above marginal

view

cost, resulting

little

too

in

problem). The natural (the fairness buyers' expense

profit

at

and fairness problems state regulation,exclusive contracting, laws. Each of these remedies entails

the efficiency

with

and management,

of

MONOPOLY

efficiency

(the

an economic

dealing

enforcement

vigorous

problemsof

NATURAL

POLICYTOWARD

PUBLIC

RECAP

include

Cost-Benefit

a

antitrust

own.

its

SUMMARY \342\200\242 Our

of

performance

that

in this

concern

the

some latitude to

and

conduct

competitive

imperfectly

at least

has

chapter was the

set its

firm, a own

firm

price.

often distinguish among three different of imperfectly types competitive firms: the pure the lone seller of a product in a given monopolist, one of only a few sellers of a market; the oligopolist, and the monopolistic competitor, one given product; of a relatively that sell similar large number of firms Economists

though

slightly

differentiated

to

courses differences

these three types of

our

advanced

\342\200\242

Although

attention

much

feature

common

competitive firm

faces

product,

firms,

(LOl)

products.

in economics devote in behavior among focus was on the them from perfectly

differentiates firms. Whereas the perfectly an infinitely elastic demand the imperfectly competitive that

competitive

curve for firm

faces

its

a

curve. For convenience, monopolist to refer to any of the demand

downward-sloping use the term three types of imperfectlycompetitive we

firms.

the perfectly firm, for which competitive market marginal revenue exactly equals price, the revenue that is always monopolist realizesa marginal less than its price. This shortfall reflects the fact that to sell more output, the monopolistmust cut the price not only to additional buyers but to existing with a straight-line buyers as well. For the monopolist demand curve, the marginal revenue curve has the same vertical intercept and a horizontal intercept that is half as large as the interceptfor the demand

\342\200\242 Unlike

(LOl)

curve.

(LOl)

Monopolists a

power,

price

economies

term

of their of

sometimes

that

over

control

exclusive

said to enjoy market their power to set the product. Market power stemsfrom are

\342\200\242

scale,

from

or franchises, and

refers to

inputs, from and patents government licenses important

from

most important and enduring

network of

market power are economies of economies.

(LOl)

economies. The five sources of scale and network

these

244

8

CHAPTER

\342\200\242

design, engineering, an increasingly large

Research, for

account

OLIGOPOLY, AND MONOPOLISTICCOMPETITION

MONOPOLY,

and other fixed costs share of all costs required

\342\200\242 Both

products successfullyto market. For products fixed costs, marginal cost is lower,often large than total cost, and average total cost substantially, average o ften as declines, sharply, output grows. This cost pattern industries are dominatedby either a explains why many firm or a small number of firms. (L02) single to bring

profit

the

equals the profit

by

Such buyer exactly his or her reservation price. are efficient because sell to producers socially they whose reservation is at least as every buyer price high

as the marginal cost. (LOS)

\342\200\242 The various

at the

market

mitigate

the monopolist maximizes cost with marginal revenue,

price, marginal

equating

ownership and

than the market price.The is best for the monopolist but smaller than would be best for society as a whole.At the profit-maximizing level of output, the benefit of an extra unit of output (the market price) is is an

result

output

greater than

level of output,

efficient and

intersects

curve

cost

marginal

(the marginal

cost of an

extra

where the the

the

costs

as well policies allowing But in

simply please.

the best

curve,the

same. (L03,

that governments employ to fairness and efficiency losses include state monopoly of natural monopolies, state

contracting,

private

combination of

socially

natural

laws. Each

antitrust

enforcementof

monopolist's

the demand are

unit

cost). At

about

management

regulation,

level that the level that

cost

its

policies

concerns

arising from

lower

is significantly

which

customers can

each

competitive firm maximizes level at which marginal cost

perfectly

producing

by

and its potential

monopolist

if the do better can grant discounts to monopolist The extreme is the price-sensitivebuyers. example w ho perfectly discriminatingmonopolist, charges

with

\342\200\242 Whereas

the

244

PROBLEMS

as benefits. In

and vigorous

of these remediesentails

some cases,a outcome than to do as they

will produce a better natural monopolists

other cases, a hands-off available option.(L06)

policy

may

be

benefit

L04)

KET TERMS to scale

returns

constant

(220)

economies

scale

of

hurdle

method of

discrimination

market

(220)

price to scale

characteristic

important

competitive

imperfectly

2. True or

false:A

whatever

chooses.

firm

quantity

firms with it wishes

(235)

monopolist

price discrimination

natural

pricesetter

(220)

monopoly

(217)

do all three share? (LOl)

types of

4.

(LOl)

price

for

do

Why patents

power can sell at whatever price it

less than marginal revenue always a monopolist but equal to price for a firm? (LOl) competitive

(216)

QUESTIONS

market

3. Why is

(231)

(216)

monopoly

pure

perfect hurdle (236)

(220)

discriminating

perfectly

monopolistic competition (216)

REVIEW

1. What

(224)

power (219)

oligopoly

(235)

returns

increasing

revenue

marginal

cost-plus regulation (241)

and

protections

most

copyright enable

industrial societies offer even though these protection,

successful sellers

to charge

higher

prices?

(LOl)

5. True or false: Becausea natural monopolist charges a price greater than marginal cost, it necessarily earns a positive economic profit. (L03)

perfectly

PROBLEMS and Volvo, have fixed costs of $1 billion and If Saab produces50,000carsper year and car. marginal Volvo calculate the average productioncost for each 200,000, produces On the basis of these which market share do you think costs, company. company's in will relative terms? (LOl) grow Two

Broomed: |ECONOMICS

car

Saab manufacturers, costs of $10,000 per

2. State

the

whether

LOl)

(LOl,

a. In a perfectly

their

competitive

it

firms

b. Choosesthe

If

the

The

marginal

The

marginal

fe?

control

McGraw-Hill

over the price they

declines

cost

as the

charge for

number of units

output range.

shortages,

few units

of

or

a good

at which marginal revenue beginsto increase. above the marginal cost of production.

marginal revenue. statements is true.

above

perfectly price-discriminate: (LOl, L04) curve and the demand curve would coincide. revenue curve and the marginal cost curve would coincide. revenue

c. Every consumer would pay a different price. d. Marginal revenue would become negative at some output level. e. The resulting of would still be inefficient. pattern exchange socially

5. What is the

why

Explain variants

the

of

discrimination price same product tend to

business

in

town

to charge? desirable

and the existence

go hand in

hand.

of slightly

Give

different

an example

from your

that

business, is the only photography in portraits of small children.George, who

specializes

runs TotsPoses, expects to encounteran average of eight in customers each with a reservation shown the table. per day, price following total cost of each portrait is $12. (L03, LOS) owns

Why

price

a profit-maximizing

Inc.,

TotsPoses,

monopoly

loss? (L04)

own experience.(L05)

7.

a natural

to chargethe socially

that attempts

monopoly suffer an economic

invariably

6.

socially desirableprice for

a natural

will

and

The

Reservationprice

Customer

($per photo)

1

50

2

46

3

42

4

38

5

34

6

30

7

26

8

22

a single price to all will price, many portraits George produce each will What be his economic day? profit? b. How much consumer is generated each day at this price? surplus c. What is the socially efficient number of portraits? a.

How

much

should

customers?At

this

George charge how

if

he

must

Visit

charge

your mobile

store and

download

the Frank:

Study

Econ

could

a monopolist

a. b.

a price

maximizes

e. None of

level

output

charges

Always

d. Also

or

why.

demand curve is horizontal,

(L03) monopolist: by selling too

profit-maximizing

single-price,

a. Causes excessdemand, service.

4.

no

have

the relevant

over

increases

explain

is downward-sloping.

a natural monopoly, average

produced

c.

false, and

product.

c. For

A

a monopoly

for

whereas

the industry

industry,

competitive

b. Perfectly

3.

are true or

statements

following

app todayl

app

246

CHAPTER

8

MONOPOLY,

COMPETITION

MONOPOLISTIC

AND

OLIGOPOLY,

d. George is very of each of his

business and knows the reservation price to charge any price he likes to any will he produce each day and how much

in the

experienced

customers. If

is allowed

he

how many portraits economic profit will he earn? e. In this case, how much consumer consumer,

8.

surplus is generated each day?

back to Problem 7 and answer the following (L03, L05) questions. a. Suppose Georgeis permitted to charge two prices. He knowsthat customers with a reservation above never bother with whereas $30 price coupons, those with a reservation of or less use them. At what level $30 price always should Georgeset the list price of a portrait? At what level should he set the discount price?How many photo portraits will he sell at each price? b. In this case, what is George's economic profit and how much consumer Refer

surplus

each day?

is generated

9. Serena is a

single-price,

patented perfume,

(L04,

whose

in the sale of her own cost curves are as shown.

monopolist

profit-maximizing demand and

marginal

LOS)

60

MC

50

45

8 40

c3 o

tQ. 30 20

j. ^r

15

i

\\

10

16

12

4 6 8

0

24

Ounces/day

a. Relative

to the and

quantity

consumer surplusthat how

price,

surplus is lost from

the monopolist's profit-maximizing quantity and if Serena b. How much total surplus would result

is a

lemonade

Person

could act

selling

as a

perfectly

8

C

$1.00

$0.90

$0.80

price

Beth knows the person

is willing

specific

(Start

distribution

D

marginal

$0.60

of reservation

revenue

would charge if

of

she

revenue; then and so lemonade;

$0.10

she knowsthat she

does

cup

of

produced find

on.)

the

no

J

$0.20

$0.30

prices (that is, so on), but

total

the cups

$0.40

has

/

H

price. (L03, L05) of selling an additional

by figuring out the price Beth

cup of lemonade,and calculate would charge if she sold two

$0.50

G

and

$0.90,

reservation

F

\302\243

$0.70

to pay $1, another

individual's

a. Calculatethe

at

sells

of lemonade

A

Reservation

any

price?

her

lemonade on a street corner in your costs Beth 20 centsto produce;she cup costs. The reservation pricesfor the 10 people who walk by Beth's stand each day are listed in the following table.

second-graderwho Each

neighborhood.

fixed

socially optimal

monopolist?

price-discriminating

10. Beth

at the

result

would

much consumer

one

not know lemonade.

only one Beth price

ANSWERS TO CONCEPTCHECKS

is Beth's

b. What

c.

At

d.

What

that

profit-maximizing price? are Beth's economic profit and should Beth charge if she wants to what

price, price

surplus?

e. Now

suppose Beth

would

she charge

her profit

the

to

each person if she wanted total surplus calculated in

cost are shown figures unit-cost is advantage

the

in

table,

following

cost

Average total

from

sale which actually

cost

to 5 units

means negative,

that or

per

week,

total

profit-maximizing

$50.20

$5.20

3 to

4 units per week, total revenue rises that the marginal revenue from the

per week.When

the

revenue drops from

revenue from the sale of

the marginal $1 per week.

\342\200\224

4

the

fifth

unit is

5

8

(units/week)

price and quantity

are

P*

= $6/unit

MC

0

expands

monopolist

$16 to $15 per week,

(L03)

3

week.(L03)

$10,400,000

means

Quantity

.3 The

$400,000

$10,040,000

per game

the monopolist expands from $15 to $16 per week,which of the fourth unit is only $1

from 4

$10,000,000

$40,000

Total cost

.2 When

2,000,000

$10,000,000

Fixed cost Variable

that

Playstation

200,000

production

which shows

- $5.20= $45.00.(L02)

now $50.20 Nintendo

Annual

CHECKS

CONCEPT

TO

ANSWERS

PlayStation's

d.

part

\342\226\240

. 1 The relevant

surplus? economic

total

price of each person.What price to maximize profit? Compare

the reservation

tell

can

consumer

total maximize

Q* = 2

6

4\\

MR

0 (units/week)

8

and Q*

2

units/

247

248

CHAPTER

8

MONOPOLY,

OLIGOPOLY, AND MONOPOLISTICCOMPETITION

8.4

As the again

and

only

Student

revenue column in the following table shows, Carla should A, B, and C in the list price submarket (at a priceof $36) student E in the discount submarket (at a price of $32). (L03, LOS)

marginal serve

students

Reservation price Total revenue ($ per paper) ($ per week) List Price Submarket

revenue

Marginal

($ per

paper) 40

A

40

40

8

38

76

C

36

108

D

34

136

36

32

28

Discount Price Submarket \302\243

32

32

F

30

60

G

28

84

H

26

32

28 24

20 104

APPENDIX

The

of

Algebra

Profit

Monopoly

Maximization

In

the analysis for

text

of this

monopoly

show how this

advantage of the algebraic numerical values of the

chapter, we developed the profit-maximization in a geometric framework. In this brief

analysis can be done in framework

profit-maximizing

is that

it

prices

an

greatly

algebraic

appendix,

framework.

simplifies

and quantities.

computing

we

The the

250

8 APPENDIX

CHAPTER

EXAMPLE

8A.

I

THE

=

P

The first the curve,

\342\200\224

IS

2Q

dollars

in

Quantity

profit-maximizing price and quantity

Find the

price

MAXIMIZATION

and

Price

Profit-Maximizing

curve

PROFIT

MONOPOLY

OF

ALGEBRA

Q is the quantity

units

in

for the

find the equation

is to

with the

a monopolist

for

cost curve MC =

the marginal

unit and

per

step

and

Q,

of output revenue

marginal

P is

where

per week.

curve

associated

demand curve. Recall that in the case of a straight-line monopolist's the associated revenue curve has the same vertical marginal intercept

demand curve and twice the slope of monopolist's marginal revenue curve profit-maximizing output level, setting

the demand curve. So the = 15 \342\200\224 is MR = MC

MR

for Q* = 3 into

solves Q*

substituting

= 3. The profit-maximizing the demand

as the for

equation

Q*

with

demand this

denote the

then yields

= Q*,

15-4Q* which

Letting

4Q.

demand

the product

P*,

price,

is then found by

equation

P* = 15 -2Q*

=

Thus, the profit-maximizingpriceand week, respectively.

= 9.

15-6

are

quantity

$9 per

unit

and

3 units

per

CONCEPTCHECK8A.I the

Find

for a monopolist with the demand price and level of output P is the price of the the marginal cost curve MC = 2Q, where per unit and Q is output in units per week.

profit-maximizing

curve P = 12 \342\200\224 Q and in dollars

product

-

1.

-

PROBLEMS

whose University of Michigan Cinemais a local monopoly \342\200\224 P is the adult tickets on Saturday night is P = 12 where 2Q, in dollars and Q is the number of tickets soldin hundreds. The price of a ticket demand for children's ticketson Sunday afternoon is P = 8 \342\200\224 and for adult 3Q, P = 10 \342\200\224 On both tickets on and

the

that

Suppose

demand

for

curve

afternoon,

Sunday

afternoon,

the marginal

a.

What

is the

b.

marginal

What

price

should

is to maximize

4Q.

cost of

an

additional

revenue curve

the cinema

each

in

charge

Saturday night Sunday child or adult, is $2. (L03) of the three submarkets? of the three markets if its goal

patron, in

each

profit?

a monopolistin the market for a specific video game.Your is given by P = 80 \342\200\224 cost curve is MC = Q/2; your marginal Your fixed costs equal $400. (L03, L04) a. Graph the demand and marginal cost curves. b. Derive and graph the marginal revenue curve. c. Calculate and indicate on the graph the equilibrium price and quantity. d. What is your profit? e. What is the level of consumer surplus?

2. Suppose

-

ANSWER

you are

curve

demand

8A.1For the

demand

is MR = 12 =

3. Q profit-maximizing 2Q

for

curve

P =

12

2Q.

Equating

Substituting

\342\200\224

Q

the

Q,

MR

and

= 3

-

(HECK

CONCEPT

APPENDIX

TO

corresponding MC, we solve

into the demand

\342\200\224 price, P = 12 3 = 9. (L03)

Q.

marginal revenue curve the equation 12 - 2Q =

equation, we solve

for

the

HAPTER

C

I

and

Games

9

I

Strategic

Behavior [\342\226\240\"j^TETynsj-i

/

I'M |

~~- PSYCHl ~ OC

*T

-,

LOI

ARCQ

L

Lip

List

basic

three

the

elements of a game.

\"6

1

10

GE

CE

.

OBJECTIVES

After reading this chapter, you should be able to:

.B.

\342\226\240 wtelon makers.

OBTtA deorange

LEARNING

inistration:

:Uu\"rSu**\302\253

IRD

discuss

Recognize

and

the effects

of dominant and

choices

strategy

dominated strategy

choices.

L02

and

Identify

explain

the prisoner's and

dilemma

it applies

how

to

real-world situations. often results attention depends on the

Visual blight

from

size

the ability of a merchant's sign and brightness of others merchants' signs. the fact that

to

attract L03

which ,

singerTony want

the 1999

of a crime played fans

you

played

family,

Billy of Bennett's by

in,\"

Brothers

Warner

in 1997, actor Robert DeNiro pulled for a moment. \"Hey, a film I Tony\342\200\224there's DeNiro said. He was referring to the project that became hit comedy the troubled head Analyze This, in which

by

Crystal. In the music.

seeks the counsel

DeNiro,

script, both the

mob

boss

of a psychotherapist, therapist are big

and his

Bennett heard nothing further about the project for almost a year. Then his son in and financial manager, Danny Bennett, got a phone call from Warner Brothers, in the which the studio offeredTony to sing \"Got the World on a String\" $15,000 movie's final scene. As Danny described the conversation,\"... they made a fatal mistake. They told me they had already shot the film. So I'm like:'Hey, shot they the whole film around Tonybeingthe end gag and they're offering me $ 15,000P'\"1 Warner

In business aAs

up paying

negotiations,

as in

had

the

Warner Brothers

May

wound

Brothers

thought

quoted by Geraldine Fabrikant, 2, 1999, Money & Business,

$200,000 for Bennett'sperformance.

life, timing can problem

\"Talking p. 1.

Money

through

be everything.

If executives

carefully, they would

with Tony Bennett,\"

The

at

have

New York Times,

timing of

matters.

aside

Bennett

the

in

players' choices

Christmas Eve dinner party

t a

_

games

Explain

L04

Discuss

strategies

that enable players to

reap gains cooperation.

through

CHAPTER9

252

GAMES

AND

STRATEGIC BEHAVIOR

negotiated

Bennett

with

the movie. At

shooting

before

that

point,

would have

Bennett

if he asked too high realizedthat the script could be rewritten a fee. By waiting, studio executivesleft themselves with no attractive option other than to pay Bennett's price. The payoff to many actions not on the actions themselves, but depends only also on when they're taken and how they relate to actions taken by others. In previous economic decision makers confronted an environment that was chapters, in fixed. This will focus on cases which must consider essentially chapter people firm the effect of their behavior on others. For example, an imperfectlycompetitive will want to weigh the likely responses of rivals when whether to cut deciding or to increase i ts of this sort are the prices advertising budget. Interdependencies rule rather than the exception in economic and social life. To make senseof the world we live in, then, we must take these interdependencies into account. Our focus in Chapter 8 was on the pure monopolist.In this chapter, we'll how a few from the of can us better explore simple principles theory games help understand the behavior of oligopolists and monopolistic competitors\342\200\224the two of types firms for which are most imperfectly competitive strategic interdependencies important. Along the way, we'll also see how the same enable us to answer a principles of drawn from social interaction. variety interesting questions everyday

ANALYZE

GAMETHEORYTO

USING

DECISIONS

STRATEGIC

In chess,tennis,

move on what game, the payoff to a given depends In choosing your move, therefore, you must how you might and what further anticipate your opponent's responses, respond, moves your own responsemight elicit. Economists and other behavioral scientists in which have devised the theory of games to analyze situations the payoffs to different actors on the actions their opponents take. depend or

other

any

does in

your opponent

response.

THE THREE basic elements of a game the

players,

available to payoffs

each

each

player,

and

the

player receives for possible combination of

strategies

EXAMPLE

9.1

has three basic elements: the players, the list of possible actions (or strateavailable to each and the gies) player, payoffs the players receive for each possible combination of strategies. We'll use a seriesof examples to illustrate how these elements combine to form the basis of a theory of behavior. The first example focuses on an important strategic decisionconfronting two who an undifferentiated and must decide how much oligopolists produce product to spend on advertising.

A game

the strategies

each

GAME

A

OF

ELEMENTS

The

Cost

of Advertising

ShouldUnited Supposethat

Airlines

spend

and

Airlines

United

serve the Chicago-St.

$6,000per flight

more

on

money on

advertising? American Airlines are the

Louismarket. Each If United

route.

this

by $1,000 per flight, does now, United's profit will

market

and rise

American

spend $1,000more

profit of $5,500 the same amount

per

United's

on

$8,000. The payoff

flight

and

each

advertising,

American's will fall to will earn an economic if United spends so that

These payoffs are symmetric, while American increases its advertising

profit

will

structure

fall

to

is also

knows what the relevant payoffs will combinations of choices. If each must

spending on advertising,

per

flight.

on

economic

currently

increases its advertising spendingin this than it spends no more on advertising

to $8,000

$2,000. If both

air carriers that only an economic profit of

earns

what

should

per

$2,000

common be

for decide

United

flight

and

knowledge\342\200\224that

both

parties under

independently

do?

spending by is, each

each of whether

$1,000,

will rise

American's

to

company

the

possible

to increase

GAME

USING

THEORY TO

ANALYZE

253

DECISIONS

STRATEGIC

TABLE 9.1

The

Matrix

Payoff

for

Game

an Advertising

American's

Choices ad

Leave

Raise ad

spending

spending

the

same

do better

Both airlines Raise

ad

spending

United's

for United

$5,500

$5,500 for

$8,000

for United

$2,000 for

American

the samethan

American

both

if

raise spending. Yet holds spending the

Choices

the

if

leave ad spending

both

other

one

if

same,

always does

better to raise spending. Leave ad spending

the same

for United

$2,000

$8,000 for

$6,000

for United

$6,000 for

American

American

situation as a game.What are its three elements? The players are Each airline must choose one of two strategies: to raise ad spending or leave it the same. The are the economic $1,000 by payoffs profits that to the four scenarios from their choices. One way to correspond possible resulting summarize the relevant information about this game is to display the players, strategies, in the form of a simple table calleda payoff and payoffs matrix (see Table 9.1). Confronted with the payoff matrix in Table 9.1, what should United Airlines of this

Think

the

two

airlines.

of strategic thinking is to begin by looking at the situation from the other of view. will raise its party's point Suppose United assumesthat American in In on left column Table that United's best (the 9.1). case, spending advertising bet would be to follow suit (the top row in Table 9.1). Why is the top row United's best responsewhen American chooses the left column? United's economicprofits, in the cell of Table 9.1, will be $5,500, compared to only $2,000 if given upper-left it keeps the same the lower-left cell). (see spending United assumes that American will keep ad spending the Alternatively, suppose in Table 9.1). In that same (that is, that American will choose the right column case, United would still do better to increasespending because it would earn $8,000 (the to only $6,000 if it keeps spending the same (the lower-right cell), compared upper-right In this which American chooses, United will cell). particular game, no matter strategy earn a higher economic profit by increasing its spending on advertising. And since this is a similar conclusion holds for American: No matter which game perfectly symmetric, do?

The

essence

United chooses, American When one player has a strategy choice the other player makes, that strategy

all games involve that is to increase

is a

dominated

will

do

player

strategy\342\200\224one

leads

players,

to a

to leave

ad spending the

lower payoff

than

an

same

alternative

of the other player'schoice. that when each player chooses the dominant strategy, the Notice,however, if are smaller than each had left When United resulting payoffs spending unchanged. and American increasetheir spending on ads, each earns only $5,500 in economic to the $6,000 each would have earned without the increase. profits, compared choice,

regardless

the

describes

payoffs

that in a

game

for each possible combination of strategies

better

that

dominant strategies,but spending on ads.For both that

on ads. by increasing its spending a no matter which yields higher payoff is said to have a dominant Not strategy. in both this have one, and players game

payoff matrix a table

dominant yields

strategy one that

a higher

what the other

payoff players

no matter in a

game choose

dominated strategy

any to

strategy

available

who

a dominant

has

other

a player

strategy

254

9

CHAPTER

GAMES AND

STRATEGICBEHAVIOR

NASH

EQUILIBRIUM

A game is said to

choose,

the

given

the

players'

if each player's strategy is the choices. This definition of equilibrium

best he or shecan is sometimes

a Nash

called

other

players' choices

illustrated

EXAMPLE

equilibrium

John Nash, who developed the equilibrium, after the mathematician in the early 1950s. Nash was awarded the Nobel Prize in Economics in concept 1994 for his contributions to game theory.2 When a game is in equilibrium, no to deviate from his current strategy. player has any incentive If each in a game has a dominant as in Example 9.1, equilibrium player strategy, in games in which not occurs when each player follows that strategy. But even we can often identify an equilibrium every player has a dominant strategy, outcome. for instance, the following variation on the advertising as Consider, game

Nash equilibrium any combination of strategy choices in which each player's choice is his or her best

choice,given

be in other

in

9.2.

Example

Nash Equilibrium

9.2

ShouldAmerican SupposeUnited

Airlines

spend

American

and

Airlines

money on

more

advertising? Airlines are the only carriers that

serve

the

Louis market. Their payoff matrix for advertising decisions is shown in Table If each firm 9.2. Does United have a dominant Does American? strategy? does the best it can, given the incentives facing the other, what will be the outcome Chicago-St.

of

this

game?

In this game, no ad spending,so raising

Incentive

will do better to raise its is a dominant strategy for American. If American does not have a dominant raises its spending, United, however, strategy. United will do better to leave its spending unchanged; if American does not raise United doesn't spending, however,United will do better to spend more. Even though have a dominant strategy, we can employ the Incentive to predict what Principle

O

what United

matter the

advertising

does, American

budget

TABLE 9.2

EquilibriumWhen One Player

Lacks

a Dominant

American's

Strategy

Choices ad

Leave

Raise

ad

spending

United's

Raise ad

spending

spending

the

$3,000

for United

$4,000 for

American

In this

lacks game, United strategy, but

a dominant

same

American's

$8,000

for United

$3,000 for

American

Choices

its ad

spending the

Equilibrium

Leave ad spending

the same

$4,000

for United

$5,000 for

American

2His

life was

$5,000

occurs

lower-left cell.

for United

$2,000 for

dominant

strategy is to raise its ad spending. Because United can predict that American will choose the left column, United will do best to leave

American

also the subject of the

Academy

Award-winning

film A

Beautiful

Mind.

same. in the

USING GAME THEORY

is likely

to

game. United's managers are assumedto know

in this

happen

payoff matrix is, so they

TO ANALYZE

can

that American

predict

will

spend

the

what

on ads,

more

since that

dominant for United, strategy. Thus the best strategy given the predictionthat American will spend more on ads, is to keep its own spending unchanged. If both do the best they account of the incentives each faces,this can, players taking will in end the lower-left cell of the matrix: American will raise its game payoff is American's

on ads

spending

the definition of

a Nash

not.

corresponding to

the choices

that

Note

and United will

raise its ad

cell

lower-left

the

found itself in

If United

equilibrium.

in Table that

cell,

9.2 satisfy its

spending, a move

that would reduce its payoff from to abandon the lower-leftcell.Similarly, if American found itself in the lower-left cell of Table 9.2, its alternative would be to leave ad spending the same, a move that would reduce its payoff from to $5,000 to abandon the lower-left cell. The $2,000. So American also has no incentive lower left cell of Table 9.2 is a Nash equilibrium\342\200\224a combination of strategies for which each player's choiceis the best available option, given the choice made by

be to

alternativewould

$4,000 to $3,000.SoUnited

the

other

no incentive

player.

CONCEPT should

What

has

CHECK

9.1

and American

United

do

if

their

matrix

payoff

is modified as follows?

American

Leave Raise ad

spending

spending

the

$3,000 for

Raise ad

spending

$8,000

same

$4,000 for

United

for American

$5,000

United

for American

United Leave

$8,000 for

spending

same

the

$4,000

three elements they

of

can choose,

Equilibrium highest payoff of

are

game

any

for American

in

a game

occurs

available, given strategies

in

is called

each combination

a payoff

when each the

the list of

the players,

and the payoffs to

can be summarized

This information

combination

$2,000

DECISIONS

STRATEGIC

which

for American

United

USING GAMETHEORYTO ANALYZE

RECAP

The

$5,000 for

United

strategies

strategiesfrom of

strategies.

matrix.

player's strategy chosen

choice

by other

a Nash equilibrium.

yields

the

players. Such a

STRATEGIC DECISIONS

255

CHAPTER

256

GAMESAND STRATEGIC BEHAVIOR

9

The prisoner's dilemma in which

each

player

first

we discussed

example

advertising

games called the prisoner's dilemma.In the

a game has

DILEMMA

PRISONER'S

THE

chooses his dominant a whole.

a

dominant strategy, and when each plays it, the resulting payoffs are smaller than if each had played a dominated strategy

the

strategy,

result

above belongs to

an

prisoner's

to

is unattractive

when

the

class

important

dilemma,

group

of

each player of players as

THE ORIGINAL PRISONER'SDILEMMA The

next

recounts the original

example

drew its name.

scenario from

the

which

dilemma

prisoner's

Prisoner'sDilemma

EXAMPLE9.3

the

Should

confess?

prisoners

Horace and Jasper,are being held in separate cells for a serious in fact commit. The has hard they prosecutor,however, only enough evidence to convict them of a minor offense, for which the penalty is a year in jail. Each prisoner is told that if one confesseswhile the other remains silent, the If confessor will be cleared of the crime, and the other will spend 20 years in prison. both confess, they will an intermediate sentence of five These are get years. payoffs summarized in Table 9.3. The two prisoners are not allowedto communicate with If one another. Do they have a dominant what is it? so, strategy?

Two prisoners,

crime that

did

is game, the dominant strategy for each prisoner Horace will a sentence does, Jasper get lighter by speaking Horace will get five years (upper-left cell)instead of confesses, remains Horace will free silent, cell) Jasper go (upper-right in jail (lower-right cell). Because the payoffs are perfectly year will also do better to confess,no matter what Horace does. when each follows his dominant strategy and both confesses, In

this

to confess. out.

what

each had shown restraint.When cell), instead of the one year they right

cell).

the name

Hence

both would

confess, have

of this game, the

20

No

cell). If

(lower-left

instead of spendinga Jasper is that

symmetric,

The

difficulty

will do worse than if each five they get years (upper-left gotten by remaining silent (lower-

prisoner's

dilemma.

TABLE 9.3

The Payoff Matrixfor a Prisoner's Dilemma Jasper

Remain Silent

Confess

Confess

5 years

for each

for Horace

0 years

20years

for Jasper

Remain

Silent

The payoffs of prison receive

describe sentences

under

the lengths the two

different

combinations of choices.

Horace 20 years 0 years

for for

Horace Jasper

1

year

for each

matter

If Jasper

will

THE

CHECK 9.2

CONCEPT

in a new process. Games I and must both decide whether to invest Chrysler show how their profits millions of (in dollars) depend on the decisionsthey make. Which of these games is a prisoner's dilemma?

2

and

GM

below might

257

DILEMMA

PRISONER'S

Game

Game

I

Chrysler

Chrysler

Don't

Invest

invest

4 for GM

Don't

10 for

invest

2

invest

4 for

GM

Don't

each

12 for

Don't

5 for each

invest

12 for Chrysler

Chrysler

GM

Invest

GM

l2forGM Invest

The

5 for each

4 for

each

4 for

Chrysler

dilemma is one of

prisoner's

l2forGM 10 for

Invest

the

most

powerful

metaphors

in

Chrysler

of human

all

science. Countless socialand economic interactions have payoff structures analogous to the one confronted by the two prisoners. Some of those interactions occur between only two players, as in the examples just discussed; many others involve Games of the latter sort are calledmultiplayer larger groups. prisoner's dilemmas. But regardless of the number of playersinvolved, the common thread is one of conflict between the narrow self-interest of individuals and the behavioral

broaderinterests

of

OF CARTELS

ECONOMICS

THE

communities.

larger

coalition of firms that to restrict production for the conspires an economic profit. As we will see in the next example, the purpose of earning problem confronting who are trying to form a cartel is a classic illustration oligopolists of the prisoner's dilemma.

A

cartel

are

Considera

market

Each firm

Spring.

Customers

land.

notoriously

agreements for bottled

can

draw

supply to join

water

their

by

two

oligopolists,

of charge from a mineral

own bottles.

Rather

than

decide

firms

monopoly

price

means that

(see each

compete

Figure 9.1). The agreement isn't legally has the option of charging less than

firm

located

spring

together by selling water at the price a would constitutes monopolist charge. Under their agreement(which would and sell half the of water demanded produce quantity by

two

and

Aquapure

economic

9.1

Mountain

on its

own

with one another, the pure

profit-maximizing

the

a cartel), each market at the

enforceable,

the agreed

however,

price.

If

one

restrict

purpose of earning

unstable?

water served free

agree to

Naturalist

Economic

The

Why

cartel a coalition

is any

cartel

firm

which firm

ife

profit

of firms output an

that

for the

258

Demand for

2.00

Water.

Mineral

Faced with

the

**\\

v

v

o

with

a

cost would

marginal

produce 1,000bottles day (the

O

curve

demand

a monopolist

shown,

quantity

V

&

per

i.oo

o u

at which

marginal revenue equals and sell them at zero) of $

STRATEGICBEHAVIOR

9.1

FIGURE

The Market

zero

GAMES AND

9

CHAPTER

3.

Q.

mr\\

a price

1.00 per bottle.

0

sP

2,000

1,000

Bottles/day

sells water for Why

is this

Since the a monopolist

it will

firm,

agreement

to

likely

water is zero, the

of mineral

marginal

cost

with the

demand curve shown revenue

marginal

abide

their

by

a price

of $ I

per day.

But suppose Mountain

its price

reduced

Aquapure

Spring, it would

to 90

capture the entire quantity

profit-maximizing

demanded

cost.

by

bottle,

cents per bottle.By demanded

for the

the quantity, each will sell half the for an economic profit

that

At

agreement, per

quantity

1,000 bottles per day,

9.1 is

in Figure

marginal

equals

monopoly price per bottle. If the firms market total, or 500 bottles per day, at

$500

quantity

collapse?

is $1

of

the entire

capture

lower price.

for which

quantity

the other

than

less

the market at the

underselling

by the market, which, economic profit would

as

in Figure 9.2, is 1,100bottles per day. Aquapure's rise = from to 100 bottles $500 1, $990 per day\342\200\224almost per day ($0.90 per bottle)( per day) twice as much as before. In the process, Mountain Spring's economic profit would fall from $500 per day to zero. Rather than see its economic Mountain profit disappear, shown

Spring

would

match

Aquapure's

price cut,

recapturing

its original

50-percent

9.2

FIGURE

The Temptation

to

Violate a Cartel

2.00

Agreement. By

its price from $ I to 90 cents per can sell Aquapure

cutting

per

bottle

bottle,

the

market

entire

half the

quantity

per

day.

of

o

oo

0.90

quantity

demanded at that price, 1,100bottles per day, rather than

;$/bottle)

____>^

Pri<

mr\\

monopoly 1,000 bottles

_\\

0

sP 1,000 1,100

Bottles/day

2,000

share of the

THE

so difficult enforce agreements

Why is it

for

259

DILEMMA

to

companies

cutting?

price

against

PRISONER'S

firm charges $0.90 per bottle and sells 550 bottles per day, each market. But when each = an economic profit of ($.90 per bottle)(550 bottles per day) $495 per day, or $5 less per day than before. as an economic game in which the two Suppose we view the cartel agreement available strategies are to sell for $1 per bottle or to sell for $0.90 per bottle. The that result from these 9.4 showsthe are the economic strategies.Table payoffs profits earns

yet

for this

matrix

payoff in

that

following

game.

dominant

firm's

Each

each earns a

strategy,

price.

higher

The knows

game does not end with that if it cuts the price a little

the process

TABLE

earn a

further,

higher

substantially

firms

both

sell at

is to

strategy

lower profit

than

if each

$0.90 per bottle. Each recapture the entire market, profit. At every step, the rival

charging

it can

economic

lower price, had sold at the

the

firm and

in

firm

9.4

The Payoff

Matrix for a CartelAgreement Mountain

Charge

$ I /bottle

Spring

$0.90/bottle

Charge

$0 for Charge

$ I/bottle

$500/day for

Aquapure

each $990/day

for Mt. Spring

cartel

Aquapure

notorious

$990/day

Charge

$0.90/bottle

The dominant strategy for each firm is to charge $0.90 per or 10 cents per bottle bottle, less than called for by the

$495/day

Mt. Spring

instability

agreements.

Aquapure

$0 for

agreement.

for

each

Hence

the

of cartel

260

9

CHAPTER

GAMES AND

STRATEGICBEHAVIOR

match

will

example,

any price cut, zero.

Cartel agreements

until

the

falls

price

all

the

way

to the

cost\342\200\224inthis

marginal

confront participants

in with the economic incentives inherent such agreements have historically been so involves not just two firms, but an arrangement that can several; In many make retaliation cutters cases, discovering against price extremely difficult. which have broken the agreement is difficult. For example, the Organization of parties Petroleum Exporting Countries a cartel of oil producers formed in the 1970s (OPEC), to restrict oil production, has no practicalway to prevent member countries from oil offshore in the dead of night. secretly pumping

dilemma, prisoner's unstable. Usually a cartel

the

which

explains

AND THE

TIT-FOR-TAT

PRISONER'S

why

REPEATED

DILEMMA

all players cooperate in a prisoner's all defect. So people who confront lookout for ways to create incentives for mutual

When

when

way to penalize playerswho once,

this

out

turns

defect.

dilemma, prisoner's

When

to be difficult. But when

each gets

a higher

dilemmas

will be

What

cooperation.

players they

interact expect

with

to interact

payoff

they need is one

than

on the another

some only

repeatedly, new

possibilitiesemerge.

repeated

a standard that

dilemma

prisoner's

prisoner's

the same players

confronts

repeatedly tit-for-tat

repeated

a strategy prisoner's

for the dilemma

in

players cooperate on the first move, then mimic their last move on each partner's which

successive

move

that confronts prisoner's dilemma is a standardprisoner'sdilemma not just once but many times. Experimental research on repeated remarkprisoner's dilemmas in the 1960s identified a simple strategy that proves effective at defection. The is called and here's how tit-for-tat, ably limiting strategy In it works: The first time you interact with each subsesomeone, you cooperate. do what that person did in the previous interaction, quent interaction, you simply if defected on first then defect on your Thus, interaction, your partner your you'd next interaction with her. If she then cooperates, your move next time will be to cooperate as well. On the basis of elaborate simulations, computer University of Michigan political scientist Robert Axelrod showed that tit-for-tat was a remarkably effective even when a host of t strategy, pitted against ingenious counterstrategieshat had been designed for the explicit purpose of trying to exploit it. The successof tit-fortat requires a reasonably stable set of players, each of whom can remember what other have done in previous interactions. It also requires that have players players in a significant stake in what the for it is the fear of retaliation that future, happens the

dilemma

deters

A repeated players

same

from

people

Since rival might seem that

prices.

And

yet,

One difficulty

in players there are

the

one another it industry interact with repeatedly, would assure collusionto raise strategy widespread

same

the

in

tit-for-tat

notoriouslyunsuccessful. on there being only two In and industries, game. competitive monopolisticallycompetitive as noted

is

the

defecting.

firms

that

earlier, cartel agreements are effectiveness depends

tit-for-tat's

there are often several. many firms, and even in oligopolies than two firms and one defects now, how do the cooperators That will penalize everyone, selectively punish the defector later? By cutting price? in an industry, not just the defector. Even if there are only two firms these firms realize that other firms may enter their industry. So the would-be cartel members have to worry not only about each other, but also about the entire list of firms that decide to compete with them. Each firm may see this as a hopeless task might and decide to defect now, hoping to reap at least some economic profit in the short run. What seems clear, in any event, is that the practical problemsinvolved in implementing tit-for-tat have made it difficult to hold cartel agreements

When

generally

there

together for

are

long.

more

THE PRISONER'S

How did Congressunwittingly

television

the

solve

9.2

Naturalist

Economic

The

DILEMMA

261

^%

dilemma

advertising

producers?

confronting cigarette

In 1970,

Congress enacted a

January

I, 1971. As

after advertising on television illegal declining proportion of Americans who smoke,this law seems to have achieved its stated purpose of protecting citizens against a proven health hazard. But the law also had an unintended effect, which was to increase the economic run. In the year before the profit of cigarette makers, at least in the short law's passage, manufacturers spent more than million on advertising\342\200\224about $300 million more than they $60 spent during the year after the law was enacted. in advertising in in Much of the saving 1971 was reflected expenditures

the ads on When that

type

steadily

if

But

television

eliminating

advertising

eliminate

the manufacturers

didn't

why

own?

their

an imperfectly

curve shifts

the

more profitable,

made companies

cigarette

making

by

at year-end.

profits

cigarette

higher

law

evidenced

for

rightward,

of product

competitive firm reasons.

two

people

learn about it, and some of the product may

consumea different brand boosts sales industrywide;

second

the

people who

buy it. Second, brands.The

switch

merely

its demand never used

its product, who have

advertises First,

redistributes

first effect existing sales

brands.

among

its produces both effects in the cigarette industry, to advertise switching. Thus, the decision of whether confronts the individual firm with a prisoner's dilemma.Table 9.5 shows the payoffs a pair of cigarette producerstrying to decide whether to advertise. If facing both firms advertise on TV (upper-left of only $ 10 cell), each earns a profit million per to a profit of $20 million per year for each if neither year, compared

advertising

Although

primary

effect

is brand

advertises

advertises. (lower-right cell). Clearly, both will benefit if neither Yet note the powerful incentive that confronts each firm. RJR sees that if Philip Morris doesn't advertise, RJR can earn higher profits by advertising ($35 million per year) than by not advertising ($20 million per year). RJR also sees that if Philip Morris does advertise, RJR will again earn more by

were cigarette manufacturers happy when Congress made it illegal for them to advertise on television?

Why

TABLE 9.5

Profits from

Cigarette Advertising

as

Dilemma

a Prisoner's

Philip Morris advertise

Don't

Advertise

onTV

onTV

In

$35 million/yr Advertise

$10 million/yr

on TV

for

for

RJR

each $5 million/yr

for Philip Morris

$5

million/yr

for advertise

RJR

on TV

$20

million/yr

for

$35 million/yr

for

Philip

Morris

each

industries,

the

primary

of advertising is to consumers to switch encourage

brands. In such industries, the dominant strategy is to advertise heavily (upper-left

cell),even

RJR

Don't

many

effect

though

firms as a

group would do better by not advertising (lower-right cell).

262

CHAPTER

GAMES AND

9

STRATEGICBEHAVIOR

($10 million per year) than by not advertising because the RJR's dominant strategy is to advertise.And

($5

advertising

million

year).Thus,

per

are

payoffs

Philip

symmetric,

firm behaves rationally Morris's dominant strategy is also to advertise.So when each from its own point of view, the two together do worsethan if they had both shown restraint.The congressionalad ban forced cigarette manufacturers to do what they could not have accomplished on their own.

As the makes clear, understanding the prisoner's dilemma following example can help the economic naturalist to make senseof human behavior not only in the world of business, but also in other domains of life as well.

m

The

Economic

Why

do

at parties?

shout

people

9.3

Naturalist

Whenever large numbers ambient noise level rises

gather for conversation in a closed space, the attending such gatherings, people often throats and hoarse voices. If everyone at a normal complain of sore spoke volume at parties, the overall noise level would be lower, and people would hear do people shout? just as well. So why of people

After

sharply.

The problem involves the difference between individual incentives and incentives. Suppose everyone starts by speaking at a normal level. But because of the crowded conditions, conversationpartners have one another, even when no one is shouting. The natural difficulty hearing the point of the individual, is to simply raise one's voicea bit. But solution, from that is also the natural solution for everyone else. And when everyone the ambient noise level rises so that no one hears any speaks more loudly, group

before.

than

better

No matter more

others

what

loudly. Doing

do, the

so is a dominant

everyone follows the dominant hear shoutingis

wasteful,

were

to speak

No one Why

do

people

often

have

to

shout

to be

than

well)

wants

prefer that

heard

strategy,

everyone

had continued

individuals

acting alone

if

while

softly

to

cost to

others

will

individual

strategy

do

better

by

to speak have

shout, that

While

normally.

better

no

person

If

option.

be

wouldn't

with raw vocal cords, but people alternative of not being heard at all.

go home the

speaking

for everyone, in fact. Yet when the result is worse (no one can anyone

heard.

apparently

at parties?

THE PRISONER'SDILEMMA

RECAP The

dilemma prisoner's in which the

is a game in which each payoff to each player when

player

has a

dominant

that strategy is smaller than if each had chosena dominated Incentives strategy. analogous to those found in the prisoner's dilemma help to explain a broad range of in business behavior and everyday life\342\200\224among them excessive on spending The tit-for-tat advertising and cartel instability. strategy can help sustain strategy,

and

cooperation

in ineffective

in

repeated prisoner's dilemmas repeated prisoner's dilemmas.

two-player

multiplayer

chooses

each

but

tends

to be

GAMES

In the

so far,

discussed

games

which

and

simultaneously,

MATTERS players were assumedto choosetheir

TIMING

263

MATTERS

TIMING

IN WHICH

GAMES

IN WHICH

moved

player

strategies

For example,

matter.

didn't

first

in

the

dominant strategieseven players if they knew in advance what strategies their opponents had chosen.But in other Brothers and Tony Bennett such as the negotiations betweenWarner situations, is of the essence. described at the beginning of this chapter, timing if We with an example of a game whoseoutcomecannot be predicted begin outcome is clear if one player has the both players move simultaneously, but whose prisoner's

before the other.

to move

opportunity

would follow their

self-interested

dilemma,

The Importance of Timing Should The

build a

Dodge

Viper?

hybrid

Chevrolet Corvette

Viper and the

Dodge

whether to bring out a

of its

version

hybrid

knows

car. If both

is considering

other

the

that

pool of

a limited

for

compete

Each company

enthusiasts.

car

domestic sports

9.4

EXAMPLE

companies bring out

million in profit. If neither brings out a hybrid, each hybrids, If Chevrolet introduces a hybrid and does not, will earn million. $50 Dodge company Chevrolet will earn $80 million and Dodge will earn $70 million. If Dodge brings does out a hybrid and Chevrolet not, Dodge will earn $80 million and Chevrolet have a dominant will earn $70 million. Does either firm strategy in this situation? with Chevrolet What will happen in this game if Dodge gets to choosefirst, choice? after seen choosing having Dodge's each

When

will

earn $60

both

companies

for the

matrix

make their decisions

simultaneously, the

payoff

9.6

TABLE

The

must

example looks like Table 9.6.

of Being

Advantage

Different Dodge

Offer

Viper offer hybrid

Don't

hybrid

Profits are

$60 for Offer

Chevrolet

for

Don't

for offer

The logic of

the

profit

of a hybrid

hybrids

profits when

million

for

Dodge

one both

$50

million

Chevrolet

and

lower-left

left

Chevrolet

for

of car

figures sports

car

for

Dodge

in Table (hence

9.6 is that

although

the same type

million

Dodge

consumers

the higher profits when

of car than

when

each

generally

both companies

to compete (and hence the offers a different have

more

lower type).

than

(upper-right cells). generally

hybrid cars (uppercell) to nonhybrids

(lower-right cell). $50

million

than when neither does), the companieswill if both offer the same type of car another offer

type

other

offers a

prefer

million

hybrid

for

heavily

different

the

Customers

$80

with

$70

million

Dodge

$70

out

Chevrolet

for

when

higher

each company

Corvette

Chevrolet

bring

million

hybrid

$60

like the idea

$80

million

264

GAMES AND

9

CHAPTER

STRATEGICBEHAVIOR

The offer

decision

tree

a diagram

that

(or game

tree)

describes

the

possible movesin

a game

in

sequence and lists the payoffs that correspond to each possible of moves

combination

FIGURE

9.3

Decision

Tree for

Hybrid

In the payoff matrix in Table 9.6, neither company has a dominant strategy. best outcome for Dodge is to offer a hybrid Viper while Chevrolet does not a hybrid Corvette is to offer (lower-left cell). The bestoutcomefor Chevrolet

a hybrid Corvette while Dodge doesnot offer a hybrid Viper (upper-right cell). if Both the lower-leftand upper-right cells are Nash equilibria of this because game the companies found themselves in either of these cells, neither would unilaterally want to change its position. Thus, in the upper-right cell, Chevrolet wouldn't want to change (that cell is, after all, the best possible outcome for Chevrolet), and neither would Dodge (sinceswitching to a hybrid would reduce its profit from million $70 to $60 million). But without told we cannot where the more, being simply predict two companies will end up. If one side can move before the other, the incentives for action become however, in clearer. For which is tree, instantly games timing matters, a decisiontree,or game a more useful way of representingthe payoffs than a traditional matrix. This payoff in which they may describes the possible moves in the sequence type of diagram and lists the final for each combination of moves. occur, payoffs possible If Dodge has the first in Figure the decision tree for the is shown 9.3. move, game If At A, Dodge begins the game whether to offer a it chooses to by deciding hybrid. offer one, Chevrolet must then make its own choice at B. If Dodge does not offer a Chevrolet will make its choice at C. In either once Chevrolet makes its case, hybrid, the is over. choice, game

r-,

Example.

This decision

tree

shows

example, which they

sequence may occur.

million for Chevrolet million for Dodge

$70

million

$80

million

$80 $70

million

B

possible moves and payoffs the game in the hybrid the

$60 $60

hybrid

the

Don't

offer

for

in

i

Offer -

in

Offer

Don't

hybrid

hybrid

offer

Offer -

hybrid

million

for for

Chevrolet

for for

Chevrolet

Dodge

Dodge

hybrid

Don't

offer hybrid

,

p ,

Dodge

decides

Chevrolet

decides

$50 million for Chevrolet $50 million for Dodge

Final

outcome

strategically about this game, the key for Dodge is to put itself in and imagine how Chevroletwould react to the various choices it In confront. it will make sense for to assume that Chevrolet might general, Dodge will respond in a self-interested way\342\200\224that is, by choosing the available option that if it chooses to offer a offers the highest for Chevrolet. knows that profit Dodge B best at will be not to offer a (since Chevy's profit hybrid, Chevy's option hybrid if it chooses not to is $10 million at E than at D). Dodge also knows that higher will offer a hybrid, best at C be to offer one is (since Chevy's profit Chevy's option F if at than at thus knows that it offers a $30 million G). Dodge higher hybrid, it will end up at E, where it will earn not offer a $80 million, whereas if it does In thinking shoes

Chevrolet's

IN WHICH

GAMES

hybrid,

it will end up at

the first

move

follows

by

this

in

strategy is to offer one. its best

game, not to

choosing

of its

a hybrid

a threat

is such

time comes skepticalof the

any

time

Chevrolet's After

all,

own, no matter

what

wouldnot have

is one

threat

credible

Dodge from

deterred

have

Chevrolet

Could

to act.As

has

Dodge

And Chevrolet

by

did? The problem In the language

then

to

threatening with

this

strategy

of game theory,

a

when

the

interest to carry suggests, people are likely

the threatener's

Incentive

the

offering a hybrid

Dodge credible.

been

be in

will

that

million. Sowhen a hybrid.

offer

265

MATTERS

PROMISES

CREDIBLE THREATS AND offer

earn only $70

it will

where

F,

TIMING

out to

be

Principle if they know there will be no incentive to follow through when comes. The problem here is that knows that it would not be in Dodge interest to carry out its threat in the event that Dodge offered a hybrid. once Dodge has already offered the hybrid, best option is to offer Chevy's threat

a threat

threat

credible

that is

an action threatener's interest

in

to

take

the

to carry

out

Incentive

a

a nonhybrid.

Theconceptof

threat

a credible

for

performing

knewthey at that

over of

the

Mr. Bennett's salary demand singer would have beenextremely

to refuse

threaten

couldn't

in the between negotiations the matter of Mr. Bennett'sfee film had been shot, managers

figured prominently

managers and Tony Bennett in Analyze This. Once most

Warner Brothers'

credibly to another

point adapting a similar threat made before productionof film

the

In contrast,

have beencredible.

the

movie

because costly.

had begun

would

in some games credible threats are impossible to make,in others credible A in are credible is one that is the interests of the prompromises impossible. promise iserto keepwhen the time comes to act. In the following example,both players suffer Just

as

of the

because

inability to

make a crediblepromise.

A Credible Should

the business

owner open a

Promise

remote office?

office in a distant city. If she she can afford to pay a weekly salary of office, manage of over what the would otherwisebe ableto $500 $1,000\342\200\224a premium manager earn\342\200\224and still earn a weekly economic profit of $1,000 for herself. The owner's concern is that she won't be able to monitor the manager's behavior. The owner knows that by managing the remote office dishonestly,the manager can boost his take-home pay to $1,500 while the owner an economic loss of $500 per causing week. If the owner believes that all managers are selfish income-maximizers, will she open the new office? The

owner

of a

thriving

hires someone to

wants

business the

to start up an

new

The decisiontree for the remote-office 9.4. At A, the game is shown in Figure candidate to which the owner to E, managerial promises managehonestly, brings whereshe must decide whether to open the new office. If she opens it, they reach must decide whether to manage honestly. If the manager's C, where the manager is to make as much as he can, he will (bottom only goal money manage dishonestly branch at C) since that way he will earn $500 more than by managing honestly (top branch at C). So if the owner opens the new office, she will end up with an economic loss of If she had not opened the office branch at E), she would have $500. (bottom realized an economic of zero. Since zero is better than the owner will -$500, profit In the end, the opportunity cost of the choose not to open the remote office. to make a credible promise is $1,500:the manager's $500 manager's inability forgone and the owner's return. $1,000 salary premium forgone

credible

to

take

promiser's

EXAMPLE

a promise that is in the interest to keep

promise

an action

9.5

266

CHAPTER

GAMES AND

9

FIGURE

9.4

Decision

Tree for

Manager manages honestly; gets $ 1,000, manager gets $ 1,000

the

owner

Game.

Remote-Office

The best

STRATEGICBEHAVIOR

outcome

owner to open at 8 and for the

the

is

for

the

office

manager

Owner opens

to

remote office

manage the office honestly at C. But if the manager is purely self-interested and the owner knows it, this will not be an equilibrium

Manager owner

manager

\342\200\224$500,

gets $

1,500

candidate

Managerial

promises to

path

manages dishonestly; gets

Owner doesnot

manage

honestly

open

remote

office

outcome.

Owner gets gets

manager

$0, $500 by

working elsewhere

CONCEPT CHECK 9.3 Smith

and

tree

shown

who

can see

If

the

of this

are

Jones below

payoffs

game?

either the

what

Smith

at the end If

a game

playing

Once

before

top or bottom

in which Smith

has

the

first move

at A

decision

in the

chosen either the top or bottom branch at A Jones, branch at 8 or C. chosen, must choose the top or bottom

Smith has has

of each branch

are as shown, what is the equilibrium chose, Jones could make a crediblecommitment branch when his turn came, what would he do?

Smith

100 for

outcome to

choose

Smith

100 for Jones

60 for

Smith

105 for Jones

500 for

Smith

400 for Jones

50 for

Smith

420 for Jones

MONOPOLISTIC

COMPETITION

WHEN

LOCATION MATTERS In

many

games, the player who gets to move the case, for instance, in the decision 9.4. In that example, the sports car in Example sequential was

first

enjoys

a strategic

to produce a first mover did better hybrid because he was able to exploit the knowledge that both firms do better if each one's from the other's rather than similar to it. But that won't productis different always be true. When the feature that differentiates one seller's product from another's is firm in or the with the last move a sometimes location, temporal spatial game 9.4 illustrates. hand, as The Economic Naturalist enjoys the upper advantage.

That

of whether

GAMES IN

we

do

Why

267

MATTERS

Ife

stores locatedon adjacentstreetcorners?

see convenience

often

9.4

Naturalist

Economic

The

TIMING

WHICH

in clusters, followed by stores located cities, it's common to see convenience with no stores at all. If the stores were more spread out, almost all would walk to the nearest convenience store. enjoy a shorter Why do stores

In many

stretches

long

consumers

tend to

cluster in

fashion?

this

In Figure 9.5, suppose was the closest store for distributed

evenly

because

they

at A

store

when

the

the

1,200

shoppers

in

live

identical

A

first

apartment

opened,

it

houses

and the freeway one mile to freeway shop elsewhere Those who live to the west of the other store still further to the west,

live

cannot cross the shop either at A or

whichever is closer.In

who

the road between A to the east of the

along

the east.3Those who

store located at

convenience

that

this

freeway.

at some

why might a

setting,

profit-maximizing

to open a new store betweenA and the freeway choose B rather than at some intermediate locationsuch as C?

planning

entrepreneur

to locateat

in fact minimize the a store located at C would living between A and the freeway would have to walk to reach the nearest store. If there were a store at C, no shopper on this stretch of road would have to walk more than xh of a mile to reach the nearest store.The 800 people who live between point D (which is

It turns out

distance

that

halfway

between

who

that

shoppers

A and

C)

the

and

D and A

between

live

would

freeway

shop at C, while

the

400

would shop at A

the fact that C is the most attractive location for a new store Despite from the perspective of consumers, it is not the most advantageous for the store's owner. The reasonis that the owner's profit depends on how many choose to shop at his store, not on how far they have to walk to people get there.Given that consumers shop at the store closestto where they do retail merchants tend to locate in his live, the best option from the entrepreneur's perspectiveis to locate Why store at B, on the street corner just east of A That way, his store will be A and the freeway. It is this logic that often closer to all 1,200 people who live between of convenience stores, gas stations, and other helps explain the clustering monopolistimost important cally competitive firms whose differentiating feature is geographic location.

9.5

FIGURE

North

West -<-

The

Curious

Competitorsto Cluster.

-\342\226\272 East

'/3

group, consumers would if the enjoy a shorter walk store at B were instead located at C, or even at D. But a second store will attract more customers by

^

'/3 mile

mile

+C+

+D+

I

4

\302\243

3

Y>

mile

locating

3\"Evenly

distributed\"

A and the

freeway

live

a segment

along

means

is exactly

that

the number

of shoppers who length of that

proportional to the

one-tenth of a mile

in length

Tendency

of Monopolistic As a

'/3 mile

clusters?

would be Vio

live

on any

segment of the

segment.For X 1,200

example,

= 120.

road between the number who

at

B.

268

CHAPTER

9

GAMES AND

STRATEGICBEHAVIOR

The

hot dog

two

why

explain

Harold

economist

the

to one another For many

Hotelling.4

vendors on a stretch of

of the beach.

the endpoints or monopolistically

midway oligopolistic

almost

beach

9.4

Naturalist

Economic

The

Hotelling employed this

between

to

insight

locate next

invariably

competitive firms, an important is location in time rather than in physical for different airlines in the New York-Los

differentiation

of product

dimension

answer the questionposedin

that helped

insight

to

is due

of flight space. The timing departures market is one example.The timing of film showings by different local Angeles In these cases, too, we often movie theaters is another. see product clustering. in the New York-Los both United and American have Thus, Angeles market, in the afternoon on the hour. And local flights throughout departing exactly many movie markets,the first evening showing starts at 7:15 p.m. in dozens of different

theaters. In other

examples, the

saidto describethe soft

degrees in

cases for

in these classic

his

close to

lie very

that

occurs

mover

differs

does best

to

or

promises

game,

of changing

make otherwise

empty

or promises credible

mimic

by

player's move. tree rather

a decision

offer the

a second

closely.

products

existing

Check

Concept

well as the

9.3, as

remote-office game, confront in which

situation

because they cannot

they have

make crediblethreats

with

players

the

achieving

difficulty

or

prisoner'sdilemma,

promises.

the

a commitment desired outcome

If both

players

in

the

could make a binding promiseto remain both silent, original prisoner's would be assured of a shorter sentence, hence the logic of the underworld code of under which the family of anyone who evidence Omerta, provides against a fellow mob member is killed. A similar logic explainsthe adoption of military-armscontrol agreements, in which opponentssign an enforceable pledgeto curtail dilemma

spending.

The

device a way incentives so as to

and the

problem\342\200\224a

weapons

commitment

their

PROBLEMS

Gameslikethe one in cartel

of each

timing

Sometimes the second mover doesbest to from existing products. Other times markedly

COMMITMENT commitment problem a in which people cannot situation achieve their goals because of an to make credible threats inability

payoffs

the

summarized

best

are

matrix.

a payoff that

according to to see rival

is common

TIMINGMATTERS

games depend on

in many

outcomes

product

Here, too,

\"productspace.\"

With

products it

be

most might

one another, such as Coca-Colaand Pepsi. Clustering the reasons to those discussed by Hotelling analogous

GAMES IN WHICH

For such games,the than

different

array

might

more abstract

paper.

RECAP The

we

or carbonation.

sweetness

of

products

product's

for example,

drinks,

in a

location

matter

that

features

differentiating

commitment

problem

candidate could managerial if hired. The candidate honestly

the candidate

with

an

find

and

have

staff

problem

to provide

back in

the

4Harold Hotelling,

remote-office way

incentive

game of committing

could be solved if himself to manage

device\342\200\224something

that

the

provides

to keep his promise. aware of commitment

problems in the workplace of commitment devices to solve them. Consider,for her table confronting the owner of a restaurant.Shewants service so that customers will enjoy their meals and come

a variety

adopted

the

example,

the some

needs a commitment

Business ownersare well

threats

in

good

future.

Since good

\"Stability

service is valuable to her, she would

and Competition,\"

EconomicJournal

39, no. 1

be

willing

(1929), pp. 41-57.

to

COMMITMENT

extra for

pay waiters

service

it. For their

would

waiters

part,

pay. The problemis

the extra

for

return

in

be

to

willing

the

that

owner

269

good

provide

cannot

PROBLEMS

always

monitor whether the waiters do provide good service. Her concernis that having been paid extra for it, the waiters slack off when she isn't looking. Unless the may owner can find some way to solvethis problem,shewill not pay extra, the waiters will not provide good service,and she, they, and the diners will suffer. A better outcome for all concerned would be for the waiters to find some way to commit to good

themselves

Restaurateurs problem

is that the

solution

should

diner

The

quality.

since doing so will

strong incentive

help to

may depend on it.

The various

tried to

have

countries

many

diners

encouraging

by

this

of

service. in

to leave

solve this

good

devices

commitment

with

a generous

tip

good service in the future. And the waiter has a service because he knowsthat the size of his tip

to assure

provide

commitment

meals. The attraction position to monitor service

of their

tips in a good diner is always be happy to reward goodservice end

the

at

just

underworld

discussed\342\200\224the

code

of

military-arms-control agreements, the tip for the waiter\342\200\224all work the incentives facing the decisionmakers.But as the next they change in precisely the desiredway is not always incentives illustrates, changing

Omerta, because example

practical.

Changing Will

leave

Sylvester

a tip when

on

dining

the

Incentives

EXAMPLE 9.6

road?

dinner at a Sylvester has just finished a $100 steak is 500 miles from where he lives.The waiter If Sylvester provided service. cares only about himself, good restaurant that

leave

he

will

a tip?

Once the waiter has provided good service,

there

is no

leave a tip. In restaurants patronized by local diners, failure to tip is not a problembecausethe waiter can simply provide poor service the next time a nontipper comes in. But the waiter lacks that diners. leverage with out-of-town Having already received must choose between good service, Sylvester paying $100 and paying for his meal. If he is an essentially selfish $115 person,the former choice may be a compellingone.

way for

him

take

to

it back

CONCEPT the the

dines at a

fails to

diner

the

9.4

CHECK

A traveler

if

restaurant

far

home. Both he and and self-interested in first choose between

from

who serves him are rational narrow sense. The waiter must

waiter

providing good serviceand bad service, must choose whether or not to leave their interaction are as summarized

a tip. on the

game tree on the next

is the

commitment meal

in

page. What

The

the diner payoffs

for

accompanying most the diner

to pay for the right to make a binding to the waiter) to leavea tip at the end (visible the event of having received good service?

be

would

whereupon

willing

of the

leaving a tip at an out-of-town of service you receive?

Will

restaurant

affect the

quality

270

CHAPTER

9

GAMES AND

STRATEGICBEHAVIOR

20 for

waiter

20 for

diner

-5

waiter

Diner

Waiter

for

30 for diner

10 for

waiter

5 for diner

PROBLEMS WITH

COMMITMENT

SOLVING

PSYCHOLOGICAL INCENTIVES In

the

all

the

obtaining

get

we have

games

best

heard, and

so

on.

The irony,

outcomes. Better selfish

incentives

material

next

conditioned

example to

develop

feelings of

treated

sympathy

games, is that players be achieved by

can

sometimes

but

not

do altering

not attain the

always.

problems

arise

less often than

in

more

narrowly

societies.

The Impact of Moral In a

face,

unjustly\342\200\224commitment

self-interested

EXAMPLE 9.7

players

of these

most

in

outcomes

relevant material incentives is not possible, commitment be solved by altering people's psychologicalincentives.As illustrates, in a society in which people are strongly moral sentiments\342\200\224feelings of guilt when they harm others, for their trading partners, feelings of outrage when they are

If altering the problems can sometimes the

were assumed to care only about players themselves.Thus, each player'sgoalwas to shortest the best chance to be jail sentence,

outcome for

monetary payoff, the

the highest

the best

possible

discussed so far,

moral society, will

Sentiments

the

business

owner

open a

remote

office?

the owner of the thriving business who is trying to decide whether again in an office a distant the open city. Suppose society in which she lives is one in which all citizens have been strongly conditioned to behave Will she open honestly. Consider

to

the remote

office?

Suppose,for if he

instance,

candidate would suffer guilt pangs owner. Most peoplewould be reluctant to assign let's suppose that feelings. But for the sake of discussion, that

the managerial

embezzled money from the

a monetary value to guilty those feelings are so unpleasant, the would be willing to pay at least manager if to avoid them. On this the he $10,000 assumption, manager's payoff manages will be not $1,500, but $1,500 $10,000 = -$8,500. The new dishonestly decision tree is shown in Figure 9.6. In this case, the best choicefor the owner at B will be to open the remote office because she knows that at C the manager'sbest choice will be to manage in The of is that the honest this course, honestly. irony, manager exampleends in richer than the selfish the w ho earned up manager previousexample, only a normal salary.

PROBLEMS

COMMITMENT

FIGURE Manager owner

manages honestly; gets $ 1,000,

9.6

The Remote Office

manager gets $ 1,000

Game

with

an Honest

Manager. If Owner

opens

remote

office

Manager

manager

Managerial candidate Owner

manage

dishonestly;

manages

owner gets

promisesto

gets

\342\200\224$8,500

not

does

Owner

gets $0,

manager gets $500 by working

Fundamentally Selfish?

Are People As

of the

sense

narrow

the assumption that term does not always capture

suggests,

in strategic

choice at

9.7

Example

settings. Think, for restaurant.

out-of-town

an

in the are self-interested full range of motives that govern about the last time you had a meal tip? If so, your behavior was quite

people

a

normal. Researchershave found that tipping rates diners are essentially the same as by out-of-town by

local

elsewhere

the

example,

Did you leave

in

restaurants

in restaurants

mostly

patronized

patronized mostly

diners.

there are many to the outcomes predicted on the basis of exceptions in the most narrow senseof the term. the assumption that are self-interested people often seek revenge even at ruinous cost to People who have been treated unjustly themselves.Every day, people walk away from profitable transactions whoseterms In these believe to be \"unfair.\" and countless other ways, peopledo not seem they to be pursuing self-interest defined. And if motives beyond narrow selfnarrowly interest are significant, we must take them into account in attempting to predict Indeed,

and explain Preferences Economists they

calculate

human

behavior.

as Solutions to Commitment Problems to view preferences as ends in themselves. Taking what actions will best serve those preferences. This

tend

them

as given,

approach

to the

used theorists, study of behavior is widely by other social scientists, and by game and others.In its standard form, it assumes purely military strategists, philosophers, self-interested preferences for present and future consumption goods of various leisure and so on. Concerns about sorts, fairness, pursuits, guilt, honor, sympathy, and the like typically play no role. Yet such concerns clearly affect the choices people make in strategic interactions. Sympathy for one's trading partner can make a businessperson trustworthy even when material incentives favor cheating. A sense of justice can prompt a person to incur the costs of retaliation, even when those costs will not undo incurring

the original

injury.

can clearly this shape behavior in these ways; however, does not solve commitment problems. The solution to such problemsrequires but also that others have some only that a person have certain preferences, Preferences

owner

can identify a candidate who

choose to manage honestly at C,she will hire that candidate at 8 and open the remote office. would

\342\200\224$500,

open remote office

honestly

the

managerial

alone not

way of

271

272

CHAPTER9

GAMES

AND

STRATEGIC BEHAVIOR

discerning them. Unless the cannot land employee

predator can identify

continue to

reliable

perfectly

always steer

be victimized

at

character

in the choice commitment avoiding)

Vigilance solving

(or

least

clear

motivate

will

in ventures

unless the retaliation,

dishonest

of

are either

trust,

requiring

perfectly accurate That

persons.

by dishonest

occasionally

judgments

prohibitively expensive.

engage

could make

If people

partners?

could

they

we might

with whom

reliable

character judgments,

whose character

employee,

become a victim.

that person is likely to From those among

can we identify

pay

victim

a potential

can identify the trustworthy is predicated on trust. And

owner

business

a job whose

that

people

persons suggests that

impossibleto make or

of trading partners is an essentialelementin in problems, for if there is an advantage

being

in only and being perceivedas such,thereis an even greater advantage will to be honest. After a liar who have all, appearing appears trustworthy better than one who about sweats and opportunities glances furtively, profusely, has difficulty making eye contact. Indeed,he will have the same opportunities as an honest personbut will get higher payoffs because he will exploit them to

honest

fullest.

the

end, the question of

can make reasonably accurate people one. that empirical Experimental studies have shown even on the basis of brief encounters are involving strangers, subjects adept at will will in who and who defect dilemma predicting cooperate prisoner's games. in which only 26 percent of subjects For example,in one experiment defected, the accuracy rate of predicteddefections was more than 56 percent. One might

In the

character judgments

that

expect

Do you that

know someonewho

to you

cash

interact

it

at

individuals can

identify

selectively

If so, then

concert?

people to solve commitment at

with them,

know well would an envelope

return

would

a crowded

can help

character

personal

as honest

lost

if you

those we

regarding

predictions

accurate.

whether

an

is

others who

some

least

be

more

even

containing $1,000 problems.

As long

are honest, and

can

honest individuals can prosper in a competitive

environment.

PROBLEMS

COMMITMENT

RECAP

AND THE

EFFECTSOF

INCENTIVES

PSYCHOLOGIAL

Commitment arise when the inability to make credible threats problems and promises prevents people from desired outcomes. Such achieving can sometimes be solved commitment devices\342\200\224 problems by employing of changing incentives to facilitate making credible threats or ways promises.

Most

applications

of the theory

interestedin the narrow senseof

of

games the

term.

that players are selfIn practice, however, many

assume

tips in out-of-town restaurants\342\200\224appear assumption. The fact that people seemdriven by a more complex range of motives makes behavior more difficult to predict, but also creates new ways of commitment incentives often can serve solving problems. Psychological as

choices\342\200\224such inconsistent

with

leaving

this

as commitment

players' material incentivesis who are able to identify honest impractical. example, people trading and interact with are able to solve them, partners, selectively commitmentproblems that arise from lack of trust. devices

For

when

changing

in

you acceptthe claim

REVIEW

-

of games to analyze of one's actions dependon the actions taken by others. Games have three basic elements:the players; the list of possible actions, or strategies,from which each player can choose; and the the players receive for those strategies. payoffs The payoff matrix is the most useful way to situations

which

in

in games

information

summarize this

the

which

in

timing

Equilibrium

the perspective of

in

Equilibrium

of

\342\200\242 A dominant

strategy

regardless of the

is one

a higher payoff by the other player. as the prisoner's dilemma, each occurs in strategy. Equilibrium each player chooses his or her that

yields

\342\226\240

basic

of a

elements

game (252)

device

commitment

commitment

(265)

(264)

dominant

(268)

problem

threat

decision tree

credible

dominated

(268)

credible promise(265)

spends

both

game helps excessive

explain

as

and failure

to reap the trust. (LOl)

requiring

these dilemmas if

can resolve

they

make

\342\226\240

TERMS

KIT

prisoner's more remain silent.

each

such as guilt, sympathy, payoffs. Moral sentiments and a sense of justice often foster better outcomes than can be achieved self-interested by narrowly to work, the players. For this type of commitment relevant moral sentimentsmust be discernible by one's potential trading partners. (L04)

In somegamessuch player has a dominant such games when dominant strategy. In other games, not all players have a dominant strategy. (LOl, LOl)

cartel (257)

often

is each

it

in certain binding commitments to behave as those involved in ways. Some commitments\342\200\224such achieved military-arms-control agreements\342\200\224are by the altering the material incentives confronting players. Other commitments can be achieved by relying on psychological incentives to counteract material

can

chosen

strategy

races,

this

of interactions

benefits

\342\200\242 Individuals

yields the highest payoff available, chosen by the other. (LOl) strategies

the

given

players

feature

arms

advertising, military potential

each player's

occurs when

a game

from The group. prisoner's

as a

The incentive structure of such disparate socialdilemmas

choice

strategy

often unattractive

are

because dominant strategy to confess,yet if time in jail if both confess than this

has

dilemma

moves is not decisive.In gamesin which a decision tree providesa much more matters, of the information. (LOl, L03) summary

\342\200\242

outcomes

\342\200\242

the players' timing useful

-

SUMMARY

the theory the payoffs

use

\342\200\242 Economists

273

QUESTIONS

strategy

Nash

(254)

equilibrium

matrix (253)

payoff

prisoner's dilemma

(253)

strategy (253)

repeated

game tree (264)

(256)

prisoner's

dilemma (260)

make a

mistake by This was almost Tony Bennett to

tit-for-tat (260)

REVIEW QUESTIONS 1. Explain

a military arms dilemma. (LOl)

why

a prisoner's

2. How is your dilemma

if you

game not just once but times

with

the

same

defect

rather

partner?

in a

many

indefinitely

(LOl)

in such

restaurants

tipping

does

seem

to assure are people

reasonably good service,do you think sense? (LOl) always selfish in the narrowest

Warner

did

Why

Brothers

filming of Analyze before with negotiating in the final scene? (L03) the

until

finished perform

5. SupposeGeneralMotors is firm

3. Describe the commitment that narrowly problem self-interested diners and waiters would confront at restaurants located on interstate highways. Given that

4.

waiting

prisoner's learn that you will play the to

incentive

altered

race is an example of

sedans.

The

expensivecapital

other small

to hire a small trying door handles for Buick task an investment in requires that cannot be used for any equipment

manufacture

to

the

purpose. Why might the firm refuse to undertake this

a long-term

contract

handles? (L03)

fixing

the

president of venture

price

the

without

of the

door

274

CHAPTER

9

GAMESAND STRATEGIC BEHAVIOR

PROBLEMS

Graw Hill

which following game, calledmatching pennies, you are playing Each of you has a penny hidden in your hand, facing either heads up or tails up (you know which way the one in your hand is facing). On the count of \"three,\" show your pennies to each other. If you simultaneously the face-up side of your coin matches the face-up side of your friend's coin, you If to the two the faces do not match, your friend getsto keep get keep pennies.

1. Consider the

Mc

connect'

| ECONOMICS

^ .Study rEcon McGraw-Hill

Visit

your mobile

store and

Econ

a

the

pennies.

a. Who

(LOl)

are the players in

app

Study

app todayl

matrix

a payoff

Construct

download

the Frank:

friend.

with

b. Is therea dominant c. Is there an equilibrium? 2. Consider the one to four

game?

are each

What

player's strategies?

Harry has four quarters. his offer, she keeps the

game.

following

of them. If

this

for the game. If so, what? strategy? If so, what?

she

He can offer

accepts

her and

from

Sally

offered

Harry

quarters

Harry keepsthe others. If Sally declines Harry's offer, they both about ($0). They play the game nothing only once, and each cares only amount of money he or she endsup with. (LOl) a. Who are the players? What are each player's strategies? Construct a decision tree for this game. b. Given their goal, what is the optimal choice for each player? and Baldrick are rational,

3. Blackadder

self-interestedcriminals

dungeon. They face the

cells in a dark medieval separate in the matrix. displayed

get the

imprisoned prisoner's

in

dilemma

Blackadder Confess

Confess

Deny

Baldrick

0 for

5 years

for each

20 years

for

Blackadder

Baldrick

20 years

Deny

0 for

for

Baldrick

1

year

for each

Blackadder

is willing to pay $1,000 for each year by which he A corrupt jailer tells Blackadder can reduce his sentencebelow 20 years. that before he decides whether to confess or deny the she can crime, tell him Baldrick's decision. How much is this information worth to Blackadder? (LOl)

Assume that Blackadder

In studying

two things: final, Sam is concernedabout only he spends studying. A good grade will give him a benefit of 20; an average grade, a benefit of 5; and a poor grade, a benefit of 0. By studying a lot, Sam will incur a cost of 10; by studying a little, a if Sam cost of 6. Moreover, studies a lot and all other studentsstudy a little, if he will get a good grade and will ones. But they get poor they study a lot for

his grade

and the

his

economics

amount

and he studiesa little, they

Finally,

if he

and all

of time

will

get

good

grades and

other students study the

same

he will get a poor one.

amount

of time,

everyone

will get

grades

time.

study

a. Model

(L02) as a two-person

situation

this

a

to study

strategies are

and

little

other students. Includethe

b.

outcome equilibrium the best outcome?

is it perspective,

5. Newfoundland'sfishing

the

Sam and all

are

players

the students'

From

game?

If

at

maintained

levels.

high

Company

A

and

has

industry

a. Model this situation

(L02)

as a prisoner'sdilemma

Company

the quota. Include appropriate payoffs in the absence of is inevitable overfishing

quota agreement.

b. Provide c. In many

environmental

another

matrix.

the

make reliable characterjudgments cooperator trustworthiness of potential partners. Explain why this solution available in many situations involving degradation of the environment. are consideringthe

airplane manufacturers

a 150-passengerjet. Both produce

the

millions

of

new

are

The payoff matrix

planes.

of a

production

to enter the

whether

deciding

why

of the

is to

would-be

and

Explain

enforcement

effective

are

players

keep the quota

of a prisoner's dilemma. a way out of the dilemma

example dilemmas,

prisoner's

potential

in

the

which

in

the strategies are to

B and

break

6. Two

the

which

recently declined sharply due to were though fishing companies supposedly bound by a quota all fishermen had abided by the agreement, yields could have been

even overfishing, agreement.

this

in

preferences regarding

prisoner's dilemma in

to study a lot, and in the matrix. payoffs

is the

What

share Sam's

students

Other

grades.

average

and

is as follows

the

is not

new product,

market and are in

values

(payoff

a

for

about

dollars):

Airbus

Don't produce

Produce

100 for Boeing

-5 for

Produce

each

0 for

Airbus

Boeing 0 for Boeing

Don't produce

The implication

to support only

100 for

of these payoffs

is that

loss.(L02)

a.

two

Identify

the

subsidize

enters

What

possible

the effect of

b. Consider

does the

hill.

for

outcomes

a subsidy.

Suppose

producer,

Airbus,

demand is large enough

firms enter, in

this

both will sustain a

game.

the European with

a check

market. two

Revise the

outcomes

subsidy have?

(pre- and

post-subsidy).

What

Union decidesto

for $25

payoff matrix to account is the new equilibrium outcome? the

c. Comparethe 7. Jill and

equilibrium

European

the market

If both

manufacturer.

one

0 for each

Airbus

for

million if this

qualitative

it

subsidy. effect

both have two pails that can be used to carry water down from a Jack Each makes only one trip down the hill, and each pail of water can be sold the pails of water down requires considerableeffort. Both $5. Carrying Jill

276

CHAPTER9

GAMES

AND

STRATEGIC BEHAVIOR

and Jack hill,

a.

would be willing market

Given

top of the b. Jill

enough

$2 each

pay

a second

pails of water will

how many

prices,

to avoid carrying

avoid carrying

one pail down the down the hill. (L02) pail each child fetch from the

hill?

and Jack's

parents are worried that

one

with

revenues

to

$3 to

an additional

and

another.

Suppose

from selling the

the payoff matrix each pails of water

for

the

the

two

children

don't cooperate

they make Jill and Jack share

water. Given

that

both

equally

are self-interested,

the number Jill and Jack face regarding What is the outcome? carry. equilibrium

decisions

should

their

construct of

Considerthe following \"dating game,\" which has two players,A and B, and in two strategies, to buy a movie ticket or a baseball ticket.The payoffs, given in are as shown the matrix below. Note that the occur points, highest payoffs when both A and B attend the same event. B Buy

Buy baseball

movie

ticket

ticket

Buy

2 for

movie

ticket

OforA

A

0 for

3 for B

Buy baseball

ticket

1

forA

1

for

B

3 forA

2 for

B

B

and simultaneously. players A and B buy their tickets separately what to do knowing the available choicesand but payoffs not what the other has actually chosen. Each player believes the other to be rational and self-interested. (LOl, L02, L03) a. Doeseither player have a dominant strategy? b. How many are there? (Hint: To see whether a given potential equilibria combination of strategies is an equilibrium, ask whether either could player his or her strategy.) get a higher payoff by changing c. Is this game a prisoner's dilemma? Explain. d. Supposeplayer A gets to buy his or her ticket first. Player B does not observe As choice but knows that A chose first. Player A knows that player B knows

Assume

Each must

that

decide

he or shechosefirst. e. Supposethe situation

What

is the

is similar

equilibrium outcome? to part d, exceptthat player

B chooses

first.

What is the equilibrium outcome?

The owner of a thriving business wants to open a new office in a distant city. If he can hire someone who will manage the new office honestly, he can afford to that a of more than the $2,000 ($1,000 pay person weeklysalary manager would be able to earn elsewhere)and still earn an economic profit of $800. The owner'sconcernis that he will not be able to monitor the manager's behavior and that the manager would therefore be in a position to embezzle if from the business.The owner knows that the remote office is money in the can earn which results an economic $3,100, managed dishonestly, manager loss of $600 per week.(L03) a. If the owner believes that all managers are narrowly self-interested income will he the new office? maximizers, open

ANSWERS

b. Supposethe owner person

religious

to

avoid

open the remote

owner

the

Will

$15,000 to

up to

pay

a managerial candidate is a devoutly dishonest behavior, and who would be willing the guilt she would feel if she weredishonest.

that

knows

condemns

who

10. Imagineyourself

office?

for

in your car sitting someone to pull out the same moment a

the

tree.

a campus

in

lot that is currently

parking

so that you can park your car. Somebody full, waiting but at driver who has just arrived overtakes pullsout, you in an obvious attempt to park in the vacated before can. spot you Suppose this in that driver would be willing to pay up to $10 to park spot and up to $30 to avoid into an with the benefit of parking is $10 (That is, you. getting argument and the cost of an argument is $30.) At the same time he guesses, accurately, that too would be willing to pay up to $30 to avoid a confrontation and you in to to the vacant $10 park up spot. (L03) a. Model this situation as a two-stage decision tree in which his bid to take the is the move and are to and (1) protest (2) not space opening your strategies to protest. If you protest (initiate an argument), the rules of the game specify that he has to let you take the Show the payoffs at the end of each space. of

branch

b. What is the equilibrium outcome? c. What would be the advantage of being ableto communicate other driver that your failure to protest would be a significant cost to you?

No

matter

the

same.

spending.Soeachplayer its ad

does, United will do United does, American

American matter what

what No

will

spending and United will

play leave

will

its dominant strategy: its ad spending the

American's

American will

spending

ad

spending

gets

$8,000

same

United gets

gets $3,000

American

the same

strategy,

the

United gets

Leave ad

matter

spending

American

$4,000 $5,000

gets

Choice

United's

In game

spending

American

raise

Choice

Raise ad

United

ad

ad spending to raise ad

same. (LOl)

Leave

Raise

(HECKS

to leave do better

better

to the

psychological

TO CONCEPT

ANSWERS

.1

credibly

1, no matter

what

GM again

what

Chrysler

$4,000

does, GM better

United gets American

will

do

will

do

$5,000

gets

$2,000

to invest, and no Each has a dominant had not invested. So

better

to invest.

does, Chrysler in following it, each does worse than if it In game 2, no matter a prisoner's dilemma. will do better to invest; but no matter what

but

game 1 is

GM

gets

$8,000

what

Chrysler

does,

GM does, Chrysler

TO CONCEPT

CHECKS

277

278

CHAPTER

9

GAMESAND STRATEGIC BEHAVIOR

not to

better

do

will

it, each gets a So

strategy.

9.3

of

payoff

2 is

game

invest. Each has a 10\342\200\2245 more

dominant

than

strategy,

not a prisoner'sdilemma.

and

in following

had played its dominated

if each

(L02)

the branch that maximizes his payoff, Jones branch at either B or C. So Jones will choose the bottom no matter what Smith chooses. SinceSmith will comes, B do better on the bottom branch at than on the bottom branch at C (60) in Smith will choose the branch at A. So this is for (50), top equilibrium game Smith to choose the top branch at A and Jones to choose the bottom branch at B. Smith gets 60 and Jones gets 105.

assumes that which is the bottom branch when his turn Smith

will

choose

100

for

Smith

100 for Jones

60for

Smith

105 for Jones

500 for

Smith

400 for Jones

50 for

Smith

420 for Jones

could make a

If Jones matter

at

what, and

A

Jones

crediblecommitment

would do better. Smith would choose the top

Jones 400. (L03)

9.4

The

to

both

would

branch at

the top branch no the bottom branch Smith 500 and giving

choose

choose C,

of this game in the absence of a commitment to tip is that will give bad service becauseif he provides good service, he knows diner's best option will be not to tip, which leaves the waiter worse if he had provided good service.Sincethe diner gets an outcome of can commit to leaving a tip (15 more than he would get in the such a commitment), he would be willing to pay up to 15 for the

equilibrium

waiter

the

the

that off

than

20

if

absence right

he of to

commit.

(L04) 20 for waiter

20 for

diner

Diner

-5 for waiter

Waiter

30 for

10 for

5 for

waiter diner

diner

I

CHAPTER||0

and

Externalities

Rights

Property

LEARNING

OBJECTIVES

After

this chapter, able to:

you

reading be

should

LOI

Definenegative

externalities

positive

and

their

analyze

effect

and

on resource

allocation.

L02 L03

theorem.

K

externalities

can be remediedand ^

When

the

how

Explain

effects of

\\

discuss

and

Explain

the Coase

costs

allocations

or benefits accrueto are often inefficient.

droll television A

ad

peoplenot

for

directly

a British

involved

brand of

in transactions,

market

pipe tobaccoopens with a quietly on a park bench,

gentleman sitting him lies a his and reading a book of poetry. Before smoking pipe f or a mother duck with her pond, unrippledexcept swimming peacefully a raucous of bursts onto the scene with a ducklings. Suddenly group teenage boys remote-controlled toy warship. and launch their boat Yelling laughing, they and maneuver it in aggressive pursuit of the terrified ducks. from his relaxation, the gentleman looks up from his book and Interrupted draws calmly on his pipeashe surveys the scene before him. He then reaches into his bag, pulls out a remote control of his own, and begins manipulating the joystick. The scene shifts underwater, where a miniature submarine rises from the in of the Once the boat is the sub's the depths pond. boys' sights, gentleman on his remote control. Seconds later, the boat is blown to pushes a button smithereens by a torpedo. The scene fadesto a close-upof the tobacco label. company's distinguished-looking

EXTERNAL

COSTS

External costsand

external

generate activities.

AND

BENEFITS

benefits\342\200\224externalities, for

short\342\200\224are

activities

that

costs or benefits that accrue to people not directly involved in those These effects are generally unintended.From the pipe smoker's point

discuss

the

why

amount

of

externality

is almost

optimal

an

never zero.

L04

the

Illustrate

of the show

tragedy

commons, and how

private

ownership is a preventing

L05

way

of

it.

Define positional externalities

effects

and

they can

and their show

how

be remedied.

280

CHAPTER

external

cost (or negative a cost

externality)

activity that falls other than those

the

AND

EXTERNALITIES

10

of an

on

people who pursue

activity

generated by the marauding boys was an external cost. Had the by boys' rowdiness, they may well have regarded the pipe smoker's retaliatory as an external benefit. gesture This chapter focuses on how externalities affect the allocation of resources. in which Adam Smith's theory of the invisible hand applies to an ideal marketplace externalities do not exist. In such situations, Smith the self-interested argued, actions of individuals would lead to socially efficient outcomes. We will see that when the parties affected by externalities can easily negotiate with one the another, invisible hand will still produce an efficient outcome. in many But cases, such as the scene depictedin the tobacco ad, negotiation is In those the actions of individuals won't lead to cases, self-serving impractical. efficient outcomes. The need to deal with externalities and other collective-action problems is one of the most important rationales for the existence of government. of

the noise

view,

others

disturbed

been

The following allocation of

external

benefit

(or positive

externality) a benefit of an activity received by people other than those who pursue the activity

externality benefit of an

an

external

activity

cost or

distort

the

Her neighborson all

sides

externalities

which

Externalities

the honeybee

Does

in

resources.

Positive

10.1

the ways

illustrate

examples

ALLOCATION

RESOURCE

AFFECT

EXTERNALITIES

HOW

EXAMPLE

RIGHTS

PROPERTY

keeper face the

incentives?

right

earns her living as a keeper of honeybees. Because bees apples. pollinate appletreesas they Phoebe keeps,the larger the harvests will be in the Phoebe

takes only her own costsand benefits keep, will she keep the socially optimal Phoebe's hives

into

(Part

number

for

forage

account

I)

surrounding

grow

nectar, the more hives If Phoebe orchards.

in deciding

how

many

hives

to

of hives?

constitute an

external or a positive externality, for the benefit, takes only her own personalcostsand benefits into account, she will add hives only until the added revenue she gets from the last hive just it. But since the orchard owners also benefit from equals the cost of adding additional the total benefit of adding another hive at that point will be greater hives, than

If she

owners.

orchard

its

cost.

then,

Phoebe,

will

keep

too

few hives.

chapter, problemslike the one in Example 10.1 have orchard owners to pay beekeepers for keeping additional hives. But such solutions often require complex negotiations between the affected are not practical. parties. For the moment, we assumethat such negotiations As we will

in the

later

discuss

severalpossiblesolutions.

EXAMPLE 10.2

One

is for

Negative Externalities Does

the

honeybee

keeper

face the

right

incentives?

(Part

2)

in Example as a keeper of honeybees. But now her 10.1, Phoebe earns her living are not apple growers but an elementary school and a nursing home. The neighbors more hives Phoebe keeps,the more students and nursing home residentswill be stung how by bees. If Phoebe takes only her own costs and benefits into account in deciding many hives to keep, will she keep the socially optimal number of hives?

As

Phoebe's hives constitute an residents, If she considers her own costs and benefits in negative externality. only how hives to she will continue to add hives until the added deciding many keep, revenue from the last hive is just enough to cover its cost. But since Phoebe's neighbors alsoincur costs when she adds a hive, the benefit of the last hive at that point will be smaller than its cost. Phoebe, in other words, will keep too many hives. For

externalcost,

the

students

or a

and

nursing

home

EXTERNAL

Every

benefits of

externalities,

allocation of

the best

produce

costs and benefits will tend externalities and too little an

generates

activity

another

too much that

activities

and

both positive

interests will coincide only one

to engage in

in

the

in

is,

is best not

does

self-interest

positive externalities. When private

externalities,

event that the opposing

unlikely

281

BENEFITS

consider only their own that generate negative

activities

generate

negative

out\342\200\224that

the activity that when an activity

who

Individuals

resources.

it

carries

AND

costs and

relevant

the

level of generates no externalities\342\200\224the will be best for societyas a whole.But be they positive or negative, individual

individual

the

generates

benefits.When all who person

directly to the

accrue

activity

the activity

when for

an

costs and

involves

activity

COSTS

and

social

effects offset

exactly.

AFFECT SUPPLYAND DEMAND? in a supply The effects of externalities on resource allocation can be shown and demand diagram. Considerfirst the case of negative externalities. Figure 10.1(a) depictsthe supply (Private MC) and demand curves for a product whose DO EXTERNALITIES

HOW

factories

powers the

be

for the optimal, last unit of the

socially

to buyers of

costs or benefits. Imagine, say, market comes from nonpolluting

equilibrium price and

The resulting then

external in this

no

productioninvolves

the

in the

quantity

reasons discussed in product consumed

the

that

that

energy

generators.

hydroelectric

for this product will 3 and 7: The value

market Chapters

(as measuredon the

demand

cost of producing it (as measured on curve) exactly equal to the marginal the supply curve), leaving no further from possible gains exchange. But now suppose that a protracted drought has eliminated hydroelectric power factories to rely instead on electric powerproduced by coalgeneration,forcing

will be

cost

pollution

cost falls

as

on

not

factories, Private again

Now each unit of output is accompanied by an produced of XC, as shown in Figure Since the external pollution 10.1(b). firm owners but on others who live downwind from their is still the supply curve for this product, and its demand curve is so the equilibrium price and quantity will be exactly the same as in

generators.

burning external

MC

before,

10.1

FIGURE

Costs

How External

Deadweight losscausedby = $2

pollution

Social MC = Private

c

0

Private MC

^^

^ 1,300

'

0

^^^X.

j\\p 12,000

2,300 \302\247

^]XC

-\\\\>\"

2,000 \302\243

^ Pri

\\D 0

8,000

1

(a)

Quantity

2,000

FDrivate \342\202\254 equilibrium

optimum

(tons/year)

+ XC

= $1,000/ton

^Private

1,300

Social

cQuantity

MC

(a)

(tc >ns/year)

(b)

MC

a market

When

external the

^

^w

Allocation.

million/year

. ^

Resource

Affect

costs

resulting

has no

or benefits, equilibrium

quantity and price are socially optimal, (b) By contrast, when production of a good accompanied by an external

is

cost, the market equilibrium price ($ 1,300per ton) is too low and the market (12,000

quantity

equilibrium

tons per year) is too high. The deadweight loss from the

negative

area of the triangle,

$2

externality is the blue-shaded million

per

year.

CHAPTER10

282

AND

EXTERNALITIES

PROPERTY RIGHTS

But this time the private market market equilibrium level of output at which the demand curve (D) intersects

Figure 10.1(a). As

before,

output

at

level

that

the

level, the value

output

to consumersof

only $1,300 per ton, external cost) is $2,300per ton. while

This

fewer

means

that

society

current

last

producing

product. Indeed, output exceeds 8,000 tons the

same

MC.

Private the

unit that

however,

Note,

last

unit

conclusion

per year,

that

produced is

of output

(including

economic surplusby

could gain additional

units of the

whenever the

cost of

true

the

equilibrium is not sociallyoptimal. is 12,000 tons per year, the the

producing

will continue to hold the level at which the output includes all relevant marginal the external pollution cost,

demand curve intersectsSocialMC.SocialMC, which costs of producing the product, is constructed by adding level of output of the XC, to every value along Private MC. The socially optimal in occurs where Social MC intersects the demand curve. As shown good Figure 10.1(b), it is 8,000 tons per year. This is the level of output that exhausts all f rom At that the benefit of the product, as possibilities exchange. quantity, marginal measured by what buyers are willing to pay for it, is exactly equal to the marginal cost of producing the marginal it, which is the private marginal cost MC plus will be higher than pollution cost XC. The market equilibrium quantity thus the socially for a whose external costs. optimal quantity good production generates of pollution reduce total economic surplus By how much does the presence from its maximum which occurs at an value, output level of 8,000 tons per year in in Note the that as 10.1(b)? Figure diagram output expands past 8,000, the cost of each successive unit measured on the Social MC is greater (as curve) marginal than the marginal benefit of that unit (as measured on the demand curve). from 8,000 tons per year to the private level, 12,000 tons Expanding output equilibrium in thus entails a cumulative reduction total economic per year, surplus equal to the in area of the blue-shaded or million $2 triangle Figure 10.1(b), per year. The in loss from is million this market. $2 deadweight pollution per year What about a good whoseproduction external benefits? In Figure 10.2, generates Private demand is the demand curve for a product whose production generates an external benefit of XB per unit. The market equilibrium quantity of this good, Q , is the output level at which Private demand intersectsthe supply curve of the product This market is smaller than the (MC). time, equilibrium quantity socially optimal level of output, denoted Qsoc.Qsoc is the output level at which MC intersectsthe in Figure demand curve (the curve labeled Socialdemand 10.2), which socially optimal is constructed by adding the external to value Private XB, benefit, every along demand. Note that the private market equilibrium again fails to exhaust all possible

FIGURE 10.2 A

Whose

Good

a

Generates

Production

PositiveExternality

for

market

equilibrium quantity, Q smaller than the socially quantity,

individual buyers

Qsoc,

vt,

MBpvt

f

are willing

loss from the externality the

positive

is the

blue-shaded

area of triangle.

^^ N.

^MC

TV^

MBsoc MBpvt

because

deadweight

productThe

+ XB

is

' ^\\^

^^^^\\^ ^^^

to

pay only for the benefits they reap from directly consuming the

/ positive externality

^^V

For such goods,the

optimal

Deadweight loss from

V^

Consumers.

|

^v

^V

\342\226\240 \342\226\240 > i i

0

^pvt

Quantity

^soc

Socialdemand Private

demand

Private demand

=

+ XB

THECOASETHEOREM

from exchange. Thus, at Q , the marginal is only MB , which is smaller than output the amount XB. The market equilibrium by

of producing an additional unit benefit of an additional marginal unit thus will be lower than the quantity for a whose external benefits. socially optimal quantity good production generates In comparison with the maximum attainable total economic surplus in this how much does the total economicsurplus associated with the private market, In fall short? note that at the benefit of the 10.2, equilibrium Figure Q , marginal XB measured on the curve labeledSocial is units (as demand) product larger than its marginal cost (as measured on MC).Total economic will continue to surplus increase by successively smaller increments as output grows from Q to Qsoc, the cost

gains of

quantity.

optimal

socially

is

area

the

the

The total deadweightloss associatedwith of the blue-shaded triangle in Figure 10.2.

the

positive

externality If the production of a product generates a positive externality, why do we say that this product causes a reduction in total economic surplus? To say that there is a in loss this market does not mean that the causes harm. deadweight positive externality it means that failure to take the into account makes the Rather, positive externality economic surplus associatedwith private equilibrium smaller than it could have been. Failure to reap an economic benefit is the same thing as sustaining an economic loss. To summarize, whether externalities are positive or negative, they distort the allocation of resources in otherwise efficient markets. When externalities are individual present, the pursuit of self-interest will not result in the largest possible economic

surplus.

thus

by definition.

inefficient

thus

THEOREM

COASE

THE

is

outcome

This

in a situation is inefficient means that it can be rearranged a way that say that would make at least somepeoplebetter off without others. Such situations, harming we have seen, are a source of creative tension.Theexistenceof inefficiency, after all, means that there is cash on the table, which usually a race to see who can triggers To

capture it. For example,we inefficiently low

output

discounts available that

inefficiencies

because

that

saw

to price-sensitive

buyers.

gave monopolists

Abercrombie

toxins

dump

Abercrombie'sfactory

an

As the

incentive

an

to make

Result

from

remedial

action.

Externalities

river? (Part I)

in the

waste by-product. If Abercrombie dumpsit located downstream. The toxins are short-lived and other than Fitch. At a cost, Abercrombie can filter out the toxins, in which case Fitch will suffer no damage at all. The relevant are listed in Table 10.1. gains and losses for the two individuals If the law does not penalize Abercrombie for dumping in the river, and toxins if Abercrombieand Fitch cannot communicate with one another, will Abercrombie with or without a filter? Is that choice operate socially efficient? in

the

produces

TABLE

Costs

a toxic

damage to Fitch, a fisherman cause no damage to anyone

river, he causes

10.1

and Benefits

of Eliminating ToxicWaste (Part I) With

Gains

to Abercrombie

Gains to

Fitch

filter

$l00/day $l00/day

Equilibrium

next examples illustrate, the

That

Inefficiencies

Will

pricing results in

create similar incentivesfor

from externalities

result

monopoly

level, the potential for gain

a

Without

filter

$l30/day $50/day

EXAMPLE 10.3

283

CHAPTER

284

10

PROPERTY RIGHTS

AND

EXTERNALITIES

has an incentiveto operatewithout a filter since he earns $30 per with a filter. But the outcome when he doesso is day operates inefficient. when Abercrombie without a Thus, filter, the total daily socially operates = + to both is $130 $50 $180, compared to $100 + $100 = gain parties only had operated with a filter. The daily cost of the filter to $200 if Abercrombie = Abercrombie is only which is smaller than its $130 \342\200\224 $100 $30, daily benefitto Fitch \342\200\224 = of $100 Abercrombie does not install the filter implies $50 $50. The fact that Abercrombie

if he

than

more

a squandereddaily

EXAMPLE

The Efficiency Principle\342\200\224Surplus

10.4

Suppose the costs and Even

This

O

will use

Abercrombie the economic

time, when

observation that

economic

surplus, it would gain than before. Fitch for

Suppose,

him for

would

result

$10 per day

7 the

Chapter have in

the

a total

cost.

use a filter?

slice (the

a larger largest

possible

have

a larger

and Fitch to

Abercrombieto usea filter.

offers Abercrombie$40 per day

to

compensate

and Fitch will then be exactly net gain of $20.

Both Abercrombie

before, for

off than

better

has

thus

a filter

both Abercrombie an incentive to pay

enable

a filter.

with

from

Recall

filter.

previous example one another at no

will Abercrombie

can

that Fitch

instance,

operating

a

the

with

pie grows larger, everyone

Efficiency Principle).Becauseuse of net

are as in

can now communicate does not require him to do so,

law

the

though

the filter

using

2)

(Part

and Fitch

Abercrombie

that

except

river?

the

of

benefits

Incentive

and

dump toxins in

Will Abercrombie

Efficiency

of $20.

surplus

daily

CONCEPT CHECK 10.1 In

Ronald

for operating

people

can

negotiate

at no

cost

the

purchase and sale of the right to perform activities that cause can externalities, they always arrive at efficient solutions to the problems caused by

externalities

EXAMPLE

10.5

solution.

efficient

important

profoundly

1991 Nobel Prize Why, not

would

and

by which be

still

better

off

Fitch could than

before?

a professor at the University of ChicagoLaw School, was the if people can negotiate with one another at no cost over the activities that cause externalities, they will always arrive at an This insight, which is often called the Coase theorem,is a was awarded the idea, for which Coase (rhymes with \"rose\")

Coase,

to perform

right if

a filter

with

see clearly that

first to Coase theorem

is the largest whole-dollar amount

10.4, what

Example

compensate Abercrombie

in

Economics.

you might ask, be there in the

should first

Fitch

pay

if not

place

to filter

Abercrombie

for Abercrombie's factory?

out toxins

that

The

is undeniable. Yet Coase out that externalities are points toxins do harm Fitch, to be sure, but preventing Abercrombie from them would penalize Abercrombie, by exactly $30 per day. emitting the Why should Fitch necessarily have right to harm Abercrombie? Indeed, as the next even if Fitch had that right, he would exercise it only if illustrates, example efficient outcome. filtering the toxins proved the most of this

rhetorical force

reciprocalin

question

The

nature.

Social Efficiency Will

Abercrombie the

Suppose

dump law

says that

has Fitch'spermission.If as shown another

at

in

Table

no cost,

toxins

10.2,

in the

river? (Part

Abercrombie the

relevant

may

costs

and if Abercrombie

will Abercrombie

not

3)

dump

toxins

in the

of filtering and Fitch can negotiate

and benefits

filter out the toxins?

river unlesshe the with

toxins one

are

THE

COASE

THEOREM

TABLE 10.2

Costs and Benefitsof Eliminating

to Abercrombie

Gains to

filter

Without $l50/day

$IOO/day

Fitch

3)

(Part

filter

With Gains

Waste

Toxic

$70/day

$IOO/day

efficient outcome is for Abercrombie to operate in that case will be as $220 surplus comparedto with a filter. Under the Fitch has the to insist that $200 law, however, only right Abercrombie usea filter. We might expect him to exercise that right since his own to $100 per day if he did so. But because this outcome $70 gain would rise from would be socially inefficient, we know that each party can do better. that Abercrombie Suppose,for example, gives Fitch $40 per day in return for Fitch's permission to operatewithout a filter. Each would then have a net daily gain of $110, which is $10 better for each of them than if Fitch had insisted that Abercrombie use a filter. Abercrombie's sure But failure pollution harms Fitch, enough. to allow the pollution would have caused even greater harm to Abercrombie. Note that without a filter,

this

The Coase liable

for

if externalities

they

time the

for

the most total daily

theorem tells us that regardless the affected parties will one negotiate costlessly with

can

the law

of whether achieve

damages,

another.

efficient

solutions

Note

carefully

holds polluters to that

this

does

will be indifferent about whether the law holds If polluters are liable, they polluters for damages. will end up with lower responsible incomes and those who are injured by pollutants will end up with higher incomes if the law does not hold pollutersliable\342\200\224even though than the same efficient production methods would be adopted in each case. When polluters are held liable, must remove the pollution at their own expense.When are not held they they not imply

affected

that

parties

liable, those who are injured by

Externalitiesare hardly of actions

examples externalities

can

distort

and deal intelligently that

that are

altogether free of resources, it

the allocation with

arises because

isolated

and

of sharedliving

Ann

and

Betty

share an

is

important

the following

Consider

them.

to recognize

example of

an

them

externality

arrangements.

Cost-Benefit

Will

pay polluters to cut back. occurrences. On the contrary, finding of them is difficult. And because

must

pollution

rare

Principle\342\200\224Shared Living

Expenses

apartment?

for $600 per month, apartment If the rent each for $400 separately apartments, per month. were the same for both the two women would be indifferent alternatives, paid between or separately, except for one problem:Ann talks living together constantly on the telephone. Ann would to month for this $250 pay up per privilege. Betty, for her part, would pay up to $150 per month to have better access to the phone. If the two cannot install a second phoneline,should live together or separately? they

Ann

and

Betty

or

Ann

and

cost. The benefit

can live together in 2 one-bedroom

Betty of

should living

a two-bedroom

live together only if the together is the reduction in

apartments would cost a total bedroom

in

of

unit, their benefit from

$800 living

per month, together

benefit of their

rent.

doing

so exceeds

Since 2

the

one-bedroom

compared to $600 for a twoper month. Their cost of

is $200

EXAMPLE 10.6

285

286

CHAPTER

10

PROPERTY RIGHTS

AND

EXTERNALITIES

living together

is the least

objectionable telephone

habits.

to Ann's to to $250 pay up per month is too small to persuade her to behavior for a compensation is smaller than the total saving in

costly accommodation

Since Ann

changing But

O

make

to

her behavior, the $200 rent saving change. Betty is willing to put up with Ann's payment of only amount $150 per month. Sincethat Ann the least solution to the is for Betty to live with and simply rent, costly problem with her behavior. put up Table 10.3 summarizes the relevant costs and benefits of this shared living Ann The Cost-Benefit tells us that and arrangement. Principle Betty should live together if and if the benefit of exceeds the cost. The cost of the shared only living together is not the sum of all costs but the least living arrangement possible costly avoid

Cost-Benefit

can

they

would be willing

in Since the $200 per month saving (or problems) of shared living. the least costlyaccommodation to the phone problem, Ann and can Betty of $50 per month their living quarters. reap a total gain in economic surplus by sharing

accommodation to the

problem

exceeds

rent

TABLE 10.3

The Gain

in

Shared

from

Surplus

Living Arrangements of Shared

Benefits

Total cost of separate apartments

Living Rent savings

of

cost

Total

shared apartment

from sharing

$6007month

(2)($400/month)

$2007month

$800/month

of Shared

Costs

Problem Ann's

Tolerate

Curtailed

usage

phone

usage:

phone

Rent

savings

Least

to

($2007month)

Betty

from Shared

costly accommodation shared

living

tolerates

Ann's phone

$ 150/month

in Surplus

Gain

phone

usage:

$250/month

\342\200\224

solution to the problem

solving problem

problem

solving

Least costly

Betty's cost of

of

Ann's cost

Living

usage:

$150/month

Living

=

Gain

in surplus:

($50/month)

problems

($ 150/month)

Some

conclude that Ann two share the rent equally, Betty added to the $150 cost of putting might

people

because

if the

which

when

the

sound, however, illustrates, is the 10.7

Cost-Benefit What is

will

up with Ann's phone behavior comes of living alone. As persuasive as that argument may it is mistaken. The source of the error, as the following example that the two must share the rent assumption equally.

to $50 morethan

EXAMPLE

should not live together Betty end up paying $300 per month\342\200\224

and

cost

the highest rent Betty

Rent

Unequal

Principle\342\200\224Paying

be

would

Amounts

to pay

willing

for the two-bedroom

apartment?

In

Example

10.6,

$400 per month, problem. Since the is $150 per month,

Betty's alternative reservation

her most the

she highest

is to

price

would

be

monthly

live

for a willing

alone,

rent she

would

arrangement

living

to

which

pay

to avoid the

would be willing

mean paying no phone

with

phone problem to

pay

for the

REMEDIES

shared apartment is

to pay the for

= $250.

\342\200\224

$150

$350

namely,

difference,

than

Ann

$400

to

paying $400

live

should

much

If she

alone.

Principle\342\200\224Splitting Economic

Ann and Betty

pay if they

to split

agree

their economic surplus

Surplus equally?

Table is $200, 10.3, the total rent saving from the shared apartment least costly solution to the phone problem is $150, the monthly gain in economic is $50. We know from 10.7 that Ann's reservation surplus Example for is month and is $400 $250. So if the two women price living together per Betty's want to split the $50 monthly surplus equally, each should her pay $25 less than reservation Ann's rent will thus be and The $375 $225. price. monthly Betty's, result is that each is $25 per month better off than if she had lived alone.

As we

saw

in

and since the

CONCEPT

10.2

CHECK

in a two-bedroom 10.6 and 10.7,Ann and Betty can live together in 2 apartment for $600 month or one-bedroom per separately apartments, each for $400 per month.Ann would to month rather than moderate her telephone habits, $250 per pay up and would to 150 month to achieve reasonable access to the $ Betty pay up per would also be to to to avoid the $60 per month telephone. Now, suppose Betty willing pay up loss of privacy that comes with shared living space. Should the two women live together?

As in Examples

EXTERNALITIES

FOR

REMEDIES

LAWS AND

REGULATIONS

efficient solutions to externalitiescan be found whenever the can with one another at no cost. But is not parties negotiate negotiation with a noisy muffler imposes costson others,yet they always practical. A motorist him In cannot a compensation flag him down and offer payment to fix his muffler. of this most that cars have recognition difficulty, governments simply require the explicit or implicit purpose of a large share\342\200\224 Indeed, working mufflers. the lion's share\342\200\224of laws is to solve problems caused by externalities. The perhaps of such laws is to achieve the solutions have reached goal help people they might

We

have

seen

that

been

able

affected

had they

When

to negotiate

negotiation

who can accomplishit up

with

Ann's

annoying

with

is costless, the the

at

phone

lowest

one

another.

task of

adjustment

cost. For

habits because

falls on the party examples, Betty put less costly than asking also place the burden

generally

instance, doing so was in

our

Many municipal noiseordinances can it at the lowest cost. Consider,for accomplish the restrictions on loud which often take effect at a later hour example, party music, on weekends than on weekdays. This pattern reflects both the fact that the gains from loud music tend to be larger on weekends and the fact that such music is more likely to disturb people on weekdays. By setting the noise curfew at different hours on different of the week, the law places the burden on partygoers days the week and on the weekend. Similar during sleepers during logic explains why noise ordinances allow motorists to honk their horns in most but not in neighborhoods, the immediate of a vicinity hospital. The list of laws and regulations that may be fruitfully viewed as solutions to externalities is a long one. When a motorist drives his car at high speed, he endangers not just his own life and property, but also the lives and property of others.Speed

Ann

to

change

her habits.

of adjustment on thosewho

EXTERNALITIES

Ann will have pays that amount, which is a better alternative per month, clearly

Cost-Benefit

How

FOR

EXAMPLE 10.8

287

CHAPTER

288

10

AND

EXTERNALITIES

PROPERTY RIGHTS

and a host of limits, no-passing zones, right-of-way rules, seen as reasoned attempts to limit the harm one party inflicts jurisdictions

laws requiring

have

even

laws

on another.

may

be

Many

on their cars by

snow tires

install

motorists

that

other traffic

the

These laws promote not just safety, but also the smooth flow of traffic: If one motorist can't get up a snow-coveredhill, he delays not only himself, but also the motorists behind him. Similar reasoning helpsus understand the logic of zoning laws that restrict the in kinds of activities that take various of cities.Because residents place parts many in an uncongested some cities have place a high value on living neighborhood, enacted laws specifying minimum lot sizes.In placeslike Manhattan, where a zoning of land t o build and tall shortage encouragesdevelopers very large buildings, zoning laws limit both a building's height and the proportion of a lot it may occupy. Such restrictions recognizethat the taller a building is, and the greater the proportion of its lot that it occupies, the more it blocks from reaching surrounding sunlight properties. The desire to control external costs also helps to explain why many cities establish zones for business and residential Even within business separate activity. cities limit certain kinds of commercial For districts, many activity. example, in an effort to revitalize the Times Square neighborhood, New York enacted a zoning City law banning adult bookstores and pornographic movie theaters from the area. Limitations on the discharge of pollutants into the environment are perhaps the clearest examples of laws aimed at solving problems caused by externalities. The details of these laws reflect the of placing the burden of adjustment principle on those who can accomplish it at least costs. The discharge of toxic wastes into for tends to be most on those whose rivers, example, strictly regulated waterways commercialfishing or recreational uses are most highly valued. On other the burden of is to fall more on fishermen, waterways, adjustment likely heavily recreational and swimmers. boaters, Similarly, air-quality regulations tend to be strictest in the most heavily populated regions of the country, where the marginal benefit of reduction is the pollution greatest. first

of November.

The following

mr

externalities

The Economic

Amendment's

First

The

that

to

used to

provide

protection the

solve

than

Court

good.

has ruled,

someone to

Why the

does right

the U.S. Constitution of free speech?

protect

yell

\"fire\"

instances, the

insights

about

economic naturalist.

if

is

there

speech

of

are

as the

that cause The

exceptions.

Amendment

First

free

well

of speech

important

theater of

legal remedies are First Amendment

communication's acts

of

pattern

The

externalities.

regulating

the

the

how

the violent overthrow

external benefits

costs.

by

are some

in a crowded

to advocate

those

external

and

of

illustration

of open

for instance, that

someone

the

value

Yet there

allow

justify

caused

problems

of identifying

difficulty

harm

free speechand

protection of are another

acknowledges the decisive practical

Coase's

which

in

purpose of free speech laws?

is the

exceptions

ways

rich fodder for the

10.1

Naturalist

What

additional

suggest

examples

how societiesdeal with

more

Supreme

does not allow no fire, nor does it the far

government. small to

too

In

The the

does

Why on

government

subsidize private

Economic

Naturalist

EXTERNALITIES

FOR

REMEDIES

10.2

289

m

property ownersto plant trees

hillsides?

their

not only to discourage activities that generate negative to encourage activities that generate externalities.The positive for example, benefits not just the landowner, but planting of trees on hillsides, In recognition also his neighbors of this fact, by limiting the danger of flooding. subsidize the planting of trees. Similarly, many jurisdictions Congress budgets in support millions of dollars each year of basic research\342\200\224an implicit associated with the generation of new acknowledgment of the positive externalities

Societies

use

laws

Q~S

also

but

externalities,

knowledge.

AMOUNT

OPTIMAL

THE

As we

saw

in

NEGATIVE

other negative externalities entails both costs and benefits. cans should be recycled, the 6, when we analyzed how many until the cost of further abatement pollution just equals the cost of abatement rises with the amount general,the marginal

and

pollution

Curbing

OF

IS NOT ZERO

EXTERNALITIES Chapter

best policy is to curtail marginal benefit.In of pollution eliminated. (Followingthe Low-Hanging-Fruit use Principle, polluters the cheapest cleanup methodsfirst and then turn to more expensive ones.)And the law of diminishing marginal utility that beyond some point, the marginal suggests benefit of pollution reduction tends to fall as more pollution is removed.As a the cost and marginal benefit curves almost intersect at less result, marginal always than the maximum amount of pollution reduction. The intersection of the two curves marks the socially optimal level of pollution If pollution is curtailed by any less than that amount, society will gain reduction. more than it will lose by pushing the cleanup effort a little further. But if regulators curves intersect, push beyond the point at which the marginal cost and benefit will incur costs that exceed the benefits.The existenceof a socially society optimal level of pollution reduction implies the existence of a socially optimal level of and that level will almost always be greater than zero. pollution, We saw in Chapter 6 that because peoplehave been conditioned to think of level of pollution as bad, many cringe when they hear the phrase \"sociallyoptimal How can any positive level of pollution be socially optimal? But to pollution.\" level of pollution is not the same as saying that speakof a socially optimal pollution is good. It is merely to recognizethat has an interest in cleaning society up the but only up to a certain point. The underlying idea is no different environment, from the idea of an optimal level of dirt in an apartment. After all, even if you spent the whole day, every day, vacuuming your apartment, there wouldbe some in it. And because you have better things dirt left to do than vacuum all day, you more than the minimal amount of dirt. A dirty probably tolerate substantially in the air you breathe. But in both is not good, nor is pollution cases, apartment the cleanup effort shouldbe expandedonly until the marginal benefit equals the

marginal cost.

COMPENSATORY As

noted,

negative

when

externalities

TAXES

AND SUBSIDIES

transaction costs prohibit negotiation among affected lead to excessive output levels because activities

parties, that

produce

Why

does

the government

subsidize scientific

research?

Increasing

a

Opportunity

Cost

290

CHAPTER10

AND

EXTERNALITIES

PROPERTY RIGHTS

negative externalities are misleadingly solution to this problem, proposed by

such activities

attractive the

British

to those

economist

who engage in them. A. C. Pigou, is to

One

make

them. Figure 10.3(a) reproducesFigure 10.1's unit of an external cost of portrayal output generates XC ton. Because fail to take this external cost into equal producers is 12,000 tons per year, or 4,000 tons per year account, the private equilibrium more than the socially optimal level of 8,000 tons per year. that same market after the of a tax of 10.3(b) Figure portrays imposition $1,000per unit of output. This tax has the effect of raising each producer's curve curve shifts upward by $1,000 marginal cost by $1,000, so the industry supply at every quantity. Note that the resulting private equilibrium output, 8,000 tons per year, is now exactly equal to the sociallyoptimal output. Although many critics insist that taxes always reduce economic efficiency, here we have an example of a tax that actually makes the economy more efficient. The tax has that effect because it forces producers to take explicitaccount of the fact that each additional unit of output on the rest they produce imposes an externalcostof $1,000 of society. attractive

less

of a market in to $1,000 per

Private

without

each

equilibrium

Private

pollution tax

with

MC =

Social

MC

Private

XC =

c 2,300

S 2,000 g

by taxing

which

tax

Private MC

+ XC

Tax =

$1,000/ton

Private

equilibrium

pollution

MC

+ Tax

$1,000/ton

Private

MC

1,300

Private

Quantity

(tons/year)

equilibrium

optimum

Quantity

8,000 12,000

0

12,000

8,000

Social

(tons/year)

(a) FIGURE

10.3

Taxing a

Negative Externality.

(b)

externalities lead to an equilibrium with more than the socially optimal level of output, (b) Imposing (a) Negative in which the output tax equal to the external cost leads to an equilibrium level is socially optimal. The tax makes the economy more efficient because it leads producers to take account of a relevant cost that they would otherwise

a

ignore.

Similar

suggests

reasoning

misallocationsthat

result

from

that

positive

serveto counteract 10.4(a) portrays a XB = $6 per benefit

to producers can externalities. Figure

a subsidy

unit of output generates an external ton. In this market, the socially of optimal output level occurs at the intersection the supply curve (MC) and the Social demand curve, which is constructed by = $6 of Private demand at each level of output. The adding XB per ton to the height level of is thus tons But 1,600 socially optimal output per year. private equilibrium in this market will occur at the intersection of Private demand and MC, which means that the equilibrium output, 1,200 tons per year, falls short of the social market

optimum

in

which

by

400

each

tons per

year.

PROPERTY

Private

RIGHTS

AND THE

TRAGEDY

OF THE

Private

equilibrium

COMMONS

equilibrium

without

subsidy

with subsidy

Social optimum

MC Social

Subsidized demand =

=

demand

Private demand

+ XB

Private

Private

demand

demand

Quantity (tons/year)

Quantity

(a)

(tons/year)

(b)

FIGURE 10.4 Subsidizing a PositiveExternality. lead to an equilibrium with less than the socially optimal level of output, (b) (a) Positive externalities benefit of the activity leads to an equilibrium in which the output level subsidy equal to the external makes the economy more efficient because it leads producers to take account of a relevant subsidy otherwise

ignore.

of paying

of $6 perton, private the socially equilibrium is 1,600 tons per year, exactly optimal level. The subsidy makes the economy more efficient because it induces to take account of producers a relevant benefit that they otherwise would have ignored. Figure

amount

the

10.4(b) shows the effect of the external benefit.

Externalities occur when the people other

than

those

AND

to producers

a subsidy

In the presence of

COSTS

EXTERNAL

RECAP

this

the new

subsidy,

BENEFITS

costsor benefits

directly involved in the

of

an

activity.

activity The

accrue to Coase

theorem

one another without says that when affected parties can negotiatewith in activities will be at efficient even the cost, levels, pursued presence of or externalities. But when is positive negative negotiation prohibitively

generally results. Activities that generate to excess, while those that pursued generate positive externalities are pursued too little. Laws and taxes regulations, including in and subsidies, are often an effort to alter inefficient behavior adopted that results from externalities. inefficient

costly,

negative

externalities

PROPERTY

behavior

are

RIGHTS

AND THE TRAGEDY

OF THECOMMONS of private grow up in industrialized nations tend to take the institution for Our intuitive sense is that have the to own any property granted. people right lawful means and to do with that as property they acquire by property they see fit. In reality, however, propertylaws are considerably more complex in terms of the confer and the rights they obligations they impose. People

who

+ subsidy

1,200 1,600

1,600

1,200

demand

Private

Paying

producers

benefit

a

optimal. The that they would

is socially

291

292

CHAPTER

10

AND

EXTERNALITIES

RESOURCES

UNPRICED

laws that govern the use of property, let's begin by asking why the institution of private property in the first place. The which show what happens to property that owns, nobody suggest the

understand

created

societies

following examples,

an answer.

EXAMPLE 10.9

OF

PROBLEM

THE To

RIGHTS

PROPERTY

IndividualIncome How

A

five residents,

has

village

use the

can

villager

will villagers

steers

many

year or to buy 1 year. The amount of weight

buy

has

a government

steer, send

onto

it

of $100. Each 13 percentinterest the commons to graze, and sellit the 2-year-old steer depends on the accumulated

bond

number

savings

that pays

price the villager will get for it gains while grazing on the commons, of steers sent onto the commons, as shown

after

on the

each of whom

money to a year-old

per

send onto the commons?

which in Table

in turn 10.4.

depends

TABLE 10.4

The RelationshipbetweenHerdSize Number of steers on the commons

The price

Steer

Price per 2-year-old

Price

steer

Income

($)

per steer

($/year)

1

126

26

2

119

19

3

116

16

4

113

13

5

III

II

of a because

commons

the

and

2-year-oldsteerdeclineswith the number the more steers, the less grassavailable

of steers grazing on each. The villagers

to

make their investment decisions one at a time, and the results are public.If each decides how to invest individually, how steers will be sent onto the villager many and what will be the village's total income? commons,

government bond, he'llearn $13 of interest income if and only if send a steer onto the commons will command that steer a price of at least $113 as a 2-year-old. When each villager chooses in this self-interested way, we can expect four villagers to senda steeronto the commons. the fourth villager would be indifferent between (Actually, investing in a steer or buying a bond since he would earn $13 either For the sake of way. we'll assume that in the case of a tie, peoplechooseto be cattle discussion, owners.) If

a villager

at the end

a $100

buys

of 1 year.

Thus,

he should

fifth villager, seeing that he would earn only $11 by sending a fifth steer onto the commons, will choose instead to buy a government bond.As a result of these income will be $65 per year\342\200\224$13 for the one bondholder decisions, the total village and 4($13) = $52for the four cattle owners.

The

Has Adam Smith's invisible these

villagers'

village

income

possibility

of

in

the

cattle

following

resources?

is only

$65\342\200\224precisely

raising not example.

the most efficient allocation of that it has not since their total the same as it would have been had the The sourceof the difficulty will become evident

hand

We can

existed.

produced

tell at

a glance

socially optimal number of steersto sendonto the commons?

is the

five villagers

the

Suppose

the

in

group rather than individually. and what will be their total

commons,

This time a whole.When

confront the same investment example decisions they are free to make their steers will they send onto the many

previous

opportunities as before,exceptthat as a

TRAGEDY

Total Group Income

Maximizing What

AND THE

RIGHTS

PROPERTY

time

this How

village income?

received goal is to maximize the income by the group as made from this perspective, the criterion is to send a steeronto the commons income is at least only if its marginal contribution to village $13, the amount that could be earned from a government bond.As the entries in the last column of Table 10.5 indicate, the first steer clearly meets this criterion since it contributes steer does not. Sendingthat $26 to total village income. But the second steer onto the commons raises the village's income from cattle from $26 to raising $38, a gain of just $12. The $100 required to buy the second steer would thus have been better invested in a government bond. Worse, the collective return from steer is only $10; from a fourth, $3. $4; and from a fifth, sending a third only only the

villagers'

10.5

TABLE

are

decisions

Marginal Income

and the Socially

Income per steer

Price per 2-year-oldsteer

Number of on the

steers

Size

Herd

Optimal

Total

income

($/year)

($)

($/year)

($/year)

126

26

26

2

119

19

38

3

116

16

48

4

113

13

52

5

III

II

55

commons

Marginal

village

income

26 I

In sum,

when investment

decisionsare made with is to

the

goal

12 10

4 3

of maximizing total and send only a single

village income, buy government steer onto the commons. The resulting income $78: $26 from sending village the single steer and $52 from the four government bonds. That amount is $13 more than the total income that resulted when villagers made their investment decisions Once the reward from from an inefficient allocation to an individually. again, moving efficient one is that the economic pie growslarger.And when the pie grows larger, everyonecan get a larger slice. For instance, if the villagers agree to pool their income and share it equally, each will or $2.60 more than before. get $15.60, the

CHECK

CONCEPT

How

would

were

I I

best

your percent

choice

bonds will be

10.3 to Examples 10.9 and rather than 13 percent? year

answers per

four

10.10

change

if

the

interest

rate

do the villagers in Examples 10.9 and 10.10do better when Why they make their investment decisionscollectively? The answer is that when individuals decide alone, the fact that sending another steeronto the commons will cause existing they ignore

OF THE

EXAMPLE

COMMONS

10.10

293

294

10

CHAPTER

EXTERNALITIES

AND

RIGHTS

PROPERTY

less weight. Their failure steer seem sending misleadingly The grazing land on the commons one owns it, no one has any incentive to gain

steers

to consider

another

tragedy tendency

of the commons

the

for a resource that has

no price to be used marginal benefit

falls

until

its

to zero

from

return

by

sending

As

the

the

to take

Principle. Each individual steer onto the commons,

behaves

villager

outcome

yet the overall

ideal.

attainable

OF PRIVATE OWNERSHIP

EFFECT

example

following

to place the

is a

Equilibrium

an additional

falls far short of

THE

EXAMPLE 10.11

of the

illustration

rationally

O

makes the

valuable economic resource. When no the opportunity cost of using it into account. And when that happens, people will tend to use it until its marginal benefit is zero. This problem, and others similar to it, are known as the tragedy of the commons. The essential cause of the tragedy of the commons is the fact that one use of held an external cost on others person's commonly propertyimposes by the property less valuable. The tragedy of the commons also provides a making vivid

Equilibrium

high

this effect

to them.

grazing

village

illustrates, one solution to the tragedy land under private ownership.

of the

commons

is

Private Ownership How

will the

much

right to

control the

sell

commons

village

for?

as before, except Suppose the five villagers face the same investment opportunities this time they decide to auction off the right to use the commons to the highest bidder. that villagers can borrow as well as lend at an annual interest Assuming rate of 13 percent, what price will the right to use the commons fetch? How will the owner of that property right use be the it, and what will resulting village that

income?

To answer thesequestions, control over how the complete way to

profitable

so, you

will

use this a total

earn

land

of $26

spent on the single yearling a bond,your economic profit $13 per year, providedyou your purchase of the property $100

savings to

buy

ask

simply

land

grazing

is to

yourself what you were used. As we

send only a

per year. Sincethe

steer is the $13 in from sending a can use the land right,

a year-old

you

would do if

single steerto grazeon it. If cost

opportunity

interest

could

you

single steeronto the

had

you

saw earlier,the

most

do

you

$100 you have earned from of the

commons

for free. But you cannot; must borrow money (sinceyou

will be to finance used

your

steer).

What is the most you would be willing to pay for the right to use the commons? Since its use generatesan income of $26 per year, or $13 morethan the opportunity cost of your investment in the steer, the most you would pay is $100 (becausethat amount used to purchase a bond that 13 percent interest would also generate pays income of $13 per year). If the land were sold at auction, is precisely the $100 amount you would have to pay. Your annual earnings from the land would be to pay the $13 interest on your loan and cover the opportunity cost of exactly enough not into a bond. having put your savings Note that when the right to use the land is auctioned to the highest bidder, the allocation of its resources because the owner has a village achieves a more efficient incentive to take the cost of more intensive strong opportunity grazing fully into account. Total village income in this case will again be $78. If the annual interest on the $100 proceeds from the land is shared the five selling rights equally among each will have an annual investment income of $15.60. villagers, again

The

logic

of economic

surplus maximization

economically successfulnations

have

all

helps

been

ones

with

to

explain well-developed

why the most private

that property laws. Property belongs is its economic value only potential no

AND THE

RIGHTS

PROPERTY

TRAGEDY

OF THE

COMMONS

295

to no one. Not ends up being of

to everyone belongs, in effect, it usually fully realized;

never

at all.

value

countries the owners of private property with it. For example,localzoning laws residential lot the to build a may building right three-story house but not a taller one. Here, too, the logic of economic surplus maximization applies, for a fully informed and rational legislature would define property rights so as to create the largest total economic surplus. In practice, of course, possible such ideal legislatures never really exist.Yet the essence of politics is the cutting of deals that make people better off. If a legislator could propose a change in the laws that would enlarge the total economic property surplus, she could also propose a scheme that would each of her constituents a slice, thus enhancing her give larger are

Bear in mind, however, not free to do precisely give the owner of a

chancesfor

as

zoning laws that

use this

naturalist, challenge yourself to

about the various

thinking

in most they wish

reelection.

an economic

As

that

restrictions

what

constrain

you can build and what types of laws that constrain what you can

on your land; traffic and environmental laws employment

conduct

you

how

constrain

that

property activities

laws:

you

do with

your

can car;

can operate your

you

business. Your

when

framework

in private

encounter

of these and countless other laws will be enhanced understanding the that can when the laws are defined by insight everyone gain private property as to create the largest total economicsurplus.

Don't be misledinto thinking and enforcing

the

efficient

examples,

following

rights

property

the costs

law

the

that

with externalities

associated

problems

IS IMPRACTICAL

OWNERSHIP

PRIVATE

WHEN

and the

do

blackberries

Wild

crowded they the

blackberries

still

of the

tragedy

grow

profusely

be left to ripen the

growing

costs in

of

at the

berries

are will

likely to be eaten

gains.

defining

edge

taste

Economic

and

a

of

best

if

eaten

and

enforcing

park are larger than common property.That

a public

end up with too soon.

Defining

Naturalist

10.3

m

area

wooded

left

to

ripen

a few days

a

in

fully,

but

early. Will

fully?

the blackberrieswill remain picks them first gets them. Even though waited until the berries were fully ripe, wait

all

parks get pickedtoo soon?

The blackberrieswill taste reasonably good if picked

Obviously,

resolution of

commons.

after all, and sometimes,as in

entails costs,

outweigh the

city park.

blackberries

blackberries

in public

an ideal

provides

The

Why

so

no berries

everyone everyone

at all. And

the property the

potential

means

that

rights

to

gains, so whoever

would benefit if people knows that those who that means that the

Why

public

does

fruit that

places get

grows in pickedtoo soon?

296

CHAPTER

10

EXTERNALITIES

mr

AND

RIGHTS

PROPERTY

Naturalist 10.4

The Economic

are

shared

Sara

and

Susan

chocolate knows that

are identical other

the

milkshake

Because drinking buds, the

is self-interested, at an optimal rate?

their

enjoy

will

too quickly shake more

a milkshake

will

twins

been

a straw

has

each

If

quickly?

have

who

twins

share.

to

milkshake

the

consume

consumed too

milkshakes

Why

twins

the

taste

the

chills if

given a and each

drink

they

it

slowly. Yet each knows that the other will drink any part of the milkshake she doesn't finish herself. The result is that each will consume the shake at a faster rate than she would if she had half a shake all to herself. Why

are

shared

milkshakes drunk

too

quickly?

is not

easily

Timber

Harvesting remote

On

are some

Here commons

further

ownership

private

defining

on Remote PublicLand

lands, enforcing

public

by

the tragedy of the rights.

in which

examples

solved

impractical. Each tree cutter

restrictions against cutting

trees

down

may

be

not harvested this year will be bigger, and hence more valuable, next year. But he also knows that if he doesn't cut the tree down this year, someone elsemight do so. In contrast, private companiesthat trees on their own land have no incentive to harvest timber grow a strong incentive to prevent outsidersfrom so. prematurely and doing

and

that

knows

whaler

breedingpopulation,

a tree that is

Waters

in International

Whales

Harvesting

Each individual

that

knows

hence

harvesting

the size of the that is not

also knows that any whale other whaler. The solution would

future

an extra whale

whale reducesthe

population.

harvested today

be

may

But the whaler by some

taken

be to define and enforce property rights to and the behavior of whalers is hard to monitor. if their behavior And even could be monitored, the conceptof national make the international enforcement of propertyrights sovereignty would problematic. More the animal species that are most severely threatened with generally, extinction tend to be those that are economically valuable to humans but that are not This is the situation confronting whalesas well as privately owned by anyone. Contrast this with the situation confronting chickens,which are also elephants. valuable to humans but which, unlike are governed whales, economically by traditional laws of private This difference property. explains why no one worries that Colonel Sanders might threaten the extinction of chickens.

whales.But

Multinational Environmental Pollution polluter may know that if he and all others pollute,the damage

Controlling individual

Each

to the environment

will

to

powerful incentive

property pollute. Enforcing

of pollution may

more

serious

suffered

economic incentive the

of international significance.

be practical if

But

government.

are much

As

than the cost of into which all are free

be greater

is common

environment

single

are vast,

oceans

the

world's

difficult

if polluters to

laws and

all

polluters

come from

implement.

Thus,

not to

polluting. dump,

regulationsthat live under many

different

But if the each has a limit

the

discharge

the jurisdiction countries,

the Mediterranean

of

a

solutions

Sea has long

none of the many nations that border it has an pollution to consider the effects of its discharges on other countries. continues to grow, the absence of an effective system population will become an economic property rights problem of increasing since

POSITIONAL

AND THE TRAGEDY

PROPERTY RIGHTS COMMONS

RECAP

EXTERNALITIES

OF

THE

When a valuable resourcehas a price of zero, people will continue to exploit it as long as its marginal benefit remains positive. The tragedy of the in which valuable resources are squandered commons describes situations because users are not charged for them. In many an efficient remedy is to cases, define and enforce rights to the use of valuable property. But this solution is difficult to implement for resources such as the oceans and the atmosphere because these

no single resources.

government has the

Former tennis amount.

in

By any

back by a

the

measure, the

reasonable archrival

deranged

ensuing months, Graf's tournament

1992pace,despite

on

have

competitors

a host of

her

of

quality

DEPEND ON

PERFORMANCE

other

situations,

competitive

how they

perform

closest they perform relative to their an incentive to take actions that will

For example,tennis

play.

RELATIVE

not only on

depend

typically

how

of her play was outstanding, But in April 1993, Seles was fan and forced to withdraw from the tour. In the accumulated at almost double her winnings quality

Seles.

Monica

in the

change

tennis and

In professional people receive

little

THAT

PAYOFFS

also

for

in tournament Steffi Graf received more than million $1.6 her endorsement and exhibition earnings totaled several times

1992;

yet she consistently lost to stabbed

rights

champion

in

that

property

EXTERNALITIES

POSITIONAL

winnings

to enforce

authority

the rewards terms

in absolute

but

In these situations, increase their odds of winning.

rivals.

of winning by hiring to travel with them on the tour. Yet psychologists the mathematics of competition tells us that the sum of all individual simple In any tennis payoffs from such investments will be larger than the collective payoff. match, for example, each contestant will get a sizable payoff from money spenton fitness trainers and sports psychologists, yet each match will have exactly one winner and one loser, no matter how much The overall gain to tennis players spend. is to be and the overall to as a group must be small, spectators likely gain players zero. To the extent that each contestant's on his or her relative payoff depends the incentive to undertake such investments will be excessive, from performance, then, a collectivepoint of view. fitness

personal

can

players

the following

Consider

increase

their chances

and sports

trainers

example.

The Economic Naturalist Why The

do

football

offensive

linemen

escalated

sharply

over

positions. Size and other

steroids?

Football more League teams currently average in offensive linemen the contrast, by league averaged the all-decade linemen of the 1940s averagedonly 229 pounds. salaries have players are so much heavier is that players'

of

330 pounds. In the barely 280 pounds, and One reason that today's

than

take anabolic

players

10.5

1970s,

the last strength

National

many

several decades,which are

things being equal, the job

the two will

cardinal

go to the

has virtues

larger

and

intensified of an stronger

competition

offensive

lineman,

of two

rivals.

for the and

\342\226\240%

297

CHAPTER

298

10

AND

EXTERNALITIES

PROPERTY RIGHTS

Size and strength,

anabolic steroids.

of players

ordering

anabolic

steroids football

drugs. So why

The problem

Jones\342\200\224who

are

each has a 50

largely

do

football

the

hence

of

consumption

the

rank

of who

question

And since

unaffected.

players take

Consider two

percent chance

of

both

take

year.

If

position.

winning

in the and

rivals\342\200\224Smith

each

takes

neither

If

the job

steroids,

on the

berths

ones analyzed

closelymatched

for a single

of

steroids?

contestants for starting dilemma, like the

is that

competing

$1 million per chance of winning

the

by

these substances,

a prisoner's

chapter.

preceding

be

here

confront

line

offensive

consume players and strength\342\200\224and

the consumption entails potentially serious long-term health as a group are clearlyworse off if they consume players

jobs\342\200\224will

consequences,

be enhanced

can

turn, all

size

by

lands the

these

in if

But

steroids,

a starting

and

has

again

of

salary

a 50

percent

the job. But if one takes steroids and the other doesn't, to win the job. The loser ends insurance for up selling likes the fact that the $60,000 per year. Neither drugs may have adverse health but each would be willing to take that risk in return consequences, for a shot at the big salary. Given these choices, the two competitors face in Table a payoff matrix like the one shown 10.6.

the first

Why

do

so many football players

is sure

TABLE 10.6

take steroids?

Payoff Matrixfor SteroidConsumption Jones

Take steroids

take

Don't

steroids

Don't

take

steroids

Secondbest for

Best for Jones each

Worst

for

Smith

Smith

Take

Best for Smith

steroids

Third

Worst

for

for both Smith and Jones Clearly,the dominant strategy do, each gets only the third-best outcome, whereas second-best outcome by not taking the drugs\342\200\224hence the the consumption of anabolic steroids. they

occurs when

person's

this

externality

positional

an

increase

reduces

performance

the expected reward in situations in which

depends

on

relative

in one

of another's reward

performance

ARMS

POSITIONAL

best for each

Jones

RACES AND

is to

take steroids. Yet

they

could

attraction

have

of rules

when

gotten that

the

forbid

POSITIONAL ARMS

CONTROL

AGREEMENTS

of a positional externality. Whenever the payoffs on how he or she performs relative to a that one side's relative must worsen the rival, any step improves position necessarily in other's. The shouting-at-parties discussed 9 is another instance example Chapter

The

steroid

to one

problem

is an example

contestant dependat

least

in part

POSITIONAL

of a positional externality. as the invisible hand of the market is weakened by Just of standard externalities, it is also weakened by positional externalities. presence We have seen that positional externalities often lead contestants to engage in an escalating series of mutually investments offsetting performance

Becausepositionalarms

races

them. Steps

to curtail

incentive

laws and rulesagainst anabolic arms control agreements.

Onceyou

almost everywhere. to

limit

achieved

the

by

Some examplesof

such as

races,

be thought

Sometimes

of

blue

as positional

will

economic

an

to see

begin naturalist

take?

What

have

steps

arms control

positional

the

by

taken

agreementsare

of legal

signing

do the

contestants

contracts.

follow.

of agreement

States, presidential candidates Yet if both candidates double

more than $100 million spend their spendingon ads,eachone'sodds of will remain essentially the same. Recognition of this pattern led Congress to winning strict limits for candidates. those have (That adopt spending presidential regulations difficult to enforce does not call into the behind the proved question logic legislation.) United

the

on advertising.

routinely

Roster Limits franchises to have only 25 players on the roster The National Football League setsits roster limit at 53; the National BasketballAssociation at 12. Why these limits? In their absence, any team could increase its chance of winning by simply adding players. Inevitably, Major

League

during

the

Baseball

permits

season.

regular

other teams would follow suit. point, larger rostersdo not add are

limits

Arbitration

In the commits

way to

a sensible

world,

to

them

the plausible assumption that, beyond some to the entertainment value for fans, roster deliver sportsentertainment at a more reasonable cost.

Agreements

business

arbitration

contracting in the

On

much

that parties often sign a binding agreement event of a dispute.By doing so, they sacrifice the

as fully as they option of pursuing their interests themselves from costly legal battles.Other sometimes take steps to limit spending on litigation.

in

Dakota

South

would

only the

read

first

15

pages

to

a year or so olderthan better, in relative terms, than

who is

perform

parties

in the

For

example,

Kindergarten

most

of her

if she

of

approval

but

they

also

legal system may a federal judge litigants\342\200\224that

he

submitted to his court.

of any brief

Mandatory Starting Datesfor A child

the

to

announced\342\200\224presumably

to later,

wish

might

insulate

classmates is likely school with children her

kindergarten

had entered

most parents are aware that admission to prestigious for on relative eligibility top jobs upon graduation depend largely academic are to their children out of performance, many tempted keep kindergarten a in than Yet there is no social all children year longer necessary. advantage holding back an extra year since their relative performance would essentiallybe unaffected. In most reach their fifth therefore, the law requires childrenwho jurisdictions,

own age.

since

And

universities and

birthday

before December 1 of NORMS

SOCIAL

year to start

a given

AS POSITIONAL

kindergarten the same year.

ARMS

CONTROL AGREEMENTS In

some

cases,

positional

arms

social races.

norms may Some

familiar

take

the

place

of formal

examples follow.

agreements

a

offsetting

in performance enhancement that is stimulated investments

positional

externality

agreement

to curtail

arms an

control agreement

which contestants

attempt

limit mutually offsetting

investments in enhancement

Spending Limits

Campaign

In

race

arms

series of mutually

them

by asking

you observe: What form

rules or

of formal

imposition

races, you

situation

enhancement

type

arms

may therefore

competitive

every

this

positional

by a positional

in performance these investments?

investments

produce

of positional arms hone your skills as

can

You

these questions about

in

outcomes, people have an

inefficient

taken to reducepositional steroids,

aware

become

the

patterns positional arms races.

such spending

call

enhancement.We

299

EXTERNALITIES

performance

in to

300

10

CHAPTER

EXTERNALITIES

AND

RIGHTS

PROPERTY

Norms

Nerd

Some students care more\342\200\224in the short run, at least\342\200\224about the grades they get than how much they learn. When such students are graded on the actually curve\342\200\224that to other students\342\200\224a is, on the basis of their performancerelative if arms race ensues because all studentswere to doublethe amount positional

* \342\226\240,v I

time would remain they studied, the distribution of grades essentially the in this situation are often same. Studentswho find themselves to embrace quick \"nerd norms,\" which brand as socialmisfits those who too hard.\" \"study of

*A\\i*t ;

A

X

Fashion Norms dress and fashion often change quickly because of positional for the who wishes to be on the instance, person competition. Consider, cutting edge of fashion. In some American social circles during the 1950s, that could be goal the practice, it accomplished by having pierced ears. But as more and more peopleadopted ceased to communicate avant-garde status. At the same time, those who wanted to make a conservative fashion statement gradually became freer to have their ears pierced. For a period during the 1960s and 1970s, one could be on fashion's cutting But by the 1990s multiple ear edge by wearing two earrings in one earlobe. lost much of their social significance,the threshold of cutting-edge status piercings had been raised to of a dozen of each or a smaller number ear, having upward piercings of piercings of the nose, eyebrows, or other bodyparts. A similar escalation has taken place in the number, and of tattoos. size, placement The increasein the required number of tattoos or body piercingshas not the value of avant-garde fashion status to thosewho desire it. Being on the changed outer limits of fashion has much the same meaning now as it once did. To the extent that there are costs associated with and other steps tattoos, body piercings, to achieve the current fashions are wasteful status, required avant-garde compared to earlier ones. In this the erosion of social norms against tattoos and body sense, has a social loss. Of the costs associated with this loss course, piercings produced are small in most cases. Yet since each body piercingentails a small risk of costs will continue to rise with the number of piercings. And once those infection, the costs reacha certain mobilize on behalf of social norms threshold, support may that discourage body mutilation. Social

on fashion's cutting edge valuable now than in the 1950s?

Is

being

more

norms

regarding

Norms of Taste Similar

cycles

occur

with

respect to

1950s, for example,prevailing accepting ads that featured powerful incentive

attention. And

to chip indeed,

behaviors consideredto be in

bad

taste.

In the

magazines from advertisers had a photographs. Naturally, in at such norms an effort to the reader's limited away capture in taboos nude have eroded the same against photographs norms

prevented

major

national

nude

taboos against body mutilation. for instance, the evolution of perfume ads. First came the nude Consider, well-lit and detailed nude silhouette; then, increasingly photographs; and more of what to be sex acts.Each innovation recently, photographs appear group achieved the desired effect: the reader's instant and rapt attention. just capturing in our sense of other advertisers followed a shift however, suit, causing Inevitably, what is considered attention-grabbing. Photographs that once would have shocked readers now often draw little more than a bored glance. of course, about whether this change is an improvement. differ, Opinions believe that the stricter norms were ill-advised,the legacy of a more earlier, Many and era. Yet even who take that view are likely to believe prudish repressive people that some kinds of photographic material ought not to be used in magazine advertisements. what is acceptable will differ from person to person, and Obviously, in part on current standards. But each threshold of discomfort will person's depend as advertisers continue to break new ground in their struggle to capture attention, the point may come when people begin to mobilize in favor of stricter standards of way as

POSITIONALEXTERNALITIES

Were

for the kind

looking

not

of bad taste

that

\"public decency.\" Such a campaign would provide yet arms control agreement.

Norms Against

will

grab\342\200\224but

appall\" another

case

of a

positional

Vanity

and

Cosmetic people,

enabling

benefits surgery has produced dramatic accident victims to recover a normal disfigured

reconstructive

badly

eliminated the extreme self-consciousness felt unusual features. Such surgery, however, is by no

also has strikingly

conspicuously

disfigured.

improvements

to

donein

Increasingly,

their

appearance. the number

for

many

appearance.

It

born with by people means confined to the

\"normal\" people are seeking surgical Some 2 million cosmetic \"procedures\" were

has just a decade earlier1\342\200\224and demand since.The American of Plastic grow steadily years Society Surgeons in cosmetic predicts that Americans will undergo some 55 million procedures 2015. Once a carefully these are now offered as secret, guarded procedures prizes in southern California charity raffles. In individual cosmetic as reconstructive cases, surgery may be just as beneficial is for accident victims. the confidence of a straight nose surgery Buoyed by having or a wrinkle-free complexion,patients sometimes on to achieve much more go than ever thought also has they possible. But the growing use of cosmetic surgery A had an unintended sideeffect: It has altered the standards of normal appearance. nose that once would have seemed than now seem only slightly larger average may once would have looked like an average jarringly big. The same personwho someone who once would have 55-year-old may now look nearly 70. And tolerated slightly hair or an amount of cellulite thinning average may now feel to hair or Becausesuch compelled undergo transplantation liposuction. procedures shift frame of reference, their payoffs to individuals are misleadingly people's large. From a social perspective, therefore,relianceon them is likely to be excessive. cosmetic are difficult to imagine. But some Legal sanctionsagainst surgery communities have embraced social norms against cosmeticsurgery, powerful scorn and ridicule on the consumers of face-lifts and tummy tucks. In heaping individual such norms may seem cruel. Yet without more cases, them, many people feel to bear the risk and expenseof cosmetic might compelled surgery. 1991\342\200\224six

times

in the

continuedto

xTbe

Economist,

January

11, 1992, p. 25.

301

10

CHAPTER

302

EXTERNALITIES

AND

PROPERTY RIGHTS

RECAP

POSITIONAL

externalities

Positional

reduces the expected depends on relative mutually offsetting

a positional

by

enactedin norms

can

an

act

EXTERNALITIES

occur when

an

of another

reward

in one

increase

person

performance

person's

in which

situations

in

reward

a seriesof in performance investments enhancement that are stimulated externality. Positional arms control agreements are sometimes to limit positional arms races.In some cases,social attempt as positional arms control agreements. races are

arms

Positional

performance.

SUMMARY are the costs and benefits of activities accrue to people who are not directly involved in those activities. When all parties affected by externalities can with one another at no cost, negotiate the invisible hand of the market will produce an efficient allocation of resources. (LOl)

\342\200\242 Externalities

that

the Coase theorem, the allocation of in such cases because the parties is efficient to

\342\200\242

According resources

taking Negotiation

these

In

however. individuals

cases, will

typically The

solutions to the is one of the most

by externalities

caused

is often impractical, the self-serving actions of not lead to an efficient

to forge

attempt

important

for collective action. Sometimescollective takes the form of laws and government that alter the incentives facing those who

regulations

generate,or are affected remedies

on

accommodation

at

the

lowest

environmental

by,

when

best

work

the

laws,

Such

externalities.

they place the parties who can

cost. Traffic

protection

laws, zoning and

examples.(L03)

burden of accomplish it laws,

free speech

laws are

and other negative externalities Curbing pollution entails costsas well as benefits. The optimal amount of pollution reduction is the amount for which the reduction marginal benefit of further just equals the In cost. this formula that marginal general, implies the socially optimal level of pollution, or of any other externality,

\342\200\242 When owned

grazing in

land

common,

commons.

is greater

than

zero.

(L03)

and other valuable resourcesare no one has an incentive to take

cost opportunity is known as problem the

governing effective

Defining and enforcing private rights use of valuable resources is often an solution to the tragedy of the commons. Not most successful nations economically

surprisingly,

have well-developed institutions of that to Property belongs everyone to no one. Not only is its potential

never \342\200\242 The certain

of using those the tragedy of the

the

it

realized;

fully

at

all.

difficulty situations such

usually

private belongs,

property. in effect,

economic value ends up having no

(L04) of enforcing property rights in a variety of inefficient explains as the excessive harvest of whales in

international waters and the premature harvest of timber on remotepublic lands.The excessive pollution

seas

of

that

also results from rights. (L04)

are bordered by many countries a lack of enforceable property

in which people's rewards depend on how in relation well they perform to their rivals give rise In to positional externalities. these situations, any that one side's relative step improves position

\342\200\242 Situations

other's.

the

worsens

necessarily

\342\200\242

negative

This

outcomes

problems

rationales action

account

resources.

value

externalities

over

\342\200\242

outcome.

compensate others for

can by externalities remedial action. (LOl)

affected

into

tend to spawnpositional of

patterns performance

mutually enhancement.

Positional

arms

offsetting Collective

externalities

races\342\200\224escalating

investments measures

in

to curb

as positional arms positional arms racesare known control agreements. These collective actionsmay take the form of formal regulations or rulessuchas

rules against

anabolic

steroids

in sports,

campaign

spending limits, and binding arbitration agreements. Informal social norms can also curtail positional arms

races.

(L05)

303

PROBLEMS

TERMS

KEY

Coase theorem

(284)

external benefit

agreement (299)

cost (280)

external

arms control

positional

externality (280)

race

arms

positional

RHItW

1.

If

imposes external costson others,would advisable?

be

legislation

the

freeways excessive

from

to

explain

you

of freeway

amount

zero?(L03)

a friend

tragedy

of the commons

(294)

the

5. Explain why

the

the

why

located

Great Salt Lake, which is state of Utah, suffer lower levels wholly of pollution than Lake Erie, which is borderedby several states and Canada? (L03) the

does

Why

within

(L03)

congestion?

3. How would optimal

4.

such

why

externality

(299)

(L02)

2. What incentive problemexplains in cities like Los Angeles suffer

(280)

positive

QUESTIONS

illegal any activity that

declare

could

Congress

externality (298)

positional

(280)

externality

negative

(280)

viewed

might

be

externality.

(LOS)

of high-heeled shoes result of a positional

wearing

as the

congestion is not

PROBLEMS

the law

Suppose

getspermission

says that from

factory unlesshe

not emit smoke from his lives downwind. The relevant

may

Jones

who

Smith,

costs

and

following

in the from Jones's productionprocessareas shown table. If Jones and Smith can with one another at no cost, negotiate

will

emit

of

benefits

filtering

Jones

smoke?

Smith

Karl or

month,

Jonesdoesnot

fe? Econ

smoke

emit

McGraw-Hill

$200

$160

$400

$420

Visit

live together

can

rent a

can

each

in

a two-bedroom

apartment

single-bedroom apartment

for

$350

for $500 per per month.

Aside from the rent, the two would be indifferent between living together and in the sink dishes living separately, except for one problem:John leaves dirty be willing to pay up to $175 per month to avoid every night. Karl would to pay up to $225 to be John's dirty dishes. John, for his part, would be willing

ableto continue a. Should sink?

the

his

(L02)

sloppiness.

John and Karl

live

b. What if John his privacy by

would sharing

be willing quarters

epic

poem.

Barton

do,

will

there

be dirty

to pay up to $30per month to avoid with Karl? Should John and Karl live

and Statler are neighbors in Manhattan. Barton is a concertpianist,

3. Barton

If they

together?

Explain.

an

rehearses his concert

apartment Statler

and

pieces on the

complex is a poet baby

dishes

in

giving up together?

in downtown

working on

grand

piano

an

in his

your mobile

store and

download

the Frank:

Study

Econ

2. John and

ECONOMICS

(L02)

Surplus for Jones for

|

the smoke

Jones emits smoke Surplus

si-connect

app todayl

app

304

CHAPTER

10

EXTERNALITIES

AND

PROPERTY

front

room,

RIGHTS

which is directly

payoffs to

the monthly

above Statler'sstudy. and

Barton

not soundproofed.The soundproofing Barton's apartment. (L02)

The

will

shows

matrix

following

room is and is

when Barton's front be effective only if

Statler

it

in

is installed

Not

soundproofed

Soundproofed Barton

$IOO/month

$ 150/month

Statler

$l20/month

$80/month

to

Gains

Gains to

has the legal right he and Statler can negotiate

a. If Barton

to

any amount of noise he wants and another at no cost, will Barton

make

one

with

install and maintain soundproofing?Explain.Is his

choice

socially

efficient?

b. If Statler

has the legal right to peaceand

at no

Barton

Is his

choice

c. Does

the

cost,

install

Barton

will

and

quiet

and maintain

can

negotiate

with

soundproofing? Explain.

efficient?

socially

of

attainment

has the legalright

an

efficient

make

to

noise,

depend on whether Barton the legal right to peace and

outcome or Statler

quiet?

Refer to Problem 3. Barton decides matrix is as follows: (L02) payoff

to

buy a

full-sized grand

piano.The new

Not

soundproofed

Soundproofed Gains

to

Gains to

a. If Statler

$IOO/month

$ 150/month

Statler

$l20/month

$60/month

has the legal at no

negotiate

Barton

Is this outcome b. Suppose that Barton that

and

Barton socially

to

right

cost, will Barton efficient? socially

negotiating install and

and quiet

install

and

has the legalright

an agreement

maintain

and Barton and Statler can

peace

maintain

to

make

Barton

with

soundproofing?

soundproofing? as much costs

Explain.

noise as he likes month. Will

$15 per

Explain. Is this

outcome

efficient?

Statler has the legal right to peace and quiet, and it costs $15 per month for Statlerand Barton to negotiate any agreement. (Compensation for noise damage can be paid without cost.) Will Barton incurring negotiation install and maintain Is this outcome efficient? soundproofing? socially d. Why does the attainment of a sociallyefficient outcome now on depend whether Barton has the legal right to make noise? c. Suppose

5. Determine whether explain

why:

the

following

statements

are true or

false, and

briefly

(L03)

in a polluting at given total emissionreduction industry will be achieved the lowest possible total cost when the cost of the last unit of pollution in the industry. curbed is equal for each firm b. In an attempt to lower their costs of production, firms sometimes succeed in costs to outsiders. merely shifting

a. A

6. Phoebe keeps a

her optimal

number

bee

farm

of

next

beehives

an apple the by selecting

door

to

orchard. She chooses honey output level at

which her private cost.

marginal

private

from beekeeping are normally

b. Phoebe'sbeeshelp the

fruit

to

Draw

shaped.

marginal benefit from

steps into their flight bees' venom. Show the

bees

path. social

that

Phoebe, marginal

the socially optimal quantity of beehives than the privately optimal quantity?

the supply curve of portable radio = 5 + P whereP is the given by 0.1Q, daily in hundreds is the volume of units rented radios is 20 - 0.2Q. (L03) portable

7. Suppose

socially

Explain.

per day. The demand curve

optimal

number?

would the imposition of

b. How

rent

radio rental affect

efficiency

a tax

in this

of $3 per market?

it

in Golden Gate Park is per unit in dollars and Q

radio imposes $3 per day in noise costs on others, exceed equilibrium number of portableradios rented

portable

much

rentals

diagram. Is

will the

each

If

on your

or lower

higher

beekeeping

who aggressively sting anyone is immune to the fortunately, naturally cost curve from Phoebe's beekeeping

killer

diagram.

your

d. Indicate

a.

Phoebe's

diagram.

c. Phoebe'sbeesare Africanized

in

and marginal cost curves a diagram of them. in the orchard, apple increasing

benefit

marginal

the blossoms

pollinate

the social

Show

yield.

in your

equals her private

beekeeping

(L03)

that Phoebe's

a. Assume

from

benefit

marginal

on

unit

each

daily

for

by

how

the

portable

has six residents, each of whom has accumulated of $100. village savings Each villager can use this money either to buy a government bond that pays 15 percent interest per year or to buy a year-old the llama, send it onto 1 year. The price the villager commons to graze, and sell it after for the gets

8.*A

llama depends on the quality of the fleece it grows while grazing on the commons.That in turn depends on the animal's accessto grazing, which on the number of llamas sent to the commons, as shown in depends 2-year-old

the

table:

following

Number of llamas

The

are

public.

a. If each

1

122

2

118

3

116

4

114

5

112

6

109

make

villagers

decisions

Price per 2\342\226\240year-oldllama

the commons

on

their investment

decisionsone after

another,

and

($)

their

(L04)

villager decidesindividually

be sent onto the

commons,

how

and

what

how many llamas will the resulting net village

to invest,

will be

income?

is the socially optimal number of llamas for this village? Why is that different from the actual number? What would net village income be if the were sent onto the commons? socially optimal number of llamas

b. What

c. The

votes to auction the right to graze llamas on the bidder. Assuming villagerscan both borrow and lend at 15 percent annual how much will the right sell for at auction? How interest, will the new owner use the right, and what will be the resulting income? village

*

Denotes

committee

village

commons

to

the

highest

more difficult problem.

306

CHAPTER

10

EXTERNALITIES

AND

RIGHTS

PROPERTY

\342\226\240

Since Fitch gains $50 per day he could pay Abercrombie as

10.1

\342\226\240

CHECKS

CONCEPT

TO

ANSWERS

when Abercrombieoperateswith as

much

$49

ahead. (L02)

10.2

If

$60 cost

would thus saving

10.3

in

the

from

from

figures

instead being

things

as shown in

Number of

steers on

commons

the

to resolve the

in

the

investment

than the $200 would

in cattle

What is different is the

table.

opportunity

of $13. The steer, which is now $11 per year instead table shows that the socially optimal number of steers is if individuals 1. And still favor holding cattle, all other instead of 4, they will now send 5 steersonto the commons

in each

investing

last column of now 2

levels of

the different

remain as before,as shown

cost of

way

amount is greater per month. Since that two should live separately. (L02)

the

rent,

efficient

$210

be

income

The

most

before, for Betty to give up reasonable access to of that cost, which is $150,Betty would also bear a top loss of her privacy. The total cost of their living together

on

But

phone.

together, the

filter,

be as

would

problem

telephone the

to live

were

two

the

per

a

day and still come out

the of

equal, the middle

column.

Price per steer

2-year-old

($)

(L04)

Income per steer ($/year)

Total village

income

($/year)

Marginal

income

($/year)

26 1

126

26

26

2

119

19

38

3

116

16

48

4

113

13

52

5

III

II

55

12 10

4 3

I

CHAPTER

I

The Economics

||

of

Information \342\226\240 n

LEARNING

After you

LOI

OBJECTIVES

reading be

should

this chapter, able to: how

Explain

value

middlemenadd

to

market transactions.

L02 Usethe the ;H7F

of

concept

search to

rational

find

amount

optimal

information

market

participants

should

obtain. Matching the

value

the

right

created

buyers

by the

with the actual

right

production

economic value of goods and services.

sellers

creates

that

is just as

real as

ago, a naive young economist spent a week in Kashmir on a the Years houseboat on scenicDal Lake,outside capital city of Srinagar. Kashmir is renownedfor its woodcarvings, and one afternoon a in a gondola man stopped by to show the economist someof his wooden bowls. When the economist expressed interestin one of them, the woodcarver quoted a priceof 200 rupees. The economist had lived in that part of Asia long enough to realize that the was more than the woodcarver price of 100 rupees. expectedto get,so he made a counteroffer The woodcarver appearedto take offense, that he couldn't possibly saying part with the bowl for less than 175 rupees. Suspecting that the woodcarver was The woodcarver merely feigning anger, the young economist held firm. appeared to become even angrier, but quickly retreated to 150 rupees. The economist restated his unwillingness to pay more than 100 The politely rupees. woodcarver then tried 125 rupees, and again the economist that 100 was his replied final offer. and with cash in hand, the Finally, they struck a deal at 100 rupees, left in a huff. with his purchase, the economist showedit to the houseboat's owner later that evening. \"It's a lovely bowl,\" he agreed, and asked how much the economist had for his negotiating paid for it. The economisttold him, expecting praise at suppressing a laugh was the economist's first prowess. The host'sfailed attempt clue that he had paid too much. When asked how much such a bowl would

woodcarver Pleased

L03

Defineasymmetric information

and

describe

how it the lemons

leads

to

problem.

L04 Discusshow advertising, conspicuous

statistical

consumption,

discrimination,

and

other devices are

responsesto asymmetric

problems.

information

of

308

CHAPTERI I

THE

OF

ECONOMICS

INFORMATION

sell for,

normally

pressedhim, at

and

the houseboat the host

owner was reluctant

speculated

the

that

to

economist for 30 rupees hoped But the

respond.

had probably

seller

most.

Adam Smith's invisible hand theory presumesthat are fully informed buyers about the myriad ways in which they might spend their money\342\200\224what goods and services are available, what prices they sell for, how long they how frequently last, break and so on. of no one is ever But, down, course, they really fully informed in about And as the transaction with the woodcarver, people sometimes, anything. are completely ignorant of even the most basic information. Still, life on, and goes most people muddle through somehow. Consumers some of information, employ a variety of strategiesfor gathering which are better than others. read Consumer talk to and They Reports, family visit kick the tires on used and so on. But one of the most stores, friends, cars, of choosing important aspects intelligently without having complete information is at least some idea of the extent of one's Someone once said that having ignorance. there are two kinds of consumers in the world: those who don't know what they're and those who don't know that don't know what they're doing. As in doing they in the second category are the the case of the wooden bowl, the people ones who are most likely to choose foolishly. in which Basic economic can help you to identify those situations principles In additional information is most likely to prove this helpful. chapter, we will what those tell us about how much information to acquire and explore principles how to make the best use of limited information.

One

of

among fully

most

the different

understand.

11.1

Consumer How

is problems consumers confront whose product many complex following example illustrates, in such

common

of a

versions

As the

sometimes rely on the

EXAMPLE

the

to choose they don't consumers can

need

features cases

of others.

knowledge

Choice decide

a consumer

should

ADDS VALUE

MIDDLEMAN

HOWTHE

which

pair

of skis

to buy?

but the technology has changed considerablysince and don't know which of the current brands and you bought your you models wouldbe best for you. Skis R Us has the largest selection, so you go there and ask for advice. The salesperson appears to be well informed; after asking about level and how the your experience aggressivelyyou ski, he recommends Salomon X-Scream 9. You buy a pair for $600, then head back to your apartment and show them to your roommate, who saysthat could have bought them on you the Internet for only $400. How do you feel about your purchase? Are the differentprices the two relatedto the services charged by suppliers they offer? Were the extra servicesyou got by shopping at Skis R Us worth the extra $200?

You need

a new pair of

skis,

last pair

Internet of full-service salespeople,

put

retailers can sell for less because their costs are much lower than retail stores. Those stores,after hire knowledgeable all, must their merchandise on display, rent spacein expensive shopping

and so on. Internet unskilled telephone

retailers

and

mail-order

clerks, and they

If you're a consumerwho extra expense of shopping

Spending $600 on the

right

doesn't

at a skis

store

know

houses, their

which

merchandise

is the

specialty retailer is is smarter

than

by

likely

spending

typically

contrast,

right

to

malls, employ

in cheap

warehouses.

product

for

you,

the

good investment. on the wrong ones.

be a

$400

those

HOWTHE

On the one

hand, eliminating

increased

costs,

the

on

Many people believe

the middleman would result sales, and greater consumersatisfaction; other hand, we're the middleman.\" that

retailers,

wholesalers,

products play a far

and other

ADDS VALUE

lower

agents who assist

role than the important In make the this the view, actually products. production worker is the ultimate source of economic value added. Sales agents are often as mere who do the real work. middlemen, disparaged parasites on the efforts of others On a superficial this view seem to be level, might supported by the fact that to to avoid for the services of salesagents. many people go great lengths paying manufacturers cater to them consumers a chance to \"buy direct\" Many by offering and sidestep the middleman's commission. But on closer examination, we can see that the economic role of sales agents is essentiallythe same as that of production manufacturers

in

one played by

those

sale of their

in

MIDDLEMAN

the

who

workers. Considerthis

example.

The How

better information

does

less

Economic

Role of

Sales Agents

affect economicsurplus?

a rare BabeRuth baseball card issued during the great like to keep the card but has reluctantly decided to sellit to for the card is $300, but he is hoping pay some overdue bills. His reservation price to get significantly more for it. He has two ways of selling it: He can place a in the local newspaper for $5 or he can list the card classified ad on eBay. If he sells the card on eBay, the fee will be 5 percent of the winning bid. Because Ellis lives in a small town with few potential buyers of rare baseball the reservation to pay $400 at cards, the local buyer with highest price is willing most. If Ellis lists the card on eBay, however, a much larger number of potential will see it. If the two eBay shopperswho are to pay the most for buyers willing Ellis'scard have reservation of and much $900 $800, respectively, prices by how will the total economic surplus be larger if Ellis sells his card on eBay? (For the sake of simplicity, assume that the eBay commission and the classified ad fee equal the respective costs of providing those services.) Ellis

has

slugger's rookie

just inherited year. He'd

In an

for an item. reports his or her reservation price with the highest reservation price wins, and reservation price of the second highest bidder.So in the Babe Ruth baseball card will sell for $800 if Ellis lists it on eBay. Ellis will receive a payment of $760, or $460 $40 eBay commission,

eBay

auction,

each bidder

When the auction closes,the the price he or she pays is the this

Net

example, of

the

bidder

EXAMPLE

11.2

309

310

II

CHAPTER

THE ECONOMICS

INFORMATION

OF

more

than

$460.

The

his reservation

price for

bidder's

winning

surplus

economic

Ellis's

card.

the

will be

surplus

be

thus

will

- $800= $100,sothe

$900

total

on eBay will be $560. If Ellis instead advertises the card in the local and sells it to the newspaper local buyer whose reservation priceis $400, then Ellis's surplus (net of the will be $0. Thus, total fee) will be only $95 and the newspaper's$5 buyer's surplus \342\200\224 = if economic will be Ellis sells the card on eBay than $560 $95 $465 surplus larger if he lists it in the local newspaper. a service by making information availableto peoplewho can make eBay provides A in use of it. real increase economic results when an item ends good surplus up in the hands of someonewho values it more highly than the person who otherwise would have bought it. That increaseis just as valuable as the increase in surplus that results from manufacturing cars, growing corn, or any other productive activity. surplus

from

the card

selling

HOW THE

RECAP In a

world of

incomplete information, value

economic

genuine

MIDDLEMAN ADDS

find their way to the

sales

by increasing

consumers who value

more

sales agent,that

on a

achievement

a doubt,

Without

Cost

Opportunity

D

is generally will

decline

the

production

having

by

economic surplus by of a $20,000 car.

more information is better than

costly to acquire.In most beyond

and services For example, when a a person who values it by it in the absence of a bought goods

an

$20,000,

AMOUNT OF INFORMATION

THE OPTIMAL Increasing

total

augments

agent

par with

to which most.

them

who would have

than the person

middlemen add

and other

agents

the extent

sales agent causesa goodto be purchased $20,000

VALUE

some point.

situations,

the

because

of the

And

having

less. But

value of

additional

information information

Principle,

Low-Hanging-Fruit

information from the cheapest sources first people tend to gather more costly ones.Typically, the marginal benefit of information then, its marginal cost will rise, as the amount of information gathered

before will

turning decline,

to and

increases.

THE COST-BENEFITTEST

FIGURE The

I

other. The Cost-Benefit any Principle tells us to gather information as long as its marginal benefit exceedsits marginal cost. Suppose, for the sake of discussion, that had analysts devised a scale that us to measure units of as on the horizontal information, permits axis of Figure 11.1. If the relevant marginal cost and marginal benefit curves are as 7* units of information, the shown in the diagram, a rational consumer will acquire amount for which the marginal benefit of information its marginal cost. equals

Information

Cost-Benefit

O

that

a rational

gathering

consumer

is an activity

like

will continue

I.I

Optimal

Amount of

Marginal

For the marginal cost and benefit curves shown, the amount of optimal information

is /*.

worth.

benefit Marginal of information

Beyond that

costs point, information more to acquire than it

cost

of information

Information.

/*

is

Units of information

OPTIMAL AMOUNT

THE

31

INFORMATION

OF

I

about Figure 11.1 is that it shows the optimal level of information exceeds its benefits, acquiring ignorance. additional information doesn't simply pay. If information could be acquiredat no decision makers of would, cost, course,be glad to have it. But when the cost of Another

to think

way

facilitate,

better

are

people

of acquiring

the gain

exceeds

information

the

acquiring

cost

the

When

off to

in

value

the decision

from

will

it

remain ignorant.

problem good or serviceis in

THE FREE-RIDERPROBLEM consumersin

available to

assure that the optimal the

be made

will

advice

of

because

example suggests one reason

The next

marketplace?

The Why is

amount

which

from

little of a

produced

cannot

nonpayers

excluded

too

be

using it

not.

it might

why

hand

invisible

the

Does

an incentive

problem

free-rider

a knowledgeable

finding

salesclerk

Naturalist

Economic

I

I.I

often difficult?

People can choosefor who

shopping. Those

those who

false:It

know

follows

The

themselves whether to bear the extra cost of retail value advice and convenience can pay slightly higher prices, while what they want can buy for less from a mail-order house.True or that private incentives lead to the optimal amount of retail service.

the optimal level of retail service for one provide except that consumers can make use of the services offered by retail stores without paying for them. After benefiting from the advice of informed and salespersons after inspecting the merchandise,the consumercan return home and buy the same item from an Internet retailer or mail-order house. Not all consumers do so, of course. But the fact that customers can benefit from the information provided by retail stores without paying for it is an example of the free-rider that problem, an incentive problem results in too little of a good or servicebeing produced. Because retail stores have the cost of providing incentives are likely to yield information, difficulty recovering private less than the socially level of retail service. So the statement aboveis false. optimal would

market

practical problem,

namely,

Why

are

there

knowledgeable

The did

Why

Books, the

Rivergate

business?

last bookstore in

Naturalist

Economic New

Lambertville,

Jersey,

11.2

go out

like

of

bookstores

independent

According

camein,

Noble

and

Barnes

few

salesclerks?

\"m

often manage to survive from large chains competition more service. by offering personalized Janet Holbrooke,the of followed this Books, proprietor Rivergate strategy successfully for more than a decade before closing her doors in 1999.What finally led her to quit?

Small

so

to

Mrs. Holbrooke, a

retired

English

teacher,

\"When

Barnes and

BOOKS

Noble

people were curious, went to look, and bought some books.But they came back and said they wanted to be able to find things more easily and have clerks that had an idea of what their grandchildren like to and we held our own.\"1 Customers read, might also were drawn in by special events such as readings and book signings by authors. But one of these Mrs. Holbrooke saw that her store's were numbered: events, during days a few

I

found

out

that Gerald Stern,

who

won

the

National

Book

Award

for

him if he would come in and poetry, was a Lambertville man, and I asked do a reading. He gave a wonderful presentation, and we had a good I overheard then one of the women turnout, but we sold very few books, and 1

Quoted

by Iver Peterson,

1999, p. 21.

\"A

Bookseller

Quits Battle

with

Internet,\"

The New

York

Times,

June 27,

Why

are

so many

booksellersgoing

independent out

of business?

312

CHAPTER

I I

THE

OF

ECONOMICS

In

INFORMATION

reply to your Worldwide

Web home

a book for Amazon.com. Here through were

who

hers

the

to the

TWO

from its

EXAMPLE 11.3

the

Searching for Should

a person than

apartment

Suppose

an

that

one-bedroom 2Ibid.

bought

something that they got

free-rider

value of

how is increased

problems,

access

surplus?

SEARCH

additional information

is difficult

to know,

one should

Apartment in

living

rents

in books

had

invest in acquiring it is not always the Cost-Benefit examples suggest, Principle provides for thinking about this problem.

following

someone

and $500 per month,

are going to bring a chance.2

RATIONAL

effort

and

framework

conceptual

thought

say that she we were bringing

have

to

exact

the time

signature

affect total economic

FOR

course,

as

people

I

I.I

GUIDELINES

obvious. But

a strong

I

likely to

so the amount of

O

if

then we don't

possible contribution

Internet

In practice,of Cost-Benefit

But

town.

Internet,

CHECK

CONCEPT

his

presenting

specialto the from

Apart

the Burke garden hoe, please visit our page at: http://www.burkel903.com.\"

regarding

inquiry

for

Paris,

Texas,

living

in

one-bedroom an

with

apartments

in

spend more

Paris,

apartments rent of

average

Paris,

France,

or lesstime searchingfor

an

France? in

Paris,

Texas,

vary between

$300

for similar $400 per month. Rents vary between $2,000 and $3,000 per

THE

with an

month,

expectto

spend

In both

average rent a longer

of

$2,500.

time searching

OPTIMAL AMOUNT

In which city should a rational for an apartment?

OF

INFORMATION

313

person

additional the visiting apartments entails a cost,largely time. In both cities, the more apartments someone visits, the more it is that he or she will find one near the lower end of the rent distribution. likely But because rents are higher and are spread over a broader range in Paris, France, in the expected saving from further time will be greater there than spent searching A Texas. rational will to more time for an Paris, person expect spend searching cost opportunity

cities,

of one's

apartment

France.

in

illustrates the principle that spending additional searchtime is example to be worthwhile for items than for cheap ones. For likely expensive one should more time for a example, spend searching good price on a diamond engagement ring than for a good price on a stonemade of cubic more time zirconium; for a low fare to than for a low fare to New Australia, searching Sydney, Sidney, and more time for a car than for a an York; searching bicycle.By extension, hiring who can assist with a search\342\200\224is more to be a agent\342\200\224someone likely good investment in searching for something expensive than for something For example, cheap. This

more

people typically engage real estate agents to help them seldom hire to help them buy a gallon of milk. agents

find

a house,

The Cost should

Who

expect to

search longerfor

a good

price

on a

but they

of Searching

11.4

EXAMPLE

used piano?

are shopping for a used upright To examine a piano piano. of the piano's current ads, they must travel to the home Tom has a car and Tim doesnot and both are rational, which one should expectto examinefewer pianos before making his purchase?

listed in owner. If

Tim

and

Tom

Both

the

classified

The benefits of

an

examining

namely, a better chance of finding is more costly for Tim to examine them than Tom.

piano are the same in both cases, instrument for a low price.But because it of pianos, he should expect to examine fewer additional

a good

the that when searching becomes more point we should t o doless of it. And as a result, the prices we expectto pay costly, expect will be higher when the cost of a searchis higher.

The preceding examplemakes

THE

GAMBLE

INHERENT

IN SEARCH

are in the market for a one-bedroom and have found one apartment in hopes for $400 per month. Should rent it or search further of you in a Even a market with vacant finding cheaper apartment? large many is no guarantee that further will turn up a cheaper or better apartments, there searching entails a cost, which might outweigh the gain. In apartment. Searchingfurther

Supposeyou

that rents

certain costs in return for carries an element of risk. Thus, In thinking about whether to take any gamble, a helpful first step is to compute its expectedvalue\342\200\224the average amount (or lose) if you played that you would win an infinite number of times. To calculate the value of a gamble gamble expected with more than one outcome, we first multiply each outcome by its corresponding general,

unknown

someone

who

benefits.

engages

in further

further

search

must

accept

search invariably

expectedvalue

of a

gamble possible outcomes of the gamble multiplied by their respective probabilities

the

sum

of the

314

a gamble whose

fair gamble

expected

is zero

value

gamble a

better-than-fair whose

gamble

THE ECONOMICS

II

CHAPTER

value is

expected

positive risk-neutral

fair

or

of occurring, and then add. For example,suppose win $1 if a coin flip probability you comes up heads and lose$1 if it comes up tails. Since 1/2 is the probability of heads + also the of the value of this is (and (1/2)($1) probability tails), expected gamble = O.A with an value of zero is called a fair (l/2)( \342\200\224$1) gamble expected gamble. If you played this gamble a large number of times, you wouldn't expect to make but you also wouldn't money, expect to losemoney. A better-than-fair is one with a positive expected value. (For instance, a gamble coin flip in which you win $2 for heads and lose $1 for tails is a better-than-fair is someone who would acceptany gamble that is fair gamble.)A risk-neutral person or better.A risk-averse is someone who would refuse to take fair person any gamble.

someone

person

who would accept that is

INFORMATION

OF

gamble

any

better

CONCEPT CHECK 11.2

risk-averse person who

would

someone

refuse any

fair

gamble

lose $2 neutral

EXAMPLE

11.5

up tails. What it? accept

person

You

search

flip

a fair

is the expected value

coin and of this

it comes up heads and gamble? Would a risk-

of whether

decision

to

Search for an

apartment? San Francisco for a one-month

further in

arrived

have

if you

an apartment.

The Gamble in the you

$4

example, we apply these conceptsto the

for

further

Should

win

it comes

if

In the next

search

in which you

a gamble

Consider

for a one-bedroomsublet

the

for

month.

summer

There are only

visit

and are

two kindsof

searching

one-bedroom

in which you wish to live, identical in every and the other for Of the vacant $360. respect except apartments in this 80 percent are of the first type and 20 percent are of neighborhood, the second type. The only way you can discover the rent for a vacant apartment is to visit it in person. The first apartment rents for $400. If you you visit is one that are risk-neutral and your opportunity cost of visiting an additional apartment is $6,should you visit another apartment or rent the one you've found? in the

apartments

that

neighborhood

for $400

rents

one

visit one more apartment, you have a 20 percent chance of it being one for $360 and an 80 percent chance of it being one that rents for $400. If the but if the latter, you'll face the same rent as former, you'll save $40 in rent, before. Sincethe cost of a visit is $6, visiting another is a apartment gamble with a = 20 percent chance to win $40 \342\200\224 and an 80 chance of $6 $34 $6 percent losing \342\200\224 means The value of this (which $6). \"winning\" expected gamble is thus = $2. Visiting + (0.80)(-$6) another is a better-than-fair (0.20)($34) apartment and since are should take it. risk-neutral, gamble, you you If you

that rents

CONCEPT CHECK 11.3 Refer

to

the

search example above.Supposeyou visit another apartment that rents for $400. If you are risk-neutral, should you visit

apartment

and discover it,

too,

is one

a

third apartment?

PROBLEM WHEN SEARCHISCOSTLY

THE COMMITMENT When

month long-term

most

people

but for

a year

tenants.

want a place to live not for just a for their part, are also lookingfor in their chosen field few people accept a full-time job

search for an or

more.

Similarly,

apartment, they

Most

landlords,

ASYMMETRIC

to hold the

for several years. Firms, too, generally prefer job for extended when most employees stay periods. Finally, people search for mates, they are looking for someone with whom to settle down. Because in all these cases search is costly, examining every possible will option never make sense. Apartment hunters don't visit every vacant apartment, nor do

unless

they expect

will

who

interview

landlords

every

do employers

nor

searcher

can

to date

manage

are rational

to end their

exists

out there

surely

seekers don't visit

tenant. Job

possible

interview every

job

And

seeker.

not even the

every

employer,

most determined

mate. In these and other cases, though they know a more attractive

every eligible even

searches,

somewhere.

people option

What happens when, by chance, a more attractive has ceased? Few people would rent an apartment if they the landlord would kick them out the moment another tenant thought came along who was willing to pay higher rent. Few landlords would be willing to rent to a tenant if they expected her to move out the moment she discovers a job seekers, and people who are lookingfor mates cheaperapartment. Employers, would have similar reservations about entering that could be relationships terminated once a better option happened to comealong. in maintaining stable matches between partnersin This potential difficulty would not arise in a world of perfect information. In such a ongoing relationships in would end the best possible relationship,sono one would be world,everyone up to But when information is and the search must be limited, tempted renege. costly there will always be the potential for existing relationshipsto dissolve. In most an exhaustive contexts, people solve this problem not by conducting search (which is usually impossible,in any event) but by committing themselves to in a relationship remain once a mutual has been reached to terminate agreement the search. landlords and tenants a lease that binds them to one another Thus, sign for a specifiedperiod,usually one and firms enter into year. Employees employmentcontracts, either formal or informal, under which each to honor his promises in to the under extreme circumstances. And most other, obligations except countries a marriage contract those who abandon their into penalizes spouses. Entering such commitments limits the freedom to pursue one's own interests.Yet most such restrictions because they know the alternative is failure to people freely accept solve the search problem. But

herein

lies

a difficulty.

option comes along after

THE

RECAP

the

search

OPTIMAL

AMOUNT

OF INFORMATION

Additional information creates value, but it's also costly to acquire. A rational consumer will continue to acquire information until its marginal benefit equals its marginal cost. Beyondthat point, it's rational to remain uninformed. Marketsfor information do not always function perfectly. Free-rider problems often hinder retailers' efforts to provide information to consumers. Search inevitably entails an element of risk because costs must be incurred A rational without assurance that search will prove fruitful. consumer any can minimize this risk by concentrating search efforts on goodsfor which the in price or quality variation is relatively the cost high and on those for which of search is relatively low.

ASYMMETRIC One

of

the

most

INFORMATION

common

information problems occurswhen

potential exchange are not equally offered for sale. For instance, the excellent

mechanical

condition,

well owner

informed about the of a used car may

but potential

buyers

cannot

the

product or service know know

in a

participants

that that

that's

the car is

in

merely

by

INFORMATION

315

316

II

CHAPTER

THE ECONOMICS

information asymmetric in which buyers and

sellers

situations

are not about

equally the

well informed

for

sale

it for a test drive. Economists in which buyers and situations

or

both

benefit

would

sellersare not

of productsor services. than buyers,

informed

better

The problem of

the

can

information

asymmetric

these

In

sometimes

but

term asymmetric

use the

taking

describe

much

typically

in

11.6

EXAMPLE

inspecting it information to

about the characteristics

of

characteristics

goods and services the marketplace

INFORMATION

OF

informed

well

equally

sellers are situations, reverse will be true.

exchanges that

easily prevent

parties. Here is a classicexample.

Information

Asymmetric

sell her car to Tom?

Will Jane

Miata has 70,000 miles on the odometer, but most of these are in Toronto. weekend to seeher highway during trips boyfriend causes less wear and tear on a car than Moreover, Jane (Highway driving city driving.) has maintained the car precisely to the manufacturer's specifications.In according her car to be in excellent condition. Because she is about to start short, she knows in school wants to sell the car. On average, 2006 Boston, however, Jane graduate in Miatas sell for a price of $8,000, but because knows her car to be excellent Jane her reservation price for it is $10,000. condition, Tom wants to buy a used Miata. He would be willing to pay $13,000 for one that is in excellent condition but only $9,000 for one that is not in excellent condition. Tom has no way of telling whether Jane'sMiata is in excellent condition. (He could hire a mechanic to examine the car, but doing so is expensive, and many cannot be detected even by a mechanic.) Will Tom buy Jane's car? Is this problems Mazda

2006

Jane's

driven

miles

outcome efficient?

BecauseJane'scarlooksno for it.

$10,000 in

just

as good

After

for

all,

condition,

Miata, and Jane'swill

go

only

different

other

from

$8,000, he can buy

as far as be cantell.Tom unsold.

This outcome

another

Tom ends up

Instead,

$1,000.

will

therefore

been

that is

had

Tom

We can't be sure,of than

sold even

created

incentives

up

for sale will

mistreat

their

course,

cars,

lemons model

George

explanation

asymmetric information to reduce the average goods offered for sale

of how tends quality

of

might

Tom ends up buying car in perfect

have a

cannot get what it is really worth. information suggest that asymmetric

by

be of lower-than-averagequality. or whose cars were never very

(or

all.

be in

Even so, the most

reason

used

is that

worse

be

that must

economic

cars that are people who

put

to begin with, are more good likely Buyers know from experiencethat cars for sale on are more than cars that are not for sale. likely to be \"lemons\" them to lower their reservation prices for a used car.

to

causes

One

will

condition

sell them.

not the end of the story. Once used car priceshave fallen, the owners of cars that are in good condition have an even stronger incentive to hold onto them. That causes the average of the cars offered for sale on the used car quality market to declinestill further. economist Berkeley George Akerlof, a Nobellaureate, was the first to explain the logic behind this downward Economists use the spiral.3 term lemons modelto describeAkerlof's of how asymmetric explanation information affects the average quality of the used goodsoffered for sale. But that's

Akerlof's

the Miata

owner

than others to want the used car market

This realization

that someone

Jane's\342\200\224since

if the

at

MODEL

LEMONS

condition

bought

condition

average

worse), and his surplus is only $1,000. Jane getsno economic surplus

THE

pay

and Jane's

$2,000 in

not

Miata that's someone else's buy 2006

efficient.If

have

a Miata

buying

other

some

is not

Jane's Miata for, say, $11,000, his surpluswould

Tom will

2006 Miatas,

3George Akerlof,\"The

Market

for Lemons,\" Quarterly

Journal

of Economics

84 (1970),pp. 488-500.

ASYMMETRIC

next example

The implications

suggests that

Lemons

The Should

to buy

car? a used Honda Accord.Your

she has a four-year-old report that the car is in and

four

years, believe her

for $10,000, which blue book value of

sellin

a

average

price for

model tells us that

quality

than

believe your aunt's claim that its blue book value is definitely the equilibrium price for a car

your

cars

for

a good

that

is of

aunt's

sale in the

deal for

lower quality

the

are

then being

than

market

which

able to

blue

book

buy

a naive

will

buyer

pay for

a used car?

only two kinds of cars: good ones and lemons. An owner which type of car she has, but potential buyers cannot between the two types. Ten percent of all new cars produced are lemons. distinguish Good used carsare worth to their owners, but lemons are worth only $10,000 Consider a naive consumer who believesthat the used cars currently for $6,000. sale have the same quality distribution as new cars (i.e.,90percent 10 good, If this consumer percent lemons). is risk-neutral, how much would he be willing to with

a world

Consider

with

pay for

certainty

car?

a used

Buying a

car of

buyer would buyer can't tell the difference between a lemon,the probability that he will end up with a lemon is simply the proportion of lemonsamongthe cars from which he chooses. The buyer believes he has a 90 percent chanceof getting a good car and a 10 percent chance of getting a lemon. Given the prices he is willing to pay for the two of the car he buys will thus be 0.90($10,000) + types of car, his expected value 0.10($6,000)= $9,600.And since he is risk-neutral, that is his reservation price

be

for

a used

Howwould

quality

is a

provided

it

gamble, is

fair.

but

a risk-neutral

If the

car.

CONCEPT of new

unknown

the gamble a good car and

take

to

willing

CHECK 11.4 your

cars that

11.8

which asymmetric are only lemons

The Naive Buyer (Part I)

knows

EXAMPLE

it

price is

aunt's.

your

under in

be

for sale. If you

not

you, since the

conditions

in a

used car market will

that

condition,

good

(The

age and model

of that Honda?

cars

same vintage

of the her car is in cars

Accords.

four-year-old

which

buy

The following two examplesillustrate information about product quality results offered for sale.

much

11.7

buys a new car every about to trade in. You and she's willing to sell it to you

book value for

Should you

for

How

EXAMPLE

she's

that

condition,

good

current blue car is the average

Akerlof's lemons of lower

Model in Action

Germaine

Aunt

Accord

is the

car market.)

used

the

practical

your aunt's

you buy want

You

has important

model

lemons

the

choice.

consumer

for

INFORMATION

answer are

to the question posed in Example had been 20 percent?

lemons

I 1.8

differ

if

the

proportion

317

318

I I

CHAPTER

THE

11.9

EXAMPLE

OF

ECONOMICS

INFORMATION

The

Naive

Who

will

2)

Buyer (Part

car for what

a used

sell

naive

the

buyer

is

to

willing

pay?

with the previous example: If you were the owner Continuing would it be worth to you? Would you sell it to a naive

what

owned a

of a good used

lemon?

Sinceyou

car,

if you

What

buyer?

car is good, it is worth to you, by $10,000 your a naive buyer would be willing to pay only $9,600, neither you nor any other owner of a good car would be willing to sell to that buyer. If you had a of be happy to sell it to a naive buyer, since the course, you'd is willing to pay is $3,600 more than the lemon would be $9,600 the buyer worth to you. the used cars for sale will be lemons.In time, buyers will only revise their naively optimistic beliefs about the quality of the cars for sale on In the used the of $6,000, and end, all used cars will sell for a price know

since

assumption.But

lemon,

So

car market.

all will be lemons.

the mere fact that a car is for sale does not guarantee because the owner of a good car will sometimes be forced to sell that does not reflect its condition. The logicof the lemons model it, even in this situation want a frustration. The first thing sellers explains this owner's to know is the reason they are selling their cars. For example, prospective buyer classified ads often Corvette\" or announce, \"Just had a baby, must sell my 2009 \"Transferred to Germany,must sell my 2011 Toyota Camry.\"Any time you pay the blue book pricefor a used car that is for sale for some reason unrelated to its are beating the market. condition, you In

of course,

practice,

a lemon at a price

it is

that

IN TRADING

PROBLEM

CREDIBILITY

THE

used car simply tell the buyer about the buyers' and sellers' interests tend to conflict. Sellersof used cars, for example, have an economic incentive to overstate the of their for their have an incentive to understate the quality products. Buyers, part, amount they are willing to pay for used cars and other products (in the hope of bargaining for a lower price).Potential employees may be tempted to overstate their for a And for mates have been known to qualifications job. people searching

The difficulty

car's condition?

engage in That

to say

surveyed worker.

after

Garrison

\"all

the

effect,\"

children

are above the

Notwithstanding

exchange

do

significant

as soon

new cars fraction

as they

the showroom?

not suffice.

are

driven

value

from

illustrates,

not

People

claims

inflated

though

impossible.

about

have

they

long

But

find

call this

some means

since

he's

trying

truth

tend

in

to interpret

as more

productive phenomenon the \"Lake

Minnesota homestead,where parties to a potential

to communicate their

statements of

relevant

information

will

the used car salesman's to unload. But as the next example it's potential adversaries may be difficult,

learned

between

do

interests.Thus, 92 percent

themselves

rated

to exaggerate, the

tendency can

people

their own

Keillor's mythical

however, mere

the cars

communication

Psychologists

average.\"

natural

gain if

In general,

knowledge truthfully.

lose a of their

often

can

partners.

that promote in one study

than the average factory Wobegon

Why

trading

potential

the

misrepresent

consciously

people

in ways

employees

factory

most

that

their

with

ambiguous information

. .rn-!:i

is that

deception.

isn't

communicating

of

a high-quality

with

someone

can't

Why

to discount

THE CREDIBILITY

Credible

knows her

Jane pay

car seller

a used

can

How

signal high

Miata to be in

excellent

such a car.What

EXAMPLE 11.10

Signals

and Tom would be willing to could be confident of getting would Tom find credible?

condition,

about the car's

of signal

kind

319

IN TRADING

credibly?

quality

reservation priceif

more than her

considerably

PROBLEM

he

quality

interests Again, the potential conflict betweenTom'sand Jane's suggests that mere statements about the car's quality may not be persuasive. But suppose Jane offers a warranty, under which she agreesto remedy defects the car develops any over the next six months.Jane can afford to extend such an offer because she knows her car is unlikely to need expensiverepairs.In contrast, the person who knows his car has a crackedengineblockwould never extend such an offer. The is a credible It enables Tom to warranty signal that the car is in good condition. the car with confidence, to both his and Jane's benefit. buy

PRINCIPLE

COSTLY-TO-FAKE

THE

The preceding examplesillustrate the which holds that if costly-to-fake principle, whose interests conflict are to communicate with one parties potentially credibly If the send must be or difficult to fake. the seller of a another, signals they costly defective car couldoffer an extensive as as the seller of a just warranty easily good offer would communicate But car, a warranty nothing about the car's quality. warranties entail costs that are significantly higher for defective cars than for good cars\342\200\224hence their as a of credibility signal productquality. To the extent that sellers have an incentive to portray a product in the most their interests conflict with those of flattering light possible, buyers, who want the

most accurate assessmentof example, quality of

the costly-to-fake

a product.

quality

product

Note that

possible.

the

in

principle appliesto a producer'sstatement

costly-to-fakeprinciple to communicate

do

insert

firms in

products

Company A behalf of

magazines

the phrase \"As advertised and newspapers? an expensive

sponsors

on TV\"

national television

disc

the

when they

sound

or

the

ife

advertise their

campaign

advertising

clearest

rival,

following about

The Economic Naturalist 11.3 Why

information

credibly to a potential a signal must be costly difficult to fake

on best

compact player, claiming similar claims in repair record of any CD player in the market. Company B makes a sales brochure but does not advertise its product on television. If you had no additional information to go on, which company's claim would you find more its

credible? Why

advertises its

CD

do

given

in

player

Accustomed information

you

suppose

are to

seem to

products. On closerexamination, advertise

its

product

product's quality.The millions of dollars,a

Company

A

has

mentions

its TV

ads

the

and

it

when

media?

print

as we

might

it

discounting

inflated

advertisers'

provide no real basisfor

a choice

claims, the between the two

we see that a company's decisionto however, on national television constitutesa credible signal about the cost of a national television campaign can run well into the sum

a company

would be foolish

to spendon

an

inferior

product.

For example, in 2002 30-second Super Bowl

Pepsi paid and it

ads,

to Britney Spears $8 million more than million $3.5 paid

in its two to Fox TV for

appear

Why product

should

buyers

is advertised

care whether a on TV?

320

I I

CHAPTER

THE

OF

ECONOMICS

INFORMATION

broadcasting those ads.National persuade a small only

if

the

initial sales

resulting

people who tried the product productfrom

ads can attract the to try a product. But

TV

of them

fraction

generate other liked

and

it or

new

sales to

investments

huge

business\342\200\224either

others who

heard

and

attention

buyers'

potential

these

repeat

about

pay

off

sales

to

the

a friend.

Because ads cannot persuadebuyers that a bad product is a good one, a company An that spends millions of dollarsadvertising a bad product is wasting its money. expensivenational that the producer thinks advertising campaign is therefore a crediblesignal its product is a good one.Of course, the ads don't guarantee that a product is a winner, in an uncertain but one more piece of information. world, they provide Note, however, that the relevant information lies in the expenditure on the advertising not in campaign, what the ads themselvessay. These observations mention their television ads may explain why some companies in their understand the costly-to-fake principle and hope that print ads. Advertisers consumers will understand it as well.

As the next

to many

ar

example illustrates, the

costly-to-fake

principle

is also

well known

employers.

The

Economic

Why

do many

Naturalist

I

1.4

companies care so much

Microsoft is looking

about

elite

educational

credentials?

a hardworking, smart person for an entry-level technical products division. Two candidates, Cooper and with the highest Duncan, seem alike in every respect but one: Cooper graduated honors from MIT, while Duncan graduated with a C+ average from Somerville should Microsoft hire? College.Whom for

in a new

managerial position

prospective employers that you are both is perhaps no more crediblesignal than to have hardworking with distinction from a highly selective educational institution. graduated Most would like people potential employersto think of them as hardworking and intelligent. But unless you actually have both those qualities,graduating with the highest honors from a school like MIT will be extremely difficult. The fact that Duncan graduated from a much less selective institution and earned a C+ is not that he is not and only average proof positive diligent In this case, the but companies are forced to play the percentages. talented, If

and

odds strongly

Why do some employers about elite degrees?

Cost-Benefit

care

O

to persuade there intelligent,

want

you

favor

Cooper.

so much

CONSPICUOUS CONSUMPTION AS A SIGNAL OF ABILITY Some individuals of high ability are not highly the best (Remember paid. school teacher ever And some as the multihad.) elementary you people\342\200\224such billionaire investor Warren Buffet\342\200\224earn a lot, little. But such yet spend very In competitive markets, the people casesrun counter to general tendencies. with the most as suggested ability tend to receive the highest salaries.And by the Cost-Benefit Principle, the more someoneearns,the more he or she is likely to spend on high-quality and services. As the following examplesuggests, goods thesetendencies often lead us to infer a person's ability from the amount and of the he consumes. quality goods

CREDIBILITY

THE

do

Why

YouVe been

seem to

clients

many

prefer lawyers who

wear

11.5

Naturalist

Economic

The

PROBLEM

IN

TRADING

321

ife

suits?

expensive

accused of a serious crime and are looking for an is between two lawyers who identical in all respects appear suit and except for the things they buy. One of them wears a cheap polyester arrives at the courthouse in a 10-year-old rust-eaten Dodge Neon.The other If this were the wears an impeccably tailored suit and drives a new BMW 750i. information available to you at the time you chose, which lawyer would only attorney.Your

unjustly

choice

hire?

you

most is salary and the abilities buyers value whose clients profession. A lawyer usually than one whose clients prevail in court will be much more in demand and their fees will reflect the difference.The fact that one of the generally lose, more than the other doesn't prove that he is the lawyers consumes much if that better lawyer, but is the only information you have, you can ill afford

The

to

strong

the

in

legal

If

it.

ignore

drives,

choice

you

lawyer

less able lawyer loses business doesn't he why simply buy

If the he

between

correlation

particularly

because suits

better

of the suits he wears and the and a more expensive car?

were on trial for a serious would you hire?

car

His

is between for retirement or spending more on his car and clothing. saving In one sense,hecannotafford in another to buy a more expensive car, but sense, he cannot afford not to. If his current car is discouraging potential clients from hiring be a prudent investment. But because all him, buying a better one may simply have an incentive to make such their effects tend to be investments, lawyers mutually

offsetting.

said and

all is

When

of low ability

their

the BMW

us that

tells

principle

done,the

about

information

relevant

afford

cannot

things

people

respective

750i is an

ability

consume levels.

The with

of conspicuous in every

force

a professional

Ohio, costslessthan

or Los

Manhattan

(We off

discussed

if everyone

consumption as an

half

ability

environment. In small towns,where who tries to impress people by

one another well, a lawyer means is likely to succeedonly wardrobe

costly-to-fake

precisely

signal

positional spent

less and

retirement.

problem

equal

to convey

because the lawyer no matter how little he saves for retirement. Yet one, the resulting spending pattern is inefficient, for the same effective

from a social perspective, reason that other positional arms races are inefficient. arms races in Chapter 10.) Society would be better

saved more for

will continue The

signal people spending

doesn't arise to know her beyond

tend

in demonstrating how foolish she is. Thus, the in \"needs\" towns like Iowa, or Athens, person Dubuque, in as much as the wardrobe the same personwould need

Angeles.

STATISTICAL DISCRIMINATION In

market with perfect information, the buyer of a service would pay of providing the service. In many the seller does markets, however, know the exact cost of serving each individual buyer. In such cases, the missing information has an economic If the seller can value.

a competitive

the

not

seller's

cost

come up with

her position. characteristics

even

to

estimate of the

she can improve missing information, firms often do so by imputing illustrates, following example individuals on the basis of the groups to which they belong.

the

As

a rough

crime, which

CHAPTER

322

I I

OF

ECONOMICS

THE

ar

INFORMATION

The

Economic

Why

do males

Naturalist

I

1.6

under 25 years of agepay

drivers for

other

than

more

auto insurance?

and is an extremely careful and competent driver. He has or even a moving traffic violation. His twin sister Geraldine two one of them serious, in the last three years and has accidents, accumulated three speeding tickets during that same period. Why does Gerald Geraldine $ 1,600 per year for auto insurance, while pay pays only $800?

is 23

Gerald

never had has had

years old

an accident,

The expected cost to depends knows

on the what

estimate rather

male teens

Why

do

auto

insurance?

pay

so

practice about

the

of making judgments the quality of people,

goods, or

servicesbased

characteristics of the which they belong

on the

groups

probability

insurance

the

is for

company

driver any

given

of insuring any given driver in an accident. No one but insurance companies can in specific who will be groups

involved

be

will

driver,

of drivers proportion in an accident in any given year. Males under 25 are much involved more likely in auto than older males and females of any age to become involved accidents. Gerald pays more than his sister because even those males under 25 who have never had an accident are more likely to have one than females the same age who have had several accidents. Of course,females who have had two accidents and accumulated several tickets in the last three years are more a female with a likely to have an accident than record. The insurance much more for spotless driving company knows that and has increased Geraldine's premium accordingly. Yet it is still less than her brother's premium. That doesn't mean that Gerald is in fact more likely to have an accident than Geraldine. Indeed, given the twins' respective driving skills, Geraldine clearly poses the risk. But because insurance companieslack such detailed information, higher they are forcedto set rates according to the information they possess. To remain in business, an insurance company must collect enough from money premiums to cover the cost of the claims it pays out, plus whatever administrative expenses it incurs. Consider an insurance that charges lower rates for young males with company clean driving records than for females with blemished ones. Given that the former group is more likely to have accidents than the latter, the company cannot break even unless it females costs of insuring them. But if it more, and males less,than the respective charges does so, rival insurance will see cash on the table:They can offer females companies lower rates and lure them away from the first company.The first will slightly company end up with only young male policyholders and thus will suffer an economic loss at the low rates it charges.That is why, in equilibrium, records young males with clean driving females with blemished records. pay higher insurance rates than young

The

statistical discrimination

that

an

that

probability

to

an

example

precisely

the

insurance industry's policy of charging of statistical discrimination. Other

high

rates

to young

examples include the

male drivers is common

salaries to people with college than to people without degrees of with SAT scores. Statistical policy favoring college applicants high discrimination occurs whenever or are people products judged on the basis of the to which groups they belong. statistical discrimination, even though knows Competition promotes everyone that the characteristics of specificindividuals can differ markedly from those of the to which group they belong. For example,insurancecompaniesknow perfectly well that some young males are careful and drivers. But unless they can competent which males are the better forces them to act drivers, competitive identify pressure on their knowledge as a males are more than others to that, group, young likely insurance claims. generate know that many people with a high school diploma Similarly, employers only are more productive than the average college graduate. But because employers tell in advance who those peopleare,competitive leads them usually cannot pressure practice

them

of

paying and the

higher

THE CREDIBILITY

to offer higher than

school

high

SAT scores will

PROBLEM

323

IN TRADING

wages to collegegraduates,who are more productive, on average, with low Universities, too, realize that many applicants graduates.

scores. But if two grades than applicants with high for their SAT scores, competitionforces applicants equally promising except universities to favor the applicant with scores since, on average, that higher applicant will better than the other. perform Statistical discrimination is the result of observable differences in group not the cause of those differences. for example, do not characteristics, males, Young earn

higher

look

generate more insurance claims becauseof statistical

occurs

discrimination

more claims.

because

Nor doesstatistical

discrimination.

statistical

companies know

insurance

Rather, that

young

males

males to

young pay insurance rates that are high in relation to the claims they generate. Among any and and others are not. group of young male drivers, someare careful competent, Statistical discrimination means the more able males will pay high rates relative to the volume of claims they generate, but it also means the less able male drivers will low rates relative to the claims On the rates will pay they generate. average, group's be appropriate to the claims its members generate. these observations do little to ease the frustration of the young male who Still, knows himself to be a careful and competent driver, or the high school graduate who knowsherself to be a highly productive employee. Competitive forces provide firms an incentive to identify such individuals and treat them more favorably whenever practical. When firms succeed in this effort, however, they have often discovered some other relevant information on group differences.For example,many insurance offer lower rates to males who belong to the National companies young Honor Societyor make the dean's list at school. Members of thosegroups generate fewer other males. But even these groups include claims, on average, than young and the fact that offer discounts to their members means drivers, risky companies that all other males must rates. young pay higher generate

discrimination

cause

SELECTION

ADVERSE

Since insurance

statistical each discrimination, practice the same rate, even though individuals within the group often differ of their likelihood of filing claims. Within each group, insurance is thus most attractive to those individuals with the buying highest likelihood of filing claims. As a result, high-risk individuals are more likely to buy insurance than low-risk a pattern known as adverse selection. Adverse individuals, selection forces insurance companies to raisetheir which makes premiums, buying insurance even less attractive to low-risk individuals, which raises still further the In risk level of those who remain insured. some those individucases, only average als faced with extreme risks may continue to find insurance an attractive purchase. individual

companies routinely

a group pays in terms sharply

within

in

which

the

pattern

tends to

insurance

be

purchased disproportionately by those who are most costly for

companies to

insure

HAZARD

MORAL

hazard is another problem that the average person. This problemrefers when precautions they know they are

Moral

example, may take less careto prevent and

cautiously

losses from people

adverse selection

makes to

insurance fact that some

buying the

insured. Someonewhose it

from

being

less attractive

for

people take fewer car

is insured,

for

damaged or stolen. Driving

for safe parking spaces requireeffort, after all, and if the in these are covered some insurance, engage precautions by

searching

failing

will become

to

less vigilant.

Insurance companieshelp many

of their clients soften the potential hazard and adverse selection consequences problems by offering policies with deductible provisions. Under the terms of an automobile collision insurance policy with, say, a $1,000 deductible provision, the insurance company covers only those collision of $1,000. For example, if you have an repair costs in excess of

like moral

the tendency

moral

hazard

people

to expend

protecting

insured

those

of

less effort goods

against theft or

that are damage

CHAPTER

324

I I

THE

OF

ECONOMICS

INFORMATION

in which

accident covers

$3,000 in damage $2,000, and you pay the

only

How does the availability companies to provide, they

sell

bargain, however, for

better

sincethosedrivers deductible which

they

are

remaining $1,000.

such

for

are

policies

cheaper

lower pricesrepresent a much least likely to file insuranceclaims

those drivers

who

are

likely to incur any uncovered also confront careless drivers with least

giving them additional incentives benefit insurance buyers in another way. deductible will not file a claim at provision

the

resources

is less

of lower

form

decides

to say

to take precautions. Because the holder of a all if the damage to his

insurance companies

threshold,

claims, savings

of statistical about controversial

public issues.Politicians

especially when a politician'sstatements about her beliefson other subjects.

\"'\"'ie

Economic

that

get

discrimination arises when

believe in, but supporting the positions they genuinely reelection. As the next the winning examples illustrate,

-^^ir

Policies with extra costs for

require along

passed

in

POLITICAL DISCOURSE

illustration

intriguing what

deductible

and investigate

of the

premiums.

DISAPPEARING An

the

than

to process

costs.

repair more

These policies

fewer

of

effects

for insurance

prices. The

lower

provisions are responsible,

policy with a car in an accident

insurancecompany

the negative

mitigate

policies

hazard? Sincethe

and moral

selection

adverse

of

car, the

to your

occurs

Naturalist

Why do

one

about

also

they

a politician have

an interest

in

have

an interest

in

motives

two

subject

often conflict,

convey information

11.7

opponents of the death penalty

often

remain

silent?

Quite apart from the question of whether executionof convicted criminals is morally legitimate, there are important practical arguments For one thing, it is extremely expensive against capital punishment. relative to the alternative of life without parole. Execution is costly because of judicial execution of innocent persons.In each safeguards against in case the United these safeguards consume States, capital prosecuted thousands of person-hoursfrom attorneys and other officers of the court, at a cost that runs well into the millions of dollars.4Such efforts the record is replete with of executed notwithstanding, examples persons who are later shown to be innocent. Another argument against is that capital punishment many statistical studies find that it does not Why

do

penalty

many politicians

refuse to

who oppose the

speakout

against

deter people from committing in both parties find leaders

death

it?

punishment punishment

these

crimes. Though capital and other arguments

compelling, few politicians publicly. Why not?

voice

their

many

political capital

against

opposition

to

capital

A possible answer to this puzzle is suggested by the theory of statistical discrimination.Voters in both parties are concerned about crime and want to elect politicians who take the problem seriously.Supposethereare two kinds of politicians: some who in their heart of hearts take the crime issue seriously and others who merely pay lip service to in it. Suppose also that voters a second favor classify politicians way: those who publicly the death penalty or remain silent and those who publicly it. Some oppose politicians will the death for the reasons but others will it because discussed, oppose penalty just oppose are reluctant to because believe that crime is they simply punish criminals\342\200\224perhaps they in more fault than the criminars. the latter ultimately society's (Politicians category are

4SeePhilip

J. Cook

The Sanford Institute

and Donna B.Slawson, \"The Costs of Processing Murder Casesin of Public Policy, Duke University, Durham, NC, 1993.

North

Carolina,\"

THE

the ones voters think to

want

being \"not serious about crime\"; they

of as

rid of.) These

two possiblemotives of death penalty opponents

get

for

opposing who take

CREDIBILITY

IN TRADING

PROBLEM

325

are the ones most voters the death penalty suggest

in the proportion the crime issue seriously, smaller than the corresponding proportion among public's view, will be somewhat of the death penalty. For the sake of discussion, imagine that 95 percent of proponents who favor the death penalty and who politicians only 80 percent of politicians oppose the death penalty are \"serious about crime.\" If you are a voter who cares about crime,how will your views about a politician be If you knew nothing about that affected by hearing that he opposes the death penalty?

that the

best guesson

his opposition to the death would hearing penalty chance that he is serious about crime.Had he instead voiced be that there is a 95 percent chance support for the death penalty, your best guess would that he is serious about crime. And since voters are looking for politicians who are serious about crime, the mere act of speaking out against the death penalty will entail a small loss of even for those politicians who are extremely serious about crime. political support this tendency on the part of voters,somepoliticians who are only Knowing to the death penalty to keep their views to themselves. As a marginally opposed may prefer that speaks out publicly the death penalty result, the composition of the group against will reluctant to punish change slightly so that it is more heavily weighted with people criminals in any way. Suppose, for example, that the proportion of death penalty opponents who are serious about crime falls from 80 to 60 percent. Now the political cost to

politician

with, your

begin

there is an

be that

80

percent

out against the death still penalty rises, leading silent. Once the dust settles,very few opponents of capital In their their views publicly. desire to convince voters that of speaking

some may most

become

even

discourse

will

outspoken proponents capital punishment.

favor

strongly

most

even

leaders\342\200\224or

that

will

are

they penalty.

is no

to remain

opponents

punishment

of the death But

favor

voters\342\200\224genuinely

more

tough In the

reason to

risk

stating

on crime, end, public

concludethat

it.

disappearingpolitical discourse

Glenn Loury was the

The economist

describedin the preceding example. discourse. Onceyou understand it, sphere

political

in

but

everyday

first

We call

it

to call the

problem

you will begin to discourse as well.

The

attention of

to the phenomenon disappearing political

notice examplesnot just

in

the

people may

who

the theory that a position support

remain

speaking of being out

a risk

Economic

11.8

Naturalist

\342\226\240%

Why

do

of legalized

proponents

remain

drugs

silent?

heroine, cocaine, and methamphetamines cause enormous of dispute. The clear intent of laws that ban commerce in these is to that harm. But the laws also entail costs. drugs prevent By making the drugs illegal, increase their addicts to commit crimes to pay for they substantially price, leading many illicit drugs.The high incomes of many drug dealers also divert people from legitimate careers and result in turf battles that often have devastating for both consequences

That

addictive is not

harm

and

participants completely.

Drug

bystanders. use would

conceivablethat no

virtually

Many legalization

policy experiencein

like

drugs

a matter

legalizing

politicians politicians could

If

these

drugs

also rise, how

were legal, drug-related crimewould we do not know. In short, significantly

might be sound

addictive

drugs publicly favor such a policy?

may simply believe to such a steep

lead

might far outweigh countries such as

that

legalizing

drugs

public

legalization. A second explanation to speak out for fear that others

and is

will

it's at

least

then, do

Why,

is a bad idea.Theoretically, that the cost of the

rise in drug consumption its benefits.This concern,however, is not

England

policy.

vanish

supported

by

which have tried limited forms of that politicians who favor legalization are reluctant them. Suppose that some people favor misinterpret the

Netherlands,

silent because would

create

misunderstood

326

I I

CHAPTER

THE

ECONOMICS

OF

INFORMATION

on careful

based

legalization

are merely crazy.

of the costs and benefits, while other proponents of crazies is higher than among among supporters someone who speaks out in favor of legalization cause may her to increase their estimate of the likelihood she is crazy. This

the

If

opponents of legalization,

those

who do not

crazies downward

know

from speaking out, which raises the proportion proponents so on in a public supporters of legalization\342\200\224and until most of the remaining public supporters really are crazy. some

deters

possibility

among

spiral,

analysis

proportion

the

The

with

had

States

One could opposecommunist communicate

antagonists

did the

President

task of reestablishing

relations

diplomatic

Richard

communist

basher?

with

Nixon,

China

normal fall to

the lifelong

in

of the

wake

the

and

expansionism

on the grounds that In the Cold openly.

war War

explainwhy relations

diplomatic

communist revolution. yet still favor is less likely when however,

environment,

were under enormouspressureto demonstrate their steadfast to communism at every opportunity. Fearing that opposition for the normalization of relations with China would be support a! misinterpreted as a sign of softness toward communism, many of the supporters < \302\251 Richard Nixon\342\200\224whose anticommunist policy remained silent. Not until credentials no one could question\342\200\224was elected were diplomatic president relations with China finally reopened. The problem of disappearingdiscoursealso helps the explain impoverished state of public debate on issuessuch as the reform of Social and other entitlement programs. Security, Medicare, American

Why

China

with

normalizedrelations

normal

reestablishing

difficulty

were severed

which

China,

problem helps to

discourse

political

disappearing

United

the

of

remaining

politicians

ASYMMETRIC INFORMATION

RECAP

of a

product

will

Such asymmetriesoften stand in the markets for high-quality high

makes

quality

situations

are equally well know more about

exchange

potential

describes

information

Asymmetric

them

its

not

which

than

quality

way of

in the

mutually

the

to

pay

to a

all parties

seller

buyers.

potential

beneficial

exchange

buyers' inability to a commensurate price.

because

goods

unwilling

in

informed. In the typical case,the

identify

Information asymmetries and other communicationproblems between can often be solved through the potential exchange partners use of signals that are costly or difficult to fake. Productwarranties are such a signal because the seller of a low-quality would product find them too costly to offer. and sellers also respond to asymmetric information Buyers by attempting to judge the qualities of products and people on the basis of the groups to which they belong. A young male may know he is a good driver, but auto insurance companies must nonetheless charge him high rates because know that is frequently they only that he is a member of a group

involved

in

Because

people's

knowing

believes

or her beliefsabout arises

discourse

about some hold

beliefs about someone

what

clue to his political

accidents.

because

issues publicly for

unpopular

beliefs about

different things tend to be correlated, about one issue providesat least some

others. The problem

of

disappearing

to speak politicians are often reluctant fear that doing so may suggest that

related issues.

out they

REVIEW

sales agents are important To the extent that they

of information. economic

add

than

productive

or perform services rider problemoften useful

information.

product

the Unfortunately, firms from offering

directly. prevents

knows whether it is in good condition, do not. Even though a buyer buyers may pay more for a good car than the owner

free-

More generally,

(LOl)

of less-than-complete beneficial both to

govern

principles

information.

more

Searching

the cost of

consumers

of buyers and sellers,merestatements

the rational search for makes sense when intensively

to terminate the

agreed

information

may

between

potential

trading

to fake.

Many

potentially

from

taking

offering quality

fact

the

by

that

one party

asymmetric

60-year-oldsthan

information

asymmetric

better-than-fair

costly-to-fake

fair

principle(319)

why a

might the

actually artist who

2. Can it without

be

rational

having

gallery owner who sellsa painting more economic surplus than

create

painted it. (LOl) for a first

consumer to buy

taken

test

drives

missing about

know

Statistical

lemons model(316) hazard

of a gamble (313)

problem

REVIEW 1. Explain

20-year-olds.

moral

risk-averse

(311)

statistical

in competing

(314)

discrimination

(322)

QUESTIONS built

models and

others?

3. Explain a Chevrolet

(323)

person

risk-neutral person (314)

(314)

gamble

free-rider

to

(325)

expected value

gamble (314)

they

to explain

political

discourse

estimate

to

TERMS

disappearing

(316)

try

of what

the phenomenon of which occurs when opponents discourse, disappearing political of a practice such as the death penalty remain silent when the issue is discussedpublicly. (L04)

the

KEY

adverse selection (323)

use

making

by

For groups to which people or things belong. example, insurance firms estimate the risk of insuring individual young male drivers on the basis of the accident rates for young males as a group.This is practice known as statistical discrimination. Other examples include more than high school paying college graduates and charging higher life insurance rates to graduates

are prevented that

owner

the

information\342\200\224

lacks information

often

consumers

and

information

search. (LOl)

transactions

beneficial place

must

of a

highcredibly signal the car's quality by a warranty\342\200\224an offer that the seller of a lowcar could not afford to make. (L04)

discrimination helps

\342\200\242

For instance, the

car can

used

quality

\342\200\242 Firms

the

about

credible. For a signal partners to be credible,it

not be

relevant

be costly

there is always the possibility that a better relationship, partner will turn up after the search is over.In most contexts, peopledeal with this problem by entering into contracts that commit them to their partners once they

mutually

often

same quality level to pay for. (L03)

and sellers often can gain buyers by finding ways of communicating what they know to one another. But because of the potential conflict between the interests

when quality is highly or when prices vary widely. Further search variable, A risk-neutral person will search is always a gamble. whenever the expected gains outweigh the expected costs. A rational search will always terminate before all in a Thus, possible options have been investigated. in an ongoing search for a partner bilateral

have

the supplying would be willing

\342\200\242 Both

is

is low,

search

a

to

basis

buyers and to sellers,but information is costly to acquire. The rational individual therefore information to the acquires only up point at which its benefit its marginal equals marginal cost. Beyondthat one is rational to remain point, ignorant. (LOl) \342\200\242 Several

potential

be willing

information

asymmetric

from

sellers

prevents

exchange takes place on the information. More information

market

every

Virtually

car

used

a but

of such a car would require,the fact that the buyer cannot be sure he is getting a good car often discourages the sale.

that \342\200\242

example, the owner of

other has. For

sources

enable

the right products and services,they value. In that sense they are no less the workers who manufacture goods

find

to

consumers

-

SUMMARY

other

and

\342\200\242 Retailers

327

QUESTIONS

different, on

sale.

why

by Ford, used

average,

(L03)

Chrysler, Honda, Toyota,

(LOl) cars

from

offered for sale are used cars not offered

for

328

4.

Explain why the function more

used-car market

to

which moral community

OF

ECONOMICS

THE

I I

CHAPTER

efficiently

norms of

honesty

would be likely

a

in

are

INFORMATION

community

than

strong

in

for

investment

a

even

such norms are weak. (L04)

in which

a leasing an aspiring

might

Why

in

he

though

be a good film producer, Hollywood afford the monthly easily

new Porsche

can't

(L04)

payments?

PROBLEMS

Graw Hill

and has an

1. Carlos is risk-neutral

Mc

connect'

in

| ECONOMICS

McGraw-Hill

Visit

your mobile

store and

the Frank: Econ

app

download Study

app todayl

Slaterville

The

Springs.

local

possible

other

only

ancient

with great character for sale is $130,000. The only

farmhouse

price for the

His reservation

house

whose reservation buyer is Whitney, price for the house is $150,000. houses on the market are modern ranch houses that sell for

reservation $125,000, which is exactly equal to each potential buyer's price for if Carlos does not hire a realtor, Whitney such a house.Suppose that will learn from her neighbor that Carlos's house is for sale and will buy it for $140,000. However, if Carlos hires a realtor, he knows that the realtor will put him in touch with an enthusiast for old farmhouseswho is willing to pay up to $300,000 for if he and this the house. Carlosalsoknows that person negotiate, they will agree If realtors charge a commissionof 5 percent on a price of $250,000. of the selling and all realtors have costs of for $2,000 price opportunity negotiating a sale,will Carlos hire a realtor? If so, how will total economic surplus be affected? (LOl) 2. Ann and Barbara are computer programmers in Nashville who are planning to move to Seattle.Each owns a house that has just been appraisedfor $100,000. But whereas Ann's house is one of hundreds of highly similar houses in a large, well-known suburban development, Barbara's is the only one that was built from her architect's more design. Who will benefit by hiring a realtor to assist in selling her house, Ann or Barbara? (LOl)

3.

sell stocks

who

Brokers

those who transact

4.

can serve

or over

mail

many

the phone.

access affect the average incomes of in the traditional way? (LOl)

Internet

expansion of

more

customers

How

will

than

the

who

stockbrokers

do business

to

continue

over the Internet

businessby

do you

income

Whose

Internet access:

predict

be

will

more

by the

affected

expansion of

(LOl)

or lawyers?

a. Stockbrokers

b. Doctorsor pharmacists? c.

owners

Bookstore

or the owners

retired accountant,and

5. Fred, a

identical twins who collect antique

of galleriesthat

Jim,

sell

manager, are 63-year-old an annual income of One buys most of his from a local dealer. Which

a government Each

has

pottery.

from a pension, Jim's from salary). and the other buys most of his auctions, brother is more likely to buy at an auction, and does his brother who buys from the local dealer? (Fred's

$100,000

pottery

at

local

(LOl)

6.

How

will

musicians

who

7. Consumers market

are

who own

access affect the number of film clubs? (LOl) know that some fraction x of all new cars produced defective. The defective onescannotbe identified

them. Carsdo not depreciatewith

8. State whether

the

a. Companies TV that

primarily the

he pay more or lessthan

Internet growing have active fan

and value nondefective cars used ones for $2,500. What following

advertised

Consumers

each. New $10,000 the fraction x? (L03)

at is

are true

spend billions of because

use.

dollars

advertising

and sold

their

the

in

by those

except

are risk-neutral

cars sell for

briefly

and

actors

explain

products

$5,000

why:

and

(L04)

on network

of their advertisements persuadeconsumers are of high quality.

the texts products

or false, and

oil paintings?

original

ANSWERS TO

b.

from a retail shop when you get the optimal level of advice go a for bike because of the free-rider problem. buy lamp your c. If you need a lawyer, and all your legal expenses are covered by insurance, with the most expensive you should always choose the best-dressed lawyer car and the most ostentatiously furnished office. d. The benefit of searching for a spouse is affected by the size of the You

not

may

in to

in.

live

community you

each pair of person drives is job. (L04)

9. For

a.

school

Elementary

10. Female

Margaret Thatcher)

than the

matters

policy

disappearing discourse,suggest

11.1

Meir,

an

Indira

as more

average male head of

-

of car a she is at her

kind

good

military India's

described

been

often

the

in

heads of state (e.g.,Israel'sGolda have

the

how

agent

engineer

sector,

private

of

administrator

government

the

in

for which

a good indication

real estate

teacher,

b. Dentist,municipal c. Engineer

to be

likely

the one

identify

listed,

occupations

more

state.

explanation

ANSWERS

Loury's

Using

for this

Gandhi, Britain's

bellicose in

of

pattern. (L04) -

(HECKS

CONCEPT

TO

foreign

theory

about cheap way to acquire information many goods of increased Internet access will be a downward in the supply shift curve of information. In equilibrium, peoplewill acquire more and the goods and servicesthey buy will more closely information, resemble those they would have chosen in an ideal world with perfect information.These effects will cause total economic surplusto grow.Someof these makes the free-rider problem however, might be offset if the Internet gains,

An

is a

search

Internet

and services,

so the

effect

more serious.(L02)

11.2

The

Since

the

expected value is better

gamble

same as the

heads is 0.5, the

of getting

probability

tails. Thus, the

of

this

gamble

than fair, a

probability

is (0.5)($4)

of getting

+ (0.5)(-$2) = $1.

risk-neutral person would

accept

it.

(L02)

11.3 Since you

still

search

should

percent chance

a 20

have

make another visit,

the

expected

again. The

and shouldnot influence

11.4

The

expected

$9,200.Any

risk-neutral

cars for the assembly line of used

of a

value

sale

bad

your

was

would

of finding

if you a cheaper apartment of the gamble is again $2, and you outcome of any previous search is a sunk cost decision about whether to search again. (L02) outcome

new car will

now

+ 0.2($6,000)

be 0.8($10,000)

believed

consumer

who

the same

as the quality distribution to pay $9,200 for a used

be willing

that

the

=

distribution quality of new cars off car. (L03)

CONCEPTCHECKS

329

FOUR

PART 1

OF

ECONOMICS

W

some

do

Why

to

be

question

single

simple

apply

this question.

answer

in

than

economic

stimulated

has

economics

interest and discussion.Our aim

nearly as much will

earn so much more money

people

other

No

others?

^

POLICY

PUBLIC

.

principles

in

We'll first discuss the

in

Chapter

12

an

attempt

to

human

capital

the importance of differences in emphasizes characteristics. We then focus on why people with personal similar characteristics often earn sharply different personal incomes.Among the factors we'll consider are labor unions, winner-take-allmarkets,discrimination, and the effect of nonwhich

model,

also whether wage conditions of employment.We'll explore income inequality is something society should be concerned about,and if so, whether practical remedies exist for it.We'll see that to redistribute income have government programs

as benefits.

as well

costs In

economic explore in the environmental,

13 we'll

Chapter

with

problems

specific

domains,

careful

how

showing

application

policies for dealing safety, and health of basic economic

that principles can help society policies the economic pie and make everyone'sslice

both

design

larger.

thread

running

unifying

problemof benefitprinciple scarcity.

In

can

In

be,

of

sorts

each

help

14 we'll

Chapter what

the examples we'll case, we'll explore

through

goods

to

consider revenue under

various among

in

the

government

ways, local,

and state,

how and

consider is the how the cost-

the resulting

trade-offs.

how big government should it should provide, and to pay for them. We'll also

and services

how it should raisethe investigatecircumstances vest

resolve

expand

The

power

which

rational

to constrain

such powers federal levels.

citizens

might

their behavior

in

should be apportioned

CHAPTER||2

Labor

Markets,

Income

and

Poverty,

Distribution V

LEARNING

OBJECTIVES

After reading this chapter, you should be able to:

LOI

wages

V,-b i v

i

i

^

4

L02

II

II

IDE

,

tt

*

'

how

Analyze

patterns in

has led

to

dramatic

changes

in consumption

decades.

recent

L03

Compare

hypotheses

Summer Olympic Games in remained

the

in

spotlight,

continuing

1984.

For

the

the

to earn millions of

dollars

question

in

economics citizenship,

high income. countries, poor

has

Many of the and many Americans are homelessand

malnourished.

and

in

trends

recent

Discuss

U.S. income

product medalist from

nearly as much interest and discussion. is neither necessary nor sufficient for receiving in the world come from wealthiest people extremely stimulated

of course,

L04

from

endorsements and motivational speeches.In contrast,the silver in the 1984 dropped quickly from view. (Even immediate aftermath of her silver-medal few people outside Romania could name She is her.) performance, Ecaterina Szabo, one of the most talented Romanian gymnasts of her era, and she came within a hairbreadth of beating wealth and Retton, although international recognition were not to be hers. are likewise Many physiciansin Szabo'shomeland every bit as talented in the United and hardworkingas physicians States. But while American physicians earn an average annual income of almost $200,000,Romanian physicians earn so little that some of them their incomes supplement by cleaning the Bucharestapartments of expatriate Americans for just $10 a day. do some earn so much more than others? No other Why people single American

earnings differences.

individual

at the Los Angeles next two decades, she

have

to explain

proposed won

contrast

and

economists slimmest of margins, Mary Lou Retton all-around gold medal in women's gymnastics

markets.

labor

the various

y only the

are

determinedin

*

competitive

earners

wages

and employment

^^L top

marginal

of

workers. -Ilk II

concentration of income among

the

and

productivity

B

.

Growing

between

relationship

\342\200\242\342\226\240r/-r

4*ifttaU/-

the

Understand

inequality

philosophical

justifications

for income

redistribution.

L05

and

Describe

analyze some of the

methods

used

reduce poverty United

States.

in

to the

_

334

CHAPTER

12

LABOR

DISTRIBUTION

INCOME

POVERTY,AND

MARKETS,

Our economic

people

aim in this chapter will be to employsimple in an attempt to explain why different principles earn different salaries. We'll first discuss the human

model, which

capital

emphasizesthe importanceof

Next, we'll focus on why characteristics often earn incomes. the factors we'll consider Among the effect of discrimination, nonwage

people

characteristics. personal with similar personal

sharply

different

differences

in

are labor

unions,

conditions of employment, and winner-take-allmarkets. we'll whether income inequality is Finally, explore should be concerned about, and if so, whether something society remedies

practical programs As

policymakers

always,

quo with government

for

redistribute

to

the

it exist. As we'll see, government income have costs as well as benefits. must compare an imperfect status

practical

of imperfect

consequences

remedies.

do small differences in performance sometimes in pay? translate into enormous differences

Why

THE ECONOMIC

VALUE OF WORK

the sale of human labor is profoundly different from the sale of and services. For someone goods example, although may legally relinquish all future to the use of her television set by selling it, the law does not permit rights to sell themselves into slavery. The law does,however, to people permit employers \"rent\" our services. And in many ways the rental market for labor services In

some

respects,

other

functions

much

category

of

like

labor

the market for most other goods and services. Each has a demand curve and a supplycurve.These curves

wage and the

both the equilibrium

determine

for each category of is more,

What

equilibrium

quantity

specific intersect

to

of employment

labor. in the

shifts

relevant

analogousto those producedby

shifts

and services. For goods of labor will generally

demand and supply curves producechanges in the demand and supply curves for other in the demand for a specificcategory increase

instance, an increase both the equilibrium wage and the equilibrium in the of quantity employment in that category. By the same token, an increase of labor to a will tend to increase the level of supply given occupation employment and

Equilibrium

O

lower the wage rate in that occupation. As in our discussions of other markets,our strategy

of productive

differentlevels

EXAMPLE 12.1

for

investigating

how

the

labor market works will be to go through a series of examples that shed light on different parts of the picture. In the first example, we focus on how the Equilibrium differ workers with Principle helps us to understand how wageswill among

Productive How much who

finishing marketplace. input

used

work for

will

the

and

potters

the

Equilibrium

Principle

earn?

of numerous identical companies that hire These companiessell the pots for $1.10 each to a in the retail that glazes and fires them and then sells them company in which is available free of unlimited is the only Clay, charge quantities, the Rennie and Laura are the two by potters. currently only potters who whose cost other than salariesis a 10-cent Mackintosh, only potters'

Mackintosh potters

Ability

ability.

Pottery

mold

Works

is one

clay into pots.

handling

cost for each pot it delivers delivers 120. If the much will each be paid?

and Laura

week

how competitive,

to the labor

finisher. Rennie delivers 100 pots for potters is perfectly

335

OFWORK

ECONOMICVALUE

THE

per

market

We with the assumption that Rennie and Laura have decided to work begin full time as potters, so our focus is not on how much they'll work but on how much they'll be paid. After costs into account, the value of the taking handling that Rennie delivers is and that is the amount Mackintosh $100 pots per week, will pay him. To pay him less would risk having him bid away by a competitor. For example,if Mackintosh would paid Rennie only $90 per week,the company then enjoy an economic profit of $10 week as a result of him. per hiring Seeing firm this cash on the table, a rival could then offer Rennie $91, thus earning an

him away from Mackintosh. additional economicprofit of $9 per week by bidding will have So under the biddingpressurefrom rival employers, Mackintosh if him Rennie it less than week. And the company $100 difficulty keeping pays per would suffer an economic loss if it paid him more than $100 per week. Similarly, the value of the pots delivered each week by Laura is $120, and this will be her wage.

equilibrium

competitive

delivered each week was that 12.1, the number of pots eachpotter or for short. More (A1P) potter's marginal physical product, marginal product firm a worker's is the extra the as a result of generally, marginal product output gets that worker. When we a worker's the net price hiring multiply marginal product by for which each unit of the product we that worker's value of sells, get marginal 12.1 the \"net of each pot was $1.00\342\200\224the (In Example product, or VMP. price\" difference between the $1.10 sale price and the $0.10 handling charge.) The in competitive general rule labor markets is that a worker's in pay long-run equilibriumwill be equal to his or her VMP\342\200\224the net contribution he or she makes to the revenue. their employer's Employers would be delighted to pay workerslessthan if to be sure. But labor markets are cannot VMPs, respective truly competitive, they so for long. get away with doing In the pottery example, each worker'sVMP was independent of the number of In other workersemployed the firm. such we cannot cases, by predicthow many 2 potters, workers a firm will hire. Mackintosh could break even with with 10, or even with 1,000 or more. In many other situations, however, we can predict exactly how many workers a firm will hire. Consider the following example.

In Example

Hiring

How many

workers

should

Adirondack

hire?

in a competitive Adirondack Woodworking Company hiresworkers labor market at a wage of $350 per week to make kitchen cutting boards from scrap wood that is available free of charge. If the boards sellfor $20 each and the company's weekly in Table varies with the number of workers hired as shown 12.1, how many output

workers shouldAdirondack

hire?

for pottery example, our focus was on wage differences employees In abilities differed. we assume here that all workers contrast, productive are equally productive and the firm faces a fixed market wage for each. The fact that the marginal product of labor declines with the number of workershired is a in of the law of returns. discussed this law (As consequence diminishing Chapter 6,

In

whose

the

marginal

product

of

labor (MP) the additional output a firm gets by employing additional unit of labor value of marginal labor (VMP) of the additional gets

by

unit

of labor

employing

EXAMPLE

product the

dollar output

one

of value

a firm

one additional

12.2

CHAPTER

12

LABOR MARKETS, POVERTY,AND

TABLE

INCOME

DISTRIBUTION

12.1

Employment and Productivity in a cutting boards sellfor $20each) Total

Number

boards/week

0

that

1

30

2

55

3

76

4

94

when a

(when

MP

(extra

VMP

cutting

($/week)

boards/week)

0 30

600

25

500

21

420

18

360

14

280

108

5

says short

number

of cutting

of workers

Company

Woodworking

firm's capital or other productive inputs are held fixed in

the

in ever smaller increases in results run, adding workers beyond somepoint The third column of the table the for each output.) reports marginal product additional and the last column the value of each successive worker's worker, reports number of boards he or she adds times the marginal product\342\200\224the cutting selling as long as the next worker's VMP is price of $20. Adirondack shouldkeep hiring at least $350 per week (the market The first four workers have VMPs wage). larger than since the fifth worker $350, so Adirondack should hire them. But hiring would add only $280 to weekly revenue, Adirondack should not hire that worker.

between the perfectly firm's decision about competitive and the perfectly competitive firm's decision we output considered in Chapter 6. When labor is the only variable factor of production, the two decisions are essentially the same. Because of the unique correspondence between the firm's total output and the total number of workers it hires, deciding how many workers to hire is the same as decidinghow much to supply. output The worker's attractiveness to the employer depends not only on how many boards he or she produces, but also on the price of cutting boards and on cutting the wage rate. For example,becauseVMP rises when product price rises, an in product increase also price will lead employers to hire more workers.Employers will increase hiring when the wage rate falls. Note

how

many

the similarity workers

to hire

CONCEPTCHECK 12.1 In

Example

12.2, how

many

workers

should

Adirondack

hire

if

the

boards rises to $26?

price

of cutting

CONCEPTCHECK 12.2 In

Example

$275

12.2, how

per week?

many

workers

should

Adirondack

hire

if

the

wage

rate

falls

to

THE

THE ECONOMIC

RECAP

WAGE AND

LEVELS

EMPLOYMENT

WORK

OF

VALUE

EQUILIBRIUM

labor markets, employers face pressure to pay each worker the a firm can hire as many workers marginal product. When it wishes at a given market wage, it should as long as expand employment value of marginal product of labor exceedsthe market wage.

In competitive

value of as the

THE

or her

his

LEVELS

EMPLOYMENT As

market occur same

3, the equilibrium price and quantity of the relevant supply and markets for labor. competitive

in Chapter

saw

we

in

is true

intersection

the

at

THE DEMANDCURVE FOR An

employer's

without

suffering

in a

employer worker'smarginal that

the

perfectly competitive labor market

rises. The individual

of labor

particular

). Because of the law of labor, and hence VMP,

(VMP

product

marginal

[part (a)] and firm a given

2

the horizontal sum of

=

Di

curve employer's programmers\342\200\224may thus

the

Do =

VMPi

that

in

the

of the returns, we know

of diminishing in the declines

for programmers firm demands individual

could pay

the value

is simply

demand

The

community.

the employer

downward-sloping function of the wage rate. that (b)] are the only two firms [part employ

as a

competitive

reservation price for

demand

computer

occupation\342\200\224say,

12.1(a),

Figure

in any

demandcurves.The

LABOR

reservation price for a worker is the most in profit. As discussed, this a decline

product

quantity

AND

WAGE

EQUILIBRIUM

short run as the for labor in any be shown, as in Suppose firm 1 in

programmers will then community

be

[part (c)].

D =

VMPQ

VMPi +

FIGURE 12.1

The Occupational

VMP2

for Labor.

Demand If

firm

only in

150

100

0

Employment firm

50

0 in

+

Employment

labor

pose the same leisure

CURVE

at

high

rates

than

question is to ask whether

wage

(person-hours/day)

rates than at low

economic theory do not provide

(c)

OF LABOR of labor for

an

a specific

at low

occupation will

consumers

wage rates. By

answer

look like? Will

wage rates? An

to this

equivalent

wish to

themselves,

more

way

to

consume less the

principles

question becausea change in

a given

labor we occupation, the

for labor

in

adding

of the

are the

that employ demand

curve

that

occupation the individual

demand curves

employment

(b)

does the supply curve be offered at high wage

What

Total

(person-hours/day)

(a)

SUPPLY

=

firm 2

I

(person-hours/day)

THE

in

firms

generate by

150 250

0

100

I and firm 2

horizontally.

337

CHAPTER 12

338

LABOR

wage rate

exertstwo

says

at

that

at

of

quantity

leisure

One is

demanded.

wage, leisure is more expensive,

a higher

less of it. The secondis the income effect, which consumers have more them wage, purchasing power,leading more leisure. Which of these two opposing effects dominates is an consume

to

consumers

leading

on the

effects

opposing

effect, which says that

the substitution

to

INCOME DISTRIBUTION

POVERTY,AND

MARKETS,

a higher

consume

question.

empirical

For the

economy as a whole during

has beendeclining

real

and

the

several

past

the workweek

centuries,

rising. This pattern

wages have been

might

to

seem

and for the economy as a supply curve of labor is downward-sloping, whole it may be. There is also evidence that individual workers sometimes may work fewer hours when rates are high than when they are low.A study of wage taxicab drivers in New York City, for example, found that drivers earlier on quit the effective wage is high because of high demand for cab rides) (when rainy days than on sunny days (when the effective wage is lower).1 Theseobservations the supply of labor to any particular notwithstanding, is almost because occupation surely upward-sloping wage differences among

the

suggest that

influence

occupations

many more people

choice. It is no

occupational

are choosingjobs as computer

accident,for

programmers

that

example,

than

now

in 1970.

Wages of programmershave risen sharply during the past several decades,which in favor has led many people to forsake other careerpaths of programming. Curve S in Figure 12.2 represents the supply curve of computer programmers.Its positive individual slope is typical of the supply curves for most occupations.

FIGURE 12.2

The Effect in

the

of an

Demand in the

increase

for

programmers

the

equilibrium

in

==

/ / / \\\\

wage (from

Wage

L2)

v

J\\

l/l/i

of

employment (from and an increase in the equilibrium

0

an increase

to L,

to

3

from D} to in

'S

_._x X ...\\ *

?w2

demand

level

/

v/\\

Programmers.

Computer An

D2 results

Increase for

\\ D2

V

W}

0

VV2).

L,

Employment

L2

of programmers

(person-hours/year)

MARKET SHIFTS become computerized in recent the demand for decades, as shown by the shift from D1 to D2 in Figure 12.2. Equilibrium in the market for computer programmers occurs at the intersection of the relevant supply and demand curves.Theincreasein demand has led to an increase in the level of programmers from L1 to L2 and a rise in the equilibrium equilibrium more

tasks

programmers

has

As

wage from

Wx

have

grown,

to

As discussed

reaches

equilibrium

W2. in

Chapter

demand curves. Labormarkets, G.

aL. Babcock, C. Camerer, Loewenstein, One Day at a Time,\" Quarterly Journal

in

by

for stocks and other

market

7, the

very quickly

the

wake

contrast,

and

of shifts are often

R. Thaler,

of Economics

\"Labor

111

in

assets

financial

supply

underlying

and

much slower to adjust.When

Supply

(1997),

the

pp.

of New York 408-441.

City

Cab

Drivers:

EXPLAINING

THIS

I

WEEK

THAT THE

FOR

DEfAAMD

ENGINEERS

INCKE&5ING

|

INSOLENCE

EXCEEDS 1

AND

1

^

*!^G(

/AY

PRODUCTIVITY.

EQUILIBRIUM

>

BEEN

HKS

i rxl

<J

\\ L

339

EARNINGS

IN

I WILL NEVER HIRE~^j KNOTHER ENGINEER J

fAY

DECREfcSING

THE SUPPLY

^

BY

RESPONDED

f\\

DISCOVERED

DIFFERENCES

tJ of \302\260 \302\243

j^o

j LU t.

*-Jm

for workers in a given profession increases, shortages may remain or even years, dependingon how long it takes people to acquire the training needed to enter the profession.

demand

the

months and

RECAP

IN THE

EQUILIBRIUM

for skills

LABOR MARKET

labor market is the competitive value of curve. The (VMP) employer's marginal product curve of labor for an individual labor market is even supply upward-sloping, the curve of labor for the as a whole be vertical though supply economy may or even downward-sloping. In each labor market, the demand and supply curves intersect to determine the equilibrium and level of wage employment. for labor

demand

The

in

a perfectly

of each

horizontal sum

IN EARNINGS

DIFFERENCES

EXPLAINING

labor markets tells us that differences in pay reflect in Example VMPs. Recall that 12.1, Laura earned 20 percentmore than Rennie because she made 20 percent more pots each week than he did. This difference in productivity may have resulted from an underlying difference in talent or training, or perhaps Laura simply worked harder than Rennie. Yet often we see large salary differences even who appear among people The

of competitive

theory

the

in

differences

corresponding

equally talented and

hardworking.Why, for instance, do lawyers earn so much as they are and work just as hard? plumbers who are just as smart And do surgeons earn so much more than These wage why general practitioners? differences might seem to violate the No-Cash-on-the-Table Principle, which says than

more

that

in talent,

differences

only

differences

those

in

earnings.

why

don't

first

place?

boosttheir

they

luck, or hard

work can accountfor

long-run

if plumbers could earn more by becoming lawyers, occupations? Similarly, if general practitioners could by becoming surgeons, why didn't they become surgeons in the

Equilibrium

a

For example, just

incomes

switch

human

theory a determination that

capital

theory of pay

says a worker's

HUMAN

CAPITALTHEORY

proportional human

Answers to these questions that

an

individual's

VMP is

are

suggested

by human

capital theory, which

of factors

proportional to his or her stock of

such as

human

capital\342\200\224an

wage

his or

will be

her stock of

capital

holds

education, experience,training, intelligence, energy, work habits, trustworthiness, and initiative. to this theory, some According occupations pay better than others because they require larger stocksof human capital. For example, a general practitioner couldbecome a surgeon, but only by extending her formal educationby several more in years. An even larger investment additional education is required for a plumber to becomea lawyer. amalgam

to

human an amalgam capital factors such as education, intelligence,

training, experience, energy,

work

and

initiative

value

of a

product

of

habits, trustworthiness, that

affects the

worker's

marginal

CHAPTER 12

340

LABOR

MARKETS,

INCOME DISTRIBUTION

POVERTY,AND

Differences in

result in some kinds

can

demand

of human

more

being

capital

for computer again the increase in demand programmers that has been occurring for the past severaldecades.During that same time period, the demand for the servicesof tax accountants has fallen as more and more have taxpayers used tax-preparation software in lieu of hiring accountants to help them with their taxes. Both occupations require demanding technical but the training received training, in now a return the labor market. by computer programmers yields higher valuable

UNIONS

LABOR

labor union who

of workers

a group

workers

which

through

wages and working

and

wages

Two workerswith the same amount of human capital may earn one of them belongs to a labor union and the other does not. A organization

with

collectively

bargain

employers for better working conditions

Consider

others.

than

Many economistsbelieve

way

affect

cartels

that

affect

unions

that

collectively

bargain

conditions.

markets. To

product

with

wages if is an for better

different

union

labor

employers

labor markets

in

the

much

illustrate, considera simple

same

economy

two labor markets, neither of which is unionized initially. Suppose the total is fixed at SQ = 200 workersper day, and that supply of laborto the two markets the demand curves are as shown and VMP2 in Figure and (b). The 12.3(a) by VMP1 sum of the two demand curves, VMP1 + VMP2 the supply curve (c)], intersects [part to determine an equilibrium of $9 per hour. At that wage, firms in market wage 1 hire 125 workers in market 2 hire 75 [part (b)]. per day [part (a)] and firms

with

12.3

FIGURE

Di =

with Two

An Economy

VMP,

VMP,

Labor

Nonunionized

Markets. and

Supply

a market

wage

in market

125 workers

3f

At that

(c).

wage, employers hire

intersect

demand

to determine of $9 per hour

per

day

3f

I

and

in market 2 hire employers 75 workers per day. The VMP is $9

in

each

75

125

in

Employment

market

market.

Employment market

I

200

0

Total employment

in

2

(workers/day)

(b)

(a)

(c)

1 form a union and refuse to work for less demand curves for labor are downward-sloping, of unionized workers reduce from 125 workers employers employment per day to in 100 [Figure The 25 workers the unionized market 12.4(a)]. would, of displaced in be to find other that market at hour. But $12 course, jobs delighted per they in and so are forced to seek the nonunionized market. cannot, they employment The result is an excess supply of 25 workers in the nonunion market at the original wage of $9 per hour. In time, wages in that market decline to WN = $6 per

suppose workers in per hour. Because

Now

$12

than

hour, the level at [Figure 12.4(b)].

It

might

losses of

seem

which

that

100

market

workers

the gains

can find jobs

in

the

of the unionized workersare exactly

nonunionized workers.On

closer

market

nonunionized

offset

we see that

by the

however, inspection, pegging union wage above the equilibrium level reduces the value of total actually output. If labor were allocated efficiently between the two its value of marginal markets, the total value of output product would have to be the same in each. Otherwise, could be increased workers from the lowVMP market to the high- VMP by moving market. With the wage set initially at $9 per hour in both the condition for markets, the

WWP?

VMPi

12

W, L/

3

3

0

12.4

FIGURE

Di =

o

IN EARNINGS

DIFFERENCES

EXPLAINING

Effect of

a

Wage

above

the

Union

Equilibrium Wage.

0

9

The

the

When

unionized wage is = $l2/hour

pegged at Wu (a), 25 workers

V \302\243

are

these

discharged.When

100125

0

75 100

0 in

Employment

market

in

Employment

2

market

I

market)

(nonunionized

market)

(unionized

in workers seek employment the nonunionized market, the wage in that market falls to VVN

=

$6/hour

(b).

(b)

(a)

allocation was met because labor's VMP was markets. $9 per hour in both But because the collective bargaining process drives hence (and VMPs) in the wages two markets the value of total is no maximized. To this apart, output longer verify if in note that a worker is taken out of the nonunionized the reduction claim, market, the value of output there will be only $6 per hour, which is less than the $12 per hour in the value of output when that same worker is added to the unionized market. gain efficient

In

12.4, by how much

Figure

rate were

$9 per

Wages paid the

above

12.3

CHECK

CONCEPT

wages

of total

value

a unionized

firm are

paid to their nonunionized

prompts

the

If unionized firms In

nonunionized

fact,

when

the

American

firms

extended manage

pay

more, how

firms sometimes do drive textile industry moved to and

escape

the

nonunionized

periods. If to survive?

their

the

wage

costs

burden

economic

alert

the

To

question:

following

12.1

Naturalist

Economic

do they manage to

nonunionized

their

from

centuries to

early twentieth Even so, unionized for

to

have

competition

if

sometimes 50 percentor more

counterparts.

The

face of

increased

be

output

market?

to workersin

this difference

naturalist,

the

would

in each

hour

in

survive

ife

the

counterparts?

the

unionized

firms

South

in the

of high

firms often are significantly

out of

late

union wages

manage to higher,

business, as and

nineteenth in

New

England.

competehead-to-head how

do the

unionized

The observed pay

differential overstates the difference between the actually two types of firm. Because the higher union wage attracts an excess of workers, unionized can adopt more stringent supply employers hiring requirements than their nonunionized workers tend to counterparts. As a result, unionized be more experiencedand skilled than nonunionized workers. Studies estimate that the union wage premium for workers with the same amount of human is only capital about 10 percent. Another factor is that unions may boost the productivity of workers actually with amount of human communication any given capital, perhaps by improving labor

costs

of the

How

union

do firms

that employ higher-paid

labor remain

competitive?

341

342

LABOR

12

CHAPTER

between management and in combination procedures, reduces

which

may be

costs per unit

and

nonunionized

than 9 percent of American half the union membership

Less less than

similar

with

in

productivity

unionized

So even

wages.

though

higher labor

significantly

counterparts.

to a labor belonged the 1950s. Because

workers

rate during

union

in

2011,

the union wage

United States

in the

membership

have

lower union

appliesto only a small fraction of the labor force, union is probablynot an important for why explanation

premium is small and workers

union

in

grievance

unionized

significantly

for the premium firms may not

formal

among

suggest that

these

firms,

than their

of output

is also

costs. Studies

training

to compensate

unionized

in

higher

boost morale

pay, may

higher

of

the implementation

Similarly,

with

hiring

high

sufficiently

are

wages

workers.

productivity. Labor turnover

to higher

workers,leading

firms,

DISTRIBUTION

INCOME

POVERTY,AND

MARKETS,

incomes.

earn sharply different

often

qualifications

COMPENSATING WAGE DIFFERENTIALS If

are

people

more than

of what

garbage collectors earn to important, be sure, but is it more of a drowning child? Similarly, we need not question

the value

paid

Picking the life

lifeguards?

valuable than saving the value of a timely

why do

produce,

they

up the trash is

to wonder

repair

plumbing

more than

get paid

plumbers

why

washers more valuable than fourth-grade teachers. Is replacingfaucet really children? As the next the for a particular educating example illustrates, wage job not on the value of what workers but also on how attractive depends only produce, they

conditions.

its working

find

The Economic

12.2

Naturalist

ar

do some

Why

ad copy writers earn morethan You plan

others?

to pursue a career in advertising ad copy for the American

write copy

-.,.j

Except v

for the

identical

When seniors

that

CEOs

get paid extra

smoking does

cigarette

not

wage

for

job, their

cause

wage

rate\342\200\224negative

positive\342\200\224that

attractiveness working

reflects

or

ads,working

youth

paid $30,000

job

market.

things

Economists

in working have

conditions. otherwise

are

conditions

for advancement,which

prospects

to

other

per year would

was

this question

at Cornell

and

you

median

to a sample of graduating of them chose

posed

recently

University, almost 90 percent job.

When

asked

how

much

more

being equal, less

attractive

response

jobs with

the they

them to switch to the Camel cigarettes was a premium of $ 15,000per year. As this

induce

employers who offer jobswith less attractive conditions cannot hope to fill them unless they also offer higher

than jobs with differences

the

of a job's

conditions

in the

jobs.

each

If

at the

the

sample suggests,

Other

a difference

differential

two

< American Cancer Society \302\251 would have to be paid to

cancer?

compensating

subject matter of the

same

the

aimed

ads

cigarette

Cancer Society,

choose?

I

Do tobaccocompany

Camel

the

in

offered

testifying

for

job offers:

have two

and

one to write

attractive

conditions.

working

conditions

working salaries.

will pay

less

Wage differences associated with

are known as compensatingwage differentials. differentials for a host of specific compensating

conditions

identified

Studies have found, for similar jobs that entail

example,

that

safe jobs

greater risks to health

and

tend to pay safety.

working

less than

Studies

also

have found

that

in accord

vary

wages

For instance, working night

in part because many with the school calendar.

lower

accept

wages

coincide

that

attractiveness of the work schedule. a wage premium, and teachersmust those with children value having hours

the

with

commands

shifts

of

DISCRIMINATION IN THE LABOR MARKET Women and minorities continue to receive lower wage rates,on males

white

standard theoriesof

challenge to

Defenders

productivity.

are

markets

effectively

these

theories

instead

reject

attribute

from an arbitrary An

another.

by

Employers

discrimination

Employer

example

a profound

the idea

the

gap

forms of discrimination.

Discrimination

than

average,

poses

labor which hold that markets, competitive in eliminate wage differentials not basedon differences of standard theories attribute the wagegap to unmeasured

capital. Many critics of competitive, and

in human

differences labor

will

pressures

competitive

capital. This pattern

of human

measures

similar

with

is the term

preference by occurs

if two

equally productive, on average,

an

used to describewage for one

employer

labor force groups,such

differentials

that

to various

that

group of workers over as

males

and females,

arise

wage gaps are

an

economic

as rapidly

preference

an

by an

employer for one group workers over another

of

wages

wage

gap). Thus, the

most

of the No-Cash-on-the-Table an wage provides opportunity for employerswho females to grow at the expense of their rivals. Because such firms make on the sale of each unit of output, their incentive is to expand profit as they can. And to do would want to that, they possibly naturally

Principle.The initial mostly

to pay higher

discrimination

will

firms

Arbitrary

hire

yet

some

that discrimination is the cause of the be ones that employ only females.

assumption profitable

are willing

and

males

employer arbitrary

are

(\"discriminators\") prefer employers to do so. Most consumers are not willing to pay more for a product producedby males than for an identical one produced by females (if indeed they even know which If of worker the is unaffected type produced product). product price by the composition of the workforce that produces the product, a firm's will be smaller the profit more males it employs because males cost more yet are no more productive (on the hiring

343

IN EARNINGS

DIFFERENCES

EXPLAINING

an

apparent

violation

differential

Equilibrium

a

the cheaper females. firms continue to pursue this strategy, the of profit-seeking supply females at the lower wage rate will run out. The short-run solution is to offer females a slightly higher wage. But this strategy works only if other firms do not pursue it. Once they too start offering a higher wage, females will again be in short supply. The only stable outcome occurs when the wage of females reaches with the parity of males. T he for both males and females will thus settle at the common wage wage continue

hiring

But

value of

only

as

their

VMP.

a preference for hiring males must now do Any employer who wants to voice so by paying males a wage in excess of VMP. Employers can discriminate against if they females are to pay premium wages to males wish, but only if they willing out of their own profits. Not even the harshestcritics of the competitive model seem willing to impute such behavior to the owners of capitalist enterprises.

Discrimination

by Others

discrimination is not the primary of the wage gap, what explanation is? In some instances, customer discrimination may provide a plausible if explanation.For believe that and clientsare less likely to take example, people juries will face a female or minority attorneys seriously,membersof these groups reduced incentive to attend law school, and law firms will face a reduced incentive to hire those who do. If employer

the

discrimination

customer

of consumers

willingness

to

pay

for a product produced members of a favored group, more

even is

if

the

unaffected

quality of the

by

product

344

CHAPTER 12

LABOR

INCOME DISTRIBUTION

POVERTY,AND

MARKETS,

Another possible sourceof the

within

socialization

not

are

ambitions

family.

children, or they

their female

families may

provide that

and for

education

less

to believe

them

socialize

may

is discrimination

gaps

wage

persistent

For example,

career

lofty

appropriate.

of the Wage Gap be explainedby compensating differentials that wage for other nonwage elements of the spring from differencesin preferences compensation package. command Jobs that involve exposure to physical risk, for example, Sources

Other

the

of

Part

gap may

wage

wages, and if men than females

higher

more

earn

are

more

relatively

to

willing

of human

if employers felt constrained same difference would result assign female employeesto risky jobs.) Elements

of human

earnings

differentials.

explain

capital

are

that

For example,

such risks,

accept

stocks

identical

otherwise

with

by

also

to measure

difficult

norms

social

productivity is influenced

may

not

will

they

capital. (The not to

help

to

only

by the

of education an individual has, which is easy to measure, but also by which is much harder to measure.Part of the black-white differential in black neighborhoods have fact that schools wages may thus be due to the beenas on as those in white neighborhoods. average, Differencesin the courses people take in college appear to have similar in productivity. For instance, students in math, implications for differences engineering,

its

quantity

quality,

in

not

good,

or

or

business\342\200\224male

who concentrate in the

in

represented

to

female\342\200\224tend

earn

The fact

humanities.

the

group gives rise to

former

a male

As economists

human capital and wage

unexplained

lit\342\200\224howabout

disproportionately that is unrelated premium

wage

more sophisticatedin their other factors that influence individual

differentials

by sex

continue

to

find

significant

unexplained

discriminationin the workplacewill differentialsare

more

2S.Polachek Human

and

Resources

fully

and race some

grown

Other

wage steadily

until

to measure

rates, smaller,

and

studies, however,

the causes

sex.Debateabout of these

understood.

Kim, \"Panel Estimates of the 29, no. 2 (1994),pp. 406-28.

M.

have

studies.2

efforts

differentials by race and continue

to

you?9

have grown

have even disappearedaltogetherin

those

are

males

that

employer discrimination.

\"English

higher salaries than

significantly

Male-Female

Earnings

Functions,\" Journal

of

MARKETS

WINNER-TAKE-ALL

Differencesin

human

capital

Yet earnings differentials which the distribution of the

Consider

unchanged.

in earnings. do much to explain observeddifferences in many have also grown sharply occupations within human capital among workers seemsessentially

example.

following

The Economic Renee

does

Why

345

IN EARNINGS

DIFFERENCES

EXPLAINING

earn millions

Fleming

more than

sopranos

Naturalist 12.3

of only

%i

slightly lesser

ability? best

the

Although

talents, the

lesser

gap

earnings

always

is sharply

earned

more

larger now

than

than others with slightly it was in the nineteenth

millions of dollarsper year\342\200\224 only marginally less talented in blind hearings often have difficulty the identifying is this differential so why earnings large?

Today, top singers like Renee Fleming earn or even thousands of times what sopranos

century. hundreds

earn. Given

that

most

paid

highly

listeners singers,

nineteenth

In the

services

in

fundamental change in the way we consume most of our all professional musicians delivered their century, virtually halls in front of live audiences. (In 1900, the state of Iowa

lies in a

answer

The music.

have

sopranos

concert

than 1,300 concert halls!) Audiences of that day would have been to the world's best soprano, but no one singer could hope to in more in than a tiny fraction of the world's concert halls. perform Today, in most of the music we hear comes recorded which enables the best contrast, form, to be at once. As soon as the master has soprano literally everywhere recording been made, Renee Fleming's can be burned onto discs at performance compact the same low cost as for a slightly less talented singer's. Tens of millions of buyers worldwide are willing to pay a few cents extra to alone

had more

delighted to

listen

be delighted to performers. Recording companieswould for so would earn an salaries, singers by doing they enormous economic unleash profit. But that would bidding by rival recording companiesfor the best singers. Such bidding assures that the top singers will earn multimillion-dollar annual salaries (most of which constitute economic rents, as discussed in Chapter less talented earn much less because the 7). Slightly singers does not need them. recording industry simply hear

the

most

talented

hire those

at

The market which

small

modest

for sopranos is

differences

in ability

an

example

or other

of a

winner-take-all market, one

dimensionsof

human

capital

Why much only

in

translate

in entertainment into large differencesin pay. Such markets have long been familiar and professional sports. But as technology has enabled the most talented individuals to serve broader has become an markets, the winner-take-all reward structure feature of modern economic such diverse life, increasingly important permeating fields as law, journalism, consulting, medicine, investment banking, corporate fashion, and even the hallowed halls of academe. management, publishing, design, to what the name seemsto imply, a winner-take-all market does not Contrary mean a market with literally one winner. hundreds of Indeed, only professional musicians earn multimillion-dollar annual salaries. Yet tens of thousands of others, of them as to their bills. many nearly good, struggle pay The fact that small differences in human often give rise to extremely capital in differences seem to contradict human Note, large pay might capital theory. the winner-take-all reward pattern is completelyconsistentwith the however, that

Renee Fleming than sopranos less able? slightly does

more

winner-take-all

one in in

which

human

earn so who are

labor market small differences

capital translate

large differences in

pay

into

346

CHAPTER 12

LABOR

MARKETS,

INCOME DISTRIBUTION

POVERTY,AND

competitive labor market with

the

EXPLAINING DIFFERENCESIN

RECAP

AMONG

Earnings

can happen

This

in accordance

paid

revenue. The into

leverage

of

large ones.

very

EARNINGS

PEOPLE

differ among people in part because an amalgam of personalcharacteristics

often differs substantially capital.

are

individuals

they make to the employer's net often amplifies small performance differentials

technology

capital,

theory'sclaim that

contributions

two

between

for many

people

of differences that

affect

in

their

productivity.

human

But pay

with the same amount of human to a labor union belong

reasons: One may

while the other does not; one may work in a job with one may be the victim of discrimination; or one may or other factors provide greater leverage technology

less

conditions; pleasant in an arena in which

work to

human

capital.

IN INEQUALITY In the United States, as in most other market economies,most citizens receive most of their income from the sale of their own labor. An attractive feature of the freemarket system is that it rewards initiative, effort, and risk taking. The harder, and more a the more she will be paid. longer, effectively person works, Yet on the to distribute income also entails an important relying marketplace drawback: Those who do well often end with more than can up vastly money they while those who fail often cannot afford even basic and services. spend, goods Hundreds of thousands of American families are homeless,and still larger numbers each go to bed hungry night. Many distinguished philosophers have argued that in such the midst of is to poverty plenty impossible justify on moral grounds.It is thus that income has been troubling inequality growing rapidly in recent decades. The period from the end of World War II until the early 1970s wasone of in the United States. During balanced income that incomes grew at growth period, In the ensuing almost 3 percent a year for rich, middle-class,and poorAmericans alike. the of income has been different. years, however, pattern growth dramatically In the first row of Table 12.2, for example, notice that families in the bottom 20 percent of the income distribution saw their real incomes grow by about TRENDS

RECENT

TABLE

Mean

12.2

Income

Received

by Families

Top 5 Percent of Families,All Quintile Bottom

20 percent

Second 20 percent

Races,

in

Each

Income

1980-2009

Quintile

(2009

1980

1990

15,889

15,643

17,590

and by the

dollars)

2000

2009 15,289

34,588

36,488

40,218

37,045

52,251

56,194

63,208

59,907

72,492

80,813

93,156

90,962

Top 20 percent

122,054

150,188

195,451

189,486

Top5 percent

173,510

235,652

346,342

325,023

Middle

20 percent

Fourth 20 percent

SOURCE:

U.S. Census

Bureau, TableF-3 (www.census.gov/hhes/www/income/historical/families).

RECENT

10 percent between 1980 and 2000, gains that with the evaporated completely economic downturn that began in 2009. The third row of the table indicates that the real incomes of families in the middle quintile grew by about 13 percentduring the 29-year period shown (a growth rate of less than one half of 1 percentper In in the top real incomes jumped almost 55 percentfor families contrast, year). in between 1980 and while those for families the 2009, quintile top 5 percent more than 80 Even for these income families, however, jumped by percent. growth II decades. rates were low relative to those of the immediate post-World War The only people whose incomeshave faster than in that grown substantially earlier period are those at the very pinnacle of the income ladder. Real earnings of the top 1 percent of U.S. earners, for example, have more than tripled since 1980, and those evenhigher up have taken home paychecks that might have seemed unimaginable just two decades who earned 42 times as ago. The CEOs of America's largest companies, as

much

the

worker

average

in

now

1980,

earn more

400

than

as much.

times

It's important to emphasize that being near the bottom of the income distributionin one there forever. On the year does not necessarily mean being stranded in the United States have a contrary, people always experienced high degree of economic international standards. multimillionmobility by Many CEOs now earning in 1980, dollar for were students paychecks, example, struggling young graduate in the bottom and were hence among those classified 20 percent of the income distribution for that year in Table 12.2. We must bear in mind, too, that not all economic mobility is upward. blue-collar for workers, instance,had higher Many incomes in 1980 than On balance, then, the

real

to

the

30

economy

prosperingas never standards

much

grow

IS INCOME

years before,

more

do

they

today.

entries in Table ago, those near those

while

12.2 the

tell an important of the income top

further

story. In contrast ladder today are

down have seentheir

living

slowly.

INEQUALITY

PROBLEM?

MORAL

a one based on the cogent critique marginal productivity system, heavily In thinking economic theory of choice itself.3 about what constitutes a just distribution of income, Rawls asked us to imagine ourselvesmeeting to choose the rules for income. The takes behind a \"veil of which distributing meeting place ignorance,\" conceals from participants any knowledge of what talents and abilities each has. Becauseno individual knows whether he is smart or dull, strong or weak, fast or no one knows which rules of distribution would work to his own advantage. slow, Rawls argued that the rules people would choose in such a state of ignorance would necessarilybe fair; and if the rules are fair, the income distribution to which The late

John Rawls, a moral

A

they

give What

rise sort

will also be fair. of rules would people

national income werea fixed an

equal

University, constructed

at Harvard

philosopher

of the

ethical

share.

That

amount,

scenario

choose from most

people

is likely, Rawls

a veil of ignorance? If the would probably give everyone

behind

argued, becausemost

people

are

Since an unequal income distribution would involve not only strongly a chance of doing well but a chance of doing poorly, most peoplewould to prefer eliminate the risk by choosing an equal distribution. for that Imagine, example, you and two friends have been told that an anonymous benefactor donated $300,000to divide among you. How would you split it? If you are like most would an equal division, or $100,000for each of you. people, you propose Yet the attraction of equality is far from absolute. Indeed, the goal of absolute is other concernswhen we make the rules for equality quickly trumped by in wealth modern market economies. after doesn't Wealth, all, generally distributing come from anonymous benefactors;we must produce it. In a large economy, if risk-averse.

3John

Rawls, A

Theory of Justice

(Cambridge,

MA: Harvard

University

Press,

1971).

TRENDS

IN

INEQUALITY

347

348

CHAPTER12

LABOR

INCOME DISTRIBUTION

POVERTY,AND

MARKETS,

each person wereguaranteed the

or

education

development

to work would

the incentive

EXAMPLE

12.3

an

be

of income,

amount

equal

of special

talents; and as the

few would invest next

in

illustrates,

example

reduced.

sharply

Income Sharing

Doesincome

labor

affect

sharing

supply?

in the University of Montana library offered a job reshelving books from 1 p.m. each Friday. Her reservation wage for this task is $10 per hour. If the library director offers Sue she $100 per hour, how much economic surpluswill Now enjoy as a result of accepting the job? suppose the library director announces that the earnings from the job will be divided equally among the 400 students who

Sue is

until

noon

in

live

Sue's

25 cents.

only

=

\342\200\224

$0.25

$10

accept?

to Sue, she accepts the job and enjoys = $90. If the $100 were divided $100 \342\200\224 $10 equally of Sue's dorm, however, eachresident'sshare would be

of surplus 400 residents

among the

still

per hour is paid directly

the $100

When economic

an

Will Sue

dormitory.

Accepting the

job would

mean

thus

not accept the

she will

\342\200\224$9.75,so

Sue of

surplus for

a negative

job.

CONCEPTCHECK 12.4 is the

What

dorm

largest

for

population

Sue would

which

accept the job on

a pay-

sharing basis?

In a country

inequality

than

smaller

material rewards argued,

for

rewards

without

would be dramatically

and

effort

for

risk

work and risk taking,

hard in a

country taking necessarily lead to with

that people would be willing however, as long as these rewards produced a

to

accept

Of course,

inequality.

a certain large

sufficiently

national income

rewards.

such

increase

Rawls

degree of in the total

amount of output available for distribution. But how much inequality would peopleaccept?Much less than the amount Rawls The idea is that behind the markets, produced by purely competitive argued. in veil of ignorance, each personwould fear a ending up disadvantaged position, so eachwould choose rules that would produce a more equal distribution of income than exists under the marginal productivity And since such choices system. define the distribution of income, he argued, fairness at least some attempt to just requires reducethe inequality produced by the market system.

TRENDSIN

RECAP

1945

From

for

year

rich,

the

income

top

earners.

John market inequality

until

the

A

grew at almost 3 percent a families alike.In contrast,most of

incomes

and poor

since the

IS INCOME

PROBLEM?

MORAL

mid-1970s,

middle-class,

growth

AND

INEQUALITY

INEQUALITY

mid-1970shas been concentratedamong

Rawls argued that the degree of inequality typical of unregulated is unfair because people would favor less systems substantially if they chose distributional rules from behind a veil of ignorance.

METHODS

we

Although

income society have an interest in limiting inequality, programs often with difficulties.The fraught practical challenge is to find

as a

for reducing it

are

to raise the incomes of thosewho cannot fend same time undermining their incentiveto work, and

for themselves,

ways

to subsidize those who or cannot find the government

pays

support from those who can

Cash transfers

the globe.

income

individuals

cannot

work,

information,

to those people, and withhold In practice, however, the two other. And so we must choose

TRANSFERS

IN-KIND

forefront

are at the

transfers are

Medicaid.

of

stamps,public

efforts

antipoverty

or servicesto low-

of goods

transfers

direct

such as food

or families,

subsidized

housing,

in-kind

of

cash

to Families with Dependent Children (AFDC), which in most cash to households. Critics of this provided payments poor single-parent that the the Incentive A FDC created program charged program ignored Principle. incentives that undermined because a mother was for family stability poor ineligible if her husband or other able-bodiedadult AFDC payments in many states male lived with her and her children.This confronted provision many long-term

transfer

a

payment

form of cash, form of a good or

not in the

made but

important federal program

1996, the most

until

mid-1960s

the

From

from each

AND

In-kind transfers

lunches, and

themselves.

resources

measures.

in-kind

and

around

for

fend

distinguish

alternative

PAYMENTS

WELFARE

school

to

hard

using

the

at

without

scarce

Of course,

poor.

could make generouscashpayments

groups are often

without

some peoplesimply In a world of perfect to live on. enough

not

are

that

work

among imperfect

349

REDISTRIBUTION

INCOME

REDISTRIBUTION

INCOME

OF

METHODS

OF

in the

service

was Aid

transfers cases

an agonizing

with

fathers

unemployed

them eligible

choice. They could leave

their

could

making

for publicassistance;or they

remain,

families,

making

them ineligible.

understandably choseto leave. to pass the Personal in Act the federal to provide cash 1996, Responsibility abolishing government's commitment assistance to low-incomefamilies.The new law requiresthe federal to government make lump-sum cash grants to the states, which are then free to spendit on AFDC benefits or other income-support programsof their own design. For each welfare t he new law also sets a lifetime limit on receipt of benefits under recipient, five-year Even

many

who

Concernabout

the

AFDC

their families

loved

deeply

incentives

work

led Congress

program.

Supporters

of the Personal

the nation's welfare reliance over the

rolls

Skeptics

that

argue

that

and

substantially

run.

long

ResponsibilityAct

it

will

fear that denial

Incentive

a

already reduced

it has encourage

of benefits may

greater

Act Responsibility law that

Personal

the 1996federal transferred

responsibility for

welfare

programs

federal

level

from the

to the

state

level

placed a five-year lifetime limit on payment of AFDC

and

benefits

to

any given

recipient

self-

eventually

on poor children if overall economic conditions deteriorateeven Debate continues about the extent to which the observed temporarily. in homelessness increases and malnutrition the nation's among poorest families the economic downturns of 2001 and 2008-2009were attributable to the during Personal Act. What is is that abolition of a direct clear, however, Responsibility in the nation's antipoverty effort doesnot eliminate federal role the need to discover efficient ways of providing assistance to peoplein need. impose

severe

hardships

BENEFIT PROGRAMS

MEANS-TESTED welfare

Many

programs,

more income programs.

The

means

testing

a family

purpose

has,

including AFDC, are the smaller are the

means-tested, which benefits

receives

it

means

under

that

the

these

of means testing is to avoid paying benefits to those who don't because of the way welfare programs are administered, has a pernicious effect on work incentives.

really need them.But Consider,

food stamps,

often for

example,

an unemployed

rent stamps, energy

stamps,

participant and

in

four

welfare

day care stamps.

programs:

Each program

means-tested

a benefit

level program whose benefit declines as the recipient earns additional income

350

CHAPTER 12

LABOR

INCOME DISTRIBUTION

POVERTY,AND

MARKETS,

gives him $100 worth of stamps per month, which he is then free to spend on are food, rent, energy, and day care. If he gets a job, his benefits in each program reduced by 50 cents for each dollar he earns. Thus, if he acceptsa job that pays he'll lose $25 in weekly benefits from each of the four welfare $50 weekly, for a total benefit reduction of week. the $100 programs, per Taking job thus leaves him $50 per weekworse off than before. Low-income need no formal persons in economics to realize that does not pay training seeking gainful employment under these circumstances. What is more, means-tested of cash and in-kind transfers are programs If to administer. the were to eliminate all extremely costly government existing in these programs, the welfare and social service agenciesthat are involved would be enough to lift every poor person out of poverty. One proposal resultingsavings to do precisely this is the negative income tax.

income tax (NIT) a system under the which would government grant every citizen a cash payment each year, financed by an additional tax on negative

earned income

INCOME

NEGATIVE

THE

Under the negative poor\342\200\224would

TAX

every man, woman, and child\342\200\224rich or income tax credit, say $5,000per year. A person receive this credit in cash. People who earn income

tax

income

(NIT),

a substantial

receive

earns no income would would receive the same initial credit, and their income would continue to be taxed at some rate lessthan 100 percent. The negative income tax would do much less than current programs to weaken who

work incentives administrative

costs

be far

would

current programs, would keep at least a

unlike

because,

who earned an extra dollar program would be administered

by

the

existing

lower than under the

it

ensure

would

portion

of

it.

Internal Revenue current

welfare

And

that someone because the

Service,

system.

the income tax is by no means a advantages, however, negative solution to the income-transfer the incentive problem perfect problem. Although under the program would be less severe than under current welfare it programs, if the negative would remain a serious difficulty. To see why, note that income tax were the sole means of insulating people against poverty, the to people payment with no earned income would need to be at least as large as the government's

Despite these

poverty

threshold

income below which

the the

level of

official

threshold.

poverty

The poverty

federal

government classifiesa family

officially

as poor

government estimates

four

threshold is the annual income level below which a family is on by the government. The thresholdis based of the so-called economy food plan, the least costly

as \"poor\" of the cost

classified

food

adequate

nutritionally

plans

designed

by

the

of of Department Agriculture. found that families Survey of their after-tax income on at three times the cost of the

The department's 1955HouseholdFood Consumption of three or more peoplespent approximately one-third so the the threshold food, government pegs poverty was approximately economy food plan. In 2009,that threshold family of

$22,000 for

a

four.

For a family of four meet. But suppose

living

in

a city,

$22,000

a group

a year is scarcelyenoughto make

families were to pool their of, say, eight negative tax payments and move to the mountains of northern New Mexico. With a total of to the fruits of their efforts at and animal $176,000 per year spend,plus gardening such a group could live very indeed. husbandry, nicely Once a small number of experimental demonstrated the feasibility of groups their and well on the income others would surely tax, jobs quitting living negative ends

ensue. First, as more and more people would eventually become government expense, And the cost of the would almost second, prohibitively costly. political program force to abandon it before that of surely supporters long point. Reports people of leisure at taxpayers' expense would be sureto appear on the living lives nightly news. People who work hard at their their tax jobs all day long would wonderwhy dollars were being used to support those who are capable of holding paying jobs, follow

suit.

left their

Two

practical

jobs to live

at

difficulties would

the program

OF

METHODS

not to work. If

yet choose

back the live

the

comfortably.

urban

family.

increase

the

This

incomes

backlash

political

resulting

did not

REDISTRIBUTION

completely

to cut program, policymakers of rural communes couldno longerafford to And that would mean the payment would no longer support an has led policymakers to focus on other ways to difficulty of the working poor.

income tax negative so that members payment the

eliminate

INCOME

MINIMUMWAGES The United States and many easethe burden of low-wage

it

force

would

countries

industrialized

other

workers

have

sought to

by enacting wage legislation\342\200\224 from paying workers less than a specified in The federal minimum the United States is set at hourly wage. wage currently and several states have set minimum levels $7.25 per hour, wage significantly in the state of Washington is $8.67 per higher. For example,the minimum wage that

laws

hour for

minimum

employers

prohibit

2011.

affect the market for low-wage labor? In law 12.5, prevents employersfrom paying less than Wmin, to Lx). Unemployment results: (a decline from employers LQ \342\200\224 The La workers who keep their jobs earn more than but the before, La LQ workerswho lose their jobs earn nothing. Whether workers earn more or less together If elasticity than before on the elasticity of demand for labor. of demand is depends If it is more than 1, less than 1, workers as a group will earn more than before.

How

does

a minimum

wage

that when the hire fewer workers

note

Figure

workersas a groupwill

less.

earn

FIGURE 12.5

The Effect

Unemployment

Wage

Employment.

1/1/ i

I

t

g

w i i

i

^^

If

*^r

^r

more

^r

^D

other

wage

point, laws,

regulations

economists arguing

were almost unanimous in that those laws reducetotal

that prevent

markets

from

reaching

their

opposition

economic

surplus,

equilibrium.

to as

do

In recent

some economistshave softened their to minimum opposition studies that have failed to show reductionsin laws,citing wage significant in minimum wage levels. These studies increases well employment following may as a low-income w orkers are better off with minimum that, imply group, wage laws than without them. But as we saw in Chapter 7, any policy that prevents a market from reaching equilibrium causesa reductionin total economic surplus\342\200\224 which means a more effective policy for helping society ought to be ableto find low-wageworkers. years, however,

than

the

to

result

pay

equilibrium will be a

employment

low-wage workers.

Employment

one

wage legislation employers

wage, the decline in

i i i i i

0

At

minimum

requires

l

minimum

of Minimum

Legislation on

for

351

CHAPTER

352

12

LABOR MARKETS, POVERTY.AND

tax

credit

(EITC) a policy under which low-income workers receive credits on their federal

income tax

One such policy is the earned-income tax credit which gives low-wage workers a credit on their federal income tax each year. The EITCwas enacted into law in 1975, and in the years since has drawn praise from both liberals and conservatives. The is essentially a wage subsidyin the form of a credit against program the amount a family owes in federal income taxes. For example, a family of four in 2011 would have received an annual with total earned income of $15,000 tax credit of approximately $5,000 under this program.That would is, the program have reduced the annual federal income tax payment of this family that by roughly amount. Families who earnedless would have received a larger tax credit, and those who earned more would have received a smaller one. Families whose tax credit exceeds the amount of tax owed actually receive a check from the government for the difference. The EITC is thus essentially the same as a negative income for the program is confined to peoplewho work. tax, exceptthat eligibility Like both the negative income tax and the minimum the EITC puts wage, extra income into the hands of workers who are employedat low wage levels. But unlike the minimum the earned-income tax credit creates no incentive for wage, to lay off low-wage workers. employers The following illustrate how switching from a minimum to an examples wage

(EITC),

tax credit can producegains

earned-income

EXAMPLE 12.4

TAX CREDIT

EARNED-INCOME

THE earned-income

DISTRIBUTION

INCOME

Surplus

in

an

By how much Suppose

a minimum

will

both

reduce total

wage

employers

and workers.

Market

Labor

Unregulated

for

economic surplus?

the demand and supply curves for unskilledlabor in the Tallahassee labor are as shown in Figure 12.6. how much will the of a By imposition at $7 per hour reduce total economic wage surplus? By how much do worker and the minimum employer surplus change as a result of adopting wage?

market minimum surplus

In the

absence

be $5

would

minimum

per hour, and

Both employersand the shaded

a

of

triangles

12.6,

S 5

minimum

minimum

wage

s

'

Tallahassee

for

surplus equal to

*

per day.

person-hours

5,000

the

area

\302\243

x

\\

y

wage

wage

/

^x

\302\243

without

surplus

v

0

surplus

Employer

without

10 .

Worker

be

enjoy economic $12,500 per day.

would

Figure

the equilibrium would

employment

workers in

wage,

5,000

10,000

L (person-hours/day)

FIGURE 12.6 Worker and Employer Surplus in For shaded

the

demand triangle,

and

supply

$ 12,500

curves

per

day,

an Unregulated Labor Market. shown, worker surplus is the area of the

the

same as employer

surplus (upper

shaded

lower triangle).

of

METHODS

OF

353

REDISTRIBUTION

INCOME

FIGURE 12.7

The Effect surplus

Employer

with minimum

Surplus.

wage

A

reduces

in this Reduction

caused

in total by minimum

surplus wage

wage of $7

minimum

hour

Worker

Minimum

of a

Wage on Economic

market

2,000

by

per

person-hours

reduction

in

for

day,

surplus

triangle).

wage

falls

3,000

5,000

10,000

to

while

surplus

Employer

$4,500

per

of crosshatched

L (person-hours/day)

worker

$ 16,500per

(area

day

triangle),

surplus

rises to

day (green-

shaded area).

per hour, employer surplusis the area of the 12.7, $4,500 per day, and worker surplus is the area of the green-shaded thus reduces figure, $16,500 per day.The minimum wage and increases worker employer surplus by $8,000 per day surplus by $4,000 per in is the area of the blue-shaded triangle shown day. The net reduction in surplus Figure 12.7, $4,000 per day. at $7

CONCEPTCHECK 12.5 In

wage example above, by how much would reduced by the $7 minimum wage if labor demand inelastic at 5,000 person-hoursper day?

minimum

the

have

been

perfectly

The

which is

following that

if the

example illustrates the central messageof economic pie can be made larger, everyone

The Suppose that, instead of imposing

Efficiency

total economic surplus in Tallahassee had been

the

can

Efficiency

have a

Principle

Principle,

larger slice.

a

in Action

EXAMPLE

wage, the government enacts an would it cost the government each to provide an earned-income tax credit under which workers as a group receive day the same as they do under the $7 per hour minimum surplus wage? (Assume for simplicity that the earned-income tax credit hasno effect on labor supply.)

earned-incometax creditprogram.

a

minimum

How

much

economic

tax creditin lieu per day at $5 per hour,

With an earned-income

a

economic

total

surplus of $4,000per day (area of the blue-shaded

with minimum

With a minimum set wage crosshatched triangle in Figure

per

employment

minimum wage, employment will be as in the unregulated market. Since 5,000 person-hours just in worker the market was $4,000per day less than under the surplus unregulated minimum wage, the government would have to offer a tax creditworth $0.80 per hour for each of the 5,000 of to restore worker person-hours employment surplus to the level obtained under the $7 minimum With an EITC of that amount wage. in effect, worker surplus would be the same If the as under the $7 minimum wage. EITC were financed by a $4,000 tax on employers, would be employer surplus than under the minimum $7 $4,000 greater wage. of a

Efficiency

12.5

12

CHAPTER

354

LABOR MARKETS, POVERTY,AND

We stress low-income

our

that

workers,

if we

workers

these

DISTRIBUTION

INCOME

is not point but rather that

wage produces no gains for to possible provide even larger gains for to prevent labor markets from reaching minimum

the

that

it is

avoid policies that

try

equilibrium.

PUBLIC EMPLOYMENTFORTHEPOOR main

The

EITC is

of the

shortcoming

income tax poor. The negative weakenwork incentives. There is

lacks

does

that

it

that

shortcoming

nothing

for the unemployed but may substantially

income to the yet another method of transferring that avoids both could poor shortcomings. Government-sponsored jobs pay wages to the unemployed for useful work. With service the poor public employment, of lives of leisure at does not arise. specter peopleliving public expense simply if But public serviceemployment has difficulties of its own. Evidenceshowsthat the same as will leave their government jobs pay wages private jobs, many people in favor of government jobs, apparently private jobs because they view government jobs as more secure. Such a would make service being migration public employment extremely such expensive. Other worrisome possibilitiesare that jobs might involve make-work tasks, and that they would prompt an expansion in government bureaucracy.

Acting negative

income

alone, government-sponsored jobs for tax cannot solve the income-transfer

these programs

Considera negative

cash grant is far too small for anyone to a service at below necessary by public job service Keeping the wage in public jobs well would eliminate the risk of a largewage And while well on either private jobs. living

minimum

wage.

below the

minimum

if

from

income tax or the public service would wage the two could lift out impossible, programstogether people

the negative

* u

/

4

^ ^

|

(see

poverty

oversee the program by

supervision,

Q \302\251otherwise

workers

perform

useful

public

service

example, do

be

public

would evidence

perform performed

landscaping

from

the

the govern-

bureaucracy,

management

private

service

companies

The fear that

many valuable

tasks that

in the private sector. They in and maintenance public

not

would can,

for

provide

parks;

12.8 NIT +

by Source in a Combination NIT-Jobs Income

Private NIT

Program. Together,

a small

income tax and at below minimum would enough poverty,

a public job

Poverty

threshold

Public job

wage

provide a family income to escape without

+

Public job

negative

weakening

work incentives significantly.

NIT

to

employment program. inevitably become a make-workprojectis that unskilled workers can, with proper

jobs?

FIGURE

be of

12.8).

an expansion of

ment could solicitbids

allayed

unskilled

Figure

To prevent

this

Can

of

a combination

whose

tax

income

is supplemented

scaleexodus

T

or the

the EITC,

OF METHODS

A COMBINATION

live on, but that

poor,

problem. But

so.

do

might

the

job

355

SUMMARY

for transportation streets and replace control

fill the elderly and those with disabilities; burned-outstreet lamps;transplant seedlings

newspapers

recycle

This combination of a small negative income at a subminimum would not employment wage

existing welfare programsare also large,and economic

terms, dealing intelligently inexpensive, once society recognizesthe cost of failing to deal intelligently with it. relatively

prove

METHODS OF INCOME

RECAP

form of

in the

costs,

of

costs

direct

the

income-transfer

the

with

service

and public

payment

indirect

buildings;

on.

attempts to control prices,are even

and misguided

incentives

work

perverse

the

tax

be cheap.But

city

in erosion

places and paint government day care centers;and so

graffiti from public and containers; staff

remove

projects;

in

potholes

problem may enormous

In

larger.

fact

in

opportunity

REDISTRIBUTION

total economicsurplus by contracting boosts the incomes of the working poor without that drawback, but neither policyprovides benefits for those who are not employed. in the battle against poverty include in-kind transfers Other instruments such as food stamps, subsidized school lunches, Medicaid,and public housing as well as cash transfers such as Aid to Families with Children. Dependent Because benefits under most of these programs are means-tested, beneficiaries often experiencea net decline in income when they accept paid employment. The negative income tax is an expanded version of the earned-income tax credit that includes those who are not employed. Combiningthis program with access to public servicejobs would enable to ensure government adequate laws reduce

Minimum

wage

employment. The

earned-income

for the

standards

living

tax credit

poor

without

incentives.

work

undermining

significantly

SUMMARY \342\200\242 A worker's

marginal

be

will

product

to the

equal

value

market

(VMP)\342\200\224the

goods and servicesshe producesfor law of

returns

diminishing

short

purchase

labor VMP

which

\342\200\242 Human

capital

is proportional amalgam intelligence,

in

theory

others

stocksof Wages

human

often

says

wage. (LOl, L02) VMP

individual's

human

capital\342\200\224an

experience, training, that influence productivity. some

capital.

pay

occupations

because

they require

larger

appear nearly

similar human

help to

whose

individuals

the

same,

stocks

as when

of

one

differences

in working

capital might why

explain

more

and,

for

explanation

important

earn

conditions\342\200\224are

generally,

different

salaries. They

earn more

individuals

why

with

individuals

why

collectors

garbage

does not.

other

the

and

differentials\342\200\224wage

differences

with

another

than

a

with

tend to earn more in jobs given stock of human capital that have less-attractive working conditions. (L03) Many

firms

blacks

and

\342\200\242

pay members females\342\200\224less

of certain groups\342\200\224notably they pay white males

than

who seemto have similar personal characteristics. such wage gaps are the result of employer do

that

firms

implies profit opportunities for not discriminate. Several other factors,

including discriminationby institutions

other

observed

Technologies

serve

customers

and

firms, may explain at least part wage gaps. (L03)

than

allow the most broader markets

that

\342\200\242

individuals to

If

existence

their discrimination,

the

(L03)

differ between

human capital

output.

an

that

to his stock of

simply

that

Firms

markets face a hire labor up to the point

the market

of education, and other factors

than

\342\200\242

will

they

equals

in

associated

lifeguards

labor

competitive

According to this theory, better

when a firm's are held fixed in

inputs

increases

smaller

constant wage,and at

of whatever The employer.

adding workers beyond somepoint

run, ever

in

results

her

wage

Compensating

that

says

capital and other productive the

belongsto a labor union

pay in a competitive value of her

equilibrium

long-run

market

labor

productive

can translate

even

of

LABOR MARKETS, POVERTY,AND

12

CHAPTER

356

DISTRIBUTION

INCOME

small differences

in human into enormous capital Such pay. technologies give rise to winnertake-all which have long been common in markets, and and which are becoming entertainment, sports commonin other professions. (L03)

Although

World

following

in the

growth

top

among

years since

earners.

(L04)

have

argued

\342\200\242

Philosophers

because

people

chose

knowing

their

if

most would favor produced

by

less

in

human

discrimination

(343)

means-tested

curve of labor for any to be upward-sloping,even occupation likely the economy as a whole,peoplework fewer when wage rates increase? (L02)

2.

True

the

supply

false:

or

be

nearly

3. How might

the recent

of

(350)

product

of

(335) labor

market

the most

enable

specific if, for

broadermarkets?

hours

(345)

productive individuals to serve L04)

(L03,

4. Mention two self-interested earner might favor policies to

reasons that a top redistributeincome.

(L04)

5.

same,

related to the proliferation

(350)

marginal

QUESTIONS

human the

threshold

winner-take-all

tax (NIT)

capital possessed by their wage rates same. Explain. (L03) in income inequality be changes

If the

two workersis nearly will

value of

of labor

(349)

income

negative

(349)

labor (VMP)

RIVIEW is

Act

poverty

(340)

(MP) (335)

human capital (339)

1. Why

(349)

product

marginal

PersonalResponsibility

(339)

theory

capital

labor union

(343)

undermining

significantly

TERMS

in-kind transfer

(352)

employer

for the poor without incentives. (LOS)

standards

work

(L04)

earned-incometax credit (EITC)

equilibrium.

reaching

income tax works much like the earnednegative income tax credit,exceptthat it includes those who are not employed.A combination of a small negative income tax and accessto public service jobs at subminimum wages could ensure adequate living

society's distributional rules own personal circumstances, than would be inequality

(342)

discrimination

lunches, Medicaid, Families with

(LOS)

has been concentrated

compensatingwage customer

from

markets

preventing

KEY

differential

to

Aid

Dependent Children. Of these, all but the earned-income tax credit fail to maximize total economic surplus, either by interfering with work incentives or by

that at least some income the name of fairness,

outcomes.

market

school

public housing, and

\342\200\242 The

redistribution is justified without

the earned-income

laws,

wage

poverty include tax credit,

for reducing

programs

food stamps, subsidized

grew at almost 3 percent a year classes during the three decades War II, the lion's share of income

income

all

for

minimum

incomes

\342\200\242

and

\342\200\242 Policies

in

differences

tax the

reliance

exclusive

is

Why

to

unlikely

poverty

on the

negative income solution to

a long-term (LOS)

constitute

problem?

that

technologies

PROBLEMS 1.

&r

Mountain

|ECONOMICS

supplies air filters to the retail An air filter sells for components.

Breeze

assemblethe

connect

buy the components for

Mountain

Breeze.

for each filter Sandra

for

$1.

can assemble

market

$26, and

Sandra

and hires Mountain

and Bobby

60 air filters

per

workers to Breeze

can

are two workers

month

and Bobby

can assemble 70. If

the labor market is perfectly competitive, how much will be paid? (LOl, LOl) rocket to Acme, Inc., supplies ships to the retail market and hires workers assemble the components. A rocket sells for and Acme can $30,000, ship the components for each rocket ship for $25,000. buy Wiley and Sam are two workers for Acme. Sam can assemble 1/5 of a rocket ship per month and Wiley can assemble 1/10. If the labor market is perfectly and rocket are Acme's other cost, how much will competitive components only Sam and Wiley be paid? (LOl, LOl)

and Bobby

Sandra

owns

Inc.,

Stone,

to

market

labor

a clothing factory and hires workers in a competitive stitch cut denim fabric into jeans. The fabric

makeeachpair

requiredto

$5. The

costs

jeans

number

with the

varies

jeans

of

workers

of

table: (LOl, L03, LOS)

a.

If

the

Jeans (pairs/week)

0

0

sell for

week,

b.

Number of workers

jeans how

the

1

25

2

45

3

60

4

72

5

80

6

85

$35 a pair and the

produce each week? $230

union. How doesthe c. If the minimum the

per week. minimum

affect

wage

wage pairs

is $250 of jeans

per will

sets a weekly minimum

workers

the

All

How many

Stone hires belong to the Stone's decision about how

to hire?

workers

many

Union now

Workers

Clothing of

acceptable wage

market

competitive

Stone hire?

should

workers

many

the company Suppose

company's weekly output of finished as shown in the following hired,

wage set by

the

had been

union

wage affect Stone's

minimum

decisionabout

$400 per week,how how

many

would

workers

to

hire?

d.

If

Stone

again

faces a

risesto $45,how 4.

a soda

owns

Carolyn

marketto bottle varies

with

(LOl, L03,

the

market wage of workers

many

the

of

number

per

week

Her

and hires company's

LOS) Number

of workers

0

but the price

company now hire?

of jeans

workers in a competitive labor weekly output of bottled soda in the following workers hired, as shown table:

factory soda.

$250

will the

Cases/week

0

1

200

2

360

3

480

4

560

5

600

fe? McGraw-Hill

Visit

your mobile

store and

download

the Frank:

Study

Econ

app todayl

app

358

CHAPTER

12

LABOR

a. If each

case sellsfor

producing

competitive should Carolyn

workers

per week?

b. Supposethe

per week.

union. How does the

c. If the wage is

case,

how

5. Sueis

a.

the

If

b. Now be

will

reshelving books Friday. Her

each

p.m.

enjoy

still

b. In

in

of has

recipients

each

cover.

if the

economic

much

how

task

this

Sue's

in

the job

from

earnings live

surplus

dormitory.

accepts a

your answer undesirable

state

incentive

one of the

b illustrate

programs.

participant

in

means-tested

three

care

Each

stamps.

be usedlike

program

to purchase

cash

(LOS)

by 40 cents for each additional labor market, how will Jones's economicposition are reduced

program

in the

7. Supposethe equilibrium hour. How will the wages change

is a

unemployed,

earns if he

light

redistribution

stamps, rent stamps, and day per month in stamps, which can

Jones

change

library from is $10 per

of Montana

University

to parts a and

income

in

grants him $150 the good or servicethey dollar

the

reservation wage for

food

programs:

a. If benefits

rises to $15 per

of soda

price

now hire?

accept?

problems inherent 6. Jones, who is currently welfare

in

the

but

director offers Sue $100 per hour, as a result of accepting the job?

how your answers

c. Explain

to the

decision about how

Carolyn's

suppose the library director announces that the divided equally among the 400 students who

Will Sue

acceptable

hires belong

Carolyn

affect

wage

will Carolyn

workers

a job

library she

will

workers

again $1,000per week

many

offered

noon until 1 hour. (L04)

minimum

a weeklyminimum

now sets the

All

be produced

will

cases

to hire?

workers

many

hire? How many

Union

Bottlers

Soda

of $1,500

wage

the cost of the materialsusedin market wage is $1,000 per week, how

than

more

$10

the

and

it

many

DISTRIBUTION

INCOME

POVERTY,AND

MARKETS,

job paying to part effects

$120

per

week?

a, explainwhy means-testing on work incentives.

welfare

for

for unskilled workers in New is $7 per Jersey and employment of unskilled workersin New Jersey legislature raisesthe minimum wage from $5.15 per hour to wage

$6 per hour? (LOS)

8*

demand

the

Suppose

labor

market are

a.

how

By reduce

surplus

much

total and

and

will the

economic worker

for unskilledlabor in

supply curves

as shown in

the

figure.

accompanying

imposition of a Calculate

surplus? surplus change

minimum

(person-hours/day) difficult

problem.

the

20,000 L

more

at $12

Corvallis

per hour

the amounts by which

as a result of

10,000

^Denotes

wage

the

(LOS)

minimum

employer

wage.

ANSWERSTO CONCEPT CHECKS

much would it cost the government each day to provide an earnedtax credit under which workers asa group receive the same economic as do under the hour minimum for $12 (Assume surplus they per wage? that the earned-income tax credit has no effect on labor simplicity supply.)

b. How

income

employers and workersare risk-neutral,and

9* Suppose

enact the $12 per hour minimum

wage

to

is about

Congress

8. Congressional

in Problem

described

consider adopting an earned-income neither workersnor employers would that support unless the value of each economic would be proposal expected party's surplus have

economists

staff

credit

tax

as under the

credit (and a tax

difficult

more

minimum

raise

would

that

receive unanimous ^Denotes

legislators to

instead. Suppose

as great

least

at

urged

support from

Describe

wage.

enough

both

a price of $26 per cutting board, week, so Adirondack shouldhire five

At

(LOl,

worker

each

of

VMP

workers.

(L05)

problem.

the

fifth worker

workers.

(LOl,

exceeds $275,

CHECKS

CONCEPT

TO

ANSWERS

12.2 Since the

and employers.

workers

\342\226\240

12.1

an earned-income tax for that would it)

money to pay

has a

of

VMP

$364

per

LOl)

Adirondack shouldhire five

LOl)

wage rate is $9 per hour in each market, 25 fewer workers will be in the nonunionized market and 25 more in the unionized market. employed The loss in output from removing 25 workers from the nonunionized market is the sum of the VMPs of those workers, which is the shadedarea in the To (Hint: right panel of the figure below. This area is $187.50per hour. calculate this first break the figure into a rectangle and a triangle.)The area, in output from adding 25 workers to the unionized market is the shaded gain in output area in the left panel, which is $262.50 per hour.The net increase is - $187.50 = $75 thus hour. $262.50 (L03) per

12.3 When the

=

Di

^

3 O

1/1///= vu

VMPi

12 9 h \342\200\224

V

9

Area =

Area =

$262.50/hour

0

$l87.50/hour

100125

75 100 in

Employment

market

Employment

market

I

(nonunionized

market)

(unionized

in

2

market)

(b)

(a)

12.4 SinceSue'sreservation she

is $10 per hour, she must be paid at least that wage she will accept the job. The largest dorm population for which 10 residents, since her share in that case would be accept is thus

before

amount

will

exactly $10 per hour. (L04)

12.5

With

hours surplus.

perfectly

inelastic

per day, so the (LOS)

demand, minimum

employment wage

would

would remain at 5,000 no reduction in

cause

personeconomic

359

CHAPTER

I

I

The

|3

Environment,

and

Health,

Safety LEARNINGOBJECTIVES After

you LOI

this chapter,

reading should

be

able

to:

Use economicanalysis show how the U.S.

to

health

care

system

can

be improved. ^>

L02 Compare and

contrast

the

ways in which taxes and tradable v

In the domain of health costs from escalating

care,

too

the challenge is

permits can be used

\\

to

to reducepollution. L03

provide

access

for all citizens

while

preventing

in

the

wake

of the

the Cost-Benefit to

Principle

rapidly.

in a second major oil supplyinterruption in officials the Carter administration met to discuss decade, In policiesfor in the risks to domestic inherent U.S. on reducing security dependence oil. The forward was a tax of foreign proposal they ultimately put gasoline 50 cents that the tax would an per gallon. Anticipating objections impose on the poor, policymakers proposed to return the revenues unacceptable hardship from the tax to the citizenry the tax\342\200\224the tax on by reducing payroll wages that the Social supports Security system. in addition of the gasoline tax argued that, to reducing the Proponents nation's dependenceon foreign the tax would reduce air and ease oil, pollution if But critics ridiculed the that the highway congestion. proposal, charging revenues from the tax were returned to the people, the quantity of gasoline demanded would remain essentiallythe same. Their argument tipped the debate, and officials never to implement the proposal. managed Whatever the ultimate merits of the administration's proposal, there wasno merit at all in the argument the critics usedto attack it. True, the proposed tax rebate meant that could have as much the people bought just gasoline as before tax. Yet the tax would have them a incentive not to do so. As we given powerful saw in Chapter 5, consumers can change their behavior to escape the effects of a steeprise in the after-tax price of gasoline\342\200\224by switching to cars with smaller,

1979,

Apply

L04

improve

workplace

safety.

Showhow

economic

contributes

analysis

debates public

regarding

health

and

domestic security spending.

to

362

CHAPTER

13

THE

AND SAFETY

HEALTH,

ENVIRONMENT,

more

fuel-efficient

money

attractivebecause

Scarcity

O

Cost-Benefit

they

In

up

relatively more

the

a

As

1940

new

have grown more States, real health care expenditures per capita for as as the relevant data have been available. per capita long share of national income, health carecostshave risen from only 4 percent in to more than 17 percent in 2009. Part of this increase is the result of costly health care technologies and procedures.Diagnostic tests have grown more income

real

sophisticated,and

organ transplantation expenditure inflation is the

have has

system. Earlier

payment

catastrophicillness just as II, and

did

they

expenses

The spreadof much

owes

medical

receiving

APPLYING

it

also

has

century,

routine

and other

way

high-tech

we pay

Rather,

developments.

for medical services.

emergence of the so-called third-party many people insured themselves against medical care out of their own pockets,

consumer goods.Starting people

mid-1960s,

after

World

War

to depend on insurance

have come

medical

services. Some

financial

spawned

THE

especially

insurance,

to the belief that care they need.

shelter peoplefrom form,

the

surgery and medical

deal of

of this insurance is provided privately by In the the latter the by government. category, Medicaidcovers of the poor and Medicarecovers those of the elderly and disabled.

some

employers,

insurance,

clothing,

these

with

in

a great

Yet

has been the

purchased

medical

routine

changes

this

in

increasinglysincethe

even

medical

but

food,

to do

bypass

coronary

common.

far more

grown

change

important

like

procedures

nothing

of fundamental

result

The most

for

\342\200\224

United

expensive and

it

CARE DELIVERY

OF HEALTH

ECONOMICS

rapidly than

O

services,

on. Such changesfree

become

which

No society can hope to formulate and economic policies implement intelligent unlessits citizensand leaderssharean understanding of basic economic principles. Our aim in this chapter is to explore how careful of these principles can application us that both the economic and make everyone'sslice help designpolicies expand pie we examine the economics of health care larger.Specifically, delivery, environmental regulation, and public health and safety regulation.The unifying thread In will these issues is the of each we case, running through problem scarcity. explore how the Cost-Benefit Principle can help to resolve the resulting trade-offs.

THE

Cost-Benefit

and so

carpools;

forming

engines;

on other goodsand are not taxed.

to spend

an

inability

medical should not prevent peoplefrom

government-financed to pay

Indeed, medical insurance

hardship.

The

literally hundreds

COST-BENEFIT

difficulty is

of billions of

has that

dollars

much to common waste each year.

surely done its most

in

of

CRITERION

To understand the nature of this waste, we must that although medical recognize services differ from other servicesin many ways, they are in one fundamental respect the same: The cost-benefit test is the only sensible criterion for deciding which services ought to be performed. The fact that a medical has some benefit does procedure that the should be it should be not, by itself, imply Rather, procedure performed. if its exceedsits cost. benefit, broadly construed, performed only marginal marginal The costs of medical procedures are relatively to measure, easy using the same methods appliedto other goods and services. But the usual measure of the benefit of a good or service,a person'swillingness to pay, may not be acceptablein the case of medical services. F or m ost of us would not conclude that a life-saving many example, is because the who needs it can afford to pay appendectomy unjustified merely person half of its cost. When someone lacks the resources to pay for what most $2,000 only of us would consider an essentialmedical service,societyhas at least some to Hence the of medical insurance. responsibility help. proliferation government-sponsored other medical are not as as an Many expenditures pressing emergency however. such surgery, for example, the patient requiresa period of appendectomy, Following

THE ECONOMICS

OF

HEALTH

CARE

DELIVERY

in the hospital. How long should that last\342\200\2242 5? 10? The period days? Cost-Benefit Principle is critically to about such important thinking intelligently B ut as the the questions. following example illustrates, third-party payment system has virtually eliminated cost-benefit thinking from the medical domain.

a

The Impact of aThird-Party

EXAMPLE 13.1

recuperation

How

David

should

long

System

Payment

stay

the

in

on Cost-Benefit

Thinking

Cost-Benefit

hospital?

recurrent sore throats, David plans to have his tonsils removed.His that the surgeon average hospital stay after this procedure is two days (some one or even five days). Hospital peoplestay only day, while others stay three, four, rooms cost$300perday. If David's demand curve for days in the hospital is as shown in Figure he stay if he must pay for his hospital room 13.1, how many days will

To eliminate tells

him

How

himself?

many

hospital room?

days will he stay

if

medical

his

insurance

fully

covers

the

cost of his

Jt 300 u

0.

13

0

I

of hospital

Length 13.1

FIGURE

The

I

stay (days)

for Hospital

Demand

Care.

hospital care is downward-sloping, just like any other curve. At higher prices, people choose shorter hospital stays, not because there benefit to a longer stay, but because they prefer to spend their money in other ways. curve

demand

The

for postoperative

demand no

must

If David

for just one day. But insurance,

the

marginal

his best option will be to stay hospital room himself, room is covered hospital completely by to him will be zero. In that case, he will stay for three days.

pay for his if the

cost

CONCEPT CHECK Example

13.1, how

insurance

covered 50

In

is

cost of his

13.1

long

David

would

percent

of

the

cost

choose

of his

to stay hospital

in

the

hospital

if

his

health

room?

concerned that people choose longer hospital stays when their insured? The Cost-Benefit expenses fully Principle tells us that a hospital stay if should be extended another the benefit of doing so would be at least as day only as the cost of the resources to extend the But when great required stay. hospital costs are fully covered the decision maker seesa marginal cost of by insurance, cost is several hundred dollars.According to the zero, when in fact the marginal cost-benefit leads to wastefully long criterion, then, full insurance coverage hospitalstays. This is not to say that the additional days in the hospital do no good at all. Rather, their benefit is less than their cost. As the next example illustrates, a shorter hospitalstay would increase total economic surplus. we be

Should

are

a

Cost-Benefit

363

364

CHAPTER

EXAMPLE

13 THE ENVIRONMENT,

13.2

AND SAFETY

HEALTH,

Hospital Stays Increase TotalEconomic Surplus

Shorter

does

waste

much

How

from

results

If

the

to

continues

as he will

if he

by his demand has full insurance

benefit David demand curve in but

extra benefit

days

pay that possible economicsurplus.If he extends accumulate at the rate of $300 per day,

care\342\200\224as measured

will

example, how much

room?

of an additional day in the hospital is $300, the supply in an open market would be horizontal If at $300. he would choose a one-day stay, which would result price,

room

hospital

David had to in the largest

the hospital stay of David's hospital

from

coverage

cost

marginal

curve of

insurance

full

cause?

coverage

and cost information

Using the demand waste

insurance

full

only

by

Figure

be

thus

his stay past one day, cost the benefit of additional If he stays three days, $300.

but

below

curve\342\200\224falls

$600 coverage, the two extra days cost society under David's $300 (the area of the lower shadedtriangle The amount by which the extra cost exceedsthe 13.2). $300 (the area of the upper shaded triangle).

additional

from

Benefit

Lost

from

surplus

additional

<

300

stay

stay

k u

1

0

3 stay (days)

of hospital

Length

FIGURE 13.2

The Waste area of the results

upper

from the

Example

reimbursed

DESIGNING

to

day

shaded

Insurance

Coverage.

triangle ($300) represents

the

loss

benefit extra

of extending

the

two days is $600,

in economic

the

surplus that

13.2

13.2, how much

hospital

Full

triangle ($300) represents the three days. Since the cost of the

longer stay.

CHECK

CONCEPT In

shaded

lower

from one

stay

hospital

from

Results

That

The area of the

room

A

waste

expenses

would

be

at the rate

caused

by an

insurance policy

that

of $ 150per day?

SOLUTION

In circumstances in which economic surplus has not been maximized, a transaction can be found that will make both the patient and the insurance always company in the previous better off. Suppose, for instance,that the insurance company David a cash payment of $700 toward and lets him example gives hospital expenses in decide for himself how to the Confronted with a price of long stay hospital. David would choose to a The cash he $300 $400 per day, stay only single day. would have left after paying his hospital bill is $100 more than to enough him compensate for the benefit he would lose by not an extra two days. (Again, staying that benefit is $300, the area of the lower shaded triangle in Figure 13.2.) A $700

THE ECONOMICS

OF

HEALTH

CARE

365

DELIVERY

also would leavehis insurance company better off by $200 than if it payment had provided unlimited at no extra charge (sinceDavid would hospital coverage have stayed three days in that at a cost of to his insurance $900 case, company). And since no one elseis harmed it represents a Pareto by this transaction, improvementover unlimited makes some people better off coverage, meaning a change that cash

without

others

harming

(see Chapter

7).

The amount of waste caused by full insurance on the price coverage depends of demand for medical services\342\200\224the more elastic the demand, the greater elasticity the waste. Proponentsof full coverage believe that the demand for medical services is almost inelastic with respect to price and that the resulting waste is completely therefore negligible.Critics of full coverage that the demand for medical argue services is actually sensitive to and that the waste is quite price resulting significant. Who is right? One way to determine this is to examine whether peoplewho lack full insurance those who have it. The coverage spend significantly less than economist W. G. Manning and several co-authors did so by performing an experiment in which to one of two different kinds of they assigned subjects randomly medical insurance policy.1 The first group of subjects received first-dollar coverage, that 100 percent of their medical expenses was covered The meaning by insurance. second group got \"$l,000-deductible\" that coverage,meaning only expenses the first someone with of $1,000 a year were covered.(Forexample, $1,200 beyond if medical bills would receive $1,200 from his insurance he to company belonged In effect, since most the first but only $200 if he belongedto the second.) group, most subjects in the people incur less than $1,000 a year in medical expenses, second group full for their medical services, while subjects in the effectively paid price first and his that with group paid nothing. Manning colleaguesfound people between40 and 50 less on health care $1,000^-deductible policies spent percent than subjects with More there were no first-dollar coverage. important, measurabledifferences in health outcomes between the two groups. Taken at face value, the results of the Manning study suggest that a large share in medical II has of the inflation since World War been caused by expenditures growth that

it

in

insurance

that

pays all

expenses generated insured activity

by

the

medical

first-dollar

ignores

completely

insurance. The problem with first dollar coverage is the Incentive Principle. Why not abandon firstsimply deductibles? would still be high People protected against

first-dollar insurance coverage

dollar coverage in favor of financial catastrophe but would have a strong incentive to whose benefit does not exceedtheir cost.

avoid

medical

a

Incentive

a

Efficiency

services

would say that Medicaid and Medicare should not carry high deductibles the resulting out-of-pocket payments would imposetoo great a burden on in in in families. But as other instances which concern for the is offered poor poor defense of an inefficient policy,an alternative can be designed that is better for rich and poor alike.For example,all health insurance could be written to include high Some

because

deductibles, and the

theirs

adopting

to

keep.

the most

economicpie grows THE

poor couldbe given

an

covered by insurance. At Here again, concern for the

not

medical expenses

HMO

efficient policy.As larger,

it's possible

the

annual year's

well-being

stipend to defray the initial end, any unspent stipend would be of the poor is no reason for not

Efficiency

for everyone

Principle

to have

reminds us, when the a larger

slice.

REVOLUTION

health insurance led many to During the 1990s, the high cost of conventional people switch to health maintenance organizations (HMOs).An HMO is a group of in return for a fixed annual physicians that its patients with medical services fee. provides As the next example illustrates,the incentive to provide medical serviceis any given weaker under the standard HMO contract than under conventional health insurance.

health maintenance a group

organization (HMO) physiciansthat

provides

services to

individuals

of

health and

families for a fixed annual aW. G. Manning, \"Health Insurance J. P. Newhouse, E. B.Keeler, A. Liebowitz, and M. S.Marquis, the Demand for Medical Care,\" American Economic Review 77 (June 1987), pp. 251-77.

and

fee

366

CHAPTER

13

^^/i'

THE

AND SAFETY

HEALTH,

ENVIRONMENT,

Naturalist 13.1

The Economic is a

Why

conventional

When

patient

with a

health

insurance

a patient

options.

After

the manually,

his

visits

may prescribe

physician

magnetic resonance imaging of the

images

inner

drugs

or she

exam if he has

maintenance

knee,the

organization?

may

the

advise

has several

physician

and examining and advise the

symptoms

anti-inflammatory

the knee patient

to

abstain

to undergo a

patient

diagnostic procedure that generates in an HMO receives no physician the MRI because all services are covered by the patient's in contrast, the physician health will be insurance, a costly

exam,

(MRI)

of the

workings

if she orders additional revenue fixed annual fee. Under conventional reimbursed at a fixed rate, usually

service

his

for a period;

activity

physical

describe

patient

an MRI

of a sore

complaining

physician

the

hearing

from vigorous

sore knee more likely to receive than if he belongs to a health

injured

joint.

above

well

The

her marginal

cost, for

each

additional

performed.

i?fl\302\256\302\251@iaca

I

'Well,

Kme>flsocaii

Bob, it looks like a paper cut, to be sure lets do lots tests.\"

but

\\

just

of

cases

difference in

physicians incentives. But

People

who

stick with

will in

cases, HMO

in these

And

the most prudent

instances,

In many such

switch

conventional

the

make many

other

to HMOs

course of

treatment

recommendation

cases, it are

physicians

health

same

less

may

not

likely to

\302\251

is unambiguous,

despite

this

and

in

striking

be obvious which decision is best. order expensivetests.

health than those who pay less for their plans since the HMO contract provides a strong

insurance

not to prescribe nonessential services. fear, Many people in their not receiving same incentive may sometimes result very valuable care. These concerns have led to proposedlegislation granting patients rights of appeal when they are denied care by an HMO. incentive

for

however, that

the

doctors

THROUGH

CARE PROVISION

HEALTH

WITH

PROBLEM

THE

OF HEALTH CARE

ECONOMICS

THE

INSURANCE

PRIVATE

not surprising, that access to medical care is extremely troubling, but perhaps in many of the world's poorestnations.After of those nations all, citizens lack enough incometo buy adequate and other basicgoodsand food, shelter, many services. What is surprising, however, is that the movement to less despite expensiveHMO almost 50 million Americans still had no health plans, coverage of any in 2009. in both parties kind when President Barack Obama took office Politicians that had to be done. But were so without health agreed something why many It is

limited

first place?

the

in

coverage

The answer to

that

Stateswas

on unregulated private among markets to orchestrate the delivery of health care to its citizens. This was a historical a accident, consequenceof the fact that many essentially unions managed to negotiate health insurance as part of employer-provided

insurance approach

labor their

nations

fact that the United

in the

is rooted

question

the world's

alone

almost

Under

years.

for employees

than

the rapidly growing economy of the government policy, employer expendituresfor

insurance

private

individually

purchased

already been taxed.That

they had

reliance

Employer-provided insurance was thus

nontaxable.

were

insurance

its

during

packages

compensation

immediate post-WWII

in

much

cheaper on which

income

with

health

employers to join health insurance. And as counterparts employer-provided as health care wasa small share of total was income, coverage long spending fairly broad and the system functioned reasonably well. An detail was that for the tax exemption was important policy eligibility conditional on insurance made available to all of being employees irrespective the

Given

conditions.

medical

preexisting

individuals

of treating

cost

high

chronic

with

private insurance companies are generally reluctant

medical

problems,

policies

to people

health

serious

with

But

problems.

employees, only a small percentageof

would

whom

issue

of

groups

large

covering

by

be likely

to

to have serioushealth

any year, insurance companies couldissuethesepolicieswithout risks. Indeed, the large new employer-providedinsurance unacceptable lucrative that most insurance companieswere sufficiently during

problems taking market

nonunion

induced

incentive

in offering

union

their

was

eagerto

it.

participatein

mechanism for private insurance markets are a deeply flawed care. Because of the adverse-selection (see Chapter problem industrial nation relies on unregulated markets for this purpose. The tax

Unregulated

to health

access

providing

11), no other

exemption, coupled with the requirement on both sides of the insurance market

arises

The problem much

generallyknow

in

about their own

more

policy in

bad

will

medical

expected seem

health.

to cover its

costs. To

potentialcustomers

spiral most

often people.

of a person with to potential customerswho

expenses

same time, its policieswill be in excellent health.

have below-average

a disproportionate

health status, which stay

in good

ensues,

with

the

the

will

end

seem

share of the means

its initial

that

companies

average know

overpriced

collect

enough

rates are health status, its themselves to be to those who

customers it premiums

sell

If its

will

will

attracts be

too

to raise its rates.But then find its policies even less attractive. A downward result that insurance becomes unaffordable

in business,

health

problem.

because individuals

health status than

At the

know themselves to The upshot is that

adverse-selection

a private insurance company must of the medical treatments it covers.

a bargain

like

coverage, has enabled participants

markets

insurance

individual

in business, insurance. To remain in premiums to cover the cost

based on the

of group

to sidestepthe

low

it will have

for

the employer-provided group insuranceapproachhelpedkeep the at bay for many this approach problem years, began to unravel as medical costscontinued to rise relative to all other goods and services. With health Although

adverse-selection

DELIVERY

368

CHAPTER 13

THE

HEALTH, AND

ENVIRONMENT,

insurance

SAFETY

heightened competition forcing healthier offers

whom

workers\342\200\224for

of

for new

to look

companies

in lieu

wages

higher

offering

began

and bigger bite out

a bigger

taking

premiums

workers'

and

paychecks

ways to cut costs,some

of employer-providedhealth are normally expenses

medical

Younger,

coverage.

these

small\342\200\224found

tempting.

increasingly

Parents who didn't buy health insurance for their families were onceviewed as but this lost some of its as the number of uninsured irresponsible, stigma sting health grew.As more and more of people took jobs without coverage, going without insurance became more socially acceptable. Making matters worse was the of the of the insured. As more families took changing composition pool healthy those left tended to be sickerand more to treat, jobs without coverage, costly In to rise still more our health insurance was forcing premiums rapidly. short, system caught

in

death

a long-term

spiral.

CARE ACT OF 2010

THE AFFORDABLE

the 2010, by President Obama in March first serious attempt to halt that death three main provisions, each one of which was essential for reform to succeed. to First, it required insurance companies to offer coverage everyoneon roughly conditions. Without equal terms, irrespective of preexistingmedical this provision, the economic imperative of every private insurance company would have beento take every step possible to deny coverage to anyone to incur expected that couldn't cover those who significant medical expenses. Any insurance system Passed

by

and signed into law was the government's

Congress

Affordable Care Act spiral. It contained

most needcarewould

everyone

requiring

cover their costs if they insure only the least also necessary for the Affordable Care Act to include a mandate to buy health insurance. Without such a mandate, healthy health insurance until they got sick, strong incentives to go without then be able to buy affordable insurance from companies that were

companiescannot

it was

people,

healthy

be unacceptable.

clearly

Because insurance

individuals would

face

sincethey

would

on preexisting conditions. Affordable Care Act was to provide for if they can't subsidies to low-income families. You can't require peopleto buy insurance afford it. With health care costs already high and rapidly rising, it was essential to include someprovision to ease the burden on those who are unable to pay. The act contained numerous other provisions, many of which were to designed slow the rate of health care costs by requiring more streamlinedmedicalrecord research on the questions of which treatments were most keeping and supporting effective. But the essence of the act lies in its three main provisions\342\200\224nondiscrimination on the basis of preexisting conditions, the and subsidies for low-income mandate, families.Without one of these provisions, the health insurance industry's death any would have surely continued. spiral to charge

forbidden

The third

major

attributablein

economic high

escalation

large

encourages

rates

based

of the

feature

THE ECONOMICSOF HEALTH

RECAP The rapid

high

part

people

in

medical

surplus would

deductibles

because

be largerif

we

such policies

War II is

since World

expenditures

to the spread of first-dollar to behave as if medical

DELIVERY

CARE

insurance

services were free

switched

provide an

serviceswhosebenefit exceeds their cost. The switch to HMOs addressesthis problem contract provides a strong incentive for physicians

of

to insurance incentive

which

coverage,

Total

charge.

coverage

to use

with

only those

the standard

not to

prescribenonessential

HMO

because

PRICE

USING

services. Some voice

that

REGULATION

lead

may

test.

cost-benefit

the

satisfy

HMO contracts

that

however,

concern,

services

withhold

to

physicians

IN ENVIRONMENTAL

INCENTIVES

in good health to for those who coverage, resulting premiums remain insured. The Affordable Care Act of 2010 was enactedin attempt to in market failures that exist to health care access remedy attempts provide insurance contracts. The act's three key through unregulated private provisions are that to all at rates independent of (1) insurance be made available be to purchase such insurance; preexistingconditions;(2) everyone required and (3) low-income peoplereceive subsidies to help meet this mandate.

insurance premiums have

Mounting

do without

caused

PRICE

USING

many

people

in higher

health

IN

INCENTIVES

ENVIRONMENTAL REGULATION 10, goods whoseproductiongeneratesnegative pollution, tend to be overproducedwhenever negotiationamong is costly. Suppose we decide, as a society, that the private parties best attainable outcome would be to have half as much pollution as would occur In that case, how shouldthe cleanup under completely conditions. unregulated effort be distributed those firms that among currently dischargepollution into in Chapter

saw

we

As

such externalities,

as atmospheric

the environment?

hence best\342\200\224distribution of effort is the one for which cost abatement is the same. To see why, polluter's marginal of exactly firm imagine that under current the cost to one of a ton of arrangements, removing from the air is than the cost to another firm. could then pollution larger Society in pollution achieve the same total reduction at lower cost by having the first firm discharge 1 ton more into the air and the second firm 1 ton less.

most

The

efficient\342\200\224and

each

Unfortunately, government how the cost of reducing pollution therefore

laws

require

different

will not

marginal

varies

all polluters

proportion or to meet the have

regulators seldomhave

costs

be efficient.

one firm

simply to cut

absolute

same

from

back their

standards.

emissions

of pollution

on

information

detailed

to another. Many pollution

abatement, however,

emissions

by the

If different these

same

polluters

approaches

TAXING POLLUTION if alternative can distribute the cleanup more efficiently, even Fortunately, policies the government lacks detailed information about how much it costs different firms to curtail One method is to tax pollution and allow firms to decide for pollution. themselves how much pollution to emit.The following illustrates the example logic

of

this

approach.

Taxing What

is the

least

costly way to

cut pollution by

Pollution

half?

each has access to five production firms, Sludge Oil and Northwest Lumber, each of which has a different cost and producesa different amount of pollution. The costs of the and the number of tons of smoke emitted are as daily processes in Table shown 13.1. Pollution is currently and between the unregulated, negotiation firms and those who are harmed is which means that each by pollution impossible, firm uses process A, the least costly of the five. Each firm emits 4 tons of pollution per

Two

processes,

day, for

a total of 8 tons of

pollution

per

day.

EXAMPLE

13.3

369

370

13

CHAPTER

TABLE

THE

ENVIRONMENT,

HEALTH,

AND SAFETY

Production

Processes

13.1

Costs and

Emissionsfor Different (4 tons/day)

Cost to

Sludge

Oil

D

E

ton/day)

(0 tons/day)

C

B (3 tons/day)

A

Process (smoke)

(2 tons/day)

(I

100

200

600

1,300

300

320

380

480

2,300

($/day)

Cost

to Northwest

Lumber ($/day)

The

government

is

is to

require each firm

One

half.

a tax

ton of half? What by

$T

of

emissions

per

curtail

to

smoke emitted would be the total

firm is required to C. The result will process

to

options for reducing total emissionsby its emissions by half. The other is to set each day. How large must T be to curtail

two

considering

If each A

cut

be

700

to society

cost

under each alternative?

each must switch from process of per day pollution for each firm. The cost = $500 per day. be $600 per day \342\200\224 $100 per day = $80 per will be $380 per day \342\200\224 $300 per day pollution

by half,

2 tons

of the switch for SludgeOil will The cost to Northwest Lumber for a total cost of $580 day, per day.

each firm would react to a tax of $T per ton of pollution. pollution by 1 ton per day, it will save $T per day in tax payments. Whenever the cost of cutting a ton of pollution is less than each firm has $T, then if the an incentive to switch to a cleanerprocess.For example, tax were set at A because switching to process stick with process $40 per ton, SludgeOil would B would cost $100 per day extra but would save only $40 per day in taxes. Northwest Lumber, would switch to process B becausethe $40 saving in taxes however, would be more than enough to cover the $20 cost of switching. in a The problem is that a $40 per day tax on each ton of pollution results 1 ton per day, 3 short of the 4-ton target. Suppose instead that reduction of only the a tax of ton. Oil would then $101 government imposed per Sludge adopt process B because the $100 extra daily cost of doing so would be less than the $101 saved in taxes. Northwest Lumber would adopt process D because, for every process up to and including C, the cost of switching to the next process wouldbe lessthan the can

resulting

how

now

Consider

If a firm

cut

tax saving.

Overall, then, a tax of $101 per ton would result in the desired pollution of 4 tons per day. The total cost of the reduction would be only $280 per day for Oil and for Northwest $180 ($100 per day Lumber), or $300per Sludge per day less than when each firm was required to cut its pollution day by half. (The taxes the firms do not constitute a cost of reduction because the money paid by pollution can be used to reduce whatever taxes would otherwise needto be levied on citizens.) reduction

CONCEPT In

Example

CHECK 13.3,

if

the

production processes

13.3 tax

were the

would

The advantage of the tax hands of the firms that emissions by the same

in the to cut reduce

pollution

much

more

$61 per ton of firms adopt?

emitted

pollution

each

day, which

two

is that it can accomplish it proportion ignores approach

cheaply than others.

concentrates

pollution

at least cost. Requiring the fact that some

Note

that

under

the

reduction each

firms

firm

can

tax approach,

of the

the cost efficiency

last

removed is the

of smoke

ton

for

same

INCENTIVES

PRICE

USING

each

IN

ENVIRONMENTAL

REGULATION

firm, so the

is satisfied.

condition

One problem

the

with

tax

is

approach

the

unless

that

has detailed

government

knowledge about each firm's cost of reducing pollution, it cannot know how high in too much pollution, to set the pollution tax. A tax that is too low will result while a tax that is too high will result in too little. Of course, the government could start a low tax rate and gradually increase the rate until pollution is by setting reduced to the target level. But because firms often incur substantial sunk costs when switch from one to that be even more another, they process approach might wasteful than all firms to cut their emissions the same requiring by proportion.

is to

alternative

Another

PERMITS

POLLUTION

AUCTIONING

permits to emit

that

level.

establish a target The virtues of this

for

level

approach

and pollution are illustrated

then auction in the

off

following example.

How much

will

pollution

EXAMPLE

Permits

Pollution

13.4

sell for?

permits

Two firms,

Oil and Northwest Lumber, again have access to the production Sludge in Table 13.2). The government's describedearlier are (which processes reproduced is to cut the current level of 8 tons goal pollution, per day, by half. To do so, the auctions off four each of which entitles the bearer to emit government permits, 1 ton of smoke per day. No smoke may be emitted without a permit. What price will firm buy, and the fetch at how will each auction, pollution permits many permits what will be the total cost of the resulting reduction? pollution

TABLE 13.2

Costs and Emissionsfor Different A

Process

(4 tons/day)

(smoke)

Cost to

Processes

Production

B (3 tons/day)

C

(2 tons/day)

Oil

100

200

600

to Northwest

300

320

380

Sludge

(I

D

E

ton/day)

(0 tons/day)

1,300

2,300

($/day)

Cost

Lumber

($/day)

Oil has no permits,it must had one permit, it could operate. the most Sludge Oil would Thus, per day. pollution permit is $1,000 a per day. With

E, which costs $2,300 per day D, which would save it $1,000 be willing to pay for a single 1-ton second permit, Sludge Oil could switch to C and save another with a third it could switch $700 process per day; permit, to processB and save another $400; and with a fourth permit, it could switch to processA and save another $100. Using similar reasoning, we can seethat Northwest Lumber would pay up to $220 for one permit, up to $100 for a second,up to $60 for a third, and up to $20 for a fourth. at a price of $90. SludgeOil will then Suppose the government starts the auction demand four permits and Northwest Lumber will demand two, for a total demand of six permits. Since the government wishesto sell only four permits, it will keep the until the two firms demand a total of four raising price together only permits. Once the price reaches$101,Sludge Oil will demand three permits and Northwest Lumber will demand for a total demanded of four one, only quantity permits. Compared to If Sludge

to

If it

use process

use process

480

700

371

372

CHAPTER

13

THE

HEALTH,

ENVIRONMENT,

AND SAFETY

the unregulated

alternative, in auction solution is $280:Sludge

firm used

each

which

process

the

A,

cost of the

daily

spends switching from process A to A to D. This total is process B, and Northwest Lumber spends $180 switching from $300lessthan the cost of requiring each firm to reduce its emissions by half. (Again, the permit fees paid by the firms do not constitute a cost of cleanup because the can be usedto reducetaxes that would otherwise have to be collected.) money

$100

Oil

has the same virtue as the tax method:It concentrates hands of those firms that can accomplish it at the lowest cost. But the auction method has other attractive features that the tax approach does not. First, it does not induce firms to commit themselves to costly investments that they will have to abandon if the cleanup falls short of the target level. And where the emission level second, it allows private citizens a direct voice in determining will be set. For example, any that believes the pollution target is too lenient group could raise money to buy at auction. permits By keeping those permits lockedaway in a safe, the group could ensure that will not be used to emit they pollution. Several decades ago, when economists first the auctioning of proposed pollution permits, reactions of outrage were widely reportedin the press. Most of those

The auction

method

in the

reduction

pollution

reactions amounted to the charge pollute to their hearts' content.\"

the proposal would \"permit rich firms to assertion betrays a total of the forces that generate pollution. Firms not because misunderstanding pollute they want to are cheaper than clean ones. pollute but becausedirty production processes real interest is in keeping the total amount of pollution from Society's only becoming not in who actually does the polluting. And in any event, the firms that excessive, do

under an auction system will reduction is most costly.

pollution

Economistshave permits

patiently

argued

the

in

CLIMATE CHANGE AND believed to bea principal of climate

consequences

firms,

those

but

these misinformed objections to fruit. The sale of pollution United and there is growing States,

the

borne

TAXES

dioxide (C02) in

of carbon

the

atmosphere

about

warming. Concerns

to global

contributor

change have

permits for

marketable

require

be rich

CARBON

concentrations

atmospheric

Growing

are widely

not

against

their efforts have finally in several parts of the in other countries. approach

and system, is now common

interest

the

an

of the polluting

most

for whom auction

that

Such

led to proposalsto tax C02emissions

them. Criticsof

these

proposals a fact

emphasize

or

that

uncertain, change are highly they view as arguing But uncertainty is a two-edged sword. Climate researchers themselves estimates based on their models are extremely readily concede that uncertain. But that means that although the actual outcome might be much better than their median forecast, it might also be significantly worse. to limit Organizers of the 2009 climate conference in Copenhagen sought to 3.6\302\260Fby the end of the twenty-first But even an increase global warming century. forecasts

that

action.

taking

there

Massachusetts

9\302\260F by

century's

to

deadly harm, and the no chance that

is essentially

amount if we

that According

the

cause

would

small

estimate that than

climate

involving

against

take no action.

estimates from the Institute of Technology,

recent

end,

in the

absence

of

most

respected

average

climate

temperature

change models

will rise

by

less

Integrated Global SystemsModel at the median forecastis for a climb of

effective

countermeasures.2

The

same

2SeeA. P. Sokolov, P. H. Stone, C. E. Forest, et al., \"Probabilistic Forecast for 21st Century Climate in Emissions (without MIT Joint Program on Based on Uncertainties Policy) and Climate Parameters,\" the Science and Policy of Global 2009, http://globalchange.mit.edu/ Change, Report No. 169, January files/document/MITJPSPGC_Rptl69.pdf.

USING

model estimates a that

10 percentchanceof

happened,

the atmosphere.Methane

INCENTIVES

IN ENVIRONMENTAL

by more than 12\302\260F.If of methane into quantities

rising

temperature

would melt,

the permafrost

PRICE

vast

freeing

a greenhousegas than COr MIT 1 in 10 chance we face a of global Thus, model, according roughly sufficientto much of life on Earth. warming extinguish uncertain. Again, forecasts from climate modelsare highly Things might not be as bad as predicted.But they could also be much worse. Shouldwe take action? To we must ask, how much would it cost? The answer, as it respond to that question, times

50

is

to the

turns

A tax

2100.3

little.

is astonishingly

out,

The Intergovernmental ton on carbon emissions that

on Climate

Panel

be needed

would

raise the

would

high

more potent

Change estimated that by 2030 to achieve climate

price of gasolineby

70

cents

tax

of $80

per by

stability

a gallon.

This

before the arrival of the more pessimistic MIT determined,however, estimates.Solet's assume a tax of $300 a ton, just to be safe.Under such a tax, the in of would rise to their carbon the case of prices goods proportion footprints\342\200\224in

figure was

a gallon. $2.60 gasoline, for example, by roughly As American motorists saw in 2008, a sudden price increase of that magnitude in gradually, it would could indeed be painful. But if phased cause much less harm. Facing steadily increasing fuel prices, for example, manufacturers would scramble to develop more efficient vehicles. now pay $4 a gallon more for Many Europeans than Americans do. But because of that automakers fact, European gas precisely have pioneered development of many of the world's most fuel-efficient cars. less on than Americans seem no less do, yet Europeans actually spend gas happy with rides.

their

traded

If a family

it would

mpg),

(32

tax could be phased closer

move

so on.

its

Ford

aging

spend less on gas than in

slowly,

Bronco (15 mpg)

to give

Some of

the

to

pay down debt

before,

even

for a FordFocuswagon as much. The

if it drove just

people time to

adjust. Peoplewould

also

car pools,chooselessdistant vacation and destinations, revenue from the tax could be used to send checksto lowease the burden of higher Portions of it could gas prices. help

to work, form

families

income

in

and rebuildcrumbling

or reduce other taxes. infrastructure, In 2009 the U.S. House of Representatives actually passed an energy bill that included a comprehensive carbon cap and trade the functional system, equivalent of a carbon tax. But seasoned observers no congressional say there's virtually in chance that meaningful climate legislation could win the U.S. Senate passage soon. Viewed within the economist's cost-benefit framework, this anytime reluctance to take remedial action constitutes a mystery of the highest order.

USING PRICEINCENTIVES

RECAP

IN

ENVIRONMENTAL

REGULATION

An efficient program for reducing is one for which the marginal pollution cost of abatement is the same for all polluters. has this Taxing pollution desirable property, as does the auction of pollution permits.The auction method has the advantage that regulators can achieve a desired abatement target without detailed of the abatement technologies available having knowledge to

polluters.

Climate

scientists gases

greenhouse

risk couldbe averted permit

3\"Climate

October,

warn that increasing atmosphericconcentrations of to cause catastrophic global warming. That of a carbon tax or equivalent carbon by imposition

threatens

system.

Change

6, 2008,

from Passenger Vehicles,\" Congressional Budget Policy and C02 Emissions www.cbo.gov/ftpdocs/98xx/doc9830/10-06-ClimateChange_Brief.pdf.

Office,

REGULATION

373

374

CHAPTER

13

THE ENVIRONMENT,

HEALTH, AND

SAFETY

REGULATION

SAFETY

WORKPLACE

Most industrialized countrieshave laws that attempt to limit the extent to which are exposed to health and safety risks on the job. These laws often are described as necessary to protect workersagainst with exploitation by employers market power. Given the working conditions we saw in the early stages of the industrial the idea that such exploitation pervadesunregulated revolution, private markets has intuitive appeal. Witness Upton Sinclair'svivid account of life in the at the turn of the twentieth Chicago meatpacking factories century:

workers

Someworkedat

and it was very seldom that pace that was set, and not give out and have a part of his hand chopped off. There were the \"hoisters,\" as they were whose task it was to press called, the lever which lifted the dead cattle off the floor. They ran a along the and the steam; and as old rafter, peering down through damp Durham's architects had not built the killing room for the convenience of the would have to stoop hoisters, at every few feet they under a beam, say four feet above the one they ran on; which got the

one couldwork long and forget himself,

them

machines,

stamping there

at the

the habit of stooping, so that in a few years they would be like chimpanzees. Worst of any, however, were the fertilizer men, and those who served in the cooking rooms. Thesepeoplecould not be shown to the visitors\342\200\224for the odor of the fertilizer-man would scare any ordinary visitor at a hundred yards, and as for the other full of steam, and in which men, who worked in tank-rooms into

walking

were open vats near the level of the floor, their trouble peculiar was that they fell into the vats; and when they were fished out, there was never enough of them left to be worth exhibiting\342\200\224sometimes would be overlooked for days, till all but the bones of them had they Pure Leaf Lard.4 gone out to the world as Durham's there

The miserable opulent

enjoyed

lifestyle

conditions of

with the often workers, factory juxtaposed seemedto affirm the idea that owners were owners, factory if conditions in the factories were in fact too dangerous,

by

exploiting workers.But how much safer shouldthey

O

have

been?

Considerthe question of whether to install rail on a lathe. are reluctant guard Many people

a specific

safety device\342\200\224say,

a

the Cost-Benefit employ to answer such a To is an absolute them, Principle question. safety priority, so the rail should be installed of its cost. Yet most of us do not make guard regardless decisions about our own health and that No one personal safety way. you know, for the brakes on his car checked even example, gets every day, though doing so would reducethe likelihood of being killed in an accident. The reason, obviously,

is that daily

brake inspectionswould

of

probability

an

accident

inspections. same

The

logic

one is

amount

can

willing

to

be

significantly

to

not reducethe to annual or semiannual compared

very

costly

and would

be applied to installing a guard rail on pay to reduce the likelihood of an accident

cost of the

a lathe.If exceeds

the

the

be installed; not be. And no otherwise, it should guard rail, it should matter how highly we value the odds of an we will almost accident, reducing settle for less than After to reduce the risk of an accident all, surely perfect safety. to nearly zero, one would have to enclose the lathe in a thick Plexiglas case and it with remote-controlled mechanical arms. Faced with the operate prohibitive cost of such an alternative, most of us would decide that the best approach is to add whose benefit exceeds its cost and then use caution while safety equipment

operating 4Upton

the machine.

Sinclair,

The Jungle (New

York: Doubleday,

Page,

and Co.,

1906), p. 106.

WORKPLACE

SAFETY

REGULATION

unregulated employers offer the level of workplace safety suggested by the Cost-Benefit Most nations to have decided that they Principle? appear will not. As noted, virtually industrial every country will

But

has comprehensive

now minimum

of

workplace\342\200\224laws

against exploitation

as safeguards

described

usually

legislation mandating in the

standards

safety

workers.

safety regulation as an antidote exploitation troubling questions. One stems from the economist's difficulty argument that for workers firms to provide the | > competition prods For example, if an sociallyoptimal level of amenities. a rail on a lathe\342\200\224costs $50 amenity\342\200\224say, guard per \"Not enough money is being \302\251< month to install and maintain, and workers value it at $100 per month, then the firm mustinstall the device or risk workers to a that does. After all, if a competing firm losing competitor were to pay workers $60 per month less than cover the they currently earn, it could cost of the device with to spare, while providing a compensation $10 packagethat is $40 per month more attractive than the first employer's. To this argument, critics there is very little respond that in practice competition in the labor market. They argue that worker information, incomplete immobility, in which workers have little and other frictions create situations choice but to if firm whatever conditions offer. But even a were the accept employers only employer in the it would still have an incentive to install a $50 safety device that is market, worth $100 to the worker. Failure to do so would beto leave cash on the table. Other defenders of regulation that workers may not know about suggest safety devices lack. But that because firms they explanation, too, is troubling competing If the would have a strong incentive to call the devices to workers' attention. problem is that workers cannot move to the competing firm's then the firm location, Yet

explaining

raises

for

can set up a branch near

the

its profit

by

cheating

on the

worker mobility existing markets; as noted

agreements because each firm

to restrain

can

increase

is high, as is entry firms into by new cartel have been 9, Chapter agreements always is may not be perfect, but if a new employer in town firms

between

in

deal, sooneror later word gets around. still manage if, despite these checks,somefirms

a better

offering Finally,

Collusive

so he careful\"

agreement.

Information

unstable.

to maintain

difficult

In fact,

notoriously

workers.

exploited

such competition shouldprove

spent on safety^

to exploit their

workers,

we shouldexpectthosefirms to earn a relatively high profit. But in fact we observe Year in and year out, firms that just the opposite. pay the highest wages are the most And so we are left with a The fear of exploitation by employers profitable. puzzle. with market power has led governments to adopt sweeping and costly safety the evidence that cannot be a major problem. As the regulations; yet suggests exploitation useful even in a following example suggests, however, safety regulation might prove perfectly

competitive

Safety

Will

Don and

environment

Regulation

with

in a

complete

Perfectly

Michael choose the optimal

amount

information.

Competitive of

Environment

safety?

Michael are the only two members of a hypothetical community. satisfaction from three things: their on the job, and their income, They get safety on the economic ladder. Don and Michael must both choose position Suppose between two a safe that week and a that $50 $80 per jobs, job pays per risky job pays week. The value of safety to each is $40 per week.Having more income than one's Suppose

Don and

EXAMPLE

13.5

375

376

CHAPTER

13

THE

HEALTH,

ENVIRONMENT,

AND SAFETY

is worth $40 per weekto each;having in satisfaction. means a $40 per week reduction no

means

neighbor

job choices possible

change this

in

in isolation,

Viewed

Granted,

it

(Having the same

Will Don and

one's neighbor

income as one's

Michaelmake

each person's than

decisionshould the

risky

be

to

the safe

take

job, but the extra

safety it

from the issue of relative income, the $40 per week. So aside safe job is $90 per week or $50 (its salary plus $40 worth of safety),

is worth

more than the Once

job chosen

the

corresponding safe job, he will

value

$10

job.

offers

of the

per week

job.

risky

we incorporate

decisionchanges in on

best

the

situation?

per week less

$30

pays

in satisfaction.)

than

income

less

neighbor

concerns about

a fundamental by

the

other.

levels of satisfaction

relative the logic of the income, however, Now the attractiveness of each way. job depends The four possible combinations of choices and their in Table 13.3. If each man are shown chooses a

from and\342\200\224 $50 of income, $40 worth of satisfaction get safety, will have the same income\342\200\224zero satisfaction from relative income. So if each man chooses the safe job, each will get a total of $90 worth of satisfaction. If instead each man chooses the risky each will get $80 of income, zero job, satisfaction from and because each has the same income as the other, zero satisfaction safety, from relative income. If we compare the upper-leftcell of the table to the lower-right

each

because

Don and Michael would be happier if each say unequivocally that if at lower income than each chose a more income. job risky job with But consider how the choice out once the two men plays recognize their interfor that Michael chooses the safe dependency. Suppose, example, job. If Don then in chooses the unsafe job, he ends up with a total of $120 of satisfaction\342\200\224$80 from more income than Michael. for his $40 Michael, salary plus having part, ends in with worth of from $50 satisfaction\342\200\224$50 $40 up only salary plus safety, minus from lower income than Don. Michael chooses $40 having Alternatively, suppose the risky job. Then Don will again do better to accept the risky for job, by doing so he gets $80worth of satisfaction rather than $50. In short, no matter which chooses, Don will get more satisfaction job Michael the no matter which by choosing risky job. Likewise, job Don chooses, Michael will do better the Yet when each follows his dominant by choosing risky job. in end the cell of the which table, strategy, they up lower-right provides only $80 per if each had chosen the safe job. Thus week of satisfaction to each\342\200\224$10 less than their job-safety choice confronts them with a prisoner's dilemma (see Chapter9). in all such situations, As when the players chooseindependently, fail to make they the most of their opportunities.

cell, then, took

we

can

a safe

13.3

TABLE

The Effect

of Concern about Relative

Income

on Worker

Choices

Regarding Safety Michael Safe

Safe job % $50/week

job

@ $50/week

$90 for

Don

$90 for Michael

Risky

job

@ $80/week

$50 for

Don

$120 for Michael

Don Risky

job

% $80/week

$120 for

Don

$50 for Michael

$80 for

Don

$80 for Michael

WORKPLACE

How would

to the question posed in $40 per week, but $20?

answer

your

of safety

value

had

differed

13.5 have

Example

if

the

not

been

13.5 suggests an alternative explanation for safety regulation, not basedon the need to protect workers from exploitation. If Don could choose collectively,they would pick the safe job and maximize

one

Example

that is Michael

standards in

the

We stress

only about person's

example,if you

workplace. about

concern

that

or better

more

having

want

in a

support

might

legislation

that

income need not mean than their neighbors. In goods

establishes

relative

is important for to send your child to

income

relative

house

Thus, each

satisfaction.

combined

377

REGULATION

13.4

CHECK

CONCEPT

SAFETY

good school district.But

reasons that everyone a good school,in most

who

gets

a house

in

that

and their

safety

people

care

our society,a

recognizes. cases you a good

For

must buy a school district?

a high Similarly, if everyone wants a housewith in and 10 of home sites have who them? The view, views, only percent gets people the top 10 percent of the income of course, and only those distribution, people. outcomes in life depend on where a person stands on the Many important economic ladder. And when people care about their relative selfincome, rational, interested actions will not always lead to efficient outcomes in the labor market. matters. The labor market may Regulation, however, does not always improve in the not be perfect, but government regulators aren't perfect either. Safety is overseen the and Health Administration (OSHA), workplace by Occupational Safety an agency that has drawn considerable much of it justified. Consider, for criticism,

Those who

example,the from

relative

have

following

an early

passage

OSHA manual:

income.

on safety

requirements for ladders,taken

verbatim

of grain in flat steps of minimum dimension shall 1 in 12, except that for ladders under 10 feet in 1 in 10. The slope of grain the slope shall not be steeper than length in areas 1 in 12 or 1 in 10 of local deviation shall not be steeperthan as specified above. For all ladders,crossgrain not steeper than 1 in 10 in lieu of 1 in 12, provided are permitted the size is increased to afford at least 15 percent greater strength than for ladders built to minimum dimensions. Local deviations of grain associated with otherwise

The

general

slope

not be steeperthan

permissible

irregularities

are

permitted.5

passage appears in a section devoted to ladders that is 30 pages long, two columns to the page. One can easily imagine the managers of a firm deciding that their best course of action is simply to abandon any activities ladders. requiring As an alternative to OSHA-styleprescriptive safety regulation, many economists favor that increase employers' financial incentives to reduce programs The workers' workplace injuries. compensation system provides a mechanism through which such a change might be achieved. Workers' is a government compensation insurance that benefits to workers who are system provides injured in the workAs the doesnot each individual emplace. currently administered, program adjust to reflect the claims its workers. ployer's premiums fully generated by Employers with low injury rates thus pay premiums higher than needed to cover the claims rates pay premiums too generated by their workers, while those with high injury small to cover the claims generated by their workers. Economists argue that revising insurance to reflect the full social premiums cost of the injuries sustained by each employer'sworkers would the provide in In incentive to curtail the set at effect, premiums optimal injuries workplace. This befogged

5Quoted Industrial and

by Robert S. Smith, \"Compensating Labor Relations Review 32 (1977),

Wage Differentials and pp.

339-52.

Public

Policy:

A Review,\"

a

workers'compensation government

insurance

that provides

benefits

workers who on the job

are

system to

injured

CHAPTER 13

378

THE

HEALTH, AND

ENVIRONMENT,

level

this

would

samereasonthat at the

whose

As

in

other

workplace

tax on injuries,and this would tax on pollution is efficient.

be an optimal

would

injury

domains, if we choose

An

achieve

to

among policieson practical

tax set

injury

to adopt all

employers

encourage

exceed their costs. we are far more likely

benefits

for the

be efficient

chosen

a properly

marginal cost of

measures

the

SAFETY

optimal

cost-benefit

safety

safety levels grounds

than on the basis of slogans about the merits or flaws of the free market. As the following example illustrates,costs and benefits play a pivotal role decisions about whether the government chooses to constrain individual choice the safety

domain and, if

so,

A

in

government require safety not for

but

cars

without

store

Seattle

with no

infants

first

In case

of

injury or death of being involved

when

by

safety

seats

in a car or seat is more

is unrestrained.

who

nearby

But

an

airplane\342\200\224an

likely

to

escape

the

probability of times higher

accident is hundreds when traveling by air, so the benefit of is greater for trips made by car. Using safety

in a

traveling

having

one

than

a safety

into

a

into a governmentcan fly with him from Miami to at all. Why this difference? him

accident\342\200\224whether

an

is strapped

who

she device

restraining

for infants in airplanes?

her six-month-oldson to strapping

approved safety seat. Yet

who

seats

travel

who

legally drive

cannot

mother

grocery

infant

in

13.2

does the

Why

travel

in

how.

The Economic Naturalist

mr

in

rather

serious

car than

seats is also far more on plane trips than on car trips. costly Whereas most cars have plenty of extra room for a safety seat, ticket to use one on an parents might need to purchasean extra Most parents appear unwilling to pay $600 more per trip airplane. for a small increment in safety, for either themselves or their in regulations is thus children. The difference a straightforward of the

consequence

Why in

are

child safety

seats

required

in cars

Cost-Benefit

Principle.

but not

airplanes?

Cost-Benefit

O

a practice often defendedas market by employers with Yet safety regulation might be attractive even in perfectly competitive marketsbecausethe social payoff from investment in safety often the tax set at the marginal cost of injury private payoff. An injury

Most countries

regulate safety

neededto protect workers power.

labor

exceeds

would

encourage

Becausepublic health

AND and

health

and safety,

on public health

and

in

from

the

being

optimal investment

HEALTH

PUBLIC

our

REGULATION

SAFETY

WORKPLACE

RECAP

workplace, exploited

in

SECURITY

law enforcement

officials are

political leadersare often

law

enforcement

safety.

workplace

reluctant

in cost-benefit

chargedwith

protecting

to discuss

expenditures

terms.

But

because

we

live in

a world

AND SECURITY

HEALTH

PUBLIC

we cannot escape the fact that spending more in these areas less on other of value. spending things like are Illnesses, accidents, costly to prevent. The socially optimal expenditure on a health measure that reduces a specificillness is that amount for which the benefit to society of the measure exactly equals its marginal cost. For marginal in how much to on a rational measles, example, deciding spend vaccinating against the proportion of the population vaccinated public health policywould expand until the marginal cost of an additional vaccination was exactly to the equal of

scarcity,

means

As the

following looks

vaccinated

become

illnesses

of the

value

marginal

thus

prevented.

the example illustrates, however, different from each individual's very

do

Why

have laws

states

many

immunization

of

Proof

and

is now

rubella

against universally

to be

students

requiring

require immunization (49 states), pertussis (44 states), mumps (43 hepatitis B (26 states). Why these requirements? vaccinated

against

a childhood

states),

illness

Contracting

in

unvaccinated.

(whooping of permanent

of every I 10,000 children vaccinated. itself also poses serious health and in an risks, which infections were sufficiently to occur, likely I

out

disease

the

would But

be exactly equal to the risk this calculation ignores the

remain unvaccinated

others who protection

against childhood

but

environment in individuals would have a compelling reasonto bear the risk of in order to reduce the even larger risk from infecbeing vaccinated in which tion.The problem is that in an environment most children were vaccinated, infection rates would be low, making the risk of in vaccination loom understandably the of individual large eyes families.The ideal situation from the perspective of any individual in an environment in unvaccinated family would be to remain which all other families were vaccinated.But as more and more families decided to forgo vaccination, infection rates would mount. the vaccination rate would stabilize at the point at Eventually which the additional risk to the individual of family becoming vaccinated

m

and

a small

entails

potentially serious risk.The vaccine against pertussis cough), for example, is believedto cause someform brain damage

vaccinated

^

13.3

Naturalist

against

tetanus

Being

to

diphtheria, measles, poliomyelitis, for entry into American required

states also

Most

schools.

public

of whether

perspective.

Economic

The

illnesses?

decision

have against

poses

decided

risk

not

to become

just

from

fact

remaining that a decision

to the

individual

vaccinated (since no

to decision vaccine

Why

are

required maker, affords

vaccinations by

law?

but also to 100 percent

infection).

in a suboptimally the vaccination decision to individuals results low vaccination rate because individual decision makers fail to take adequate account of the cost that their infected will impose on others. It is for this reason that most states becoming vaccinations childhood illnesses. require against specific Even these laws, however, allow parents to apply for exemptions on religious or in Communities the extent to which avail themselves philosophical grounds. vary parents of these exemptions. In Colorado, for example, Boulder County heads the list of parents who opt to exempt their children from taking the pertussis vaccine(with an exemption Relegating

against

many

childhood

illnesses

379

CHAPTER 13

380

THE

HEALTH, AND

ENVIRONMENT,

of 8.4

rate

percent, more

of whooping

incidence

than

people)

childhood

like

Cost-Benefit

O

next invests

much

higher

(9.4 cases per year

as a whole

state

benefit of

reducing

in

which

for

amount

that

Principle helps to explainwhy

the Cost-Benefit

illustrates, example so much more heavily

100,000

people).6

exactly equals its marginal cost. As

crime

that

of crime is

type

specific

any

100,000

per

the per

costly to prevent. The socially optimal

are also

illnesses,

on avoiding

to spend

the marginal

is

the rate statewide). Not surprisingly, in Boulder (34.7 cases per year

times

four

than

cough

the

in

Crimes, amount

SAFETY

than

crimes

some

preventing

in

the

society

others.

preventing

The Economic Naturalist 13.4

ar

do

why

Service agents guard the presidentthan Service agents guard collegeprofessors?

Secret

more

do

Why

no Secret

vice

the

and

president,

the president of the United States flies to Cleveland to give a speech, hundreds of him against attack by an assassin. federal agents are assigned to protect But when the vice president flies to Cleveland to give a speech, many fewer agents are assigned, and when a college professor goes to Cleveland for the same purpose, no agents are at all. Why this difference? assigned When

Accordingto the Cost-Benefit Principle, in each

agents

Increasing Opportunity

Cost

D

case

the

until

the

should

government

of an additional agent

cost

equals the

keep

assigning

the

of

value

extra

cost of assigning agents is protection provided. In each of the three cases, the marginal in Figure 13.3, marginal cost to be upwardessentially the same. As shown (MQ is likely the most sloping because of the Low-Hanging-Fruit Principle, according to which effectiveagents should be assigned first.

MBP

MC

X

MC

MC

MBVP $/agent

^.t*000*

$/agent

$/agent i i i

)

C

C)

NP

of agents

Number

\\>MBCP ()

NVP

protecting the

the president

vice

(a)

(b)

(c)

Differential Investment in Crime Prevention. in the marginal benefit of protection, Because of differences to

protect

assigned to protect

The important additional

protecting a

collegeprofessor

president

13.3

FIGURE

assigned

Number of agents

of agents

Number

protecting

agents.The

6ColoradoDepartment

the president an

ordinary

(a) than

citizen

difference among

marginal

benefit of

of Public

to protect

more

Secret

the vice president

Service agents are

(b),and

are

none

(c).

these an

Health and

three

agent

Environment,

www.cdphe.statexo.us/dc/Epidemiology/VPDreportabletable.pdf.

cases lies in to the

assigned

Vaccine

the

value

president

Preventable

of assigning [MBp,

Diseases

part

in

(a)] is

Colorado,

SUMMARY

much

the

than

higher

vice president[ME>vp,

marginal part

benefit of an agent assigned at least two reasons.First,

381

to the

(b)], for

the government have a stronger motive to attack vice president because the president'srole is so much more important than the vice president's.Thus, assigning an additional agent to the president is more likely to prevent an attack. And benefit of preventing an attack second, the against the president is much than that of preventing an attack higher against the vice president\342\200\224 the president's role is so much more again, because importantThese observations that the optimal number of agents to assign to imply the president [Np, part the optimal number (a)] is much greater than of agents to assign to the vice president part (b)]. Finally, the [Nvp, opponents

president

of the

the

than

of agents

number

optimal

[part (c)] becausethe small. After

is so and

in the

less

serious

to

marginal

benefit

people have

all, few

unlikely event of an than if a prominent

to

assign

any

a traveling of such an reason

professor is zero assignment

(ME>cp)

professor, would be far

the consequences government leader were

attack,

college professors receive Secret Service when they give out-of-town lectures?

Should

to attack a

protection

attacked.

cost-benefit approach complain that, when applied in of human life. discussed, it gives short shrift to the dignity On closer inspection, however, this is difficult to support. The complaint recommendation to assign no Secret Service agents to protect a traveling college professor does not imply that the lives of ordinary citizens are not to be cherished. Rather, it simply that even without Secret Service protection,not even a acknowledges single traveling professor is likely to be assassinatedin the course of the next 100 years.For the same money that we would spend to sendagents on largely pointless rails on dangerous mountain roads, purchase assignments, we could install guard additional mobile care units, or make any number of other investments coronary that would save thousands of lives. The logic of the Scarcity Principle doesnot ceaseto apply whenever the choices we must make involve human health or safety. critics

Many

the

like

examples

of the one just

HEALTH

PUBLIC

RECAP

Scarcity

a

AND SECURITY

The Cost-BenefitPrinciple appliesto public health and safety measures just as in other areas of public policy. Society'sefforts to promote security should be expanded only to the point at which their marginal benefits their equal costs.

marginal

SUMMARY \342\200\242 Basic

of

variety principles

for

help

health

medicalservices

the

can be principles policy questions.

microeconomic

gains

achieved

government to show

applied to a These

methods of paying care affect the efficiencywith which In the case of health are delivered. care, from marginal cost pricing can often be insurance with through policies large how different

deductibles.(LOl) understanding

environmental policy

measures

that

will

of

pollution

pollution

rights

cost of

the

forces that give riseto help to identify those achieve a desired reductionin

lowest possible and the sale of

this promote environmental

marginal cost of pollution all polluters.(LOl) \342\200\242 A

perennially

can

pollution

taxing

controversial

cost. Both the

transferable

goal. Each distributes the effort so that the cleanup abatement is the same for

topic is the application

of

to policies involving public Principle and the health, safety, security. Many critics feel that use of cost-benefit analysis in this domain is not because it involves putting a monetary morally legitimate the

of the

\342\200\242 An

at the

pollution

Cost-Benefit

CHAPTER13

382

price

THE

life.

on human

HEALTH, AND

ENVIRONMENT,

fundamental

the

Yet

Scarcity applies to human

health

and

Principle safety, just

issues. Spending more on means spending necessarily

to other

does and

safety

SAFETY

of

as

insurance

public

less on other

coverage (365)

that

means

society

will

the relevant be

less

achieve its stated goals.(L03, L04)

health

costs

likely

to

TERMS

workers' compensation (377)

maintenance

health

to weigh

Failure

value.

of

benefits

and

KEY

first-dollar

things

it

(365)

(HMO)

organization

REVIEW QUESTIONS Why

health

is first-dollar

4.

inefficient?

care coverage

(LOl) Why

and

believe that are a more

economists

do effluent

permits

board cutbacks?

illnesses

laws

a

against requirement

legal

5. Does it

across-the-

mandating

schools?(L04)

is not

robberies

make to

Administration

(LOl)

vaccination

is

pollution taxes efficient way to

expensivesafety

jets than

many childhood for entry into public

explain to a skeptical bank socially optimal number of bank zero? (L04) you

the

why

manager

curb pollution than Why

would

How

in

for the Federal Aviation more sophisticated and in large commercial passenger

sense require

equipment small private

planes? (L04)

PRO BIEMS David's demand for hospital requires an appendectomy, is as shown in the diagram.David's current insurance covers the cost of hospital stays. The cost of marginal room is $150 per day. (LOl)

the event he accommodations

1. In

connect'

policy

|ECONOMICS

providinga

I

fully hospital

/^Study

McGraw-Hill

Visit your mobile app store and download

the

Frank:

Econ

app

Study

2

todayl

8

Hospital

a. If David's only will

choose

he

b. By how David's exceed

total

the

an

appendectomy,

how many

days

hospital? economic

surplus

have

covered only the cost

been higher this

of hospitalstays

year if

that

David's employer adopts a new health care plan that pays 50 medical full expenses up to $1,000 per illness,with coverage How will economic under this surplus plan compare with

all

of

thereafter. economic

much would

in

insurance hospital illness? $1,000 per

c. Suppose percent

illness this year resultsin to stay

(days)

stay

surplus

with

the policy

in

Part

b?

PROBLEMS

Los Angeles, the demand for Botox (a procedure injections wrinkles and smoothesthe skin) is as shown in the following marginal cost of a Botox injection is $1,000 and the procedure covered by health insurance.(LOl)

that removes The diagram.

2. In

is not

currently

c #0

u

gl

S o

1,000

O &\342\226\240

u

0.

19000s of

a. By

how much

will

total

economic

law requiring employersto include in

their

employees'

b. How would the

requiredhealth

health change

80

40

0

procedures/year

change if the city council passes a for Botox injections

surplus full

coverage? economic

in total

reimbursement

surplus

be

affected

if the

law instead

only $500

per procedure? 3. Two firms, Sludge Oil and Northwest Lumber, have access to five production has a different cost and gives off a different processes, each one of which amount of pollution. The daily costs of the processes and the corresponding in the following number of tons of smoke emitted are as shown table: (LOl) insurance

Process

A

(smoke) Cost

to

to pay

B

(4 tons/day)

Sludge Oil

(3 tons/day)

50

C (2 tons/day)

70

120

180

500

D

(I ton/day)

200

\302\243

(0 tons/day)

500

($/day)

Cost to

100

Northwest

Lumber

1,000

($/day)

a. If pollution is unregulated, which will each firm use, and what will process be the total daily smoke emission? b. The City Council wants to curb smoke emissions by 50 percent. To it requires each firm to curb its emissionsby 50 percent. What accomplish this, will be the total cost to society of this policy? c. The City Council again wants to curb emissions by half. This time, it sets a tax of $T per day on each ton of smoke emitted. How largewill T have to be to effect the desired reduction? What is the total cost to societyof this policy?

to Problem

3. Instead of

the city council decides to entitles the bearer to emit 1 ton of permits, smoke per day. No smokemay be emitted without a permit. Suppose the government conducts the auction by starting at $1 and askinghow many permits each firm wants to buy at that it then four, price. If the total is more than raises the price by $1 and asks again, and so on, until the total of quantity demanded permits falls to four. How much will each permit sell for in this auction? How many permits will each firm buy? What will be the total cost to in pollution? (LOl) of society this reduction

4. Refer

auction

off

four

each

taxing

pollution,

of which

2,000

383

384

CHAPTER

13

THE

HEALTH,

ENVIRONMENT,

AND SAFETY

5. Tom and Al are the only two members from three things: his income, his safety

of a household.Each at

and his

work,

satisfaction

gets

income relative to his

roommate'sincome.Suppose Tom and Al must each choose between two jobs: a safe job that pays $100 per week and a risky job that pays $130 per week. The value of safety to each is $40 per week. Each person evaluates relative income as follows: Having more incomethan his roommate the provides of week worth of less a $30 satisfaction; equivalent per having implies the $30 per week worth of satisfaction; and earning roommate means no change in satisfaction. Will Tom and between the two jobs? (L03)

same

reduction of

6.

Problem

Refer

to

one

another

Tom and Al could cost, which job would

5. If

at no

is impractical, and that workplace safety is for

the

Tom and to

government

their

to

13.1

With day

in

greater

safety regulations. If would

week,

Tom

and

Al

(L03)

adoption?

mswm

optimally

achieve

can

Al

adopt

enforcementof the regulationscosts$25per favor

as his

negotiate binding agreements with each choose? Suppose negotiation

way

only

the

income

choose

Al

checks

(QHdPT

50 percent coverage, David would have the hospital, so he would chooseto

\342\226\240

to

$150

pay for

stay

two

for each

days.

additional

(LOl)

300

150

13.2 The optimal stay

is

still

day. If

one

insurance reimburses $150 per day,

marginal charge seen by David will be the remaining so he will stay two days. The cost to society of the additional day, to David of the extra day is only $300 and the benefit $225 (the

then

the

the lower is thus

shadedfigure).The

$75.

loss

from the

in surplus

/

1*300

Benefit

from

additional

Lost surplus additional

S 150

12

0 Length

of hospital

3 stay (days)

from

stay

day is of

area

additional day's stay

(LOl)

<

$150 per

stay

TO

ANSWERS

13.3

of $61 Lumber

a tax

With

Northwest

per ton

Process to Sludge

Oil

would

Oil

Sludge

adopt process

process C. (L02) B (3 tons/day)

A

(4 tons/day)

(smoke)

Cost

each day,

would adopt

A

100

200

600

300

320

380

CHECKS

and

C

D

(2 tons/day)

CONCEPT

(1 ton/day)

\302\243

(0 tons/day)

1,300

2,300

480

700

($/day)

Cost to

Northwest

Lumber

($/day)

13.4 The payoff

would now be as shown below, and the and collectively,would be the risky job. (L03)

matrix

individually

best

Michael Safe Safe

job

@ $50/week

job

@ $50/week

$70 for Don

$70 for

Michael

Risky

job

<

!

$80/week

$30 for Don

$120 for

Michael

Don Risky

job

@ $80/week

$120 for Don

$30 for

Michael

$80 for Don

$80 for

Michael

choice,

both

385

CHAPTER

I

I

and

Goods

Public

Tax

|4

Policy r. \\

LEARNING

OBJECTIVES

After reading

this

chapter,

be able to:

you should

LOI Usethe

rivalry and *-\"\"\"

if HI

to

*-**

1

L02

h,

\342\226\240

goods,

goods.

to find

can be the

the mix of

markets are also imperfect, production to meet their

all successful societies economic demands. and

rely

on a

of a

L03

mix

of goods

and servicesprovided.

on the legitimate use of force. If people has the power to restrain them, using force if to deprive lawbreakersof their liberty for extended can draft lawperiods, and, in some places, even to execute them. Government abiding citizens into the armed forcesand send them into situations in which killed themselves. they must kill others and risk being These are awesome powers. And although they are often used in the pursuit of noble ends, the historicalrecordabounds with illustrations of their abuse. Voters and politicians of both abuses. Indeed, parties are keenly aware of these rhetoric almost invariably entails criticism of bloated, out-ofcontemporary political control the government bureaucracy. Even mainstream Democrats\342\200\224ostensibly Government

also

has

a monopoly

break the law, government has the power necessary. It also

party

of activist

government

in

the

United

States\342\200\224have

conceded

the need

Clinton remarked government's role.For example,former president State of the Union Message, \"the era of big government is over.\"

to curb

in his

1996

firms can goods.

public

supply

overnment has the power to tax. Unlikea private which business, if we voluntarily can get our money only buy its product, the government can take our money even if we don't want the particular

public

describe in which

ways

private

used

optimal

and

good

is imperfect. But and private government

economic

how

Show

concepts

i:

public

and commons

quantity

Government

among

collective

goods,

i^l

i\"'tj

\\

excludability

distinguish

private goods,

*> \342\226\240>.

1

of

concepts

Analyze the types

of efficienciesand that

inefficiencies

are associated the

with

of

provision

public goods.

L04 Discussthe that

to

should taxation

to promote

criteria

be applied in order

efficiency.

388

14

CHAPTER

TAX POLICY

PUBLIC GOODS AND

radical retrenchment. For instance,Harry Browne, of the Internal Party presidential candidate, called for abolition Revenue Service,the agency for the federal income tax. This responsible collecting would be tantamount to the federal for without itself, step abolishing government tax revenues, there would be no way to pay for public goods and services. Browne is right, of course, that a sure way to prevent government abuse of power is simply to have no government. But since virtually no society on earth lacks a we that on do more than harm. balance, government, may suspect governments, good But how big, exactly, should government be? What goods and services should it provide? How should it raise the revenue to pay for them? What other powers should it have to constrain the behavior of its citizens? And how should the various be apportioned powers we assignto government among local, state, and federal in levels? Our this will be to the goal chapter employ principles of microeconomics in an to answer these attempt pragmatic questions. even more

advocate

Others

Libertarian

1996

the

good

public that,

both

to

or service some degree,is and nonexcludable

a good

at least

nonrival

of the

One

goodssuch

primary tasks as

of government

does

a good

good

by one

not

diminish

whose

person

its availability

Public

goods are

nonexcludable.A

consuming

is one

good

what economists

provide

justice system.

\342\200\224

call public

that

are,

in varying

whose consumption by

others.For example,if

the

degrees, nonrival and

military

one

person

prevents

does not a hostile

does not your city, your enjoyment of that protection if it is difficult to exclude neighbors. A good is nonexcludable from consuming it. For instance,even if your neighbors don't pay their nonpayers share of the cost of maintaining an army, they will still enjoy its protection. Another of a nonrival and nonexcludablegoodis an over-the-air example broadcastof The Late Show with David Letterman. The fact that you tune in one evening does not make the program any less available to others, and once the broadcast has been beamed out over the airwaves, it is difficult to prevent anyone from tuning in. if the City of New York on a fireworks display in New York harbor to Similarly, puts celebrate a specialoccasion, it cannot admission because the harbor may be charge viewed from many different locations in the city. And the fact that additional persons view the display does not in any way diminish its value to other viewers. potential In contrast, the typical private good is diminished one-for-one by any individual'sconsumption of it. For instance, when you eat a cheeseburger, it is no longer available for anyone else. Moreover, people can be easily from prevented they don't pay for. consuming cheeseburgers diminishits

nonexcludable good a good that is difficult, or costly,to exclude nonpayers from

nonrival

diminish its availability for

nation from

for others

those goodsor services

GOODS

PUBLIC

GOODS

PRIVATE

VERSUS

consumption

is to

and the criminal

defense

national

PUBLIC GOODS nonrival

OF

PROVISION

GOVERNMENT

value

invading

to your

CONCEPT CHECK 14.1 Which

of the

a. The

website of

b. TheWorld c.

Goods

pure

public

servicethat, both

nonrival

good

a good

to a high and

or

degree, is

nonexcludable

any,

is nonrival?

Bureau

the

Cup

The World

if

following,

soccer

of Labor Statistics at 3

championship

Cup soccer championship

both

that are

pure public goods. First, for-profit private their cost of production. the cost of producing

highly

a.m.

game watched game

nonexcludable

watched

and

in

person.

on television.

nonrival

are often

called

government provision of such goods. would have obvious companies difficulty recovering Many people might be willing to pay enough to cover the good, but if it is nonexcludable, the company cannot

Two

reasons

favor

the free-rider problem discussedin cost of additional users is zero once second, serving the good has been produced,then charging for the good would be inefficient, if there were some practical way even to do so. This inefficiency often characterizes the of collective for which it is possible to provision goods\342\200\224nonrival goods exclude nonpayers. Pay-per-view cable television is an example. People who don't pay to get HBO don't get to watch programs shown on HBO, a only restriction that excludes viewers who would have benefited from many watching. in is literally zero, excluding Since the marginal cost to society of their tuning easily charge

these viewers

(an

private good is one from one

which

availability 6

Chapter

can easily be excluded and nonpayers creates a one-for-onereductionin the good's

which

person's consumption for others. The theory of perfectly applies to pure private goods,of which

perhaps the best examples.A so-called

nonexcludable,

almost always result in a are an example.

pure

commons

developed products are in

competitive supply basic agricultural

is a rival

good

good

is

that

also

because goods with this combination of properties of the commons (see Chapter 10).Fish in ocean tragedy

waters

The classification schemedefined

propertiesis

summarized

which

one

others.

The rows the consuming

of

14.1. The columns of the of a good fails to diminish its availability for consumption in column are nonrival and those the left column are right

table indicate the difficulty Goods in the top row are

the

good.

Private goods

excludable.

are

cell)

(upper-right

by

and nonexcludable table indicate the extent

nonrival

the

in Table

person's in the

Goods

collectivegood a service that, to degree, is nonrival

at

or

good least

some

but

excludable

is wasteful.

A pure for

of example if the marginal

it

for

And

Chapter 11).

389

OF PUBLIC GOODS

PROVISION

GOVERNMENT

are

rival

and nonexcludable. The two hybrid which are rival but nonexcludable, cell), are excludable but nonrival.

cell),

unit consumed

means one for others

by

less unit

one

means one for others

by

less unit

one

and

row,

collective

Goods

Hybrid

Nonrival Low

High

Commons good in the ocean)

High

(fish

Public

good

defense)

(national

Nonexcludable Private

Low

Collective good

good

(wheat)

goods are provided sometimes by Most companies. pure publicgoodsareprovided can sometimes find companies profitable ways Collective

nonexcludable.

nonrival

and

covers

its costs

by

The mere fact

selling

(pay-per-view

by

government,

of producing An example is broadcast radio airtime to advertisers.

is a

pure public good doesnot

TV)

sometimes

government,

by private but even private

goods that are both

and television,

which

mean that the government ought provide only public goods governmentshould even consider providing are those whosebenefits exceed their costs. The cost of a public good is simply the sum of all explicit and implicit costs incurred to it. The benefit of a is measured how much provide public good by asking people would be willing to pay for it. Although that sounds similar to the way we measure that to

a good

it. On the

person

necessarily

contrary, the

a

person

available

TABLE 14.1

Private, Public,

be

each

pure commons good one for which nonpayers cannot easily be excluded and for which each

categoriesare and

easily

available

Public goods

and excludable.

nonrival which

bottom

the

nonpayers can excluded and for which

which

unit consumed

not.

from

nonpayers

excluding

nonexcludable;those in

cell)

(lower-left

commonsgoods(upper-left goods (lower-right

of

to

good onefor

pure private

Cost-Benefit

CHAPTER

390

14

PUBLIC GOODS AND

TAX POLICY

of a private good, an important distinction exists. The benefit of an of a private good such as a cheeseburger is the highest sum that any In individual would be to for it. the benefit of an contrast, buyer willing pay additional unit of a public good such as an additional broadcast of Sesame Street episode is the sum of the reservation prices of all people who will watch that episode. Even if the amount that all beneficiaries of a public good would be willing to if exceeds its of that makes sense there cost, government provision pay good only the

benefit

unit

additional

is no other lesscostly of providing way often for fireworks pay displays, they

put on theseevents. better off

we are

PAYING

if the

Finally,

example, whereascity

benefit of

governments

companies to

hire private

invariably

a publicgooddoesnot

its cost,

exceed

it.

without

GOODS

PUBLIC

FOR

it. For

almost

Not everyone benefits equally some people find fireworks about them, and still others of financing equitablemethod

from the displays actively

provision of a given

highly entertaining, dislike them. Ideally,

public others

but it

might

For example, don't care simply seem that the most

good.

in public good would beto tax people proportionto their to for the To illustrate this willingness pay good. approach, suppose Jones values a public goodat $100, Smith values the same good at $200, and the cost of the then be taxed $80 and Smith would be taxed $160. The good is $240.Joneswould in would be and each this would good provided, taxpayer example reap a surplus to 25 of his tax for for Smith. $20 $40 Jones, equal percent payment: In practice, however, officials government usually lack the information they would needto tax peoplein proportion to their willingness to pay for specific publicgoods. about it: If an IRS agent askedyou how much you would be (Think to to have a new freeway and willing pay you knew you would be taxed in proportion to the amount you responded, what would you The following three examples say?) illustrate some of the problems that arise in financing public goods and suggest solutionsto these possible problems.

EXAMPLE

14.1

Purchase

Joint

Will Prentice

Prentice and of

a given

shoreline

each must becoming

and

Wilson

own

Wilson

on

a water

buy

Cayuga

adjacent

filter? summer

Lake. Because

cottages

add chlorineto his water intake valve clogged

by the

tiny

mollusks.

along an

of a recent invasion each

of

week

A manufacturer

isolated stretch zebra

mussels,

to prevent

from

it

a new

has introduced

the nuisance of weeklychlorination. The cost which has the to serve both is B oth device, houses, $1,000. capacity owners feel equally But because Wilson earns strongly about having the filter. twice as much as Prentice,Wilson is willing to pay up to $800 to have the its value to Prentice, a retired schoolteacher, is only $400. Would filter, whereas either person be willing to purchase the device individually? Is it efficient for them to share its purchase? device

filtration

of

that

eliminates

the

will purchase the filter individually because each has a its But because the two price selling price. together value If its use would be efficient. $1,200, sharing socially they were to do if economic would be than did not buy the filter. $200 higher surplus they

reservation the filter at

Neither that

is below

so,

Since sharing the

Wilson would quickly

filter

reach

efficient outcome, we might to purchase it. Unfortunately, agreement

is the

expect

that

total

Prentice

however,

and

the joint

purchase and With

is often easier proposed than One accomplished. incur costs to to discuss people merely get together joint purchases. two people involved, those costs might not be significant. But if hundreds or of people were involved, communication costs could be prohibitive. numbers of people, the free-rider problemalso large

only

thousands

facilities

of

sharing

is that

hurdle

OF PUBLIC GOODS

PROVISION

GOVERNMENT

must

emerges(see

With

After

Chapter11).

of

independently

to withhold

all, everyone knows that the project will either succeedor fail thus has an incentive any one person's contribution to it. Everyone contributions\342\200\224or a free ride\342\200\224in the that others will give. get hope

I

%

c O

spa

Z 8>

tw

|*J*l

even when on a Finally, only a few people are involved, reaching agreement fair sharing of the total expense and Wilson may be difficult. For example, Prentice true reservation might be reluctant to disclosetheir prices to one another for the same reason that you might be reluctant to discloseyour reservation for a price

public good to

IRS

an

agent.

concerns may

These practical

behalf. But as the the need to reach political on our

on

agreement

empower government to buy public goods makes clear,this approach does not eliminate how public purchases are to be financed.

us to

lead

next example

Head

Will

buy

government

the water

Suppose Prentice and Wilson And suppose purchase.

filter

filter if there is

\"equal

the

EXAMPLE

14.2

tax\" rule?

the government to help broker the tax policy must follow a government's

ask

could that

an

Taxes

water

charging any citizen more for a public good Another rule is that public goods can be charges neighbor. if provided a of citizens of only majority approve them. Will a government bound by these rulesprovide the filter that Prentice and Wilson want? his

it

A

tax

that

Wilson.

against provide

the

prohibits

or her

the same amount from every citizen is called a head tax. If on a head it must raise from Prentice and $500 $500 tax, rely since the device is worth only to Prentice, he will vote $400 thus denying it a majority. So a democraticgovernment cannot

collects

the government must from

that

rule

\"nondiscrimination\"

than

But project,

the water

filter

if it

must

rely on

a head tax.

head the

tax same

taxpayer

a tax that amount

collects

from every

391

392

a tax

tax

regressive

under

proportion in taxes declines

paid

TAX POLICY

tax is a regressive

A head

incomethat

of income

the

which

PUBLIC GOODS AND

14

CHAPTER

as income

It goodconsidered. almost

14.3

EXAMPLE

third

example

government

all taxpayers

same proportion in taxes

worthwhile

to

this

public is to

problem

goods.

allow taxes

to

if there is

filter

proposes

a proportional

raise revenue

that the government

on incometo finance as much as Prentice,

the

water this proposal? of the

provision

support

tax on income? by filter.

a

imposing Will

Wilson,

tax is one under which all taxpayers pay the same in taxes. Under such a tax, Wilson would support if he didn't, each would fail to enjoy Prentice's proposal because a public good whose benefit exceeds his share of its cost. Under the proportional tax on income, Prentice would contribute toward the $1,000 purchase price of the filter and Wilson $333 would contribute $667. The government would buy the filter, resulting in

one

tax

income

which

equal-tax

earn

people

these circumstances will

under

rule

the provision of many one solution suggests,

the

buy

Prentice

that

Suppose

proportional tax who earns twice

under

always happen

different

whenever

Income Tax

Proportional Will the

proportional

out

rule

invariably

An

significantly

place

income.

by

vary

incomes.

different

As our

taxpayer's

of a taxpayer's

rises.

income

taxpayers

as will almost

goods,

public

significantly

the

whenever

applies

on

valuations

the proportion

illustrated by this exampleis not confinedto the specificpublic

The point

rises

for which

one

tax,

declines as the

in taxes

is paid

A

pay

of their

incomes

income

proportional of

additional

surpluses

The

incomes

their

percentage

example

following

often a poor way

The

makes the point goods, they

married

most

don't

Given

$20,000.

much more their

than

children,

happen

that

if

the

contributions a poor way to

as equal

just

are

also

often

are

share

couples contribute

equally to joint purchases?

Bill earns only her husband $2,000,000 per year while her income, Hillary as an individual would want to spend Bill would on housing, travel, entertainment, educationfor and the many other items they consume jointly. What will each must contribute an equal couple adopts a rule that earns

Hillary

Suppose

Wilson.

14.1

Naturalist

Economic Why

pay household.

the

within

and $133 for

for public

to

expenses

ar

for Prentice

of $67

amount toward the purchase

of such

items?

rule would constrain the couple to live in a small house, take only and skimp on entertainment, dining vacations, out, and their children's education. It is therefore easy to see why Hillary might find it attractiveto more than 50 percent for jointly consumed pay considerably goods because doing so would enable both of them to consumein the manner their This

inexpensive

combined income

permits.

Public goodsand Why

do

married

couples

usually

pool

their

individually Different

jointly

consumed individuals

consumed

private are

free to

goods

private goods are different in the following important

consume whatever quantity

and

from

way:

quality

THE OPTIMAL QUANTITYOFA

to buy, but jointly consumed goods must be and provided quality for all persons. As in the goods, people's willingnessto pay for public goods is generally an increasingfunction of income. individuals tend to assign Wealthy value to than low-income greater public goods people do, not becausethe A head have different tastes but because have more money. tax wealthy they would result in high-income personsgetting smaller amounts of public goods than they want. By increasing the total economic surplus available for all to a larger share of the tax burdento peoplewith share, a tax system that assigns incomes makes a better outcome for both rich and poor alike. higher possible all industrialized nations have tax systems that are at least Indeed, virtually in which means that the of income taxes mildly progressive, proportion paid rises with a income. actually family's and even proportional taxation often have beencriticized Progressivetaxation as being unfair to the wealthy, who are forced to pay more than others for public in in that all consume common. The this is that goods irony charge, however, exclusivereliance on head taxes, or even proportional taxes,would curtail the provision of public goods and servicesthat are of greatest value to high-incomefamilies. Studieshave for instance, that the income shown, elasticity of demand for publicgoods such as parks and recreation facilities, clean air and water, unconpublic safety, and is 1. gested roads, aesthetically pleasing public spaces substantially greater than Failure to rely on progressivetaxation would result in gross underprovision of such

of most

private goods they

PUBLIC

GOOD

choose

same quantity case of private

the

in

publicgoodsand

tax one in which progressive the proportion of income paid taxes

rises as income rises

services.

PUBLIC GOODS

RECAP

is both nonrival and nonexcludable.Private firms good typically recover the costs of producingsuch because goods they cannot exclude from them. Nor would charging for a public nonpayers consuming since one of the good does good promote efficiency, person'sconsumption not diminish its availability for others. A

public

cannot

Both obstacles can be overcome by creating Even high-incomecitizens often proportional or regressivetaxes may generate the those taxpayers favor. public goods to levy taxes.

OPTIMAL

THE

a government

the

with

power

taxes because progressive insufficient revenue to pay for

favor

OF A PUBLIC GOOD

QUANTITY

considered thus far, the question was whether to provide a particular and, if so, how to pay for it. In practice, we often confront additional questionsabout what level and quality of a public provide. Standard cost-benefit New logic also applies to these questions.For if and York should add another rocket to a fireworksdisplay City only if the amount that citizens would be willing to pay to see the rocket is at least collectively In

the

public

examples good

goodto

as great as its

THE To

calculate

important

example,

cost.

DEMAND

the demand

393

the

CURVE socially

FOR A PUBLIC

optimal

quantity

curve for that public way from the one we

private good.

good.

of

GOOD

good, we must process for doing

a public

The

use to generatethe

market

construct

first

so differs

demand

curve

in

an

for a

a

Cost-Benefit

in

14

CHAPTER

394

14.1

FIGURE

the Market

Generating

Demand Curve

for

'E

a

To construct

the

demand curve

'E 24

24

^3

CO

TS

($/unit)

Good.

Private

^

V

=V

\\a

market Price

a private

for

good (c), we add the individual demand curves and

TAX POLICY

PUBLIC GOODS AND

0

24

O

0.

(a)

36

9

0

9

0 = Q,

+

(a)

(b)

60 +

(b) horizontally.

private good, all buyers each choosesthe quantity purchase at that price. Chapter 5 to construct the demand For a

FIGURE

14.2

Generating the Curve

Q2

(c)

for a

To construct curve for a

Price

Demand

Public Good. the

public

demand good

($/unit)

42

\\i

(a),

face

price and wishes to private

D=

D^

+

D2

consumers,

sideby

we add the individual demand curves (b) and (c) vertically.

side

Recall curve

same she from

for a

curves for individual the individual demand curves them horizontally. That is, for

we place and add

series of

of a

each

or

the demand

from

good

the he

fixed prices,we

add

the

resulting

demanded on the individual demand In Figure 14.1, for example,we add the curves. individual demand curves for a private good, D1and (a) and (b)], horizontally to obtain the D2 [parts market demand curve for the good D [part (c)]. quantities

8 ^^>

0

36

r>

Q

(a)

Price

For a public

($/unit) consume

24

terms of

^V ^V.

24 36

Q ^2

willingness

must add the prices that pay for an additional unit

(b)

Price

and D2 in

($/unit)

demand

18

people.

^i 0

24

quantity,

good. Constructing of the good thus entails not horizontal summation individual demand curves but vertical summation. That is, for each of a seriesof quantity we values,

8

0

all buyers necessarily although each may differ in to pay for additional units of the the demand curve for a public

good,

same

the

36

Figure

14.2(b)

for a

curves

At each

good. The

(c) show

and

public good

quantity,

are

individuals of the

these

curves

by

two

willing

to

curves D1 individual

different

tell how much to for an pay

the individual would be willing additional unit of the public good. If we add D1and we obtain the total demand curve D for D2 vertically, the public good [part (a)].

Vl

(c)

CONCEPT CHECK 14.2 Bill

and

\342\200\224

0.5Q

are the only and Tom's is PT

Tom

In the might optimal

be level

demanders =

12

of a public the Q, construct

\342\200\224

following example, we

in conjunction with in a city. of parkland used

see how information

the

good. If Bill's demand curve is P6 = demand curve for this public good.

demand about

curve costs to

6

for a public good determine the

OPTIMAL

THE

the

Using

Curve to Determine

Demand

optimal

of

quantity

The marginal

EXAMPLE

Levels

GOOD

395

14.4

then

to more

urban

parkland

The city acquires the

Principle:

turns

how much curve for

decide demand

curve

cost

these

urban

upward-

curves, what is the

parkland?

cost schedulefor

Low-Hanging-Fruit

only

PUBLIC

is the

of urban optimal quantity parkland? The city government of a new plannedcommunity must parkland to provide. The marginal cost curve and the public in Figure 14.3. Why is the marginal parkland are as shown Given sloping and the demand curve downward-sloping?

What

Optimal

OF A

QUANTITY

expensive parcels.

is upward-sloping

cheapest parcels of

Likewise,the

marginal

because of the land

first

and

willingness-to-pay

downward-sloping becauseof the law of diminishing marginal utility. Just as to pay less for their fifth hot dog than for their first, people are generally willing they are also willing to pay less for the 101st acre of parkland than for the 100th acre. Given these of parkland. For any quantity less than curves, A* is the optimal quantity A*, the benefit of additional parkland exceedsits cost, which means that total economic be made larger by expanding the amount of parkland. For example,at AQ, the surplus can would be willing to pay $200,000 for an additional acre of urban community its cost is only for any quantity of parkland in excess of parkland, but $80,000. Similarly, off some parkland. A*, the community would gain more than it would lose by selling curve is

Marginal

cost

Demand

A)

A*

Acres of parkland FIGURE

14.3

The Optimal The

optimal

Quantity of

number

of acres

Parkland. of urban

PRIVATE

PROVISION

is A*,

parkland

the quantity at which the public's willingness additional parkland is equal to the marginal parkland.

pay for cost of to

OF PUBLIC GOODS

One of using the government to provide publicgoodsis that once a tax advantage collection agency has been established to finance a single public good, it can be at relatively low cost to generaterevenue for additional expanded public goods. Another advantage is that because has the government power to tax, it can for the cost of a publicgoodwithout endless summarily assign responsibility haggling over who bears what share of the burden. And in the case of goodsfor which noncannot be the be the feasible excluded, payers government may only provider. But exclusive reliance on government also entails disadvantages. Most the one-size-fits-all fundamentally, government's approach invariably requires many don't to do without want, while others end up having people to pay for public goods they

Increasing

a a

Opportunity

Equilibrium

Cost

CHAPTER14

PUBLIC

AND TAX

GOODS

POLICY

desperately. For example,many people vehemently oppose in the public schools, while others fervently education believe that far more such instruction should be provided than is currently offered in most current school curriculums. taxation strikes public Mandatory many people as if even of the coercive, they approve particular public goodsbeing provided. It is no surprise, then, that are not the exclusive providers of governments in any society. Indeed, many publicgoods are routinely provided through public goods in channels. T he each is to devise a schemefor raising the case, private challenge, revenues. Here are some methods that seem to work. required they want

goods

public

of any

the provision

sex

by Donation

Funding

In 2008Americans

more

gave

public goods

provide

to their

$300 billion to private charities,many also volunteer their time People goods. When you paint your house,

than

of

of organizations that provide public or plant a flower garden, you are lawn, in that sense you are voluntarily and neighborhood,

enhancing providing

the quality of life in a public good to

which

on behalf

communities.

mow your

your

your neighbors.

Development of New Meansto Exclude Nonpayers

makes it possible to exclude technology nonpayers from many in the could not be thus restricted. For broadcast instance, goods past television stations now have the ability to scramble their signals, making them available to those consumers who purchase descrambling devices. only electronic

New

that

Private Contracting

Americans now live in gated private communities\342\200\224private that wall off contiguous properties and provide various services to residents. Many of theseassociationsprovide services, schools, and fire security in other ways function protection and much like ordinary local governments. Recognizing that individual incentives levels may not be strong enough to assuresocially optimal of maintenance and landscaping,these associations often bill homeowners for those services directly.Many of the rules imposed by these associations are even more restrictivethan those that is defended on the imposed by local governments, a distinction if they don't grounds that people are always free to choosesome other neighborhood like the rules of any particular homeowners' association. Many peoplewould be 8 million

than

More

associations

homeowners'

reluctant to

ordinance restrictions are common

a municipal

tolerate

yet such

purple,

that

bylaws

Sale of By-Products

are financed

goods

public

Many

by

the

sale

of the public goods.For instance,

by-products

is a

programming

good

public

that

up or Given

it

might

appear the

seem

headers

the

in

quintessential^

reliance

that

proved feasible. But as entails problems of its

^%'// \342\200\224^

the

is paid

In a given

the Jerry

networks

time slot, a

or margins

as

are

generated

as

noted

of web pages.

nature of privately provided publicgoods, voluntary on private provision might be preferred whenever it makes often clear, private following example provision

14.2

Naturalist

do television

or servicesthat

houses

own.

The Economic Why

of rights

their

associations.

earlier, radio and television for in many cases by the sale of advertising in part by commercial messages that

messages. Internet servicesare also underwritten pop

from painting of homeowners'

people

prevents in the

favor Jerry

television network

Show or

Springer over faces

Masterpiece Theatre. If

the

Masterpiece

alternative

Theatre?

of broadcasting

either

Springer Springer, it will win 20 if percent of the but 18 it chooses audience, viewing only percent Masterpiece. Suppose those who would choose Springer would be willing to pay $10 million collectively for the right to see that program, while those who choose Masterpiece would be And to million. that the time slot is to be financed $30 willing pay suppose, finally, by a it chooses

THE OPTIMAL QUANTITYOFA

detergent company. Which be socially optimal?

will the

program

network choose? Which

program

PUBLIC

397

GOOD

would

maker cares primarily about the number of people who will see its and will thus choose the program that will attract the largest audience\342\200\224 the Springer Show.The fact that those who prefer Masterpiece would be willing to here, a lot more to see it is of little concern to the sponsor.But to identify the optimal pay result from society's point of view, we must take this difference into account. Because the people who prefer Masterpiece could to pay the Springer viewers more than enough them for relinquishing the time slot, Masterpiece is the efficient outcome. compensate But unless its supporters happen to buy more soap in total than the Springer viewers, the latter will prevail. In short, reliance on advertising and other indirect mechanisms for the chosen will maximize financing public goods provides no assurance that goods A

detergent

advertisements

economic

surplus.

Of

course, needs

advertisers'

government

imagine,for

choose television

few of us

that

but

the fact that the programs that best suit not be may socially optimal doesnot mean that decisions would necessarily be better. One can a cultural affairs ministry that would example, that would be \"good for us\" programming

One way

would want to

watch.

the inefficiency that arises when advertisers choose is to programming employ pay-per-view methods of for television programming. These methods paying allow viewers to register not just which programs they prefer but also the strength of their preferences,as measured by how much they are willing to pay. But although pay-per-view TV is more likely to select the the most it is also less efficient than values, programs public to

broadcast TV

in

avoid

one

important a fee for

respect. As noted

w\\\\\\vv\\

Why

size to

-TTJiTnTTY^-

do detergent companies care more about how much people would

than

see the

earlier,

programs they

about

sponsor?

households from tuning in. additional household is serving exactly in this way is inefficient. Which the audience of the two inefficiencies zero, limiting in choosing among programs or pay TV's is more important\342\200\224free TV's inefficiency household

chargingeach

since

And

the marginal

viewing

social cost of

in

inefficiency

In

any

excluding potential the mix between event,

some

discourages

an

an

beneficiaries\342\200\224is

empirical

private and public provision

question. of

public

goods

and

services differs substantially from to society and from arena to arena within society These differences on the nature of available any given society. depend technologies for deliveringand paying for public goods, and also on people'spreferences.

The

the

much is economic

charge

per-view if

of Pay-Per-View

surplus reducedby Mystery Theater is shown on pay-per-view demand curve for each episode is as given

By how

If

Impact

same

the

With a fee of

charge?

at 10 p.m. on Thursdays, If the regulated pay14.4. Figure much would economic surplus rise broadcast TV? public

television in

per household, by how were shown instead on \"free\"

is $10

episode

a pay-per-view

on Economic Surplus

10 million householdswill watch (see Figure 14.4). were shown insteadon broadcastpublic TV, 20 million episode households would watch. The additional economic surplus reaped by the extra 10 million households is the area of the blue triangle, which is $50 million. The marginal cost of these additional householdsto watch the is so the total zero, permitting episode gain in surplus is $50 million. But

if

the

same

$10

per episode,

EXAMPLE

audience

be willing

14.5

to

pay

398

CHAPTER

14

TAX POLICY

PUBLIC GOODS AND

14.4

FIGURE

The Loss in Surplus from a Pay-per-View Fee. as many households Twice would

the

watch

its price

were zero

In general, in a loss cost

elastic, to see

loss

the

that

the

area

a good whose marginal cost is zero will loss that results when price is set above surplus. on the When demand is more depends price elasticity of demand. in surplus is greater. Concept Check14.3provides an opportunity

CHECK 14.3 answer

your

to the

been as shown

THE

the

demand curve

demand

curves

of

quantity

vertically.

public

goods

Optimal

if

the

demand

the

intersects

always be the by

GOOD

PUBLIC

for

every consumer,

by adding individual

production of a publicgoodoccurs

demand curve

need not

contributionsor the can becomeproviders

QUANTITY OF A

a public good must be the same a public good is constructed

good.

Such goodscan be provided

different

been

below?

for

for which the

Government

previous examplehave

OPTIMAL

Because

convert

for

price

at work.

the total

public

(millions)

size of the

The

in

RECAP

the

households

Viewing

charging a positive

curve had instead

quantity

20

10

principle

CONCEPT

How would

from

fee

instead

economic surplus is of the blue triangle, or $50 million.

marginal

$10 viewing

additional

of $ I O.The

result

Lost surplus

if

program

private

best

way

organizations

of by-products. Private when new technologies such

sale

into collective

goods.

marginal to provide

at

cost curve

the

for

public goods.

that rely on

charitable

for-profit companies as pay-per-viewtelevision

also

THE

AND

REGULATIONS,

LAWS,

AND THE

REGULATIONS,

LAWS,

QUESTIONOF CENTRALIZATION

QUESTION

OF CENTRALIZATION The

goods is not the only rationale for the creates and enforces the rules without

of public also

provision

government.

Government

of private goodswould

production

AND

EXTERNALITIES As

we

saw

allocation

unlikely

to

of the commons).

the

which

efficient

be possible.

PROPERTY RIGHTS

in Chapter 10, externalities often in private activities. We result whenever property rights

resource

tragedy

not

of

existence

in the

stand

too,

saw,

that

way of optimal

are poorly defined

These observationssuggest

the

socially optimal

allocations are

(for

existence

the

example,

of two

roles for government: the regulation of activities that generate and the definition and enforcement of property rights. These rationales for government action explain why most governments

additional

important

externalities

that an generate pollution, subsidize education (on the grounds creates control access to waters and externalities), public positive fishing in and enforce laws. Most laws, fact, represent attempts public timberland, zoning to define property or to control externalities.The law requiring motorists to rights drive on the right, for example, is an attempt to prevent the activities of one regulate

that

activities

educated

motorist from

causing

to others.

harm

Proponents freedomwhen

minimalist

of

curtails our

fines imposes such regulations or

government it uses

zoning

often

laws to

on motorists who violate highway is precisely the sameas for the

object speed

the

that

the

limit

government

unjustly

the houses we build Yet the justification for

size of

limits.

that prohibit your fist from the same as nose. You are free to swing your occupying physical space your neighbor's as you please, provided you cause no harm to others. But if your fist strikes your neighbor's nose, you become a violator of the law and subject to punishment. If the proponents

minimalist

of

government

laws

approve of restricting

behavior in

this

way,

fists

why do

that cause harm to others? they disapprove attempts to discouragebehaviors their fear is because externalities are so that, Perhaps pervasive, governments that were empowered to regulate them might quickly get out of control. This is by no means an idle fear, and we emphasize that the mere fact that an externality exists does not necessarily mean that the best outcome is for the government to regulate it. As we will see in the next section, regulation entails costs of its own. The ultimate question is therefore a practical one:Will government of the regulation in do more than harm? about free to live externality question good Slogans being in without interference little such government provide help answering questions.

of other

STATE, OR

LOCAL,

FEDERAL?

of the U.S. Constitution were deeply skepticalof centralized government In the the powers Constitution, therefore, they explicitly tried to limit power. drafting of the federal government as much as possible, most delegating important powers to in the who turn of their to states, delegated many powers governments at the locallevel. Framers

the dangers of remote, centralized government ranked high in their memories was the fathers' concerns. After all, fresh among autocratic treatment received the American colonies at the hands of the monarchy in by will The fathers that be more responsive England. founding recognized government the shorter the distance between officeholders and the voters who electthem. It is

no surprise founding

that

the

Another

obvious

is that

of giving as much advantage communities often have

authority

to

local

governments

markedly different preferences about how much to spend on public goods, and even on what kinds of public to W hen such decisions are made at the local level,peoplecan shop goods provide. for a community whose voters' preferences largely coincide with their own. Those as possible

different

399

400

CHAPTER

14

PUBLIC GOODS AND

TAX POLICY

can band together high levels of public goodsand services to pay for them. Others who place less value on public communities in which both services and taxes are lower.

who

like

high

taxes

choose

the

given

Why,

of decisions made

attractions

many

the

at

and authorize can

services

local

level,

did the

One reasonis governments to survive it must be able to deter politically, A hostile aggressionby governments. country consisting only of, say, Concord, New would be ill-equipped to do that. Large,well-equipped armies Hampshire, and navies cost a lot of money, and countries without sufficient population simply and founding fathers create federal in defense. For a country economies of scale

them.

afford

cannot

at all?

state

Defense, however, is not the only reason or state level. The problem of pollution,

local

sources of

the various

Much of the acid rain experienced dioxide emissions from industrial

government. sulfur

of

result

not subject

are

pollution

United States. Theseemissions

are

instances, as

In many

regulations.

governments beyond the is

to

difficult

sources in

the

Midwest

upper

of Canadian

discharge

North,

of the

environmental

gases, not even America would

of greenhouse and South Central,

the

when

solve

to regulatory control by a single in Canada, for instance, is the

the reach

beyond with

of all the governments in to take effective action.

a coalition

to empower for example,

Carbon dioxide emitted

on the anywhere the globe in a matter of months. of government, then, often confronts us with difficult trade-offs. the of taxation to a federal government often Ceding power in entails painful for voters individual states. But the loss of political compromises is an even less attractive nations are autonomy option. Similarly, understandably reluctant to cedeany of their sovereign powers to a higher but failure to authority, take such stepsmay entail unacceptable environmental costs in the long run. have

power

concentrations planet disperses to uniform The choice betweendifferent levels

around

LAWS, REGULATIONS, AND

RECAP

THE QUESTIONOF

CENTRALIZATION

creates

Government also

but

and

by

activities

property

enforcing

governments

economic

regulating

rights. These subsidize

pollution,

regulate

surplus not only by providing public goods that generate externalities and by defining

rationalesexplain why

education,

most

control accessto fishing

waters

laws. timberland, and enforce zoning the framers of the Constitution dislikedcentralized Although government are not best power, they recognized that some government functions performed at the local or even state level. Economies of scale argue for provision of defense at the national level. Externalities that transcend local boundaries or even international provide an additional rationale for national government.

and

public

SOURCES OF INEFFICIENCYIN THE POLITICAL PROCESS In

most

countries, expenditures in large are determined

behavior

This

representatives.

\"the worst the

public

Barrel

The following private

life,

the

for

of democratically Churchill

any other.\") or

ignorant

called

elected

democracy

Inefficiencies often arisein but because of legislators

problems.

Legislation example,

illustrates

goods, tax policy, and laws regulating

votes part by from perfect. (Winston

form of government, except sphere not because of incompetent incentive

structural

Pork

process

is far

on public

drawn

one of the

public sector but incentive important gaps. not from the

from

everyday

does

Why

and

Sven Torvaldsen

simplify

of

task

the

arrives with are pumpkin

reservation

respectively.

Will

%

higher?

which

two

Sven's

in

advance

one-tenth

the waiter items

favorite

and chocolate mousse ($6). items are $4 and $3, dessert, and, if so, which one? Would he

order

he

^N

($10) for these

pudding prices

order dessertif

agreed

equally, with each paying cleared the entree dishes,

menu, on

were

he

dining

by

himself?

When Sven and his friends split the total of the menu payment goes up by one-tenth he orders. Thus, the prices\342\200\224to him\342\200\224ofthe

chocolate mousseare $ I and 60 = $3 of consumer $ I gets $4 \342\200\224

check equally, price of any

Sven's dessert

bread pudding and respectively. Because he from the bread pudding

cents, surplus

= $2.40

from the chocolate mousse,he will If Sven order the bread pudding. were dining alone, however, his bill would increase dollar for dollar with the menu price of any dessert he ordered. And since the menu exceed his prices Doescheck-splitting make reservation corresponding prices, he would not order dessert at all. dessert? if Sven's The irony, of course, is that nine friends have the same each will order bread pudding and each person's share of the dessert, preferencesregarding total bill will rise not by $ I but by the full $ 10. Compared to the alternative of no one having each diner suffers a $6 loss in consumer dessert, Still, it made sense for each to surplus. order bread pudding, since failure to do so would have reduced each diner's bill by only $ I. and

\342\200\224

$3

only

$0.60

more

people

likely

to

order

CHECK 14.4

CONCEPT The

Economic

only 5

people

In

401

having dinner at La Maison in Minneapolis. To

meal

dessert

bread

Sven's

restaurant bill

meal, they have

their

for

paying

the

restaurant

four-star

the cost of their total check. Having

to split of the

are

friends

nine

de La Casa House,a

the total

make

check-splitting

QUESTIONOF CENTRALIZATION

14.3

Naturalist

Economic

The

AND THE

REGULATIONS,

LAWS,

Naturalist the

splitting

14.3, would check

have

Sven

ordered

dessert

if

there

had

been

of 10?

instead

have noticed the similarity between the problem posedin the and the one posed in Chapter 10, The Economic Naturalist 10.4, preceding example in which identical twins had a single milkshaketo share with two straws. The same incentiveproblemleads to the inefficient outcome in both cases. readers

Alert

will

Economic Naturalist illustrates how in the rears its head problem legislative process. The

following

The do

Why

barrel

Pork

questionable

often

exceeds

project

that

same

incentive

Naturalist

Economic

one another's pork barrelspending

14.4

taxpayers. generates

a congressional

district

Suppose that voter's benefits of $100 million

that contains one one-hundredth

representativeis able for

the

district

to

but

deliver that

Ifc

programs?

that benefit local areas but are of programs are government programs from a national perspective. Why do voters seem to support legislators such projects even when the total effect of all such projects on local tax bills the local benefits?

Consider a voter in country's

support

very

value

initiate

who

far

legislators

the

of the

a public costs the federal

pork barrel

spending

a public

than expenditure the total benefit it creates but that is favored by a legislator because his or her constituents is larger

that

benefit by

more

resulting

from the

expenditure share of the

than their extra

taxes

402

CHAPTER

TAX POLICY

PUBLIC GOODS AND

14

$150 million. Since the district's share of the tax bill for the project will be 150 million/100 = $ 1.5million, residents of the district are $98.5 million better off with the project than without it. And that explains why so many voters favor legislators with a successful record of \"bringing home the bacon.\" A support such a project in legislator But why would B's home district? legislator After A's constituents' taxes to rise\342\200\224albeit by a small amount\342\200\224 all, B's project will cause the answer is that if A does not yet they will get no direct benefit from projectThe government

only $

whereby

practice

legislators support one legislative proposals

another's

B

practice whereby legislatorssupport This practice creates a bias toward excessive much like the bias created when a dinner check is split equally, spending, ^^^^^^^^^^^^^^^^^^^^^^^^^^\342\200\224^^^^^^^^^^^^^^^^^^^^^^^^^^\342\200\224 B's

support

the

logrolling

then

project,

one another's

A's.The support as logrolling.

not

will

pet projectsis

known

Rent-Seeking A

of inefficiency in the public sphere occurs because the gains from in are often concentrated the hands of a few beneficiaries, projects costs are spread among many. This means that beneficiaries often have a source

related

government the

while

public projects. Individual taxpayers, by contrast, project and therefore have in opposition. little incentive to incur the cost of mobilizing themselves for that a bill for Suppose, example, price support sugar will raise the price of 10 cents and that the American sugar by per pound average family currently consumes 100 of sugar per year.How will this legislation affect the average pounds of sugar? Recall from the chapter on demand that a good such as family's consumption salt or sugar whose share in most family budgets is small is likely to have a low price will decline only slightly each elasticity of demand. family's sugar consumption as a

to

incentive

powerful

result of the

and organize have little at

Hence,

10-cent pricehike.The resulting

expenditures on sugar\342\200\224roughly enough to induce many people will

legislation,however,

industry

that the

is certain

family's annual

burden, and surely not

to their representatives.The

revenues

vote against

citizens

don't

Why

to complain

in each

increase

a noticeable

$10\342\200\224is scarcely

raise sugar

large at stake, it

sum that

lobby in favor of stake in any public

by

nearly $1 billion will

industry

lobby

those legislators who

same With

annually.

vigorously

support such

a

in its

favor.

bills?

One

in Chapter 11. Most voters is the problem of rational discussed ignorance, have no idea that a price supportbill for sugar and other special-interest bills even much less how individual legislators vote on them. If all voters became wellexist, in the quality informed about such bills,the resulting increase of legislation might well be sufficient to compensateeachvoter for the cost of becoming informed. But because of the free-rider problem, each voter knows that the outcome of votes in will not be much affected whether he or she becomes well-informed. Congress by reason

Still benefits

other

its

announced

of inefficiency arise even in the case of projects whose costs. In the 1980s, for example,the federal government decision to build a $25 billion research facility (the high-energy physics sources

their

exceed

\"superconducting supercollider\,") which ignited an intense competitionamong 20 states vying to be chosen as the site for this facility. Hundreds of millions of dollars were spent on proposal preparation,consultants' and various fees, other activities. Such investments are known as and lobbying rent-seeking, they

morethan rent-seeking unproductive

or firms

the

socially

efforts of people

to win a

prize

tend to be inefficient

for

same reason

the

incentive problemillustrated

EXAMPLE 14.6

that

(see Chapter positional arms races are inefficient Efforts devoted to rent-seekingare socially in

the

investments

by contestants

in other

10). unproductive

because

of the

simple

example.

following

Incentives Why

would

Suppose

particular

anyone a $20

bill

auction

for a

$20 bill? is to be auctionedoff pay $50

require

an

initial

bid

to

of at

the

highest

least 50

rules of this and cents, succeedingbids bidder. The

REGULATIONS,

LAWS,

AND THE QUESTION

OF CENTRALIZATION

must exceed the previous high bid the ceases, by at least 50 cents. When bidding both the highest bidder and the second-highest bidder must give the amounts they bid to the auctioneer. The highest bidder then receives the $20, and the secondif bidder For the bid is $11 and the secondhighest getsnothing. example, highest \342\200\224 = bid is the winner earns a net of $20 $11 $10.50, $9, and the highest payment will loses How the bid on $10.50. be, runner-up high winning average?

in these

subjects

although

have been extensively studied have from experiments ranged

this one

like

Auctions

undergraduates, the pattern offers

bid,

opening

of

is almost

bidding

proceed quickly to $10, or

in the

laboratory.

always the same. amount

the

half

And

to college

executives

business

Following the

being

A

auctioned.

to digest the fact that with the next bid the pause then occurs as the subjects appear sum of the two highest bids will exceed $20, thus taking the auctioneer off the hook. At this the second-highest bidder, whose bid stands at $9.50, offers point, invariably a shot at to a sure loss of $9.50 $9.50. $10.50, apparently preferring winning In most cases, all but the top two bidders drop out at this point, and the top two escalate their bids. As the a second this occurs, quickly bidding approaches $20, pause time as the bidders appear to recognize that even the highest bidder is likely to come out behind. The second-highestbidder,at $19.50, is understandably reluctant to offer $20.50.But consider the alternative. If he drops out, he will lose $19.50 for sure. But if he offers $20.50 and wins, he will lose only 50 cents. So as long as he thinks there is even a small chance that the other bidder will out, it makes sense to continue. drop Oncethe $20 threshold has been crossed, the pace of the bidding quickens again, and from then on it is a war of nerves between the two remaining bidders. It is common in frustration. for the bidding to reach $50 before someonefinally yields

One might be tempted to think that well-informed any intelligent, person would know better than to become involved in an auction whose incentives so have strongly favor costly escalation.But many of the subjects in these auctions in been experienced business professionals; others have had formal training many the theory of games and strategic interaction.For example, Max psychologist Bazerman one $17,000 reports that during 10-year period, he earned more than by $20 bills to his MBA students at Northwestern auctioning University's Kellogg Graduate School of Management, which is consistently among the top-rated MBA in the world. In the course of almost 200 of his auctions, the top two programs bids never totaled less than $39, and in one instance they totaled $407. in the $20 bill auction are strikingly The incentives that confront participants similar to those that confront companies that are for lucrative government vying contracts. Considerthe following example.

much

How

The State

will

cellular

companies

phone

bid for

Exclusive License

for an

Bidding

an exclusivelicense?

has announced its intention to grant an exclusivelicenseto services within its borders. Two firms have met the deadline provide phone for applying for this license. The franchise lasts for exactly one year, during which time the franchisee can expect to make an of million. The $20 profit of Wyoming

cellular

economic

state legislaturewill

legislators.

If the

If both

spendthe

If

the

lobbyists

amount on

applicant

cannot collude,

applicants

which means an

the

choose

same,

each

expected profit could

lobbying.

in

how much

will

most money

each

spend

lobbying

on lobbying?

will have a 50-50 chance at the $20 million prize, $10 million minus the amount spent lobbying.

of

collude, each But

that spends the

the

would agree to

absence

spend

of a binding

the

same

small,

token

agreement, each will

be

EXAMPLE

14.7

403

404

CHAPTER 14

PUBLIC

GOODS

AND TAX

POLICY

reaches outspend the other. Once eachfirm's spending an expected of zero 50-50chanceto earn $20 (a profit minus the million on $10 million, spent lobbying). Further would an expected loss. And yet, if one firm spent bidding guarantee $10,000,001 while the other stayed at $10 million, the first firm would get the franchise for sure and earn an economic profit of $9,999,999. The other firm would have an economic loss of $10 million.Rather than face a sure loss of $10 million,it may be tempted to bid $10,000,002. But then, of course, its rival would face a similar incentive to respond to that bid. No matter where the escalation stops, it is sure to dissipate much of the gains that could have beenhad from the project. And perhaps, as in the $20 bill auction, the total amount dissipated will be even more than the value of the franchise itself.

to try to

tempted

strongly

$10 million,

From

each

will

have

this

however,

educated,

perspective, it's easy to

the individual

fashion for a chance to

win

benefits.

government

is almost purely wasteful. and socially skilled. The opportunity

activity

seewhy From

firms

might

Lobbyists are typically cost

lobby

in this

society's perspective,

of their

intelligent,

well-

time is high. If they

clients, they could be can discourage such according to the amount they spend lobbying but on the basis of the price they to charge for their services. Society will promise be more successful the more its institutions citizens to pursue activities encourage that create wealth rather than activities that merely transfer wealth from existing one person or company to another.

were not lobbying government

of

value.

behalf of their Governments

Government?

the

Starve

on

officials

producingother goodsor services waste by selecting contractors not

Nobel laureate Milton Friedman said that no bureaucrat spends taxpayers' money as carefully as those taxpayers themselves wouldhave.And there can be indeed, little doubt that many government are wasteful. the fact that expenditures Beyond in often results barrel that would not the costlogrolling pork programs satisfy benefit test, we must that government face worry employees may not always strong incentives to get the most for what The for they spend. Pentagon, example,once a coffeemaker for $7,600 and on another occasion purchased paid $600 for a toilet seat. Suchexpendituresmay have been aberrations, but there seems little doubt that private contractors often deliver comparableservices at substantially lower costs than their public counterparts. In their understandable outrage

over

government

waste,

many

critics have

goods and services.Thesecritics if we let the government spend more money, reason that there will be more waste. This is true, of course, but only in the trivial sense that there would be more of

urged major cutbacks in the

everything

the

government

volume

does\342\200\224good

One of our most extensive reductions

in government

spending

of public

and

experiences

comes from the

bad\342\200\224ifpublic

with

spending

the consequences

Proposition13 movement

were higher.

of major in California.

of State Proposition 13 in 1978, which began passage reductions in property taxes. As Californians have belatedly for government waste is like trying to starve a tapeworm by not recognized, this remedy does harm the sure but it harms the host even eating. Fasting tapeworm, enough, more. Residentsof the Golden State, who once proudly sent their children to the nation's best schools, are now sendingthem to some of its worst. The physician treats an infected patient by prescribing drugs that are toxic to the A but not to the host. similar should parasite strategy guide our attack on government

This movement mandated large

waste. that tobacco

For

example,

would industry

prevent and

with

the

the adoption of campaign-finance reformlaws from from the legislators accepting campaign contributions other special interests whose government subsidies they support.

we

might

consider

WHAT SHOULD

The question, Rather,

money. services?\"

Although

that

remember

then, isn't whether

SOURCES OF

RECAP

barrel

a source of

money.

more

function

economy

efficiently,

it

but

example, legislators may support pork do not satisfy the cost-benefit criterion but which benefit more than their share of the extra taxes to by required pay for

can be

For

waste.

which

projects,

constituents the

our

for

INEFFICIENCYINTHE

to help the

does much

Government

government

against

PROCESS

POLITICAL

also

money

deliver good value

public services

many

how to spend our to spend on public waste, we also must

want

we

do

405

TAX?

best

know

bureaucrats

\"How much of our we must remain vigilant

it's

WE

projects.

a second important source of inefficiency, occurs when resources in an effort to win favors from the government.Voters because the discipline legislatorswho abet rent-seeking free-rider problem gives rise to rational on the of voters. ignorance part many Concern about government waste has led many to conclude that the best is t he smallest one. The solution favored these government necessarily by critics is to starve the amount of it can collect in government by reducing money taxes. Yet starving the government reduces one kind of wasteonly to increase another exceeds their cost. by curtailing public serviceswhosebenefit Rent-seeking,

use real often fail to

firms

or

individuals

the

Although

to fund

WE TAX?

SHOULD

WHAT

public goods and other

other consequences, someintended, costs and benefits of engagingin of real purchasing powerin the side deleterious,

Although

1990s,

different

economy.

then

until

fact that increases

causing firms to government

had to borrowtrillions the

century,

phenomenon

its demand

in the

cancelsomeof

their

modest

since dollars

of

1969, during to pay its bills. And in

market for borrowedfunds,

late

in the

time now,

deficit.

borrow money in the call crowding out. When

corporations

economists

same crowding out

rates

interest

rise,

projects. When the

investment

planned

particularly

surplus

which

budget is again

federal

governments and private

a

the amount enough revenue from taxes to cover it thus diverts funds from investments that services,

to raise

it spends would

the economy

to grow.

about

the

of taxes

on

have

on incentives?

Taxes will hold production and in in markets which the costs optimal private with all relevant social costs and benefits.Suppose, for that the long-run private marginal cost of producing cars is $20,000 example, in unit and that the demand curve for cars is as shown per Figure 14.5. The If equilibrium and will be 6 million and $20,000, quantity price per year respectively. What

effect

consumption below socially and benefits coincideexactly

levels

no externalities the per

or accompany the production levels for and socially optimal quantity price. car, the new equilibrium price and quantity

respectively.The loss in

economic

surplus

will

consumption But if we will

be

be equal

of cars, these will be now add a tax of $2,000 $22,000 and 4 million,

to the area of

the

borrowing interest

and

fails

public goods helped

or least

beneficial,

criterion, the federal tax system has not performed

capital market explainsthe government

most

the

having

the federal budget began to show it had been in continuous deficit

the federal government early in the twenty-first The

many

For example, taxes alter the relative activities. They also affect the distribution The best tax system is one that raises the not.

others

effects.

On the first well.

needed

revenue

also have

taxes

expenditures,

government

revenues while at the same time

needed

system is to generate the

of the tax

purpose

primary

blue

firms

government

that leads

to

higher

rates, causing private to cancel planned

investmentprojects (i.e., the tendency of increased government deficits to reduce investment spending)

CHAPTER

406

14

PUBLIC GOODS AND

TAX POLICY

sum of the differences ($2 billion per year), which is the cumulative between what excluded buyers would have been willing to pay for extra cars and the marginal cost of producing those cars. Economists who write for the popular press have focused on the loss in long in caused taxes like the one shown 14.5. These economists surplus by Figure argue that the would perform better if taxes were lower and total economy government expenditures were smaller. if a tax But for that claim are far from compelling.For example, even arguments in a market like the one shown in Figure 14.5 did produce a loss in surplus for in if that it nonetheless be it led to an even market, participants might justified from the public expenditures it financed. larger gain in surplus Another with the argument that taxes harm the is more difficulty economy in that taxes need not cause loss at all, even in fundamental\342\200\224namely, any surplus in which they the markets are for directly applied. Suppose, example, that in the market for cars considered earlier, cost is private marginal again $20,000 but that the production and use of carsnow generates air pollution and congestion, negative externalities that sum to $2,000 per car each year.The socially optimal of quantity 4 cars would then be not 6 million but million (see Figure 14.5). per year only Without a tax on cars, the market would reach equilibrium at a price of $20,000 and a of 6 million quantity per year. But with a tax of $2,000 per car, the equilibrium would shrink to 4 million the socially optimal number. quantity per year, precisely the direct effect of the tax is not to reduce total economic surplus but Here, only to it billion $2 actually augment by per day. triangle

14.5

FIGURE

The

Loss

a Tax on If

the

in

Surplus

from

Cars.

supply and

curves for cars embody relevant cost benefits of producing

cars, then will

lead

^

demand

O

\342\226\240 -r 1 1

0

U

to underproduction and a corresponding economic

o

^^^ ^^

20 \302\247

all

and consuming placing a tax on cars

of them reduction in

22

^\\ 0

surplus.

4

Quantity

Could we raise enoughtax revenue

6

(millions

of cars/year)

if we limited to run the government those activities that externalities? No one taxing only generate negative knows for sure, but it might be possible, for the list of such activities is a long one. For instance, when someoneenters a congested freeway, he creates additional for the motorists there. delays already Existing technology would enableus to levy road-use taxes that reflect these congestion externalities. Each time fossil fuels are emit into the which will accelerate the burned, they greenhouse gases atmosphere, A tax on carbon would increase economicsurplus trend toward globalwarming. decision makers to take this external cost into account. Taxes on other by causing forms of air and water pollution would have effects on resource similarly benign allocation. Recent experiencewith refundable taxes on food and beverage containers demonstrates that taxes like these can raiseneededrevenue while at the same ourselves

to

time contributing to a cleanerenvironment.

407

KEY TERMS

SUMMARY \342\200\242 Our

in this

aim

the

to

microeconomics

modern

chapter was to study

One of

society.

of

principles

apply

role in

of the government's

provision

government's principal tasksis

equal

\342\200\242 Goods

are both

that

are often

goods such

public

provide

called pure public goods.A

collective

\342\200\242 The

exceedsthe

cost.

marginal

agency has

collection

single public

good, it

been established

has the

second

to tax, it

of a

cost

for which

government \342\200\242 One

for

may

simply be the only

the

a tax

a

goods tax system,

goods they

don't

which

want,

makes

(LOl)

for the consumption

of a nonrival

good.

collectivegood (389) head

exceed

their

benefits.

the

(405)

tax (391)

logrolling (402)

nonexcludablegood(388)

the result

nonrival

optimal in too

little

critics

have beenpursued

activity would absence

the

in

of a

tax, taxing

of

the

negative effectsof

of the

against the benefits

financed

by

revenue.

tax

(388)

pure

tax

(393)

income tax

publicgood(388)

good

public

good

regressive tax

(389)

(388)

(392)

rent-seeking(402)

has

public

(L04)

pure private good (389) pure

(392)

commons

will

on

taxes

TERMS

good

at it

activity. This observation to denounce all taxes as harmful

and services

pork barrel spending (401) proportional

level

the economy. Yet the incentives must be weighed goods

progressive

is

(L03)

If the

activity.

led many

(LOl)

KET

crowding

has shown of government, it

history

at public goods and services,governments must tax. But a tax on any activity not only it also creates an incentive to reduce generatesrevenue,

goods

out

form

all levels

they do want. Many public goodsare channels, with the necessary provided through private funding provided by donations, by sale of by-products, of new means to exclude nonpayers, by development in many and cases by private contract. A loss in surplus are levied results, however, whenevermonetary charges without public

government

\342\200\242 To finance

pay

people while others do

goods,

that democracy is the far from perfect. For example,practicessuch as logrolling and rent-seeking, common in most democracies, often result in the of laws and public projectswhose costs adoption

case of goods be excluded, the

some

levy higher systems with

been criticized on the grounds to the wealthy, but this criticism fact that alternative tax schemes worse outcomes for both rich and poor

best

Although

the

feasible provider.

two

\342\200\242

reliance on government is the element of coercion provision

in the

for public

in

poor. Tax

the regulation of activities that and the definition and enforcement of property rights. Despite a general view that is more government responsive the shorter the distance between citizens and their elected factors such as economies of scale in the representatives, of with broad provision public goods and externalities reach often dictate the assignment of important functions to state or national governments. (L03)

assignresponsibility

cannot

the

to providing public other important roles: externalities generate

\342\200\242 In addition

serves

finance

on

to

have unfair

to exclusive

disadvantage

public

inherent

can easily

public good. And

nonpayers

to

to

therefore

governments

As

alike.(LOl,L03)

but

because government

is that

advantage

power

the

for

generally lead

rival

of using once

they

ignores the

be expanded at relatively low to finance additional public

can

costto generaterevenue goods. A

One advantage

public goods is that

property are

that

for providing the optimal quantity or a public good is to keepincreasing quantity as long as the marginal benefit of doing so to provide

government

most

and

this

criterion

of quality or quality

desirable.

taxeson the rich than

good\342\200\224

such as pay-per-view cable television\342\200\224is nonrival excludable. Commons goods are goodsthat are but nonexcludable. (LOl)

any

income,

nonrival

and

nonexcludable

highly

of

will generally not be either feasibleor in the case of private goods, people'swillingness for public goods generally increases with pay

as national defense and the criminal justice system.Such goodsare, in varying nonrival and nonexcludable. The first degrees, for which one person's property describes goods consumption does not diminish the amount availablefor others, while the second refers to the difficulty of preventing (LOl) nonpayers from consumingcertain goods. to

everyone benefits equally from the given public good, charging all taxpayers amounts for the provision of public goods not

\342\200\242 Because

to

PUBLIC GOODS AND

14

CHAPTER

408

TAX POLICY

REVIEW

1. Answer

the

A tax on an activity that generates externalities will improve resource allocation in the private sector and also generate revenue that could be used to pay for useful public goods.

to these

related

questions

following

QUESTIONS

2.

Give

of

examples

goods

that

negative

Considera goodthat

part:(LOl)

a.

nonexcludable.

but

Rival

3. Why

tax

income

the tax?

a wealthy person prefer to a head tax? (LOl)

be provided efficiently Why is the direct loss in

result from loss in

would

overstatement

an

and nonexcludable.

even

might

proportional

that

surplus

excludable.

would

forces.

market

private

by

b. Nonrival but c. Both nonrival

L04)

Explain. (LOl,

most

are, for the

false:

or

True

street goods: apples, StephenKing novels, lighting on campus, and NPR radio broadcasts. (LOl) a. Which of thesegoodsare nonrival? b. Which of these goods are nonexcludable?

of the

a tax on this good caused

surplus

by

(LOl, L04)

a

PROBLEMS 1. Two

connect'

consumers,

and

Smith

Radio

Public

Podunk

have the following demand curves of recorded opera on Saturdays:

Jones,

broadcasts

|ECONOMICS

Smith:

Ps

= 12

for

- Q

Jones: P; = 12- 2Q, f

(Tr*\302\261 Econ McGraw-Hill

Visit

your mobile

store and

Econ

Ps

and

Study

app todayl

P. represent

marginal willingness-to-payvalues

respectively, and Q representsthe Saturday.

app

download

the Frank:

where

number

of hours

for

of opera

Smith

and Jones,

broadcast each

(LOl)

a. If Smith

and Jones

are the

only

public

radio

listeners

curve for opera broadcasts. b. If the marginal cost of opera broadcasts is $15 per hour, optimal number of hours of broadcast opera?

in

Podunk,

construct

the demand

what

is the

socially

of the Jerry SpringerShowand hour-long episodes are as shown in the following diagram. A television network is to add one or both programs to its upcoming fall lineup. The consideringwhether two time slots remaining are sponsored by Colgate, which is under contract only to pay the network 10 cents for each viewerwho watches the program, out of which the network would have to cover its production costs of $400,000per episode. can be estimated accurately with (Viewership telephone surveys.) Any time

2. Suppose the Masterpiece

demand curvesfor

Theatre

Masterpiece

12 Millions

of viewers

0 per episode

slot the network does not fill with Springer or Masterpiece will be filled by infomercials for a weight-lossprogram, for which the network incurs no production in costsand for which it receives a fee of $500,000. Viewers will receive $5 million economic from each installment of the infomercial. (L02) surplus watching a. How will the network fill the two remaining slots in its fall lineup? b. Is this outcome efficient? socially c. By how much would total economic be higher if each episode of surplus if it were shown by a were shown on PBS free of than Masterpiece charge 3.

network?

pay-per-view

profit-maximizing

a TV company chooses a pay-per-viewschemeto pay which of the following statements is true? (L02) Explain. a. The outcome is socially efficient. b. The programs selected will maximize revenue. advertising

When

marginal cost to an lower than when advertising

c. The

d. Theoutcomeis always to finance programming. e. The

variety of

a group of service,the free-rider

4. When

a. Peoplehave to

more

is used socially

viewer of watching the programs is to finance programming. efficient than when advertising is used

programs provided is likely must

people

programming,

to

rise.

whether to buy a shared public occurs because: (L03)

decide

good or

problem frequently incentive to understate

how much the facility is really worth have to pay taxesto finance it. individual's needed contribution is an insignificant amount of the total

them

b. Each

an

if they

required.

c. Peoplehave them if

d. People

they

hope

an

incentive

don't

have

to overstate how much the facility is worth to to pay taxes to finance it. will value the facility enough to pay for it entirely. statements is not a reason for the existence of the

others

that

one of the above free-ride problem.

e. Only

5. The town money

additional

for

of

Smallsville

Smallsville

year. Each table, and

will

citizen'smarginal this

marginal

Citizen

a museum. The interest on the building to build the museum will be $1,000 per benefit from the museum is shown in the following benefit schedule is public information. (L02, L03)

is considering to borrow

have

Marginal

benefit

from museum

Anita

340

Brandon

290

Carlena

240

Dallas

190

Eloise

140

($/year)

each citizen voted his or her private would a referendum interests, to build the museum and raiseeachcitizen'sannual taxes $200 by pass? b. A citizen proposes that the city let a private build the museum and company charge the citizens a lump-sum fee each year to view it as much as they like. to view the museum. If the Only citizens who paid the feewould be allowed were allowed to set a offer private company single fee, would any company to build the museum? c. A second citizen proposes allowing the private company to charge different to different citizens and auctioning the right to build the museum to prices the highest bidding company. Again, only the citizens who pay the fee may view the museum. What is the highest bid a private company would make

a.

Assuming

to supply the

museum

to Smallsville?

410

CHAPTER

14

PUBLIC GOODS AND

6.

TAX POLICY

are the only two residentsin a neighborhood, and they would like The value of a is $50 guard. securityguard permonth to Jack and $150 per month to Jill. Irrespective of who pays the guard, the guard will the entire protect neighborhood. (L02, L04) a. What is the most a guard can charge per month and still be assured of being hired by at least one of them? b. Supposethe competitive for a security guard is $120 per month. The wage local government a and each 50 Jack Jill proposes plan whereby pays percent of this to vote on this plan. Will the plan be voted fee, and asks them monthly if the neighborhood in? Would economic surplus be higher had a guard? and Jill

Jack

to hire a security

7. Refer

Jack earns

6. Suppose

Problem

to

$11,000 per month. (L02, L04)

a.

tax on

a proportional

Suggest

pay for the

and would

vote

b. Suppose

instead

that

Jack

$1,000 per month

income that would

security

guard.

proposes

a tax

is the

working

problem

practical

the

to this scheme? like the one in

ideas

prevents

majority

and

Jack

guard.

How part

earns

Jill

much b from

situations?

real-life

in

that

hiring

Jill

be acceptedby

scheme under which

receive the same net benefit from would Jack and Jill pay now? Would Jill agree would each

c. What

and

benefits for each voter in a small following table showsall the marginal whose town council is consideringa new swimming pool with capacity for at least three citizens.The cost of the pool would be $18 per week and would not depend on the number of peoplewho actually used it. (L02, L04)

8. The town

Voter

Marginal

benefit ($/week)

A

12

B

5

C

2

will the pool must be financed by a weekly head tax leviedon all voters, vote? Is this outcome sociallyefficient? pool be approved by majority Explain. b. The town council insteaddecides to auction a franchise off to a private monopoly to build and maintain the pool. If it cannot find such a firm willing to operate the pool, then the pool project will be scrapped. If all such monopoliesare constrained the franchise be sold, and if by law to charge a single price to users,will outcome efficient? Explain. so, how much will it sell for? Is this socially c. Suppose now that all such monopolies can perfectly price-discriminate.Will the franchise be sold, and if so, how much will it sell for? Is this outcome a. If the

socially efficient? d. The give members.

what

-

Explain.

town council it away

to the

decides that,

are four will happen?

If there

ANSWERS 14.1 a. The BLS users than

that

firm

identical

the most in

(HECKS

CONCEPT

TO

firms

the

off the franchise, it money lobbying council

auction

than

rather

spends

bidding

and

they

cannot

will

collude,

-

has the capacity to serve far more additional user calling up the site does not prevent some other user from doing so. Other websites,however, do not show the nonrival property, at least during certain hours, because they attract more usersthan their servers can accommodate. (LOl) website

it attracts,

at 3 in

the morning

so an

ANSWERS

The stadium at the watches the game in c.

Additional

14.2

To construct

Tom'sdemand vertically.

14.3

The

person

can

people

the availability

championship prevents

watch

game is someone

the game

of the telecast for

on television

million

blue triangle)

without

who

diminishing

others.

curve (a),we first graph Bill's demand curve (c) and and then add the two individual demand curves (b) \342\200\224 for the demand curve isP = (L02) 1.5Q.

the demand curve

equation

18

Whereas elasticity of demand was 1 at a price it is 2 on the new demand curve. As a curve,

20

always full, so anyone else from doing so.

viewers, is now

and

$100

the resulting

loss

in

of $10 on the original demand the $10 fee now excludes the area of the surplus (again

result,

million. (L02)

Lostsurplus $10 viewing

Millions

of viewing

from

fee

households

14.4 If Sven ordersbread pudding,his share of the bill would now go up by $2 instead of $1. If he orderschocolatemousse,his share of the bill would go up by $1.20 instead of $0.60. So he would still order the bread pudding (surplus = $4 \342\200\224 $2 = \342\200\224 \342\200\224 = the chocolate mousse (surplus $3 $1.20 $2) rather than $1.80). (L03)

TO

CONCEPT

CHECKS

FIVE

PART

MACROECONOMICS:

scientists

Physical

ISSUES

AND

DATA

at many different scales, the atom to the vast

world

the

study

ranging from the workings dimensionsof the cosmos,

of

inner

and

depending naturalist finds

it

between

the

or

apply

may

tools

different

of analysis. Similarly, an economic useful to be able to move back and

level

the

on

very

or \"micro-\" level, and

small-scale,

forth

the large-scale,

level.

\"macro-\"

I,we

In Chapter

is the

which

microeconomics,

group behavior which is the

the differences between study of individual choices and of

discussed

in

individual

the

of

study

and the policiesthat

and

markets,

of national

performance use

governments

performance.Thechapters

this

in

macroeconomics,

section

to

economies

try to improve that begin our discussion central and concepts

of macroeconomics by introducing the measurements used in the field. We begin in Chapter 15 with a discussion of gross domestic product(GDP),probably the most well-known but often misunderstood concept in In addition macroeconomics. to describing how GDP is constructed, we examinehow U.S. GDP has grown over time and the ways in which it is (or is not) related to the economic of well-being the

person.

typical

the Chapter 16 explains how economistsmeasure general level of prices in an economy, what we call the price level,and inflation. We also discuss the costs imposed on an economy on interest rates. by inflation, including the effects of inflation in the 17 studies trends labor market from Chapter long-term two perspectives. First, we analyze four labor significant in real wages and employment. Second, we carefully market trends work how economists measure employment and through

unemployment Throughout connect key

the

living

this section

concepts

issues

standards

factors

to

and those that follow,

we

will

we develop with some These include the questions.

measurements

and

macroeconomic

search for the

economies.

real-world

in

that

rise

and cause

over

productivity

long periods

to improve

of time

in

and many

414

CHAPTER 15

SPENDING,

GDP

INCOME,AND

also

stagnating and even decliningin others. shorter-term fluctuations in the economy

while

countries

study

Macroeconomists

(called

business

and the consequences cycles), the causes of unemploymentand inflation, of economic interdependence among nations,amongother topics.Finally, we will begin to consider macroeconomic policies\342\200\224government actions to improve the performance of the economy\342\200\224since these are of particularconcern to macroeconomists. As you will learn in the sections to is an important come, the quality of macroeconomic policymaking determinant

of

a nation's

economic

health.

CHAPTER

I

Income,

Spending,

GDP

and onfarm

payrolls

2 percent rate in \"The Dow closed

yesterday

of

STREET

WALL

THE

JOURNAL.

LEARNING

price only

0.2

registered

rose

to 5.8

level since...\" News

airwaves\342\200\224some

carry

else.

nothing

peopleare interested The average person hopes to learn that

something business

decision,

or a in

will be

useful

a financial

in

much

depends the same

L03

*n

that

data

iit, the

economy's

a doctor

in measuring the economy, and attempts to do so, date back as far mid-seventeenth conducted a (1623-1687) century, when Sir William Petty detailed survey of the land and wealth of Ireland. Not until the twentieth century, did economic measurement come into its own. World War II was an though, importantcatalyst for the development of accurateeconomicstatistics since its very outcome was to depend on the mobilization of economic resources. Two thought in the United States and Richard Stone in the United economists\342\200\224Simon Kuznets for measuring a nation's output of Kingdom\342\200\224developed comprehensive systems to Allied leaders in their wartime goods and services, which were of great help in economics and Stone each received a NobelPrize for their work, planning. Kuznets which became the basis for the economic accounts used today all the by almost world's countries.The governments of the United States and many other countries now collect and publish a wealth of statistics covering all aspectsof their economies. Interest

the

measuring

to analyze activity.

and compute GDP

and

real GDP.

and temperature\342\200\224to make depends on a patient'svital signs\342\200\224pulse, blood pressure, an accurate diagnosis. To understand economicdevelopments and to be able to give useful advice to policymakers, businesspeople, and financial investors,an economist leaders and policymakers also simply must have up-to-date, accuratedata. Political need economicdata to help them in their decisions and planning. as

Define nominal

\"^

How do economistsmeasure overall health?

the expenditure

economic

a

on economic

way

GDP

ol

.^

Apply

method for

-\302\253?%\302\273

*?&

investment,

career move.The professional

economist

L02 w^* <-*2rJ\302\273?

TV

an economy's

output.

percent, its highest these fill the and radio stations In fact, all kinds of in economic data.

and

define

measure

like

reports

how

Explain economists

last

percent

OBJECTIVES

reading this chapter, should be able to:

LOI

as

\"The unemployment rate last month

After you

...\"

trading

index

1 \342\226\240\302\273*** fwilwim I]iank <>fAmerica \\ lor Credit-Card Is '\342\226\240\"*\" '\"#\342\200\242 ti-ii

points

appears subdued

consumer

an increase month ...\"

93

up

\"Inflation the

third

the

Jones Industrial

moderate

in

grew at a

...\"

quarter

Average

|5

I

L04

Discussthe between relationships

GDP and

real

economic

well-being.

416

CHAPTER

15

SPENDING,

INCOME,AND GDP

Beginning macroeconomic

inflation;

and

chapter, variables:

of economic

level

overall

spotlight inflation

gross domestic product,

unemployment. The focus of

rate of

the

measuresthe

discuss how

we will

this

with

basic

and

unemployment,

activity

in

this

economistsmeasurethree or GDP;the rate of is on GDP, which The next two chapters

chapter

a country.

respectively. will understand

how official measuresof output gain insight into the debates over their the and limitations of economicdata is the first accuracy. Understanding strengths critical step toward becomingan intelligent user of economic statistics, as well as a for the economic analysis in the chapters to come. necessary background By the end of this are constructed and

chapter,

used and will

DOMESTIC

GROSS

you

some

PRODUCT:

MEASURING

THE NATION'S OUTPUT domestic

(GDP)the

final

final

goods in a

market

country given period produced

value of the

and services during

product, goods

services

and

this

understand

To

a

used frequently or GDP.

most

The

gross domestic product

separately.The first

key

measure of an Gross domestic

is economy's output product (GDP)is the

called market

the gross value of the

produced in a country during a given period. let's take it apart and examine each definition, in the definition is \"market value.\" phrase

of its parts

VALUE

MARKET

and services, from dental floss goods able to talk about conceptslike the \"total (a service). or \"total to the output\" production\"\342\200\224as opposed production of specificitems like dental floss\342\200\224economists need to aggregate the quantities of the many different and services into a number. do so the market values goods single They by adding up of the different and services the 15.1 will goods economy produces. Example illustrate the process.

A modern

economy producesmany

(a good)to acupuncture

EXAMPLE 15.1

different

To be

Measuringa Nation'sOutput What

is Orchardia's

GDP?

total is 4 apples and 6 Orchardia, production of Orchardia, we couldadd the number of apples to the number of bananas and conclude that total output is 10 piecesof fruit. But what if this economy also produced3 pairs of shoes? There really is no sensible to add and bananas to shoes. way apples that we know that apples sell for bananas for $0.25 each, Suppose,though, a pair. Then the market value of this economy's $0.50 each, and shoesfor $20.00 or its GDP, is equal to production,

In the imaginary

bananas.

To

find

economy of

the total output

(4 applesX + (3

$0.25/apple)

+ (6

pairs of shoes X

bananas

$20.00/pair)

X

$0.50/banana)

= $64.00.

that when we calculatetotal output this way, the more expensive items than the (the shoes) receivea higher weighting cheaper items (the apples and In general, the amount people are willing to pay for an item is an bananas). indication of the economic benefit they expect to receive from it (see Chapter 3). For this reason, higher-priceditems should count for more in a measure of

Notice

aggregate

output.

GROSS DOMESTIC

the original quantities produces 15.1. In addition, it produces

Orchardia

prices as in Example the GDP of Orchardia

THE

NATION'S

417

OUTPUT

15.1

CONCEPT CHECK Suppose

PRODUCT:MEASURING

goods at the same each. What is

three

of the

5 oranges at

$0.30

now?

values provide a convenientway to add together, or aggregate, the many and services produced in a modern goods economy. A drawback of using is that not all are values, however, economically valuable goodsand services

Market different market

and sold in markets. For example, the unpaid work of a homemaker, of economic value, is not sold in markets and so isn't counted in

bought

it is

although

But

and child care services,which

paid housekeeping

are

GDP.

do count.

in markets,

sold

are excluded from measured GDP,in a few cases sold in markets are included in GDP. By far the most and local state, important are the goods and services provided by federal, governments. The the and the convenience protection provided by army navy, transportation of the interstate highway and the education school system, provided by public systems are examples of publicly and services that are not sold in markets. provided goods

goods and services that

As market

not

are

prices for add

statisticians

economic

activities

homemaking

Although

as rough measuresof

GDP the costs of

those

providing

For instance,

value.

economic

their

and services

goods

provided

publicly

to the

do not exist,

and services

goods

to include public

of teachers and GDP, the statisticians add to GDPthe salaries costs of textbooks and supplies, and the like. Similarly, the economic value of the national defense establishment is approximated, for the purposes of the costs of defense: the earned soldiers and the GDP, by sailors, measuring pay by costs of acquiring and maintaining and so on. weapons, the

education in

administrators, the

few exceptions,like

With a

calculated

adding

by

a market value are goods and servicesthat

are

goods

Many

in the

used

produce a loaf of bread, flour. The flour is then three

and

goods

next,

GDP

that have includes only those services

of the production process,calledfinal

end products

AND SERVICES

GOODS

FINAL

the

are

all

GDP is

and services,

goods

services.

and

goods

provided

publicly

up market values. However, not in GDP. As we will see counted

major

grain

used

that are

goods

production process. For instance,before must be grown and harvested and then along

other

with

produced during

to make

ingredients this

process\342\200\224the

grain,

a baker

can

ground

into

bread. Of

the

flour, and

the

consumers. Because producingthe bread is the ultimate purpose of the process, the bread is called a final good. In general, a final good or serviceis the end product of a process, the product or servicethat consumers use. The goods or servicesproducedon the way actually the

bread\342\200\224only

toward mediate that in

are

the

is used by

bread

the and the flour\342\200\224are making the final product\342\200\224here, grain in measuring or services. Economistsare interested goods only of direct economic value. Thus, only and services final goods

Intermediate

GDP.

To illustrate,

goods

suppose

that

grain

those

inter-

items

are included

are not included.

and services the

called

from

the previous

of

the grain

$0.50

value of the

would then be flour,

and

countedthree times:onceas grain,

finally

as part

of the

value

of the

or services

as

example has a market

(the price the milling company paid for the grain). The grain is then into which has a market value of $1.20 flour, (the price the baker paid for ground the flour). Finally, the flour is made into a loaf of fine French bread, worth $2.00 at the local store. In calculating the contribution of these activities to GDP,would we want to add together the values of the grain, the flour, and the bread? No. This would incorrectly measureGDP as $.50 + $1.20 + $2.00 = The value of value

or services goods consumed by the ultimate user; becausethey are the end products of the production process, they are counted

$3.70. then

as part

bread. The grain

of the

and flour

goods

final

part

of GDP

intermediate goodsor services goods

or services

used

up

in the

goods and therefore not

of final

production services

and

counted

as part

of GDP

418

CHAPTER

15

SPENDING, INCOME,ANDGDP

are valuable only their

Since

bread.

because

total contribution 15.2 illustrates Example

of bread, the

EXAMPLE15.2

GDPfor the Barber we count a

How do

For each taken

assistant,

value

is $2.00. distinction but

of the

be usedto make

final

product,

with

a focus

the

loaf

time

this

on services.

Assistant

GDP?

a haircut.

for sharpening the haircut what is the given, to GDP? together, return

in

haircut

in

haircut

charges $10 for

Your barber

same

His

and

$2.00

the

in

GDP

to the

goods that can

are intermediate

they

value is included

barber pays his assistant$2 per scissors, sweeping the floor, and other chores. total contribution of the barber and his In turn, the

The answer to this problemis $10,the price, or market value, of the haircut. in GDP because it is the final service, the one that is counted actually has value to the final user. The servicesprovided have value only by the assistant because they contribute to the production of the haircut. Their $2 value is included in the $10 price of the haircut.

The haircut

Our next or

EXAMPLE

15.3

A Good

the

same

can be

good

either intermediate

That Can BeEither Intermediateor Final intermediate

is an

What

example demonstrates that on how it is used.

depending

final,

good?

Farmer Brown produces$100worth of milk. He sells $40 worth and uses the rest to feed his which he sellsto his neighbors pigs, to the GDP? $120. What is Farmer Brown's contribution The

final

in this

goods

of pigssoldto the

neighbors.

example are the $40 worth $40 and $120, Adding

of

milk

of

milk

neighbors

and the

to

his for

$120 worth

we get $160,which

is Farmer

to the GDP. Note that part of the milk Farmer Brown produced serves as an intermediate good and part as a final good. The $60 worth of milk that is fed to the pigs is an intermediate good,and so it is not counted in GDP. The $40 worth of milk sold to the neighbors is a final and so it is counted. good, contribution

Brown's

A

capitalgood a

good of production

long-lived

that is used in the other goods and services

is difficult type of good that A is a good. capital good long-lived

capital

other goods

Housesand of

capital

purpose the

or services.Factoriesand

apartment

buildings,

which

good machines

goods

that are

as intermediate or is used examples

in

the

final

is a

production

of

of capital

goods.

dwelling services,are alsoa form the definition of final goods since their other hand, they are not used up during so they are not exactly long period,

produce

Capital goods do not fit produce other goods. On the process, except over a very

good. is to

production

intermediate

to classify

special

either.

of measuring GDP,economistshave agreed to classify newly produced as final goods even though they are not consumed capital goods by the in ultimate user. a that invested its future Otherwise, country by building modern factories and buying new machines would be counted as having a lower GDP than a country that devoted all its resources to producing consumergoods. We have established the rule that final goods and services (including only newly in are counted GDP. Intermediate produced capital goods) goods and services, For purposes

GROSS DOMESTIC

used up in

which are

practice,however,

the

this

THE

NATION'S

OUTPUT

419

and services,are not counted.In to because the often easy apply production process of final goods

production

rule

PRODUCT:MEASURING

is not

several periods. For example,recallthe earlier

stretches over

of the grain that was milled into flour, example baked into a loaf of French bread. The contribution of the whole processto GDP is $2, the value of the bread (the final product). Suppose, though, that the grain and the flour were produced near the end of the year 2011 and the bread In this case, should we attribute was baked early the next year in 2012. the $2 value of the bread to the GDP for the year 2011 or to the GDP for the year 2012?

which

in

was

turn

Neither choiceseemsquite

occurred

each

in

in

the

the

year

2011

year.

since

right

of the value

Part

GDP and

part

in

the

year

of the bread's

part

of the

should

bread

2012

production process be counted

probably

GDP. But how

should we make

split?

economists determine the market value of final in the goods adding up the value added by each firm firm The value added the market value of its production process. by any equals or service minus the cost of from other firms. As we'll product inputs purchased the value added by all firms (including producers of both see, summing intermediate and final goods and services) gives the same answer as simply adding together the value of final goods and services.The value-added method thus eliminates the of the value of a final or service between two problem dividing good periods. To illustrate this method, let's revisit the example of the French bread, which is the result of multiple of production. We have already determinedthat the stages total contribution of this production process to GDPis $2, the value of the bread. Let's show now that we can get the same answer by summing value added. that the bread is the ultimate of three ABC Grain Suppose product corporations: and Hot'n'Fresh Company, Inc., produces grain; General Flour produces flour; Baking If the bread. we make the same as before about the market produces assumptions value of the grain, the flour, and the bread, what is the value added by each of these To

three

deal with this problem, and services indirectly, by

companies?

of grain, with no inputs from Company produces $0.50worth other companies,so ABC's value added is $0.50. General Flour uses $0.50 worth of grain from ABC to produce $1.20 worth of flour. The value added by General Flour is thus the value of its product ($1.20) lessthe cost of purchased inputs or $0.70. Finally, Hot'n'Fresh from ($0.50), Baking buys $1.20 worth of flour General Flour and uses it to produce added $2.00 worth of bread. So the value by

ABC Grain

is $0.80.

Hot'n'Fresh

Table 15.1 shows contribution

to

GDP,

the value added by as the method based

that

$2.00,

each

gives the

company

on counting

final

goods

same and

services

the portion of the value of only. Basically, the value added by each firm represents firm creates in its stage of production.Summing the final good or service that the in the economy the value added by all firms yields the total value of final goods and services, or GDP.

TABLE

15.1

Value Added

in

Bread

Production

Revenues

Company

\342\200\224

Cost

of purchased

inputs = Value

added

ABC Grain

$0.50

$0.00

$0.50

General

$1.20

$0.50

$0.70

$2.00

$1.20

$0.80

Hot'n'Fresh

Total

Flour

$2.00

value

added

market value

serviceminus purchased from

for any firm, the of its the

product or

cost of inputs other firms

420

CHAPTER

15

SPENDING,

INCOME,AND GDP

This example also illustrates how the value-added method solves the problem of productionprocesses that two or more bridge periods. Suppose that the grain and flour are produced during the year 2011, but the bread is not baked until 2012. the value-added the contribution of this method, Using production process to the year 2011 GDP is the value added by the grain company plus the value added of the production by the flour company, or $1.20.The contribution process to the year 2012 GDP is the value added by the baker, which is $0.80.Thus, part of the value of the final product, the bread, is countedin the GDP for each year, the fact that part of the production of the bread took place in each year. reflecting

CONCEPT CHECK 15.2 card

Amy's

pays

Amy

receives a shipment of wholesale distributor of the

shop the

sells the cards for a total of $700.What GDP in the years 2012 and 2013?

a given

countryduring

the

the

Day total

in December

cards

of $500.

In

February

of these

contributions

2012.

2013

she

transactionsto

period.\"

A COUNTRY DURING

WITHIN

PRODUCED A

cards a

that GDP is equal to the market value of final goods last part of the definition, \"producedwithin a

established

now

have

We

and services.Let'slook at

are

Valentine's

PERIOD

GIVEN

term gross domestic product tells us that GDP is a within a given country.Thus, only production that takes the country's borders is counted. For example,the GDP of the United place within States includes the market value of all cars produced within U.S. even if borders, cars produced in Mexico However, they are made in foreign-owned plants. by a U.S.-based company like General Motorsare not counted. We have seen that GDP is intended to measurethe amount of production that occurs during a given period suchas the calendar year. For this reason, only

domestic

The word of

measure

economic

the

in

activity

goods and servicesthat in

included demonstrate

EXAMPLE

15.4

GDP for

the

this

of a Houseand

produced during following example

a particular year are and concept check

house is sold

real estate agent

GDP

existinghomecount in

of an

the sale

A 20-year-old this

actually The

year.

point.

The Sale Does

are that

a 6

percent

to a young commission,

family

GDP?

for

$200,000.

or $12,000. What

The family pays the contribution of

is the

to GDP?

transaction

was not producedduring the current year, its value is not in the GDP GDP. value of the house was included (The year's 20 years earlier, when the house was built.) In general,purchases and sales of existing assets such as oldhousesor used cars do not contribute to the current year'sGDP. the $12,000 fee paid to the real estate agent represents the market value However, Because the house

counted in

of

the

agent's

this

services

Sincethoseservices in

current-year

in helping the family find the house and make the purchase. fee is counted provided during the current year, the agent's

were

GDP.

THE

CONCEPT CHECK Doe

sells

broker

a 2

Lotta

her

the

transaction affect

15.3

of stock in Benson Buggywhip commission for executingthe sale. percent 100 shares

for $50 per share.She pays How does Lotta's

GDP?

current-year

MEASURING GDP

RECAP

Grossdomesticproduct (GDP) equals the servicesproducedwithin a country during is an

\342\226\240 GDP

the

sold in

not

are

of

markets,

An

important

services providedby the government, them. government's cost of providing

which

housework,

\342\226\240 Final

and

goods

user\342\200\224are

as

such

counted

factories

counted

in

GDP.

production

the

goods and

period. goods and

many

services

economy.

services that are not in GDP. counted

and

\342\226\240 Goods

value of final

market

a given

market values

aggregate of the

producedin

the

METHOD

EXPENDITURE

as unpaid is goods exception such

are included

in

and at the

GDP

and services consumed by the ultimate convention, newly produced capital goods, and machines, also are treated as final and are goods Intermediate goods and services, which are used up in of final goods and services, are not counted. services\342\200\224goods

in GDP. By

of final goods and servicesis determined by the The value added by any firm equals the firm's revenue from selling its product minus the cost of inputs purchasedfrom other firms. Summing the value added by all firms in the production process yields the value of the final good or service. the value

\342\226\240 In practice,

method.

value-added

\342\226\240 Only

goods

and services

produced

within

a nation's

and services

produced

during

the

\342\226\240 Only

of the

goods value

the current

during

produced

current-year

are included

current

year (or the

year) are countedas part

portion of

the

GDP.

METHOD

EXPENDITURE

THE

borders

GDP.

in

FOR

MEASURING GDP measure of the quantity of goods and services produced by an economy. or service that is also will be purchased and used by some any good produced in new economic consumer Christmas agent\342\200\224a buying gifts or a firm investing for For not how much is machinery, example. many purposes, knowing only produced but who uses it and how is important. Economistsdivide the users of the final goods and servicesthat make up the GDP for any given year into four categories: households, firms, and governments, the foreign sector (that of domestic assume is, foreign purchasers products). They in a given year that all the final and services that are produced in a country goods GDP

is a

But

will

be

Furthermore,

and purchased the amounts

be equal to GDP

values

the

market

used

by

members

that purchasers values of those

be measured by of all the final goods and can

thus

either

or more of thesefour groups. on various and services should spend goods and services. goods of two methods: (1) adding up the market of one

servicesthat

are

produced

domestically

or (2)

FOR MEASURING GDP

421

422

15

CHAPTER

SPENDING,

INCOME,AND GDP

spent by each of

adding up the total amount

servicesand

on final goods and and services. The values goods four

the

on imported subtracting spending obtained the two methods will be the same. by to the four of final Corresponding groups

expenditure: dollar values

the table

shows, GDP for

the

make government Table 15.2 gives the

governments nation's exports.

components for the U.S. economy States in 2010 was about Let's examine each type of expenditure United

the

person.

per

$47,000

roughly

invest,

of these

each

for

four components of and net exports. purchases,

users are

government

investment,

consumption,

That is, householdsconsume, firms and the sector purchases, foreign buys

groups

of the

As

2010.

in

$14.7trillion,

important subcomponents.As we walk through refer to Table 15.2to a sense of the relative importance of each one, get as individually,

some

well

each type

of spending.

TABLE 15.2

Expenditure Componentsof U.S.GDP,

2010

of dollars)

(billions

Consumption Durable

10,350.6 1,089.3

goods

Nondurable

2,337.4

goods

Services

6,923.9

Investment

1,822.5

1,413.2

investment

fixed

Business

340.4

Residential investment

68.9

investment

Inventory

Government

3,000.3

purchases

-515.7

Net exports 1,838.5

Exports

2,354.1

Imports

Gross domestic

Total:

Source:U.S.

consumption)

by

spending

on goods

households services

(or

expenditure

consumption

and

such as food, clothing,

and entertainment

Bureau

\342\226\240 Consumer furniture.

www.bea.gov.

Analysis,

or

expenditure,

Consumption

by households

is spending

consumption,

simply

servicessuch as food, clothing,and entertainment. Consumption is subdivided into three subcategories: durable as cars and goods are long-lived consumer goodssuch Note that new houses are not treated as consumerdurables but as

on goods and expenditure

of Economic

14,657.8

product

part

of investment. nondurable

\342\226\240 Consumer

is the

\342\226\240 Services

on

final

primarily

by firms and services,

spending goods capital

goods

goods.Investment \342\226\240 Business

as

is divided

fixed

rather

of

calculating

than

final

on

firms

into three

is the

investment

and

factories,

machinery,

purposes

goods like food and clothing.

largest single component of consumer and taxi rides to legal,financial,

is spending by

Investment

are shorter-lived

and spending and educational

haircuts

everything from investment

goods

capacity to produce.

services.

and services, primarily

capital

subcategories:

purchase by firms

office

GDP, long-lived

as intermediate

goods

includes

buildings.

of

new

goods such

(Remember that for the

capital goods are

goods.) Firms buy

capital

capital

treated as final

goods

to increase

goods

their

homes and apartment

Recall that

are also capital

households.

For

goods.

as an

treated

of new homesand

is construction

investment

\342\226\240 Residential

GDP accounting

purposes, residential investment

investment by the business sector,which

MEASURING

GDP

423

capital, is

the homes

sells

then

FOR

buildings.

apartment

called residential

sometimes

buildings,

METHOD

EXPENDITURE

THE

to

investment is the addition of unsoldgoodsto company inventories. the words, the goods that a firm produces but doesn't sell during current period are treated, for accounting purposes, as if the firm had bought those goods from itself. convention (This guarantees that production equals

\342\226\240 Inventory

In other

expenditure.)Inventory People often

does not

generally

in

Government

local

planes to transfer

These

governments.

school

public

paying

Social Security

welfare

excluded from

equal

are

they

imports

is

investment

We will as \"financial

chapter.

and

bonds, new

in

goods

capital

made by the

of transfer

Examples benefits, pensions

Interest paid on the

in

government

paid to

return

for

payments are government

debt

government

is also

minus imports.

exports

purchases

produced

final

by domestic are

goods

and

buyers of included

that are

services

goods

sold abroad.

that were investment, and

do not

-?f^tt\302\243>e_

\"My parents

sent back all

my

stuff

that camefrom

China.

government purchases by federal, state, and local governments of final goods and services; government do not include transfer purchases which are payments payments, purchases

made by the government in return for which no current or services are received, goods nor do they include interest on the government debt

services

and

in consumption,

purchases represent spending on domesticproduction, be subtracted. A shorthand way of addingexports and subtracting to add net exports, which minus imports. equal exports

but

must

this

in

received.

are

produced abroad.Sinceimports

government

term

goods and services bought by federal, state, run the from buying fighter expenditures gamut teachers. Government purchases do not include

payments.

are domestically

\342\226\240 Imports

A the

government purchases.

exports

\342\226\240 Exports

a firm's

from

unemployment

benefits,

and

workers,

as

final

current goodsor services

which no

of

assets, such as stocks

are payments

which

payments,

Net

are

purchases

stock

we are using the

of financial

investments,\" to distinguish them such as factories and machines. and

of financial assets, such as stocks or bonds, is different from the definition we give here.

company's

sense

the

to purchases

refer

the

over

acquires partial ownership assets controlledby the company. A stock purchase to the creation of new physical capital, however, and

correspond

usually

not investment

so is

rises or falls

to purchases term

refer

\"investments.\" That use of the person who buys a share of a existing physical and financial

or negative, dependingon course of the year.

be positive

can

investment

of inventories

value

the

whether

*

net exports exports minus imports

paid

424

CHAPTER

15

SPENDING, INCOME,ANDGDP

A country's net exportsreflect the net demand for its by the rest of the world and services.Net can be since can exceed goods exports negative, imports exports in any States had significantly greater given year. As Table 15.2 shows,the United

imports than

exports

The relationship summarized

by

in 2010.

between GDPand

an equation. Y

=

C= J =

G=

The equation for

GDP

domestic

gross

15.5

GDP by

Measuring

the same

Do

we

An

economy

get

can be

product,

or output

investment purchases

government

exports.

is thus

Y=C

EXAMPLE

and services

expenditure

consumption

= net

NX

on goods

expenditures

Let

+ J+

G+

NX.

Production and Expenditure

GDP using two different

methods?

at $15,000 each. Of these, 1,000,000 automobiles valued are sold to businesses, 50,000 are soldto the 200,000 are imported. The 25,000 are sold abroad. No automobiles at the end of the year are held in inventory by the auto producers.

produces

700,000 are soldto consumers, and

government, automobiles left

unsold

value of the production of final goods and servicesin this economy autos times $15,000per auto, or $15billion. To measure GDP in terms of expenditure, we must add on spending and net exports. Consumptionis 700,000 consumption, investment, government purchases, autos times $15,000, or $10.5 billion. Government are 50,000 autos times purchases Net are equal to exports (25,000autos at $15,000, $15,000, or $0.75billion. exports or $0,375 billion) minus imports (zero),so net exports are $0,375 billion. What about investment? Here we must be careful. The 200,000autos that are sold to businesses, worth $3 billion, count as investment. But notice too that the auto (700,000 + companies produced 1,000,000 automobiles but sold only 975,000 200,000 + 50,000+ 25,000). Hence, 25,000 autos were unsold at the end of the inventories. This addition to year and were addedto the automobile producers' producer inventories autos at $15,000, or $0,375billion) counts as inventory (25,000 total investment spending equals investment, which is part of total investment. Thus, the worth of autos sold to businesses the $0,375 billion in inventory $3 billion plus investment, or $3,375billion. in this economy, consumption is $10.5 billion, investment Recapitulating, is $3,375 billion, government purchasesequal $0.75billion, investment) (including inventory and net exports are $0,375 billion. Summing these four components of expenditure yields $15 billion\342\200\224the same value for GDP that we got by calculating the market value of production. The market

is 1,000,000

CONCEPTCHECK 15.4 that 25,000 of the automobiles purchased by than domestically produced.Domesticproduction remains find GDP in terms of (a) the at 1,000,000 autos valued at $15,000 each.Onceagain, market value of production and (b) the componentsof expenditure. Extending

households are

Example

imported

15.5, suppose

rather

THE EXPENDITURE METHODFOR

INCOMES OF CAPITALAND

AND THE

GDP

425

GDP

MEASURING

LABOR

measure of total productionor as a measureof total There is, however, a third gives the same final answer. is as the incomes of capital and labor. Whenever a good or service is produced and sold, the revenue from the sale is in the production distributed to the workers and the owners of the capital involved of the good or service.Thus, exceptfor some technical that we will adjustments can be

GDP

as a

of

thought

expenditure\342\200\224either method to think of GDP, which way

ignore, GDPalso equals

(equal to

income

\342\226\240 Labor

the incomesof

income

labor

the

plus capital

about two-thirds of

income.

GDP)

comprises

wages,

salaries, and

self-employed.

income to owners of (about one-third of GDP) is made up of payments and office buildings) and intangible machines, physical capital (such as factories, income (such as copyrights and patents). The components of capital capital include items such as profits earned by businessowners, the rents paid to owners of land or buildings, interest received by bondholders, and the royalties received by the holders of copyrights or patents.

\342\226\240 Capital

Both laborincomeand

are to be understood as measured prior a portion of both types of income is course, in the form of tax collections. the three equivalentways of thinking about you visualize the total value of and the sum production, expenditure,

Figure 15.1 may

help

GDP: the market value of of labor income and capital

importance expenditure

and

expenditure is consumption

the rest is we

income

income.The figure and

income

been

labor

mentioned, up

making

(a) Production

the

also

roughly

the relative

captures

components. About 70

spending, about 20

investment spending and net

net exports have As

of

the

of

income

capital

of taxes; ultimately, payment the captured by government to

exports.

percentis government (Actually,

percent of purchases,

as Table

15.2 shows,

in recent years, reflecting the U.S.trade deficit.) income is about two-thirds of total income, with capital

negative

rest.

(b) Expenditure

(c)

Income

FIGURE 15.1

TheThree Facesof The GDP can equally

as

well

(a)

investment,

purchases, income

Market value

(c)

total

government

net exports), income

income and

of

final

goods and

Investment

Government

purchases

Net exports

Capital

income

(b) total

(consumption,

expenditure

Labor

market

the

value of production,

Consumption

GDP.

be expressed

capital

or

(labor income).

CHAPTER 15

SPENDING,

GDP

INCOME,AND

GDPcan be expressed as the final

the GDP,

and

the

economic

Type

of

that

groups

are as follows:

makes

Who

on domestically

of expenditures

sum

The four types

services.

and

goods

OF GDP

COMPONENTS

EXPENDITURE

RECAP

of expendituresthat

make up each type

the

expenditure?

Examples

Consumption

Households

Food, clothes, haircuts,

Investment

Business

New factories

firms

new houses,

New school

Government

purchases

or

sector

Foreign

soldiers

and

GDPin

a given

REAL

VERSUS

GDP

year is useful

in

manufactured

by domestic

residents

activity

different

foreigners

GDP

of economic

comparisons

goods,

services

in

places.

down state by state, could be year 2010, in New used to compare aggregateproduction York and California during that in comparing levels of economic activity year. However, economistsare interested in not different locations but over time as well. For instance, a presidentwho only is running for reelection on the basis of successful economic policies might want to know how much output in the U.S. economy increased during his term. GDP to economic at two different Using compare activity points in time may as the shows. for give misleading answers, however, following example Suppose, the sake of illustration, that the economy and calzones. T he produces only pizzas in and of the two the 2009 and the 2013, prices quantities goods years beginning If we calculate GDP in and end of the president's 15.3. term, are shown in Table each as the market value of production, we find that the GDP for 2009 is year = $175. The GDP for 2013 X X + calzones (10pizzas (15 $5/calzone) $10/pizza) = $420. X X + is (20 calzones (30 $6/calzone) pizzas $12/pizza) Comparing the GDP for the year 2009 to the GDP for the year 2013, we might conclude that it is 2.4 times greater ($420/$175). Can you see what is wrong with this conclusion? The quantities of both pizzas and calzonesproducedin the year 2013 are exactly twice the quantities produced For example,

TABLE

GDP data

officials

government

financial

provided

to

NOMINAL

new

buildings,

hardware, salaries of

Exported

imports

equipment,

increases in

military

legal or

exports minus

and

cars

new

stocks

inventory

Net exports,

in

of expenditure,

expenditure?

Government

produced

counted

are

for

15.3

Prices and

Quantities in

2013

2009

and

2013

pizzas

Price of pizzas

10

$10

15

$5

20

$12

30

$6

Quantity of 2009

broken

the

of

Quantity

calzones

Price of

calzones

NOMINAL

year 2009.

in the

exactly

goods,

If

economic

by actual

as measured

activity,

over the four years, why

doubled

production

427

REAL GDP

VERSUS

both

of

values of

calculated

the

do

GDP

GDP

showa greaterincrease? The answer, as you also

can see from the table, is that prices as well as in prices, the market and 2013. Because of the increase value of production the physical volume of grew more over those four years than in So this GDP is a of economic case, production. misleadinggauge growth during the president's term, sincethe physical of the goods and services quantities 2009

between

quantitiesrose

the dollar values, are what determine people's of and calzones had risen 2.4 times Indeed, well-being. prices pizzas in the quantities of pizzas and calzones between 2009 and 2013 with no changes produced,GDP would have risen 2.4 times as well,with no increase in physical had more production! In that case, the claim that the economy's (physical)output than doubled during the president's term would obviously be wrong. in

produced

given

any

year, not

if the

economic

in time. We therefore to measure GDP at different points GDP that excludes the effects of Put calculating price changes. another we need a of GDP for inflation. Economists make this way, way adjusting in different years. adjustment by using a common set of pricesto value quantities produced often

Economists

need a method

need

for

The standardapproach

the prices from

that

year

is to

pick a

particular year, calledthe

the market

to calculate

value of

year, and There is no

base

output.

use

year to choose as the base year, but it is usually some calculated year. using the prices from a base year, rather than the current it is called real GDP, to indicate that it is a measure of real year's prices, Real GDP is GDP real physical production. adjusted for inflation. To distinguish in which are valued at from GDP GDP, quantities produced base-year prices, valued at current-year measure as nominal GDP. prices, economists refer to the latter about

rule

particular

When

recent

which GDP is

Calculating

did real

How much

Real GDP overthe President's Term

the Change in

GDPgrow

the

during

term?

president's

Using data from Table 15.3 and assuming that for the years 2013 and 2009. By how much

2009 is the base year, find real GDP did real output grow between 2009

2013?

and

To that

year

find real GDP for the using the prices in the

Year 2013

real GDP =

we must value the quantities produced 15.3 year, 2009. Using the data in Table

2013,

year

base

2013

(year

2009

price

= (20 X

$10)

of pizzas

quantity

pizzas) +

(year

2013

X

2009

year

of calzones

quantity

price X

of

year

of calzones) + (30

X

$5)

= $350.

The real

GDP of

What

2009

quantities

is

the

this

economy

real

GDP for

valued

be 2009,so real GDP

is the nominal is also

in the

2009?

year 2013 is $350.

as nominal GDP for 2009. GDP are the same. We already the real GDP for 2009. can now determine how much

same

By

definition,

the

at base-year prices. The base year for 2009 equals 2009 quantities In general, in found nominal

real GDP in

this

for 2009

example

equals

happens to

valued at 2009 prices,which

the base GDP for

year, real GDP and 2009, $175,so that

real productionhas actually over the grown in in Sincereal GDP was 2009 and the $175 $350 2013, four-year period. physical volume of production doubled between 2009 and 2013. This conclusion makes sense,sinceTable 15.3 shows that the production of both pizzas and calzones We

real GDP

a measure

of GDP

in

the quantities produced are valued at the prices in a base

which

year rather than at current prices; real GDP measures the actual physical volume of production

nominal

GDP in

GDP which

a measure

of

the quantities

produced are valued

at

current-year prices; GDP measures the current

nominal

value of production

EXAMPLE

15.6

dollar

428

CHAPTER 15

SPENDING,

GDP

INCOME,AND

exactly doubled of price changes physicalproduction

over the period. By using real GDP, we have eliminated the and obtained a reasonablemeasureof the actual change in over the four-year span.

Of course,the in the

as

proportion,

when pizza

production

previous calzone

and

of all

goods

not

will

in equal

to find

you

real GDP

rates.

grow at different

production

grow

necessarily

example. Concept Check15.5asks

effects

CONCEPTCHECK 15.5 and

production

Suppose

prices of pizzas

2009

pizzas 10

2013

30

These data

same as those doubled between

than

and calculatethe is the

2009

that

After

in real

growth

Quantity of

$10

15

$12

30

Table

in

2009

and

15.3, except Find 2013.

over the

output

four-year

of

Price

calzones

pizzas

the

are

rather

tripled

Price of

of

Quantity

and 2013 are as follows:

in 2009

calzones

and

calzones

$5 $6

that pizza production has real GDP in 2013 and 2009, to assume period. (Continue

base year.)

Check 15.5, you will find that the growth in real Concept and 2013 reflects a sort of average of the growth in physical and calzones.Real GDP therefore remains a useful measure of even when the production of different and production, goods

complete

you

between 2009 of pizzas production GDP

overall

physical

services grows at

Mttjfi'

different rates.1

The EconomicNaturalist15.1 Can

In most

real GDP

and

nominal

countries,

United States was from $8.03 trillion of goods

quantities

from $5.00

than

to move in

to

$8.02

trillion. This

and services $5.99

2005

directions?

different

real GDP

opposite

1990-1991. Using to

trillion

and

nominal

both

for them

possible,however,

ever move in

increase

reflected

trillion, over the

almost

every

time this year, real GDP fell

as a base

produced.Nominal

in

The last

directions.

an

overall

GDP,

reduction

however,

rose

same period becauseprices

year. It is happened by

in the by

in the

0.2 percent, 3.3

rose

physical

percent, by more

fell.

quantities

the fact that nominal GDP will be less than example also illustrates the current year are lessthan prices during the base year. This will be the case when the current generally year is earlier than the base year. Could real GDP ever rise during a year in which nominal GDP fell? Once again, the answer is yes. For example, this could happen when a country economic experiences in Japan and growth falling prices (deflation) at the same time.This actually happened several during years in the 1990s.

The

preceding

real GDP

if

prices

during

aThe method of calculating real GDP just described was followed for many decades by the Bureau of in Economic Analysis for GDP statistics. However, (BEA), the U.S. government agency responsible recent years the BEA has adopted a more complicated procedure of determining real GDP, called chain The new procedure makes the official real GDP data less sensitive to the particular base year weighting. chosen. and traditional However, the chain-weighting approaches share the basic idea of valuing output in terms of base-year prices, and the results obtained by the two methods are generally similar.

REAL

in

is calculated using the

GDP

Real

GDP VERSUS REAL

NOMINAL

RECAP

year rather than in Real current-year prices.

a base

using

activity at different

economic

not nominal

AND

shows

15.2

Figure Government

that prevailed GDP is calculated

services

and

year. Nominal

times should always

be

it may

inflation;

done

using

GDPin

of real

the level

real GDP,

United States from 1929 to 2010. to these data, often as if behaving is an imperfect measure of economic only those goods and servicesthat that contribute to people'seconomic and thus are largely or even entirely

the

attention

close

pay

the higher the real GDP,the better. At best, it because, for the most part, it captures are priced and sold in markets. factors Many

well-being

not priced and sold in markets GDP. Maximizing real GDPis not, therefore, always the for government GDP policymakers. Whether or not policiesthat increase make people better off has to be determined on a case-by-case basis. are

from

omitted

be of

Comparisons

WELL-BEING

ECONOMIC

policymakers

well-being

goal

right

will also

15.2

FIGURE

14,000

U.S. Economy, 1929-2010.

r

^ 13,000

Output

\342\200\242J 11,000

Real

c 12,000

s

10,000

was

7,000

\302\2516,000

5,000

\302\2434,000

3,000

g

\342\226\240= 2,000

fl

\302\2431,000

*

0


I

I

I

#

I

^

I

I

I

<$

I

I

I

<8>

i

i

i

*

i

\342\226\240f

Year

SOURCE: U.S. Bureau of Economic Analysis, www.bea.gov.

WHY To

GDP

REAL

understand

why

SAME AS ECONOMICWELL-BEING

ISNTTHE an increase

well-being,let'slookat

some

in

factors

real

GDP

that

does

are not

not always

included in

promote economic GDP

but

do affect

whether people are better off. Time

Leisure

countries as well) work (and most peoplein other industrialized in the than their did 100 many great-grandparents years ago. Early twentieth century, some industrial workers\342\200\224steelworkers, for example\342\200\224worked as many as 12 hours a day, 7 days a week. Today, the 40-hour workweekis typical. Americans also tend to start working later in life (after college or graduate Today, in are able to retire earlier.The increasedleisuretime school),and, cases, they many in the United Statesand other industrialized available to workers countries\342\200\224which Most

Americans fewer

hours

in 2010 is

its

level

about 5 times as

8,000 \302\253\302\243

w

of the

GDP

13 times

c 9,000

io

429

WELL-BEING

GDP.

GDP

REAL

goods

AND ECONOMIC

GDP

GDP is GDP adjusted for the physical volume of production.

as measuring

of

thought

prices of

current

the

GDP

in

I960.

roughly

in 1929 large

and

as it

430

CHAPTER

15

SPENDING, INCOME,ANDGDP

allows them to pursuemany participating

friends,

activities\342\200\224is

Jlf

The

Economic

Why

do

week\342\200\224isthe

per

a summer

job

retire

life,

their

than

earlier, and

working

less\342\200\224retiring

Cost-Benefit

We

O

and

work fewer hours

a department

economic

in

growth

If

the

you

or

per

job two weeks fact that people

cost. Why

help

the

fewer

working

can, say, make

of $800.The cost of forgone earnings

opportunity

great-grandparents'

rapid

for example,

earlier,

you forgo by working. store, then leaving

earnings in

Cost-Benefit Principle to

can use the

Over the past century,

cases

many

not

a trip with some friends has an opportunity cost fewer hours today suggests that their opportunity

their grandparents'

in

did?

great-grandparents

or 100 yearsago.

cost of

opportunity

week at

hours today

later in

of 50

people

The

hours

15.2

work fewer

Americans start work

week than

markets,

Naturalist

people

activities,

and

sports

in

and including being with family and cultural and educational hobbies, pursuing in a wealthy of living society. These extra hours of and therefore are not reflected in GDP. however,

worthwhile

benefit

a major

not priced

are

leisure

in

$400 per

early

are

to

take

working

is lower

than

difference?

this

this phenomenon. States and other of the average worker's wages the typical worker today can than ever before. This fact

understand

us

United

increased the purchasing power on real wages). In other words, (see Chapter more his or her hourly earnings buy goods and services with would seem to suggest that the opportunity cost of forgone earnings (measured in in earlier terms of what those earnings can buy) is greater, not smaller, today than times. in But because the buying of is so much than the power wages higher today past, Americans can achieve a reasonablestandard of living by working fewer hours than they did in the past. Thus, while your grandparents may have had to work long hours to pay the rent or put food on the table, today the extra income from working hours is long more likely to buy relative luxuries, like nicer clothes or a fancier car. Becausesuch are easier to give up than basic food and shelter, the true discretionary purchases cost of it was 50 years ago. As the opportunity opportunity forgone earnings is lower today than cost of leisure has fallen, Americans have chosen to enjoy more of it. has greatly 17 for data

industrialized countries

Activities

Economic

Nonmarket

Not all economically important few exceptions, such as government

omitted from

services.

Another

We mentioned

GDP.

example

are

activities

is very

values

nonmarket

services,

in

economic

markets;

with

activities

a

are

of unpaid housekeeping such as the volunteer fire and rescue services, The fact that these unpaid services are left out are unimportant. The problem is that, because earlier the example

is volunteer small towns.

squads that serve many of GDP doesnot mean that they there are no market prices and quantities market

and sold

bought

for

unpaid

services,

estimating

their

difficult.

How far do economistsgo wrong out of GDP?The answer on depends

nonmarket economic activities of economy being studied.Although nonmarket economic activities exist in all economies, they are particularly in important in economies. For rural of developing countries, poor example, villages trade services with each other or tasks people commonly cooperate on various in without Families these communities also tend to be exchanging any money. their own food and providing of their own self-sufficient, relatively growing many in basic services (recall the many skills of the Nepalese cook Birkhaman, described in Because such nonmarket economic activities are not counted official Chapter 2). GDP data may substantially understate the true amount of economic statistics,

activity

in

the

poorest

countries.

by

leaving

the type

REAL

GDP

AND ECONOMIC

to nonmarket activities is the undergroundeconomy, which that are never reportedto government officials and data

related Closely includes transactions

encompasses both legal and illegal activities, to babysitting jobs organized crime.For instance,somepeoplepay or workers like housecleanersand painters in cash, which temporary part-time allows these workers to avoid paying taxes on their income. Economists who have tried to estimate the value of such services by studying how much cash the public holds have concluded that these sorts of transactions make up an important share in advanced of overall economic activity, even industrial economies. The

collectors.

economy

underground

informal

from

Quality and Resource Depletion

Environmental has

China

experienced

recently

its manufacturing

base,

also

it

Increased pollution certainly water this

not

are

quality

downside

of its

When

an oil

value

of the

oil.

But

suffered from

detracts

and sold

bought

in

growth a severe the

markets,

in

real

GDP.

But in expanding

decline in air and water quality. air and quality of life, but because the Chinese GDP does not reflect

economic growth.

resources also tends to be overlookedin and sellsa barrel of oil, GDP increases by the company pumps the fact that there is one less barrel of oil in the ground,

The exploitationof GDP.

tremendous

has

finite

natural

sometime in the future, is not reflected in GDP. of efforts have beenmade to incorporate factors like air quality and resource into a measure of GDP. so is difficult, depletion comprehensive Doing since it often involves placing a dollar value on intangibles,like having a clean river to swim in instead of a dirty one. But the fact that the benefits of environmental and resource conservation are hard to measurein dollars and cents does quality be pumped

waiting to

A number

not mean that

they

are

unimportant.

of Life

Quality

attractive placeto live? Some desirable you might spacious, well-constructedhomes, restaurants and a of medical stores; entertainment; and high-quality good variety in services. other indicators of the life are not sold markets and so However, good be omitted from GDP. include a low crime minimal traffic rate, may Examples active civic and while some citizens of congestion, organizations, openspace.Thus, a community the construction of a new Walmart because believe may oppose they it may have a negative effect on the quality of life, others may it because support Walmart sells goods at lower and increase local GDP. prices may town or city an

a particular

makes

What

features

think

of

are reflected

in GDP:

Poverty and EconomicInequality

of goods and servicesproducedand sold in an about who gets to enjoy those and economy, goods services. Two countries may have identical GDPs but differ radically in the distribution of economic welfare across the population. Suppose, for example, that in one it have a comfortable middle-class existence; country\342\200\224call Equalia\342\200\224most people both extreme and extreme wealth are rare. But in another poverty country, Inequalia\342\200\224 which has the same real GDP as Equalia\342\200\224a few wealthy families control the in and the of the lives While most people would economy, majority population poverty. that has a better economic situation that would not overall, say Equalia judgment be reflected in the GDPs of the two countries, which are the same. In the United States, absolutepoverty has been declining. Today, many families whoseincomeis below today's official \"poverty line\" (in 2011, $22,350 for a own a television, a car, and in some cases their own home. Some familyof four) economists have that people who are consideredpoortoday live as well as many argued GDP

measures

but

the

total

it conveys

middle-classpeopledid

quantity

no information

in

the

1950s.

WELL-BEING

431

432

CHAPTER

15

SPENDING,

INCOME,AND GDP

absolute

But, though

income

of

inequality

U.S. corporationmay only

absolute

their

economic

and shelter they

have\342\200\224but

you own an old,

beat-up car but

a car, you

it

are

does

You

might

figures

that

Environmental

GDP.

in

questions is to apply the to people

jobs?If

extent

that such

comparisons

neighborhood

of output,

on the distribution

than

Again,

poverty.

Cost-Benefit

that

fact

good or bad. The right Are the

Principle:

the regulations

costs

in

to

way

of lost

terms

they

for to

such

decide

benefits of cleaner air

impose should be adopted;otherwise,

the regulations

then

so,

the

than

may reduce production of steel, is not a sufficient basis on which

regulations

example, which reduces the GDP.But decide whether such regulations are more

neighborhood

economic

that

considering

captured

O

the

from the list of important factors omitted from the official is useless as a measure of economic welfare. numerous critics Indeed, in claim. the effects of a Clearly, evaluating proposed Planners must only the likely effects on GDP is not sufficient. the will affect of economic that are not policy aspects well-being

also ask whether

Cost-Benefit

rather

If

have.

others

what

conclude GDP

have made policy,

to

TO ECONOMIC WELL-BEING

IS RELATED

GDP

BUT

quality

as well as absolute

matters

inequality

the

To

depends not of food, clothing, to have owns a

else in

But if everyone

GDP focuses on total production not capture the effects of inequality.

because

quantity

large same

the

satisfaction

and

they have compared the only person in your

to be lesssatisfied.

well-being,

people's

what

of a

typical worker in

economic

people's

position\342\200\224the

on

privileged.

are likely

you

car,

luxury affect

feel

may

that

United States,

officer

executive

of times what the

Psychologists tell us

firm receives. on

been rising.The chief

hundreds

earn

in the

be decreasing

to

seems

poverty

has generally

worth

output and lost should

not.

Although looking at the effectsof a proposed policy on real GDP is not the only basis on which to evaluate a policy, real GDP per person does tend to be positively associated with many things people value, including a high material standard of better health and life and better education. W e discuss next some living, expectancies, of the ways in which a higher real GDP impliesgreater economicwell-being.

Obviously,

of

citizens

better

goods

higher-quality

access

better

of material

to transportation

advantages.

While

consumption\342\200\224and

of

happiness or

peace on achieving

high

is what

that

are likely to GDP measures).

GDP

possess more and On average,peoplein

enjoy

and other

sanitation;

with a

(after all, homes; larger, better-constructed, and more comfortable food and clothing; a greater of entertainment and cultural variety

countries

opportunities;

a country

services

and

high-GDP

Services

and

Goods

of

Availability

mind\342\200\224the

we

majority

material prosperity.

and travel; better

social

agree that of people

commentators

and

communications

may question the value

riches do not necessarilybring in the world place great importance

Throughout history

people

have

made

tremendous

sacrifices and taken great risksto securea higher standard of living for themselves and their families. In fact, to a great extent the United States was built by people who in hopes of were willing to leave their native lands, often at great personal hardship, their economic condition. bettering

Health and Education of consumer goods, a high GDP other more basic brings shows the differences between rich and with advantages. poor countries to some indicators of life infant regard important well-being, including expectancy, and child mortality of nutrition, and educational rates, number of doctors,measures Beyond

abundance

an

Table

opportunity. group

(total

15.4

Three groups of

population,

countries

3.6 billion);

(1) developing countries as a compared: the least (2) (50 countries developedcountries are

GDP

REAL

AND ECONOMIC

433

WELL-BEING

15.4

TABLE

Basic Indicatorsof Well-Being

GDP and

All

Least developed

Industrialized

2,200

1,001

40,976

69.3

57.7

80.3

38

82

49

126

74

36

99

57

30.8

91.8

59.9

99.9

developing

countries

countries

Indicator GDP

person

per

countries

(U.S. dollars) Life

at

expectancy

birth (years) Infant

rate

mortality

(per 1,000 live

births)

mortality rate

Under-5

(per 1,000live

births)

Births attended health

Net

skilled

by

personnel (%)

Adult

for

rate

enrollment

secondary schools

(%)

80.7

rate (%)

literacy

(2005-2008) Total

in group

population

of countries

854.7

3,597.2

1,026.3

(millions)

Source: United Nations, Human at http://hdr.undp.org/en/ Development Report 2010, available at birth, total reports/global/hdr2010/. Data are for the following years: 2010 (life expectancy population), 2008 (GDP per person, mortality rates), 2005-2008average (literacy), 2001-2009 attended by skilled health (births average (net enrollment rate), 2000-2008average personnel). Data for OECD countries is used for all data in the \"Industrialized countries\" column. GDP data are adjusted to account for local differences in prices of basic commodities and services(i.e.,they are adjusted

a total

with

for

population of

(24 countries,including countries,

and

power parity).

purchasing

United

a total

with

Japan,

Table 15.4 shows, these three GDP per person. Most notably,

morethan 40 times How do these developing

the least before

fare

countries

her

million); and States, Canada,

population groups GDP

or his

first

fifth

differences

of

some

on

much

worse

0.5 percent

and

birthday

birthday.

about

have radically

of countries person

per

in the

of

levels

different

industrialized countries is

developed countries.2 relate to other measures the most basicmeasuresof human in GDP

than

The

(5/1,000) and

about

8 percent

an

a 13

corresponding

0.6 percent

industrial

the

developed countrieshas roughly

her or his

of

(3) the industrialized countries the western European 1 billion). As the first row of

of the least

that large

Table 15.4 showsthat

854

about the

countries.

A child born

(82/1,000)

(6/1,000),

in

of dying countries

industrialized

respectively. about 80 years,

the one

of

chance of dying

percent (126/1,000) chance figures for the

of well-being? welfare,

before are

born in an compared to about

A child

country has a life expectancy of 58 years for a child born in one of the least developed countries. Superior nutrition, and medical services in the richer countries account for these large sanitation, in basic welfare. Skilled health discrepancies assist in the delivery of 99 percent of births personnel in industrialized countries but only 36 percent of births in the least developed countries. industrialized

On another

of human well-being, literacy and education in the the advantage. Table 15.4 shows that countries, the percentage of adults who can read and write is virtually important

rates, high-GDP

countries

industrialized 2The GDP data

basic goods and

measured

GDP

dimension

also

have

Table 15.4 use U.S. prices services tend to be cheaper in those countries. in

to value in poor

nations. Since goods and servicesin developing increases countries, this adjustment significantly

A child

born

in

one

developedcountries

of the has a

least

15 percent chance of dying her or his fifth birthday.

before

434

CHAPTER15

SPENDING,

GDP

INCOME,AND

100

in the poorest while this is only true of about 60 percent of adults in countries. The of children enrolled developing percentage secondary schools is 92 percentin industrialized to 31 countries, compared percent in the least countries. enrollment rates do not Furthermore, developed capture important differences in the quality of education available in rich and poor countries, as measured indicators such as the educational backgrounds of teachers and student-teacher by in ratios. Once again, the average an industrialized person country seemsto be percent,

the average

than

off

better

do

Why

far

in

a poor

country.

developing

Naturalist 15.3

The Economic

ar

person

children

fewer

complete

high

school

in poor

countries

than

in

rich

countries? in poor countries on getting place a lower priority countries. This seems since from people unlikely immigrants countries often a on it be that poor put heavy emphasis education\342\200\224though may people who emigrate from as a whole. poor countries are unrepresentative of the population An economic naturalist's for the lower schooling rates in poor explanation countries would not on cultural differences but on differences in opportunity costs. In rely most of which are children are an source societies, poor heavily agricultural, important of labor. Sending children to school beyond a certain age imposesa high opportunity cost on the family. Children who are in school are not available to help with planting, if the and other tasks that must be done harvesting, family is to survive. In addition, the cost of books and school on poor families. The supplies imposes a major hardship Cost-Benefit Principle thus implies that children will stay at home rather than go to

One possible an education

Cost-Benefit

O

school.

In

is that

explanation

rich,

nonagricultural

potential low opportunity cost

reason for the

of sending enrollment

higher

countries,

earnings are

their

and opportunities,

people

in rich

than

small

children

rates

school-age to

in those

have

children

school

in

few work

sources of family

to other

relative

rich

countries

income.

The

is an important

countries.

will discuss the costs and benefits of economic growth\342\200\224 In that means growth in real GDP per person\342\200\224in greater depth. context we will return to the question of whether a growing real GDPis necessarily with greater economic well-being. equated

In Chapter

which

18, we

in practice

RECAP

REAL

Real GDP is at

GDP

AND

ECONOMIC

WELL-BEING

measure of economic well-being. the Among omitted from real GDPare the availability of leisure nonmarket services such as unpaid homemaking and volunteer time, environmental services, quality and resource conservation, and quality-of-life indicators such as a low crime rate.The GDP also does not reflect the degree in a country. of economicinequality Because real GDP is not the same as in economic well-being, proposed policies shouldnot be evaluated strictly terms of whether or not they increase the GDP. Although GDP is not the same as economic well-being, it is positively associated with a higher material many things that people value, including standard of better health, longer life expectancies, and higher rates of living, and educational attainment. This relationship between real GDPand literacy in economic has led many people to emigrate from nations well-being poor search of a better life and has motivated policymakers in developing countries to try to increase their nations' rates of economic growth. factors

affecting

best

an imperfect

well-being

REVIEW QUESTIONS

-

\342\226\240

SUMMARY

domestic

of an economy's output the market value

measure

\342\200\242 The basic

(GDP),

product

and services produced in period. Expressingoutput

goods

services

in a

produced

\342\200\242

terms

during a given of market values

production of final

in the

value

the

Summing

process

is a

of

goods

final

\342\200\242 GDP

added

of expenditure:

firms,

services,

in

the

are not

of four

These four types of

the spending of and the foreign

levels

\342\200\242 To

compare

the

eliminate

them,

the

services,

their

at

of the as

such

indicators

of unpaid

value

the

quality

of economic

degree

or

environment, the the crime rate, and (L04)

inequality.

is still a useful indicator of economic wellhowever. Countries with a high real GDP per person not only enjoy high average standards of also tend to have higher life expectancies, living, they

\342\200\242 Real

GDP

being,

sector,

(LOl)

respectively.

time available to

the

consumption,investment, net exports.

GDP

quality-of-life

types

of goods

purchases

are included in

volunteer

sum

(L03)

and services (which cost of production), GDP includes those only goods and services sold in markets. It excludes factors that affect important people's well-being,such as the amount of leisure

up

production the value

determining

over time.

activity

in GDP.

well-being.

government

used

GDP, while GDPmeasured

per person is an imperfect measure of With a few exceptions, notably

GDP

economic

(LOl)

to correspond the government,

expenditures

must

of

expressed as the and

government purchases,

households,

services.

and

and

\342\200\242 Real

of existing assets.

by each firm

useful method

can be

also

goods

are sales

nor

GDP,

economic

comparisons of

are the only final users.

a base

of current-year prices is callednominal GDP should always be usedin making

Real

include capital are

prices in is called real

way

terms

the millions of goodsand modern economy.(LOl)

goods) are counted in GDP, since they benefit goods and servicesthat directly Intermediate goods and services,which counted in

this

of goods and services in year. GDP measured in

value

market

of the

terms

a country

in

and services (which

goods

final

Only

final

to aggregate

economists

allows

measuring the

is gross

of the

435

of GDP over time, economists of inflation. They do so by

low rates of

effects

of school

and

infant

enrollment

child mortality, and and literacy. (L04)

high

rates

KEY TERMS

consumption final

goods

grossdomestic

(418)

good

capital

expenditure (422) or services (417)

government purchases (423)

(GDP)

(416)

intermediate goods investment

net exports

product

or services

(417)

(422)

(423)

GDP

nominal

real GDP

(427)

(427)

value added (419)

REVIEW QUESTIONS 1.

Why

do economists GDP?

giving

high-value

use market values is the economic items more weight

in

GDP

agricultural sector in developing countries is subsistence farming, in which much the food that is produced is consumedby farmer and the farmer's family. Discuss the implications of this fact for the measurement of GDP poor countries. (LOl)

A

large

3.

when

rationale

for

than

items? (LOl)

low-value

2.

What

calculating

part

Give

examples

aggregate

expenditure.

of the

in

Which

of the

four types of four represents

of the

the largest shareof GDP in the United States? Can an expenditure componentbe negative? Explain.

of the

of each

(LOl)

4. Al's Shoeshine Stand shined of shoes pairs last year and 1,200 pairs this year. He charged $4 for a shine last year and $5 this year. If last year is taken as the base year, find Al's contribution to both nominal GDP and real GDP in both years.

1,000

15

CHAPTER

436

SPENDING, INCOME,ANDGDP

Which measure would trying

to

over the

be better

the change

measure

past year? Why?

to

were

if you

use

Al's

in

useful

productivity

real GDPper person is

you say that

5. Would

of economic

measure

well-being?

answer. (L04)

(L03)

a

Defend your

PROBLEMS George

|ECONOMICS

^ .Study rEcon McGraw-Hill

Visit

your mobile

store and

app

download

the Frank: Econ

Last island, use clamshells for money. year In boars. John grew 200 bunches of bananas. the two-person economy that George and John set up, fish sell for 1 clamshell a bunch. each, boars sell for 10 clamshells each, and bananas go for 5 clamshells George paid John a total of 30 clamshells for helping him to dig bait for fishing, and he also purchased five of John's mature banana trees for 30 clamshells each. in terms What is the GDP of George's and John'sisland of clamshells? (LOl)

1. George

h connect\"

Study

app todayl

and John, stranded

caught 300

2. How would each States? (LOl)

of the

a. The U.S.government

b.

The

c. The

d.

U.S.

following

U.S.

pays a U.S.firm pays

government

in salaries

billion to

pays $1

U.S. government

transactions affect the

$1 billion

pays

government

parts. The

an

on

5 wild

and

fish

billion

in

interest

$1 billion

United

for government workers.

SocialSecurity

$1

of the

GDP

recipients.

for newly

produced airplane of U.S.

to holders

government bonds.

e. The

U.S. government

U.S.

pays $1 billion oil

government-owned

to

Saudi

Arabia

for crude

oil to addto

reserves.

and sells them for $200 Incorporated produces 100 computer chips each to BellComputers.Using the chips and other labor and materials,Bell produces 100 Bell sells the computers, bundled with software personal computers. that Bell licenses from Macrosoft at $50 per computer, to PC Charlie's for $800 each. PC Charlie's sells the computersto the public for $1,000 each. Calculate the total contribution to GDP the value-added method. Do you get the same using answer by summing the market values of final and services? (LOl) up goods

3. Intelligence

no inputs from other companies)from its It sold these logs to MNLumber for and $1,500 MNLumber cut and planed the logs into lumber. MNLumber then sold the lumber for $4,000to MNFurniture. MNFurniture used the lumber to produce 100 tables that it sold to customers for $70 each.(LOl) a. Complete the table below to calculate the value added by each firm.

4. MNLogs harvested property in

logs

(with

Minnesota.

northern

Cost of purchased inputs

Revenues

Company

added

Value

MNLogs

MNLumber MNFurniture

b.

Suppose

that

all of

these transactions took placein

GDP increasebecauseof

c. Suppose

that

MNLogs

MNLumberin

December

in April to MNFurniture the rest of 2012. By how of these transactions?

these

harvested 2011.

2012 much

2011.

By how

much did

transactions?

the logs in MNLumber

then sold the

and MNFurniture did GDP increase

them to finished lumber

and sold

2011

October

sold all

100

2011

and

in

tables

during

2012

because

5. For each of

state the effect both on U.S.GDP and transactions, of aggregate expenditure.(L02) a. Your mother buys a new car from a U.S.producer. b. Your mother buys a new car imported from Sweden. c. Your mother's car rental businessbuys a new car from a U.S. producer. d. Your mother's car rental business buys a new car imported from Sweden. e. The U.S. government buys a new, car to be used by domestically produced who has been the ambassador to Sweden. mother, your appointed

6.

the

following

four components

on the

an economy

for

GDP

Calculate

features

that

the

following

data. (L02)

$600 75

expenditures

Consumption

Exports

200

purchases of goods and services of new homes and apartments

Government Construction

Sales of existing

homes

and

100

200

apartments

50

Imports

Beginning-of-year End-of-year

Government Household

the

100

investment

payments to

of durable

purchases

2011

years

goods

Root Beer Price

Quantity

Assume The

policy, taken

9. We

of

Quantity

Price

300

$20

100

$20

125

$7

250

$20

110

$25

government

the use

goods

Sandals

Price

Quantity

and

beer,

$5

2011

that

root

the three

100

is the

years.(L03)

8.

150

and 2014.

Pucks Year 2011 2014

100

retirees

produces hockeypucks,casesof of following table provides pricesand quantities

sandals. The in

125

of Potchatoonie

nation

The

7.

inventory stocks

fixed

Business

100

stocks

inventory

\"dirty\"

base year.

is considering fuels

by

Find

nominal

GDP

and real

GDP for both

a policy to reduceair pollution by restricting In deciding whether to implement the effects of the policy on real GDP be likely

factories.

how, if at all, should the into account? Discuss. (L04)

how the opportunity cost of sendingchildren to school affects of schoolenrollment across countries. The United Nations Human data for per capita income in Development Report 2010 reportsthe following 2010 the of 2008 U.S. (in dollars):(L04) equivalent discussed

the level

Canada

39,035

Denmark

35,736

Greece

28,608

Lesotho Ethiopia

1,605

991

438

CHAPTER

15

SPENDING,

INCOME,AND GDP

country would you rate? The lowest rate?

a. Which

b. Discuss

the

the highest

school enrollment consider

might

or not

of whether

school.

(HECKS

-

$64.00.

GDP was calculated to be Orchardia If, in addition, at $0.30 each, GDP is increasedby $1.50 to $65.50. (LOl)

text,

5 oranges

produces

15.2 The value to

payments

cards

other

the year

during

Amy

wholesale distributor together with the ultimate is $500. Amy's value added\342\200\224her revenue less her firms\342\200\224is $200. Since the cards were produced and purchased of the

added

the

of

producers

by

to

TO CONCEPT

ANSWERS In

have

factors besides GDP per capita a family the Cost-Benefit applying Principle to the decision

to senda child

15.1

to

other

what

when

-

expect

2012 GDP.The $200 in

2012 (we assume),the

value

added

originating

$500

toward

counts

in Amy's card in that year.

year

shop counts in

(LOl) actually sold the cards 15.3 The sale of stock represents a transfer of ownership of part of the assets of Benson Buggy whip, not the production of new goodsor services.Hence,the stock sale itself does not contribute to GDP.However, the broker's commission of $100 for a (2 percent of the stock sale proceeds) represents payment current service and is countedin GDP. (LOl) 15.4

GDP since Amy

2013

year

value of domestic is original example,the market production 1,000,000 autos times $15,000per auto, or $15billion. Also as in the original example, consumption is $10.5 billion and government purchases are $0.75 billion. However, because 25,000 of the autos that are purchased are imported rather than the domestic producers domestic, have unsoldinventories at the end of the year of 50,000 (rather than 25,000 as in the original example).Thus, inventory investment is 50,000 autos times and total investment $15,000, or $0.75billion, (autos purchased by businesses are investment) is $3.75 billion.Sinceexports and imports plus inventory to exports minus imports) equal (both are 25,000 autos),net exports (equal are zero.Noticethat since we subtract imports to get net exports, it is to subtract as unnecessary also imports from consumption. Consumption is defined total purchases by households, not just purchasesof domestically produced

As in the

goods.

is C + I $0.75 billion + 0 = $15billion, Total expenditure

+ G the

+ NX same

= $10.5 billion as the

+

$3.75

market value of

+

billion production.

(L02)

15.5

Real GDP produced

in

the

in

the

year

year 2009. Soreal GDP = $450.

$5/calzone)

equals the quantities of pizzas and calzones in the base valued at the market pricesthat prevailed = + (30 calzones X in 2013 (30 pizzas X $10/pizza)

2013

year 2013,

in 2009 the quantities of pizzas and calzonesproduced equals valued at 2009 prices, which is $175. Notice that since 2009 is the real GDP and nominal GDPare the same for that year.

Real GDP 2009, year,

the what year 2013 is $450/$175, or about 2.6 times Hence the expansion of real GDP lies between the threefold in pizza and the doubling in calzone that production production between 2009 and 2013. (L03)

The real

was in 2009. increase occurred

GDPin

in base

it

CHAPTER

I

Inflation

Price

I

|6

the

and

Level LEARNING

After you

LOI

^v

OBJECTIVES

this chapter, to:

reading

be able

should

^^

the

how

Explain

price index

consumer

(CPI) is constructed -fj

^

\\ L02

it to

and

use

the

inflation

calculate rate

CPI is

Show how the

usedto

dollar

adjust

amounts to eliminate the effects of inflation. L03

the CPI.

How do we measureinflation?

L04 great baseball player was pointed out to him

n 1930 the

Babe

Ruth

earned

a salary

of $80,000.

earned more than President \"I had a better year than Ruth with some he Hoover, replied, justification, did.\" In 2001 Barry Bonds broke the major home run record 73 league by hitting home runs and earned $10.3 million. Which baseball player was better off? Was Bonds able to buy more and services in 2001 with his $10.3 million or Barry goods was BabeRuth better off with his $80,000 in 1930? The answer is not obvious becausethe price of just about everything increased between 1930 and dramatically in the inflation that occurred the United States over that time 2001, reflecting period. Inflation can make a comparisonof economic conditions at different points in time difficult. Your grandparents remember being able to buy both a quite comic book and a chocolatesundae for a quarter. the same two items Today cost kids were much $4 or $5. You might conclude from this fact that might better off in \"the good old days,\" but were they really? Without more we can't have gone information, tell, for though the prices of comicbooks and sundaes so have allowances. T he real is whether up, question young people's spending money has increasedas much as or more than the prices of the things they want to buy. If so, then they are no worse off today than their grandparents were

when they

When

were

it

young

in

biases

important

I

most

the two

Discuss

and candy

that

between

inflation

and relative

price changesin

he had

bars cost a nickel.

Distinguish

L05

to

find

of

inflation.

the

Summarize

true

er

or

costs

the

connections among inflation,

interest

nominal

rates, and

interest rates.

real ^

CHAPTER

440

16

INFLATION AND

THE PRICE

LEVEL

that are

Quantities

for

measured

last chapter). By incomes of Babe Ruth

(or other

dollars

in

real quantities

called

are

inflation

currency

(recall, for example,the economists

and

units)

concept

then

adjusted

of real

GDP

in

real

can compare the

working quantities, and Barry Bonds, as well as any economic measurement that is in In dollars. this we'll discusshow economistsmeasure inflation expressed chapter, and you will learn how dollar amounts can be adjusted for the effects of inflation. Inflation also makes it difficult to compare interest rates acrosstime. The interest rate on a 30-year mortgage was 18.5 percent in October 1981, while the interest rate on the same type of mortgage in October 2010 was 4.2 percent. Which one was higher in real terms, that is, which mortgage cost more in terms of purchasing power? We will discuss the answer to this question, and in the process you'll discover how to calculate the real interest rate, the interest rate adjusted for the effects of inflation. An important benefit of studying macroeconomics is learning how to avoid the confusion inflation creates when we compare economicconditions over time. It is to understand the true costs of inflation. Economic equally important policymakers claim that a low and stablerate of inflation is one of their chief usually objectives. We'll see why this is an important goal and show how the costs of inflation the

might be

basic

consumer

any

price index (CPI) a measure of the period of a standard

period,

cost in that basket of goods and services relative to the cost of the same basket of goods and services in a fixed year, called the base year

think

they

are.

AND INFLATION

INDEX

-

to measurethe price level in the U.S. economyis the short. The CPIis a measure of the \"cost of living\" during a particular the consumer price index (CPI)for any period measures period. Specifically, the cost in that period of a standard to the set, or basket, of goods and servicesrelative cost of the same basketof goods and services in a fixed year, calledthe base year. To illustrate how the CPI is constructed,supposethe government has desigin 2010 nated 2010 as the base year. Assume for the sake of simplicity that a typical American on just family's monthly household budget consistedof spending three items: rent on a two-bedroom apartment, and movie tickets. In hamburgers, hundreds of different items each month, but the reality, of course, families purchase basic principles of constructing the CPI are the same no matter how many items are included. Suppose too that the family's average monthly expenditures in 2010, the base year, were as shown in Table 16.1.

The

consumer

you

PRICE

CONSUMER

THE

for

what

than

different

very

real

with

price

TABLE

tool

economists use or CPI for

index,

16.1

Monthly Household

Budget of the Typical

Family

Cost(in

Item Rent, two-bedroom (60

Hamburgers Movie Total

tickets

apartment

at $2.00

(10 at

(Base Year) 2010)

$500 120

each)

60

$6.00 each)

$680

expenditure

Now let's fast-forward and services are likely goods

Let's supposethat bedroom apartment

in 2010

to the to

year

have

2015.

changed;

Over that

some

will

period, the prices of have

risen

various

and some

fallen.

our by year 2015 the rent that family pays for their twohas risen to $630. Hamburgers now cost $2.50each,and the in of movie tickets has risento each. have been $7.00 So, general, prices price rising. cost of living increase between 2010 and 2015? By how much did the family's Table 16.2 shows that if the typical basket family wanted to consume the same of in in and services the 2015 as did the would have to goods year they year 2010, they or $170 more than the $680 per month spend $850 per month, they spent in 2010. In

the

CONSUMER

THE

PRICE INDEX AND

INFLATION

16.2

TABLE

Reproducing the 2010(Base-Year)

Cost of

Services Item

(in 201 5)

Cost

Rent, two-bedroomapartment (10 at

tickets

Movie Total

Cost (in

150

each) $7.00 each)

120

60

70

$680

$850

expenditure

2010)

$500

$630

(60 at $2.50

Hamburgers

and

of Goods

Basket

2015

Year

in

the same did in the year 2010, the way in the year 2015 as they to 25 more e ach month. ($170/$680) So, in this family spend percent the cost of for the rose 25 between 2010 and 2015. example, living typical family percent The Bureau of Labor Statistics (BLS) calculates the official consumerprice in deriving index (CPI)using essentially the same method. The first the CPI is step to pick a baseyear and determine the basket of goods and servicesthat were

words, to

other

consumed

live

have

would

the typical

by

Expenditure Survey, services

prices

the

in

of base-year

Cost

the

in

year is

given

any

basket. Then,

conduct numerous

and services

goods

The CPI

to the example of the typical in the year 2015 as CPI

In other

year

2015

purchase

of goods employees

they

and visit

the current

determine

to

goods

family

formula:

this

basket of goodsand of

BLS

learns how Consumer

basket.1

base-year

calculate the

CPIm

each month

interviews

computed using

Cost of base-yearbasket Returning

In practice, the government a detailed survey, called the

year.

selected families record every randomly over a given month. Let's call the basket

base-year

of stores and

thousands of

the

results

that

paid

they

that

through

spending

in which

and the price

make

during

family

consumersallocatetheir

in current

services

and services that

consumes

=

in

base

year year

three goods, we can

1.25.

|\302\247=

in the year 2015 is 25 percent the cost of living base Notice that the CPI is always higher year. base-year in to since that the numerator and the denominator of the CPI 1.00, equal year formula are the same. The CPI for a given period (such as a month or year) measures the cost of living in that relative to what it was in the base year. period The BLSmultiplies the CPI by 100 to get rid of the decimal point. If we were to do that here, the year 2011 CPI would be expressedas 125rather than 1.25, and the base-year CPI would be expressed as 100rather than 1.00. However, many if the CPI is stated in decimal calculations are simplified so we will not adopt form, the convention of multiplying it by 100.

words, in

this

example,

in 2010, the

it was

than

Calculating How

we measure

do

the typical family's

the CPI

cost of living?

to the three goods and services the typical family also four sweaters at each.In the $30 2015, they bought year same sweaters cost $50 each.The prices of the other goods and servicesin that

Suppose consumed

in

aMore details cpi/cpifaq.htm.

in addition

2010,

on how

the Bureau

of Labor Statistics

constructs the

CPI

are available at

the 2010

www.bls.gov/

EXAMPLE 16.1

441

CHAPTER

442

16

INFLATION AND

THE PRICE

were the same

2015

and

LEVEL

change

as in

With

16.2.

Table

family's cost of living

in the

2010

between

this additional item, what and 2015?

was the

In the example in the text, the cost of the base-year (2010)basket was $680. four sweaters at each raises the cost of the basket to $30 $800. Adding base-year What does this same basket (including the four sweaters) cost in 2015? The cost of the apartment, the hamburgers, and the movie tickets is $850, as before. Adding the cost of the four sweaters at $50 each raises the total cost of the basket to in The CPI the cost of the basket 2015 divided the cost of the $1,050. equals by (the base year), or $l,050/$800 = 1.31.We living rose 31 percent between 2010 and 2015.

in 2010

basket

of

family's cost

to

Returning if

hamburgers

goods or services

relative

to

the price of the same goods or services in a base year

apartment

falls

tickets

movie

and

example

three-good

from

16.1 and

Tables

in

in 2010

$500

in the two

years

remain

16.2, find

to $400 in the

the

year

20l5.The

as

same

in

the

2015 CPI prices for two tables.

The CPI does not measurethe price of a specific good or service.Indeed, it has in the numerator of measurement at all since the dollars of the fraction cancelwith the dollars in the denominator. Rather, the CPI is an index. The value in a particular year has meaning in comparison of an index with the value of only in another that index a index measures the year. Thus, price average price of a class in of or services relative to the of those same or services a base goods price goods The CPI is an well-known one of economists use year. especially price index, many to assess economic trends. For example,becausemanufacturers tend to pass on increases in the prices of raw materials to their customers, economists use indexes no

price index a measure of the average price of a given class of

the

on the

rent

the

16.1

CHECK

CONCEPT

the

that

conclude

units

materials'pricesto forecast Other indexesare usedto study care, and other major sectors. of raw

CONCEPT consumer

rate

in the prices of of price change in

manufactured goods. energy,

food,

health

or

average

family.

16.2

CHECK

The

changes the

price index captures the

cost of

living

for the

\"typical\"

in your a personal Suppose you were to construct price index to measure changes own cost of living over time. In general, how would you go about constructing such an index? Why might changes in your personal price index differ from changes in the CPI?

INFLATION in the of the average level of pricesrelative to prices provides a measure in contrast, base year. Inflation, is a measure of how fast the average level is price in over time.The rate of inflation is the annual rate of changing percentage change the price level, as measured,for example, by the CPI. Suppose, for example,that in the year 2011. the CPI has a value of 1.25 in the year 2010 and a value of 1.30 in the price The rate of inflation between 2010 and 2011 is the percentage increase in the price level (0.05) divided by the initial level level,or the increase (1.25), price which is equal to 4 percent.

The CPI

rate of

inflation

percentage

rate

the annual of change

the price level, as measured, for example, by the CPI

EXAMPLE

16.2

in

How do we

CPIvalues

Rates:

Inflation

Calculating

calculate for

the

the

years

inflation

2006 to

2006-2010 rate using the

CPI?

2010 are shown on the

next

page.

THE CONSUMERPRICE

price

2.02

2007

2.07

2008

2.15

2009

2.15

2010

2.18

between 2006 and 2007 is the percentageincreasein the = 2.8 those years: (2.07 \342\200\224 2.02)/2.02 percent. On your own, rate for the remaining years.

level between

calculate the

CPI

2006

rate

inflation

The

Year

443

AND INFLATION

INDEX

inflation

CONCEPTCHECK 16.3 are 1929

and

1929through

for the years

CPI values

Below between

1930, 1930

and

Year

How did

inflation

The results of of

negative

services

are

1930s

in

the

inflation

over falling was the last

experienced Figure

rate

rates

the

in the

1929

0.171

1930

0.167

1931

0.152

1932

0.137

1933

0.130

that

inflation

1933.

those

from

since 2006?

Check 16.3 include someexamples the prices of most goods and negative is called deflation. The early

for Concept

A situation

time so

rates of

1932 and

CPI

1930s differ

calculations

rates.

Find the

1933.

1932, and

and

1931,1931

inflation

in

which

is

time the United Statesexperienced significant

the relatively mild deflation during 16.1 puts the previous examples in United States for 1900 to 2010.

deflation.

Japan

1990s. context

the prices of most goods and services

by

showing

the inflation

in which

a situation

deflation

that

are

inflation

FIGURE

falling

over

time so

is negative

16.1

The U.S.Inflation

Rate,

1900-2010.

The U.S.Inflation rate has fluctuated over time. Inflation was high in the 1970s but has been quite low recently.

Source: 1900-1959:www.measuringworth.com; 1960-2010: the President, February 2011, Table B-60,www.gpoaccess.gov/eop.

Economic

Report of

CHAPTER

444

INFLATION ANDTHE

16

^mff'

LEVEL

PRICE

is core

What

16.1

Naturalist

Economic

The

inflation?

from March 18,2010, began,\"Prices showed no volatile food and fuel month, the Labor Department said,but when costs were excluded, costs as measuredby the consumer price index rose 0.1 percent.\" would we exclude food and energy costs when measuring inflation? Food and fuel Why are two of the most important households things buy, so isn't that messing up our

An article movement

inflation

NewYorkTimes

inTfie

last

overall

measure?

defined inflation as a measure of how fast the average price level is changing over Over the course of a month or so, this rate can fluctuate to greatly, making it difficult sort out short-run movements in prices from the long-run trend in the inflation rate. The core rate of inflation is defined as the rate of increase of all prices except energy and in the inflation fluctuations food, the two items most frequently responsible for short-run rate. Because core inflation excludes the sources of the most volatile it is price changes, considered to be a useful short-term measure of the underlying inflation trend. For example,Table 16.3 presents the general and core rates of inflation for 2007 to 2010. The CPI inflation rate rose from 2007 to 2008,fell to a negative value in 2009, and then turned positive in 2010. The core rate of inflation, showed a slight however, downward drift, implying that the inflation rate had not changed significantly from its We

time.

core rate of of increase energy

inflation

of all prices

and food

the rate

except

trend.

long-run

16.3

TABLE

U.S. Annualized

Inflation

2007-2010

Rates,

Core inflation

CPI inflation

(CPI

inflation

excluding

Year

(%)

food and energy) (%)

2007

2.85

2.35

2008

3.84

2.30

2009 2010

-0.36

1.70

1.64

Source: Calculated using

data

from Economic

B-62,www.gpoaccess.gov/eop.

Report of the

President,

February

2011, Table

mean increases in oil and food prices are us to monitor what is happening to Rather, unimportant. inflation over the long run, and whether or not policies need to be instituted to keep inflation in check.We can use both measures together: the inflation rate to see what is on from and the core inflation rate to monitor inflation. month-to-month, going long-run Thus,

a focus

on core

0.96

the

inflation

does

not

rate

allows

INFLATION

FOR

ADJUSTING

The CPIis

inflation

core

tool. Not only does it allow us to measure changes be used to adjust economicdata to eliminate the effects of inflation. In this section we will see how the CPI can be used to convert measured at current dollar values into real terms, a process called quantities We also will see that the CPI can be used to convert real into deflating. quantities current-dollar a called Both are useful not terms, procedure indexing. procedures in

the

cost

an

useful

extremely

of living,

it

also

can

FOR

ADJUSTING

only to

economists but other

or

measures,

needs to adjust payments, for the effects of inflation. quantities

to

who

anyone

economic

A NOMINAL

DEFLATING

accounting

QUANTITY

use of the CPI is to adjust nominal measured quantities\342\200\224quantities current dollar values\342\200\224for the effects of inflation. To illustrate, supposewe know that the typical family in a certain area had a total income of metropolitan in in in 2010 and 2015. Was this better off $40,000 $44,000 family economically

An

important

at their

the

all,

year 2015 than in 2010? Without any more information their income rose by 10 percent

have been

rising, as fast

as

or faster

than

five-year period.

But

is one

divide 16.4. The

must

quantity, we

in

Table

terms, the initial

the nominal quantity calculations in the income

family's

real income

in

also

prices

quantity

in terms

of its

dollar value

might

in terms of terms\342\200\224for example, a nominal quantity into a real a price index for the period, as shown show that in real or purchasing power

physical

To convert

services.

current

a

quantity

is measured

than the family's income. Supposethe prices of consumes rose 25 percent over the same period. 10 percent, we would have to concludethat the

is measured

that

quantities of goods and

nominal that

to say yes.After

be tempted

we might

this,

over the

the goods and servicesthe family Since the family's income rose only is worse off, in terms of the goods and services they can afford to buy, family in the increase their or income. nominal, current-dollar, despite We can make a more precise comparison of the family's purchasing power in in In 2010 and 2015 by calculating their incomes in those real terms. years general,

a real quantity

445

INFLATION

by

table

decreased

actually

of $40,000, between 2010 and

or 12 percent of

by $4,800,

real quantity measured example, of goods

a quantity in

physical

that is

terms\342\200\224for

in terms of quantities and services

their

2015.

TABLE 16.4

Comparing the Real Year

Values

Nominal

family

$40,000

2015

$44,000

terms,

(dollar)

index to

price quantity.

this

it has

family

express

is that quantity

Real

CPI 1.00 1.25

Nominal

inflation.

in real

in

2010

family

and

2015

=

income

family

$40,000/1.00

income/CPI = $40,000

$44,000/1.25 =

their

though

not kept up with the

Income

Family's

income

2010

The problemfor

of a

$35,200

has been rising in a nominal quantity Dividing

income

terms is

called deflating

the

nominal by

a

nominal

with (Be careful not to confuse the idea of deflating a nominal quantity or negative inflation. The two conceptsare different.) deflation, a nominal tool. It can be used to eliminate Deflating quantity is a very useful the effects of inflation from comparisons of any nominal quantity\342\200\224workers' health care expenditures, the components of the federal time. wages, budget\342\200\224over In if does this method work? know both how dollars Why general, you many you have on a given item and the item's of spent price, you can figure out how many the item you bought (by dividing the For your expenditures by price). example,if on last month and cost $100 $2.50 each, you you spent hamburgers hamburgers if can determine that 40 divide a family's you purchased hamburgers. Similarly, you dollar income or expendituresby a price index, which is a measure of the average price of the goods and servicesthey buy, you will obtain a measure of the real of and services Such real quantities are sometimes quantity goods they purchased.

referred to as inflation-adjusted

quantities.

(a nominal quantity) process of dividing a nominal quantity by a price index (such as the CPI) to express the in real terms quantity deflating

the

446

INFLATION AND

16

CHAPTER

LEVEL

earned

Who

to

earned

Bonds

1930

in

Babe

more,

Let's return was

Barry Bonds

Ruth versus

Babe

16.3

EXAMPLE

THE PRICE

the

Ruth or

Barry Bonds?

posed at the beginning of this chapter.When was he better or worse off than Babe 2001,

question

$10.3 million

Barry

Ruth

in

$80,000?

earning

To answer this question, we need to convert both men's into real earnings terms.The CPI(using the average of 1982-1984 as the base year since an extensive in this period) was 0.167 in 1930 and survey of consumer purchaseswas made 1.78 in 2001. Dividing Babe Ruth's salary by 0.167, we obtain approximately In other words someone which is Ruth's salary \"in 1982-1984 dollars.\" $479,000, would need $479,000in the 1982-1984 of goods period to buy the same amount and servicesas Babe Ruth could in 1930 with his $80,000 salary. Dividing Barry in Bonds' 2001 salary 2001 CPI, 1.78, yields a salary of $5.79 million by the 1982-1984 dollars. Thus, someonewould need million in the 1982-1984 $5.79 period to buy the same amount of goods and servicesas Barry Bonds could in 2001 with his $10.3 million salary. We can now comparethe real earnings of the two in 1982-1984 dollars: $479,000 and $5.79 million. Although power hitters inflation Bonds still adjustingfor brings the two figures closer together,in real terms earned more than 12 times Ruth's salary. Incidentally, Bonds alsoearnedabout 25 times what President Bush earned in 2001.

in or earnings at two different points in time, we comparing wages in for the level. so the real adjust changes price Doing yields wage\342\200\224the wage in terms of real purchasing power.Thereal wage measured for any given period is calculated by dividing the nominal (dollar) wage by the CPI for that period.

Clearly,

wage the wage workers measured real

purchasing power; for any given by

in

terms

of

the

real

wage

period dividing the nominal

wage

by

the

must

paid to

is

calculated (dollar)

CPI for that

period

CONCEPT CHECK 16.4 In

2009

the CPI real

EXAMPLE

16.4

Alex

as stated

earnings,

Real Wages do you

How

of the New York

Rodriguez

was 2.15.How did

factory

assembly

1970

and

Example

earned

real earnings

$27.5

million.

In

that

year

compare to Bond's2001

16.3?

of U.S. ProductionWorkers compare lines.

$19.00

workers9 real

wages?

are nonsupervisory The average U.S.

workers

Production

in

Yankees

2009

Rodriguez's

in

2010.

Compare

such as those who work on workerearned $3.40perhour production the real wages for this group of workers workers,

in

in

these years.

To find the real wage in 1970 and 2010, we need to know the CPI in both in and then divide the each the CPI for that For 1970, the years wage year by year. nominal wage was $3.40and the CPI was 0.39 (using the 1982-1984 average as the base period), so the real wage in 1970 was $8.72. Similarly, in 2010 the nominalwage was $19.00, and the CPI was 2.18, so the real wage in 2010 was $8.72. in we find real terms, production workers' wages the Thus, that, actually stayed same between 1970 and 2010, despite the fact that the nominal wage in 2010 was 5.5 times the nominal wage in 1970.

FOR

ADJUSTING

nominal wages and real wagesfor 1960-2010. Noticethe dramatic difference

16.2 shows

Figure

for the period

U.S.

workers

production

the two

between

447

INFLATION

trends.

workers Lookingonly wages, one might conclude that production-line were much better paid in 2010 than in 1960. But once wages are adjustedfor see that, in terms of buying workers' inflation, we power, production-line wages have since the 1970s. 16.4 illustrates the crucial stagnated early Example importance of for inflation when dollar values over time. adjusting comparing nominal

at

Nominal and Real Wages

18

Nominal

16

/~\\

-

16.2

FIGURE

20

Production

for

wage^X

Workers,

1970-2010.

14

Though

nominal

wages

\302\243 12

production workers

w

risen

10

(/>

8

&

real

Real wage

6

of

have

since 1970, dramatically have wages stagnated.

\302\243

4

2

0

I

I

o r^

I

I

o

Q)

Q)

r^

Q)

I

m

I

CO

I

I

I

m

o

Q)

Q)

CO

I

m Q) Q)

Q)

I

oo

o

CM

CM

o T\342\200\224 o

m

o

o

CM

Year Economic

Source:

minimum

the

1950

was $7.25

per hour.

CPI was

1950? The

consumer

0.24 in

Social

recipients' at what level

goal,

2.18

and

in

wage

$0.75 per hour. In compare to

2010

in 2010

it of

that

2010.

BUYING POWER can be usedto convert real that

example,

in the

$1,000 per

year 2010 in

month

living

is

should Congress set the

quantities government

to nominal paid

Let's assume that remain constant over

benefits.

power of thesebenefits of

the

to

by inflation.

unaffected

Social

monthly

Security

time so To achieve that benefit

in

the

2015?

year

The nominal, maintain

also

standard

the

that

for

Security recipients like the buying

would

Congress

1950

index

price

quantities. Suppose, certain

law was

wage prescribed by federal does the real minimum

How

TO MAINTAIN

INDEXING The

2010, Table B-47,www.gpoaccess.gov/eop.

February

President,

16.5

CHECK

CONCEPT In

Report of the

the

power

purchasing

taken place between

or dollar, benefit

between 2010 and

2010

consumersbuy

and 2015.

Congress

of retired 2015.

That is, on

pay in the

should

people dependson how

much

inflation

has

the CPI has risen 20 percent of the goods and services prices

that

Suppose average

year 2015 to

the

over that period. For SocialSecurity recipients to \"keep with their benefit in the year 2015 must be $1,000 + inflation, up\" = $1,200per month, or 20 percent more than it was in 2010. In .20($1,000) must be increased each general, to keep purchasing power constant, the dollar benefit in the increase the CPI. year by percentage The practice of increasing a nominal to changes in a price quantity according In the index to prevent inflation from eroding purchasing poweris called indexing. case of SocialSecurity, federal law provides for the automatic indexing of benefits. have

risen

20 percent

the practice of a nominal quantity increasing each period by an amount equal

indexing

to

the

increase

percentage

in a

specified price Indexing prevents the purchasing power index.

of the

nominal

being eroded

quantity by inflation

from

448

CHAPTER 16

INFLATION

THE PRICE

AND

Each

to that

EXAMPLE

16.5

any action by in the

without

year,

the

LEVEL

increase

percentage

are

wages

adjusted

get paid when they

do workers

much

for changes

partially

in

are

by an amount equal indexed as well so

inflation.

Labor Contract

An Indexed How

or

fully

increase

benefits

Congress,

CPI. Some labor contracts

have an indexedcontract?

a first-year wage of $12.00 per hour and specifies in the second year of the contract and by another 2 percent in the third year. The CPI is 1.00 in the first year, 1.05 in the second that must be year, and 1.10 in the third year. What are the dollar wages paid in the second and third years of the contract? real

the

that

for provides will rise by

contract

labor

A

wage

2 percent

the CPI is 1.00 in the first year, both the nominal wage and the real are $12.00. Let W2 stand for the nominal wage in the second year. Deflating by in the second year as CPI in the second year, we can expressthe real wage Because

wage the

contract be 2 percent says that the second-year real wage must higher = $12.00 X 1.02 = $12.24. wage in the first year, so W2/1.05 = $12.85, the nominal wagerequired Multiplying through by 1.05 to solve for W2, we get W2 in the second year. In the third the contract by year the nominal wage W3 must

W2/1.05.

The

real

the

than

satisfy

the

for

W3 yields

equation

= $12.24

W3/I.IO

$13.73 as the

nominal

= $12.48.

1.02

X

wage

that must

CHECK 16.6 The minimum wage is not indexed to inflation, 1950. What would the nominal minimum wage Check 16.5for the data necessaryto answer this

(Why?) Solving this

be paid in

the

equation

third

year.

been

starting

CONCEPT

the minimum

Because to

periodically

the real

keep

process

in the

nominal

the

expresses

can be compared.

Indexing.

DOES

each year

FOR

the

rises by

different

such a price in

terms

years

CPI

See

2010?

in

Concept

question.

its

power

purchasing

the nominal minimum wage from eroding.

wage

INFLATION

as a family's dollar income,for index such as the CPI. This of real purchasing are deflated by a

purchasing power

of

the

two

deflated

power. If

price index quantities

a nominal payment, such as a SocialSecurity level of real purchasingpower, increasethe nominal for that percentage equal to the rate of inflation year.

a

MEASURE

\"TRUE\" INFLATION?

close attention to the latest pay to take. Furthermore,becauseof

Policymakers

changes in

by

CPI

THE

what actions CPI

a constant

represents

in

that

ensure

To

quantity

quantity two

from

base year, the

same

the

benefit,

minimum

a nominal quantity, price level, divide it by

nominal quantities with

value of the

To correct

Deflating. changes

raise

therefore

METHODS TO ADJUST

RECAP

it had

suppose

have been

wage is not indexedto inflation,

prices rise.Congressmust

falls as

but

directly

3 percent during

inflation

the

numbers

widespread

when

deciding

use of

indexing,

impact the government's budget. For example,if the a given year, by law Social Security benefits\342\200\224which

DOES

are a

significant part

Many other contracts,

However, indexing of SocialSecurity if

federal

the

costing

other

and

true improvement in nominal

family's

be

to

reported

inflation?

to the

more than

over

time.

per year, then the

(the

percent inflation).

the

First,

CPI couldbe every

necessary

us to

3 percent

real

family's

increase

income

in nominal

is actually

income minus 2

Report,concluded

known as the Boskin Commission report, CPI inflation rate overstates the true inflation

1996

percent.

labor

underestimate the For instance, if the typical

lead

could

by 3

is per year, and inflation economistswould conclude that American per year, no increase in their real income.But if the \"true\"

3 percent

rising by 1 percentper year A

\"true\"

benefits

of dollars

inflation

by 3 percent

increases

rate

inflation

of

standards

living

income

are experiencing is really 2 percent

families

government

billions

government

contracts, such as union

measure of

the

Second, an overstated rate

year.

private

CPI as well. CPI is a poor

to the

what

automatically

budget\342\200\224increase

and

payments

government

indexed

are

federal

the

of

THE CPI MEASURE

that

as 1 to 2 percentagepoints a year. It gave a number of reasons why this might be this case; two are particularly important.First, in practice,government statisticians cannot for changes in the quality of goods and always adjust adequately services. Suppose a new personal computerhas 20 percent more memory, and data storage capacity than last year's model.Suppose too computational speed, for the sake of illustration that its price is 20 percent higher. Has therebeen in computer inflation Economists would say no; although consumers prices? are paying 20 percent more for a computer, they are getting a 20 percent better machine.The situation is really no different from paying 20 percentmorefor a that is 20 because is difficult to pizza percent bigger.However, quality change measureprecisely and because have thousands of and services they many goods to consider, government statisticiansoften miss or understate changes in In whenever statisticians fail to for quality. general, adjust adequately improvements in the of or will tend to overstate inflation. services,they quality goods This type of overstatement is called quality adjustment bias.1 An extreme of quality adjustment bias can occurwhenever a totally example new good becomes available. For instance,the introduction of the first effective AIDS drugs significantly increased the quality of medical care receivedby AIDS In arise from patients. practice, however, quality improvements that totally new if are to be the at all. The CPI, products likely poorly captured by problemis that since the new good was not producedin the base year, there is no base-yearprice with which to compare the current price of the good. Government statisticians use various approachesto correctfor this problem, such as comparing the cost of the new drug to the cost of the next-best But such methods are therapies. the

official

necessarily

imprecise

2There

are

and

open

rate

by as much

to criticism.

The secondproblememphasizedby the Boskin Commission arises from the fact that the CPI is calculated for a fixed basket of goodsand services. This does not allow for the that consumers can switch procedure possibility from whose are to those whose are stableor products prices rising prices the fact that consumers can switch from more to less falling. Ignoring expensive in the leads statisticiansto overestimate the true increase expensive goods cost of living. for instance, that people like coffeeand tea equally well and in the base Suppose, consumed amounts of each. But then a frost hits a year equal major coffee-producing the price of coffee to double.Theincreasein coffee nation, causing prices encourages consumers to forgo coffee and drink tea instead\342\200\224a switch that doesn't make them many hardworking

changes. Someimprovements, measure.

But

many

others are

the Bureau of Labor Statistics trying as increases in computer speeds and memory, harder to quantify.

employeesat such much

to measure

are relatively

quality easy

to

\"TRUE\"

INFLATION?

449

450

CHAPTER16

INFLATION

AND

THE PRICE

worse

significantly that

since they like coffeeand tea equally of buying the base-year basket of

off,

cost

the

measures

LEVEL

the

when

can

people

16.6

worse of

off, exaggerates is called

inflation

Bias

Substitution

bias matter?

substitution

does

Why

the

bias.

substitution

EXAMPLE

coffee doubles.This rise in the CPI, tea for coffee without made being cost of living. This type of overstatement

price of substitute

the true increasein

CPI, which will rise which ignores the fact

the However, and services, goods

well.

Suppose the CPI basketfor

base year, is

the

2010,

Expenditure

Item

Coffee Tea

as follows:

(50 cups at

Scones

$ 50.00

(50 cups at $ l/cup)

(100 at

50.00

$ l/cup) $1

100.00

each)

Total

that

Assume

consumers

In 2010, coffee

of coffee

and

In the

per cup, measured

and

$200.00

are equally happy to drink coffee or the same, and the average person

tea cost

tea with their scones. drinks equal amounts

tea.

year 2015, coffee

has

doubled

and sconesare $1.50each.What by the CPI? How doesthis result

to $2 per cup.Tea remains at to the cost of living to the true cost of living? compare

in price has

happened

$1 as

of the CPI for the year 2015, we must first find the cost 2010 basketof goods in that year. At year 2015 prices, 50 cups each of coffee and tea and 100 sconescost (50 X $2) + (50 X $1) + (100 X $1.50) = cost $200 in 2010, the base year, $300. Since consuming the same basketof goods in 2015 is $300/$200, or 1.50.This the CPI calculation leads us to conclude that the cost of living has increased 50 percentbetween 2010 and 2015. that consumers can substitute a However, we have overlookedthe possibility cheapergood(tea) for the more expensive one (coffee). Indeed,sinceconsumers like coffee and tea equally well, when the of coffee doubles they will shift price to tea. Their new consumption basket\342\200\224100 cups of tea and 100 scones\342\200\224is entirely If we allow for the substitution of as enjoyable to them as their basket. just original lessexpensive how much has the cost of living increased? The cost of goods, really 100 cups of tea and 100 scones in the year 2015 is only $250, not $300.From the consumer's has risen by only $50, or 25 point of view, the true cost of living To

calculate

the value

of consuming the

percent.

The

of living

50 percent

increase

as the result of

in

substitution

the

CPI

therefore

overstates

the increase

in

the

cost

bias.

The Boskin Commission's findings have been controversial. While quality distort the measurement of adjustment bias and substitutionbias undoubtedly inflation, estimating preciselyhow much of an overstatement they create is difficult. knew exactly how big thesebiaseswere,they could (If economists simply correct the data.) But the Bureau of Labor Statistics has recently made significant efforts to improve the quality of its data as a result of the commission's report.

THE COSTSOF INFLATION:

THE

COSTS

YOU

THINK

OF INFLATION: NOT

late 1970s, when inflation told poll takers that they viewed nation's most serious problem. In the

U.S.

Although

do people worry many people are When

people

relative

inflation remain

Americans

many

was

so much about inflation? confused about the meaning

complain

about

inflation,

than

enemy number

rates have not been very concerned about inflation or Detailed

high

it

opinion

is now,

one\"\342\200\224that

in recent

the threat

of inflation

they are

451

of

surveys

the public is, as the

years, today inflation.

often

Why find

and its economic

often concernedprimarily

that

effects. about

costs of inflation, which are real and and its costs. people experience about inflation We need first to distinguish between the price leveland the relative of a price good or service.The price level is a measure of the overall level of prices at a particular point in time as measured by a price index such as the CPI. Recall that the inflation rate is the percentage change in the price level from year to year. In conis the price of a specificgoodor service in comparison to the trast, a relative price if the of other goods and services.For example, prices price of oil were to rise by 10 percent while the prices of other goodsand services were rising on average by 3 percent, the relative price of oil would increase. But if oil prices rise by 3 percent while other prices rise by 10 percent, the relative price of oil would decrease.That to other it is, oil would becomecheaperrelative goods and services, even though has not becomecheaperin absolute terms. Public opinion surveys suggest that are confused about the many people distinction between which is an increase in the overall inflation, price level, and an in the Middle increase in a specific relative price. Suppose that supply disruptions East wereto double the price of gas at the pump, leaving other pricesunaffected. the Appalled by the increase in gasoline prices, people might demand that government do about \"this inflation.\" But while the increase in gas prices hurts something of inflation? Gasoline is only one item in a consumer's consumers, is it an example of goods and services that budget, one of the thousands people buy every day. Thus, the increase in the price of gasoline might affect the overall price level, and In this example, hence the inflation rate, only slightly. inflation is not the real problem. What consumers is the change in the relative price of gasoline, upsets to the price of labor (wages).By increasing the cost of using a car, particularlycompared in the relative price of gasolinereducesthe the increase income have left people over to spendon other things. in relative prices do not necessarily a significant amount Again, changes imply of inflation. For example,increasesin the prices of some goods could well be in the prices of other goods,in which counterbalanced case the price level by decreases and the inflation rate would be largely unaffected. Conversely, inflation can be that all prices in high without affecting relative prices. Imagine,for instance, the economy, including wages and salaries,go up exactly 10 percenteachyear. The inflation rate is 10 percent, but relative are not changing. Indeed, because prices wages(the price of labor) are increasing by 10 percentper year, people's ability to buy goods and servicesis unaffected by the inflation. in the price level and changesin the relative These examples show that changes different issues. The public's tendency to prices of specific goods are two quite confuse the two is important because the remedies for the two problems are different. To counteract changesin relative prices, the government would need to implement In the case of an that affect the supply and demand for specific policies goods. in oil prices, increase for example, the government couldtry to encourage the of alternative sources of energy. To counteract inflation, the however, development must resort (as we will see) to changes in macroeconomic policies such government let's

THINK

price changes.

Before describing the

serious,

WHAT YOU

WHAT

higher

considerably

it as \"public

NOT

examine

true

economic

this confusion

price level a measure overall ular by

point a price

of the

of prices at a

particas measured index such as the CPI

level

in time

the price of a price specific good or servicein cornto the prices of other parison goods and services relative

452

CHAPTER

16

INFLATION AND

THE PRICE

LEVEL

or fiscal

as monetary

policies. If,

adopt anti-inflationary the economy why

EXAMPLE

16.7

economic

in confusion, the public when the real problem

policies

are the

relative

price

change,

could actually be hurt by the effort. This is an important example of and the general literacy is important, to both policymakers public.

The Price Level,RelativePrices,and How

forces the government to

is a

price level,relative

Suppose the value of

CPI

the

Inflation

and

prices,

inflation

related?

is 1.20 in the year 2010, 1.32 in 2011, and 1.40 in of oil increases 8 percentbetween 2010 and 2011 2011 and 2012. What is happening to the price relative price of oil?

2012. Assume also that the price and another 8 percent between level, the inflation rate, and the

can be measured by the CPI. Since the CPI is higher in 2011 and higher still in 2012 than in 2011, the price level is rising throughout the Since the CPI increases by 10 percent between 2010 and 2011, the period. inflation rate between those years is 10 percent.However, the CPI increases only \302\253 about 6 percent between 2011 and 2012 so the inflation (1.40/1.32 1.06), rate decreasesto about 6 percentbetween those The decline in the inflation years. rate implies that although the price level is still rising, it is doing so at a slower

The price level

than

in

2010

pace than the

year before.

The price of

general

price

relative

10%

=

rises

oil

over

inflation

that

between 2010 and 2011. But is 10 period percent,the relative price 8 percent

to all other

Between \342\200\2242%).

goods and services\342\200\224falls

2011

and 2012 the

while the general inflation rate rises between 2011 and 2012 by

THE

TRUE

COSTS

is about about

about

by

price of oil risesby

6 percent. 2 percent

Hence

(8%

because

the

of oil\342\200\224that is, its 2 percent (8% \342\200\224 another 8 percent,

the relative

price of

oil

\342\200\224

6%).

OF INFLATION

between inflation and relative price Having dispelledthe commonconfusion we are now free to address the true economic costs of inflation. There are changes, a variety of such costs,eachof which tends to reduce the efficiency of the economy. Five of the most important are discussedhere.

\"Noise\" in

In Chapter

the

Price

System

3 we describedthe

to provide the

right

amount

remarkable

and the

right

economic kinds

coordination

of food

to New

that is necessary

Yorkers every

day.

not orchestrated by some Food Distribution Ministry staffed by bureaucrats. It is done much better by the workings of free markets, operating without central than a ministry ever could. guidance, How do free markets transmit the enormous amounts of information to tasks like the provisioning of New York City? The necessary accomplish complex in as we saw is the owners of answer, 3, Chapter through the price system. When French restaurants in Manhattan cannot find sufficient quantities of chanterelles, a rare and desirable bid its market mushroom, they particularly up price. Specialty food suppliersnoticethe higher price for chanterelles and realize that they can make a profit by supplying more chanterellesto the market. At the same time, price-conscious diners will shift to cheaper, more available mushrooms. The market for chanterelles will reach equilibrium only when there are no more unexfor profit, and both suppliers and demandersare satisfied at ploited opportunities

This

feat is

THE COSTS

the market

and

price (the

of how gain economic coordination.

you

of

degree

through

makes static, or \"noise,\" little or no inflation, the is

inflation

increase

however, in the

which

causes

high,

system subtle to

difficult

signals interpret,

of specialty

supplier

that

foodstuffs

a

remarkable

in the way that with

economy

will immediately

market.If

prices as a signal to bring more to

the supplier must

ask whether a price increaserepresents

demand for chanterellesor is just a result of the general inflation, prices to rise.If the price rise reflects only inflation, the price of chanterelles relative to other goods and serviceshas not really changed. The supplier therefore shouldnot changethe quantity of mushrooms he brings to a true

all food

market. In an inflationary

to discern whether the increase in of increaseddemand,the supplier needs to know not the of chanterelles but also what is to the only price happening prices of other and services. Since this information takes time and effort to collect, the goods in to the chanterelle is to be slower and supplier's response change prices likely is a

chanterelleprices

environment,

true signal

tentative.

more

price changes are

In summary, information to

and demanders.

suppliers

tells demanders more of it bring

example,

the

market's

increase

An

to economizeon their

way in the use

of communicating

price of a good or service, good or serviceand

for

of the

But in the presence of inflation, are prices and demand for a but only by changes supply product by changes in the general price level. Inflation creates or \"noise,\" in the price system, static, and reducing the efficiency of the obscuring the information transmitted by prices in market This reduction real economic costs. system. efficiency imposes to

suppliers

market.

to

not

affected

the

in

of the Tax System

Distortions

are indexed benefits, expenditures, such as SocialSecurity In taxes are also indexed. the United with States, people many higher in taxes. Without indexing, an incomes income pay a higher percentage of their inflation that raises people's nominal incomeswould force them to pay an increasing in of their income even their real incomes not have taxes, percentage though may increased. To avoid this phenomenon, which is known as bracket creep, Congress has indexedincometax brackets to the CPI. The effect of this indexation is that a whose nominal income is at the same rate as inflation does not have family rising to pay a higher percentage of income in taxes. has solved the problem of bracket Although indexing creep, many provisions of the tax codehave not been indexed, either because of lackof political or support because of the complexity of the task. As a result, inflation can unintended produce changes in the taxes people pay, which in turn may cause them to change their as

Just

some

government

to inflation,

in

behavior

undesirable

economically

To illustrate, an important inflation

problems

poses

Suppose a firm

follows.

Under U.S.tax law, as

is the

from

a deduction

fraction

of

The exact

buys the

the

purchase

amount

of

ways.

tax code for provisionin the business which allowance, capital depreciation

a machine

firm

can take

for $1,000,

expecting

one-tenth of the

it

to

last

which as

works

for 10

years.

purchaseprice,or $100,

its taxable profits in each of the 10 years. By deducting a reduces its taxes. price from its taxable profits, the firm the yearly tax reduction is the tax rate on corporate profits

$100.

times

The idea is a

machine

behind this provision of the tax code is that the wearing out of the cost of doingbusiness that should be deducted from the firm's profit. in new machinery, firms a tax break for investing Congress intended

Also, in giving to encouragefirms

to

modernize

their

plants.

Yet

capital

depreciation

NOT WHAT

YOU

THINK

million times,

are transmitted

much

interpret.In an

message harder to

a radio

in chanterelle

increase

recognize the

the

become more

system

price

price

is high, however,

When inflation the

the

this example a achieves a truly

Multiply

Principle).

Equilibrium

a sense

will

INFLATION:

OF

allowances

Equilibrium

453

CHAPTER

16

INFLATION AND

THE PRICE

LEVEL

to inflation. Supposethat, at a time when the inflation rate is a The know that high, purchasing $1,000machine. managers the purchase will allow them to deduct $100 per year from taxable for the profits next 10 years. But that $100 is a fixed amount that is not indexed to inflation. that the 5, 6, or 10 years into future, Looking forward, managerswill recognize the real value of the $100 tax deduction will be much lower than at present because of inflation. will have less incentive to buy the machine and may They decide not to make the investment at all. Indeed, many studies have found that a in rate of inflation can reduce the rate at which firms invest new high significantly factories and equipment. Becausethe U.S. tax code contains hundreds of provisionsand tax rates that are not indexed, inflation can distort the incentives provided by the tax seriously for to and invest. The resulting effects on economic work, save, system people and economic a real cost of inflation. efficiency growth represent are

indexed

not

is considering

a firm

Costs

\"Shoe-Leather\"

As all

shoppers know, cash is convenient.

Unlike which are not accepted checks, for which a minimum is often required, cash cards, everywhere, purchase can be used in almost any routine transaction. Businesses,too, find cash convenient to hold. Having plenty of cash on hand facilitates transactions with customers and reduces the need for frequent and withdrawals from the bank. deposits Inflation raises the cost of holding cash to consumers and businesses.Consider a miser with $10,000 in $20 bills under his mattress.What happens to the buying If of his hoard over time? inflation is zero so that on the prices of power average and servicesare not the of the $10,000 does not goods changing, buying power over time. At the end of a the miser's change year, purchasing power is the same as it was at the beginning of the year. But the inflation rate is 10 percent. In suppose and

that

case,

year.

the

credit

purchasing power he will have

a year,

After

higher the rate of inflation, loss of purchasing power Technically, currency

the that

of the miser's hoard will fall by 10 percent each In general, the only $9,000 in purchasing power. less people will want to hold cash becauseof the

they

will

suffer.

is a debt owed

to the currency holder. by the government the losses to holders of cash are offset by gains to the value, currency in which now owes less real terms to holders. from the Thus, government, currency in of view of as a the loss of is not itself a whole, point society purchasing power cost of inflation because it does not involve wasted resources. n o real (Indeed, goods or services were used up when the miser's currency hoard lost part of its value.) when faced with are not likely to accept a loss in However, inflation, people but instead will take actions to cash purchasing power try to \"economize\" on their For instead of out cash for a month the next holdings. example, drawing enough

Sowhen

loses

the bank, they will draw out only enough to last a week.The the bank more often to minimize one's cash holdings is a real visiting cost of inflation. businesses will reduce their cash Similarly, holdingsby sending to the bank more frequently, or by installing employees computerized systems to monitor cash To deal with the increase in bank transactions required to use less cash, banks will need to hire more by consumers and businesses trying time

they

inconvenience

visit

of

usage.

employees and expandtheir operations. The costs of more frequent trips to the

and expandedemployment time including

and

effort,

in

that could

of economizing on cash have shoe leather is worn out during

banks

be used for been

bank,

are real called

new

cash management

costs. They use up

other

purposes.

shoe-leather

systems,

resources,

Traditionally, costs\342\200\224the

idea

the costs being

that

trips to the bank. Shoe-leathercostsprobably are not a significant problem in the United States today, where inflation is only 2 to 3 percentper year. But in economies with high rates of inflation, they can become quite

significant.

extra

THE COSTS

inflation

INFLATION:

of Wealth

Redistributions

Unexpected When

OF

it may

is unexpected, Consider a group

from one

wealth

redistribute

arbitrarily

group

who signeda contractsetting their If for the next three those are not indexed to then the inflation, wages years. wages workers will be vulnerable to upsurgesin the price level. Suppose, for example, that inflation is much higher than expected over the three of the contract. years In that case, the buying of the workers' real be power wages\342\200\224their wages\342\200\224will to

another.

anticipated when From society's point of

than

less

paying

is

workers to

the

would have

been the

have

Another example of

the

borrowers (debtors)and wants

to

(creditors).

on a

lake and

anticipated

the than

Suppose

one of

workers

and the

takes place between

the authors

borrows $150,000from agreement,

mortgage

How

expected.

the

macroeconomist,

rising,

they

the

expected,

by inflation

caused

redistribution

lenders

pay for it. Shortly after signing is likely to be much higher

Perhapsas a public-spirited hear that inflation is

than

loser.

a house

buy

lower than

had been

If inflation

employer.

enjoyed greater purchasingpower

would

employer

book

contract.

is the

answer

The

\"lost\"?

an

inflation

the

signed

they

lose to inflation view, buying power that workers is no; the loss in their is buying power exactly matched in the because the real cost of unanticipated gain employer's buying power In the workers is less than other the effect of the words, anticipated. in not to destroy purchasing power but to redistribute this case from the it,

really by

of union workers

should author

the

to

he learns that inflation he react to the news? should be saddened to

a consumerhe should be pleased.In

but as

this

of

bank

real

terms, repay his loan in the future will be worth much less than expected. The loan officer should be distraught because the dollars the bank will receive from the author will be worth less, in purchasingpower than at contract signing. Once again, no real wealth is \"lost\" to the terms, expected In general, the borrower's is offset the lender's loss. inflation; rather, gain just by

the dollars

he will

which

with

at the expenseof lenders in their loans less-valuable dollars. repay in low inflation lenders and hurt borrowers rates, contrast, help Unexpectedly by forcing borrowers to repay in dollars that are worth more than expected when the loan are

borrowers

because

help borrowers

rates

inflation

high

unexpectedly

able to

was made.

do not directly destroywealth, are still bad for the economy. another, only they Our economicsystem is based on incentives. For it to work well, people must know that if they work hard, save some of their income, and make wise financial will be rewarded in the long run with greater real wealth and a investments, they better standard of living. Some observers have compared a high-inflation economy to a casino,in which wealth is distributed largely by luck\342\200\224that is, by random in the inflation fluctuations rate. In the long run, a \"casinoeconomy\" is likely to perform as its from and poorly, unpredictability discourages people working saving. can take away your savings overnight?) Rather, a high(Why bother if inflation in trying to anticipate inflation economy encourages people to use up resources inflation and protectthemselves it. against it from

transfer

with

Interference

The fifth the

final

and

investment

and

Clearly, Suppose, retire.

for How

are in

business

we will examine is its tendency to interfere with of households and firms. Many economicdecisionstake horizon. Planning for retirement, for example, may begin

their

strategies

high and

example, much of

Planning

Long-Term

a long

when workers

one group to

cost of inflation

planning time

long-term

placewithin

by inflation

caused

redistributions

Although

but

twenties

or thirties.

that look

erratic inflation

that you want

your income

can

make

to enjoy a certain

do you

firms

And

decades into

need

the

develop future.

long-term

to save

standard

long-term

planning of living

to make your

difficult. when you

dreams a reality?

NOT WHAT

YOU

THINK

455

456

CHAPTER

INFLATION AND

16

THE PRICE

LEVEL

on what the goods and servicesyou plan to buy will cost 30 or 40 With high and erratic inflation, even what your chosen years guessing will cost the time retire is difficult. You lifestyle by you extremely may end up saving too little and having to compromise on your retirement plans;or you may save too much, sacrificing more than you need to during your working years. Either way, will inflation have proved costly. In summary, inflation damages the economy in a variety of ways. Someof its effects are difficult to quantify and are therefore controversial. But most in maintaining economists agree that a low and stable inflation rate is instrumental a That

depends

now.

from

healthy economy.

fAATHEnATICAL

ns/Dist.

.

YEAR

OLD

NO MATTER KOC0 HARD YOU WORK\302\273 WILL HAKE INFLATION

1

AdaInc.

A

Scott

k

J^m

THE

(jl)AY

\302\273 I'M

ALL

WITH

THAT

CERTAINTY

DILL BE NO RAISE5 OR PROMOTIONS

THI5

I HATED

A

NOL^THERE'S

THERE.

ANNOUNCED

United by

HAS

CO/APAW

THE

NOT

TUST A

THE

MANAGER,

UNCERTAINTY-

I'M

A

LEADER'

you

poorer.

Syndicate,

\\Mm

rr^k

Ulo

DILBERT:\302\251 Feature

HYPERINFLATION

5 percentper year

economic performance.

disrupts

hyperinflation which the

inflation

extremely

high

a situation rate

in is

high is called per In

(400 percent

there

in

and

and

per

year

the inflation rate is extremely is no official threshold above which rates in the range of 500 to 1,000

of

1985),

occurred

in Israel

countries (including in 1988), (33,000 percent inflation

South American

Brazil),

capitalism, including Russia.Perhaps

have

hyperinflation

several

Nicaragua in (officially 24,470 percent inflation several countries to make the attempting

Zimbabwe

most

the

unofficially

2007, transition

well-known

from

150,000 communism

episode occurred

to in

when inflation was 102,000,000 percent.In the German rose so rapidly that for a time workers were paid twice each day could food before the afternoon buy price increases,and many

in 1923

Germany

prices

hyperinflation,

so their

families

people's

life savings

recorded was in inflation

became worthless. But

3.8

1027

X

the short-lived

although

hyperinflation,

inflation

during the

Confederacyroseto 92

times

the

most

extreme

at the end of the Second The United States percent.

in 1945,

Hungary

at

peaked

severe

500 percentor 1,000percent

qualify.

decades, episodes

inflation

Argentina,

percent),

surely

inflation rate of, say, few economistswould

in which

inflation

hyperinflation,

year would the past few

Bolivia,

rate of situation

A

an

whether

on an economy,

costs

hyperinflation. Although

becomes

inflation percent

important

imposes

fact that an inflation

the

question

some disagreementabout

there is

Although

Civil

their

War.

ever hyperinflation when War,

World

has never experienced Confederate States of America suffered Between 1861 and 1865, prices in the levels.

prewar

of inflation. For example, shoein times of low inflation\342\200\224become when people may visit the bank two or quite important during hyperinflation, three times per day to hold money for as short a time as possible. With prices markets work quite poorly, slowing economic changing daily or even hourly, Massive redistributions of wealth take place, impoverishing many. Not growth.

greatly magnifies

Hyperinflation

leather

costs\342\200\224a relatively

surprisingly,

so disruptive

episodes that

they

minor

the

costs

consideration

of hyperinflation rarely last quickly lead to public outcry

more than for

relief.

a few

years;

they are

INFLATION

COSTS OF INFLATION

THE TRUE

RECAP

sometimes confuses changesin relative (such as the price of prices which is a change in the overall level of prices. This confusion can cause because the remedies for undesiredchangesin problems relative prices and for inflation are different. There are a number of true costs of inflation, which together tend to reduce economic and efficiency. These include: growth

The public

oil) with

inflation,

price system, which occurs when general inflation for market participants to interpret the information

in the

\342\226\240 \"Noise\"

it difficult

makes

conveyed

by prices.

code are not \342\226\240 \"Shoe-leather\"

by making

cash management

redistributions wage

benefit of with

\342\226\240 Interference

forecast

to

for example,when

of the

provisions

economizing on cash (for bank

or installing

tax

example,

a computerized

system).

hurts

inflation

difficult

indexed.

or the costs of costs, more frequent trips to the

\342\226\240 Unexpected

to the

tax system,

of the

\342\226\240 Distortions

earners

debtors.

of wealth, as when higher-than-expected to the benefit of employersor hurts creditors

long-term planning, arising prices over long periods.

because peoplefind

it

AND INTEREST RATES

INFLATION

focused on the measurement and economiccosts of inflation. of inflation is its close relationship to other key macroecoaspect nomicvariables. For economists have long realized that during of example, periods with high inflation, interest rates tend to be high as well. We will close this chapter a look at the relationship between inflation and interest a rates, which will provide useful background in the chapters to come. we

far

So

Another

have

important

AND THE

INFLATION

RATE

in which inflation redistributes wealth, we ways creditors and help debtorsby reducing the value of the dollars with which debts are repaid. The effect of inflation on debtors and creditors can be explainedmore precisely an economic called the using concept

Earlier

sawthat

discussion of

INTEREST

REAL

in our

tends

inflation

real interest rate. An

to

remain

at

10 percent and annual

interest

will

example

Suppose that there

whose currency

the

to hurt

illustrate.

are two neighboring countries,Alpha

is calledthe

the

alphan,

inflation

rate is

and

Beta.

In Alpha,

zero and is expected

where the currency is the betan, the inflation rate is is expected to remain at that level. Bank deposits pay 2 percent in Alpha and 10 percent annual in Beta. In which countries interest

zero.

In Beta,

are bank depositorsgetting You may answer \"Beta,\"

deal?

a better

in that rates on deposits are higher will think about the effectsof inflation, that not you recognize Alpha, offers the better deal to To see think about the over a Beta, depositors. why, change in in In the real of the two countries. someone year purchasing power deposits Alpha, in the who deposits 100 alphans bank on January 1 will have 102 alphans on country.But

since

if you

December 31. Becausethere is at the end of the year as they depositor

interest

can

withdraw

no inflation were

represent a

at the

on average pricesare the same beginning. Thus, the 102 alphans the

in Alpha,

2 percent increasein

buying

power.

AND

INTEREST

RATES

457

CHAPTER16

458

INFLATION

AND

THE PRICE

LEVEL

In Beta, the

betans by

the

rate

interest

annual

in the

increase

percentage

purchasing power of a financial the real interest rate on

asset;

any asset equals the interest rate on that minus the

(or market annual

in the

interest

rate) increase

value

of a

financial asset

percent

on

than

110

1 will have January she started with. But

the

we have

an asset.

of

we can calculate the real interest the rate of inflation from the market or by subtracting nominal interest rate on that asset. So in Alpha, the real interest rate on deposits the nominal interest rate (2 percent) minus the inflation rate (0 percent), or equals 2 percent.Likewise in Beta, the real interest rate equalsthe nominal interest rate As the example rate for any financial

the

year\342\200\22410

more

Beta, assumed, also will rise by 10 percent. prices the Beta can afford to the same amount of goodsand Thus, depositor buy precisely services at the end of the year as shecouldat the beginning; she gets no increase in So the has the better after all. deal, buying power. Alpha depositor in Economists refer to the annual increase the real purchasing percentage of a financial asset as the real interest or the real rate rate, power of return, on that In our example, the real purchasing power of deposits asset. rises by 2 percent per in Alpha in Beta. and by 0 percent per year So the real interest rate on deposits year in Alpha and 0 percentin Beta. The real interest rate should be is 2 percent from the more familiar market interest rate, alsocalledthe nominal distinguished interestrate. The nominal interest rate is the annual increase in the nominal, percentage

or dollar, value

rate

percentage nominal

asset rate

inflation

interest

nominal

nominal

of the

and servicesin

of goods

real

depositor who deposits100 betans

end

the

(10 percent)

Beta

and

illustrates,

asset

the

minus

write

can

We

of Alpha

(10 percent), or 0 percent. of the real interest rate in mathematical

rate

inflation

this definition

terms:

\342\200\224

/

77,

where, r =

the real

i = the 77 =

Note the

that

price in

measured

EXAMPLE

16.8

the

interest rate, interest rate,

or market,

nominal,

rate.

inflation

the real interest rate is not equal to the nominal interest rate divided level. The reason is that the nominal interest rate is a rate of return, in dollars. not a nominal quantity measured percent,

by

Real Interest Rates, 1975to 2010 What

is the

good

Following

are

real interest

interest

1975. In which of

bonds get the Year 1975

1980

1985

1990

1995

2000

2005 2010

best

rates

rate?

on 10-year

these years did the deal?

The worst

Interestrate (%) 8.0

11.4 10.6 8.6 6.6 6.0 4.3

3.2

government bonds for

financial

investors

who

deal?

Inflation

rate

(%)

Real

selected

years

since

bought government

interest

rate (%)

9.1

-I.I

13.5 3.6 5.4 2.8 3.4 3.4 1.6

-2.1 7.0 3.2 3.8 2.6 0.9 1.6

INFLATION

INTEREST

AND

459

RATES

and lenders do bestwhen the real (not the nominal) interest in their purchasing real interest rate measures the increase We can calculate the real interest rate for each power. year by subtracting the in column inflation rate from the nominal interest rate. The resultsare shown 3 of the table in Example 16.8. For purchasers of government bonds,the best of these years was 1985, when a real return of 7 percent. The worst year was 1980, they enjoyed In when their real return was negative 2.1 other words, despite receiving percent. 11.4 nominal interest, financial investors endedup losing percent buying power in Financial

rate is high

investors the

since

rate exceeded the interest rate earned by their investments. 1980, as the inflation 16.3 shows the real interest rate in the United States since 1960 as Figure measured by the nominal interest rate paid on the federal debt minus the government's inflation rate. Note that the real interest rate was sometimes negative this during in and reached levels the mid-1980s. period, historically high

9

8 7

0s

W

2

5

the

4

A

borrowed

3

government

-2

-3

-4 c c

I

I

I

I

o

CO

I

I

I

I

I

o

CO

I

I

I

o

I

I

I

o

o

o

o

CM

CM

o

J

m

o

CM

Year Report of the President,

Economic

.gov/eop and authors'

February

2011,

Tables B-73 and B-64, www.gpoaccess

calculations.

real interest rate helps to explainmore precisely an why is bad for lenders and good for borrowers. For any given nominal interest rate that the lender charges the borrower, the higher the inflation the lower the real interest rate the lender receives. So rate, actually inflation leaves the lender worse off. Borrowers, on the other hand, unexpectedly high are better off when inflation is unexpectedly high because their real interest rate is concept

of the

unexpected

surge

lower than

anticipated.

in

inflation

high inflation hurts lenders and helps borrowers,a is expected may not redistribute wealth at all because can be built into the nominal interest rate. Suppose,for example, expectedinflation that the lender requires a real interest rate of 2 percent on new loans. If the inflation rate is confidently can get a 2 percent real expected to be zero,the lender interestrate a nominal interest rate of 2 percent. But if the inflation rate is by charging high

Although unexpectedly rate of inflation that

rate is the rate\342\200\224here

rate on

funds

by the federal for a term of

months\342\200\224minus

rate of inflation.

-1

The

interest

three

0

Source: The

States,

interest

nominal

intei

*

Interest Rate in

United

1970-2010. The real interest

\342\226\240LJ
75

16.3

the

T 6 \302\243

FIGURE

The Real

the

460

CHAPTER

THE PRICE

INFLATION AND

16

interest

rate

States

United

hurt lenders\342\200\224as long to reflect the expected

introduced

lenders can

as the

Treasury

to

rate plus the actual of inflation during that year real

percent

if it is

nominal

the

in 1997

inflation,

inflation-protected bonds, which pay a fixed these bonds receive a nominal interest rate each of inflation

rate

actual

bonds suffer no

of inflation-protected

Owners

adjust the

unexpected

of 2

rate

inflation,

high

inflation rate.

rate. Peoplewho buy to a fixed real rate plus the year equal real interest

that

a fixed

charge

a real interest

of 12 percent.Thus,

In response to people'sconcernsabout

inflation-protectedbonds pay a nominal rate each year equal

not

need

interestthey

still ensure

can

lender

interest rate

a nominal

charging

expected,

bonds

10 percent, the

to be

expected by

LEVEL

loss in

during that year, even if inflation

wealth

real

is unexpectedly high.

THE FISHER EFFECT the observation that interest rates tend to be high when and low when inflation is low. This can be seen in high relationship which shows both the U.S. inflation rate and a nominal interest rate 16.4, Figure rate at which the borrows for short from 1970 to 2010. (the government periods) in periods Noticethat nominal interest rates have tended to be high of high in such as the and low of low inflation, inflation, such early 1980s, relatively periods as the late 1990s and early 2000s. is

^

and Interest

Inflation in

the

United

interest

Nominal

to be high

when

effect.

16 r

\302\243 12 (A
rates tend inflation

high and low when low, a phenomenon

mentioned

\302\24314

1970-2010.

States,

Fisher

we

inflation

16.4

FIGURE

Rates

Earlier

inflation

is

10 \302\243

is

called the

Nominal

i rr\342\200\224.

\302\2538

interest

^w

&.

rate

6

^

J\302\243

4

i

rt

2

1

\\r

^^^

rate

Inflation

+j \302\2530

c

n

2

ch-d

O)

L

1 LO hO)

1

1

1

o

1

1

1

O

1

0)0)0 0)0)0

LO CO O)

CO O)

l-

1 LO

l-

1

1

1

O

1 LO

o

o

CM

<M

1

I

o

o

<M

Year

Source:

Economic Report of the

President,

February

2011, Tables B-73and

B-64,

www.gpoaccess

.gov/eop.

interest rates tend to be high when inflation is high? Our discussion interest rates provides the answer.Supposeinflation has been recently in so borrowers and lenders that it will be the near future. high, anticipate high We would expect lendersto raisetheir nominal interest rate so that their real will be unaffected. rate of return For their part, borrowersarewilling to pay nominal interest rates when inflation is because understand higher high they that the higher nominal interest rate only serves to compensate the lender for the fact that the loan will be repaid in dollars of reduced real value\342\200\224in real their cost of borrowing is unaffected increase in the nominal terms, by an equal interest rate and the inflation rate. when inflation is low, lendersdo Conversely, not needto charge so high a nominal interest rate to ensurea given real return. Why do

of real

461

KEY TERMS

interest rates will

Thus, nominal

for nominal

This tendency Fisher

low when

is high and

inflation

when

high

Fisher effect the tendency for nominal interest rates to be high

first

rates is calledthe

to follow inflation

rates

interest

the early twentieth-century American the relationship.

after

effect,

who

be

is low.

inflation

economist

Fisher,

Irving

out

pointed

when

inflation

when

inflation

is high and low is low

SUMMARY

consumer

for measuring inflation is the (CPI). The CPI measures the

tool

basic

\342\200\242 The

price

any

basket of

a fixed

of purchasing

period relative to

goods is the

in a

services

and

measuredby

a price

same basket

of the

base year.

percentage rate

annual

level as

cost

the

of

cost

services

and

goods

The inflation

change

index

relative

is a

quantity

quantity

that

Since the remedies for

price

in

current dollar value. Dividing a nominal income or a worker's quantity such as a family's CPI wage in dollars by a price index such as the in terms of real purchasing that expresses quantity

power.This

is called

procedure

including

distortions

of

economize redistributionsof

planning.

agree

deflating the nominal

that

two different quantity. If nominal quantities from years are deflated by a common priceindex,the of the two quantities can be purchasing power To ensure that a nominal payment suchas a compared. SocialSecurity benefit a constant level of represents

disruptive

the

to the inflation

calledindexing.(LOl)

real hurts

U.S. inflation

the true

overstate

rate, based on the rate

inflation

for two

reasons: First,

reflect improvements in the adequately of and services. Second,the method of quality goods the CPI the fact that consumers calculating ignores can substitute cheaper goods and services for more not

expensive ones.

(L03)

price index

corerate

of

deflating

(a nominal

quantity)

inflation

(445)

(443)

Fisher effect

(461)

(CPI) (440) (444)

nominal

interest

nominal

quantity

index

a

inflation

interest

price level (451)

rate of

(447)

inflation-protected

price

stable.Hyperinflation,

rate is extremely high, the costs of inflation and is highly economy. (L04)

the

to the

(456)

hyperinflation

indexing

which

TERMS

KEY

consumer

system; \"shoe-leather\" costs, which that are wasted as peopletry to on cash holdings; unexpected and interference with wealth; long-term Because of these costs, most economists sustained economic growth is more likely tax

is unexpectedly low, lenders benefit and borrowers are hurt. To obtain a given real rate of return, lenders must a high nominal interest rate when charge inflation is high and a low nominal interest rate when inflation is low. The tendency for nominal interest rates to be high when inflation is high and low when inflation is low is called the Fisher effect. (LOS)

may

CPI,

prices are

this

rate is the annual percentage increase purchasing power of a financial asset.It is equal or the nominal, market, interest rate minus rate. When inflation is unexpectedly high, the interest rate is lower than anticipated, which lenders but benefits borrowers. When inflation

\342\200\242 The real in

level.

resources

magnifies

greatly

real purchasingpower, the nominal should payment be increased each year by a percentage equal to the inflation rate. This method of adjusting nominal to maintain their purchasing power is payments

\342\200\242 The official

in

for inflation, (L04)

price

a number of true costs on the in the price system;

if inflation is low and situation

general

in relative

\"noise\"

the real

the

in

a change

problems.

imposes

economy,

are the

terms of its

deflation

cause

confusion can

the

in

goods or services with

remedies

the

from

different

confuses increases

increase

of

the CPI.

is measured

specific

is an

which

\342\200\242 Inflation

\342\200\242 A nominal

may

prices

inflation,

(LOl)

it

sometimes for

in rate

in the

such as

public

\342\200\242 The

index

(442)

bonds (460) rate (445)

(458)

inflation

real interest

real quantity real

wage

(442)

rate (458) (445)

(446)

relative price (451)

INFLATION AND

16

CHAPTER

462

THE PRICE

LEVEL

REVIEW

1. Explain

cost of

for

living

5.

any

official cost-of-livingindex,the

in the

6.

between the

is the difference

the rate is

Why

of inflation

an economy?

in

to adjust

it important

for

level

price

(LOl)

guarantee that

to in

the

purchasing labor

a multiyear

by inflation.

be

when

inflation

will

true

the

that

to

debtors,

of the bargain loses, the other sidegains. of the society as a whole, there

perspective

real cost.\"Do you

does inflation

holding cash?

inflation redistributes for example. But

unexpected creditors

the

rate

(L03)

examples.

one side

7. How

Discuss.

agree? affect

(L04)

on

real return

the

(L05)

or false: If

both

the

potential borrowercorrectly

potential anticipate

lender and

the

rate

of

the

inflation, inflation will not redistribute wealth from the creditor to the debtor. Explain. (L05)

be eroded

not

\"It's

is no

power of the wage agreed contract

by

8. True

to

used

Illustrate

Sofrom

quantities (for example,workers' at different average wages) points in time? What is the basic method for adjusting for inflation? (LOl)

4. Describehow indexation might

understate

what

nominal

comparing

may

wealth, from

and

why the official inflation \"true\" rate of inflation.

reasons

two

Give

from

differ

may

family

(LOl)

2. What

3.

or

individual

changes CPI.

in the

changes

why

particular

QUESTIONS

(LOl)

PROBLEMS month

JECONOMICS

20

in

the

pizzas

Rent of I

/^Study

Frank: app

at $10 apartment,

that

as the base

designated

typical

family

year are as follows:

expenditures

each

each per month

$600

In the year following the base have risen to $11 each, apartment

year, rent

calls),

the survey takers is $640, gasoline

$50

determine that

pizzas

and maintenance have

to $120, and phone servicehas droppedin price to $40. (LOl) a. Find the CPI in the subsequent and the rate of inflation between the year base year and the subsequent year. b. The family's nominal income rose by 5 percent betweenthe base year and the subsequent year. Are they worse off or better off in terms of what their income is able to buy?

risen

Visit your mobile app store and download Econ

year

Gasoline and car maintenance, $100 Phone service (basic service plus 10 long-distance

McGraw-Hill

the

determine

survey takers

1. Government

connect'

Study todayl

2.

are values of the CPI (multiplied by 100) for each from 1990 to year 2000. For each year beginning with calculate the rate of inflation from 1991, the previous What to inflation rates over the 1990s? (LOl) year. happened Here

1990

130.7

1991

136.2

1992

140.3

1993

144.5

1994

148.2

1995

152.4

1996

156.9

1997

160.5

1998

163.0

1999

166.6

2000

172.2

3. Refer

the

in 1997

wage

Consider

the table

The

below.It showsa hypothetical year 2012:

income

income

due

Taxes

(percent

$20,001-$30,000

10 12

$30,001-$50,000

15

$50,001-$80,000

20

pushedup

6.

schedule,

expressed

of income)

higher

to ensure that tax brackets

a given real income are not CPI (times 100) is 175 in tax schedule above be adjusted

with

families by

The

inflation.

185 in 2014. How should the income year 2014 to meet the legislature'sgoal? (L02)

the

for

5.

wants

into

and

2012

tax

25

$80,000

legislature

1997.

1990?

< $20,000

>

entry-

for the

terms,

Family

real

1997?

in

c. What

nominal

the

was $13.65 per hour.(L02)

was the real entry-levelwage in 1990? was the nominal entry-levelwage in

in

that

between 1990 and

by 8 percent

declined

real entry-level

report found

2. A

Problem

in

wage

entry-level was

What

b. What

4.

given

for collegegraduates

The nominal

a.

CPI data

the

to

level wage

to the U.S. Census Bureau (www.census.gov),nominal income for the typical family of four in the United States (median income) was $24,332in in 1985, $41,451 in 1990, in 2000. In purchasing and $62,228 1980, $32,777 in how did income each of those four years? You power terms, family compare = will need to know that the CPI (multiplied by 100, 1982-1984 100) was 82.4 in 1980, 107.6 in 1985, 130.7 in 1990, and 172.2 in 2000. In general terms, how would your answer be affected if the Boskin Commission's According

CPI were

conclusions about

the

The

consumer's

typical

30 chickens

at

10 hams at

10 steaks A chicken 2013.

year

at

confirmed? (L02,

the

Calculate

7. The the

inflation

year. Would this

period

price

to rise to $5.00eachin the of steaks is unchanged.

example,

how

large

is the substitution

bias

in

the

index?

the change

oil market playing

the

\"cost-of-eating\" index between 2012 and 2013. are completely indifferent between two chickens

for

previous during

ham. For this

and

chickens

in the

change

\"cost-of-eating\"

rate

as follows:

each

$8.00

following table lists the actual per-gallon June of each year between 1978 and CPIs for those years. For each year from

gasoline

year 2012 is

$6.00 each

that consumers

and one

L03)

base

the

feed shortage causesthe price of Hams rise to $7.00 each,and

b. Suppose official

in

each

$3.00

(LOl, L03)

a.

basket

food

it

were a role

in

be

the

fair

prices 1986, 1979

for unleaded together to 1986,

regular

the values find the CPI with

of

the (real) price of gasoline, both from in gas prices to say that most of the changes or were factors specific to the general inflation,

relative

due to as well? (LOl,

L04)

464

CHAPTER

16

INFLATION AND

THE PRICE

LEVEL

Gasoline price ($/gallon)

Year

CPI

=

(1982-1984

1978

0.663

0.652

1979

0.901

0.726

1980

1.269

0.824

1981

1.391

0.909

1982

1983

1984

1985

1986

1.309 1.277

0.965

1.229 1.241

1.039

1.00)

0.996

1.076

1.136

0.955

8. On January

Albert invested $1,000 at 6 percentinterest 1, 2011, per year for three years. The CPIon January stood at 100. On 1, 2011, 1, 2012, January the CPI (times 100) was 105;on January 1, 2013, it was 110; and on January the day Albert's investment matured, the CPI was 118. Find the real 1, 2014, rate of interest earned of the three years and his total real by Albert in each return over the three-year period. Assume that interest are reinvested earnings each year and themselves earn interest. (LOS)

9. Frank is lending $1,000 to Sarah for two years. Frank and Sarah agree that Frank should earn a 2 percent real return (L05) per year. a. The CPI (times 100) is 100 at the time that Frank makes the loan. It is in 121 in to be 110 one and two What nominal rate of expected year years. interest shouldFrank Sarah? charge b. Suppose Frank and Sarah are unsure about what the CPI will be in two Show how Frank and Sarah couldindexSarah's annual years. repayments 2 percent to ensure that Frank gets an annual real rate of return.

\342\226\240

TO

ANSWERS

16.1

CHECKS

\342\226\240

cost of the family's basket in 2010 remains at $680, as in Table 16.1. If the rent on their apartment falls to $400 in 2015, the cost of reproducingthe 2010 basket of goods and servicesin 2015 is $620 ($400 for rent + $150 for

The

hamburgers

$620/$680, percent

16.2

CONCEPT

between

+ $70 for movie tickets). The CPI for or 0.912. So in this example, the cost of 2010 and 2015. (LOl)

is accordingly

2015 living

fell

nearly

9

construct own personal price index, you would need to determine your the basket of goods and services that you personally purchased in the base would then be defined as the year. Your personal price index in each period cost of your personal basket in that relative to its cost in the base year. period To the extent that your mix of purchasesdiffers from that of the typical American consumer,your cost-of-living index will differ from the official if in the base year you spent CPI. For example, a higher share of your budget than the American on goods and servicesthat have risen typical relatively rapidly in price, your personal inflation rate will be higher than the CPI To

inflation

rate.

(LOl)

ANSWERS TO CONCEPTCHECKS

16.3

The percentage follows:

in

the

in each

year from the previous year

= \342\200\2242.3% (0.167

1931

-9.0%

1932

-9.9%

1933

-5.1%

called

is

inflation

were falling, contrasts

prices

CPI

1930

Negative 16 A

changes

real

Rodriguez's

$12.8

million.

0. l7l)/0.171

of

since

inflation

the

2006.

in 1982-1984 dollars, were $27.5 earned $5.79 million (in 1982-1984 121 percentmore in 2009 than Bonds

Bonds

Barry

when

1930s,

(LOl)

or million/2.15,

earnings,

earned about

Rodriguez

\342\200\224

The experience

deflation.

sharply with

as

are

so

dollars),

did

in

2001.

(LOl)

16.5

The real dollars.

The

dollars. what

16.6

minimum

So the it was

in

in 1950

wage

minimum

real

real 1950.

wage

minimum

in

wage

is $0.75/0.24, 2010

or $3.12 in

is $7.25/2.18,

in 2010

1982-1984

or $3.33

was almost 7

in

1982-1984

percent higher

than

(LOl)

in the The increase in the cost of living between 1950 and 2009 is reflected ratio of the 2010 CPIto the 1950 CPI, or 2.18/0.24 = 9.10. That the cost is, in 2010 of living was roughly nine times what it was in 1950. If the minimum its purchasing wage wereindexedto preserve power, it would have been 9.10 = $6.83. X in in times 2010 than or 9.10 $0.75 1950, (LOl) higher

465

CHAPTER

I

|7

and

Wages

Unemployment LEARNING

After you

OBJECTIVES

reading this chapter, should be able to:

LOI Discussthe

four

that have characterized trends

important

>

labor markets

( * \342\226\240 .:.\342\200\242\342\226\240<

the

in

States

United

since I960.

L02

and

a supply

Apply

demand model to

\\

labor

the

understand

market. -\\

L03 How do

how

Explain

in the and

globalization

technological

change

affect

wages

and employment?

New York Times best-sellingbookabout the

I

columnist changing

published a The Lexusand the economy,

Thomas

aNew York:

Farrar,

Tree.1

Straus,

The theme

global

& Giroux,

1999.

labor

in real

trends

wages

L. Friedman

of Friedman'sbook is that one of the most features of the modern world is the juxtaposition of rapid economic and striking the Lexus with traditional values automobile) technological change (represented by and customs (represented by the olive tree, a tree with roots that cannot be deep in Friedman notes the that, easilytransplanted). many countries, conflictingpulls of modernization and traditional ways of life have created enormous social conflicts. Further, the powerful forces of modernizationhave widened the gap between the \"haves\"\342\200\224those who can take advantage of rapid technological and economic the \"have-nots\"\342\200\224those who are unable or to do so. change\342\200\224and unwilling To understand how economicgrowth and affect different change groups, we must turn to the labor market. Except for retirees and others receiving governmentsupport, most people rely almost entirely on wagesand salaries to pay their in bills and put something for the future. it is the labor market that Hence, away most will see the benefits of economic people growth. Olive

of and

the demand for explain

n 1999,

changes

supply

and

I960.

employmentsince

L04

Define the

rate

calculate

and

unemployment and

the

rate.

participation

L05

Differentiate among the three types of unemployment

defined

by economists

and

the costs with

each.

associated

468

CHAPTER

17

WAGES AND

UNEMPLOYMENT

This markets

of

chapter industrial

economy

as

a whole.

describes countries.

and explains some important We will see that two key

labor

in the

trends

factors contributing to in wages, recent trends and employment, unemployment are the globalizationof the economy, as reflected in the increasing of international trade, and importance see we focus first on several important this, ongoing technological change.To trends in real wages and employment and then develop and apply a supply and demand model of the labor market. We then turn to the problem of unemployment and how the rate and some relatedstatistics are explain unemployment defined and measured. We close with a discussion of different types of unemployment and the costs of unemployment, both to the unemployedand to the

labor

understand

To

four

mind involves

important

employment.

1. Over

growth

markets at a macroeconomic level, trends. Three of thesetrends involve We discuss each of them in turn.

the twentieth century, in real wages.

In the United Statesin command

as

in

other

TRENDS

MARKET

LABOR

IMPORTANT

FOUR

it

is helpful

real

all industrial countrieshave

wages,

enjoyed

to keep and one

in

substantial

the average worker's yearly earnings could in and services as 1960 and nearly five times as much goods in to the Great Similar trends have prevailed 1929, just prior Depression. industrialized countries. 2010,

as many

twice

2. Sincethe

1970s,

early

the rate

however,

II period the post-World War Though the fastest rates of increase wages,

of real wage growth seen impressive

has

occurred

has

during

the

1960s

slowed.

increases in

and early

real

1970s. In

the 13 years between 1960 and 1973, the buying power of workers' incomesrose at a rate of 2.5 percent per year, a strong rate of increase. But from 1973 to 1996, real yearly earnings fell by 1.1 percent per year. The good news is that, from 1996 2 percent to 2010, real earningsgrew at about per year, despite two recessions in the 2000s. Annual for the whole 1973 to 2010 period was earnings growth zero.

roughly

3. Furthermore, in

inequality

the

recent decades United States.

have brought

a pronounced

increase

in wage

unskilled workershas been doubled between 1960 and particular Although per capita real workers and fell, 2010, average weekly earnings among production actually the real wages of the least-skilled, least-educated workers have declined by as much as 25 to 30 percent, according to somestudies. At the same time, the best-educated, workers have highest-skilled enjoyed continuing gains in real wages. Data for a A growing

gap in

real

between

wages

skilled and

real GDP

concern.

of

in the United an advanced States, the typical worker with earned almost three times the income of a degree beyond college high school and four times the income of a worker with less than a graduate, high school degree. observers that the United States is a \"two-tier\" labor Many worry developing market: plenty of good jobs at good wages for the well-educated and highly skilled, but less and less opportunity for those without or skills. schooling

recent

year showed that,

4. In the United In 1970,

jobs. By

States, the

of people

number

with jobs

has grown substantially

in

decades.

recent

about 57 percentof

2007,

63 percent

of the

total

the

U.S. employment

over-16

population.

in the United States had population exceeded 146 million more than people, Between 1980 and 2007, the U.S. economy

over-16

SUPPLY AND

DEMAND

IN THE

in total employment of 46 percent\342\200\224while 38 has not occurred population grew only percent. Similar job growth in most other industrialized however.2 countries, What these trends in employment and wages? In the next two explains we will show that a and demand of the labor market can help sections, supply analysis

new

46 million

created

jobs\342\200\224an increase

over-16

the

to explaintheseimportant

developments.

a long

Over

the United

average real

period,

States and in

slowed significantly

wages have

in

both

substantially

real

has

real wage growth

wages,

early 1970s.

States since the

United

the

in

risen

countries.

industrialized

other

upward trend in

Despite the long-term

In the

LABOR MARKETTRENDS

IMPORTANT

FOUR

RECAP

in recent wage inequality has increased dramatically wages of most unskilled workers have actually declined, while the real wages of skilled and educated workers have continuedto rise. United

that

downturn

the

Until

States,

The real

decades.

substantially\342\200\224indeed,

the

United

in recent

States

AND

SUPPLY

began

in

2008,

faster

much

than

decades.

population\342\200\224in

IN THE LABOR

DEMAND

been growing

had

employment

the working-age

\342\200\224

MARKET

saw how supply and demand analysis can be used to determine and services. The same equilibrium prices and quantities for individual goods I n the market for labor, the is useful for labor market conditions. approach studying in is the real to workers for their services. The wage is \"price\" wage paid exchange unit of for hour or time, expressedper example, per per year. The \"quantity\" is the amount of labor firms use, which in this book we will generally measure by number in terms of of workers employed.Alternatively, we could state the quantity of labor the number of hours worked;the choice of units is a matter of convenience. Who are the demanders and suppliers in the labor market? Firms and other in demand labor order to produce goodsand services. Virtually all of us supply employers labor some of our lives.Whenever work for pay, they are during phase people In labor services at a to the receive. this we'll discuss supplying price equal wage they chapter, both the supply of and demand for labor, with an emphasis on the demand side of the In

3 we

Chapter

market.

labor

Changes trends in wages

aggregate

The labor

for labor

demand

the

in

and

employment

market is studiedby

turn

described

this

key

in

the

explaining

section.

the

preceding as well as macroeconomists,

microeconomists

and both use the issues

to be

out in

tools of supply and demand. However, microeconomists focus on In such as the determination of wagesfor specific of or workers. jobs types we take the macroeconomic and examine factors that affect chapter, approach

aggregate,

or economywide,

WAGES

AND THE

Let's

by

start

want

thinking

trends in

employment

about

to hire at any given

what determines the

wage,

that

is, the

demand

demand for labor depends on both the productivity sets on workers' output. The more productive cycle peaks

wages.

DEMAND FOR LABOR

market 2Business

and

occurred

in

1980

and 2007.

number

of

for labor.

workers we

As

of labor and the workers

are,

employers will see, the price

that

or the

the

more

LABOR MARKET

469

470

17

CHAPTER

WAGES AND

UNEMPLOYMENT

the

valuable

and services they produce, the to hire at any given wage.

goods

an employer will

17.1 shows the

Table

employed

Banana

at

relationship between output

Computer

the table

1 of

computers. Column

technicians BCCcouldemploy the

more

employed.

The

For the

sake of simplicity,

the

workers,

number

of workers

Company

in

and

the

number

of workers

on

depending

and

Production

shows how many

Product for

(2) per

produced

0

1

25

2

48

3

69

4

88

5

105

6

120

7

133

8

144

(4)

(3)

Computers

0

Column

3 of

Value

year

(at $3,000/computer)

product

$75,000

worker adds the inputs

of capital and other in use is held constant,

amount

the greater the quantity labor already employed, the each additional worker adds

then

production

Increasing

Opportunity

Cost

D

of less to

marginal

less

product returns

diminishing

to total

adding

69,000

21

63,000

19

57,000

17

51,000

15

45,000

13

39,000

II

33,000

more

each

worker,

worker. Note that

the extra

each additional

worker did.The tendency are added is called if the amount of Specifically, capital and other inputs

production

to decline to labor.

23

marginal product of

one

of

product

marginal

Marginal

17.1 shows the

Table

production that is gainedby

if

produce. materials

Banana Computers

25

to labor

computers

computers are fixed quantities.

Marginal

of

workers

returns

of

of workers

the number

the greater the number of computersBCC can will assume that the plant, equipment, and

(1) Number

diminishing

the number

for

possibilities

Column 2

its plant.

17.1

TABLE

for

and sells

we

use to build

workers

the

(BCC), which builds

shows some different

each year,

can produce

company

greater

want

than the previous

as more and

more

workers

of labor constant, then the greater the quantity already employed, the less each additional workeradds to production. The economic basis of diminishing returns to labor is the Principle of also known as the Cost, Increasing Opportunity Low-Hanging-Fruit Principle.A firm's want to use their available managers inputs in the most productive way possible. an who has one worker will that worker to the most Hence, employer assign If productive she hires a second she'll that worker to the secondworker, job. assign most productive The third worker will be the third-most job. given productive job and so on. The greater the number of workers the available, already employed, in lower the marginal product of adding another as shown Table 17.1. worker, If BCC computers sell for $3,000each,then 4 of Table 17.1 shows the column value the of eachworker.The value of a worker's of marginal product marginal is the amount of extra revenue that the worker product generates for the firm. of each BCC worker is that worker's Specifically, the value of the marginal product in stated terms of the number of additional marginal product, computersproduced, We now have all the multiplied by the price of output, here $3,000 per computer. information necessary to find BCC's demand for workers. in

use

is held

How

Suppose that

the

hire

cannot

be

answer

hire an

will

BCC

(which

product

the wage

exceeds

is the

this

qualified

would the

marginal

for computer technicians is $60,000per year. BCC so they wage being offered by all their competitors, workers for less. How many technicians will BCC hire? What if the wage were $50,000per year? wage

going

that

know

managers

BCC hire?

should

workers

many

extra worker if and only if the value of that worker's equals the extra revenue the worker createsfor the

BCC must pay. The goingwage

which BCC takes as given, of the marginal product

$60,000.

the

generates

first,

will

exceeds the

for

firm)

technicians,

computer

the value per year. Table 17.1 showsthat and third workers each exceeds second,

is $60,000 of

workers

these

Hiring

each

revenue

for Labor

Demand

BCC's

DEMAND

AND

SUPPLY

be profitable

wage that

for BCC becausethe

extra

pay. However, the If BCC's managers

must

BCC

fourth worker's marginal product is worth $57,000. only hired a fourth would be paying $60,000 in extra wages for worker, they additional that is worth only $57,000. Sincehiring the fourth worker is output a money-losing three workers. the Thus, proposition, BCC will hire only the quantity of labor BCCdemands when going wage is $60,000 per year is

three technicians.

for computer technicians were $50,000per year instead technician would be worth since the value of his hiring, be $7,000 more than his wages. The fifth marginal product, $57,000,would technician also would be worth hiring, since the fifth worker's marginal product is worth $51,000\342\200\224$1,000 more than the going wage. The value of the marginal is only so hiring a sixth worker $45,000, product of a sixth technician,however, would not be profitable.When are $50,000 wages per year, then BCC's labor If

market

the

is five

demand

wage

the fourth

of $60,000,

CONCEPT

technicians.

CHECK 17.1

with 17.1, how Continuing Example for technicians is $35,000 per year?

The lower the wage a demand for labor is like the demanded rises as the price labor

hypothetical

and

axis

firm

must

many

workers

pay, the for other

will BCC

more workers

hire

it

if

will

the

going

hire.

wage

Thus,

the

goods or servicesin that the quantity 17.1 shows a (in this case, the wage) falls. Figure curve for a firm or industry, with the wage on the vertical on the horizontal axis.All else being equal, the higher the

demand

employment

demand

will demand. wage, the fewer workersa firm or industry In our example thus far, we have discussed how labor demand dependson the or dollar, wage. As we explained in Chapter nominal, 16, it is generally more to examine the real which is the illuminating wage, wage expressedin terms of its We shall hold the so that purchasing power. temporarily general price level constant in in the nominal also reflect the real changes wage changes wage.

SHIFTS

in

value the

DEMAND FOR LABOR

of workers

number

The the

IN THE of their

economy

that BCC

will

employ

at any

given real wage dependson 4 of Table 17.1. Changes

marginal product, as shown in column that increase the value of workers'marginal

product

will

increase

IN

THE

LABOR

MARKET

EXAMPLE 17.1

471

472

FIGURE

CHAPTER

17

WAGES AND

UNEMPLOYMENT

17.1

The Demand

Curve

for Labor. demand curve for labor is downward-sloping. The the wage, the fewer higher workers will hire. employers The

of extra workersto BCC,and thus BCC's demand for labor at any given that raises the value of the marginal wage. In other words, any factor product of BCC's workers will shift BCC's labor demand curve to the right. in the Two main factors could increase BCC'slabor demand:(1)an increase in of the and an increase the (2) price company's output (computers) productivity of BCC's workers. The next two examplesillustrate both of these possibilities. the value

real

EXAMPLE 17.2

Real Wage and an Increasein Will

BCC hire

Suppose an computers

to

more workers if each.

is $60,000per year?

of computers

rises?

demand for BCC's computersraisesthe price of its How many technicians will BCC hire now if the real the real wage is $50,000?

If

wage

increase in computer prices is shown in Table 17.2. Columns are the same as in Table 17.1. The number of computers a given number of technicians can build (column 2) has not changed; the marginal of technicians is the same. But because (column 3) product particular computers can now be sold for $5,000 each instead of $3,000, the value of each worker's has increased two-thirds marginal product by (comparecolumn4 of Table 17.2

1 to

The effect 3 of the

price

in the

increase

$5,000

the

Demand

of

the

table

hence,

with column 4 of Table 17.1). How does the increase in the price of computers affect BCC's demand for labor? Recall from our first example that when the price of computers was $3,000 and the for technicians was for labor was $60,000, BCC'sdemand going wage three workers. But now, with computers for the value of the $5,000 each, selling of each of the first seven workers exceeds $60,000 (Table 17.2). marginal product technicians is still $60,000, BCC wouldincrease So, if the real wage of computer its demand from three workers to seven. In the that the going real wage for techniciansis $50,000. Supposeinstead when the of was and the $3,000 example above, price computers wage was

$50,000,BCC

see the the

demanded five workers. But if computers sell for $5,000, we can column 4 of Table 17.2 that the value of the marginal product of even worker exceeds the of So if the real wage is $50,000, eighth wage $50,000. in computer increase raises BCC's demand for labor from five workers prices

from

to eight.

SUPPLY

17.2

TABLE

(1)

(2)

Number of

Computers

workers

IN

THE

LABOR

473

MARKET

Prices

in Computer

Increase

DEMAND

Product for Banana Computersafteran

and Marginal

Production

AND

per

produced

0

0

1

25

2

48

3

69

4

88

5

105

6

120

7

133

8

144

(4)

(3) year

Value

marginal

Marginal

of

product

(at $5,000/computer)

product

$125,000

25

23

115,000

21

105,000

19

95,000

17

85,000

15

75,000

13

65,000

II

55,000

CONCEPTCHECK 17.2 will BCC hire if the going wage for technicians of computers is $5,000?Compareyour answer to the demand for technicians at a wage of $ 100,000when the price of computers is $3,000. Refer

is $

to

Example

17.2. How

100,000 per year

and

the

workers

many

price

in The general conclusionto be drawn from 17.2 is that an increase Example increases the demand the labor of workers'output for labor, shifting demand curve to the right, as shown in Figure 17.2. A higher price for workers' workers more valuable, leading employers to demand more workersat output makes

the price

any

real wage.

given

FIGURE

A Higher

17.2

Price of Output

Increasesthe Demand

for

Labor.

An increase in the price of workers' output increases the value of their marginal product, shifting the labor demand curve to the right.

0)

8P

Labor

demand

(after price increase) Labor

(before

Employment

demand

price increase)

474

CHAPTER

17

WAGES AND

UNEMPLOYMENT

product,

EXAMPLE

17.3

Suppose BCC adoptsa new

be assembled,permitting

technician

the number of componentsto 50 percent more machines per

reduces to build

the price of computers is $3,000per machine.How many hire if the real wage is year?

17.3

shows

that

will

Table

$60,000per

products after the

marginal products and the value in productivity, assuming

workers'

50

increase

percent

each.

for $3,000

Before the

(see Table 17.1).After

of their that

the

sell

three workers

increase,

productivity

marginal

computers

have demanded

would

BCC

increase,

productivity

of $60,000

a wage

at

that

technology each

BCC

Assume

technicians

workers?

hurt

improvements

productivity

year.

shows.

17.3

Productivity and Demand for Labor

Worker Do

productivity.

of a worker'smarginal

for labor, as Example

the demand

is worker

labor

the value

increases

productivity

increases

it also

the demand for

that affects

factor

second

The

Since an increase in

however,

TABLE 17.3

Production and Marginal Product Increase in Worker Productivity

for

Banana

(2)

(1)

Number of

(3)

Computers

workers 0

per

produced

Computers

(4)

Value of

Marginal

year

37.5

72

3

103.5

4

132

5

157.5

6

180

7

199.5

8

216

of the workers

4). So at a to six.

CONCEPT CHECK back

Refer increase

figure

shifting

to Example

in productivity

to the

of the

product

marginal

column

17.3, three

from

$112,500

37.5

2

the value

product

marginal

($3,000/computer)

product

0

1

Table

after an

if

wage

of

34.5

103,500

31.5

94,500

28.5

85,500

25.5

76,500

22.5

67,500

19.5

58,500

16.5

49,500

first six

workers exceeds$60,000(see demand for labor increases

BCC's

$60,000,

17.3 17.3. How

the

will BCC

workers

many

going wage

for

demand for workers at a $50,000wage

In general, an increase in worker the labor demand curve to

productivity

the

right,

hire

as

before

the

50 percent

Compare this productivity.

the demand 17.3.

increases in Figure

after

per year? the increase in

is $50,000

technicians

for labor,

AND

SUPPLY

DEMAND

IN

LABOR

THE

17.3

FIGURE

Higher

475

MARKET

Productivity

Demand

the

Increases

for Labor. An

increase

in productivity

raises workers' product

8P

change

in the

output\342\200\224the

a:

marginal

Labor demand

(after

increase)

productivity

We've discussedthe

willing

wage is the

by employers;

of labor.The suppliers

of

to complete the

labor

real wage, potential suppliers of The total number of peoplewho are of labor.3

given

any

work.

to

labor

for

demand

to consider the supply

workers.At

supply

we need story, are workers and potential labor must decide if they're to work at each real willing

Price for

Reservation Will

you clean

You

were

Unlessyou

to go to the

like

are

the beach

severe and

beach

than

but your fighting

neighbor asksyou cobwebs.

to clean

Do you

out his

take the job?

on

you $500

you would be

payment

(to take an

willing

extreme

example),

the unrealistic figure to tackle the dirty accept

and

$20 to

you would very likely

of $500 is the basement.

minimum

This

is the compensation labor, price you set for your indifferent between and not you just working working. In economic whether to work at any given wage is a terms, deciding straightforward of the Cost-Benefit Principle. The costto you of cleaning out the application basement is the opportunity cost of your time (you would rather be surfing) the plus the

payment,

level that

reservation

leaves

in unpleasant conditions. You can measurethis to work having in dollars simply by asking \"What is the minimum amount of yourself, I would take to clean out the basement instead of going to the beach?\" The money minimum that would is the same as reservation payment you accept your price. The benefit of taking the job is measured the which will by pay you receive, go toward that new DVD player you want. You should take the job only if the promised pay cost you total

cost

(the

benefit

17.4

by neighborliness, your answer to this job how much my neighbor will pay.\" You depends to take the job for $10 or $20, unless have a you cash. But if your neighbor were wealthy and

be, be willing

say yes. Somewherebetween

minimum

EXAMPLE

primarily

\"It

immediate needfor to offer

today,

a lot more

motivated

would probably would not probably offer

eccentricenough

Labor

your neighbor's basementor go to the beach?

planning

basement. You

labor the

LABOR

OF

SUPPLY

Since a

wage, shifting the demand curve to

Employment

THE

of their

value

product.

the

demand

Labor

(before

place on

of working)

3We are still holding an increase in the

the general

real wage.

exceeds your reservation

price

level

constant,

price (the

so any increase

in

cost

of working).

the nominal

no

price of

productivity increase raises value of marginal product, will hire more employers workers at any given real

increase)

productivity

marginal

and\342\200\224assuming

wage also represents

a

Cost-Benefit

right.

476

FIGURE

labor

WAGES AND

UNEMPLOYMENT

17.4

The Supply The

17

CHAPTER

of Labor.

supply curve is

upward-sloping because,in the higher the wage, the more people are willing general,

to work.

In Example

willingnessto supply

17.4, your

wage.In general,the

is greater,

labor

the higher

as a whole.Certainly

for the population

is true

same

the

people

the to reasons, including personal satisfaction, opportunity skills and and the chance to socialize with co-workers. for most talents, Still, develop income is one of the benefits of so the the real people, principal working, higher the more are to sacrifice other uses of their time. The wage, willing they possible fact that people are more willing to work when the wage they are offered is higher is captured in the upward of the curve of labor (see Figure 17.4). slope supply

for many

work

CONCEPT CHECK a career

want

You summer

to take?Would labor supply

Any

that

factor

labor

At the

valuable

quantity

the

offered at a given level, the most important working-age population, which of

immigration

first enter the

normally

an unpaid Your alternative to the would which job you decide the conclusion that the is offering

station

experience.

labor

macroeconomic

supply of labor is the size of such as the domesticbirthrate, people

you

SUPPLY OF LABOR

affects the

curve.

supply

give

is upward-sloping?

curve

IN THE

SHIFTS

local radio

The

broadcasting.

would

in a car wash. How earn $3,000 working a decision to take the internship contradict

is to

internship

in

that

internship

17.4

and

emigration

workforce and retire.All

raises working-age population the labor curve to shifting supply

the

the

quantity

the

of

labor

else

real

wage factor

is influenced

will shift the affecting

the

by factors

rates, and the ages at which being equal, an increase in supplied at each real wage,

in the percentage of people of right. Changes seek as a result of social changes that working employment\342\200\224for example, women to work outside the home\342\200\224also can affect the supply of labor. encourage Now that we've discussed both the demand for and supply of labor, we're ready to apply supply and demand analysis to real-world labor markets. But first, try your hand at using and demand to answer the supply analysis following question. age who

CONCEPT

CHECK

Laborunions

typically

to favor more affect

liberal

real wages?)

17.5 favor

tough

rules.Why?

restrictions on immigration, while tend employers is an influx of potential workers likely to

(Hint: How

THE

EXPLAINING

SUPPLYAND DEMANDIN

RECAP

IN

REAL WAGES

MARKET

for labor

demand

The

LABOR

THE

TRENDS

The extra productiongained by adding one more worker is the marginal product of that worker. The value of the marginal productof a worker is that worker's marginal product times the of the firm's output. A firm will price of marginal which is the employ a worker only if the worker's value product, same as the extra revenue the worker generates for the firm, exceeds the real wage that the firm must pay. The lower the real wage, the more workers the firm will find it profitable to employ.Thus, the labor demand curve, like most demand curves, is downward-sloping. For a given real wage, any change that increases the value of workers' the demand for labor and shift the labor marginal products will increase demand curve to the right. Examples of factors that increase labor demand are an increase in the price of workers' output and an increase in productivity. The

of labor

supply

to supply

is willing

individual

An

greater

the

than

cost

opportunity

labor

if

of the

the real wage that is offered is individual's time. Generally, the

the real wage, the more people are willing to work. Thus, the labor supply curve, like most supply curves, is upward-sloping. For a given real wage, any factor that increases the number of people available and willing to work increasesthe supply of labor and shifts the labor curve to the right. Examples of facts that increase labor supply supply include an increase in the working-age or an increase in the share population of the working-age population seekingemployment.

higher

THE

EXPLAINING

IN REAL WAGES

TRENDS

AND EMPLOYMENT We

are

now

ready

discussed earlier in

Why

real

wages

and employment

BY

SO

IN

MUCH

the United States have quintupled since have experienced similar gains. These in these countries. have the standard of living of workers greatly improved have real wages increased by so much in the United States and other

real annual

discussed,

1929,and increases

trends in

chapter.

REAL WAGES INCREASED INDUSTRIALIZED COUNTRIES?

THE we

the

HAVE

WHY

As

to analyze the important

earnings

in

countries

industrialized

other

industrialized countries? in real results from the wages the industrialized countries during productivity experienced by discuss the sources of this growth in productivity in the

The

large

by Figure employment

increase

17.5, increasedproductivity and

the

raises

the

sustained growth the

next

twentieth

chapter.)

in

century. (We As illustrated

for labor,

increasing

in the industrialized

countries,

demand

real wage.

Of the factors contributing two of the most important

to

productivity

were (1) the

growth

dramatic technologicalprogressthat

occurred

the twentieth century and which (2) large increases in capital, during provided workerswith more and better tools with which to work. Labor supply increased the during in in as of course shown the the increases labor well, (not However, century diagram). have been so great as to demand, driven by rapidly expanding productivity, overwhelm the depressing effect on real wages of increased labor supply.

AND

EMPLOYMENT

477

478

17

CHAPTER

FIGURE

WAGES AND

UNEMPLOYMENT

17.5

An Increase Productivity

in

Raises

S

the

Real Wage. An

increase

in productivity

raises the demand for labor, shifting the labor demand curve from D to D'.The real wage rises from w to w' and employment

rises from

rt

i g

\\\\

w'

\\

t w

en

N

y

toN'.

^D'

Employment

SINCETHE

1970s,

STATESHAS SLOWED,

EMPLOYMENT

THOUGH

EVEN

WAS

GROWTH

INTHE UNITED

GROWTH

REAL WAGE

RAPID DURING THE

1990s

of the late 1990s, rates of real wage growth after 1973 in the have been significantly lower than in previous decades prior to 1973. But most of the 1990s, the economy creatednew at a record rate. What during jobs accounts for these trends? in real wage growth since the early Let's begin with the slowdown 1970s. in real wage growth must demand a slowdown result Supply and analysis tells us that in the supply from slower growth in the demand for labor, more rapid growth of United States and labor, or both. On the demand side, since the early 1970s the in productivity growth. other industrialized nations have experienced a slowdown in the growth of real wagessince for the slowdown Thus, one possibleexplanation the 1970s is the decline in the pace of productivity gains. early Someevidence for a relationship between productivity and real wagesis given in Table 17.4, which shows the average annual rates in labor productivity and growth real annual for each decade since 1960. You can see that the growth in earnings in real earnings. decade productivity by decade corresponds closely to the growth the

With

United

exception

States

TABLE 17.4

Growth Rates in

Productivity

and

Real

Earnings Annual

1960-1970 1970-1980 1980-1990

Growth

Rate

(%)

Productivity

Real earnings

2.74

2.27

1.71

1.23

1.60

0.71

1990-2000

2.04

1.50

2000-2010

2.60

0.92

Source: 1960-2000:Economic 2000-2010:

nonfarm sector.

Bureau

of Labor

business sector; real

Report of the President, 2010 (www.gpoaccess.gov/eop); Statistics (www.bls.gov).Productivity is output per hour in the business earnings equal real compensationper hour in the nonfarm

EXPLAINING THE TRENDS

is the rapid growth of both productivity in both productivity and 1970s, growth

striking

Particularly

1960s. Sincethe

and

IN REAL

EMPLOYMENT

479

the

during

wages

real wageshas

WAGES AND

been

some improvement in productivity is apparent after 1990. of the slowdown in productivity on the demand for labor are an reason for declining real wage growth, they can't be the whole story. important in labor We know this because, with labor supply held constant, slower growth demand would lead to reducedrates of employment as well as reduced growth, in in real But until the recent the United downturn, job growth growth wages. in the face States in recent decades had been rapid. Large increasesin employment of slow growth of labor demand can be explained only increases by simultaneous in the supply of labor (seeConceptCheck significantly

slower,

although effects

While

the

Labor

supply

United States

in the

17.6).

does appearto have

grown

recently.

rapidly

increased participation in the labor market by women has increased the U.S. of labor since the mid-1970s. Other factors, including the supply coming of age of the baby boomersand high rates of immigration, also help to explainthe in the supply of labor.The combination increase of slower growth in labor demand result of the and accelerated (the slowdown) productivity growth in labor supply in result of increased women the with (the workforce, participation by together other factors) helpsto explainwhy real wage growth has been sluggish for many of rapid employment growth. years in the United States, even during periods What about the future? Labor supply growth is likely to slow in the coming in the labor force decades as the baby boomers retire and the percentage of women stabilizes.Productivity has more recently grown quickly, reflecting the benefits of new other factors. trend technologies, among Especiallyif the recent productivity there seemsto be a chance that workers will see continues, good healthy gains in in real the to come. wages years In particular,

CONCEPT

17.6

CHECK

As we

just discussed, in

growth growth point

labor

supply

and (2) the graphically

corresponding before endingjust

weak

relatively

after about

more rapid

in productivity

growth

1973 can

expansion

the

and

strong

relatively

slowdown

in

real

wage in employment after about 1973.Show this and demand one diagrams of the labor market,

by drawing two supply to the period 1960-1972and the 2001 recession).Assuming

explain

the

other

(I)

to 1973-2000

(the period

productivity growth was strong but modest during show that we would to 1960-1972, expect in in but only moderate that growth employment period. that

labor supply growth was see rapid real wage growth Now apply the same analysis to 1973-2000, assuming that productivity growth weaker but labor supply growth stronger than in 1960-1972.What do you predict in the real wage and in 1973-2000 relative to the earlier period? growth employment

WAGE

INCREASING

INEQUALITY:

THE

is

for

EFFECTS

OF GLOBALIZATION Another Specifically,

important many

trend commentators

in U.S. labor markets is increasinginequality in wages. have blamed the increasing divergence between the

and unskilled workers on the phenomenon of \"globalization.\" This term refers to the fact to an the markets for that, extent, popular increasing many rather than national or local in scope. goods and servicesare becominginternational, The main economic benefit of globalization is increased and the specialization that it Instead of each to its efficiency brings. country trying produce everything citizens consume, each can concentrate on producingthose goodsand services at which it is relatively most efficient. As implied the of by Principle Comparative consumers of all countries enjoy a greater 2), the result is that Advantage (Chapter of goods and services, of better quality and at lower prices, than would variety they without international trade. wages

of skilled

I

J Comparative

Advantage

CHAPTER 17 WAGES AND

480

UNEMPLOYMENT

of globalization on the labor market are mixed, however, which free trade trade means why many politicians oppose agreements.Expanded consumers stop buying certain and services from domestic goods producers effects

The explains

that and

switch

unless

the

to foreign-made foreign

products

better off.

them

makes

But

products. Consumers would not make this switch were better, cheaper, or both, so expandedtrade clearly the workers and firm owners in the domestic industries suffer from the increase in foreign competition.

business may well The effects of increasing trade on the labor market can be analyzed using in two 17.6. The contrasts the and demand for labor different Figure figure supply industries: (a) textiles and (b) computersoftware. that, Imagine initially, there is little or no international trade in these two goods. Without trade, the demand for in each industry is indicated by the workers curves marked ^textiles and ^software5 that lose

and employment in each industry are determined by the in each demand curves and the labor supply curves industry. As we have drawn the figure, initially, the real wage is the same in both industries, equal in software. to w. Employment is Ntextiles in textiles and Nsoftware Wages

respectively.

of

intersection

the

17.6

FIGURE

The Effect of the

Globalization

on

Demand

for Workers

Two

real

Initially,

After

equal at

are

industries

in the

wages

an increase

in

declines,

(textiles)

real wages and while

(b)

workers

\\

s

in

i

N

that

software

X/'X

.^^X.

textiles\"^-

^/j^V^S

^

^textiles

i^^^

' ! ^^

Employment

LJ software n ^software

i

'^

'^software

^textiles

^^w

i

!

D textiles

i

(a) Importing

industry (software) increases, real wages and raising in

W

/

\\

\\\\/ V-_V

X^

^/V!

lowering

exporting

\\

.^^X.

X.

,

+ CC W textiles

employment,

the

employment

\\

i

for

/ f

w

\"73

trade,

demand in

\\ \\

2P

^software

\\

/

\\

\\

two

w.

(a) demand for workers the importing industry

^textiles

-

in

Industries.

software

Employment

(b) Exporting

industry

industry

industry.

When

countries

will open themselves to trade, they begin to produce for export at which are more efficient and to import they relatively goods in this are relatively less efficient at producing. Supposethe country more efficient at producing software than textiles. manufacturing of trade, the country gains new foreign markets for its software and for export as well as for domestic use. Meanwhile, becausethe

those goodsor services that they is example relatively With the opening begins to produce or services

countryis

relatively

less efficient at

made textiles, which

In short, software These in the

changes

or of

cheaper becomes an exporting

demand for

domesticsoftware,

producing textiles,consumersbegin

are

in

the

demand

labor.The opening

higher

instead

quality,

of

export

markets

foreign-

purchase

domestic product.

textilesan importing products are translated

industry and

for domestic

to

of the

industry. into

changes

increases the demand

for

in turn, The higher price for domestic software, raising raises the value of the marginal of software the labor workers, shifting products in the software industry demand curve to the right, from to ^software D'soitware in Figure in in the software from w to and 17.6(b). Wages industry rise, employment w'software, the industry rises as well. In the textile industry the Demand for opposite happens. domestictextiles falls as consumers switch to imports. The priceof domestic textiles falls with demand, reducing the value of the marginal product of textile workers and

its price.

EXPLAINING THE TRENDS

IN REAL

WAGES AND

481

EMPLOYMENT

for their labor, to \302\243)'textilesin Figure 17.6(a). Employment in the industry falls, and the real wage falls as well, from w to w'textiles. In sum, to increasing Figure 17.6 shows how globalizationcan contribute we assumed that software workers and textile workers wage inequality. Initially, receivedthe same wage. However, the opening up of trade raised the wages of in the \"winning\" workers and lowered the wages of workersin (software) industry the \"losing\" (textiles), increasing inequality. industry In practice, the tendency of trade to increase wage inequality be even worse may than depicted in the example because the great majority of the world's workers, those in developing have relatively low skill levels. Thus, countries, particularly when industrialized countries like the United States open up trade with developing the domestic industries that are to face the countries, likely toughest international are those that use low-skilled labor. competition mostly Conversely, the industries in that are to do the best international are those that likely competition employ skilled workers. increasedtrade lower the Thus, mostly may wages of those workers who are already are well paid. poorly paid and increase the wages of thosewho The fact that increasing trade exacerbate some of may wage inequality explains in general it does not justify the political resistanceto globalization, but to attempts reverse the trend. Increasing trade and specialization is a major source of in living improvement both in the United States and abroad, so trying to stop the standards, is the economic forces behind process counterproductive. Indeed, globalization\342\200\224 the desire of consumers for better and cheaperproducts and of producers primarily, for new markets\342\200\224are so powerful that the process would be hard to stop even if officials were determined to do so. government Rather than to stop globalization, helping the labor market to adjust to trying the effects of globalization is probably a better course. To a certain extent, indeed, the economy will adjust on its own. Figure 17.6 showedthat, the following in in to real and fall textiles and rise trade, (a) (b) software. opening wages employment At that point, wages and job opportunities are much more attractive in the in textiles. Will this situation persist?Clearly, software industry than there is a strong incentive for workerswho are able to do so to leave the textile industry and seek the demand

hence

textile

employment in

software

the

The movement

industry.

of workersbetween

mobility. In our example,worker textiles

it in software,

increase

and

the growing one.This process by raising wages in textiles a less

workersfrom

then, the labor

competitive

mobility

and firms, will tend to

as workers move will

and

jobs,

reverse

lowering

from

industries is called worker reduce labor supply in the contracting industry to

worker

the movement

mobility

of workers between and industries

some of the increase in wage inequality them in software. It also will shift

sector to a more

market can adjust on its own

to

competitive

the

effects

sector.

To

some

extent,

of globalization.

Of course,there are many barriers to a textile worker becoming a software So there also be a need for transition aid to workers in the affected engineer. may sectors. Ideally, such aid helps workers train for and find new jobs. If that is not

because a worker is nearing retirement\342\200\224transition aid possible or desirable\342\200\224say, take the form of government to the worker maintain his or her payments help standard of living. The transition aid and Efficiency Principle reminds us that similar programs are useful because trade and specializationincrease the total economic The \"winners\" from can afford the taxes to pie. globalization necessary finance aid and still enjoy a net benefit from increased trade.

can

WAGE

INCREASING

TECHNOLOGICAL

INEQUALITY:

CHANGE

wage inequality is ongoing technologicalchange that educated workers.New scientific and the knowledge advances associated with it are a source of technological major improved

A

of increasing highly skilled or

source

second

favors

more

productivity and

economic

growth.

Increases

in

worker

productivity

are in turn

a

driving

a

Efficiency

jobs, firms,

CHAPTER

482

skill-biased

technological

technological change

change that

affects the

productsof differently

WAGES AND

17

marginal

higher-skilled workers from those of lower-

skilled workers

FIGURE

UNEMPLOYMENT

force behind wage increasesand higher average living standards. In the long run and on average, is the worker's friend. technological progress undoubtedly This sweeping statement is not true at all times and in all places, however. Whether a particular technologicaldevelopment is good for a particular worker dependson the effect of that innovation on the worker's value of marginal product and, hence, on his or her wage. For example, at one time the ability to add numbers rapidly and accurately was a valuable skill; a clerk with that skill could expectadvancement and higher wages. and mass production of the electronic calculatorhas rendered However, the invention human skills less valuable, to the detriment of those who have that skill. calculating is with of workers who History replete examples opposed new technologies In England in the early out of fear that their skills would becomeless valuable. nineteenth century, workmen introduced rioting destroyed newly labor-saving in The name of the workers' reputed leader,Ned Ludd, has been preserved machinery. the term Luddite, meaning a person who is opposed to the introduction of new in American folk history in the tale of John technologies. The same theme appears in the man who died an to show that a human Henry, mighty pile-driving attempt could tunnel into a rock face more than a machine. quickly steam-powered Howdo theseobservations bear on wage inequality? According to some recent advances have taken the form of skill-biased economists, many technological that that affects the is, technological change, technological change marginal product of higher-skilled workers workers. differently from that of lower-skilled in recent decades to have favored Specifically, technological developments appear more-skilled and -educated workers. are a case in point. The advent of mass Developmentsin automobile production in the 1920s work for several generations production techniques provided highly paid of relatively low-skilled auto workers. But in recent years automobile production, like the automobilesthemselves, has become more considerably sophisticated. The simplest have been taken over robots and production jobs by computer-controlled machinery, which require skilled operatives who know how to use and maintain the new equipment. Consumer demands for luxury features and customized also have raised options in the automakers' demand for highly skilled the skill Thus, craftspeople. general, in for automobile have risen. requirements jobs production of technological favors skilled Figure 17.7 illustrates the effects change that workers. shows the market for unskilled workers; Figure 17.7(b) Figure 17.7(a) showsthe market for skilled workers. The demand curves labeled DunskiUed and DskiUed

17.7

The Effect

of Skill-Biased on

Change

Technological

Inequality. The figure shows the effects of a skill-biased technological change that increases the

Wage

marginal

product

workers

and

of skilled the

reduces

marginal product of unskilled workers.The

resulting the demand

(a). Wage

inequality

\\ wage

-3

s

^unskilled

,

W unskilled+ 0\302\243

\\

wages increases.

/

\\ \\

____V_N/

0>

/

^

\"c5

i

a: i^V^ i

^skilled

\\y\\.

^

^Xi^S^^ \\

\"

^^

! ''

^unskilled

Employment

^skilled

\\\\f

I

i i

U unskilled

'^unskilled

(a) Unskilled

^skilled

8P

-~-^V'sS.

A' unskilled

\\

^unskilled

i

increase in for skilled workers raises their wages (b), while the decline in demand for unskilled

workers reducestheir

-

^skilled ^skilled

'

i_]

^skilled

~*~A/

skilled

Employment

workers

(b) Skilled

workers

for each type

TRENDS

THE

EXPLAINING

IN

REAL WAGES

before a skill-biased technologicalchange. of worker are determined by the intersection Wages employment in each market. of the demand and supply curves Figure 17.7 shows that, even before the technological change, unskilled workersreceived lower real wages than skilled workers (^unskilled < Skilled)' reAectmg tne lower marginal products of the unskilled. Now suppose that a new technology\342\200\224computer-controlled machinery, for introduced. This is biased toward skilled workers, example\342\200\224is technological change which means that it raises their marginal productivity relativeto unskilled workers. in this example that We will assume the new also lowers the marginal technology of unskilled because are unable to use the new workers,perhaps productivity they but all that is for our conclusions is that they benefit less technology, necessary in marginal than skilled workers. 17.7 shows the effect of this Figure change in products. In part the increase the of skilled workers raises (b) marginal productivity the demand for those workers; the demand curve shifts to rightward \302\243)'skilled. the real wages and employment of skilledworkers also rise. In contrast, Accordingly, because they have beenmade less productive by the technological change, the demand for unskilled workers shifts leftward to D'^^^ Lower 17.7(a)]. [Figure demand for unskilled workers reducestheir real and wages employment. In summary, this analysis supportsthe conclusion that technological change that is biased in favor of skilled workers will tend to increasethe wage gap between the skilled and unskilled. Empirical studies have confirmed the role of skillthe demand

show

of worker

for each type

and

biased technologicalchange in recent Because new technologiesthat should

most economistswould technological standards.

necessary

labor-saving machinery the

since trying to block new technologies for economic growth and improved living succeeded in

had somehow

Luddites

the

If

Great

in

Britain,

change are similar to

those for

among

As the mobility. unskilled workers

unskilled

worker

is

them

work

increases,

education and skills,to everyone's Government

if they

growth and development over

should

policymakers are

programs if

increasein

The long-term results

for

and modernizedcapital The slowdown

growth

in

labor supply,

labor

incentive to acquire is transition aid. remedy will to retrain help workers

that

are

they

not.

WAGES

REAL

labor. stock

enjoyed

wages

from large

by workers

industrial

which

gains,

productivity

in

have

and an expanded

Technological progress are two important reasons

for theselong-

in productivity.

increases

part from the

real

primarily

demand

raised the

First

and

EMPLOYMENT

AND

countries

skilled

a stronger

A second

EXPLAINING THE TRENDSIN

RECAP

term

consider

technological

by

by globalization. between

differential

have

will

benefit.

income support

or provide

able,

pay

caused

caused

inequalities

wage

of

introduction

the

preventing

economic

few centuries might have been greatly reduced. remedies for the problem of wage inequalities

past The

wage inequality, of globalization,

against

argue

are

advances

in wage inequality. workers increase them? As in the case

skilled

block

act to

regulators

government

increases favor

in

real

wage

slowdown in

growth

that began

productivity

that occurred demand) from such factors

growth

in

the

(and,

at about the

1970s

resulted

in

hence, the slower

same time. Increased

as the increased participation of women and the coming of age of the baby boom generation, depressed real wagesfurther while also expanding employment. In the latter part of in productivity the 1990s, resurgence growth was accompaniedby an in real wage growth. increase arising

AND

EMPLOYMENT

483

484

CHAPTER

17

WAGES AND

UNEMPLOYMENT

\342\226\240 Both

technological change contribute to the wages of workers in exporting

skill-biased

and

globalization

wage inequality.

raises

Globalization

the by raising the demand for those workers,while reducing of workers in importing industries. Technological change that favors more-skilled workers increases the demand for such workers,and hence their wages, relative to the wages of less-skilled workers. to block either globalization or technologicalchangeis Attempting not the best response to the problem of wage To some extent, inequality. worker mobility of workers from low-wage to high-wage (movement industries

wages

created

the inequality

offset

will

industries)

is not

practical, transition employment prospectshave

ANDTHE

UNEMPLOYMENT

RATE

Economists

last two

such as GDP and inflation to measuresof employment is a

rate

is low,

unemployment rate

jobs are

often associatedwith

the

secureand relatively wages

and retain

Where mobility to workers whose

best solution.

of economic activity in economists use measures Here, we turn our attention

level

how

discussed

of conditions in

improving

to attract

employers compete

chapters,we

to carry out this assessment. In and unemployment.

indicator

sensitive

be the

to assessthe

of statistics

a variety

analyze

In the

a country.

assistance

worsened\342\200\224may

UNEMPLOYMENT

forces.

these

by

aid\342\200\224government

particular, the unemployment market.

labor

to find.

easier

When the Low unemployment is

conditions as well,as

and working

workers.

MEASURING UNEMPLOYMENT In

United

the

the Bureau

olderis placed 1. Employed.

A

A

Unemployed.

person

preceding week but

job interview)

in

made

the

Each month in

those

is the

who

households

of

responsibility

the BLS surveys

about 60,000 is 16 years or

categories:

is employed if he the past during

person

(even for a few hours) from a regular job.

2.

BLS.

Each person

of three

in one

measuring unemployment

or

households.

selected

randomly

defining and

States,

of Labor Statistics,

or she worked full-time week or is on vacation

if he or is unemployed some effort to find work

past four

she did (for

not

or or

work

part-time leave

sick

the

during

by going

example,

weeks.

to a

force. A person is considered to be out of the labor force if he or work in the past week and did not look for work in the past four weeks. In other words, peoplewho are neither employed nor unemployed (in the sense of looking for work but not being able to find it) are \"out of the labor force.\" Full-time and to work retirees, students, homemakers, unpaid people unable because of disabilities are examples of peoplewho are out of the labor force.

3. Out of the

labor

she did not

Basedon the country

fit

results into

each

of the

survey, the BLS estimateshow many

of the

three categories. The

people

in the

working-agepopulation

the

of employed and

people in

the

total

number

unemployed

is

the

these three categories,and consists of the population age 16 and over.4 To find the unemployment rate, the BLSmust first calculate the size of the labor force.Thelabor force is defined as the total number of employed and unemployed in the economy (the first two of respondents to the BLSsurvey). people categories sum of

labor force

whole

economy 4See www.bls.gov/cps/cps_htgm.htm categorizes these data.

for

complete

details on how the government

collects and

UNEMPLOYMENT AND THE UNEMPLOYMENT

rate is then defined as the number of unemployed people divided the labor force.Notice that who are out of the labor force (because by people they are in school, have retired, or are disabled,for example) are not counted as and thus do not affect the unemployment rate. In general,a high rate of unemployed indicates that the is unemployment economy performing poorly. Another useful statistic is the participation rate, or the percentage of the workingin the labor force the that is either or (that is, age population percentage employed for The rate is calculated the labor force work). looking participation by dividing

The unemployment

by

the

(16 + ) population.

working-age

Table 17.5 illustrates

basedon the

BLS

for April

survey

labor market statistics, using data

of key

calculation

the

2011. In

month

that

force. The

labor

the

4

low\342\200\224just above

the latter

part of the

However,

unemployment

percent\342\200\224in

rose

divided

by

the

participation

rate

percentage

of the

population

in the

is, the

(that

either

people

labor force

the

working-age labor force

percentage that is

employed

or

looking

for work)

was 9.0 that is, about percent; work. 17.8 shows Figure were

rates

1990s. By

exceptionally this

measure,

good time for American workers. following a recessionin 2001.

an exceptionally

was

1990s

of unemployed

number

64

and the late

1960s

late

the

the

rate

unemployment

unemployment

participation rate was about two out of every three adults had a job or were looking for the U.S. unemployment rate since 1960.Unemployment of

percent

485

RATE

in 2001-2003

TABLE 17.5

U.S. Employment Data,April

I (in

201

millions)

139.7

Employed Plus:

13.7

Unemployed

153.4

Equals: Labor force Plus:

in labor

Not

85.7

force

Equals:

16) population

239.1

= unemployed/labor = rate labor force/working-age

force =

(over

Working-age

rate

Unemployment

Participation

Source:Bureau

of Labor

13.7/153.4= 9.0% =

population

153.4/239.1 =

64.2

Statistics, www.bls.gov.

The U.S. Unemployment

/~\\

&

10

^

\302\2438 +j

I

X

6 K

\342\226\240v

X

0

a. 4

\\

>^ U

//>

/

^

\\

/

\\

V

J

1f

V

J 1 >v // /v

/ \\

A

Rate, 1960-2010.

^

i \342\226\240n #/ \\\\

a>

c

J

\\

Sf

A

\\

that is

=

^^\302\273\302\253/ /

rose

0

o

CD

a>

i

I

m

CD

a>

I

o r^

a>

1

1

1

1

m

o

a>

a>

r^

CO

1

1

m

CO

a>

Year

Source: Bureau

of Labor

Statistics, www.bls.gov.

1

i

o

O) G>

i1

1

m

G> G>

i

i

o

1

1

m

o

o

CM

CM

o

o

1

U.S.labor

unemployed\342\200\224was

force just

percent in the late the lowest recorded 1990s, rate since the latter part of the 1960s.Unemployment

2 l

of the

above 4

r / \\ >v^J JA/r

^v>

rate\342\200\224the

unemployment

fraction

1I

k

V

The

E
D

17.8

FIGURE

12

1

o T\342\200\224 o CM

above 9 percent

in

2009

during the recession that began in December 2007.

486

CHAPTER

17

WAGES AND

UNEMPLOYMENT

17.7

CHECK

CONCEPT

Following are April Americans.

of Labor Statistics

I Bureau

201

U.S.employment

Unemployed

Not in the

labor force,the

participation

COSTS

THE

is lost reduced

they

and

compare

2.88

million

1.19

million

the unemployment rate, and the 17.5. your results to those in Table

OF UNEMPLOYMENT economic,

and social

psychological,

the main

costs on a nation.

cost of

is the output that perspective, unemployment the workforce is not fully utilized. Much of the burden of the is borne output by the unemployed themselves, whoseincomesfall when are not working and whoseskills deteriorate from lack of use. However, may economic

an

From

1

population,

Americans

imposes

Unemployment

labor force

working-age

for African

rate

for African

14.97million

Employed

Find the

data

because

society at

bears become

also

large

who

example,workers

payments

support

government

receiving

part of the unemployed

economic cost of unemployment. For are liable to stop paying taxes and start such as unemployment benefits.This

net

government's budget is a costto all taxpayers. The psychological costs of unemployment are felt primarily by unemployed workers and their families. Studiesshow that of unemployment lengthy periods can leadto a loss of self-esteem, of loss of control over one's life, feelings and even suicidal behavior.5 The worker's is likely to feel depression, unemployed family increased psychological stress,compoundedby the economic difficulties created on the

drain

by

the

of income.

loss

The social costs of

are a result of the economicand been People unemployed for a while tend not only to face severe financial difficulties but also to feel anger, frustration, and Not despair. in in increases tend to be associated with increases crime, surprisingly, unemployment domestic violence, alcoholism, drug abuse, and other social The costs problems. unemployment

who have

psychological effects.

created by theseproblems

are

borne

not only

by

the

unemployed

but by society

in

be spent to counteract these problems\342\200\224for public resources must more to control crime or increasingspending on social hiring police

as more

general,

by

example,

services.

THE

DURATION

OF UNEMPLOYMENT

In assessing

the impact of unemployment on jobless people,economists must know how long individual workers have beenwithout work. the longer a Generally, person has been out of work, the more severeare the economic and psychological costs that will face. People who are unemployed for only a few weeks, for person not likely to suffer a seriousreduction in their standard of living, since for a example,are

short periodthey

Nor

would

can

we expect

experiencepsychological

the same extent

as

draw

upon

their savings

someonewho is unemployed

problems someone

and perhapson government for

only

such as depression or lossof who has been out of work for

a short

benefits.

time to at least

self-esteem, months

not to

or years.

5For a survey of the literature on the psychological effects of unemployment, see William Arthur H. Goldsmith, \"Social Psychology, Unemployment and Macroeconomics,\" journal 1996), pp. 121-40. Perspectives 10 (Winter

Darity Jr. and of Economic

In its

surveys, therefore,

unemployed. A

called

an

and

the BLSasks

which an during it begins spell;

period

unemployment

the worker either outside the labor force

when

ends

(Remember, people

finds

how respondents long they have been individual is continuously unemployedis when the worker becomesunemployed a job or leaves the labor force.

are not countedas unemployed.)

spell is calledits

an unemployment

THE UNEMPLOYMENT RATE

AND

UNEMPLOYMENT

duration.

duration

The

The

length

of

of unemployment work during finding

rises during recessions,reflectingthe greaterdifficulty of those periods. At workers have been time, a substantial fraction of unemployed any given will for six months or we refer to this as more; unemployed group the longterm creates the unemployed. Long-term unemployment highest economic, and social both for the themselves and for society costs, psychological, unemployed as a whole. When the is not in a recession, most unemployment economy spells are in short. For 35 of the had relatively example, January 2008, percent unemployed been out of work for just 5 weeks or less, another 32 percenthad been for 5 to 14 weeks, and about 33 percentof the unemployed had been unemployed without a job for more than 14 weeks (about three months).However, the during recession that began in December have 2007, unemployment spells grown longer. For example,in April 2011, 20 percent of the unemployedhad been out of work for 5 weeks or less,22 percent had been for 5 to 14 weeks,and unemployed 58 percent of the unemployed had been searchingfor work without any success for more than 14 weeks. Even these statistics are a bit deceptive,however, because short unemployment can arise from two different of labor market spells very patterns experience. For some have short instance, people unemployment spells that end in their finding a stable long-term job. Theseworkers,whom we will refer to as the

short-term unemployed, contrast,

not

do

other workers

typically

short

have

bear a

cost

high

of unemployment.

which

during

a period

an individual is

continuously unemployed the

duration

unemployment

length of an

spell

By

end either

spells that typically

unemployment

spell

unemployment

487

the labor force or in a short-term or temporary job worker unemployedagain.Workers whose unemployment or withdrawals from the spells are broken up by brief periods of employment In labor force are referredto as the chronically terms of the costs unemployed. of the of these workers is similar to that of the unemployment, experience longterm unemployed. in

from

withdrawal

their

leaves the

soon

that

RATE VERSUS \"TRUE\"

THE UNEMPLOYMENT

UNEMPLOYMENT GDP

Like them

argue

measurement, that the They

unemployment.

counted among the part-time workers.

has its critics. Most of rate understatesthe true extentof unemployment in particular to two groups of people who are not

unemployment

official point

measurement

unemployed:so-calleddiscouraged

and

workers

involuntary

Discouraged workersare peoplewho in not made an effort to find one

like to have a job but say they would the past four weeks. Often, discouraged workers tell the survey takers that have not searched for work becausethey they have tried without success in the past, or because they are convinced that labormarket conditions are such that they will not be able to find a job. Because they have not sought work in the past four weeks, discouraged workers are countedas have being out of the labor force rather than unemployed. Someobservers have

suggested

accurate

that

treating

Involuntary

part-time

full-time but are

workers

discouraged

picture of the labor

able to

market.

workers find

only

as unemployed would provide

are people part-time

who say they work.

would

a more

like

Because they do

to work

have jobs,

workers

discouraged

who

say

they

would

people

like to

have a job but have not made an effort to find one in the past four

weeks

488

CHAPTER 17 WAGES AND

UNEMPLOYMENT

economists

Some

as employedrather than

workers are counted have suggested that these

part-time

involuntary

unemployed.

as partially

be counted

should

workers

unemployed. recent years the BLS has released special estimates of the number of discouragedworkers and unemployment In workers. when the official rate 2011, involuntary part-time April unemployment if both was 9.0percent (see Table 17.5), the BLS calculated that discouraged workersand workers were counted as unemployed, the involuntary part-time unemployment rate would have been 15.9 percent.6Thus, the problem of discouraged and

to these

In response

criticisms,in

include

that

rates

underemployed workers appearsto be fairly

TYPES Economists

OF

UNEMPLOYMENT

have

found

unemployment. Each

type social

and

economic

as being of three broad and cyclical

unemployment

unemployment,

has different causesand

of unemployment costs.

different

imposes

UNEMPLOYMENT

FRICTIONAL

The function

of

think

-

COSTS

THEIR

AND

structural

unemployment,

frictional

types:

to

it useful

significant.

to match available jobs with available were the same, or if the set of jobs and workers were static and unchanging, this matching processwould be quick and easy. But the In real worldis more complicated. both jobs and workers are highly practice, of

the

in their

differ

Jobs

heterogeneous.

and hours,

conditions

market is

labor

and workers

all jobs

workers. If

and in

location,

their

willingnessto

travel,

their

in

their

working career

working hours, their

their preferred

and experience, and so on.

skills

aspirations,

the skills they require, ways. Workers differ in

in

other

many

The real labor market

is also or constantly changing and evolving. dynamic, side of the labor market, technological advances, globalization, and changing consumer tastes spur the creation of new products, new firms, and even new while outmoded products, firms, and industriesdisappear. As industries, a result of this upheaval, new jobs are constantly while some old created, being in a modern economy is equally The workforce jobs ceaseto be viable. dynamic. the labor force for a time to rear children or go move, gain new skills, leave People On

demand

the

backto school,and

matching jobs with or

loses

who

an

find

quits

appropriate

areas of

even

the labor

Because

change

careers.

market is heterogeneousand

workers

her job in Silicon Valley may new job. In her search she will

software development or even

the

dynamic,

of

process

example, a software engineer take weeks or even months to

time. For

takes

often

alternative

consider

probably

She also may want to think about different regions of the country in which software are companies Park or New York City's located, such as North Carolina'sResearch Triangle in which she is searchingfor a new job, she is SiliconAlley. During the period new

totally

challenges.

counted as unemployed. Short-term frictional short-term

associated matching

unemployment

the

unemployment

with the workers

process of

with jobs

ployment

be economically chological the

search

frictional

6This

that

unemployment

with jobs is called frictional are low and may even

workers

beneficial.

with

The

that is,

be negative;

frictional

effects and direct economiclossesare minimal. leads to a better match between worker

is known

is actually

as the

productive,

U-6 unemployment

rate

in

the

the

process

costs of

of matching

frictional unem-

frictional unemployment

unemployment

process

unemployment

measure

First,

is associated unemployment.

is short-term,

may

so its psy-

to the extent that and job, a period of sense that it leads to higher Second,

and is available at

www.bls.gov.

OF UNEMPLOYMENT

TYPES

output over

the

major type

of

skills, language

contribute to

unemployment

economy.

time

of chronically

definition

unemployment, or the long-term the economy is producing at

structural

keeps some

workers from in

one

structural

unemployment

the long-term and

a

of

unemployment

that

chronic exists

even when the economy is at a normal rate producing

stable, who find

finding

workers

but never stay

to time,

a lack

First,

unemployment.

farmworkers and unskilled construction

or temporary jobs from

the

fit

is structural even when

exists

that

or discrimination

barriers,

jobs. Migrant

short-term

long,

functioning

frictional

changing, dynamic

a rapidly

of

unemployment

chronic unemployment normal rate. Several factors and

long-term

of

a certain amount

Indeed,

UNEMPLOYMENT

STRUCTURAL

A second

run.

long

to the smooth

essential

seems

489

AND THEIR COSTS

for very

job

unemployed.

Second, economic changessometimescreatea mismatch between the skills some workers have and the available for jobs. The U.S.steel industry, has declined over the years, while the example, software has grown rapidly. Ideally, computer industry steelworkerswho lose their jobs would be able to find new so their jobs in software firms (worker mobility), In would only be frictional in nature. unemployment long-term

of course,

practice,

necessary to work in the skills are no longer

education,

ability,

or interest

computer

industry.

Since

their

workers

may

these

demand,

term unemployment.

structural features to

barriers

of

unions and minimum keep wagesabove unemployment. features

of such

Examples

employment.

wage their will

We

V

\\v

\\\\

in

id can unemployment the labor market that

structural

Finally,

N?

or long-

chronic

into

drift

^

the

lack

ex-steelworkers

many

\\

laws,

both

market-clearing discuss some

result from act

^;

as

barriers include of which may level, creating

of these

tWv

structural

\"\\CH>

shortly.

costs of structural unemployment are much \"The one single thought that sustains \302\251 than those of frictional unemployment. Because workers do little structurally unemployed productive work over long periods, their idleness causes substantialeconomic losses both to the unemployed workers and to society.Structurally unemployed workersalso lose out on the opportunity to developnew skills on the job, and their The

me is that

higher

existingskills

wither

from

disuse.

Long spells

for workers to handle psychologically spells associated with frictional unemployment.

more difficult

CYCLICAL

of

are

unemployment

than

the

also

relatively

periods

of

are good.\"

much

brief

UNEMPLOYMENT

of unemployment

during periods of recession (that is, and is called The sharp unusually cyclical unemployment. in in shown 17.8 reflect the peaks unemployment Figure cyclicalunemployment that occurs during recessions. Increases in cyclical unemployment, although they in real GDP and are relatively short-lived,are associated with declines significant are therefore quite costly economically. We will study cyclical unemployment in more detail later in the chapters dealing with booms and recessions. In principle, frictional, structural, and cyclical unemployment add up to the total unemployment rate. In practice,sharp distinctions often cannot be made between the different so breakdown of the total rate categories, any unemployment into the three types of unemployment is necessarily and subjective approximate.

The third type

thefundamentals

low production)

occurs

cyclicalunemployment extra during

the

unemployment that occurs of recession periods

490

17

CHAPTER

WAGES AND

UNEMPLOYMENT

In discussing the

discuss

structural

market

labor

a few

federal

and it

demand raise

must

and

most states

chronicunemployment.

have minimum

which

to workers.Basicsupply law

has any

17.9 shows why.

rate. Figure

Let's

laws,

wage

wage that employers may pay shows that if the minimum wage

analysis the unemployment

features of

structural

that

mentioned

to long-term and

of those features.

government lowest hourly

the

prescribe

we

unemployment,

contribute

may

Minimum Wage Laws The

EMPLOYMENT

FULL

TO

IMPEDIMENTS

effect at all, The

figure

and supply curves for low-skilled to whom the workers, minimum is most relevant. The market-clearing real wage,at which the wage of labor demanded equals the quantity of labor is w, and quantity supplied, the correspondinglevel of employment of low-skilled workers is N. Now is a legal minimum wage wmin that exceeds the market-clearing suppose there wage in Figure 17.9. At the minimum as shown w, wage, the number of people who want are willing jobs, employers NB, exceeds the number of workers that in the amount NB \342\200\224 to hire, NA. The result is unemployment also equal NA, If there were no minimum to the length of the line segment AB in the figure. this unemployment would not exist, sincethe labormarketwould clear wage, shows

the demand

w. If minimum

at wage A

minimum

wage

wages create unemployment, creates

why

are

they

of workers: thosewho

two classes

politically are

lucky

popular? enough

out because the minimum exceeds the market-clearing wage wage. Workers who do find jobs at the minimum wage will earn more than would have otherwise because the they minimum is higher than the market-clearing wage. If the minimum wage wage were who benefit from the legislation, and put to a vote, the number of workers who could thus be expected to support it, might well exceedthe number of workers who are hurt and minimum \"losers,\" by it. In creating groups of \"winners\" to find jobs

at the

minimum

and

wage

those

who are shut

FIGURE 17.9 A

Minimum

Legal

May Create

Wage

Unemployment. If

the

minimum

exceeds wage

w

w . wage \302\260 mm the market-clearing for low-skilled

workers,

it

will create

equal to between the

unemployment difference

\\a

By

wage the

*

^

Real

number of peoplewho want the minimum wage, N6, and the number of to work at

peoplethat willing to

employers hire,

!

are

NA. NA

N

Employment

NB

^D

TYPES OF

wage legislation resemblesrent controllegislation

controls,

minimum

wages

such

poverty,

attacking

UNEMPLOYMENT

3). But like rent other methods of inefficiency. Thus, as direct grants to the working poor,might more prove (see

Chapter

economic

create

effective.

Unions

Labor

Labor unions are organizations workers.Among they firing,

draw the

that with employers on behalf of negotiate in the contracts issues that unions negotiate, which are embodied with are the workers rules for and earn, up employers, wages hiring duties of different types of workers,working hours and conditions, and

the

procedures for resolving disputesbetween

negotiating power by

their

workers

to call

power

a

and

strike\342\200\224that

employers. is, to refuse

Unions gain work until a

has been reached. the threat of a strike, a union can Through usually get employers to agree to a that is than the 17.9 could wage higher market-clearing wage. Thus, Figure in a unionized industry if represent conditions is as the union interpreted wage wmin instead of the legal minimum a union wage wage. As in the case of a minimum wage, in the amount that is higher than the market-clearing wage leadsto unemployment, \342\200\224 in 17.9. a union creates a trade-off similar Furthermore, high Figure wage NB NA to the one created by a minimum wage. Thoseworkers who are lucky enough to will be paid more than would be otherwise. get jobs as union members they their comes at the of other workers who are unemployed as Unfortunately, gain expense a result of the artificially union high wage. Are labor unions goodfor the economy? That is a controversial, in the twentieth who emotionally charged question. Early century, some employers in faced little local competition for workers\342\200\224coal-mining companies Appalacontract

agreement

by forcing workers to toil long bitter and sometimes Through labor organizations succeeded in of the worst abuses. Unions also with to their eliminating many point pride historic political role in supporting such as laws legislation, that banned child labor. Finally, union leaders often claim to increase in the workplace by giving workers some voice productivity and promote democracy in the operations of the firm.

chia, for

example\342\200\224exploited

their

advantage

hours in dangerousconditionsfor low pay. bloody confrontationswith these companies,

progressivelabor

Opponents

while acknowledging that these organizations may have in the their value a modern past, question economy. and more workers are professionals or semiprofessionals, rather than firm so can move from to firm. workers, Indeed, they relatively easily markets have become national or even so today's international, of unions,

played a positive role in more

Today,

production labor

many

numerous potential employers.Thus,the forces of competition\342\200\224the must persuade talented workersto work for them\342\200\224should employers for workers. would that Indeed, opponents provide adequate protection argue unions are becoming increasingly self-defeatingsincefirms that must pay union not be able to artificially high wages and abide by inflexible work rules will will be the compete in a global economy. The ultimate effect of such handicaps in failure of unionized firms and the loss of union jobs. Indeed,unions are in the United decline States and now represent 12.3percentof the workforce\342\200\224a fraction of which are government workerssuch as public schoolteachers large

workers have fact

that

and

the

police.

Unemployment

Another structural

rate is the

availability

Insurance

feature of the

labor

of unemployment

that may increase the unemployment insurance, or governmenttransfer payments

market

AND THEIR COSTS

491

CHAPTER 17 WAGES AND

492

UNEMPLOYMENT

to

workers.

unemployed

in that

benefit they

it

helps

for a

are looking

insurance provides an important social Unemployment to maintain a decent standard of while unemployed living But because its allows the job. availability unemployed to

the

searchlongeror less intensively

for a job, it may lengthen the average amount of worker is without a job. insurance should be argue that unemployment generousenough to provide basic support to the unemployed but not so generous as to remove the incentive to actively seek work. Thus, unemployment insurance should last for only a limited time, and its benefits should not be as high as the income a worker receiveswhen working.

the typical unemployed Most economists would

time

Other Government Regulations

legislation, many other governmentregulations bearon the include health and the safety They safety regulations, which establish must and rules that racial or follow, employers prohibit gender-based

minimum

Besides

wage

market.

labor

standards

in

discrimination Cost-Benefit

Efficiency

and

D

Principle and

hiring.

and other

Legislators

policymakersneedto keepin

both

mind

the Cost-Benefit

Efficiency Principle considering labor market regulation. in are some cases the costs of complying beneficial; however, Many regulations with them exceed the benefits to the extent that Further, may they provide. regulations increase costs and reduce the demand for employer productivity, they depress to unemployment and reducing the labor, lowering real wages and contributing

size of

the

when

the

economic

UNEMPLOYMENT ANDTHE

RECAP Defining

pie.

and

measuring

employed,the unemployed,

unemployment and

those

RATE UNEMPLOYMENT

involves distinguishing among the in the labor force. We can then

not

use these concepts to calculatemeasuressuch as the rate, unemployment which is the number of people divided unemployed by the labor force,and the rate, which is the labor force divided participation by the working-age

population.

Economists distinguish among three

broad types

of

tional unemployment is the short-term unemployment the process of matching workers with jobs. Structural

unemployment. is associated

that

Fric-

with

unemployment is the or chronic that occurs even when the economy is long-term unemployment at a normal rate. is the extra producing Cyclical unemployment unemployment that occurs during periods of recession. Frictional unemployment may be economically beneficial, as improved of workers and jobs may matching in the long run. Structural increase output and cyclicalunemployment impose economic costs on workers and costs heavy society,as well as psychological on workers and their families. Structural features of the labor market may cause structural unemployment. of such features are minimum or union contracts Examples legal wages that set wages above market-clearing levels; unemployment insurance,which allows workers to search for a job; and unemployed longer or lessintensively that extra costs on government regulations impose employers. Regulation of the labor market is not necessarilyundesirable,but it should be subject to the

cost-benefit criterion.

493

SUMMARY

-

four

are

\342\200\242 There

employment, and

trends

important

in

wages,

First, over a long period,average have risen substantially both in the United in other industrialized countries. Second, chapter.

long-term upward trend in real wages, has slowed significantly

growth

on in

we focused

that

unemployment

real

this

wages

States

and

despite the real

early 1970s. Third, in the United States, in recent wage inequality has increased dramatically decades. The real wages of most unskilled workers have actually declined,while the real wages of skilled and educated workershave continued to rise. Fourth, since the

recent

the

until

employment

downturn,

decades had grown population. (LOl)

in recent

States

working-age in real

\342\200\242 Trends

wages and

in faster

United

the

than

the

employment can be studied model of the labor the productivity of labor

a supply-and-demand At a given price level,

using market.

the

and demand

of workers' output determine price for labor. will hire workers Employers the value of the marginal product of

long as

hired equals

worker

pay. Becauseof

workers a

employs,

obtained

be

will

firm

lower the

going

or exceedsthe the

by adding yet the more

the

last

must

more product

to labor, the

less additional

wage,

the only as

the firm

wage

returns

diminishing

caused by such factors as immigration and increased labor force participation by women, also has contributedto the continued expansion of employment. there has been some improvement in the rate Recently, of growth of productivity and real wages. (L03)

wage

States

United

the

in

-

SUMMARY

another worker. The workers will be hired

thus the demand-for-labor curve slopes Factors that increase the value of labor's such as an increase in the price of marginal product, workers' output or an increase in productivity, shift the labor demand curve to the right. Conversely, that reduce the value of labor's marginal changes shift the labor demand curveto the left. (LOl) product and

downward.

in the for the increasing wage inequality States are economic globalization and skillbiased Both have increased the technological change. demand for, and hence the real wages of, relatively skilled and educated workers. Attempting to block and globalization technological change is since both factors are important in counterproductive,however, increased To some extent, the promoting productivity. movement of workers from lower-paying to highercounteract the trend paying jobs or industries will

United

toward

\342\200\242 The conducted

supply

people

willing

supply

curve

generally

curve for labor to work at any downward slopes work at a higher

shows the

number

of

real

wage.

The

given

since more people will in real wage. An increase

population or a socialchangethat labor market (such as the participation in the labor force) will role of women labor and shift the labor supply curve supply

all

unemployed,

with

workers to the

is based on surveys of Labor Statistics.The surveys over age 16 as employed, respondents or not in the labor force.The labor force

unemployment by the Bureau

classify

of providing transition obsolete skills is a problem. (L03)

A policy

inequality.

wage

aid and training for more useful response

rate

sum of

workers

unemployed

divided

participation rate is the age population that is in \342\200\242 The

costs

cost of

lost

the

with

their

families,

problems

argue

that

understates

it

\"true\"

promotes

time workers.

to the

right.

(LOl)

Improvements demand

for

which productivity, account for the bulk of

in

\342\200\242

labor,

raise the the increase in

wages over the last century. The slowdown in real that has occurred in recent wage growth decades is the result of slower growth in labor demand, which was caused in turn by a slowdown in the rate of productivity improvement, and of more rapid in labor growth supply. Rapid growth in labor supply, U.S.

real

the economic costs borne by and the

like increased

crime and violence.The greatest costsare imposed long unemployment spells (periods of of the official unemployment rate unemployment).Critics excluding discouraged workersand

changing

working-

force. (L04)

of unemployment include the output, psychological

associated

The

force.

labor of the

the labor

unemployed workers and costs

by

percentage

the working-age

increase

is

workers\342\200\224that employed and unemployed is, people who have a job or are lookingfor one. The rate is calculated as the number of unemployment

the

social \342\200\242 The

reasons

\342\200\242 Two

unemployment involuntary

by

by part-

(LOS)

broad types of unemployment: fricand cyclical. Frictional tional, structural, unemployment is the short-term associated unemployment in a with the of workers with process matching jobs labor market. Structural dynamic, heterogeneous is the long-term and chronic unemployment unemployment that exists even when the economy is producing at a normal rate. It arises from a variety of factors,

\342\200\242 There

are

including structural

features

long-term

three

barriers, discrimination, labor market, lack of skills, or mismatches between the skills workers

language

of the

WAGES AND

17

CHAPTER

494

UNEMPLOYMENT

the available jobs. Cyclical unemployment extra unemployment that occurs during periods of recession. The costs of frictional unemployment are low, as it tends to be brief and to create more productive matches between workers and jobs. Structural unemployment, which is often long term, and cyclical unemployment, which is associated with in reductions real tend to be more GDP, significant have

and

laws, which workers;

market-clearing

regulations,

unemployment

diminishing

returns

frictional unemployment

(489)

to labor

discouraged workers (487)

labor

(470)

force

skill-biased

spell) (487)

List

trends given

2.

Acme

in the

the four important first section of the is

Corporation

Smith. Based on her other Jane has told Acme them for $40,000per year.

3.

Why

real

have

early

1970s?

wages

recently?

structural

(485)

(485) (486)

spell

unemployment

worker

(488)

unemployment

unemployment rate

that How

mobility (481)

True

or false:

A

for

economy

implies

a low

her? (LOl)

Briefly,

are

What

why

do

increasing

inequality

high

terms

in

(L03)

rate in an

participation

rate. Explain.

unemployment

(L04)

risen

in wages?

inequality? Contrast possible

economic efficiency.

job

will work should Acme

she

Do

the

of a high rate? unemployment providing more generous to the unemployed would increase

costs

you think

government

benefits

these costs,reducethese unchanged?

Discuss.

costs,

or

these

leave

them

(LOS)

List three types of unemployment Which of these types is economically the least costly? Explain. (LOS)

(L03)

inequality

effects on

of their

by so much in the in the past century? Why did real slow for 25 years beginning in the What has been happening to real wages

to

responses

policy

Jane the

raise wage

factors

are two major factors contributing to

increased

benefits\342\200\224

workers. (LOS)

QUESTIONS

hiring

opportunitiesin

to employ

whether

United States wage growth

4. What

government conferring

possibly

of employing

costs

(488)

labor market chapter. (LOl)

considering

market, determine

the

other

change(482)

discuss

and

which\342\200\224although

technological

RHItW

1.

and

quickly;

(484)

participation rate

an unemployment

levels; unemployment insurance, incentives of the unemployed to

TERMS

KEY

(of

work

find

the

reduces

which

costly.(LOS)

duration

to

contribute

increase

cyclical

labor market that may include minimum wage unemployment firms from discourage hiring low-skilled labor unions, which can set wages above of the

features

Structural

the

is

their

and

and

causes. socially

PROBLEMS 1. Production Hill

data for

Bob's BicycleFactory

are

as follows:

connect'

|ECONOMICS

Number of workers

Bikes assembled per day 10

1

2

18

3

24

4

28

5

30

I

/^Study

McGraw-Hill

Visit your mobile app store and download

the

Frank:

Econ

app

Study todayl

Other

than

wages,

assembled.(LOl)

Bob

has costs

of $100

(for

parts

and

so on)

for each bike

a.

$130

for

sell

Bikes

product

marginal

a table

b. Make

for

showing Bob'sdemand

part b for

c. Repeat

each. Find the marginal each worker (don't

part b for the case in which Bikes sell for $130 each.

percent.

2. How would

supply of labor? (L02)

each.

$140

productivity

be likely

following factors

of the

each

worker

parts).

labor.

for

bikes sell for

in which

case

the

forget about Bob'scost for

curve

d. Repeat

of the

the value

and

product

increases

50

the economy-wide

affect

to

by

a. The age at which people are eligiblefor Medicare is increased. b. Increased productivity causes real wagesto rise. c. War preparations lead to the institution of a national draft, and many young are called people up. d. More peopledecideto have children both short-term and long(consider term

effects).

3.

of

each

would

How

are made more generous.

Security benefits

e. Social

workers

unskilled

of the following likely on an automobile

for the type of

a. Demand

increase in mass transit.

b. A sharp

c. Because

of

car made by

the

alternative

the

many

people become

opportunities,

and employment (L03)

increases.

plant

causes

of gas

price

real wage

the

affect

plant assembly line? commuters

to

less willing

to

switch

to

do factory

work.

4. Skilledor unskilledworkerscanbe used to produce a small toy. Initially, assume that the wages paid to both types of workers are equal. (L03) a. Suppose that electronic is introduced that increases the marginal equipment of skilled workers can use the to (who product equipment produce more hour The of unskilled workers are worked). marginal toys per products unaffected. words and what to the Explain, using graphs, happens equilibrium for the two groups. wages

b. Suppose

workers

unskilled

that

find

wage differential betweenskilled

point.Explain supply of

will

what

skilled

to acquire skills when the workers reaches a certain

worthwhile

unskilled

to the supply of

happen

and the

workers,

it

and

unskilled workers,the

equilibrium wage for

two

the

groups. relative to

workers particular, what are equilibrium wagesfor skilled unskilled workers after some unskilled workers acquire training? 5.

The

is a

following

were 65 peoplein people

had

time

full-time

homemakers,

disabled and

said they

report

from

houses

the

a not-very-efficient BLS survey taker: \"There I visited, 10 of them children under had part-time There were 10 retirees, 5 fulljobs.

jobs, and 5 5 full-time

16; 25

students over age

couldn't work.The like

would

one.

population,

the

of employed

number

remaining

One of

work for three months, however.\" workers.

In

people

16, and

these people had

Find

the

labor

2

did not not

people

who

were

have jobs but all

looked

actively

for

force, the working-age

workers, and the number

of

unemployed

(L04)

is downloadinglabor market data for the most recent month, but her connection is slowand so far this is all she has beenableto get:

6. Ellen

Unemployment

Participation

Not

in

the

rate

rate labor force

5.0%

62.5%

60 million

496

CHAPTER

17

WAGES AND

UNEMPLOYMENT

labor force, the working-age population, the number and the number of unemployed workers.(L04) workers, the

Find

7.

of the

each

For

following

scenarios, state whether

tional, structural, or cyclical.Justify a. Ted lost his job when the steel in another

b. Alice

had a job as a clerkbut

c. Gwen

(L05)

mill closed

up.

picks

economy

off

demand

the

reduced

your

is fric-

unemployment

down. He lacksthe skills to work and so has been unemployed over a year. from her job at the auto plant because the recession for cars. She expects to get her job back when the

industry

laid

was

the

answer.

of employed

another state.She

for

looked

quit

when

a month

her husband was transferred to before finding a new job that she

liked.

towns of Sawyer and Thatcher each have a labor force of 1,200 people. In Sawyer, 100 peoplewere unemployed for the entire year, while the rest of the labor force was employed continuously. In Thatcher, member of the every 1 month labor force was unemployed for and employed for 11 months.

8. The

(L04,

LOS)

average unemployment rate

is the

What

a.

towns?

b. What

is the

duration

average

towns?

c. In which town do

think

you

of unemployment the

costs

Explain.

\342\226\240

17.1

The

of the

value

and the the

CONCEPT

TO

ANSWERS

value of but

seventh

the

not the

$35,000. (L02)

17.2

With

wage

the

at $5,000, it since the third

worker

seventh

of the eighth

eighth worker is profitable

price

computer

of $100,000,

spellsin

of the

each

two

are higher?

\342\226\240

CHECKS

product

of the two

in each

year

of unemployment

marginal product of the marginal

the

over

is profitable

worker's value

is

$39,000,

worker is $33,000.So to hire at a wage of

to hire of

three workers at marginal value of

a

product

worker's ($105,000) exceeds $100,000, but the fourth marginal At a computer price of $3,000,we product ($95,000) is lessthan $100,000. can refer to Table 17.1 to find that not even the first worker has a value of so at that computer price, BCCwill marginal product as high as $100,000, In short, at a wage of $100,000, in the hire no workers. the increase raises the demand for technicians from zero to three. (L02) computer price

17.3 The

seventh but not the eighth worker's value of marginal exceeds product to hire seven workers if the going $50,000 (Table 17.3), so it is profitable in productivity, the increase the wage is $50,000. From Table 17.1, before first five workers have values of marginal productgreaterthan so $50,000, the demand for labor at a given wage of $50,000 is five workers. the Thus, increase in productivity raises the quantity of labor demandedat a wage of to seven workers. (L02) $50,000 from five workers

17A

Even

you

though

intern is likely to

investment

in

are receiving

raise the

human

pay

capital.

no pay, the valuable experienceyou gain as an so it is an you will be able to earn in the future, in the radio station more You also find working

ANSWERS

enjoyable than working in take, you should ask yourself,

a car

wash,

\"Taking

presumably. into

To decide which

job

to

both the likely increase in in the radio working radio station rather than is yes, then you should

account

earnings and my greater enjoyment from I be willing to pay $3,000 to work in the would station, in the car wash?\"If the answer earn $3,000 working work in the radio station; otherwise, you should go to the car wash. A decision to work in the radio station does not contradict the idea of an if we are willing to think labor supply curve, of the total upward-sloping my

future

compensation as the value

for

of the

upward-sloping internship

17.5

experience,

as including not just that you receive. Your

job

training

in

the

the

cash wages but labor

labor

raises

supply\342\200\224indeed,

factors

drawing immigrants accompanying figure, an increase in labor that have to pay (from w wages employers most

powerful

lower the overall employment immigration

(from

N to

to reduce real

employers support it.

N'). Because of the

wages,labor unions

place

for work is place. As will tend to

first

supply to

w'),

while raising of large-scale

tendency

oppose

generally

is still the

(L02)

the

in

the

on

search

the

factors

such

curve

supply

the greater the value you more likely you are to acceptthe job. that

sense

to a country

Immigration

one of the shown in

that

it, while

Immigration

raises

labor

supply

Employment

Although the figure shows the overall, or aggregate,supply of labor in the on wages depend on the skills and economy, the specific effectsof immigration of the Current U.S. occupations immigrants. immigration policy makesthe reunification of families the main reason for admitting and for immigrants, the most part immigrants are not screened their education or skills.The by United States also has a good deal of illegal made up largely of immigration, for economic These two factors create a tendency peoplelooking opportunity. for new immigrants to the United Statesto be relatively low-skilled. Since tends to increase the of unskilled labor it more, immigration supply by relatively of domestic low-skilled workers more than it does the depresses wages wages of domestichigh-skilled workers. Some economists, such as George Borjasof Harvard have argued that low-skilled immigration is another University,

TO

CONCEPT

CHECKS

497

498

CHAPTER

17

WAGES AND

UNEMPLOYMENT

workers reducing the wages of less-skilled skills and education. Borjas argues that

factor

important workerswith

greater

approach used by

should adopt the

and

Canada

relative

United

the

to

States

preference to potential

give

and education.(L02) 17.6Part (a) of the accompanying figure shows the labor market in 1960-1972; For comparability, we set the part (b) shows the labor market in 1973-2000. in initial labor and demand curves the same both (S) (D) supply parts, same initial values of the real wage (w) and employment (N). In part implyingthe in we show the effects of a increase labor demand (a) (from D to D'), large in the result of rapid productivity and a small increase growth, relatively labor S to The real risesto w' and rises to (from S'). supply wage employment N'. In part (b) we observethe effects of a somewhat smaller increase in labor demand (from D to D\") and a larger increase in labor (from S to S\. supply in Part to the 1973-2000 showsa smaller increase (b), corresponding period, the real wage and a larger increasein employment than part (a), in to 1960-1972. These results are consistent with actual corresponding developments the U.S. labor market over these two periods. (L03) with

immigrants

levels of skills

higher

relatively

Nf

N

N

Employment

(a) 1960-1972

17.7 Labor

force =

(b)

+

Employed

2.88 million

population = Laborforce = 17.85million = 29.04

rate =

Unemployment

+

2.88

Labor force

Working-age

= 61.5

In April 2011, African and 12.1 percent of

while the

unemployment

a whole.

(L04)

million

in labor force million

11.19

million

17.85million

force population

~

17.85

=

16.1 percent

million

29.04 million

percent

11.6 percent of the labor force The participation rate for working-age population. lower than that of the population as a whole slightly rate was 79 percent higher than that of the

Americans the

was

Americans

African

populationas

Not

+

17.85

million

Unemployed

Labor

=

rate

Participation

1973-2000

Unemployed

million +

= 14.97

Working-age

A/\"

Employment

represented

SIX

PART

ECONOMY

THE

the

millennia

For narrowly

majority existence

great a sparce

made

RUN

LONG

THE

IN

world's inhabitants tilling the soil. Only a

of the by

small proportion of the populationlived above the level of or traveled more than subsistence, learned to read and write, a few miles from their birthplaces. cities Large grew up, as and centers of but the trade, serving imperial capitals great of urban populations malnutrition and disease. majority

in

lived

Then, aboutthree centuries ago,

occurred. entrepreneurial

fundamental

a

to

subject

poverty,

change

by technological advances and

Spurred

a

innovations,

Sustained over

dire

this

years,

many

of economic

process

growth began.

in the

growth

economy's

of productive capacity has transformed almostevery aspect how we live\342\200\224from what we eat and wear to how we work and What caused this economic growth? And why have play. some countries enjoyed substantially greater rates of growth

than others?As

on economic

human

welfare

staggering:

think attach are

a classic

in

it

are

like these to think about them,

in questions

starts

one

Jr. put

development, \"The consequencesfor

involved

Once

E. Lucas

Robert

Nobelist

article

it

is

simply

hard

to

anything else.\" Although most peoplewould to these questions than Lucas did, they significance of very great importance. undoubtedly about less

in the The subject of Part 6 isthe behavior of the economy the economy to grow long run, including the factors that cause and develop. Chapter 18begins the causes by tackling directly and consequences of economic growth. A key conclusion of the chapter is that improvements in average labor productivity are the primary source of rising living standards; hence, policies

to

improve

standards

living

should

on

focus

productivity. Capital accumulationis an important of economic growth, and Chapters 19 and 20 this

subject. Chapter

national behind

reasoning

saving, firms'

the

19 examines the

reasons

capital

stimulating determinant

both

touch

on of

measurement

why people save, and the

formation

decisions, and

it

develops

a

500

CHAPTER18 ECONOMIC GROWTH

markets. Chapter 20 looksmore closelyat the roles played by banks, bond markets, and stock marketsin to productive uses, then introduces the concept of allocating saving and discusses how the actions of the banking system affect the money of 20 concludes with an examination of the supply money. Chapter supply

relationship

and

model

demand

between

the

money

of financial

supply

and inflation

in

the

long

run.

CHAPTER

8

LEARNING

After reading this chapter, you should be able to:

Growth

Economic

OBJECTIVES

LOI

small

how

Show

differences

in

growth

can lead

rates

to

large differencesin standards.

living

L02 \\

the proportion

and productivity

r

of the this

and use

L03

sources of

growth.

Discuss the determinantsof

\\

flourish?

attended a at

development

would

The

word.

be?

An

at the

ordinary,

time of

audience spoke out

GeorgeWashington?\"

immediately:

\"I can

answer

that

drew a laugh

because

it

reminded

people

of George

that

doctors had

no effective

pneumonia,

weapons

and other

against

tuberculosis,

evaluate

policies

typhoid fever,

promote

economic

Washington's

L05

the

influenza,

and

Discuss

government

communicable diseases.Suchillnesses, now were major killers in Washington's time. Infants and children were treatable, quite to deadly infectious diseases, especiallywhooping and particularly susceptible cough measles. Even a well-to-dofamily often lost two or three childrento these illnesses. an unusually Washington, large and vigorous man, lived to the age of 67, but the his era was probably not much more than 40 years. average life expectancyduring diphtheria,

L04

question

it was a good answer. Dentistry in early America\342\200\224 affair. Most dentists patient was rich or poor\342\200\224was a primitive a patient's rotten teeth, with a shot of whiskey for anesthetic. pulled Other types of medical care were not much better than dentistry. Eighteenth-

century

across countries.

Dentistry.\"

answer

famous woodenteeth.But whether simply

the effects of economic growth and posed the following question: \"Which middle-class American living today, or

a speaker

capita

per

GDP differences

on

conference

which

America

of the

A member

in one

rather

you

the richest personin

and

use these conceptsto analyze

ne of us

a

within

country

particular and

labor

average

productivity grow

to

decomposition

discuss the \342\200\242 if

that

population

economic

economies

of

the

is employed

How do

per

capita product average labor is

v

GDP

why

Explain

Compare contrast

the

economic with

L06

growth. and

of

benefits growth

its costs.

Describe the

trade-offsbetween economic

growth

environmental

and

quality.

CHAPTER

502

18

ECONOMIC GROWTH

Medical care is not the only aspect of ordinary life that has changed in his account over the past two centuries.Author Ambrose, Stephen and Clark expedition, described the limitations of transportation and A critical fact in the than the speed of a

no bushel matter),

of 1801

ever

nothing

And except in

conditions

century living

rather be a rich living in the eighteenth or a middle-class person in the twenty-first century?

was

moved faster nothing no manufactured item, being, of wheat, no side of beef (or any beef on the hoof for that no letter, no information, no idea, order, or instruction of any world

horse.No

kind moved faster, and, as far

to tell,

person

Lewis

America:

in early communication

Would

drastically

of the

the

that

human

as Jefferson's

were able

contemporaries

would.

on a racetrack,

United

no

horse

Road

very fast.

moved

States ranged from bad of them. The best highway

to

and

abominable,

in the country there weren't very many ran from Bostonto New York; it took a light stagecoach . . . three full miles from New days to make the 175-mile journey. The hundred York to Philadelphiatook two full days.1

you

New Yorkers

Today What

would

George

nineteenth-century

reacted to

the

idea

can go to

Washington

Philadelphia

pioneers, who crossed the

that

their

by

have thought

great-grandchildren

train of

in an

continent

hour and a

And

that?

by

wagon

would be ableto have

York and lunch the same day in San Francisco? No doubt you can think of other enormous changes people live, even over the past few decades. Computer

half.

would

how

train,

have

breakfast

in New

in the

way average

technologiesand

the

people work and study in just a few years, for these changes are due in large part to scientific advances, example. Though such discoveries by themselves usually have little effect on most people'slives. New scientific leads to widespread improvementsin living knowledge standards when it is commercially applied. Better understandingof the human only immune unless it leads to new therapies system, for example, has little impact or drugs.And a new drug will do little to help unless it is affordable to those who need it. A tragic illustration of this point is the AIDSepidemicin Africa. Although Internet

have

changed

the ways

new drugs will moderate the effects of the virus that causes AIDS, they are in poverty-stricken that they are of little value African practical nations with the disease. But even if the drugs were affordable, grappling they would have limited benefit without modern hospitals,trained health in a and nutrition and sanitation. In short, most improvements professionals, adequate nation's standard are the result not just of scientific and living technological advances but of an economicsystem that makes the benefits of those advances some

so expensive

available

to

the

average

person.

we will explore the sourcesof economic and rising growth the modern world.We will begin by reviewing the in the industrialized countries, as measuredby real GDP remarkableeconomic growth in some countries), a earlier (and per person. Since the mid-nineteenth century in living radical transformation standards has occurred in these countries.What this transformation? The key to rising living standards is a continuing explains increase in average labor which depends on several factors, from productivity, the skills and motivation workers bring to their jobs to the legaland social in which environment factors and discuss they work. We will analyze each of these its implications for government to promote policies growth. We also will discuss the costsof rapid economic growth and consider whether there may be limits to the amount of economicgrowth a society can achieve. In this chapter, living standards in

E. Stephen the American

Lewis, Thomas Jefferson, Ambrose, Undaunted Courage: Meriwether West (New York:Touchstone [Simon & Schuster], 1996), p. 52.

and the Opening of

THE

STANDARDS: THE RECORD

503

STANDARDS:

IN LIVING

RISE

REMARKABLE

THE

RISE IN LIVING

REMARKABLE

THE RECORD The

in health

advances

care and

transportation mentioned in the impressive changes that

the

of this

beginning

have taken chapter illustrate only a few of place in in people's material well-being over the past two centuries, particularly industrialized countries like the United States. To study the factors that affect living standards we must go beyond anecdotesand adopt a specific however, systematically, measure of economic well-beingin a particular country and time. In Chapter 15, we introduced real GDP as a basic measureof the level of in a country. Recall that, in essence, economic real GDP measures the physical activity volume of goods and services produced within a country's borders during a specific a period,such as a quarter or a year. Consequently,real GDPperperson provides measure of the quantity of goods and services available to the typical resident of a real GDP per person is certainly not a country at a particular time. Although perfect indicator of economic 15, it is positively well-being, as we saw in Chapter related to a number of pertinent variables, such as life expectancy, infant health, and focused on real GDP per personas a key literacy. Economists have, therefore, measure of a country's living standard and stageof economic development. in real GDP per person that in occurred Figure 18.1 shows the remarkablegrowth the United States between1929and 2010. For comparison, Table 18.1 and Figure 18.2 in selected years from 1870 to 2008. show real GDP per person in eight countries These data tell a dramatic story, and you should take a moment to lookat them closely. For example, in the United States (which was already a relatively wealthy in 1870), real GDP per personin 2008 industrialized was 13 times its 1870 level. In country real GDP per person was 31 (!)times its 1870 level. Underlying these statisticsis Japan, In just a few an and transformation. amazingly rapid process of economic growth generations societies became highly industrialized economies with relatively poor agrarian that could As average standards of living scarcely have been imagined in 1870. Table 18.1 and Figure 18.2 has occurred since show, a significant part of this growth in Japan and China. Further, both China and India have grown 1950, particularly

1979 than they did in earlier periods. in time we go, the less preciseare of caution is in order. The farther back historical estimates of real GDP. Most governments did not keep official GDP statistics until after World War II; production records from earlier periods are often incomplete or of questionable accuracy. Comparingeconomic over a century or moreis also output since

faster

significantly

A note

FIGURE

90,000

^ 80,000

the

\302\251 70,000

The red

^

I 50,000 40,000 \302\243\" Output

30,000 \302\243

per

3 B- 20,000

in

persori^^

3

O 10,000

4

I

I

I

I

I

>> >\302\260P

^

i

i

<$>

&>

i

i <&>

$P

Year

Source:

line

shows

in

the

output per person in the U.S. economy since 1929. Output per person today is over five times what it was

60,000

0

18.1

per Person U.S., 1929-2010.

Output

Bureau of Economic

Analysis,

www.bea.gov.

i

i

i

i

i

i

4^

&

\342\226\240f

I

I

1929.

CHAPTER18 ECONOMIC GROWTH

504

18.1

TABLE

GDP per

Real

Person

in

Selected

1870-2008

Countries,

Annual

Country States

United

United

Kingdom

1870

1913

1950

2,445

5,301

9,561

18,789

1990

31,178

23,201

4,921

6,939

13,167

16,430

23,742

1,839

3,648

3,881

13,993

15,929

20,801

1,387

1,921

13,163

18,789

22,816

Japan

737

China

530

552

448

1,039

1,871

Brazil

713

811

1,672

4,890

4,920

India

533

895 1,210

2,975

439

619 1,122

1,309

Ghana

673 781

1,062

1,650

Source:Angus

Maddison, GDP

.net/maddison.Real

RealGDP per Person

of Countries,

U.S., the

1870

and remained

Ghana

1.8

2.1

2.1

2.9 4.4 4.8 2.3 2.7 0.7

1.4 1.9 6.7 0.9 4.2

I.I

downloaded

from www.ggdc

and 1979.

in 1950

Germany

30,000

Id

%

25,000

%

20,000

c

high-

o

growth

China

and the

15,000

c

has been especially rapid since the 1950s in Japan and India.

2.1

throughout

the period.Economic

since 1979in

tables

to West

1979-2008

o

U.K., and

countries

1950-2008

c 35,000

Germany began with high levels of GDP per person income

change

40,000

in

1870-2008.

The

6,429

%

Annual

change

1.9 1.5 1.8 2.5 1.9 1.6 1.3 1.0

The World Economy:A Millennial Perspective (OECD: 2001), updated dollars. \"Germany\" refers per person is measured in 1990 international

FIGURE 18.2 a Sample

6,725

%

Annual

1870-2008

2008

3,190

Germany

in

1979

%

change

Z 10,000

5,000

and

rest

of sub-Saharan

Africa

experienced

very low

0

growth rates.

problematicbecausemany

goods

comparisons,

however,

we can

available goods and nineteenth

and

say

and

services

produced today

the difficulty Despite that the variety, certainty

with

servicesincreasedenormously

twentieth

that are

1870.

inconceivable\342\200\224in unavailable\342\200\224indeed,

centuries,

of

the

data

precise

making and

quality,

in industrialized

a fact reflected in

were

countries

on real

WHY \"SMALL\"DIFFERENCESIN GROWTHRATES

quantity

of

during the

GDP per capita. MATTER

columns of Table 18.1 show annual rates of real GDP per growth the entire 1870-2008 and two more recent period periods.At first these growth rates don't seemto differ much from country to country. For glance, example,for the period 1870-2008, the highest growth rate is 2.5 percent(Japan) and the lowest is 1.0 percent (Ghana). But don't let small differences in growth rates fool you. For example, in 1870 Brazil's twice that of Ghana, yet by 2008 Brazil was output per person was roughly The

last three

personfor

both

STANDARDS: THE RECORD

RISE IN LIVING

REMARKABLE

THE

505

richer than Ghana. This widening of the gap between these two of the difference between Brazil's1.6percent annual rate growth and Ghana's 1 percentannual maintained for almost 140 Small rate, growth years. in growth differences rates can have large long-run effects because of the power of rates that are compounded over time. A good illustration of this power is growth the effect of compound interest on a bank deposit. four

times

countries

is the

result

Compound Interest: Part is compound

What

In 1800 your each year

that

receives

When you

withdrew

account

The

X 1.04

$10.00

$10.00

deposited

Interest is compounded annually interest itself in later years).

(so that

in a checking account interest paid at the end

Great-Great-Grandpa'swill

be turned over to his most direct descendant (you) in in that year, how much was the account the funds

the account

X

EXAMPLE

18.1

interest?

great-great-grandfather

interest.

4 percent

I

was worth $10.00 = $10.00

1.04

X

in

X 1.04 = $10.00 = $10.82 in 1802; and

1800;

(1.04)2

at

of

specified

2010.

the year worth?

$10.40 in so on. Since

1801; 210

years elapsed between 1800, when the depositwas made, and the year 2010, when the account was closed,the value of the account in the year 2010 was $10.00 X (1.04)210, X 1.04 or $10.00 to the 210th power. Using a calculator, will find that $10.00 you times 1.04 to the 210th power is $37,757.33\342\200\224a good return for a $10.00 deposit!

in which interest is paid not only on arrangement all accumulated interest\342\200\224is original deposit previously distinguished from simple interest, in which interest is paid only on the original deposit.If your account had been deposited at 4 percent great-great-grandfather's simple interest, it would have accumulated of the original (4 percent only 40 cents each year = X + for a total value of 210 after 210 $10.00 deposit), $10.00 $0.40 $94.00 in The tremendous the value of his account came from the years. growth of the interest\342\200\224hence the \"the of interest.\" compounding phrase power compound

Compoundinterest\342\200\224an but on

the

Compound is the

What

difference between 2% with

Continuing

$10.00

deposit

18.1, what after 210

Example

have

been

worth

2 percent?6 percent? 2 percent interest, = $10.20 in 1801;

At

1.02

2010,

the value

$10.00 of the account

= $10.40

(1.02)2

$10.00

in 1802;

would be $10.00X

interest rate were6 percent,after 210 years (1.06)210, or $2,061,729.60. Let's summarize

Interestrate (%)

compounded

annually?

would your great-great-grandfather's years if the annual interest rate had been

would be worth

the account X

6% interest,

and

interest

Part 2

Interest:

(1.02)210,

the account

Value

the

results

of $

in 1800;

$10.00

and so on.In the or

$639.79.

year

If the

would be worth $10.00 of these two examples:

10 after

X

X

210 years

$639.79

$37,757.33

$2,061,729.60

interest is so powerful that Compound sum, compounded over a long enough

at relatively low rates of interest, can period, greatly increase in value.

even

a small

A more

compound

previously

EXAMPLE

the

interest

payment of interest the original deposit

only on but on all not

accumulated

18.2

interest

506

CHAPTER

18

ECONOMIC

GROWTH

subtle point, illustrated by this example, is that small differencesin interest rates a lot. The difference between a 2 percentand a 4 percent interest rate doesn't seemlike much, but over a long period of time it implies large differences in the amount of interest accumulated in a bank account. Likewise, the effect of switching from a 4 percent to a 6 percent interest rate is enormous, as our calculations show.

matter

of a bank

the value

as

Just

rate, so the size of growth. This analogy per

depositgrows each year at economy expands each year

equal to the interest rate of economic

a rate

the

at

in output that even a relatively modest rate of growth suggests 2 percent per year\342\200\224will produce tremendous increases in average in growth rates, as over a long period. And small differences relatively 1 to

person\342\200\224say,

standards

living

a nation's

and Ghana, will ultimately standards. produce very different living a useful formula for the number of employ approximating years it will take for an initial amount to double at various growth or interest rates.The formula is 72 divided rate is by the growth or interest rate. Thus, if the interest 2 percent per year, it will take 72/2 = 36 years for the initial sum to double. If the interest rate is 4 percent,it will take 72/4 = 18 years. This formula is a good for small and moderate interest rates. approximation only Over the long run, then, the rate of economic is an extremely growth important variable. Hence, government or other factors that affect the longpolicy changes term growth rate even by a small amount will have a major economic impact. in

of Brazil

case

the

Economists

CONCEPTCHECK 18.1 as Japan's

year,

much

larger

GDP per capita in the United States had grown 1.9 percent did, instead of the actual per year, from would real GDP per personhave been in the United real

that

Suppose

RICH:

BECOME

NATIONS

WHY

at

2.5 percent

per

1870 to 2008.How States in 2008?

THE CRUCIAL

ROLE OF AVERAGELABORPRODUCTIVITY question, we

average output

labor per

productivity

employed

worker

a nation's

determines

What

economic growth rate? To get some insight into this vital to express real GDPper person as the product of two and the share of the population that is working.

it useful

find

will

terms: averagelabor productivity To do this, let Y equal total real output (as measured by real GDP, for example), N equal the number of employed workers, and POP equal the total population. Then real GDP per person can be written as Y/POP; average labor productivity, or and the share of the population that is Y/N; output per employed worker,equals is N/POP. The relationship betweenthese three variables is working Y POP

which, as you

can

always holdsexactly.

see In

N

Y_

~NX

POP'

by canceling out N on the right-hand this basic relationship is words,

Real GDPper person =

Average

labor

X Share This intuitive:

employed.

for

on (1)how of the total population)are working.Furthermore, times the equals average labor productivity

equation,

productivity

of population

real GDP per person tells us something of quantity goods and servicesthat each person much each worker can produce and (2) how many

expression The

of the

side

because

share

very

basic

can consume people

real

of the

(as a

GDP

and

depends fraction

per person

population

that

is

BECOMERICH:

WHY NATIONS

THE

CRUCIAL ROLE OF

AVERAGE

507

PRODUCTIVITY

LABOR

GDP perpersoncan grow only to the extent that there is growth in and/or the fraction of the population that is employed. productivity 18.3 and 18.4 show the U.S. for the three Figures figures key variables in the above for the 1960-2009. 18.3 shows both real GDP per relationship period Figure and real GDP worker labor 18.4 shows person per (average productivity). Figure the portion of the entire U.S. population the (not just working-age population) that was that Once we see that the expansion in output employed during period. again, in the United States has been Between 1960 and 2009, real per person impressive. GDP per personin the United States grew by 120 percent. Thus, in 2009, the about 2% times as many and services as in 1960. average American enjoyed goods in both labor productivity Figures 18.3 and 18.4 show that increases and the share of in the population a contributed to this rise standard. holding job living Let's look more closely at these two contributing with the share factors, beginning of the population that is employed. As Figure 18.4 shows,between 1960 and 2009, the employed, real

worker

18.3

FIGURE

1,00,000

Person and

90,000

Labor

80,000

United Output

|

per worker^

Real

70,000

in

*

60,000

c

^ 50,000

g| jjw

30,000

5

20,000

3

10,000

0

per person

States grew

United

and 2009, and real

0c CJD

I

I

i

I

CD N-

c Ti

1964

1968

1972

i

i

O

^

Gi

Gi

CX)

Gi

i

worker

1960

output labor

(average

productivity) grew

person

Output per

by

167 percent.

Q_

Q.

in the Productivity States, 1960-2009.

120percent between

\302\260-8

per

Average

output

the

per

40,000

Real GDP

Annual

i

i

i

i

I

1992

1996

2000

2004

2009

CX) CX)

CX)

Gi

Year

Source:

Bureau

of Labor

Statistics, www.bls.gov.

Share

1

U.S.

Employed,

1960-2009.

Share of population

40

The share of the

employed

E
of the

Population

50 \342\226\240o

\"5.

18.4

FIGURE

60

population

increased from 36 percent I960 to 46 percent in 2009.

30

o Percenta

o

0

c

CJD c Ti

1

1964

I

1968

I

1972

I

1976

I

1980

I

I

'siCO

CO CO

Gi

Year

Source:

U.S.

holding a job

Bureau of Labor

Statistics,

www.bls.gov.

Gi

I

I

I

I

I

1992

1996

2000

2004

2010

in

508

CHAPTER18 ECONOMIC GROWTH

of people

number

employed

in

the

from 36 to 46 percent of the entire of women to work outside tendency this rise in employment. Another factor was an increase in the share of the general States rose

United

The population, a remarkable increase. growing the home was the most important reason for

leadingto higher

of employment

rates

is of

that

population

generation,

workers

of young

years after World

rising

increase

the

significantly to

other

from

the

Although

(ages 16to 65).The

working age

born in the

trend almost certainly

cause

helped

countries,

of age

coming

II, and

War

lesserextent

this

growth

share of the U.S. population in real GDP per person during will in the future. not continue

with

employment,

began

retire,the

fraction

reaching of the

retirement

age

population

contributed

jobs

As more

2010.

in

immigration

workforce. decades, this

four

past

Women's participation in as

rate in

the

in

its prime

and more

will begin

is employed

that

boom\"

\"baby

the

in the

the

continue rising at the same decades. More important, the baby boomgeneration,now seems unlikely to

force

labor

of the

to a

the

four

past

years of

baby boomers

to drop, probably

standards long run, then, the improvement in living brought about by the rising share of Americans with jobs will likely prove transitory. What about the other factor that determines output per person, average labor As 18.3 between and labor shows, 2009, productivity? Figure average in the United States increased by 167 percent,accountingfor a sizable productivity share of the overall increase in GDP per person. In other periods, the link between in the United States has often average labor productivity and output per person In

significantly.

the

1960

was

holding jobs

This quick increases

run,

look at

recent

in output

per

productivity. Furthermore,

more

the

Real GDPper person,a compound of

the

in

time,

labor

average

is employed.

Since 1960 the

share of

the

U.S.

population

has risensignificantly, but this variable is likely to decline in In the long run, increases in output per person and hence living

decades.

arise

from

primarily

increases

in

labor

average

coming

productivity.

OF AVERAGE

DETERMINANTS

THE

reasons

standards, has grown This growth reflects the power of if sustained over a long rate, the size of the economy. times the share of the productivity

with jobs standards

can

the

of living

interest: Even a modestgrowth can lead to large increasesin that

more they

understand

long

labor

AND PRODUCTIVITY

countries.

industrialized

Output perpersonequals population

grow, then, we must

indicator

basic

can produce, the

people

GROWTH

ECONOMIC

RECAP

period

been

labor productivity.

for increased

dramatically

earlier

has

why economies

understand

To

consume.

periods the share of the population recently. data supports a more general conclusion.In the arise increases in average person primarily from

stronger, since in most more stable than it

even

been

LABOR

PRODUCTIVITY determines

What

a particular time? the

with productivity else

being

worker

the

of the average worker in a particular country of this issue often equate worker of workers of a given to work hard. Everything nationality

productivity

Popular

willingness equal, a culture

productivity.

But

that promotes hard

intensity

labor productivity average in labor example, average productivity differences

in

at

discussions

of effort that

we

the United

work certainly

alone cannot

observe

around

to

tends

explain

the

huge

the world.

States is about 24 times

increase

For

what

it is in

and 100 times what it is in Bangladesh, that though there is little doubt Indonesians and Bangladeshis work very hard. In this section, we will examine six factors that appear to account for the major differences in average labor both between countries and between productivity, Indonesia

THE

Later

generations.

the

in

chapter

to spur

factors

these

influence

we will discuss

OF AVERAGELABOR

DETERMINANTS

509

PRODUCTIVITY

how economic policiescan

productivity and growth.

HUMAN CAPITAL that determine average labor productivity, assembly-line workers, Lucy and Ethel.

factors

the

illustrate

To

two prototypical

Assembly Are

more productive

Ethel

and

Lucy

as a team or by

we

introduce

Line Productivity

EXAMPLE 18.3

themselves?

have jobs wrapping chocolatecandies and them into boxes. placing can 100 candies hour. who has had Ethel, wrapper, wrap only per can 300 candies hour. Each works40 hours on-the-job training, wrap per per week. in terms What is average labor productivity, of candies wrapped per weekand candies wrapped and Ethel as a team? per hour for (a) Lucy, (b) Ethel, and (c) Lucy and Ethel

Lucy

Lucy, a novice

In the previous section,we

worker.Note,though, on the time tell us how

period that much the

concernedwith

defined labor productivity as output per average measurement of average labor productivity depends is specified. For example, the data presented in Figure 18.3 In worker in a this we are average produces year. example, that

how

Ethel's

and

Lucy

(40

X

hours/week) Ethel's

hour), or

weekly

Ethel

and

(100

work is

~^\\

or per

*x N,

equally

are given in the problem: Lucy can wrap 300. is wrap Lucy's weekly productivity = candies 4,000 wrapped wrapped/hour) per is (40 hours/week) X (300 candies wrapped/

productivities

hourly

100 candies per hour

week.

Lucy and Ethel can produce per hour of of these ways of measuring labor productivity clearabout the time unit we are using.

much

week of work. Any one valid, as long as we are

DA e-

the

candies

productivity

can

How productive

are these

workers?

12,000 candiesper week.

and Ethel can wrap 16,000 candiesper week.As a team, their individual is candies weeks of average weekly productivity (16,000 wrapped)/(2 or candies week. T heir individual 8,000 work), per average hourly productivity as a team is (16,000 candies wrapped)/(80 hours of work) = 200 candies hour. per Notice that, taken as a team, the two women's lies between productivity midway Lucy

Together,

individual

their

productivities.

is more

Ethel

has allowed Lucy's. Because of number of hours.

which

than Lucy because shehas had on-the-job training, her to develop her candy-wrapping skillsto a higher level than her training, Ethel can produce more than Lucy can in a given

productive

CONCEPT CHECK 18.2 Refer

output

attends additional classes Example 18.3. Suppose Ethel Find the output how to wrap 500 candies per hour. and Ethel, both individually and as a team. per hour for Lucy

back

wrapping and

to

learns

in

candy

per week

and

in the two women's performanceby Economists would explainthe difference Ethel has more human capital than Human Lucy. capital comprises the talents, and skills of workers. Workers with a education, training, large stock of human capital are more productive than workers with less training. For a secretary who example, knows how to usea word processing will be able to more letters than one program type who doesn't; an auto mechanicwho is familiar with computerized diagnostic equipment will be able to fix engine that less-well-trained mechanics couldnot. problems saying that

human

capital

an amalgam

factors such as education, experience,

work

habits,

of

training,

intelligence, energy, trustworthiness,

initiative that affects worker's marginal

the product

and value of a

510

CHAPTER 18 ECONOMICGROWTH

EXAMPLE

Economic

The

18.4

did

Why

West

World War

of West Germany and Japan

Recovery

and Japan

Germany

recover so successfully

from

the

devastation

of

II?

and Japan sustained extensive destruction of their cities and industries Germany II and entered the postwar period impoverished.Yet within during World War 30 years both countries had not only been rebuilt but had become worldwide industrial and economic leaders. What accounts for these\"economic miracles\"?

to the economic recoveryof West Germany and Japan the substantial aid provided by the United States to Europe under the Marshall Plan and to Japan during the U.S. occupation. Most economists that role in both countries. agree,however, high levels of human capital playeda crucial At the end of the war, Germany's population was exceptionally well educated, with a large number of highly scientists and engineers. The country also qualified had still does today) an extensive apprentice system that (and provided on-the-job workforce. training to young workers. As a result, Germany had a skilled industrial In addition, the area that became West benefited from an Germany substantially influx of skilled workers from East Germany and the rest of Soviet-controlled Many

contributed

factors

from World

War

II, including

20,000 trained including 1949, this concentration of human

Europe,

Germany's By

1960

engineers and technicians.Beginning capital

sophisticated,

technologically West Germany

was a

as

early

as

to a

major expansion of highly productive manufacturing sector. contributed

leading exporter of

manufactured

high-quality

in Europe. standards of living goods, and its citizens enjoyed one of the highest Japan, which probably sustained greater physical destruction in the war than In with a skilled and educatedlabor Germany, also began the postwar period American forces restructured the Japanese schoolsystem and addition, occupying all Japanese to obtain a good Even more so than the encouraged

force.

education.

Germans, however,the lifetime

Japanese

system,

employment

under

emphasized

on-the-job

which workers

training. As part

were expectedto

invested company their entire career, Japanesefirms in human training. The payoff to theseinvestments capital labor average productivity, particularly in manufacturing.

same

manufactured goods were among the most advanced workers among the most skilled.

extensively

was a in

stay

of a

with

the

in worker

steady increasein

By the 1980s Japanese the world and Japan's

of human capital were instrumental in the rapid alone cannot create a Germany and Japan, human capital A case in point standard. is Soviet-dominated East Germany, which had high living a level of human capital similar to West Germany's after the war but did not enjoy in the chapter, the the same economic growth. For reasonswe'lldiscuss later communist far system imposed by the Soviets utilized East Germany'shuman capital less effectively than the economic systems of Japan and West Germany.

Although

economic

O

high

levels

of West

Human capital is analogous to physicalcapital (such as machines and factories) it is acquired the investment of and money. time, primarily through energy, For example, to learn how to use a word a secretary might processing program, need to attend a technical school at night. The cost of going to school includesnot the tuition time spent only paid but also the opportunity cost of the secretary's in wages class and The benefit of the is the increase the attending studying. schooling will earn when the course has been We know the Costsecretary completed. by if the benefits Benefit Principlethat the secretary should learn word processing only exceed the costs, including the opportunity costs. In general, then, we would expect to see people acquire additional education and skills when the difference in the wages paid to skilled and unskilled workersis significant. in that

Cost-Benefit

growth

Workers'

depends not only on their

productivity

work with. Even

tools they have to

open-heart surgery

programmeris

without of

capital allows example shows. better

effort but on the surgeon cannot perform and an expert computer

equipment,

These examplesillustrate

a computer.

as factoriesand

capital such

workers to producemoreefficiently,

More

machines.

candy-wrapping machine make Lucy

Continuing electric

with

Example

candy-wrapping

Using

this

an

machine,

for the

sake of simplicity that

assigned to one worker only.

now? Will

shift.)

Concept Check18.3.) can wrap

Ethel

rules

machine on the day one machine, she will

Now

while

18.5

productive?

Lucy

only 300

wrapped candies (40 hours X

will

be able

per hour. Lucy's

500

answer

the

candies

out sharing it to

assign

to wrap

on the

night

See

Lucy. (Why?

500 candiesper hour,

be 20,000

will

output

weekly

must be

arrangements, in

another

and

shift

the

if

change

machine

a candy-wrapping

assumption

(This

worker uses the If the boss buys just one

which

EXAMPLE

Efficiency

that Lucy and Ethel'sboss acquired an which is to be one worker. machine, designed operated by untrained worker can wrap 500candiesper hour.What are

Ethel's hourly and weekly outputs a second machine? A third? gets Suppose

next

suppose

18.3,

and

Lucy boss

more

Ethel

and

the

as

Physical Capital and Will a

51

skills and

skilled

most

the

sophisticated value without

limited

of physical

importance

and

PRODUCTIVITY

CAPITAL

PHYSICAL

the

OF AVERAGELABOR

DETERMINANTS

THE

per hour). Ethel's weekly

wrapped

candies (40 hours X 300 candies wrapped per can now hour). Together they wrap 32,000 candies per week, or 16,000candies each. On an hourly basis, average labor productivity for the two women per week taken together is 32,000candies 80 hours of work, or 400 candies wrapped per hour\342\200\224twice their labor before the boss bought wrapped per average productivity the

still

is

output

12,000

wrapped

machine.

two candy-wrapping

With

use a

machine.Each couldwrap candies

wrapped

per week.

per hour.

would

a

workers,

output or

happen

if the would

machine

third

average labor productivity.

CHECK

CONCEPT

500

candies

per

Average labor productivity

together would be 20,000wrapped What

machines available,both candies

per

hour, for a total

week,

for

of

40,000

women

both

or 500

could

Ethel

and

Lucy

taken

wrapped candies

boss purchased a third machine? With be useless: It would add nothing to

only

either

two

total

18.3

18.3 and 18.5, explain Using the assumptions made in Examples machine to Lucy rather give the single available candy-wrapping of Increasing Opportunity Apply the Principle Cost.)

why

than

boss should Ethel. (Hint:

the

Increasing

a machine is an example of a capital good, which was a long-lived good, which is itself and used to produced other and services. include machines and produce goods Capital goods equipment or assembly (such as computers,earthmovers, lines) as well as buildings (such as The

defined

factories

in

candy-wrapping 15 as Chapter

or

office

buildings).

Opportunity

Cost

I

CHAPTER18 ECONOMIC GROWTH

512

like the candy-wrapping machine enhance workers'productivity. goods summarizes the results of our Lucy and Ethel examples. For each number of machines the boss might acquire (column 1),Table 18.2 the total weekly gives of and Ethel taken the total number of hours output Lucy together (column 2), Capital

18.2

Table

worked by the two women (column 3), and to total divided total equal weekly output by Table 18.2 demonstrates two important

capital on output. First, for first

per hour.

Output,

Capital,

(I)

Number of machines

(capital)

returns

amount employed

inputs

to capital

of labor and is held

other

constant,

then the greater the amount of in the less an use, capital already additional unit of capital adds to

adds

turn

by

wrapped

and Productivity (2)

in

the

of

Total number

(4)

Candieswrapped

hours

Total

candieswrapped each week(output)

Factory

Candy-Wrapping

worked

week

per

per

hour

worked

(productivity) 200

32,000

400

2

40,000

80

500

3

40,000

80

500

the

illustrated

the smaller the

more

output than returns to

next

the

third.

capital are a natural

as productively capital first machine that a firm

machine

to the next

acquires to

most productive

of firms'

consequence

as possible.

To maximize the

most

use,

and

output,

productive

so

incentive to managers

use

on\342\200\224anillustration

of Increasing Opportunity Cost. When many machines are of them have been exploited. highly productive ways using already machine will not raise output or productivity Thus, adding yet another by very much. If Lucy and Ethel are already two candy-wrapping machines, there operating is little point to buying a third machine, except perhaps as a replacement or spare. The implications of Table 18.2 can be applied to the question of how to stimulate economic the amount of available to the First, growth. increasing capital workforce will tend to increaseoutput and labor The more average productivity. workers the more will be. the are, Second, adequately equipped productive they to which can be increased an stock of degree productivity by expanding capital is limited. Becauseof diminishing returns to capital, an economy in which the available to each worker is already very high will not benefit much quantity of capital from further of the capital stock. expansion of the

D

candies

the more by Table 18.2 is that capital that is benefits of extra Notice that the first already place, adding capital. machine adds 16,000 candies to total but the second machine adds output, only The third machine, which cannot be usedsincethereare only two 8,000. workers, does not increase output or productivity at all. This result illustrates a general of called returns to capital:If the amount of labor economics, principle diminishing and other inputs employedis held constant, then the greater the amount of capital already in use, the less an additional unit of capital adds to production. In the case of the the first candy-wrapping factory, diminishing returns to capital implies that in machine adds more than the which second, candy-wrapping acquired output

available,

Opportunity

200

80

will assign the

Cost

labor productivity (column4) by

80

use each pieceof

Increasing

example,

output (column 2)

16,000

Diminishing

production

For

1

in

the

of additional more adding capital

0

The secondpoint

if

4),

18.2

TABLE

diminishing

(column

the effect

about

points

total

and average

candies

16,000

weekly

of workers,

number

hour

hours.

output and average labor productivity. machine increases weekly candy-wrapping both

generallyincreases adding the

a given

output per

average

available,

Principle

all

the

empirical evidencethat

Is there

Figure

productive?

(real GDP countries.

per worker) in

The

figure

are

less productive

per

capital and productivity

at

high

account for many other differences among or systems government policies.Thus, we should not between the two variables. relationship

countries.

richest

States, but

on average.

to see

expect

between

relationship

capital. In addition, Figure countries, such as differences

levels of

per

the

that

the

of the

weakening

productivity in 15

the United

than workers

American

than

may help to explain the

to capital

returns Diminishing

weaker for

worker

does

18.5

not

in economic

a perfect

FIGURE

000 w

30,

000 000

\302\243 20, &. (D

Q. 15,

0-

O

000

\342\200\242 UK

-India

Thailand I

\342\200\242 Iran

productivity,

Philippines

Penn World

AND

LAND

Tables,The

among

them

land,

to

_L

_L

50,000 60,000

(1990 $) Research,www.nber.org.

RESOURCES production

energy, and raw

agriculture, and modern manufacturing raw materials.

In general,an

worker

per

Bureau of Economic

NATURAL

OTHER

_L

40,000

30,000

capital

National

Besidescapital goods,other inputs productive,

_L

L

20,000

10,000

help to

make workers more

materials.Fertile make

processes

land

intensive

is essential

use of

to

energy and

of natural resources increases the productivity of them. For example,a farmer can a much produce larger in a country like the United States or Australia than crop in a land-rich country where the soilis pooror arableland is limited in supply. With the aid of modern farm and great expanses of land, American farmers are so machinery today's that even constitute less than 3 of the productive though they percent population, to feed the country but to export to the rest they provide enough food not only the

of

workers

the

abundance

who use

world.

there are limits to a country's other Although supply of arable land, many such as petroleum and metals, can be obtained resources, through international markets. Because resources can be obtained through countries need trade, not possess large quantities of natural resources within their own borders to achieve economic become rich without Indeed, a number of countries have growth. natural

natural resources of their and Switzerland.Just as important substantial

use

them

productively\342\200\224for

example,

own, as

including

possessing by means

Japan, Hong Kong, Singapore, natural resources is the ability to

of advanced

large

as measured

real GDP per

\342\200\242\342\200\224

0

with

amounts of capital per worker also tend to have high average labor

\302\251Turkey

Nigeria|

in

1990.

15 Countries,

Mexico

Real

Source:

Capital per Worker

\342\200\242Germany

Countries

000 0

Australia

\342\200\242Japan

10.000

15

France

18.5

Labor

Productivity and

Canada

Italy

I&. 25,000 o

Average

\342\200\242 us

000

\302\251 35,

513

PRODUCTIVITY

more

of capital

amounts

Note, though,

is somewhat

and productivity

Germany has more capital

workers

German

the theory.

with

consistent

capital

For example,

between average labor of capital per worker

relationship betweenthe

a strong

shows

worker and productivity, between relationship

1990

capital makes them

more

workers

giving

the relationship and the amount

shows

18.5

OF AVERAGELABOR

DETERMINANTS

THE

technologies.

worker.

by

514

CHAPTER

18

ECONOMIC

GROWTH

TECHNOLOGY

Besides to

human

develop

capital,

physical

capital,

and natural

new, more productive

and apply

technologies

resources, a country's ability will help to determine its Two centuries ago, as of the chapter, the beginning

productivity. Consider just one industry, transportation. from Stephen Ambrose in the by the quote horse and wagon were the primary means of transportation\342\200\224a slow and costly method indeed. But in the nineteenth century, technological advances such as the steam the expansion of riverborne and the engine supported transportation of a national rail network. In the twentieth century, the invention of the development internal combustion engine and the development of aviation, supported by the construction of an extensive infrastructure of roads and airports, produced and reliable transport. Technologicalchange has clearly beena increasinglyrapid, cheap, in the transportation force revolution. driving suggested

New technologiescan improve

which

they

couldsell

introduced.

are their

produce

rapid shipping and

allows American farmers to sell their world. With a broader market in which to sell,farmers in those products best suited to local land and weather can conditions. specialize factories can obtain their raw materials wherever Similarly, they are cheapest and most abundant, the goods they are most efficient at manufacturing, and sell produce their products wherever they will fetch the best price. Both these examplesillustrate the of Comparative Advantage, that overall increases when Principle productivity at which producers concentrate on those activities they are relatively most efficient. Numerous other technological developments have led to increasedproductivity, in communication advances and medicine and the introduction of including All indications are that the Internet will have a major impact on computer technology. the U.S. economy, not just in retailing but in many other sectors.In fact, most economists would most probably agree that new technologies are the single important in general. source of productivity improvement, and hence of economic growth does not automatically follow from breakthroughs However, economic growth in basic science. To make the best use of new knowledge, an economy needs who can exploit scientific advances commercially,as well as a legal and entrepreneurs the practical political environment that encourages application of new knowledge. products

Comparative

Advantage

O

in industries other than the one in productivity For instance, in the late 18th century, American farmers the availability of only in local and regional markets.Now

virtually

refrigeratedtransport in the

anywhere

CONCEPT

18.4

CHECK

kind of wrapping and easier. The use of

A new

by

hand

by 200

per

paper this

hour,

has been

invented

makes

that

candy-wrapping

quicker

person

can wrap

paper increases the number of candiesa and the number of candies a person can

wrap

18.5, construct by per hour. Using the data from Examples 18.3and Table 18.2that shows how this technological advance affects averagelabor Do diminishing returns to capital still hold? productivity. 300

EXAMPLE

18.6

by machine a table like

Labor Productivity

rapidly since 1995? the 1950s and 1960s, most industrialized countries experienced During rapid in real GDP and average labor productivity. Between 1947 and 1973, for growth example, U.S.labor productivity grew by 2.8 percent per year.2 Between1973 Why

has

U.S. labor

and

1995,

however,

2Data

refer to labor

productivity

labor

productivity

grown so

productivity growth

growth

in the nonfarm

in

the

United

States

business sector and can

be found

fell by half,

to

at www.bls.gov.

THE

DETERMINANTS

OF AVERAGELABOR

515

PRODUCTIVITY

similar slowdowns, per year. Other countriesexperienced productivity In recent articles and bookswerewritten to uncover the reasons. trying in in there has been a rebound however, years, productivity growth, particularly the United States. Between1995and 2007, U.S. labor productivity growth Can averaged 3 percent per year. What caused this resurgencein productivity growth? it be sustained?

1.4 percent and many

Economists agreethat rapid

the

progress

technological

in productivity pickup growth was the product of and increased investment in new information and

has (ICT). Research indicatesthat productivity that such as silicon ICT, grown rapidly produce chips and fiber use ICT. The application of these optics, and those industries that advances had effects in areas ranging from automobile production to retail ripple The rapid growth of the Internet, for made it inventory management. example, for consumers to and find information online. But it also possible shop helped coordination between companies improve their efficiency by improving manufacturers and their On the other hand, there has beenno acceleration suppliers. in in those industries that labor neither nor use productivity growth produce much ICT.3

communication

technologies

in

those

both

Optimistsarguethat

industries

in computers,

advances

and other ICT fields will allow productivity rate. Others are more cautious,arguing that from these developmentsmay be temporary riding on which view

will

ENTREPRENEURSHIP

The productivity

turn

out

to be

communications, biotechnology, growth to continue at this elevated in productivity the increases growth rather than permanent. A great deal is

correct.

AND MANAGEMENT

depends in part on the people who help to decidewhat to are produce produce it: entrepreneurs and managers.Entrepreneurs who create new economic Because of the new people enterprises. products, services, are technological processes, and production methods they introduce, entrepreneurs In critical to a dynamic, the late nineteenth and twentieth healthy economy. early individuals like Henry Ford and Alfred Sloan Andrew centuries, (automobiles), D. Rockefeller and P. (oil), J. Carnegie (steel), John Morgan (finance)played central in the development of American industry\342\200\224and, roles not amassed huge incidentally, in fortunes the These and others like them personal process. people (including like Bill Gates) have been criticized for some of their contemporary entrepreneurs in some cases with business practices, and dozens of justification. Clearly, though, they other business leaders of the have contributed prominent past century significantly to the growth of the U.S. economy.Henry Ford,for example, the idea of developed mass production,which lowered costs to automobiles within sufficiently bring in reach of the average American family. Ford his business his a began garage, tradition that has been maintained ever since. by thousands of innovators Larry Page and SergeyBrin, the co-founders of Google, revolutionized the way college students and many professionals conduct research by developing a method to prioritize the list of websites obtained in a search of the Internet. Entrepreneurship, like any form of creativity, is difficult to teach, although some of the supporting and can be skills, like financial analysis marketing, learned in college or business school. How, then, doesa society encourage that the entrepreneurial spirit will always exist; entrepreneurship? History suggests the challengeto society is to channel entrepreneurial energies in economically to

3Kevin

Data

of workers

and how

J. Stiroh, \"Information Technology and the U.S. Productivity Revival: 92 (December 2002), pp. 1559-76. Say?\" American Economic Review

What

Do the

Industry

entrepreneurs

createnew

people who economic

enterprises

516

CHAPTER

18

ECONOMIC

GROWTH

ways. For example,economic policymakers

productive

to ensure

need

that

that small businesses\342\200\224some regulation not so inflexible, of which become big businesses\342\200\224cannot off the ground. get in factors a role as well. Societies which business and Sociological may play commerce are considered to be beneath the dignity of refined, educated people are less likely to produce successful entrepreneurs. In the United States, for the most as a respectable part, business has been viewed activity. Overall, a socialand economic milieu that allows entrepreneurship to flourish appears to promote economic and eras like growth rising productivity, perhaps especially so in high-technology taxation

so heavy, and will eventually

is not

our own.

EXAMPLE 18.7

Inventingthe PersonalComputer Does

pay?

entrepreneurship

Steve Jobs and

Wozniak were two 20-year-olds who designed had an idea to make a that was smaller and computer games They computer in than the closet-sized mainframes that were then use. To set cheaper up shop in Steve and their sold their two most Jobs's parents' garage buy supplies, they valuable possessions, used van and Wozniak's Hewlett-Packard Jobs's Volkswagen scientific for a total of $1,300. The result was the first personal calculator, computer, which they named after their new company (and Jobs's favorite The fruit): Apple. rest is history. Clearly, Jobs's and Wozniak's labor as the average productivity inventors of the personal became times what it was computer eventually many when they designed computer games. Creative entrepreneurship can increase like additional productivity just capital or land.

In 1975

Steve

for Atari.

^%//'

The Economic

18.1

Naturalist

Why

China stagnate

did medieval

economically?

China (a.d.960-1270) was one of considerable technological included paper, waterwheels, water clocks, and gunpowder, the compass.Yet no significant industrialization occurred, and in subsequent centuries possibly and technological innovation than China.Why did Europe saw more economicgrowth medieval China stagnate economically?

The

Sung

sophistication;

in period inventions

its

researchby

According to

during the

industrialization

William

economist

Sung

period

was

Baumol,4

a social

the

system

main

impediment

to

inhibited

that

low-statusactivities,

were considered

not fit for an his subjects' property and to take control of their that greatly reduced his right incentives to undertake business ventures. The most direct subjects' path to status and riches in medieval China was to go through a system of demanding civil service examinations scorers on these given by the government every three years. The highest in the imperial bureaucracy, national examinations were granted lifetime positions entrepreneurship.

where they corruption.Not

and

Commerce

educated person.

In

\"Entrepreneurship:

had the right emperor business enterprises\342\200\224a

the

power and often medieval China did not

much

wielded

surprisingly,

and consequently its 4

industry

addition,

scientific

Productive,

1990,pp. 893-921.

and

Unproductive,

became develop

technological

and

Destructive,\"

to

seize

in

wealthy,

a dynamic

advantages

Journal

part

through

entrepreneurial did

not

of Political

translate

class, into

Economy,October

THE

OF AVERAGELABOR

DETERMINANTS

economic growth. China's experience showswhy scientific advances alone cannot guarantee economic growth; to have economic benefits, scientific knowledge must be commercially applied through new products and new, more efficient means of sustained

producing goods and

services.

entrepreneurship may be more glamorous,managers\342\200\224the people run businesses on a daily basis\342\200\224also play an important role in determining labor productivity. Managerial jobs span a wide of positions, from average range the supervisor of the loading dock to the CEO (chief executive at the helm officer) Although

who

to satisfy customers, dealwith assign workers to jobs, and motivate them to work hard and effectively. Such activities enhance labor productivity. For example,in the 1970s and 1980s, Japanese managers introducednew production methods that greatly increased the efficiency of Japanese manufacturing plants. Among them was the just-in-time inventory system, in which suppliers deliver production to the factory just when they are needed,eliminating the need components for factories to stockpile components.Japanese also the idea managers pioneered of organizing workers into semi-independent teams, which allowed production workers more flexibility and than the traditional assembly line. responsibility in the United States and other countries studiedthe Japanese Managers managerial of them. techniques closely and adopted many of a Fortune

500

work Managers obtain financing,

company.

production,

suppliers,organize

THE

POLITICAL

Sofar

we

have

emphasized But

productivity.

government

and legalenvironment productiveways\342\200\224to

the role of the private too has a role to

key contributions

of the

productivity. One

LEGAL ENVIRONMENT

AND

that

work

encourages

save and

hard,

defined when resources

(through

incentive

what

country,

in a

society

whatever

would

labor

in

he

you have

demands. public to be crucial appears

and

the

to economic

property rights. Property

the law providesclearrules for a system of deeds and titles, for

can be used.Imagine living and the police, could take

in increasing average fostering improved

people to behave in economically invest wisely, acquireuseful information

of well-defined

establishment

the

play

in

government can make is to provide a political

skills, and provide the goods and servicesthat One specific function of government that

successis

sector

which

wanted,

are well rights who owns what determining and how those resources example)

backed by the military and regularly did so. In such a

a dictator,

to raisea largecropor to produce

other

since much of what you produced would little, goods and services? Very be taken from of the world likely away you. Unfortunately, in many countries this situation is far from today, hypothetical. Political and legalconditions affect the growth of productivity in other as well. Political scientists and economists have documented the fact that ways, can be detrimental to economic This political instability growth. finding is in since and savers are to invest their resources reasonable, entrepreneurs unlikely if a country whose government is unstable, the for particularly struggle power involves civil or guerrilla warfare. On the other hand, a unrest, terrorism, politicalsystem that promotes the free and open exchange of ideaswill speed the of new and For development technologies products. example, someeconomic historians have that the decline of as was suggested Spain an economicpower valuable

due

in part

from

whose

to the

religious

like the

orthodoxy.

of

the Spanish Inquisition, which permitted no Because of the Inquisition's persecution of

natural world contradictedChurch and technology languished, and Spainfell behind more

theories

science

advent

about the

Netherlands.

doctrine,

tolerant

dissent those

Spanish

nations

PRODUCTIVITY

517

518

CHAPTER

18

ECONOMIC

GROWTH

CHECK 18.5

CONCEPT A

to America is likely

who immigrates

worker

Bangladeshi

that

find

to

his average

labor productivity is much States than it was at home. The higher in the United worker is, of course,the same person he was when he lived in Bangladesh. How can the simple act of moving to the United States increase the worker's productivity? does

What

EXAMPLE

18.8

Look at

Economic

An

communism

did

Why

the incentive to

say about

answer

your

immigrate?

Communism

fail?

in 1917 until For more than 70 years,from the Russian revolution the collapse of the Soviet Union in 1991, communism was believed by many to posea major market-based economic Union's challenge to systems. Yet, by the time of the Soviet the poor economic record of communism had become breakup, apparent. Indeed,

low living

communist

did

in communist

standards

a major reasonfor

West, were

in Europe.

system

compared to

countries,

the

speaking,

Economically

those achieved

that brought

discontent

popular

did

why

in

the

down the

communism

fail?

The poor growth records of the Soviet Union and other communist countries reflect a lack of resources or economicpotential.The Soviet Union had a

not

of natural workforce; a large capital stock;a vast quantity land and and accessto at Yet, including energy; sophisticatedtechnologies. of its collapse, output per person in the Soviet Union was probably less

highly educated resources,

the

time

it was

what

one-seventh

than

States.

United

the

in

would agreethat

Most observers

and legal environment that political communist economic system wasa majorcauseof its ultimate failure. The economic system of the Soviet Union and other communist countries had two main elements: First, the capital stock and other resourceswere owned the rather than or private corporations. by government by individuals decisions and distribution were made and Second, most regarding production implemented a rather than and firms by government planning agency by individuals markets. This we now understand, interacting through system performed poorly, the

established

for

One major

acquire a in

is strongly

problem was the

the

absence

property rights.

of private

With

no

ability

to

to significant property, Soviet citizenshad little incentive firm The owner of an American or economically productive ways. Japanese motivated to cut costs and to producegoodsthat are highly valued by the amount

public because the contrast,

of the

structure

reasons.

several

behave

the

of a

Soviet firm

of goods

quantities

is determined

income

owner's

performance

produced the

of private

manager

specified

by

the quality of the goods produced or whether managers had little incentive to reduce costsor

by

was

the

In profitability. on whether the manager

firm's

judged

the

government's consumers wanted

producebetter,

more

plan\342\200\224irrespective

of

them. Soviet highly valued products,

nor any profits government and not to the manager; were there any opportunities for entrepreneurs to start new businesses.Likewise, workers had little reason to work hard or effectively under the communist system, as rates were determined the rather than pay by government planning agency by the

as

would

extra

value of what A second major

economic

example

workers

weaknessof

much

information,

system, changes

the

economies,

activities relatively basiceconomic

deal of

produced.

system was the absence of free are planned replaced by detailed that specify what should be producedand how. But, as we saw in the of New York City's food supply (Chapter the coordination of even 3),

markets.In centrally government plans

the

accrue to the

in

prices

can

of which is both

convey

communist

markets

be extremely

complex

and require a great

In a market dispersed among many people. information about the goods and services

PROMOTING

and services in a market Principle, in equilibrium leaves individuals with no unexploited opportunities. Central planners communist countries far less able to deal with this than proved complexity decentralized markets. As a result, under communism consumerssuffered constant people want and

provide suppliersthe

to market.Indeed,as we

and

shortages

shoddy

goods.

of communism,

After the collapse

to bring

incentives

communist countries began formerly economic system. Changing an entire economic system (the most extreme exampleof a structural policy) is a slow and difficult and many countries saw economic conditionsworsen at first rather task, than improve. Political instability and the absence of a modern legal framework, laws to commercial transactions, have often the particularly applying hampered of reforms. a number of communist However, countries, progress formerly in the Czech Republic, and the former East Germany, have succeeded Poland, including market and have to achieve implementing Western-style systems begun significant economic growth.

the

many

market-oriented

to a

transition

difficult

LABOR

OF AVERAGE

DETERMINANTS

RECAP

PRODUCTIVITY factors

Key

and training

The skills

The and

and

quantity

The

sophistication

The

effectiveness

The broad the

of

of physical

quality

include:

a country

human capital.

called

workers,

in

equipment,

capital\342\200\224machines,

buildings.

of land and other natural

The availability

Labor

labor productivity

average

determining

of the technologies of management and

1980s. Since

and

1970s

slowed

growth

productivity

United States), largely

resources.

applied in production. entrepreneurship.

legal environment.

and

social

1995,

it

has

of advances

because

the industrialized

world in

rebounded (especially in information and

in the

throughout

communicationtechnology.

If a society decidesto try to raise measures that policymakers might

list of in

average

productivity

POLICIES TO Because

governments

citizens

by

supporting

of economic growth, what are some of the to achieve this objective? Here is a short our discussion of the factors that contribute to growth and, hence, output per person.

INCREASE

skilled and

labor,

on

based

suggestions,

labor

GROWTH

ECONOMIC

PROMOTING

its rate take

CAPITAL

HUMAN

well-educated workersare more productive

countries try education and training

in most

provides public educationthrough

postsecondaryschools,

high

to

increase

programs.

school

than

unskilled

the human capital of their In the United States, government and grants extensive support to

schools, colleges, and universities. like Head Start also to build early programs attempt human capital children for school. To a lesser by helping disadvantaged prepare degree than some other countries, the U.S. government alsofunds for unskilled job training skills have become obsolete. youths and retraining for workerswhose including

Publicly funded

intervention

technical

GROWTH

these goods

the Equilibrium

from

know

ECONOMIC

a

Equilibrium

519

520

CHAPTER

18

ECONOMIC

ar

GROWTH

The

Economic

Naturalist

Why

do

almost

all countries

All

should

why

most needy?Furthermore,

supplied An

free

public

demand curve for educationalservicesdoesnot Equilibrium

O

the

education. (Recall

may not

exploit

all

political

system

relies on

achievable

gains

an

educated

of educational

demander

individual

Principle,

Equilibrium

that

education

can be,

services

educational

private market, without for free or at least subsidized

argument

important

high school,

through

this

may

question

when it does not provide free education such as food or medical care for free, except

on the

demanded

and

education

postsecondaryschools.Why?

so used to the idea of the government essential goods and services

But

more

even

citizens free public

are

Americans

seem odd. provide

provide their college and other

subsidize

most

to the

provide free publiceducation?

countries

industrial

and

18.2

include

states

which

in

from collective action.) to operate citizenry

services has

little

indeed

and

commonly

are,

the government. education is that the private all the social benefits of part that a market in equilibrium the

aid of

For example,the effectively\342\200\224a

reason

democratic

factor

that

an

consider. From a do not capture the

to

we might argue that individuals full from their schooling. For example,peoplewith high human capital, and thus can be used to finance government high earnings, pay more taxes\342\200\224funds that services and aid the less fortunate. Because of income the private benefit to taxation, human the social benefit, and the demand for educationon acquiring capital is less than the private market may be less than optimal from society's viewpoint. educated Similarly, than others to contribute to technologicaldevelopment, and people are more likely hence to general productivity which other besides growth, may benefit many people themselves. Finally, another for public support of education is that poor people argument who would like to invest in human of capital may not be ableto do so because economic

narrower

perspective,

returns

economic

insufficientincome. Why

do

almost

provide free

all countries

public

education?

Nobel

laureate

many economists, suggested that called educational vouchers, to help in the private sector, but they do not justify citizenspurchase educational services the as through the public school system. government providing education directly, Defenders of public on the other hand, that the government should have education, argue in order to set standards and monitor some direct control over education quality. The

these

arguments

What

do

justify

THAT

capital

Friedman,

government

PROMOTE

among

grants,

SAVING AND

increases when productivity stock. To support the creation

labor

Average

Milton

think?

you

POLICIES

modern

may

INVESTMENT

workers can utilize a of new capital,government

and

sizable can

and investment in the private sector. in the U.S.tax codeare designed to stimulate Many provisions expressly households to save and firms to invest. For example, a household that an opens Individual Retirement Account (IRA) is able to save for retirement without paying taxes on either the funds deposited in the IRA or the interest earned on the account. taxes are due when the funds are withdrawn at retirement.) The (However, intent of IRA legislation is to make saving more financially attractive to American households. Similarly, at various times Congresshas instituted an investment tax in which reduces the tax bills of firms that invest new credit, capital. (Private-sector in Chapters 19 and 20.) and investment are discussed in greater detail saving Government can contribute directly to capital formation through public or the creation of government-owned capital. Public investment includes investment, in the building of roads, bridges, airports,dams, some and, countries, energy and encourage high

rates

of saving

PROMOTING

networks. The construction of

communications

begun during

economy.

Today,

of computersand

effect. This

infrastructure, be a

activities, can

confirmed

have

the public

significant

capital supports source of growth. that

is enhanced

by

progress,

technological

and development

research

in

(R&D). In

many

reduced

Internet is

funding

in its

that government investment economic private-sector

in

DEVELOPMENT

AND

RESEARCH

Productivity

we call the

links

communications

POLICIESTHATSUPPORT investment

highway system, is often citedas an

project, too, receivedcrucial government

stages. Many researchstudies

early the

the web

a similar

having

interstate

U.S.

public investment. The interstate system substantially costs in the United States, improving productivity transportation

long-haul throughout the

the

Eisenhower,

successful

of

example

of President

administration

the

in turn

which industries,

requires

private activities.

adequate incentive to conduct researchand development for the government to finance researchfor need, for example,

developing

firms have There is no a better

deodorant.

underarm

particularly basic scientific knowledge,may that cannot be captured by a single private widespread firm. The developers of the silicon computer chip, for example, were instrumental in creating new received industries, huge yet they only a small portion of the profits from their inventions. flowing Because societyin general, rather than the individual inventors, may receive much of the benefit from basic research,government need to may support basic The research, as it does through agencies such as the National ScienceFoundation. in federal also a deal of research, government sponsors great applied particularly and T o the extent that national the allows, military space applications. security can increase of such research with the government growth by sharing the fruits sector. F or the Global which was private example, Positioning System (GPS), for military developed originally purposes, is now available in private passenger But

of knowledge, economic benefits

some

types

have

vehicles,

helping

drivers

THE LEGAL

find their way.

AND POLITICAL FRAMEWORK

economic comes primarily from activities in the private sector, growth the government plays an essential role in providing the framework within which the private sector can operate productively. We have discussed the importance of secureproperty and a well-functioning rights legal system,of an economic environmentthat and of political stability and the free and encourages entrepreneurship, of ideas. Government also should consider the open exchange policymakers potentialeffects of tax and regulatory policies on activities that increase productivity, such as investment, innovation, and risk taking.

Although

THE POORESTCOUNTRIES: SPECIAL A

CASE?

Radical disparities in living standards exist between the richest and poorestcountries of the world. Achieving economic growth in the poorest countries is thus particularly Are the of this section relevant to those countries, or are urgent. policy prescriptions in different of measures to the poorest nations? very types necessary spur growth in To a significant the same factors and policies that extent, promote growth richer countries apply to the poorest countries as well. Increasing human capital by education and training, increasing rates of saving and investment, supporting in public investing capital and infrastructure, supporting researchand development, and

encouraging

growth

in

poor

entrepreneurship countries.

are all

measuresthat

will

enhance

economic

ECONOMIC

GROWTH

521

522

CHAPTER18 ECONOMIC GROWTH

to a

However, countries

to improve

need For

economies.

example,

which

systems,

legal

about

uncertainty

in richer much greater degree than the legal and political environment

that

their

underpins

many developing countries have poorly developedor corrupt discourage entrepreneurship and investment by creating rights.

property

and regulation

Taxation

most poor

countries,

administered by inefficient years to obtain the approvals

in

to the

heavy-handed and take months or

are often

countries

developing

bureaucracies, needed to

extent

that

it may

start a small businessor expanda factory. excessive many poor government regulation or government of markets from operating efficiently to achieve economic ownership companies prevents For rather than the market, growth. example, government regulation, may determine the allocation of bank credit or the prices for agricultural products. Structural policies that aim to ameliorate these problems are important in preconditions for the most generating growth poorest countries. But probably countries,

In

most for some countries\342\200\224is establishing difficult, rule of law. Without domestic and political stability, to invest in the country, and economic growth will

political

important\342\200\224and

the

stabilityand

be

reluctant

impossible to achieve. Can rich countries help poor countries have tried to help by providing financial countries

individual

the World do

that

effective,

THE

system, is of should

countries

rich

undertake

structural

undertake

the legal

the necessary

reforms, such as reducing value.

limited

help poor

reforms to the

richer nations

achieve

of their

from

aid to

excessive

as

such

agencies

financial

To make their

countries

structure

countries

regulation

or

foreign aid most stability

political

and

economies.

GROWTH

OF ECONOMIC

COSTS

that

however,

if not

difficult

loans or grants

made by international

aid) or by loans

(foreign

be

Historically,

develop?

aid through

Bank. Experiencehas shown,

not

improving

to

foreign savers will

emphasized the positive effectsof But should societies always growth person's living strive for the highest rate of economic The answer is no. Even if we possible growth? for the moment the idea that increased is accept output per person always desirable, a rate of economic does costson attaining higher growth impose society. What are the costs of increasing economicgrowth? The most straightforward is the cost of creating new We know that the capital stock we capital. by expanding

In

this

(and earlier, in on the average

chapter

economic

standard.

can increasefuture productivity must divert resources that could consumer

For

goods.

must employ in

example,

more of

its

video games.

designing

15), we

Chapter

and

output.

otherwise

to add

But, to be used

increase the

to increase the

more robot-operatedassembly

we stock, of supply a society lines,

capital

in building industrial robots and fewer To build new factories, more carpentersand lumber must

skilled

technicians

be assigned to factory construction and lessto finishing basements or renovating In in rooms. rates of investment new short, family high capital require peopleto their consume and save more\342\200\224a real economic cost. belts, less, tighten in capital goods at the Should a country undertakea high rate of investment sacrifice of consumer The answer depends on the extent that people are goods? and able to sacrifice to have a economic willing consumption today bigger pie

or is experiencingan economic crisis, and and investment people may prefer consumption relatively high savings is not the time to be putting relatively low.The midst of a thunderstorm something tomorrow.

In

a country

that is very poor,

to keep

aside

for a

rainy

day!

But

in a

society

that

is relatively

well off,

people

may

be

more

sacrificesto achieve economic willing higher growth in the future. sacrificedto formation is not the only cost of achieving Consumption capital In in the United States the nineteenth and higher growth. early twentieth centuries, in of economic were often times which periods rapid growth many people worked to make

extremely long hours at

helpedto build

the

Americans

and,

in some

enjoy today, the

of

were

in

great

that

and development

research

of acquiring training and skill improve technology The fact that a standard tomorrow must be (human capital). higher living purchased at the cost of current sacrifices is an example of the Scarcity Principle, that more of one good thing means having usually having less of another. Because economic real economic costs, we know from achieving higher growth imposes if the benethe Cost-Benefit Principle that higher growth should be pursued only fits

outweigh

costs.

GROWTH?

ARE THERE LIMITS TO chapter, we saw a long period, will

this

in

Earlier

for

sustained

without

even

that

huge economic

low rates of economic growth, if increases in the size of the economy. can continue indefinitely growth

and causing massive damage to

resources

natural

depleting

relatively

produce

question of whether

fact raises the

This

the costs

and

the

the global

environment.

1972

influential

simulations that

were halted,

economic growth may The Limits to Growth,5

that

concern

The An

unless

that

would

world

growth and of natural

out

running

in the

works

later

be done

cannot

that

questions

is not

full

results

the

reported

population

soon be

water, and breathable air.This book, and fundamental

not be sustainable

book,

suggested

the

economic expansion

resources, drinkable same vein, raise some

here.

justice

a new one. of computer

in some

However,

ways its conclusionsare misleading.

One problem

assume

we

implicitly

have

the planet

were

\"limits to

the

thesis

growth\"

who emphasizethe

economic

that

now\342\200\224more

If that

restaurants.

with

growth. Those

economic

smoky

growth

will

more

factories,

its

lies in

always

take

polluting

indeed the case, then surely

can sustain.

of

concept

underlying

on growth

limits

environmental

the form of more cars, more fast-food

there would be limits

the

to

of

what

growth

in real GDP does not necessarily take such a form. Increases in real arise from new or higher-quality For example, not too long products. of wood. ago tennis rackets were relatively simple items made primarily Today they are made of newly invented materials and designed for optimum synthetic performance using simulations. Because these new high-tech sophisticated computer tennis rackets are more valued by consumers than the old woodenones,their introduction increased real GDP. Likewise, the introduction of new pharmaceuticals has contributed to economic growth, as have the number of TV expanded and Internet-based sales. Thus, economic growth need not channels, digital sound, take the form of more and more of the same old stuff; it can mean newer, better, and perhaps cleanerand more efficient goods and services. But

growth

also can

GDP

A

second

the fact that

problem

with

the

\"limits

increased wealth and

measures to safeguard the

to

is

conclusion

growth\"

productivity

expand

society's

overlooks

it

that

capacity

to take

polluted countries in the world are not the richest but those that are in a relatively early stage of industrialization. At this stage countries must devote the bulk of their resources to basic needs\342\200\224food,

shelter,

health

environment.

care\342\200\224and

In fact,

continued

the most

industrial

expansion.

In these

rather than a basic need. countries, clean air and water may be viewed as a luxury In more economically developedcountries, where the most basic needs are more to keep the environment clean. Thus, easilymet, extra resourcesare available economic may lead to less, not more,pollution. continuing growth H. Meadows, Dennis L. Meadows, Randers, and Jorgen Growth (New York: New American Library, 1972).

5Donella

GROWTH?

those workers

costs

the

health and safety.

cases, workers'

include the cost

of growth

costs

Other

is required to

jobs. While

unpleasant

that

economy

reduced leisuretime

terms of

and

dangerous

LIMITS TO

THERE

ARE

William

W. Behrens

III,

The Limits

to

^^ ^\"^J

f f

^

J

Scarcity

Cost-Benefit

523

524

CHAPTER

18

ECONOMIC

GROWTH

A third with the pessimistic view of economicgrowth is that it ignores problem the power of the market and other social mechanisms to deal with the scarcity. During of the were filled with headlines about 1970s, oil-supply disruptions newspapers the energy crisis and the imminent of world oil supplies.Yet 30 years later, depletion the world's known oil reservesare actually than they were in the 1970s.6 greater situation is so much better than was 30 years ago Today's energy expected in prices that because the market went to work. Reducedoil suppliesledto an increase

changed the behavior of

and suppliers. Consumers insulated their cars and appliances,and switched to purchased energy-efficient alternative sources of energy. Suppliers engaged in a massive hunt for new reserves, openingup major new sources in Latin America, China, and the North Sea. In short, market forces helpedsociety to the energy crisis. respond effectively In general,shortages in any resource will trigger price changes that induce and demanders to deal with the current suppliers problem. Simply extrapolating economic trends into the future ignores the power of the market system to recognize and make the corrections. Government actions shortages necessary spurred by political such as the allocation of public funds to preserve pressures, open space or demanders

both

more

homes,

reduce air pollution, can be expectedto supplement market adjustments. the of the \"limits to Despite shortcomings growth\" perspective, most economists would agree that not all the problems created by economic can be dealt with growth the market or the G lobal environmental effectively through political process. as global warming or the ongoing destruction of rain are a problems, such forests, particular for economic and institutions. Environmental challenge existing political is not bought and sold in markets and thus will not automatically reach its quality Equilibrium

O

level

local or

national governments

through

these

environmental problems,

EXAMPLE

18.9

is the

countries

problems

Principle).

that are

global

Nor in

can

scope.

are establishedfor dealing with global continues. may become worse as economicgrowth

so poor

in

Mexico

City?

like Mexico, which are neither fully industrialized environmental problems. Why?

nor

have severe

often

poor,

desperately

problems

air quality

Developing

Equilibrium

in Mexico

Air Pollution Why

effectively

address

mechanisms

international

Unless

processes (recall the

market

optimal

growth is that it will cause ever-increasing that the pollution. Empirical studies show, however, between and real GDP is morelike an inverted U relationship pollution per person In other as countries move from low levels of real words, (see Figure 18.6). very GDP per personto \"middle-income\" most measures of pollution tend to levels, but environmental as real GDP worsen, quality improves per personriseseven further. One study of the relationship betweenair quality and real GDP per person found that the level of real GDP per personat which air is the quality A in worst\342\200\224indicated 18.6\342\200\224is to the by point Figure roughly equal average in Mexico.7 in Mexico income level And indeed, the air quality City is as any visitor to that sprawling metropoliscan attest. exceptionally poor, That as a country industrializes is understandable, but pollution may worsen does environmental when real GDP climbsto why quality improve per person very levels? There are a variety of explanations for this phenomenon. Compared to high middle-incomeeconomies,the richer economies are relatively more concentrated in concern

One

levels

of

about

economic

environmental

in oil prices have

again stoked concerns. Alan B. Krueger, \"Environmental of a North American Free Trade Impacts in Peter Garber, ed., The Mexico-U.S. Free Trade Agreement(Cambridge, MA: MIT Press, Agreement,\" and Krueger, \"Economic Growth and the Environment,\" 1993). SeealsoGrossman Quarterly Journal of Economics, May 1995, pp. 353-78; and World Bank, World Development Report: Development and the Environment, 1992. 6Recent

increases

7Gene M.

Grossman

and

ARE

THERE

LIMITS TO

18.6

FIGURE

The

Relationship

between and

GROWTH?

Air

Pollution

Real GDP

Person. Empirically,

increases

per

air pollution with

real

GDP per

person up to a point and then begins to decline. Maximum

air pollution

(point A) occurs at a level of real GDP per person roughly equal to that of Mexico.

productionas opposedto Rich economies are also the expertise to develop sophisticated and cost-effective The most important reason richer economies tend to be cleaner

antipollution

like

industries

morelikely

have

to

technologies.

is the same

reason that

and software

like finance

services

high-value

\"clean,\" pollution-intensive

homes

the

heavy

manufacturing.

of rich

people are generally

cleaner

and

in better

of the poor. As income rises above the level necessary to resources remain to dedicateto \"luxuries\" like a clean environment For the rich family, the extra resources will pay for (the Scarcity Principle). a cleaning for the rich country, they will service; pay for pollution control devicesin factories and on automobiles. and Indeed, antipollution laws are generally tougher more strictly enforced in rich countries than in middle-income and poor countries.

condition fulfill

basic

homes

the

than

more

needs,

DEVELOPMENTS

GROWTH:

ECONOMIC

RECAP

AND ISSUES

Policiesfor

economic

promoting

include policies

growth

to increase

and (education capital training); policies that promote saving that research and and formation; capital policies support development; the of a legal and political framework within which the private provision in the legal and political sector can operate productively. Deficiencies framework official corruption or poorly defined property (for example, are a for countries. rights) special problem many developing

and

human

Economic growth has substantial costs,notably consumption that is required to free resources

and new technologies.Higherrates of

the

benefits

Some have growth. better,

outweigh

rather

than

sacrifice

of current

new capital creating should be pursued only if

the costs.

that

argued

This view

growth

the

for

finite resources

overlooks the more,

facts

to economic imply ultimate limits can take the form growth

that

goods and services;that

increased

wealth

of

frees

and that political and economic of the many problems associatedwith growth. these mechanisms not work well when environmental or However, may in scope. other problems arising from economicgrowth are global

resources to mechanisms

safeguard the

exist

to address

environment;

a

Scarcity

525

526

18

CHAPTER

GROWTH

ECONOMIC

SUMMARY the

\342\200\242 Over

past

two centuries,

productivity growth has reboundedsince 1995, as a result of advances in information and largely communication technology.(L03)

the industrialized

in living improvements in large increases in real GDP per of compound interest, person. Because of the power in growth rates, if relatively small differences reflected

as

standards,

continuedover

real

in

enormous

saw

nations

can produce long periods, GDP per person and average

Thus, the rate of economic variable

\342\200\242

the encourage

standards.

is long-term economicgrowth of critical importance.(LOl)

and investment,

an

that

infrastructure;

productivity share of the

population real GDP per personcanoccuronly average labor

is working, in the share

populationthat increases

contributed

job

person.

in

But

main

the

periods,

in

productivity,

the

growth

through

share

the

are

significantly to rising real GDP per past four decades, as in most source of the increase in real GDP per that determine

talents, education, or human capital;

workers,

the

as

has costs as well benefits. growth them is the need to sacrifice current among to achieve a rate of investment consumption high

Prominent

of

quality

use; the physical capital that workers of land and other natural resources; the availability applicationof technology to the production and distribution of goods and services; the effectiveness of entrepreneursand and the broad social and legal managers; environment. Because of diminishing returns to a certain capital, beyond point expansion of the capital stock is not the most effective way to increase Economists average labor productivity. generally agree that new are the most important single technologies

\342\200\242 In the experienced

in productivity.

improvements

and 1980s,

1970s a

slowdown

(L03)

the industrial world

in productivity

stability. (L04)

political

\342\200\242 Economic

more

growing

in

new

quickly

of research

costs

the

growth, but

limits to

\342\200\242 Are there

must be

growth

the

and

problems

that

in

output

environmental

resources ignore the

take the

problems

associated

Indeed,

additional resources for

together

of the

fact

of increasing

form

as increasingquantity. can provide

economic

that

Arguments

up the environment. Finally, with political processes,

cleaning system,

growth can

as well

quality

growth?

(LOS)

constrained by

limits of natural

economic

increases

the costs.

outweigh

growth

of the

sourceof

in

often

not

skills of

and

poorly

and development.Thus, more economicgrowth is whether increased economic better; necessarily is desirable on whether the benefits growth depends

labor productivity

quantity

increased

and

private-sector

improved legal and political

capital goods; other costs of include extra work effort and

(LOl)

training, and

need of an

greatest

framework

or both. In the period since 1960, of the U.S. population holding a

the

factors

the

Among

the

a legal

provide

systems, are

and regulatory

tax,

legal,

developed

of the

person was rising average labor productivity. \342\200\242

in in

Growth

is employed.

that

saving

promote

the basic sciences; and that and political framework that supports activities. The poorest countries, with

labor per person is the product of average GDP and the (real per employedworker)

GDP

that

stimulate

in including public investment research and development, support

in

particularly \342\200\242 Real

government can policies that

in which

ways

are by adopting growth creation of human capital;

economic

large differences living

the

Among

with

the

market

can solve many

economic

hand, global environmental which can be handled neither by the individual national governments,have constrain economic growth. (L06)

On

growth.

the other

problems, market the

nor

potential

KET TERMS average

labor

compound

productivity

interest (505)

(506)

returns

diminishing

capital

REVIEW

1.

What

has

happened

century? the average past

to real GDP per personover What implications does this have

entrepreneurs (515)

to

(512)

person? Are the implications different

human

capital

(509)

QUESIIOHS countries

the

for

for

Ghana)?

(LOl)

in different

regions (e.g.,Japan

versus

by to

527

PROBLEMS

labor

productivity

living

is human

What

have

You

know?

Why is it economically human capital created? (L03)

in

and

productivity

7.

shovels

returns

to capital.

enhance

can

What

the

U.S.

labor

can

of increasing

goal

the government average labor

(L04)

productivity?

statement: \"Becausethe natural resources are fragile economic must come to growth

the following

8. Discuss

is

environment

ultimately

finite, an

in

How do we

entrepreneurs and effective average labor productivity.

contributions

major

make to

should don't have

concept of

(b) the

how talented

managers

you assign shovels to workers if you How should enough shovels to go around? you additional shovels that assign any you obtain? Using this example,discuss between (a) the relationship the availability of physical capital and average labor

growth

since 1995?

(L03)

6. Discuss

How

ditchdigging.

of the resurgence

(L03)

of varying a ditch. Workers without

zero productivity

have

cause

the

was

What

productivity

five workers

employed to dig

physicalstrength

5.

average

in

capital} is new

How

important?

4.

in

be the key factor standards? (L02)

to

determining long-run

3.

consider growth

do economists

2. Why

end.\"

and

(L06)

diminishing

(L03) PROBLEMS

Richland's real

GDP perpersonis

real GDP

per person at 1 percent per per person growing at 3 percent per year. Comparereal GDP year and Poorland'sis growing per in the two countries after 10 years and after 20 years. Approximately person how (LOl) many years will it take Poorland to catch up to Richland? Calculate how much higher U.S. labor productivity will be in the year 2030 is

However,

$5,000.

to

(relative

Poorland's

and

$10,000,

real GDP

Richland's

is

if: (LOl)

2010)

continues to grow by 3.1 percent per year. b. Productivity growth falls to 1.4 percentper year, its average rate during the of period 1973-1995. (Note:You do not need to know the actual values a. Productivity

average

labor

The \"graying

productivity

any

to solve this

year

will substantially

America\"

of

in

problem.)

increase the fraction of

that

is retired

in the

Average labor

4. Consider the of employment

table

decades to

suppose

below

that

Share

productivity

data for

containing

to population

in

1979

Using data from Table 18.1, find in 1979 and in 2008. How much

and

of population

employed

Germany and Japan on the

ratio

2008.

average

labor

of the

increase

productivity in output

for each per person

Graw Hill

country in

each

conned:-

|economics

fer McGraw-Hill

Visit

your mobile

store and

download

the Frank:

Study

Econ

the

come.To illustrate the implications for over the 49 years following 2009 the share that is working returns to its 1960 level,while average labor increases by as much as it did during 1960-2009. Under this productivity what would be the net change in real GDP per person between 2009 scenario, and 2058?The following data will be useful: (LOl) population

U.S. living standards, of the population

Mc

app todayl

app

528

CHAPTER 18 ECONOMICGROWTH

increased

5.

relative to

employment

increasedlabor productivity? population? (L02)

period is due to

the 1979-2008

over

country

To

to determine whether to go completed high school and is trying for two or to work. Her college years go directly objective is to in maximize the she will have the bank five from now. If she goes savings years to she will earn for each of the next five years. If work, $20,000 per year directly she goesto junior college, for each of the next two years shewill earn nothing\342\200\224 she will have to borrow $6,000 each year to cover tuition and books. indeed, This loan must be repaid in full three years after graduation.If she graduates from junior college, in each of the subsequent three years, her wageswill be has

Joanne

just

to junior

and taxes, excluding tuition per year. Joanne's total living expenses books, equal $15,000 per year. (L03) for simplicity, that Joanne can borrow and lend at 0 percent Suppose, interest. On economic or work? purely grounds, should she go to junior college b. Does your answer to part a change if she can earn $23,000 per year with $38,000

and

a.

school degree?

a high

only

c. Does your

to

answer

$8,000 per

d.*Supposethat

part

a change if

year?

at which are as

rate

interest

the

Joanne's

cost

books

and

tuition

Joanne can borrow and

lend

is

are deposited at

per year, part the end of the year they are earned and receive (compound)interest at the end of each subsequent year. Similarly, the loans are taken out at the end of in which they are needed, and interest doesnot accrue the until the end year of the subsequent year. Now that the interest rate has risen, should Joanne 10 percent

but

other

data

a. Savings

in

go to collegeor go to work? 6.

Grocery Store has two checkoutlanesand four employees. are equally skilled, and all are able to either operatea register or bag one checker (checkers) groceries (baggers). The store owner assigns and one bagger to each lane.A lane with a checker and a baggercan check out 40 customers a checker per hour. A lane with only can check out 25 Good'n'Fresh

The

Employees

customers

hour.

per

b.

average labor The

productivity adds a

owner are

employees

What are

per

part b for

observe 7. Harrison,

added,

total output

checkedout c. Repeat

(L03)

of customerscheckedout

a. In terms

what are total output and per hour, Good'n'Fresh Grocery Store? third checkout lane and register.Assuming that no what is the best way to reallocatethe workers to tasks? and labor productivity (in terms of customers average for the

hour)

Carla, and

80 square feet per hour. roller. (L03)

a.

fourth

checkout this

and a

lane,

a

Any of the

standard

fifth.

Do

you

example?

Fred are housepainters. Harrisonand

feet per hour using

using a

of a

returns to capital in

diminishing

100 square

now? addition

the

paintbrush,

three can paint

Carla

and Fred

200 square

feet

can

paint

can paint per

hour

and Fred have only paintbrushes at their Harrison, Carla, disposal. in terms is the average labor productivity, of square feet per painterfor the three painters taken as a team? Assume that the three painters hour, always work the same number of hours. b. Repeat part a for the cases in which the team has one, two, three, or four rollers available. Are there diminishing returns to capital? in paint quality increases the area that c. An improvement can be covered per hour (by either brushesor rollers) by 20 percent. How does this technological affect your answers to part b? Are there returns to improvement diminishing Assume

What

*Denotes

more

difficult problem.

ANSWERSTO CONCEPT CHECKS

improvement increaseor reducethe

Does the technological capital? value of an additional roller?

economic

8. Hester'sHatchery

raises fish. At the end of the current season she has 1,000 fish She can harvest number of fish that she wishes,sellingthem hatchery. any to restaurants for $5 apiece. Becausebig fish make little fish, for every fish that she leaves in the hatchery this year, she will have two fish at the end of next The of fish is to be eachnext as well. Hester relies $5 year. price expected year on income from current fish sales to herself. (L03) entirely support a. How many fish should Hester harvest if she wants to maximize the growth of her stockof fish from this season to next season? in the

b. Do

think the growth of her fish stock is an economically you maximizing sound strategy for Hester? or not? Relate to the text discussion Why why on the costs of economicgrowth. if she wants How to maximize her current many fish should Hester harvest

c.

Do

income?

you think

d. Explain why will

instead

the

9. Discuss illustrate

is unlikely

harvest

some and

conditions.

economic

leave the

of her fish,

none

or

but

to reproduce.

rest

concrete using examples where possible For advances in basic science to translate into of living, they must be supported by favorable

arguments: in standards

improvements

strategy? to harvest either all

good

statement,

following

your

is a

this

Hester

L04) evaluating the U.S. economy in

to

(L03,

10. Write a short essay determinants of average

labor

discussed

productivity

of the six

of each

terms in

Are there

text.

the

any

the United Statesis exceptionally strong,relative to other countries? Areas where the United States is less strong than some other countries? Illustrate your arguments with numbers from the Statistical Abstract of the United States (available online at www.census.gov/compendia/statab) and other in which

areas

as appropriate.

sources,

(L03,

18.1

the

-

(HECKS

CONCEPT

TO

States had

United

per person in

can wrap 4,000 candies per week,or 100candies hour. per 500 candiesper hour, and working 40 hours weekly she can week. wrap 20,000candies per Together Lucy and Ethel can wrap 24,000 candies week. Since they work a total of 80 hours between them, their per is 24,000 candies wrapped per 80 hours = 300 output per hour as a team candies wrapped per hour, midway between their hourly productivities as As

Lucy

before,

can wrap

Ethel

individuals.

18.3

ANSWERS

grown at the Japanese rate for the period 1870-2008, = 2008 would have been ($2,445) X (1.025)138 in 2008 Actual GDP per person in the United States was $73,819.70. have been $31,178, so at the higher rate of growth, output per personwould 2.37 times higher. (LOl) If

real GDP

18.2

L04)

(L03)

Ethel can

Because Ethel

the

machine

BecauseLucy Lucy

the

of giving lently,

the

wrap 500 +

300

= 200

additional

hand,

the

benefit

of

giving

candies wrapped per hour.

100 candies per hour by hand, the benefit of giving additional candieswrapped hour. So the benefit per to Lucy is greater than of giving it to Ethel. Equivaand Ethel between them can goes to Ethel, then Lucy

is 400

machine

machine 100

\342\200\224

only

wraps

machine

if the

wrap 300 candiesper hour by

is 500

= 600

candies per hour, but = 800 candies per

team can wrap 300 + 500 letting Lucy use the machine.

(L03)

if Lucy

uses the

hour. So output

machine, the

is increased

by

529

530

CHAPTER18 ECONOMIC GROWTH

18.4

working by hand, Lucy can wrap 300 candiesper hour and Ethel can 500 candies either Lucy or Ethel can wrap wrap per hour. With a machine, 800candiesper hour.As in Concept Check 18.3, the benefit of giving a machine to Lucy exceeds the benefit of giving (500 additional candies per hour) a machine to Ethel (300 additional candiesper hour),so if only one machine is available, Lucy shoulduseit. The table analogous to Table 18.2 now looks like this: Now,

Number of machines

and Productivity Factory

of Capital,

Output, Candy-Wrapping

Relationship

Candies

Total hours worked (N)

wrapped

per week (Y)

(K)

in the

Average

labor

hourly

(YIN)

productivity

32,000

80

400

1

52,000

80

650

2

64,000

80

800

3

64,000

80

800

0

this

Comparing

table with

has increasedlabor productivity

Table 18.2, you for

any

technological advance of K, the number of machines

see that

can

value

available.

per

week,

all (because

there

capital still

18.5 Although average labor

worker

individual

the

States he gains the

better

more advanced a political-legal

guaranteed that not, for example, U.S. economy),

the

by

Bangladesh,

that enhance

and and technologies, sophisticatedentrepreneurs managers, environment that is conducive to high productivity. It is not the

but

of the immigrant's human speaks no English and has

value

if he

United

leads to higher worker

Bangladeshi

States

capital

will

no skillsapplicable

rise (it to

may the

it will.

normally

Since increased productivity to

of factors

relative to his homeland.Theseinclude to work with, more natural resources per person,

capital

economic groundsthe immigrate

benefit

in this country,

productivity

and

improvement. (L03) is the same person he was in

the technological

after

to the United

coming more

hold

machine

second

the

adding

wrapped

output by 20,000 candies wrapped per increases output by 12,000 candies and adding the third machine does not increase output at is no worker available to use it). So diminishing returns to increases

machine

one

Adding

week,

if

he

is able

to do

wages

has a

and

living standards,

strong incentive to

so. (L03)

on

CHAPTER

I

I

|9

Capital

Saving,

and

Formation,

Markets

Financial

LEARNING

After you

OBJECTIVES

reading this chapter, should be able to:

LOI

the

Explain

between relationship

saving

and wealth.

L02

and

Identify

apply

of

the components national

L03

rather

and

does

why

L05

it matter?

probably heard Aesop'sfable You've

ant worked hard laying mocked the ant's efforts and

grasshopper

the sunshine, ignoring the

well-fed, while the put

aside

of

the

summer

ant and the grasshopper. for the winter. The

starved.

something for the future.

contented himself

Moral:

All

food

ant's earnest warnings.When

grasshopper

Of course,there is

up

the

winter

When times

with

came

basking

in

the ant

was

are good,the

wise

the ending to the fable, in which over the sues the ant for anthill, grasshopper leg by tripping negligence, and ends up living on the ant's savings. (Nobody knowswhat comfortably to the ant.) Moral: Saving is risky; live for today. happened The pitfalls of modern life notwithstanding, saving is important, both to individuals and to nations. need to save to for their retirement People provide and for other future needs, such as their children's educationor a new home. An individual's or a family's savings also can provide a crucial buffer in the event of an economic emergency, such as the loss of a job or unexpected medical bills. At the national level, the production of new capital goods\342\200\224factories, breaks

his

also

the

modern

choose

firms

to invest

is saving

save.

people

Discuss the reasons why

What

reasons

Discuss the why

L04

saving.

in

capital

than

in

financial

assets.

Analyze

financial

markets

using

tools of

supply

demand.

the and

CHAPTER19

532

SAVING,

CAPITAL

AND

FORMATION,

MARKETS

FINANCIAL

factor promoting economic growth in see this the resources living chapter, to new come from a nation'scollective necessary produce capital primarily saving. In this of new chapter, we will look at saving and its linksto the formation We the of and wealth and the capital. begin by defining concepts saving exploring connection between them. We then turn to national saving\342\200\224the collective of saving Because national determines the households, businesses, and government. saving to create new capital, it is the most important measure of capacity of an economy and

equipment,

standards.

perspective.

discussthe economicsof

We next by firms. We

consider

first

income. Then,

their

important

we will

a macroeconomic

from

saving

an

As

housing\342\200\224is

and higher

why

in

capital

about whether to increaseemployment. demand

current income minus on current needs

spending

AND

In general,the

saving divided

rate

by

income

on

minus

of assets

liabilities

assets

one

value

anything

of value that

owns

liabilities

the debts

one

owes

economic liabilities

sheet

a list

of

Consuelo

on a

specific date

EXAMPLE 19.1

out that a

respects analogous to its conclude

are related

all

spending

it turns

the chapter

decision

by showing

using a supply and

current earns

Consuelo

such

a household, a business, a income minus its spending on $300 per week, spends $280

unit\342\200\224whether

as its

as rent,

food, clothes,and

entertainment,

is $20 $20 in the bank, her saving per week. The economic unit is its saving divided by its income. Since of her weekly income of $300, her saving rate is $20/$300,

any $20

percent. The saving of an economic unit is closely relatedto its wealth, which is the value of its assets minus its liabilities. Assets are anything of value that one either financial or real. Examples of financial assets that owns, you or your own include a and bonds. cash, account, stocks, family might checking assets include a home or other real estate,jewelry, consumer Examples of real durables like and valuable collectibles. Liabilities, on the other hand, are the cars, debts one owes. Examples of liabilities are credit card balances, student loans,

of an

unit's assets and

by

than

the remaining

deposits

saving rate

and balance

economic defined

expenses

living

or 6.7

the

of an

nation\342\200\224is

saves

wealth

We

formation

capital

if current needs.For example, weekly

saving

is in many

firms;

formation

capital

WEALTH

saving

university, or a

and

and

approach.

SAVING saving

and

saving

saving

people choose to save, rather

we examinecapital formation

firm's decisionto invest how national

household

that

mortgages. By comparing unit's

an economic unit's also called its

wealth,

assets and liabilitieson a particular

assets and liabilities,economistscalculate

net worth. This comparisonis done called a balance sheet. date,

using

a list

of

Constructing a BalanceSheet What

To

answer

this

on January

wealth

is Consuelo's

question,

January 1, 2012, in

Consuelo

a balance

1,2012?

must assemble her assets and result is shown in Table

sheet. The

liabilities

as of

19.1.

financial assets are the cash in her wallet, the balance in her the current value of somesharesof stock. her financial Together in real assets, the sum of the market assets are worth $2,280.Shealso lists $4,000 values of her car and her furniture. Consuelo's total assets, both financial and real, cometo $6,280.Her liabilities are the student loan she owesthe bank and the balance due on her credit card,which total Consuelo's $3,250. wealth, or net is the value of her assets($6,280) minus the value of worth, on January 1, 2012, her liabilities ($3,250), or $3,030. Consuelo's

checkingaccount,

and

SAVING

AND

WEALTH

533

TABLE 19.1

Consuelo's Balance Sheeton January

1,2012

Liabilities

Assets

Cash

Checking

$ 80

Student

1,200

Credit

account

of stock

Shares

500

value)

(market

$6,280

$3,250

Net

CONCEPT CHECK

Saving and wealth this

be if her student balance sheet for her.

net worth

Consuelo's

would

a new

Construct

loan

because saving contributes to wealth. To we must better, distinguish between stocksand flows.

Saving is an example of example,

$3,000?

related

FLOWS

AND

Consuelo's

than

are

relationship

STOCKS

$3,030

worth

19.1 19.1. What

to Example

back

were for $6,500 rather

understand

250

3,500

Total

Refer

$3,000

card balance

1,000

Car (market value) Furniture

loan

saving

a flow,

is $20

a measure

per unit is a contrast,

is defined

that

per week. Wealth,

in

of time. For stock, a measure

wealth of $3,030, for example,is her point in time. Consuelo's 2012. particular date\342\200\224January 1, To visualize the difference between stocksand think of water running flows, into a bathtub. The amount of water in the bathtub at any specific moment\342\200\224for 40 gallons at 7:15 p.m.\342\200\224is a stock because it is measured at a specific example, in 2 time. The rate at which the water flows into the tub\342\200\224for example, point In many cases, a gallons per minute\342\200\224is a flow because it is measured per unit of time. If we know that flow is the rate of change in a stock: there are 40 gallons of water in the tub at 7:15 p.m., for example,and that water is flowing in at 2 gallons per minute, we can easily determine that the stock of water will be changing at the rate of 2 gallons per minute and will equal 42 gallons at 7:16 p.m., 44 gallons at 7:17 p.m., and so on, until the bathtub overflows. at a

is defined

that

wealth

on a

CHECK

CONCEPT Continuing

of the bathtub: example is being drained at addedto the tub), what will be the

7:15 p.m. and

water

19.2

Does the

water

flow

still

equal

the rate

If

of changein

40 gallons

are

there

the rate of 3 the stock and the

gallons flow

of water in

the tub at minute per (and no more at 7:16 p.m.? At 7:17 p.m.?

stock?

(a stock) is similar to the and the stock of water in the relationship tub in that the flow of saving causes the stock of wealth to change at the same rate. dollar that a person saves addsa Indeed, as the following exampleillustrates, every dollar to his or her wealth. The relationship between

between saving (a flow) the flow of water into

and

wealth

a bathtub

flow a measure per

unit

that

is defined

of time

stock a measure at a point in time

that

is defined

534

CHAPTER

EXAMPLE

19

19.2

SAVING, CAPITAL FORMATION,

FINANCIAL

AND

Saving and Wealth

Link between

The

is the

What

$20 per

saves

Consuelo

week. How doesthis saving affect wealth depend on whether

could use the

Consuelo her

assets\342\200\224for

her

down

$20

example,

$3,050 (seeTable

her saving

uses

liabilities?

during the first week in January to the $20 to her checkingaccount\342\200\224or paying down her credit cardbalance.Suppose

saved

she

her liabilities\342\200\224for example, by adds the $20 to her checkingaccount, increasing Since her liabilities are unchanged, her $20.

by

on January 8,

her wealth Consuelo

by adding

reduce she

her wealth?

in her

change

to accumulate assetsor to pay

increase

Consuelo's saving and

between

relationship

2012?Doesthe

MARKETS

her

assets also

wealth

to

on January 8, 2012, by $20, to

increases

19.1).

use the $20 she saved during the first week in January down her credit card balance,shereducesit from $250 to $230. That action would reduceher liabilities by $20, leaving her assets unchanged.Sincewealth assets minus liabilities, reducing her liabilities by $20 increasesher wealth equals to $3,050. Thus, saving $20 per week raises Consuelo's stock of wealth on by $20, she uses her saving to increase her 8, 2012, January by $20, regardless of whether If Consuelo

decides to

to pay

assetsor reduceher liabilities.

close

The important wealth,

rate of saving

today

GAINS AND LOSSES

CAPITAL

the only factor that in the values of

is not

Saving because

between saving and wealth explains why saving is so rates of lead to faster accumulation of Higher saving today a nation is, the higher its standard of living. Thus, a high in the future. contributes to an improved standard of living

relationship

an economy. and the wealthier to

of

changes

for example, that Consuelo's $1,000 to $1,500.This increase

assets by

$500

without

rises by $500, from (see Table 19.2 ).

TABLE

$3,030

determines wealth.Wealth the real or financial assets

can

change

owns.

Suppose,

rise in value during January, from of Consuelo's stockraisesher total her liabilities. As a result, Consuelo's wealth affecting on January 1, 2012, to $3,530 on February 1, 2012 of stock in the value

shares

19.2

Value of

Sheet

Balance

Consuelo's

Her Stocks

on February

1,2012,after an

Cash

Checking

80

$

account

1,200

Shares of stock

1,500

Car (market

3,500

Furniture

value)

(market

value)

Increase

in the

Liabilities

Assets

Total

also

one

Student loan

Credit

card

$3,000 balance

250

500

$6,780

Net

worth

$3,250 $3,530

Changes

gains increasewealth, during

any

capital

losses

CHECK

CONCEPT

How would

of the

each

the saving

done

=

the

during

terms of

an

capital gains

value of existing

Capital gains and lossesare wealth change in a person's period plus capital gains minus

the

assets

capital lossesdecreasesin value of existing

assets

equation,

+ Capital

Saving

increasesin

an asset's

as capital

decrease wealth. however. Instead, the

saving,

wealth

in

when

gains

decreases. Just

value

asset's

an

losses

that period. In

during

Change

her

of

equals

period

losseswhen

capital

not countedas part

assets are calledcapital

of existing

value

the

in

value increases and capital

535

WEALTH

AND

SAVING

gains \342\200\224 Capital

losses.

19.3

or

following actions

affect

events

Consuelo's

saving and

wealth7.

$20

a.

Consuelo

b.

charges$50 on her credit Consuelo uses $300 from

deposits

old car is

Consuelo's

c.

the

in

her

end of the her credit card

at the

bank

card, raising

account

checking

recognized as a

to

pay

Its market

classic.

off

She also

as usual.

week

to $300.

balance

her

card

credit

value rises from

bill.

$3,500

to $4,000.

Consuelo's

d.

is damaged

furniture

and as a result

Capital gains and lossescan have

next exampleillustrates.

The

How did

Bull

Market

a major

falls

effect on

in value

1990s and HouseholdWealth

of the

American households increasetheir wealth

On the whole, Americans wealth

households

increasetheir

felt

very

this period

during

was quite low throughout wealth

in the

to $200.

one's overall wealth, as our

in the

1990s while

little? household

from $500

19.3

EXAMPLE

saving very

during the 1990s: Measures of showed enormousgains.Yet saving by U.S. those How did American households years.

prosperous

1990s while saving

very

little?

FIGURE

19.1

450

The

Market

400 h

the

Bull

of

1990s.

Stockprices rosesharply

\302\251 350

during

the

1990s, greatly the wealth

increasing

that

households

This figure

shows

of

held stocks. the

Standard & Poor's 500 index of stock prices, divided by the CPI to correct for for the

inflation,

period

1960-2004.Stockprices peaked fell

Year

Source: EconomicReport

of the

President, www.gpoaccess.gov/eop.

in 2000,

sharply

a trough

in

and then

until reaching early 2003.

the

536

CHAPTER

19

SAVING, CAPITAL FORMATION,

MARKETS

an increasing

1990s

the

During

FINANCIAL

AND

number

directly through purchases or indirectly

funds. At the same strongly rising\"bull

which

market,\"

rose

at

rates

record

the prices

increased

stocks, either and retirement

acquired

their

through

stock prices

time,

Americans

of

pension (see Figure

19.2). The

of most stocks,enabled

to enjoy significant capital gains and increased wealth without if some economists that the low much, Indeed, saving anything. argued household saving rate of the 1990s is partially explained by the bull market; because wealth capitalgains increasedhousehold by so much, many people sawno need Americans

many

to

save.

market peaked in early 2000 and stock prices fell quite two did not following years. It is interesting that U.S. households in 2000 and in subsequent in more the decline their years, despite stock

The the

over

to

save

One explanation

wealth.

market

wealth\342\200\224the

partly offsetting the effect

of

AND

SAVING

RECAP

in stock

Wealth is the

debts

liabilities\342\200\224the

on

spending

assets\342\200\224anything of value that one owes. Saving is measured

of

value

householdwealth.

WEALTH

saving is currentincomeminus

In general,

stock

in 2000-2006,

significantly

values on

choose

of household

component

larger

homes\342\200\224rose

decline

the

even

an

owned

of privately

value

is that

sharply

needs.

current

one

owns\342\200\224minus

per unit

of

time

(for

per week)and thus is a flow. Wealth is measuredat a point is a stock.In the sameway the flow of water through the faucet increases the stock of water in a bathtub, the flow of saving increases the stock of wealth. Wealth also can be increased by capital gains (increases in the value of existing assets) or reduced by capital losses (decreasesin example, dollars in time and thus

asset

values).

ITS COMPONENTS

AND

SAVING

NATIONAL

far we have examined saving and wealth But macroeconomists are interestedprimarily

individual's perspective. and wealth for the country saving of saving, or the aggregate saving

from

Thus

in

the

as a whole.In this section we will study national National saving includes the saving of business firms and the government as well as that of households. Later in the chapter we will examine the close link in an economy. between national saving and the rate of capital formation the economy.

THE To

OF NATIONAL SAVING

MEASUREMENT

define

the

saving

rate of

introduced

a

as

country

we will start 15. According to this

a whole,

in Chapter

accounting

identity

economy

as a whole, production(orincome)must

symbols,

the

Y stands

C equals

For now, be the case if

for

identity,

the

In

expenditure.

G+

+ I+

NX,

for either productionor aggregateincome(which

consumption expenditure,I

government purchases

equal

a basic

is

identity

Y=C where

total

with

of goods

investment

equals

and services,

and NX equals

let's assume that net exports a country did not trade at

(NX) all

with

spending, net

must

be equal),

G equals

exports.

are equal to zero, which other countries or if its

would

exports

SAVING

NATIONAL

and imports were With net exports

always balanced.(We discuss the set at zero, the conditionthat

sector

foreign

in

ITS

COMPONENTS

537

26.)

Chapter

expenditure

equals

output

AND

becomes

Y= C +

1

+

G.

how much saving is done by the nation as a whole, we can apply of saving. As for any other economic unit, a nation's saving general its current income less its on current needs.The current income of equals spending the country as a whole is its GDP, or Y, that is, the value of the final goods and servicesproducedwithin the country's borders during the year. the part of total expenditure that to the nation's Identifying corresponds on current needs is more difficult than the nation's income. The spending identifying of that is easiest to is investment component aggregate spending classify spending I. To determine

definition

the

We know

of new factories, equipment, acquisition as residential construction\342\200\224is done to expand the capital goods, future or more for the not to future, economy's productive capacity provide housing current needs. So investment is not of on satisfy spending clearly part spending investment

that

and other

current

spending\342\200\224the

as well

needs.

much of consumption spendingby households, and services, G, shouldbe counted as

how

Deciding

of goods

government purchases

needs is less straightforward. on

clothing,

food,

spending

consumption

utilities, entertainment, also includes purchases

and appliances.

furniture,

cars,

Certainly

the current

As

to provide on

consumer

and spending on future consumption spending, most needs

current

with

services are

intendedto provide

spending

consumption

for

on current

spending by

households\342\200\224

and so on\342\200\224isfor current needs. But of long-livedconsumer durablessuch

Consumer durablesare only

year; they may continue So householdspending purchase. spendingon

most

C, and

service, durables

partially

for

fact,

is a

years

as

up during after their

combination of

needs. purchases

government

needs.

current

in

used

However,

and

of goods

like household

of government purchases is devotedto the acquisitionor long-lived capital goods such as roads,bridges, government and hardware. And like consumer durables, these forms of buildings, military will are used the current most public capital only partially up during year; provide useful services far into the future. So, like consumptionspending, government purchases are in fact a mixture of spending on current needs and spending purchases,

a portion

construction

on future

schools,

of

needs.

in official data, the government has begun to distinguish investment public capital from the rest of government purchases.Nevertheless, this is a relatively small portion of the total, and determining precisely how much of spending is for current needs and how much is for future needs is extremely difficult. For in this book we will follow the traditional sake, simplicity's practice of treating all of both

In its

on (C) and government purchases(G) as spending expenditures in mind that because and keep consumption spending government rather than current needs, purchases do in fact include some spending for future will all of C and G as on current needs understate the true treating spending

consumption current

needs.

But

of national saving. treat all consumption spending and government on current needs, then the nation's saving is its income Y current needs, C + G. So we can define national S as saving amount

If we

S =

purchases less

as spending

its spending

on national

saving

entire economy, Y

\342\200\224 \342\200\224

C

G.

(19.1)

less consumption expenditures government purchases of and or Y - C - G services, goods and

Figure 19.2 showsthe U.S. national saving rate (national saving as a percentageof for the 1960 2010. Since 1960 the U.S. national GDP) years through saving rate fell from 21 percentof GDP in 1960 to 11 percent in 2010.

the saving of the equal to GDP

CHAPTER 19

538

FIGURE

SAVING,

CAPITAL

AND

FORMATION,

MARKETS

FINANCIAL

19.2

U.S. National Saving

Rate, 1960-2010.

U.S. national

Since

1960,

saving

has fallen from

21

percent of GDPto II

percent of GDP.

CO CO CD

co CD

CD CD CD

CM CD CD

O

<^-

CO

O

O

O

O

CM

O

CM

O

CM i\342\200\224

CM

CM

o

Year

Bureau of Economic

Source:

AND

PRIVATE

NATIONAL

www.bea.go^.

Analysis,

OF

COMPONENTS

PUBLIC

SAVING

saving better, let's examineits two major components: private Private save saving is the amount householdsand businesses from income. Public is the amount save from private-sector saving governments publicsector income. Although the private sector's total income from the production of and servicesis it must taxes from this income and it collects additional Y, goods pay

To

national

understand

saving and public saving.

of transfer payments and interest to paid bonds. Transfer are government payments to the public for which it receives no current goods or

amounts from the government

transfer

payments

payments

makes to government for which it receives public

the

current goods in

individuals the

no

or services

return

payments

the

servicesin

who

institutions

government return. For

makes

the

in

form

hold

Social Security benefits, welfare payments, farm to workers are transfer support payments, pensions government payments. transfers and government interest payments from total taxes yields Subtracting the net amount paid by the private sector to the government\342\200\224the amount it pays to the government minus the amount it receives from the government. We call this amount net taxes, which we label T: instance,

and

T= saving the saving of the private sector of the economy is equal to the after-tax income of the private sector minus

and

private

spent

Total

taxes

\342\200\224

Transfer

payments

\342\200\224

interest

Government

payments.

Private saving is the amount of the private sector's after-tax income that on current consumption expenditures. Private S rivate is therefore saving

to total minus

private income from

consumption,

the

production

of goods

and servicesminus

net

is not

equal taxes

or

consumption expenditures (Y

\342\200\224 \342\200\224

T

C); private

saving broken down

can be further into household saving business

saving

and

T-

private

Private saving can be further business

firms.

Household

saving,

broken

down

also called

C.

into saving

personal saving,

done

by

households

is saving

and

done by families

and individuals. Household saving to the familiar image of families corresponds in aside of their incomes each and it is the focus of much attention month, putting part the news media. But businesses are important savers as well\342\200\224indeed business saving makes up the bulk of private saving in the United States. Businesses use the revenues from their sales to pay workers' salariesand other costs, to pay taxes, and operating to provide dividends to their shareholders. The funds after these payments remaining A business have been made are equal to businesssaving. firm's savings are available

SAVING

NATIONAL

purchase of new capital

for the

a business

Alternatively,

or the

equipment

can put its savings in is the amount of the

the

bank

expansion of its for future use.

add public

and private

Sprivate + Spublic

confirms that equation saving. Since private saving

business saving, we

groups:

households,

see that

19.1

Equation

C) + national can

national

we can derive the in another way:

(T- G)

saving be broken saving

businesses, and the

S is the

C- G = sum of private

S

the saving of

sector is

purchases (T

government

equal

minus \342\200\224

G)

(19.2)

saving

and

and three

government. BUDGET

that households and businessescan save is familiar to most the government also can save is less widely understood. Public decisions about spending and taxing. saving is closely linkedto the government's Governments finance the bulk of their spending by taxing the private sector. If taxes and spendingin a given year are equal, the government is saidto have a balanced the collects in taxes is budget. If in any given year the amount that government than the amount it the difference is called the greater spends, government budget When a government has a surplus, it uses the extra funds to pay down its surplus. people, the

saving

the government to net tax payments

idea

the

Although

public

expression for

down in turn into household is made up of the saving of

GOVERNMENT

ANDTHE

SAVING

PUBLIC

in

(Y-T-

This

public

together,

saving

saving that appears

national

539

COMPONENTS

T

public

If we

ITS

operations.

Public saving public sector's income that is not spent on current needs.The publicsectorincludes state and local governments as well as the federal Public sector income is net taxes T. Government government. merely current needs is equal to government G (remember that, for the spendingon purchases sake of simplicity, we are ignoring the investment portion of government purchases). S as Thus, we calculate public saving blic

total

AND

that

fact

budget

government

surplus

outstanding

the excess of government tax collections over government

written

spending

debt to the public. Algebraically, the governmentbudget surplus may be as T \342\200\224 or net tax collections minus G, government purchases. If the algebraic expression for the T \342\200\224 G, looks government budget surplus, that is because it is also the definition of familiar, Thus, public saving. public saving

is identical

to

the

government

budget

surplus.

In other

(T

government equals

public

\342\200\224

G);the

budget surplus saving

words, when the

in taxes than it spends, public saving will be positive. In the in the federal had the largest budgetsurplus year 2000, example, government The illustrates the history. following example relationships among public saving, in that year. the government budget surplus,and national saving more

government collects

for

Government

Howdo we Following billions

calculate

saving?

government

are data on

U.S.government

revenues

and

expenditures

of dollars.

Federal government: 2,057.1

Receipts

1,871.9

Expenditures

State and local

Source:Bureau

governments:

Receipts

1,322.6

Expenditures

1,281.3

of Economic

Saving

Analysis, www.bea.gov.

for 2000,

in

EXAMPLE 19.4

540

CHAPTER

SAVING, CAPITAL FORMATION,

19

Government government:

surplus of $185.2

of the budget surplusesof local. In 2000, the federal government

and

billion,and

therefore $226.5 billion.So national

over

tax

collections

the

deficit spending

(G

-

T)

levels

all

ran

of a budget

ran a collective budget entire sector was government the government sector to U.S.

local governments

surplus of

the

of

contribution

billion.

in taxes, it collects hand, the government spends more than In this circumstance, we speakabout the government negative. exceeds taxes and is calcudeficit, which is the amount by which budget spending lated by G \342\200\224 T.1 If the government runs a deficit, it must make up the difference by from the public by issuing new government bonds. borrowing in the year the had a budget surplus of $226.5 billion Although government ran deficits. By 2010, the budget deficit was 2000, it subsequently budget \342\200\224 billion. The box below provides detailsfor 2010. all amounts $1,300.6 (Again, public

saving

are

billions

in

other

the

on

If,

government budget excess of government

the

was $226.5

in 2000

saving

and

state

The budget

billion.

$41.3

of

MARKETS

consists

saving state,

federal,

surplus

FINANCIAL

AND

be

will

of dollars.)

Federal government: Receipts

2,385.2

Expenditures

3,718.7

State and local

Source:Bureau

governments:

Receipts

2,128.1

Expenditures

2,095.2

of Economic

Analysis, www.bea.gov.

federal government ran a record budget deficit of $1,333.5 local governments typically keep balanced budgetsor earn budget and in 2010 they ran a collective surpluses, budget surplus of $32.9 billion.Thus, the deficit for all levels of government was $1,300.6 billion. This means budget in 2010 was \342\200\224$1,300.6 billion. that government saving In 2010, the and

State

billion.

three main

were

There government

First,

budget.

reasons

in the

turnaround

dramatic

this

for

fell because

receipts

government

of

the

recessions

in 2001

and in 2007 to 2009. During a recessionincomesfall. Since taxes are many based on income, during a recessiontax receipts also fall or rise more slowly in tax rates enacted than expected. The secondreason was the reduction President Bush and Congress during the president's first term. by Finally, government rose between 2000 and 2010, in large expenditures dramatically and part as a result of the wars in Iraq and Afghanistan expenditures by the in response to the terrorist attack on Department of Homeland Security September

11,2001.

Figure the

behavior

19.2 showed the U.S. national since 1960 of the three

saving, business Note

GDP.

that

years, while the Figure

19.2,

aNote

that

since 1960.

rate

of

national

Figure 19.3 shows saving:

household

each measured as a percentage of saving, and government saving, business saving played a major role in national saving during these role of household saving was relatively modest.As we saw in

household

a budget

saving

components

saving

has

until

deficit of $100billion

recently

is the

been

same as a budget

declining.

surplus

of -$100

billion.

Business

J

O^tOO

CDCDCD O O

I CM 1^

I CO

1^

I

I

O

^-

0)0000

0

O

saving

CO

L GO CO

CO

O O

CM CD

II COf*

<*

i-

o

oCM

oCM

oCM

L CM

O

O

CM

Year

19.3

FIGURE

The Three Components of National 1960-2010. Saving, Of the three components of national saving, business saving is the most important. Household been declining. Government saving has generally saving has until recently negative, except in the 1960s and for a brief period in the late 1990s.

Source: Bureau

of Economic

The contribution about

Analysis, www.bea.gov.

of

state, and

a positive surplus, making public saving had turned the federal level. For the national

National saving,

the

\342\200\224 \342\200\224

C

G,

saving

Y is

where

GDP, C

or

r

Private Y

the

late

ITSCOMPONENTS

is consumption spending,and

T

saving,

the

saving

equals the

saving

of the government, is defined by

government budgetsurplus,T

budget is in surplus,government the government budget is in deficit, public government

DO people

PEOPLE save part

Economists have meet

the

is

the saving of the private is defined sector, by S rivate T is net tax payments.Private can be C, where saving further into household and business saving saving.

down

Public

do

is

G

and services.National saving = S . , + S ... . saving: o S private public

=

saving,

Public

Why

S =

by

\342\200\224 \342\200\224

broken

WHY

1990s.

nation as a whole,is defined

of the

government purchases of goods sum of public saving and private

the

by

large budget deficits, particularly at the government was a net drain on

decades,

brief period in

saving. But

a combined late 1970s,

ran

typically

to national

NATIONAL SAVINGAND

RECAP

Y

two

over time. Until

varied considerably

reflecting

negative,

next

has

local governments

contribution

for a

except

saving

saving

public

the federal,

1970,

been

long-term

identified

saving

saving

S

= T

\342\200\224

G.

ublic G. When

\342\200\224

is positive; is negative.

the

when

SAVE?

of their income instead of three

broad

reasons

objectives such as a comfortable

spending

everything

for saving. First, retirement.

they earn?

people

By putting

save

to

away part

542

CHAPTER

life-cycle

saving

long-term

objectives

SAVING, CAPITAL FORMATION,

19

saving to meet such as

retirement, college attendance, the purchase

precautionary for protection setbacks such job

or a

saving

saving

unexpected

against

as the

of a

loss

medical emergency

bequest saving for the

or

of a home

done

saving

purpose of leaving

an

inheritance

FINANCIAL

AND

MARKETS

of their income during their working years, they can live better after retirement than they would if they had to rely solely on SocialSecurity and their company Other include tuition for one's pensions. long-term objectives might college children and the purchase of a new home or car. Economists call this type of saving since of these needs occur at life-cyclesaving many fairly predictable stages in a life. person's A second reason to save is to protect oneselfand family against unexpected setbacks\342\200\224the loss of a job, for example, or a costly health Personal problem. financial advisors typically suggest that families maintain an emergency reserve (a to three to six months' worth of income. fund\") \"rainy-day equal Saving for protection is called against potential emergencies precautionary saving. A third reason to save is to accumulate

an estate to

or

|

*

|

other

to one's heirs, usually but possibly a favorite charity cause. Saving for the pur-

leave

children

one's

d

worthy

pose

of leaving

called

bequest

or bequest,is

an inheritance,

saving

Bequest

saving.

is

done primarily by people at the higherend of the income ladder. But because these peo-

^ 8

|

pie control

8

wealth,

8

of

a

2

their

categories;rather,

|

most

motivate

the nation's

important part

sure, people usually

separate

tally

is an

saving.

To be

| S

saving

bequest

overall

of

share

large

all

savers

do

not

men-

into these three saving three reasons for saving to varying

degrees. Our

next exampleshows how the three reasons for saving can explain householdsaving be-

S I

havior in Japan.

|

fl***d?juijuq ;tFortunately,

you

have times

EXAMPLE 19.5

the life savings your age\"

of a

three

man

Household Savingin Why

Japan

saving rates

did Japanese

rise until

and

1990

decline since

then

then?

World War II Japanese households increasedtheir rates to 15-25 percent saving of their income, an unusually high rate. Although cultural factors often were cited as a reasonfor the high Japanese propensity to save, saving rates in Japan were much lower before World War II. Moreover, household saving rates in Japan have declined since 1990(although remain they higher than those in the United States). Why did the save so much until about 1990, and why have Japanese Japanese saving rates declined somewhatsincethen? After

Among

the most expectancies,

the

reasons

and

many

finance, Japanese families When

the

for saving

important determinants

working-age

the overall saving

rate

we discussed,life-cycle

of

saving

retire relatively must

in Japan.

save

was population was high. As the

early. With a great

a

high

a

are

reasons

deal during their

percentage

probably

The Japanese have long life of retirement to long period of the

working years.

total population,

reachedthe baby boom generation

age

of

WHY DO

and the

retirement

Japanese fertility

rate

declined,

so too

PEOPLE

SAVE?

has the Japanesesaving

declined.2

rate

help to explainthe

factors also

Other

requirements

payment

Before 1990,land

and

are

houses

on

prices

housing

in

high

saving rates. Down to other countries.

in Japanese

changes

compared

Japan

were extremely high, so that

in Japan

young

dealor borrow their parents' to buy their first savings homes. After the Japanese real estate market crashedat the beginning of the 1990s, however, land and housing pricesfell, so young people do not need to save as

save a great

had to

people

as before.

much

Studies also have people live with their

older bequest saving is important in Japan. Many after retirement. In return for support and attention later years, parents feel they must substantial inheritances for provide

their

during

that

found

children

their children.

than in some other countries, Japan troubles have reducedthe practice of Although Japan's firms still make extensive use of the which employment, Japanese system, a job for life to workerswho a firm after graduating guarantees join

lower economic

is probably

saving

Precautionary

recent

however.

lifetime essentially

from college.This type unemployment

of

reduces

rate,

in

job security, coupled with Japan's the need for precautionary saving.

low

traditionally

most for at least one of the Although people are usually motivated to save three reasonswe have discussed, the amount they choose to save on may depend the economic environment. One economic variable that is quite significant in is the real interest rate. saving decisions

SAVING AND THE REAL

RATE

INTEREST

Most people don't save by putting cash in a mattress. Instead, they make financial investments that they hope will provide a good return on their saving. For example, a checking account may pay interest on the account balance. More sophisticated in a financial investments such as government bonds or shares of stock in the form of interest we discuss in the next chapter, also pay returns corporation,which

returns are desirable,of

or capital gains. High dividends, the higher the return, the faster one's savings The rate of return that is most relevant payments,

rate, denotedr. Recallfrom Chapter which the real purchasing power of

16

will to

that

a financial

because

course,

grow.

decisions is the real interest the real interest rate is the rate at asset increases over time. The real saving

interestrate equals the market, or nominal,interestrate (/\")

minus

the

inflation

rate (n).

The real interest

rate is relevant to savers because it is the \"reward\" for are of this year. If saving. Suppose you thinking increasing your saving by $1,000 in a year your extra saving will give the real interestrate is 5 then you extra dollars. But if the real purchasing power of $1,050, measuredin today's interest rate were sacrifice of $1,000 this year would be your

percent,

rewarded by

10 percent,

$1,100

in

equal,

would

to

rather than

But the

Statistics

is

the

extra

saving\342\200\224giving

up

your

in terms of benefit of the extra saving, if the real interest rate is 10 higher percent

5 percent.

2Maiko Koga, \"The and

same.

save

the cost of

weekly night increased purchasing powernext year, out\342\200\224isthe

next year. Obviously,all elsebeing today if you knew the rewardnext year

power

purchasing

be more willing you be greater. In either case would

Decline

Department,

of the Saving Rate and the DemographicEffects,\" November 2004.

Bank

of Japan

Research

^~%.

f

^\"^

j

Cost-Benefit

543

544

SAVING, CAPITAL FORMATION,

19

CHAPTER

19.6

EXAMPLE

versus

Saving By

The percent

MARKETS

Consumption does

much

how

FINANCIAL

AND

a

and the Thrifts are similar income each year and the save in 1980 and plan to continue

Spends

their

of

to

began

in the

breadwinners retire

year 2015.

a family's future

enhance

rate

saving

high

Spends save 5 The two families their respective

that the except save 20 percent.

families, Thrifts to

Both families

standard?

living

save

earn

until

a year

$40,000

real

in

terms

in the

in a mutual fund labor market, and both put their savings that has yielded a real return of 8 percentper year, a return they expect to continue into the future. amount that the two families consumein each year from 1980 to 2015, Compare the

and comparethe In the

first

$38,000

1981, the return

8 percent

Thrifts'

only $32,000 in income was $40,640,

an income

grow by only $160 (8 percent of their savings of $40,640, the Thrifts consumed $32,512 to $38,152 (95 percent of $40,160) compared between the two families, which started gap

$40,640) consumption

in

$8,000 that

year,

the extra

savings. The Spendssaw

on their $8,000

of $2,000) in in 1981 (80

income

their

$40,000

saved

consumed

hence

and

their

of $40,000).TheThrifts

(95 percent

1980 (20 percent of $40,000) $6,000 less than the Spends. In

$640 representingthe

saved $2,000 (5 percent of

the Spends

1980,

year,

consumed

and

income)

at retirement.

wealth

families'

for out

1981.

With

percent

of

the Spends. The at $6,000, thus fell to

$5,640 after one year.

Becauseof

more wealth and hence interest rapid increase in the Thrifts' the Thrifts' income grew faster than the Spends'; each year the Thrifts continuedto save 20 percent of their higher incomes compared to only 5 percent for the Spends. Figure 19.4 shows the paths followed by the consumption spending of the two families. You can see that the Thrifts' consumption, though at a lower starting income,

each

the

year

more level, grows relatively quickly. By 1995 the Thrifts had overtaken the Spends, from that point onward, the amount by which the Thrifts outspent the Spends the Spends continued to consume 95 grew with each passing year. Even though percent of their income each year, their income grew so slowly that, by 2000, they were consumingnearly $3,000 a year less than the Thrifts ($41,158 a year versus$43,957). And the Thrifts will be consuming more by the time the two families retire, in 2015,

and

19.4

FIGURE

Trajectories

Consumption

of the

and

Thrifts

C

the

Spends.

The figure each

year

spending by

two

in

families,

the Thrifts and the Spends. Because the Thrifts save more than the Spends, their annual consumption spending rises more

relatively

time of retirement

quickly. By the in the year

2015, the Thrifts are both more consuming significantly Spends and a retirement nest is five times as much.

each year

also have egg that

than

Thrifts'

consumption

path

consumption

path

g^ 50,000

shows

consumption

~~

60,000

the

w>

|c 40,000 8-

Spends'

\342\226\240\"\342\204\242\"^

30,000

c Q *s

20,000

E

=

c

0

y

10,000

oC

0 c aou

i

I

I

I

I

I

1983

1986

1989

1992

1995

I

I

I

I

I

I

1998

2001

2004

2007

2010

2013

Year

than

per year

$12,000

striking is the

more than

Whereas the Spends will

These dramatic funds

mutual

rate

1980

since

debt

card

U.S.

typical

at

rates

high

of Example19.6,which rate and

interest high

rate

in Example

but

still

households, of interest remains

is 8

return

of

perspective.On the other hand, the more than

than

illustrated

differences

that the real

assumption

to

more

versus $43,698). Even more ($55,774 retirement nest eggs of the two families. with total accumulated savings of just over five times as much. $385,000,

Spends

the

retirement

enter

will have

the Thrifts

$77,000,

the

between

difference

percent\342\200\224lower

a relatively Spend

19.6 depend in than

the

on

part

actual

the

return

high rate of return from a historical in our example actually saves family

many of which carry $5,000 or more in credit and have no significant at all. The point savings valid under alternative assumptions about the real

saving rates, is that, because pays off handsomely in

of saving

of the the

long

power of

compound interest, a

run.

for saving, which tends higher real interest rate increasesthe reward to strengthen people'swillingness to save, another force counteracts that extra incentive. Recall that a major reason for saving is to attain specific goals: a If comfortable a or a first home. the goal is a specific retirement, college education, for a down on a home\342\200\224then a higher rate of $25,000 amount\342\200\224say, payment return means that households can save less and still reach their goal because funds that are put aside will more at $25,000 grow quickly. For example, to accumulate the end of five years, at a 5 percent interest rate a person would have to save about $4,309 per year. At a 10 percent interest rate, reaching the $25,000 goal would that people are require saving only about $3,723 per year. To the extent savers who save to reach a interest rates actually target specific goal, higher decrease the amount need to save. they In sum, a higher real interest rate has both positive and negative effects on effect because it increases the reward for and a saving\342\200\224a positive saving negative effect because it reduces the amount people need to save each year to reach a given target. Empirical evidence suggeststhat, in practice, higher real interest rates lead

While a

to modest

increases

SAVING, The

reasons

rational decision

in saving.

SELF-CONTROL, for saving makers

we

just

AND DEMONSTRATION EFFECTS are based

discussed

who will choose

their

saving

on the notion that to maximize

rates

people their

are welfare

over

economists, have argued instead that many psychologists, behavior is based as much on as on economic factors. people's saving psychological For example,psychologists stress that many people lack the self-controlto do what know is in their own best interest. Peoplesmoke or eat greasy food, despite the they known health risks. have long-term Similarly, they may good intentions about saving but lack the self-control to put aside as much as they to each month. ought One way to strengthen self-control is to remove temptations from the A person who is trying immediate environment. to quit smoking will make a point of not in the and a with a weight will avoid house, having cigarettes person problem to a a who is not going bakery. Similarly, person saving enough might arrange to use a payroll savings which a amount is deducted from plan, through predetermined in each and set aside a account from which withdrawals are not paycheck special until retirement. automatic and withdrawals difficult permitted Making saving eliminates the temptation to spend all of current or squander accumulated earnings have to increase the amount that savings. Payroll savings plans helped many people save for retirement or other they purposes. An of the self-control hypothesis is that consumer credit implication arrangements that make and easier reduce the amount that borrowing spending may the long run.

Yet

and some

546

CHAPTER

19

SAVING, CAPITAL FORMATION,

the

against

FINANCIAL

For example, in their equity

save.

people

AND

MARKETS

recent

in

outstanding

mortgage. Such financial

spend,may

have

spending by demonstrationeffects some

yardstick

by

a family

house has

3,000 square feet

houseas

being

friends in

the

of

small\342\200\224too

uncomfortably

to which

manner

a similar family

In contrast,

very same house

temptation.

in a

for

cramped,

low-income

consumemore than

to entertain

example,

accustomed.

become

neighborhood

they

consumption spending. When satisfaction dependsin in which household relative living an upward spiral may result standards, and than would be best for either the individual lower, higher, saving

EXAMPLE19.7

the

or

involved

Household U.S.

U.S. household

is the

households

decreased

to around 3 percenttoday. to

saving

United

States

saving rate

so low?

their saving

rates from

reason for possible the elderly. From a

One assistance

is to

lesscomprehensive

provide

\"social

U.S. government

of

life-cycle perspective,an important In general,

safety

net\" than

relatively fewer programs to

it offers

10 percent

roughly

low saving is the availability

retirement.

for

the

part

on

spending is families

whole.

the

in

Saving

Why

as a

economy

find

might

do

own

their

increase

average

for saving is that families who live be motivated to may strongly

effects

demonstration

of

among others who

the

which

might regard a 1,500-square-foot

luxuriously large.

The implication

suburb in

community members have

living

of

may occur when additional additional spending by others. Such use the spending of others as a of their own standards. For living

space

living

to

also

rate

saving

arise when people to measure the adequacy in an upper-middle-class American

which

example,

is another

stimulates

consumers

of the

the temptation

saving rate. The increasedavailability

limits

borrowing

high

by increasing

innovations,

Downward pressure on the

borrow

is, the

that

the household

reduced

with

cards

credit

banks have encouraged people to value of the home less the value

years

homes,

the U.S.

around

government motivation

need.

for

government provides a

other industrialized countries;that

assistpeoplein

1980

To the

is,

extent that the

income support, however, it is heavily of the and segment population.Togetherthe SocialSecurity Medicare both of which are to assist retired programs, designedprimarily people, constitute a major share of the federal government's These expenditures. have been very successful; indeed, they have virtually out poverty programs wiped will the To the extent that Americans believe that the among elderly. government in retirement, ensure them an adequate living standard however, their incentive to save for the future is reduced. Another important life-cycleobjective is buying a home. We have seenthat the must save a dealto a homebecause of house Japanese great purchase high prices and down payment requirements. The same is true in many other countries. But in the United financial States, with its highly developed system, people can buy homes with down payments of 20 percentor lessof the purchase price. What about precautionary saving} UnlikeJapan and Europe, which had to rebuild after World War II, the United States has not known sustainedeconomic since the Great of the 1930s (which fewer and fewer hardship Depression Americans are alive to remember).Perhaps the nation's has led prosperous past Americans to be more confident about the future and hence less inclined to save for economic than other people, even though the United States does not emergencies concentrated

offer the

on

the

level

does

provide

older

of employment

security found

in

Japan

or in

Europe.

AND

INVESTMENT

U.S. household saving

only low by of the stock

is not

declining.The good performance

international

market

in

the

it standards, 1990s along

CAPITAL FORMATION

has been with

the prices of family homes probably help to explainthis decline. savings as Americans enjoy capital gains, they see their wealth increase almost without and their incentive to save is reduced. effort, factors also may explain Americans' saving behavior.For Psychological in unlike most U.S. homeowners can easily borrow against their countries, example, in

increases

As long

home

This

equity.

spend.

made

ability,

demonstration

Finally,

17 discussed

Chapter

improved

relative

the

on

spending

effects

position

and

cars,

houses,

now

may

the

To

they need Volvos that demonstration their saving rate.

feel

extent reduce

they

have

temptation recent

to

decades.

which has

inequality,

to

with medium-priced cars with up community standards. to spend beyond their means,

content

once

were

that

and BMWs

keep

effects lead families

WHY DO PEOPLE

RECAP

wage

in

financial

educatedworkers.Increased other consumption goodsby households at the top led those just below them to spend more as well, skilled and

of more

families

Middle-class

on.

so

the

increasing

increasing

U.S.

developed

highly

may have depressed saving

the phenomenonof

of the earnings scalemay and

by the

possible

may exacerbate self-controlproblemsby

markets,

SAVE?

include saving to meet long-term objectives such as saving for emergencies (precautionary saving), and to leave an inheritance or bequest(bequest The amount saving saving). that people save also depends on macroeconomic factors such as the real A higher real interest rate stimulates interest rate. the saving by increasing reward for saving, but it also can depress saving it easier for savers by making to reach a specificsavings On net, a higher real interest rate appearsto target. for saving

Motivations retirement

saving),

(life-cycle

leadto modest

increases

control problems,then deductions)that make People's

saving

be

to spend

not be ableto afford

AND

INVESTMENT

difficult to may

rates.

saving

arrangements

it more

compelled

they may

affect

may

financial

decisions also

when peoplefeel though

in saving.

factors also

Psychological

(such

spend will increasetheir by demonstration

influenced

at the same to

If people have selfas automatic payroll

rate as their

saving.

effects, as

neighbors,

even

do so.

CAPITAL

FORMATION

of view of the economy as a whole,the importance of national it provides the funds needed for investment. Investment\342\200\224the creation of new capital goods and housing\342\200\224is critical to increasing labor average productivity and improving standards of living. What factors determine whether and how much firms choose to invest? Firms new for the same reason hire new workers: acquire capital goods they They expect that doing so will be profitable. We saw in Chapter 17 that the profitability of an extra worker on two factors: the cost of employing depends primarily employing the worker and the value of the worker's marginal product. In the same way, firms' From

the

point

saving is that

willingness using that

them they

to acquire new factories and machines and the expected benefit, equal to

will

provide.

depends the

value

on the expected cost of marginal product

of the

a

Cost-Benefit

547

CHAPTER

548

EXAMPLE

19

19.8

SAVING,CAPITALFORMATION,

in a

Investing Should

is

Larry

MARKETS

into the lawn care a loan at 6 percent annual

going

out

taking

I

mower?

lawn

riding

of

thinking by

FINANCIAL

Capital Good: Part

buy a

Larry

mower

AND

business. He can buy

a $4,000

this mower

With

interest.

riding

and his

$6,000 per summer, after deductionof costs such as Of the $6,000 net revenues, 20 percentmust be paid to the government in taxes. Assume that Larry could earn $4,400 after taxes by working in an alternative job. Assume also that the lawn mower can always be resold for its

own labor, Larry gasoline

can

net

maintenance.

and

original purchase priceof

To decidewhether

Should

$4,000.

buy the lawn mower?

Larry

capital good (the lawn mower), Larry should With the mower he can earn revenue of maintenance costs. 20 percent of that, or However, $1,200,must be paid in taxes, leaving Larry with $4,800. Larry could earn $4,400 after taxes by working at an alternative benefit to Larry of job, so the financial the mower is the difference between $4,800 and or $400; $400 is $4,400, buying the value of the marginal of the lawn mower. product Since the mower does not lose value over time and since gasoline and maintenance costs have already been deducted, the only remaining cost Larry should take into account is the interest on the loan for the mower. Larry must 6 percent pay interest on $4,000, or $240 per year. Since this financial cost is less than the financial benefit of $400, the value of the mower's marginal product, Larry should buy the

in the

invest

to

compare the financial benefits net of gasoline and $6,000,

costs.

and

mower.

Larry's decision might change if the costs change, as Example 19.9 shows.

and benefits

of his investment

in

the

mower

EXAMPLE

19.9

in a

Investing do

How

changes

Good: Part 2

Capital

costs and

benefitsaffect same assumptions as in Example

in the

Begin with all the of these (considered changes

a.

If

the

interest

rate is

12 percent rather

c. If the

d.

If

the

price of the tax rate on Larry'snet mower

revenues will

is less be

$5,500

In each case,Larry

than

rather

revenues

is 25

compare

than

each

$4,000.

20 percent.

percent rather than

efficient than Larry originally rather than $6,000.

must

consider how

6 percent.

is $7,000

mower

then

19.8,

affect Larry's decision.

one-by-one)

b. If the purchase

decision?

Larry's

the financial

so

thought

costs and benefits

that

of

his net

buying

the

mower.

a. If the interest rate $4,000,

or

$480,

is 12 percent,then

which exceeds the

($400). Larry shouldnot buy

the

the

interest

value of

the

cost will be mower's

12 percent

marginal

of

product

mower.

cost of the moweris $7,000,then Larry must borrow $7,000 instead of $4,000. At 6 percent his interest cost will be $420\342\200\224too high interest, to justify the purchase since the value of the mower's marginal product is $400.

b. If the

AND

INVESTMENT

549

CAPITAL FORMATION

c. If the tax rate on net revenues is 25 percent,then Larry must pay 25 percent in taxes. After of his $6,000net revenues, or $1,500, his revenues taxes, from mowing will be $4,500, which is only $100 more than he could make the $100 will not cover the Furthermore, working at an alternative job. that would have to should not $240 in interest Larry pay. So again, Larry the mower. buy

d. If

than

so that

expected

originally

Larry can earn net

$5,500, Larry will be left with only $4,400 after taxes\342\200\224the could earn by working at another job. So in this case, the the mower's rate greater marginal product is zero. At any interest should not buy the mower. Larry

of only amount he

same

value of than

efficient

is less

mower

the

revenues

zero,

CONCEPT

19.4

CHECK

Repeat Example reducesthe resale

assume that, over the courseof of the lawn mower from $4,000 to

but

19.9,

value

the

year,

wear

$3,800. Should

and tear Larry

buy

the mower?

Examples 19.8 and

19.9 illustrate

firms must consider when On the cost side, two important deciding capital goods. factors are the price of capital goods and the real interest rate. Clearly, the more new the more reluctant firms will be to invest in them. are, expensive capital goods the mower was for when its was $4,000, but not Buying profitable Larry price to invest

whether

when its pricewas

in

the

main

factors

new

$7,000.

in investment decisions? The an factor Why important most straightforward case is when a firm has to borrow (as Larry to purchase did) its new capital. The real interest rate then determines the real cost to the firm of back its debt. Since costs are a of the total cost of paying financing major part and a of much as are a owning operating piece capital, mortgage payments major part of the cost of owning a home, increasesin the real interest rate make the purchase of capital all else being equal. goods less attractive to firms, Even if a firm does not need to borrow to buy new capital\342\200\224say, because it has accumulated enough profits to buy the capital real interest rate outright\342\200\224the If a firm does remains an important determinant of the desirability of an investment. not use its profits to acquire new capital, most likely it will use those profits to assets such as bonds, which will earn the firm the real rate of acquire financial If the firm uses its profits to buy interest. rather than to purchase a bond, it capital the to earn the real rate of interest on its funds. Thus, the real forgoes opportunity rate of interest measures the opportunity cost of a capital investment. Since an in the real interest rate raises the in increase cost of new opportunity investing capiif they do not literally need to the willingness of firms to invest, even tal, it lowers borrow to finance new machines or equipment. is the

On the benefit

real interest rate

key factor in of the new product

side,

the

determining

business

investment

is the

marginal capital, which shouldbe calculatednet of both and maintenance operating expenses and taxes paid on the revenues the The value of the capital generates. marginal product is affected by several factors. For a advance that allows a pieceof capital to example, technological produce more and services would increase the value of its goods marginal product, as would lower taxeson the revenues produced by the new capital. An increase in the price of the good or servicethat the is used to produce will also capital increasethe value of the marginal product and, hence,the desirability of the if investment. For the for services were to rise, example, going price lawn-mowing in the mower then all else beingequal,investing would become more profitable

value of the

for

Larry.

f*\\

^J

Increasing Opportunity

Cost

550

CHAPTER 19

SAVING,

aif

CAPITAL

The

Economic

Why

has

2.5

MARKETS

FINANCIAL

19.1

Naturalist

1980,investment

in new

19.5). Purchases of percent of GDP and amount

has investment

systems

computer

in

recent

by

U.S.

new computers and software to about 24 percent of all

Figure

investment.Why

increased so much

in computers

investment

Since about (see

AND

FORMATION,

in

has risen

firms

sharply

now exceed

by firms

nonresidential

private

so much?

increased

computers

decades?

~20

& 18

1 16

Investment

in

software

^^

S\302\243 14

12

it

\302\260-=-,/x *-\342\200\24210

0 *

\342\200\236

8

Q'Z

in

Investment

Shariden

4

8

computer

2

o

c

equipment

ou

O

CD CD CD

CO CD CD

CD CD

I

I CD CD CD

C\\J

h-

CD

I

1

1

LO

00 1^

i-

h-

CD

00

CD

CD

1

1

1

1

r^ o -*\342\226\240 00 00 CD CD CD CD

00

CD CD

1

1

1

CD CD CD

CD CD CD

C\\J

1

1

1

LO

00

o

O O

O O

o

o

C\\J

o

C\\J

Year

19.5

FIGURE

Investment

in

nonresidential

private

since

significantly

1960-2010. Software, and software since I960 shown equipment investment. Computer-related investments and

Computers

in computer

Investment

and

the

the

tax rate)

factors

are not

www.bea.gov.

Analysis,

in computers

Investment

percentage of have risen

by U.S. firms

1980.

Source: Bureau of Economic

investment. Hence,

as a

has increased

that affect likely

to

all

types

by

types of as the real interest rate (such for the boom. The two main causes of

much

more

than other

of investment

be responsible

increased investment in computers to be the declining of computing appear price power in the value of the marginal In recent the increase of product computers. years, the has fallen at a precipitous rate. An industry rule of thumb is price of computing power

and

of computing power that is obtainable at a given price doubles every in computers As the price of computing an investment becomes falls, power more and more likely to pass the cost-benefit test. On the benefit for some years after the beginning of the computer side, boom, economists were unable to associate the technology with significant productivity gains. in computer in goods Defenders of investment systems argued that the improvements

that

amount

the

18 months.

Cost-Benefit

O

create are particularly hard to measure. How does one to consumers of 24-hour-a-dayaccessto cash or of the ability to make airline reservations online? Critics responded that the expected benefits of the because of problems such as user-unfriendly computer revolution may have proved illusory and

services

quantifythe

software noticeablyin

computers

value

and recent

poor technical years (as we

However,

training.

saw

in

the

previous

U.S. productivity

chapter),

and

has increased many

people

are

now

in computers and computer-related crediting the improvement to investment like the Internet. As more firms become convinced that computers do add technologies in to and the boom investment can be expected significantly productivity profits, computer

to

continue.

SAVING,

INVESTMENT

RECAP the

Any

of

new

capital:

following

1. A decline

2. 3.

A

in

in the

decline

real interest

taxes on the

4.

Lower

5.

A higher

increase

of new

price

willingness

the

of firms

to invest

in

rate. raises the

marginal product of

revenues generatedby

INVESTMENT,

FINANCIAL

the

capital goods.

that

relative price for

551

MARKETS

FINANCIAL

AND CAPITAL FORMATION will

improvement

Technological

SAVING,

the

factors

INVESTMENT, AND

firm's

capital.

capital.

output.

AND

MARKETS

like that of the United States, savings are allocatedby means market-oriented financial system.The U.S.financial system consists both of financial markets such as bond institutions, like banks, and financial markets and stockmarkets.Here,we examine the basic workings of financial markets without to the assets or stocks) that are being traded. (bonds regard particular In particular, we focus on the role that the real interest rate plays in allocating resources from savers to borrowers. In the next chapter, we will examine financial institutions and financial markets in more institutional detail and relate this discussionto the role of money in a market economy. in a of saving and the demand for investment Figure 19.6 shows the supply financial market. Quantities of national and investment are measured on the saving horizontal axis. As we will axis; the real interest rate is shown on the vertical see, in the market for saving, the real interest rate functions as the \"price.\" In the figure the of is shown by the upward-slopingcurve supply saving marked S. This curve shows the quantity of national saving that households, firms, and the government are willing to supply at each value of the real interest rate. In

a market

of a

economy

decentralized,

19.6

FIGURE

The Saving

of and

Supply

Demand for Saving.

S

is supplied

Saving

by

households, firms, and the and

government by borrowers

invest

The

in

Investment

/

wishing

new

interest for saving

capital goods.

with the real rate,

and

the demand

by investors (/) decreases with the real

interest rate.

In

financial

equilibrium, the real rate takes the value that equates the quantity of and saving supplied market

S,l Saving and investment

to

of saving (S)

supply

increases

demanded

interest

demanded.

552

CHAPTER

19

SAVING, CAPITAL FORMATION,

FINANCIAL

AND

MARKETS

is upward-sloping because empirical evidencesuggeststhat real interest rate stimulate The demand for saving is given saving. the curve marked I. This curve shows the of by downward-sloping quantity investment in new that firms would choose and hence the amount capital they would need to borrowin financial at each value of the real interest rate. Because markets, and reduce firms' willingness higher real interest ratesraise the cost of borrowing

The

curve

saving

increases

in the

to invest,

the

for saving curve is downward-sloping. in of borrowing from foreigners (which we discuss Putting possibility a can invest those resources that its savers make Chapter 26), country only available. In equilibrium, and desired then, desired investment (the demand for saving) national saving (the supply of saving) must be equal. As Figure 19.6 suggests, demand

aside

the

is equated with desired investment through adjustments in the real of saving. The movements of the real rate, which functions as the \"price\" in much the same way that the price of interest rate clear the market for saving clears the market for apples. In Figure the real interest rate that clears 19.6, apples the market for saving is r, the real interest rate that corresponds to the intersection desired

saving

interest

Equilibrium

O

of the supply and demand curves. The forces that push the real interest rate toward its equilibrium level are in any other similar to the forces that lead to equilibrium market, as we first saw in 3. Suppose, for example,that the real interest rate exceeded r. At a higher Chapter real interest rate, savers would provide more funds than firms would want to invest. As lenders themselvesto attract borrowers (savers) competed among the real interest rate would be bid down.The real interest rate would fall (investors), until it equaled lenders are r, the only interest rate at which both borrowersand in the financial market. The and no opportunities are left unexploited satisfied, in others that we have thus holds in this market as it does Equilibrium Principle

studiedthrough Changes

demand for

book.

this

other

in factors saving

will

the

than

shift the

real

interest

rate

that

affect

curves, leading to a new equilibrium

the

supply in

of or

the

real interest rate cannot shift the supply or demand the supply or demand for price of apples cannot shift because the effects of the real interest rate on are apples, saving already incorporatedin the will illustrate the use of slopes of the curves. The following examples the and demand model of financial markets. supply financial market.

Changes

in the

curves, just as a change in

EXAMPLE

19.10

of New

Effects

The

the

Technology

Howdoesthe introduction

real

of

new

affect saving,

technologies

investment, and the

rate?

interest

new technologies have been introducedin recent Exciting years, ranging from the A number Internet to new applicationsof genetics. of these technologies appearto have commercial How does the introduction of new technologies great potential. affect saving, investment, and the real interest rate?

potential for commercial who can application profit opportunities bring the fruits of the In to the economists' the technical raises technology public. language, breakthrough the marginal product of new capital. 19.7 shows the effects of a Figure The introduction creates

of any

new

technology

with the

for those

with a resulting increase in the marginal of capital. At product in real interest an increase the of rate, any given marginal product capital makes firms more to invest. the advent of the new causes the Thus, eager technology demand for saving to shift upward and to the right, from I to V. At the new equilibrium and national point F, investment saving are higher than as is the real interest which rises from r to r'. The risein the real interest before, rate,

technological breakthrough,

AND FINANCIAL MARKETS

INVESTMENT,

SAVING,

FIGURE 19.7

The Effects

of a

New

Technology on National Saving and Investment. (%)

A

w./

rate

and interest

Real

rate reflects the

investi

and

the

demand

for saving.

The real interest rate rises, as do national saving and investment.

/

Saving

breakthrough

technological

raises the marginal product of new capital goods, increasing desired investment

nent

increased demand for

funds

by investors

as

they

race

to apply

the

new technologies. Becauseof the incentive of higher real returns, saving increases in the as well. Indeed, the real interest rate in the United States was relatively high late 1990s (Figure 16.3), as was the rate of investment, reflecting the opportunities

createdby

new

technologies.

how a change in

let's examine

Next,

markets.

in the

Increase

An

an

does

How

and the

increase

real interest

Supposethe government

Government in the

rate?

increasing its budget deficit affect

national

Budget

supply

of saving

reducing

its

saving, investment, and

affects the financial

EXAMPLE 19.11

Deficit

government budget deficit affect

increases (or

the

without spending its budget surplus). the real interest rate?

saving,

investment,

raising taxes, thereby

How will

this

decision

saving includes both private saving (saving by households and which is to the public saving, equivalent government budget surplus. An increase in the government reduces budget deficit (or a declinein the surplus) in that does not the reduction public saving. Assuming private saving change, public saving will reduce national saving as well. 19.8 shows the effect of the increased government deficit on the Figure budget market for saving and investment. At any real interest rate, a larger deficit reduces national to the left, from S to S'. At the saving, causing the saving curve to shift new equilibrium the real interest rate is at r' and both national F, point higher investment are lower. In economic terms, the government has dipped saving and further into the pool of private savings to borrow the funds to finance its budget deficit. The government's extra forces investors to for a smaller borrowing compete of available the real interest rate. The real quantity saving, driving up higher interest rate makes investment less attractive, assuring the investment will decrease with national along saving. National

businesses)

and

553

554

CHAPTER

SAVING, CAPITAL FORMATION,

19

MARKETS

19.8

FIGURE

of an Increase

The Effects in

FINANCIAL

AND

Government

the

Deficit on National Saving and Budget

Investment. An

in the

increase

government the

reduces

deficit

budget

of saving,

supply

rate raising the real interest and lowering investment.

The tendency

of increased

government deficits to

reduce

in new

investment

capital is called

crowding

out

the tendency

increasedgovernment reduce investment

deficits spending

of to

crowding

The tendency of government budget deficits to reduce investment spending is called crowding out. Reducedinvestment lower capital formaspending implies lower economic as we saw in the previous tion, and thus growth, chapter. This adverse effect of budget deficits on economicgrowth is a key reason that economists advise to minimize their deficits. Note that this governments analysis keeps in Chapters 22 and 24, an the level of national income constant. As we will discuss in government increase spending may increase the level of GDP; thus, an increase in government spending might lead to only a small decreasein national saving.

CHECK

CONCEPT

Suppose

the

19.5 more

becomes

public

general

affect

the

rate of

country's

and

\"grasshopper-like\"

becoming less concernedabout

saving decisions, in public attitudes

EXAMPLE 19.12

out.

for the

saving capital

formation

less \"ant-like\"

future. How

the

will

and economic

in

their

change

growth?

Increasing National Saving Are

there

Most

policies that

government

policymakers

higher

national

reducing

budget

recognize

would increasenational saving?

that the United

saving rates. The government

Stateswould eventually

benefit

from

increase

public saving by to accomplish in the coming deficits years. Earlier, we pointed out that budget grew primarily because of the in the early 2000s, the increased tax-rate reductions defense needed to spending in in wars and and the reductions tax revenue and increases fight Iraq Afghanistan, in government All associated with the current recession. of these factors spending will have to be addressedin order to decrease future budget deficits,yet each has a or need of each one. Thus, the political climate is powerful constituency in favor in the near future. not conducive to reducing budget deficits the incentives for households and firms to save would Alternatively, increasing increase private saving. Someeconomists,for example, believe that the federal income tax should be scrapped in favor of a federal consumption tax. A consumption tax would be similar to the sales tax collectedin most wherein states, people

are taxed

deficits.

only

but not the

when

portion

However,

they that

spend.

is saved

this

will

could

be

difficult

Taxing the portion of income that is increase the incentive to save.

would

consumed

555

SUMMARY

favor

economists

Other

national

At the

economic

as president.

term

to saving and thereby more

by

of wealth and have studiedsomeof

the the

The next chapter will look at how the financial system allocatesthe

current income minus saving rate is the percentageof

general, saving equals current needs; the

is saved.

that

income

market value

or

(debts).

Saving

liabilities

minus

Wealth, or net

of assets(real

worth,

financial

equals

items of

is a flow,

of

pool

projects. \342\226\240

SUMMARY

on spending

new

in

or family level, a achievement of factors that underlie more closely at how

individual

the

At

\342\226\240

\342\200\242 In

the

than

greater investment

lead to

most productive investment

to the

saving

and

wealth

first

rise.

decisions.

investment

savers hold their available

rates

saving

chapter, we

In this

security.

saving and

also will

higher standards of living. the accumulation promotes

rate

saving

high

level, high

saving rises

If private

thus

and

capital goods

after-tax

revenues, national saving

in tax

immediate loss

W. Bush's George rate of return

during

on dividends and

tax rates

in the

reductions

further

capital gains beyondthose passed These tax cuts would increasethe promoteadditional private saving.

the

value)

being

The

amount

Evidence

that

suggests

modest increasesin affected

per unit of time; wealth is a stock, at a point in time. Just as the amount of in a bathtub water changes according to the rate at which water flows in, the stock of wealth increases at if the value of the saving rate. Wealth also increases

by

in dollars

self-control

measured

in dollars

one's neighbors

rises

assets

existing

(capital

decreases if

the

assets falls (capitallosses).(LOl)

of existing

value

gains) and

capital goods

costs. Two

saving National saving

represents total goods

into

or T

private

G equals

services.

National

Y

C equals

government purchases of saving can be broken up

\342\200\224 T \342\200\224 C, and public saving, or Y saving, T stands for taxes paid to the where transfer and interest paid by the payments to the private sector.Private can be saving

\342\200\224

G,

government less

government

further broken business

output

income,

and

consumption spending,

and

or

S.

In the

saving.

is done

saving \342\200\242 Public

down into

household

United States, the

businesses.

by

saving bulk

and of

private

(LOl)

is equivalent to the government budget the government runs a budget

saving

G; if surplus,T \342\200\224 deficit,

then

public rate is

saving

countries,but household

saving is negative. The U.S.national low relative to other industrialized it is higher and more stable than U.S.

saving.

(LOl)

including

reasons, for

retirement

prepared the

and

for desire

an to

households life-cycle or a new

emergency leave an

save for objectives,

home; the

a variety such as

of

saving

need to be

(precautionary saving); and inheritance (bequest saving).

purchase or housing.

can be such as the degree of

construction of Firms

in new

of doing so outweigh determine the cost of

that

of

new

invest

will

benefits

the

if

factors

the

are

interest

marginal product

relative \342\200\242 In the the

of the

price

capital,

productivity

which of new

depends on capital goods,

revenues they generate, and the firm's output. (L04)

the

of international borrowing or demand for national saving

absence

lending,

of and

supply

be equal.

new

of

factors such as the the taxes levied on

The supply

of national

the saving decisions of and the fiscal policies of

households

saving

and

must

depends

on

businesses

the (which government The demand for public saving). saving is the amount business firms want to invest in new capital. The real interest which is the \"price\" of rate, borrowed to funds, changes equate the supply of and determine

demand

national

for

supply

of

or

demand

Factors that affect the saving. for saving will change saving,

real interest rate. For equilibrium in the example, government budget deficit will reduce national saving and investment and raise the equilibrium real interest rate. The tendency of government deficits to reduce investment is budget and

investment,

\342\200\242 Individuals

rates lead to

also

Saving

the price of new capital goods and the real rate. The higher the real interest the more rate, firms are expensive it is to borrow, and the less likely to invest. The benefit of investment is the value of the investment

entire country is national saving \342\200\224 is defined by S = Y \342\200\224 C G, where

of an

\342\200\242 The

real

the

by

saving.

real interest

saving.

factors

including

goods,

for

desire to consume at the level (demonstration effects). (L03)

is the

\342\200\242 Investment

affected

\"reward\"

higher

psychological and the

measured

capital

also is

save

people

rate, which is the

interest

an

the

increase

called crowdingout.(L05)

SAVING,CAPITALFORMATION,

19

CHAPTER

556

FINANCIAL

AND

TERMS

KET

assets (532)

government budget deficit

balance sheet(532)

surplus (539)

capital losses(535) out

crowding

flow

national

(554)

saving (537)

precautionary saving

REVIEW

1. Explain the relationshipbetween

of flows and stocks. the means saving only by which wealth can Explain.

understate the

true

the

(LOl)

economy?

3. Household

saving rates in

very low. Is this economy?

Why

does

Why

5.

to

definition

your

the

a problem

fact

or why

Why

States

United

(538)

payments

(532)

for saving. Illustrate other factors would

motivations What example.

basic

three

an

do

are

saving.

for the U.S.

investment,

for

interest rates reducethe are the (Hint: Who

increases

in real

of saving

demanded?

of saving?)

\"demanders\"

6. Name

important

(L03)

quantity

saving

the

(532)

psychologistscite as beingpossibly

of national saving potentially amount of saving being done in

definition

U.S.

Give

saving?

national saving, relating the general concept of saving. standard

transfer

each with

Is

(LOl)

2. Define

rate

wealth

(542)

4.

and

saving

(532)

saving

QUESTIONS

using the concepts

wealth,

saving

stock (533)

(542)

saving

life-cycle

(533)

increase?

public saving (539)

liabilities (532)

gains (535)

(538)

saving

private

(540)

budget

government

(542)

saving

bequest

capital

MARKETS

(L03)

that could increase the supply of and one that could increase the demand for Show the effects of each on saving, and the real interest rate. (L05) one

factor

not? (LOl)

PROBLEMS 1. a.

connect

&\342\226\240

|ECONOMICS

I

affects Corey'sassets,liabilities, and wealth. and finds out that his baseball goes to a baseballcard convention card is a worthlessforgery. c. Corey uses $150 from his paycheck to pay off his credit card balance. The remainder of his earnings is spent. d. Corey writesa $150checkon his checking account to pay off his credit b. Corey

/^Study

McGraw-Hill

Visit your mobile app store and download

the

in bike worth $200 $300, a credit card debt of $150, Corey has a mountain in a checking cash, a Harmon Killebrew baseballcard worth $400, $1,200 account, and an electric bill due for $250. Construct Corey'sbalancesheet and calculate his net worth. For each remaining how the event part, explain

Frank:

Econ

app

card balance.

Of

todayl

on Corey'spart?

the

previous three parts, which,

in the

events

Study

whether each of the following a. The gross domesticproduct.

2. State

b.

National

c. The

if any,

corresponds

to saving

a flow,

and

(LOl)

(LOl)

saving.

value of the

is a

stock or

U.S. housing stockon January

in circulation d. The amount of U.S.currency e. The government deficit. budget f. The quantity of outstanding government

explain.

1, 2012.

as of

debt on

this

morning.

January 1, 2012.

3.

In

each

follows, use the

that

part

private saving, publicsaving,

a. Householdsaving Government

200

transfers

Consumptionexpenditures

=

payments = 100

Government

purchases

Government

transfers

motivations for

month?

saving.

(L03)

learns she is

a. Ellie

reads

c. Vince

had hoped that

the

= 500

payments

the

Explain your

with

following

degrees

college

events

answersin terms

to affect the

of

and

the

jobs.

amount

basic

pregnant.

b. Vince

in

of

= 1,000

Net exports = 0

married couple, both

expect each

each

save

they

interest

and

are a

Vince

How would you

Investment

4,000 1,000

=

Tax collections= 1,500 and

= 400

4,500

=

expenditures

Consumption

4. Ellie

payments

budget surplus = 100

Government

saving,

(L02)

= 100

and services

interest

and

transfers

national

find

to

national saving rate. Business saving = 400 the

= Tax collections=150 GDP 2,200 = GDP Tax collections= 1,200 6,000 Government

c.

economic data given

of goods and interest

purchases

Government

b.

=

and

about

paper his

parents

possible layoffs in his industry. would lend financial assistancetoward

the

of a house, but he learns that they can't afford it. couple's planned purchase in the next few years. d. Ellie announces that she would like to go to law school e. A boom in the stock market greatly increasesthe value of the couple's funds.

retirement

and Ellie

f. Vince local

5.

agree that

in their

charities

they

like to

would

leave a substantial amount

to

wills.

retirement accounts (IRAs) were established by the U.S. government to encourage saving.An individual who deposits part of current earnings in an IRA does not have to pay income taxeson the earnings nor are any deposited, income taxes charged on the interest earned by the funds in the IRA. However, when the funds are withdrawn from the IRA, the full amount withdrawn is treated as income and is taxed at the individual's current income tax rate. In in a non-IRA account has to pay income contrast, an individual depositing taxes on the funds deposited and on interest earnedin each year but does not have to pay taxeson withdrawals from the account. Another feature of IRAs that is different from a standard savings account is that funds deposited in an IRA cannot be withdrawn prior to retirement, of a except upon payment Individual

substantial

(L03)

penalty.

a. Greg, who is five years from retirement, receives a $10,000 bonus at work. He is trying to decide whether to save this extra income in an IRA or in a account. Both accounts earn 5 regular savings percent nominal interest, in in and is the 30 tax bracket his Greg percent every year (including in retirement year). Compare the amounts that will have five Greg years

under each of deal for

b.

Would

two

saving

strategies,

net of all taxes.Is the IRA

a good

Greg?

the availability of IRAs to increasethe expect save? Discuss in light of (1) the response of saving

you

households

that

amount

to

in

changes

interest rate and (2) psychological theoriesof saving. and Vince are trying to decide whether to purchase a new home.The

the real 6. Ellie

the

housethey

taxes, and maintained,

the

want

house's

is 6

at $200,000. 4

percent

real value is

Annual

expenses

such

home's value. If

of the

as maintenance, properly

not expected to change.Thereal interest

percent,and Ellie and of the purchase price(for simplicity,

the economy

amount

is priced

insuranceequal

Vince

can

assume

qualify

to

no down

borrow

in

rate

the full

payment) at

that

558

CHAPTER

19

SAVING,CAPITALFORMATION,

FINANCIAL

AND

the fact States. (L04)

rate.

that

Ignore

United

MARKETS

interest

mortgage

are tax-deductible

payments

in

the

a. Ellie and Vince would be willing to pay $1,500 monthly rent to live in a house of the same quality as the one they are thinking about purchasing. Should they buy the house? b. Does the answer to part a change if they are willing to pay $2,000 monthly rent?

rate is 4

interest

real

the

percent instead

6 percent?

of

answer to part a change if

d. Does the

house

the

Vince

e.

to part a change if

the answer

c. Does

do

Why

theater

movie

Number of screens

a. Make

the

2

75,000

3

105,000

4

130,000

5

150,000

distributors and meeting

a table first

noninterest

other

all

expenses,

expects to net $2.00 per ticket sold.Construction per screen.

$1,000,000

of patrons

40,000

the movie

paying

the owner

(L04)

the value

showing

fifth. What

the

through

of marginal

How many screens b. 5.5 percent?

be built

will

if

the

screen from of

behavior

rate is:

interest

real

the

by

are

costs

each

for

product

property is illustrated

products?

marginal

many

of patrons the screens available.

Total number

1

After

to decide how

is trying

complex

her estimates of the number of year, depending on the number

each

attract

will

complex

Ellie and

rates?

interest

high

Below are

wants.

she

screens

to sell

offers

developer

dislike

companies

home-building

builder of a new

7. The

the

for $150,000?

c. 7.5

percent?

d.

10 percent?

e. If the

real interestrate is 5.5 percent, how

have to

before

fall

the

builder

would

complex?

8.

For

each

the

resulting

following scenarios, use supply and in the real interest rate, national changes

of the

Show all your diagrams.

a. The legislature program,

for

receives

an

b. A

costs

build a five-screen

demand analysis to predict saving,

and

investment.

(L05)

passes

in military

spending moves the

it

government's budget from

surplus.

new generation of computer-controlled These machines producemanufactured

c. A

fewer

construction

would

a 10 percent investment tax credit.Under this firm that a on new $100 every spends capital equipment, extra $10 in tax refunds from the government.

reduction

deficit into

far

be willing to

machines goods

much

becomes available. more quickly and with

defects.

government raises its tax on are made, such that the government's

d. The

e. Concernsabout f. New environmental

job

security regulations

corporateprofits.

Other tax changes also remains unchanged. raise precautionary saving. increase firms' costs of operating capital.

deficit

ANSWERS

19.1

If

student

Consuelo's

would be

$6,750

ANSWERS

loan student

(the

were for $6,500 instead of $3,000, her liabilities loan the credit card balance) instead of plus

In this case, Consuelo's assets, $6,280,is unchanged. wealth is negative,sinceassetsof $6,280 less liabilities of $6,750 equals \342\200\224$470. wealth or net worth means one owesmorethan one owns. (LOl) Negative

being drained from

19.2 If water is gallons

at

value

The

$3,250.

per

7:17

minute.

p.m. The

as the

is the same 19.3

a. Consuelo liability

of her

-

(HECKS

CONCEPT

TO

the

gallons

flow.

in

the

stock

tub

is

\342\200\2243 gallons

per

which

minute,

(LOl) her

$20, but

usual

net saving for the

So her

(hercheckingaccount)

card balance) have

the

is negative, equal to \342\200\2243 at 7:16 p.m. and 34 gallons

the flow

tub,

rate of change of

has set aside

$50.

of

are 37

There

have increased

week

she has also incurred a new is minus $30. Since her assets

by $20 but her wealth $50,

increased by

her

(her credit

liabilities

also has declinedby

$30.

(LOl)

b. In paying off her credit card bill, Consuelo reduces her assets down her account and reducesher liabilities drawing checking

by

by

$300

the

by

same is no

her credit card balanceto zero.Thus, there in is also no her (note that change change saving Consuelo's income and spending on current needs have not changed). c. The increase in the value of Consuelo's car raises her assetsby $500. So in her wealth also rises by $500. the value of assets are Changes existing not treated as part of saving, so her saving is unchanged. however, d. The declinein the value of Consuelo's furniture is a capital loss of $300. Her assets and wealth fall by $300. Her saving is unchanged. 19.4 The loss of value of $200 over the year is another financial cost of owning in making his decision. His the mower, which Larry shouldtake into account amount

by reducing

in

total

cost

her

is now

There

wealth.

$240

in

interest

costs

plus $200

in

anticipated

loss

of value

of the mower (known as depreciation), or $440.This exceeds the value of marginal product, $400,and so now Larry should not buy the mower. (L04) A decline in household 19.5 Household saving is part of national saving. saving, and hence national saving, at any given real interest rate shifts the saving to the left. The results are as in Figure 19.8. The real interest rate supply curve risesand the equilibrium values of national saving and investment fall. Lower investment is the same as a lower rate of capital which would be formation,

expected to sloweconomic growth.

(LOS)

TO

CONCEPT

CHECKS

559

CHAPTER|20

I

and

Prices,

Money,

Financial

the

System v

J

L

LEARNING 2B

7S.0

\342\200\242 |'\302\2435

I ^'llll

\\

f\\

After reading this

>

you \342\226\240*\" i'H-; in**\"

:

-:, |j

'\"\"'?'

\"\342\226\240 \342\226\240 i \342\226\240 11 1. fe lPt|

l':ffij{'

Describethe such as

J!.

^

,1\"^ \342\226\240\342\226\240

I I

commercial

L02

L 3

V financial

work

system

in a modern

stocks

why their

cial system

economy?

the

the

come

on, my honey, Let's lend it, spendit, send it rolling along!' \"We're in the Money,\" lyrics by Al Dubin, music by Harry Warren (from the film Gold

fy^fl

in

the

hen

money,

people

use

the word

\"money,\"

they

and

Diggers of 1933)

often

mean

uses.

three

of money the

money

supply is measured.

L05 something

how

n-

of saving

L04 Discussthe functions

fin

improves

allocation

to productive

'We're

prices

rates.

how

Explain

and

related

inversely

to interest

1

en

betw

Differentiate

show

does the

financial

system.

V.i''

are

How

of

role

in the

banks

bonds and

<

to:

financial intermediaries

i LI1

chapter,

be able

should

LOI

7,,,,.

OBJECTIVES

different

than what economists mean when they use the word. For an economist, when you get a paycheck,you are receiving income, and any amount that about someone who has done well in the stock you do not spend is saving. Or think market: Most people would say that \"made they money\" in the market. No, an economist would don't make for a catchy answer, their wealth increased. Theseterms song, but a good economic naturalist must use wordslike income, saving, wealth, and money carefully becauseeach plays a different role in the financial system. We stated in the previous chapter that the U.S. financial system consists of financial like banks, and financial markets such as bond markets institutions, and stock markets. We then developed a supply and demand modelof financial markets that showed how the real interest rate acts to allocate resourcesfrom In this chapter, we build on this foundation savers to borrowers. and examine

how

Analyze

the lending

behavior of commercial

LA^ ^^^^^

banks

affects

the money

supply.

L06

Explain

how

a central

bank controls the money

and how

supply

control of the

money

to long run.

supply

is related

inflation

in the

562

20

CHAPTER

MONEY,

THE FINANCIAL SYSTEM

AND

PRICES,

some important institutional details of the financial system. institutions such as banks, bond markets, and stockmarkets

First, we study

how

allocate

actually

uses. Second, we examine what economists mean by the term and discuss how economists measure its and how it's createdby \"money\" supply the behavior of banks. we how central like the Third, banks, lending analyze in Federal Reserve the United can affect the of States, System supply money and determine the long-run rate of inflation in a market the end of this economy. By not be able to write a classic but understand the chapter, you may song, you'll in between common and and bonds, stocks, relationship \"money\" parlance money, to

saving

productive

other financial

assets.

SYSTEM AND THE ALLOCATION

THE FINANCIAL

OF

USES

PRODUCTIVE

TO

SAVING

We have emphasizedthe

of high rates of saving and capital formation importance and increased growth productivity. High rates of saving and investment by themselves are not sufficient, however. A successful not only economy saves but also uses its saving wisely by applying these limited funds to the investment projects that seem likely to be the most productive. The financial system of a country like the United States improves the in two distinct ways. First, the financial allocation of saving system provides information to savers about which of the many funds are likely to prove possible uses of their most productive and hence the return. the potential pay highest By evaluating of alternative the financial investments, productivity capital system helpsto direct to its best uses. financial markets savers to share the risks of Second, saving help individual investment projects. Sharing of risks protects individual savers from to direct saving to bearing excessiverisk,while at the same time making it possible such as the of new which are but projects, development technologies, risky as well. potentially very productive In this section, we discussthree key components of the financial system: the In doing so, we elaborate the bond and the stock market. market, banking system, in on the role of the financial as a whole information about system providing investment projects and in helping savers to share the risks of lending. for

economic

THE The

that extend using

funds

credit

raised

to

borrowers

from savers

most

the

are

Banks

Other

firms

that

and use

example of a credit

extend

Advantage

O

intermediaries are

financial

such as

intermediaries

necessary? The main reason and other intermediaries develop a comparative quality of moment

borrowers\342\200\224the

ago.

class of

to borrowers

and investors, Comparative

those depositsto make loans. financial

called

institutions

using funds raised from and

savings

loan

associations

unions.

are

Why

important

banks that accept

of commercial

thousands

businesses

of financial

examples

and credit

and

individuals

from

intermediaries, savers.

system consists of

U.S. banking

deposits firms

intermediaries

financial

SYSTEM

BANKING

Most

savers,

banks, which

is that,

information-gathering

particularly

small savers,

themselves In

which

contrast,

savers

between\"

specialization, banks

through

the

in evaluating

advantage

function

for knowledge to determine receive most they productively.

\"stand

that

do not

we referred

to a

or the borrowers are likely to use the funds banks and other intermediaries have have

the

time

in performing the information-gathering activities necessaryfor gained expertise profitable lending, including checking out the borrower's background, determining whether the borrower's business plans make sense,and monitoring the borrower's in evaluating activities during the life of the loan. Because banks specialize potential borrowers, can perform this function at a much lower and with cost, they better results, than individual savers could on their own.

FINANCIAL

THE

Banks alsoreducethe borrowers by

pooling

needsto be evaluated

only

hundreds of individuals

costs

of

the saving

of gathering individuals

many

SYSTEM AND

THE ALLOCATION

OF SAVING

about potential large loans. Each large loan

information to make

by the bank, rather than separately by each of the be to make the loan. saving may pooled their need to gather information about eliminating once,

whose

help savers by and by directing their saving toward higher-return, more-productive investments. Banks help borrowers as well,by providing access to credit that might otherwise not be available. Unlike a Fortune 500 which typically has corporation, to raise funds, a small businessthat wants to buy a copier or remodel many ways will have few options other than its offices to a bank. Because the bank's going in officer has small-business loans, and even lending developed expertise evaluating Banks

potentialborrowers

business relationship with the small-business owner, the bank the information it needs to make the loan at a reasonable cost.Likewise, consumers who want to borrow to finish a basement or add a room to a housewill find few good alternatives to a bank. In sum, banks' expertise at gathering information about alternative lending allows them to bring together small savers lookingfor good uses for opportunities their funds and small borrowerswith worthwhile investment projects. may

have

will

be

an ongoing to gather

able

L

%>$s\\y.

'O.K.,

folks,

lefs

move

someone

qualify

along. for

Ym sure you've all seen before.\"

a loan

to being ableto earna return on their saving, a second reason that is to make it easier to make people deposits payments. Most bank allow the holder to write a check them or draw on them using a deposits against debit card or ATM card. For many transactions, paying by check or debitcard is more convenient than cash. For example, it is safer to send a check through using the mail than to send cash, and paying by check gives you a record of the a cash payment does not. transaction,whereas In addition hold

bank

TO PRODUCTIVE USES

563

20

CHAPTER

564

EXAMPLE

MONEY,

PRICES,

THE FINANCIAL SYSTEM

AND

The Japanese BankingCrisis

20.1

the

did

How

the 1990sin

crisis of

banking

the Japanese

affect

Japan

economy?

in Japan. Japanese banks made soared During the 1980s, real estate and stockprices loans to real estate developers, and the banks themselves acquired stock in in the United States, in Japan it is legal for commercial banks to own (Unlike corporations. in the early 1990s, land in Japan, leading many However, stock.) prices plummeted bank borrowers to default on their loans. Stock prices also came down sharply, the value of banks' shareholdings. The net result was that most Japanese banks fell reducing into severe financial trouble, with many large banks near bankruptcy. What was the effect of this crisis, which lasted more than a decade, on the Japanese economy?

many

has

relied

traditionally

the severe financial \"credit

been particularly

to

such as

small- and medium-sized

dependent on banksfor after

the 1990s.

throughout

obtain

difficult

borrowers

The Japaneseeconomy,

recession

the

it unusually

Smaller

crunch.\"

heavily

very

problems of

found

borrowers

many

has more developedstockand bond markets, on banks to allocate its saving. Thus, when banks them from operating normally, prevented

to the United States, which

Relative Japan

and

credit

disproportionately.

growth,

a severe

suffered

sharp slowdown. did not help the

to this

contributed

as a had

businesses

thus suffered

of robust

years

many

Many factors

known

credit\342\200\224a situation

of the banking system certainly However, the virtual breakdown interfered with smaller firms' ability to make situation, as credit shortages capital investments and, in some cases, to purchase raw materials and pay workers.

The Japanesegovernment

slowly, in

to a healthy

out of

part

large

to

have

The commercial banking in the economy. money

BONDS bond

a

promise

legal

debt, usually principal

including

amount

interest, or

coupon,

maturation which the

the

amount

date principal

the

date

of a

at

bond

be repaid

payments

interest

payments

regular

made to

bondholder

rate the interest rate when a bond is issued; promised the annual coupon payments are to the rate times equal coupon the principal amount of the bond coupon

Large

and

bonds and stocks,and

well-established

firm

usually

has

go to

markets

the

to this point in which they

banking

Japanese

remain and the

of growth.

rate

that wish to

corporations

banks.Unlike stock

the

ways of

alternative

bond market and the and stocks, then return

return

will

the

problems

although

the

determining

shortly, are

we need

first

but

traded.

STOCKS

AND

will sometimes

years, the health of

of returning

market.

to the

raising funds,

We first

role of

small

typical

obtain

notably

discuss some of

bond and stockmarkets

for

funds

borrower,

investment

however, a larger

the through mechanics

corporate of bonds

the

in

saving.

allocating

BONDS

coupon the

payments

lent

originally

will

and regular

amount

principal

to repay a both the

costs

system plays a central role in We

but responded very the banks

problems high

returned to its earlier high

quantity of

to look at

these

bear the

significantly,

improved

has not

economy

Japanese

In recent

condition.

financial

system appears

recognized

reluctance to

A bond is a legal promiseto repay a debt. These repayments typically the which is the amount originally amount, First, lent, parts. principal in date the called the maturation date. t he owner future, Second, specific

called the bondholder,receivesregular maturation date. For example, a

interest,

bond may

consist

or coupon payments, until a principal amount

have

of two

is paid at some of the bond, the

bond's

of $1,000

and annual coupon payments of $50. These coupon 1, 2030, payable on January are also to the amount times the coupon rate, where the payments equal principal rate is the interest rate when the bond is issued. (The coupon rate coupon promised therefore is also equal to the annual coupon payment divided by the principal.) In the example above, the principal is $1,000 and the coupon rate is 5 percent, resulting in annual coupon payments of (.05)($1,000),or $50. raise funds by issuing bonds and Corporationsand governments frequently them to savers. The rate that a issued bond must promise in selling coupon newly

BONDS

order to be attractive to savers bond's term, its credit risk, and of time

until

the

on a depends tax treatment.

coupon

number

of

the

including

factors,

The term

of a bond is

the

length

30 days to 30 years date, which can range from on long-term (30-year) bonds generally exceed

maturation

bond's

or more.The annual

its

AND STOCKS

rates

(1-year) bonds becauselendersrequirehigher couponrates (and, higher coupon payments) to lend for a long term. Credit risk is the risk that the borrower will go bankrupt and thus not repay the loan. A borrower that is viewed as risky will have to pay a higher coupon rate to lenders for taking the chance of losingall or part of their financial investment. compensate For example,so-calledhigh-yield less formally known as \"junk are bonds, bonds,\" bonds issued by firms judged to be risky by credit-rating these bonds agencies; pay to be less risky. higher coupon rates than bonds issued by companies thought Bonds also differ in their tax treatment. For example, interest on bonds paid issued local called is from federal bonds, taxes, by governments, municipal exempt whereas interest on other types of bonds is treated as taxable income.Because of this tax advantage, lenders are willing to accept a lower coupon rate on municipal bonds. Bond owners are not required to hold their bonds until their maturation dates. in are free to sell their bonds the bond an market market, They always organized run bond traders. The market value of a particular bond at any by professional in time is called the of the bond. The of a bond can be greater given point price price less than, or equal to the principal amount of the bond, depending on how the than, current or prevailing interest rate in financial markets with the interest compares rate at the time the bond was issued.The closerelationship between the price of a bond and the current interest rate is illustrated by the following example. on short-term

those

annual

hence,

Bond is the

What

relationship between

bond pricesand

Prices and interest

Interest Rates

rates?

government bond rate on the coupon bond is 5 percent,paid annually, the interest rates on reflecting prevailing will 2012. or whoever ownsthe bond at the receive a 1, Hence, time, January Tanya, of of on 2013. The owner of $50 1, (5 percent $1,000) couponpayment January the bond will receive another coupon payment of $50 on January 1, 2014,at which time she also will receive repayment of the principal amount of $1,000. On January after receiving her first year's 1,2013, coupon payment, Tanya decides to sellher bondto raise the funds to take a vacation.She offers her bond for sale in the On January

1, 2012, Tanya

with

a principal

bond

market.

the representing much prevailing

amount

The

a newly

purchases

of $1,000

issued, two-year

for a price of

$1,000.

The

will receive on January 1,2014, $1,050 of of the $1,000 $50, coupon payment plus repayment principal. How can Tanya to for her \"used\" bond? The answer expect get depends on the interest rate in the bond market when she sellsher bond on January 1,2013. buyer

of the

bond

second

Suppose first that, market, the prevailing

on January

1, 2013, when

interest rate on

Tanya takesher bond

to

the

bond

to newly one-year 6 percent.Thus, someone who buys a new one-year bondon January with 1,2013, a 6 percent couponrate for $1,000 will receive $1,060 on January 1,2014 ($1,000 a that also be $60 principal repayment plus coupon payment). Would person to the for her bond? No. Note that the $1,000 willing pay Tanya Tanya paid coupon on \"used\" bond does not rise when interest ratesrise but remains payment Tanya's to $50. Consequently, the purchaser of Tanya's \"used\" bond will receive only equal when the bond matures. In order to sellher \"used\" $1,050 on January 1, 2014, will have to reduce the price below bond, $1,000. Tanya This example illustrates the fact that bond prices and interest rates are inversely related. When the interest rate being paid on newly issued bonds rises, the price financial investors are willing to pay for existing bondsfalls. issued

bonds

has risen

EXAMPLE

20.2

565

CHAPTER

566

20

MONEY,

AND THE

PRICES,

SYSTEM

FINANCIAL

the price for Tanya's \"used\" bond have to fall? Recall that the newly issued one-yearbond on January 1, 2013, for a 6 $1,000 will receive $1,060 on January 1, 2014. This $60 gain represents percent return on the price he paid. That will \"used\" bond person buy Tanya's only if him bond also will a 6 return. The for bond that Tanya's give percent price Tanya's allows the purchaser to earn a 6 percentreturn must the satisfy equation much would who buys person How

the

Bond price X Solving the

equation

$1,050/1.06,or just

the

January 1, 2013.

prevailing

rise

until

would

$991.

if the interest

too, the satisfy it,

result,

Tanya's note that

bond will sell for on January 1,2014,

relationship X

=

1.04

$1,050,

bond would riseto $1,050/1.04, or almost $1,010. interest rate when wants to sellis 5 percent, Finally, happens Tanya same as it was when she originally bought the bond? You should showthat case the bond would sell at its original price of $1,000.

implying

the

that

of her

price

what

this

that

find

receive or $59 more than he paid on $1,050, is $59/$991, or 6 percent,as expected. interest rate had instead fallen to 4 percent? When prevailing rates fall, bond prices rise.The priceof Tanya's \"used\" bond would gave a return of 4 percent.At that point, the price of Tanya's bond

Bond price

the

$1,050.

of the bond will His rate of return

purchaser

What

price, we To check this

bond

the

for

under

=

1.06

if

the

in

CONCEPT CHECK20.1 bonds are issued with a principal amount of $ 1,000and an rate of 7 percent.Thus,theowner will receive three coupon payments of (0.07)($1,000)= $70 at the end of each year. One year prior to the maturation date of thesebonds, a newspaper headline reads,\"Bad Economic News CausesPrices in of Bonds to Plunge,\" and the story reveals that these bonds have fallen three-year interest rates? What is the one-year price to $960.What has happened to prevailing interest rate at the time of the newspaper story? government

Three-year

annual

coupon

Issuing bonds is obtain

funds

to corporations, is by

a corporation or a important way of raising funds, by which

means

one

Another

savers.

from

issuing stockto the

can

government

but

one

restricted

public.

STOCKS

stock for

to

partial

a claim

equity)

ownership

of a firm

A share of stock (or equity) if a corporation has 1 million is

equivalent

dividend a regular received

each share

payment

by stockholders that

they own

for

of stock

shares

of one-millionth

to ownership

returns on their

to partial ownership of a firm. For example, outstanding, ownership of one share

claim

is a

financial investment

in

two

of the

company.

Stockholders

receive

forms.

stockholders receive a regular payment called a dividend for each share First, of stock they own. Dividends are determined by the firm's management and usuin the on the firm's recent s tockholders receive returns Second, ally depend profits. form of capital gains when the of their stock increases discussed (we price capital and losses in the previous chapter). gains

Pricesof

the

stocks

New York

stock changes. the

prospects

are

determined

Stock Exchange.A

Demand for

stocks

of the company.

such as trading on a stock exchange rises and falls as the demand for the price turn depends on factors such as news about

through stock's

in

For example,the stock price of

a pharmaceutical

BONDS AND STOCKS

new drug is likely to rise and production marketing of the drug are some time away, because financial investors the expect company to become more in the future. 20.3 illustrates some profitable Example numerically key factors that affect stock prices. company that

on the

the

announces

of an important

discovery if actual

even

announcement,

Buying Shares in How much

should

pay for

you

a

New

Company

EXAMPLE

20.3

a share of FortuneCookie.com?

in a new company calledFortuneCookie.com, shares fortune cookies online. Your stockbroker estimates that in a year the company will pay $1.00 per share in dividends a year from now, and that will be $80.00 per share.Assuming the market price of the company that you accept broker's estimatesas what is the most that should be accurate, your you willing to pay How does your answer changeif you expect a today per share of FortuneCookie.com? but an $84.00 stock price in one year? $5.00 dividend? If you expect a $1.00dividend You

which

the opportunity to to sell plans gourmet

have

buy

that in one year each share of estimates, you conclude in will be worth $81.00 $1.00 you your pocket\342\200\224the dividend the could the stock. the $80.00 plus you get by reselling Finding maximum price boils down to asking how therefore, you would pay for the stock today, much would from this you invest today to have $81.00 a year today. Answering in turn one more of which is the rate information, question requires piece expected in order to be willing of return that to buy stock in this company. you require How would you determine rate of return to hold stock in Foryour required tuneCookie.com? For the moment, let's imagine that you are not too worried about the riskiness of the either because think that it is a \"sure thing\" stock, potential you In that or because are a who is not bothered risk. you devil-may-care type by Your rate of return to hold case, you can apply the Cost-Benefit Principle. required FortuneCookie.com should be about the same as you can get on other financial investments such as government bonds. The available return on other financial investments the cost of funds. gives opportunity your For example,if the interest rate currently being offered by government bonds is 6 percent, you should be willing to accept a 6 percent return to hold FortuneCookie.com as well. In that case, the maximum price you would pay today for a

Based

on your broker's

own

FortuneCookie.com

shareof

the equation

satisfies

FortuneCookie.com

Stock price X

1.06

= $81.00.

This equation defines the stock price you should be willing to pay if you are willing to accept a 6 percent return over the next year. Solving this equation yields stock for $76.42, then price = $81.00/1.06= $76.42.If you buy FortuneCookie.com

- $76.42)/$76.42= $4.58/$76.42= 6 percent, which is the rate of return you required to buy the stock. the total benefit of holding If, instead, the dividend is expected to be $5.00,then the stock in one year, equal to the expected dividend plus the expected is price, that are to a 6 $5.00 + $80.00, or $85.00.Assuming again you willing accept percent return to hold FortuneCookie.com, the price you are willing to pay for the stock = $85.00. today satisfies the relationship stock price X 1.06 Solving this equation = for the stock price yields stock price $85.00/1.06 = $80.19.

your return over the

good

dividend

news

about

will

price with in the future

this

Comparing expected

year

the

future

be ($81.00

that

prospects

by a pharmaceutical company that stock

price

immediately.

a higher case, we see that the stock today. That's why of a company\342\200\224such as the announcement has discovered a useful new drug\342\200\224affects its

in

the

previous

increases the it

value

of

a

Cost-Benefit

567

CHAPTER

568

20

MONEY,

PRICES,

AND THE

SYSTEM

FINANCIAL

If the expected future of the stock is $84.00, with the dividend at $1.00, price then the value of holding the stock in one year is once again $85.00,and the calculation is the same as the previous one. Again, the price to pay you should be willing for the stock is $80.19.

Theseexamples

an increase

that

show

in

the

future

dividend

or

in

the

future

raises the stock price today, whereas an increase in the return a expected saver requires to hold the stock lowers today's stock price. Sincewe expectrequired in the stock market to be closely returns tied to market interest rates, this last result in that increases interest rates tend to stock implies depress pricesas well as bond prices. Our examples alsotook the future stock as price given. But what determines the future stock price? Just as today's stock on the dividend price depends shareholders to receive this and the stock a expect year price year from now, the stock a from now on the dividend for next year and the price year depends expected stockpricetwo years from now, and so on. stock price is affected not only then, Ultimately, today's by the dividend A this but future dividends as well. to pay dividends expected year company's ability I f in on its a are to increase depends earnings. company's earnings expected rapidly in the future, its future dividends will probably too. as we noted the Thus, grow announces the discovery of a new example of the pharmaceutical company that in news about future far the future\342\200\224is drug, earnings\342\200\224even earnings quite likely to affect a company's stock priceimmediately. stock price

20.2

CHECK

CONCEPT

to be you expect a share of FortuneCookie.com in and also to a dividend of 1.00 one $ year, pay year. What should you be willing to pay for the stock today if the prevailing interest rate, if the interest rate is equal to your required rate of return, is 4 percent? What 8 percent? In general, how would you expect stock pricesto reactif economic news arrives that implies that interest rates will rise in the very near future? Continuing

worth

with

In the examples a return

to

financial

hold

rate of

the

investors

of return

rate

require

the risky assets minus on safe assets

return

EXAMPLE20.4

one

we have

studied,

we

assumed

that you were

bond.

However,

financial

investments

return in

the

willing

that stock

to

accept

you could market are

stocks can be highly variable and quite risky unpredictable. For a share of FortuneCookie.com to be worth example, although you expect in one also realize that there is a chance it sell as low as $80.00 year, you might or as as share. Most financial investors dislike risk and $50.00 $110.00 high per and thus have a rate of return for unpredictability higher required holding risky assets like stocks than for holding relatively safe assets like government bonds. The difference between the required rate of return to hold risky assets and the rate of return on safe assets,like government is called the risk bonds, premium. that

in

risk premium

in

of 6 percentto hold FortuneCookie.com, the same

get on a government

that

20.3,

Example

per share

$80.00

Riskiness

and

What

is the

returns

Stock

to holding

Prices

relationship betweenstockpricesand

risk?

build on our previous examples by introducing risk. that Suppose FortuneCookie.com is expected to pay a $1.00 dividend and have a market price of $80.00per share in one year. The interest rate on government bonds is 6 percent to be to hold a asset like a share of FortuneCookie per year.However, willing risky than the rate .com, you require an expected return four percentage points higher 4 safe assets like bonds risk of (a paid by government premium percent).Hence, a 10 percent expected return to hold FortuneCookie.com. What is the you require most you would be willing to pay for the stock now? What do you conclude about the relationship between perceivedriskiness and stock prices? Let's

BOND MARKETS, STOCKMARKETS,

THE ALLOCATION

AND

OF

569

SAVING

As a share of FortuneCookie.com is expected to pay $81.00 in one year and = $81.00. Solving the required return is 10 percent,we have stock price Xl.l0 for = the stock price, we find the price to be $81.00/1.10 $73.64,lessthan the price of and the required rate of return $76.42 we found when there wasno risk premium was 6 percent. We conclude that financial investors' dislike of risk, and the risk lowers the of assets like stocks. resulting premium, prices risky

BOND

STOCK

MARKETS,

SAVING

THE ALLOCATION OF Like

borrowers with

savers to

a corporationthat

markets provide a means of

and stock

markets

bond

banks,

from

is planning

from a bank has two other

investment

productive

bond

stock

to

section,

two

about

know

that

you

role

of bond

THE

uses?

the

prospective

is

saving

of this

and stock markets.

Saversand their

borrowers

and plans for the future performance professional analysts on Wall Street and other financial have doubts about the future potential purchasers offer a relatively low price for the newly issued shares recent

rate on newly

borrowers

with

the

on most

to

incentive

carefully.

companiesconsideringa new issueof

For example,

returns

possible

highest

find

must

This knowledge providesa powerful

opportunities.

scrutinize potential

that, to get the the potential

know

advisors

investments, they

MARKETS

STOCK

AND

BOND

OF

ROLE financial

their financial

their

available

at the beginning

mentioned

we

As

served by these markets are gathering information borrowers and helping saversto sharethe risks of lending. Now the basics of how bonds and stocks are priced, we can look at the

INFORMATIONAL

profitable

to be sold to savers in bonds, in which are then sold in the itself, new bonds or stocks are then new

markets help to ensure that

stock and bond most productive functions important do

How devoted

For example, want to borrow

not

does

but

funds

channeling

opportunities.

investment

a capital

options:It can issue

or it can issue new shares market, market. The proceeds from the sales of firm to finance its capital investment. available to the

the

AND

MARKETS,

or bonds

stocks

studied

be carefully If the investors.

will

know

that

by

analysts and other firm, they will demand a high interest

of the

profitability

or they

will

to go to the Knowing this, a company will be reluctant bond or stockmarket for financing unless its management is confidentthat it can convince financial investors that the firm's planned use of the funds will be profitable. Thus, the search by savers and their financial advisors for high returns leads the bond ongoing and stock markets to direct funds to the uses that most likely to be productive. appear bonds.

issued

RISK SHARINGAND DIVERSIFICATION highly

Many

of

development

investment

promising a new

drug to lower

profits for a drug company, effective

than

An

recouped.

others

some

development

individual

the chance

takes

risks,so without very

the

of

hard

for

Bondand

for

means

the company stock

markets

to

drug

the

Rather

than

putting

all

of his

out

turns

development

life

to

savings

generally

the risk

funds

help reduce

the

are

Savers

of

risk

in

less costs will be help finance the but

also

to take large saver, it might be

reluctant

faced by

to develop the

dollars

to be

each

new drug.

a means to diversify of practice spreading one'swealth to reduce overall risk. The idea of shouldn't \"you put all your eggs in one or her saving in one very risky project, a

their financial investments. Diversification over a variety of different financial investments diversification follows from the adage that basket.\"

successful

The

might enjoy a handsomereturn

of reducing find

risky.

but if the drug

example;

of losingeverything.

also quite

cholesterolcould createbillions

on the market, none of who lent his or her

anticholesterol

some

projects are

by

is the

giving

savers

diversification

of spreading a variety of investments overall

risk

the

practice

one's wealth different

over

financial

to reduce

570

CHAPTER 20

MONEY,

AND THE

PRICES,

SYSTEM

FINANCIAL

investor will find it much safer to allocate a small amount of a large number of stocks and bonds. That way, if some financial in value, there is a good chancethat others will rise in value, with gains losses. The following example illustrates the benefits of diversification.

EXAMPLE

20.5

financial

saving

each of

assets

to fall

offsetting

The Benefits of Diversification the

are

What

benefits

of diversification?

has to invest and is considering two stocks,Smith Umbrella Co. and $200 Suntan Lotion Co. the of one share of each stock is The $100. Jones Suppose price if umbrella will turn out to be the better investment the weather is company rainy, but the suntan lotion company will be the better investment if the weather is sunny. In Table 20.1, we illustrate the amounts by which the price of one share of each Vikram

stock

and how this dependson the

will change

weather.

20.1

TABLE

Changes

in

the

Stock

Price

of Two

Smith

Umbrella

Companies

Increasein Actual weather

Price

per Share

According to Table 20.1, the by

Unchanged

+$10

Unchanged

Sunny

$10

(from

$100

price

$10

share of

of one

to $110) if of one share

weather is sunny. The price other hand, is expectedto rise by

Lotion Co.

Jones Suntan

+$10

Rainy

will rise

Stock

Co.

it

rains

of Jones Suntan

(from

$100

if

it

stock

unchanged if the Co.

Lotion

to $110)

Co.

Umbrella

Smith

but will remain

stock,

is sunny

on the but will

is rain. is 50 percent, and the chance of sunshine is 50 percent. How should Vikram invest his $200? If Vikram were to invest all his $200 in Smith he could buy two shares. Half of the time it will rain and each share Umbrella, will rise by $10, for a total gain of $20. Half of the time, however,it will be sunny, in which case the stock price will remain be Thus, his average gain will unchanged. 50 percent times $0, which is equal to $10. (or one-half) times $20 plus 50 percent Vikram invested all of his $200 in Jones Suntan Lotion Co., he If, however, could again buy two shares for $100 each. Each share would rise by $10 if the if the weather is weather is sunny a total gain of $20) and remain (for unchanged rainy. Since it will be sunny half the time, the average gain will be 50 percent times times $20 plus 50 percent $0, or $10. Vikram can earn an average gain of $10 if he puts all of his money into Although in only either stock,investing one stock is quite risky, since his actual gain varies on whether there is rain or shine.Can Vikram himself a widely depending guarantee the uncertainty and risk? Yes, all he has to do is buy one share gain of $10, avoiding of each of the two stocks. If it rains, he will earn $10 on his Smith Umbrella stock and on his Jones Suntan stock. If it's sunny, he will earn nothing on Smith Umbrella nothing but $10 on Jones Suntan. Rain or shine,he is guaranteed to earn risk. $10\342\200\224without remain

unchanged

Suppose the

if there

chance

of rain

existence

of bond markets a small amount

and stock markets of their saving

for savers to wide of diversify by putting variety different financial a share of a assets, each of which represents particular company or investment From project. society's point of view, diversification makesit possiblefor without individual savers risky but worthwhile projects to obtain funding, to bear too much risk. having The

makes

into

each

it easy

of a

BOND

MARKETS,

STOCK

MARKETS, AND

THEALLOCATION

convenient way to diversify is to buy A mutual funds. mutual fund is a financial indirectly through in that sells shares itself to the then uses the funds raised to intermediary public, in a wide of financial assets. shares a mutual fund thus buy variety Holding amounts to owning a little bit of many different financial assets, which helps to achieve diversification. The advantage of mutual funds is that it is usually less in and to shares one or two mutual funds than to costly time-consuming buy buy Over the past 40 years, mutual funds many different stocks and bonds directly. have become increasingly popular in the United States.

stocks

and

The did

Why

the

U.S. stock

market rise

sharply in

the

Naturalist

Economic 1990s,

then

fall

in

the

20.1 new

millennium?

Stock prices soaredduring

the 1990s in the United States.The Standard & Poor's 500 index, stock price performance of 500 major rose 60 companies, percent between 1990and 1995, then more than doubled between 1995and 2000. However, in the first two years of the new millennium, this index lost nearly half its value. Why did the U.S. stock market boom in the 1990s and bust in the 2000s?

the

summarizes

which

We discussedthe

market boom of the late 1990s in Example 19.3 and did household wealth. we not ask However, analyzed why the value of stocks rose dramatically and then fell. We can now address this question. The prices of stocks depend on their about future purchasers' expectations dividends and stock prices and on the rate of return required by potential stockholders. The in rate of return turn the interest rate on safe assets plus the risk required equals premium. In principles rise in stock could be the result of increasedoptimism about prices future dividends, a fall in the required return, or some combination. in the 1990s. both factors contributed to the boom in stock Probably prices in Dividends grew the the overall 1990s, rapidly reflecting strong performance of the U.S. this

how

expected

future

stock

affected

Encouraged

economy.

dividends

by the

to be

promise of new technologies,many

financial

investors

even higher.

is also evidence that the risk premium that people requiredto hold stocks fell the the total stock 1990s, during thereby lowering required return and raising prices. One possible explanation for a decline in the risk premium in the 1990s is increased diversification. that decade, the number and of mutual funds available During variety in increased Millions of Americans invested these who had funds, markedly. including many never owned stock before or had owned stock in only a few companies.This increasein diversification for the typical stock market investor may have lowered the perceived risk in of holding stocks she could now own stocks mutual (because by buying funds), which turn reduced the risk premium and raised stock prices.An alternative explanation is that in the investors and, simply underestimated the riskinessinherent economy in the stock market.To the extent that investors underestimated the riskiness of consequently, stocks,the risk premium may have fallen to an unrealistically low level. in dividends was After 2000 both of these favorable factors reversed.The growth in did not prove as to because firms stockholders, disappointing large part many high-tech An as had been additional blow was a series of profitable hoped. corporate accounting in 2002, in which scandals it became known that some or large firms had taken illegal in A unethical actions to make their profits seem than fact were. number of larger they a a terrorist and the also factors, recession, attack, scandals, including major accounting increased stockholders'concernsabout the riskiness of stocks, so that the risk premium rose from its 1990s lows.The combination of lower expected they required to hold stocks in 2003, dividends and a higher premium for risk sent stock prices sharply downward. Only did stock when the economy began to grow more rapidly, to recover. prices begin There

571

typical person, a particularly

For the

bonds

OF SAVING

mutual

fund a

intermediary in the

financial

that sells

shares

to the public, then uses funds raised to buy a wide

itself

variety of financial

ife

assets

20

CHAPTER

572

MONEY,

PRICES,

THE FINANCIAL SYSTEM

AND

money

in making

used

are particular types of financial And what exactly is money? To the

stocks

and

Bonds

be

any asset that can

scheme?

this

ITS USES

AND

MONEY

does money fit money is any asset

Where

assets. economist,

can be used in making Common purchases. examples world are currency and coins.A checking account balance that can be used in making payments (as when write you

purchases

and so is

groceries)

weekly

also counted as money.

example,cannot be used directly

In

transactions.

most

in

of money

the

in

into

that

modern

represents another asset a check to pay for your shares of stock, for contrast, Stock must first be sold\342\200\224

checkingaccountdeposit\342\200\224before further can be made. a wide of Historically, variety objects have been used as money, including and silver on the Island of Yap, large, coins, shells, beads,feathers,and, gold immovable boulders. Prior to the use of metallic coins, by far the most common into cash or a is, converted as buying your groceries,

that

transactions, such

in the South Pacific. shell found of Africa until parts very recently, being accepted for payment of taxes in Uganda until the beginning of the as in the case of century. Today money can be virtually intangible,

of

form

officially twentieth

a type

the cowrie,

was

money

Cowrieswere used as money

of

some

in

your checkingaccount. medium of exchangean asset used in purchasing goods and

the direct

barter

goods or services

trade of for

other

goods or services

use money? Money has three principaluses:a medium of and a store of value. account, exchange, of serves as a medium of exchangewhen it is used to purchase goods and Money services,as when you pay cash for a newspaper or write a checkto cover your Think utilities bill. This is perhaps money's most crucial function. about how if life would become there were no Without complicated daily money. money, all economic transactions would have to be in the form of barter, which is the direct trade of goods or services for other goods or services. Barter is highly inefficient because it requires that each party to a trade has do

Why

people

a unit

of wants. party wants, a so-calleddouble coincidence barter a musician could her dinner example, system, get only by to trade food for a musical performance. such a finding someone willing Finding match of needs, where each party to want what the other happens exactly person hasto offer, would be difficult to do on a regular basis.In a world with money, the musician's problem is considerablysimpler. she must find someone who is First, to for her musical with the money Then, received, willing pay money performance. she can purchase the food and other goods and services that she needs. In a uses money, it is not necessary that the who wants to hear music society that person and the person willing to provide food to the musician be one and the same.In other words,thereneednot be a double coincidence of wants for trades of goods and services to take place.

In

a world eat

someone

for a musical

without money, she only by finding to trade willing

food

to trade,

produce and

material

efficiency

Comparative

unit

Advantage

of account

a basic

measure of economicvalue

O

problem

the use

particular most

producing village

the

eliminating

By

order

performance.

other

under a

For

could

the

that

something

of money

goods of what it standards

developed the Principle of making

transactions

of having to in

or services, needs.

greatly

Specialization

of living, as

every

hold

money,

This even

in

specializein

family

or

increases economic

we discussedin

Advantage.

why savers

of wants

coincidence

permits individuals to

as opposedto having

Comparative

explains

a double

find

a society

Chapter

usefulness though

2 when

we

of money in money

rate of return. Cash,for example, pays no interest at all, and the accounts a lowerrate of interest than could be checking usually pay

generally pays

a low

balances

in

obtained

in

alternative

financial

investments.

As a unit of account, Money's second function is as a unit of account. money is the basic yardstick for measuring economic value. In the United States virtually all prices\342\200\224including the price of labor (wages) and the of financial assets prices in dollars. in such as sharesof stock\342\200\224are expressed economic values a Expressing common unit of account allows for easy comparisons. For example, grain can be measuredin bushels and coal in tons, but to judge whether 20 bushels of grain are

MONEY AND

economically dollar terms.

more or less valuable than a ton of coal, we express both values The use of money as a unit of account is closelyrelatedto its use

in

as a

is used to buy and sell things, it makes sense exchange; becausemoney in of all kinds terms. prices money As a store of value, its third function, money is a way of holding wealth.For in the miser who stuffs cash his mattress or buries gold coins under the example, in money old oak tree at midnight is holding wealth form. Likewise, if you in a balance are account, regularly keep your checking you holding part of your wealth in the form of money. Although is the medium of exchange money usually primary or unit of account in an economy, it is not the only store of value. There are numerousother or real estate. stocks, bonds, ways of holding wealth, such as owning For most people,money is not a particularly to hold wealth, good way apart from its usefulness as a medium of exchange. Unlike government bonds and other most forms of money pay no interest, and there is always assets, types of financial the risk of cash being lost or stolen. However, cash has the advantage of being and difficult to it an attractive store of value for trace, anonymous making and others who want their assets to out of the view of dealers, smugglers, drug stay

medium of to express

Private such a

Is there

Money is

as

thing

Hours and LETS

Money: Ithaca

money?

private

in part this but government, not private individuals, money issuance. Where the law allows,private sometimes issued currencies circulate in more moneys do emerge.1 For example, privately In Ithaca, New York, than 30 U.S. communities. a private currency known as \"Ithaca Hours\" has circulated since 1991. Instituted resident Paul Glover, each Ithaca by town Hour is equivalent to $10, the averagehourly of workers in the county. The bills, wage inks to prevent counterfeiting, honor local people and printed with specially developed the environment. An estimated and businesses have earnedand spent 1,600 individuals Hours.Founder Paul Glover can't be spent argues that the use of Hours,which in the local economy. induces to do more of their elsewhere, people shopping A more form of private money is associatedwith high-tech computerized called These are quite LETS, for local electronic trading trading systems system. by the

issued

usually

reflects legalrestrictions

on

private

in a LETS post a list and Great Britain. Participants like to buy or sell. When transactions are made, the number of \"computer credits\" is subtracted from the appropriate buyer's account and added to the seller's account. Peopleare allowed to have negative in their balances so participants have to trust other members not to abuse accounts, the system by buying LETS credits many goods and services and then quitting. exist online of paper or metal. In this respect,LETS only and are never in the form foreshadow the electronic monetary systems of the future. may in common? What do Ithaca Hours and LETScredits have By functioning as a medium of exchange, each facilitates trade within a community. popularin

Australia,

of goodsand

New

Zealand,

services

MEASURING

they

would

MONEY

How much money, defined as financial in

the

because

U.S. in

economy it is practice

at

any

given

aBarbara A.

Everything

Good, \"Private

This

Money:

April 1, 1998.

those

that

for making

question

not easy to draw a clear distinction and

Commentary,

usable

assets

time?

should be counted as money

Economic

store of

value

an asset that

serves as a means of holding wealth

Service.

Revenue

Internal

the

ITSUSES

is not

Old Is New

Again,\"

simple to answer

between

should not.

purchases, is there those

assets

that

Dollar bills are certainly

Federal Reserve Bank

of Cleveland,

a

EXAMPLE

20.6

573

CHAPTER 20

574

MONEY,

AND THE

PRICES,

form of money, offer

now

SYSTEM

FINANCIAL

and

a van

accounts

Gogh painting that allow their

is not.

certainly

However, brokerage

owners to combinefinancial

firms

in

investments

stocks and bonds with and credit card privileges. Should the balances check-writing in these accounts, or some part of them, be counted as money? It is difficult to tell. Economists skirt the problem of deciding what is and isn't money by using in how broadly the concept of several alternative definitions of money, which vary A is defined. \"narrow\" definition of the amount of money in the money relatively MI

the sum of currency and balances

held

in

M2

All

some

checking

usable in at greater than

assets

the

additional

making

in MI plus that are

assets

payments

cost or inconvenience

currency

is called

economy

held in

accounts

but

Ml. Ml is the

sum of currency outstanding and balances measure of called all the M2, includes checking money, assets in Ml plus some additional assets that are usable in making payments, but at greater cost or inconvenience than currency or checks.Table 20.2 lists the of Ml and M2 and also the amount of each of asset components gives type outstanding as of April 2011. For most purposes,however, it is sufficient to think of money as in the sum of currency and balances or Ml. outstanding checking accounts,

U.S.

outstanding

A broader

accounts.

or checks

20.2

TABLE

and M2, April

of MI

Components

201I 1,901.00

Ml

Currency

949.10

Demand deposits

553.20

Other checkabledeposits

394.10

4.60

checks

Travelers'

M2

8,946.00 Ml

1,901.00

Savings deposits

5,497.90

Small-denomination time Money

market

Notes:Billions

862.80

deposits

684.30

funds

mutual

In Ml, currency refers to cash and adjusted for seasonal variations. noninterest-bearing checking accounts, and \"other checkable of Ml, deposits\" includes checking accounts that bear interest. M2 includes all the components balances in savings accounts, \"small-denomination\" (under $100,000)deposits held at banks for a fixed term, and money market mutual funds (MMMFs). MMMFs are organizations that sell shares, use the proceeds to buy safe assets (like government bonds), and often allow their

coin. Demand

of dollars, are

deposits

shareholders somecheck-writing Source:

Note

privileges.

Federal Reserve,release www.federalreserve.gov/releases/h6/current.

credit

that

including

food,

clothing,

use

cars,

balances are not includedin

people'swealth.

pay someone

Indeed,

are not includedin cards to pay for many and even college tuition. The

card balances

though people increasingly

the

a credit

else $1,000.

RECAP

Money is any

AND

MONEY

asset

that

money

supply

card charge

is

that

they

Ml

either

credit

of

even

purchases, reason credit

main do not

of $1,000represents

or M2

their

represent an

card part of

obligation

ITS USES

can be

used

in

making

purchases,

such

as currency

or a checkingaccount.Money serves as a medium of exchange when it is used to purchase goods and services.The use of money as a medium of eliminates the need for barter and the difficulties of finding a \"double exchange

to

BANKS

COMMERCIAL

of wants.\"

coincidence

of value. In

narrow measure,is madeup plus some

in

a more held in

M2. Ml, and balances and

Ml

includesall the

in Ml

assets

payments.

making

AND

BANKS

a store

and

account

of

currency

measure, M2,

additional assetsusable

COMMERCIAL

are

of

primarily

The broader

accounts.

checking

of money

basic measures

two

practice,

also serves as a unit

Money

AND THE

THE CREATION

OF MONEY amount

the

determines

What

money consistedentirely

just be

would

money the

government.

supply

consists

not

Earlier in

currency

Here,

value

government million identical

but

also

If the

economy?

the money

economies

modern

balances held

of deposit

supply of

economy's

be simple:The supply of created and circulated by the

by

in

public

role commercial banks play as how commercialbanks and their money supply. To seehow, we will use the example of of Gorgonzola. make

we

Initially,

trading

directs the central bank

paper notes, and distributes them to the

money supply is a million

the

we discussed the we will examine

an economy's the Republic

the

in

the answer would of the currency

have seen, in

commercial banking system.To a

circulation

chapter,

country,

barter,

guilders

the

only of this

affect

has no for

equal to

as we

financial intermediaries.

a fictional

of money currency,

However,

banks.

commercial

depositors

of

easier

Gorgonzola

assume,

and eliminate the

of Gorgonzolato put

called guilders.The central bank

populace.At

this

point

the

need

into prints

the

Gorgonzolan

guilders.

of Gorgonzola are unhappy with a money supply made since the notes may be lost or stolen.In response to the demand for safekeeping of money, some set up a Gorgonzolan entrepreneurs banks. At first, these banks are only vaults where system of commercial storage When can people can deposit their guilders. people need to make a payment, they either physically withdraw their guilders or, more conveniently, write a check on their account. Checks give the banks permission to transfer guilders from the account of the of the person to whom the check is made person paying by check to the account out. With a system of payments based on checks, the paper guilders need never leave the banking one bank to another as a system, although they flow from of one bank makes a payment to a depositorin another bank. do depositor Deposits not pay interest in this economy; indeed, the banks can make a profit only by for safeguarding their cash. charging depositors fees in exchange Let's supposefor now that people prefer bank deposits to cash and so deposit all of their guilders with the commercial banks. With all guilders in the vaults of commercial banks taken together is banks, the balance sheet of all of Gorgonzola's However,

up entirely of

as shown

the citizens paper

in Table

guilders

20.3.

TABLE 20.3

Consolidated BalanceSheetof Gorgonzolan

Commercial

1,000,000

(Initial)

Liabilities

Assets Currency

Banks

guilders

Deposits

1,000,000guilders

CREATIONOF MONEY

20

CHAPTER

576

MONEY,

AND THE

PRICES,

of the commercial banking system in Gorgonzola are the paper vaults of all the individual banks. The sitting banking system's liabilities are the deposits of the banks' customers since checkingaccountbalances represent owed by the banks to the depositors. money Cash or similar assets held by banks are called bank reserves. In this bank for all the banks taken reserves, example, together, equal 1,000,000guilders\342\200\224 the currency listed on the asset side of the consolidated balance sheet. Banks hold reservesto meet depositors'demands for cash withdrawals or to pay checks In drawn on their accounts. this the bank reservesof depositors' example, 100 of banks' which are also 1,000,000guilders equal percent deposits, A in situation which bank reserves 100 of bank guilders. equal percent is called 100 reserve deposits percent banking. Bank reserves are held by banks in their rather than circulated among vaults, the and thus are not counted as of the public, part money supply. However, bank assets

The

in the

guilders

bank reserves cash or similar assets held by commercial banks for the purpose of meeting withdrawals and depositor payments

/ 00

percent reservebanking

a situation

in which

reserves equal of their

banks'

100 percent

SYSTEM

FINANCIAL

1,000,000

can be used in making transactions, are countedas money. the introduction of the money supply, So, \"safekeeper\"banksin Gorgonzola, to the value of bank is which is the same as it 1,000,000 guilders, equal deposits, was to the introduction of banks. prior To continue the story, the commercial bankers of Gorgonzola eventually realize that 100 True, a few keeping percent reserves against depositsis not necessary. in flow and out of the bank as receive or write guilders typical depositors payments in but for the most the stacks of sit the bank vaults. checks, part paperguilders just

depositbalances,which

deposits

after

It occursto the

that they can meet the random inflow and outflow of with reserves that are less than 100 percent of their deposits. After some observation, the bankers conclude that reserves keeping equal to only 10 percent of deposits is enough to meet the random ebb and flow of withdrawals and payments from their individual banks. The remaining 90 percent of deposits, the bankers realize, can be lent out to borrowers to earn interest.

Sothe

bankers

banks

their

to

guilders

cheese

producers loans

taken together

The other

TABLE 20.4

Consolidated

100,000guilders,

Balance Sheet of GorgonzolanCommercial Banks Assets

(= reserves)

Currency

Loans to

bank

reserve-deposit

ratio

reservesdivided

by deposits

fractional-reserve banking a banking

system system which bank reserves are less than so that the deposits ratio reserve-deposit

than

100 percent

is less

10 percent

after

farmers

Liabilities

100,000guilders 900,000

Deposits

1,000,000

guilders

guilders

After the loans are made, the banks' reserves of 100,000 guilders no longerequal 100 percent of the banks' depositsof 1,000,000 Instead, the reserve-deposit guilders. is now ratio, which is bank reservesdivided by deposits, equal to 100,000/1,000,000, A banking in or percent. which banks hold fewer reserves than deposits so system

10

that in

or

of Loans

Round

One

reserves equal to

900,000 guilders they lend out at interest to Gorgonzolan who want to use the money to make improvements to their farms. are made, the balance sheet of all of Gorgonzola's commercial banks has as shown in Table 20.4. changed,

the

After

to keep

decide

bankers

of their deposits.

banking

the

reserve-deposit system.

ratio is less

than

100

percent

is called

a fractional-reserve

Notice that 900,000 have flowed out of the banking (as loans to guilders system in and are now the hands of the But we have assumed that farmers) public. private citizens prefer bank depositsto cash for making transactions. So ultimately people will redeposit the 900,000 guilders in the banking system. After these deposits are made, the consolidated balance sheet of the commercial banks is as in Table 20.5.

COMMERCIAL

TABLE

20.5

Balance Sheet of Gorgonzolan CommercialBanks

Consolidated Are

Guilders

Liabilities

to farmers

900,000 guilders

deposits, and

bank

that

Notice

1,900,000 guilders.Thesedeposits, of 1,000,000

assets

1,900,000 guilders

Deposits

1,000,000 guilders

reserves)

(=

Currency

after

Redeposited

Assets Loans

AND THE

BANKS

guilders

in

hence the

which reserves

money supply, now equal of the banks, are balanced by and 900,000 guilders in loans owed to the banking system has thus led to the creation economy's

are liabilities

banks. The fractional-reserve commercial of additional money over and above the initial The story doesnot end here.On examining

guilders

1,000,000

their

balance

in currency. sheets, the bankers

are surprisedto see that they once again have \"too many\" reserves. With deposits of 1,900,000 guilders and a 10 percentreserve-deposit ratio,they need only But they have 1,000,000 guilders in reserves\342\200\224810,000 190,000 guilders in reserves. too many. Since lending out their excess is always more profitable than guilders in them in the vault, the bankers proceed to make another 810,000 leaving guilders in the banking loans. Eventually these loaned-out guildersare redeposited system, after which the consolidated balancesheetof the banks is as shown in Table 20.6. TABLE 20.6

Balance Sheet of GorgonzolanCommercial Banks and Redeposits

Consolidated Two

Liabilities

Assets

1,000,000guilders

(= reserves)

Currency

Loans to

after

of Loans

Rounds

1,710,000

farmers

Deposits

2,710,000

guilders

guilders

Now the money supply has increasedto 2,710,000 to the value guilders, equal of bank deposits. Despitethe expansion of loans and deposits, however, the bankers find that their reserves of 1,000,000 guildersstill exceed the desired level of 10 percentof deposits, which are 2,710,000 guilders. And so yet another round of

lending will

take

place.

CHECK

CONCEPT

Determinewhat after a third commercial banking

of the Gorgonzolan banking will look like system to farmers and redeposits of guilders into the is the money supply at that point?

balance

the

round

20.3 sheet

of lending

system.What

loans and deposits will only end when reservesequal because as of deposits, deposits long as reservesexceed10percent the banks will find it profitable to lend out the extra reserves. Since reserves at the end of every round equal 1,000,000guilders,for the reserve-deposit ratio to equal

The process

10 percent

of

of expansionof

bank

10 percent, total

deposits

must

equal

sheet must balance,with assets equal the process, loans to cheeseproducers

10,000,000 to liabilities, must

equal

since guilders. Further, we know as well that

9,000,000

the at

the

balance end of

guilders. If loans

equal

CREATIONOF MONEY

577

CHAPTER

20

MONEY,

THE FINANCIAL SYSTEM

AND

PRICES,

guilders,

9,000,000 will

guilders),

The

deposits).

bank

then

10,000,000 equal final consolidated

TABLE 20.7

the sum

assets,

of loans and reserves (1,000,000

guilders, which is the same as bank liabilities balance sheet is as shown in Table 20.7.

Balance Sheetof GorgonzolanCommercial Banks

Final Consolidated

Liabilities

Assets

Loans to

farmers

9,000,000

of the process.We

has multiplied system with no banks or the a 10

with system

can To

the money supply

economy with

percent

the

ratio

actual

of a

supply

this

in

ratio. So ultimately,

deposits

ratio

.

Bank deposits

This equation can be rewritten i

*

solve

to

.

Bank deposits

=

satisfy

the

desired

the

following

banking

Bank

reserve-deposit relationship:

ratio.

reserve-deposit

for bank

deposits: reserves

\342\200\224\342\200\224:\342\200\224

Desired

another way,

will directly, notice that deposits as the ratio of bank reservesto desired by banks. The expansion stops

banking system

Bank reserves

the

economy

as long

lending

\342\200\224\342\200\224-\342\200\224 = Desired :\342\200\224

banking the

more

example

reservesto depositsequals

in the

guilders at

is 10,000,000

of 10, relative to reserve banking. Put

percent

reserve-deposit

of bank

guilders

fractional-reserve

a factor

by

100

through additional rounds of

bank depositsexceeds the

when

deposits,

reserve-deposit ratio, each guilder depositedin 10 guilders worth of deposits.

\"support\" find the money

expand

total

the existence

that

see

10,000,000

Deposits

guilders

which is equal to

The money supply,

the end

1,000,000 guilders

reserves)

Currency (=

(bank

reserve-deposit

:

\342\200\224.

ratio

(20.1)

In Gorgonzola, since all the currency in the economy flows into the banking bank reserves The ratio desired system, equal 1,000,000guilders. reserve-deposit banks is 0.10. we find that bank 20.1, Therefore, using Equation by deposits equal or 10million guilders, the same answer we found in the (1,000,000guilders)/0.10, consolidated balance sheet of the banks, Table 20.7.

CONCEPT

CHECK

20.4

Find deposits in Gorgonzola if the and the money supply banks' than 10 percent. What if the deposit ratio is 5 percent rather currency circulatedby the central bank is 2,000,000 guilders and the deposit ratio remains at 10 percent?

THE

MONEY

SUPPLY

WITH

desired

reserve-

amount of desired reserve-

total

BOTH CURRENCY

AND DEPOSITS we assumed that all money is held in the form of example, In of course, peoplekeeponly part of their money holdings deposits reality, in the form of bank accounts and hold the rest in the form of currency.Fortunately, for the fact that people hold both currency and bank deposits does not allowing the determination of the as 20.7 shows. greatly complicate money supply, Example In

the

Gorgonzola banks.

in

BANKS

COMMERCIAL

The

is the

What

money supply in

with Both

Supply

Money

Currency and Deposits

CREATIONOF MONEY

EXAMPLE

20.7

currency and bank

is both

there

when

Gorgonzola

AND THE

deposits?

Banks keep reservesequalto

10

of

percent

their

of

money

is the

What

deposits.

of 500,000 in banks.

a total

form

the

in

guilders

the citizens of Gorgonzolachooseto hold of currency and to deposit the rest

that

Suppose

money supplyin

Gorgonzola?

supply is the sum of currency in the hands of the public and bank in the hands of the public is given as 500,000guilders. What is the quantity of bank deposits? Since500,000of the 1,000,000 guilders issued by the central bank are being used by the public in the form of currency, only the is available to serve as bank reserves.We know that remaining 500,000 guilders The

money

deposits.

Currency

so deposits are ratio, equal bank reserves divided by the reserve-deposit The total 500,000 guilders/0.10= 5,000,000guilders. money supply is the sum of currency in the hands of the public (500,000 guilders) and bank deposits (5,000,000 guilders), or 5,500,000 guilders. deposits

a general write out the

write

can

We

let's

example.First,

of this relationship that captures the reasoning fact that the money supply equals currency plus bank

deposits: =

supply

Money

Currency

held

by

the

public

+ Bank

deposits.

also know that bank deposits equal bank reservesdivided by the reserve-deposit ratio that is desired by commercial banks (Equation 20.1).Using that relationship to substitute for bank deposits in the expression for the money supply, we get

We

Money supply = Currency ^

i

i

We can use Equation In

that

500,000 values

into

500,000/0.10

ii-

by public

+

Bankreserves :

\342\200\224\342\200\224:\342\200\224

Desired

to confirm our held by the public is 20.2

currency

example,

in

held

reserve-deposit

reasoning

in

the

previous

500,000 guilders,bank

ratio is 0.10. guilders, and the desired reserve-deposit we that the 20.2, Equation get money supply = the same answer we found before. 5,500,000,

The

\342\200\224.(20.2)

ratio

Money

Plugging

example. reserves

equals 500,000 +

Supply

at Christmas

affect the

money supply? the Christmas amounts season, people choose to hold unusually During large for With no action the central how would this bank, currency shopping. by change in currency affect the national holding money supply? How

does

Christmas

To illustrate

500, the

in

the

of

numerical example,suppose that bank reserves are initially held the is and the desired reserve500, currency by public the banking is 0.2. these values into 20.2, system Inserting Equation = + 500 500/0.2 3,000. money supply equals with a of

amount

deposit ratio we find that

shopping

are

these

EXAMPLE 20.8

579

580

20

CHAPTER

MONEY,

PRICES,

THE FINANCIAL SYSTEM

AND

because of Christmas shopping needs, the public increases to 600 100 from commercial banks.These holdings by withdrawing reduce bank reserves to 400. Using Equation we find now that 20.2, = + is 600 So the increased 400/0.2 supply public's holdings of

Now suppose its

currency

withdrawals

the

2,600.

money

currency have for the drop

the

caused

can

supply to

drop, from reserve-deposit ratio of 20

money

with a

is that,

of banks

vaults

that

hands of the

The reason in the dollar every

to 2,600.

percent,

and hence

of deposits

$5

\"support\"

3,000

$5 of

money

supply.

$ 1 of currency, to the total S o when the withdraws cash from the $1 contributing only money supply. public will in the overall declines. see the next banks, (We section, however, money supply in practice that the central bank has means to offset the of the public's impact dollar

same

However, the

actions on the

in the

supply.)

money

BANKS AND THE CREATION

COMMERCIAL

RECAP

OF

public

becomes

MONEY

in private of the money supply consists of deposits commercial banks. Hence, the behavior of commercial banks and their depositors

Part

helpsto determine

Cash or similar

the

supply.

money

assets held by

economies,banks' reserves fractional-reserve

the reserve-deposit is less than 1.

are

are

less

than

The ratio

banking.

ratio;

banks

in

called bank reserves. In their deposits, a situation

of bank reservesto deposits

a fractional-reserve

banking

system,

modern called is called

this

ratio

not held as reserves can be lent out by the deposits interest. Banks will continue to make loans and accept as as the ratio exceeds its desired level. This deposits long reserve-deposit when the actual and desired process stops only reserve-deposit ratios are At that total bank divided equal. point, deposits equal bank reserves by the desired reserve-deposit ratio, and the money supply equals the held currency by the public plus bank deposits.

The portion of banks

to earn

CENTRAL

AND Federal

Reserve

System (or bank of the

the Fed) the central United States

monetary policy of the

determination

nation's money

supply

BANKS,

THE

MONEY

SUPPLY,

PRICES

System is one of the most important agencies of the federal in The as it is referred to the is the central bank of the Fed, government. press, United States. Central banks in general have two main responsibilities. First, they are responsiblefor monetary which means that a country's central bank policy,

The

Federal

Reserve

other Second, along with money circulates in the economy. the central bank has for the government agencies, important responsibilities of financial markets. In particular, central banks play oversight and regulation important roles markets. during periods of crisis in financial In Chapter 23, we will review the history and structure of the Fed and analyze how the Fed's actions affect the U.S. economy during financial crises and recessions. In this we focus on how a central bankcan controlthe money chapter, in and how the affect the level and the rate of supply changes money supply price in the long run. inflation determines

how

much

CENTRAL

THE MONEY

CONTROLLING

BANKS,

THE MONEY

AND

SUPPLY,

581

PRICES

SUPPLY WITH

OPEN-MARKET OPERATIONS involves primary responsibility is making monetary policy,which in the the appropriate size of the nation's As we saw money supply. in in central banks and the Fed do not control section, previous general, particular, the money supply directly. Nevertheless,they can control the money supply in In several this we discuss the most indirectly ways. chapter important of these,called In we discuss three other methodsthe Fed 23, open-marketoperations. Chapter can use to change the money supply:lending at the discount window, changing reserve requirements,and paying interest on reserves. with the ultimate goal reserves, Suppose that the Fed wants to increasebank central

bank's

decisions

about

A

supply. To accomplishthis, the Fed the assets, buys usually government bonds, from the public. To simplify actual procedure a bit, think of the Fed as buying bonds that the public had from the government and paying the public for these bonds with originally purchased newly printed money. that the public is already holding all the currency that it wants, they Assuming in will the cash receive as for their bonds commercial banks. deposit they payment will the reserves of the commercial increase an amount Thus, banking system by equal to the value of the bonds purchased by the Fed. The increase in bank reserves in will lead in turn, through the process of lending and redepositof funds described the previous section, to an expansion of bank deposits and the money supply, as summarized 20.2. The Fed's purchase of government bonds from the by Equation with the result that bank reserves and the are increased, is public, money supply

of increasingbank

deposits

and

the money

financial

called an

It

procedure.

purchase.

open-market

To reduce sells

bank reservesand hence the money some of the government bonds that

the Fed reverses the supply, in previous it holds (acquired that the public pays for the bonds

Assume open-market purchases) to the public. in checks on their accounts commercial banks. Then, when the Fed by writing presents the checks to the commercial banks for payment, reserves equal in value to the bondssold the Fed are transferred from the commercial banksto government by the Fed. The Fed retires these reserves from the circulation, lowering supply of bank reserves and, hence,the overall The sale of bonds money supply. government the Fed to the for the of bank reserves and hence the by public purpose reducing is called an sale. money supply open-market and sales together are called open-market operations. Open-marketpurchases are the most convenient and flexible tool that the Federal Open-market operations Reserve has for affecting the money supply and are employed on a regular basis.

How

do

operations

open-market

In a particular

affect the

money supply?

held by the public is 1,000 shekels,bank reserves currency and the desired r atio is 0.2. What is the shekels, reserve-deposit money if the central bank prints 100 shekels supply? How is the money supply affected and usesthis new currency to buy government bonds from the public? Assume that the public does not wish to change the amount of currency it holds. are

economy,

200

As bank

reservesare 200 shekels

and

the

reserve-deposit

ratio is

shekels/0.2, or 1,000 shekels.The money deposits equal the sum of currency held by the public and bank deposits, is therefore a result can confirm shekels, you using Equation 20.2. must

200

0.2, bank equal

supply, 2,000

bonds the Fed for

of government

from the

public

the

to

the

purchase

purchase

by

of increasing the of bank reserves and the

purpose

supply money

supply

sale the sale by open-market Fed of government bonds to the public for the purpose of the

reducing money

bank

reserves

and the

supply

open-market

operations

open-market

purchases

open-market

sales

EXAMPLE 20.9

Operations

Open-Market

open-market

and

20

CHAPTER

582

MONEY,

THE FINANCIAL SYSTEM

AND

PRICES,

The open-market purchaseputs 100 more that the public continues to want will deposit the additional 100 shekels

they

into the hands of the public. 1,000 shekels in currency,

shekels

assume

We

hold

to

commercial

the

in

so

system,

banking

raising bank reservesfrom 200 to 300 shekels. As the desired reserve-depositratio is 0.2, multiple rounds of lending and redeposit will eventually raise the level of bank deposits to 300 shekels/0.2,or 1,500shekels. The money supply, equal to shekelsheld the bank of 1,000 1,500shekels,equals 2,500 by public plus deposits shekels. So the open-market purchase of 100 shekels, by raising bank reserves by

100 shekels,has

the

increased

result

this

confirm

supply

money

shekels.

500

by

Again,

you can

Equation 20.2.

using

CONCEPT CHECK20.5 central bank

100 shekels, the of

20.9,

Example

Continuing

an

open-market

sale of

an open-market

conducts

happens to

What

bonds.

government

of

that instead

suppose

bank

bank

reserves,

purchase

of

50 shekels'worth and the

deposits,

supply?

money

PRICES

AND

MONEY

macroeconomicperspective, a major reason that control of the supply of is important is that, in the long run, the amount of money in an circulating economy and the general level of prices are closely linked. Indeed, it is virtually unheard of for a country to experience a high, sustained inflation without in the amount of money held comparably rapid growth by its citizens. For instance, the link in Latin America between countries money growth and inflation for nine 1995-2007 is illustrated in Figure 20.1. Although the relationship is during the period somewhat loose,countries with rates of money growth clearly tend to have higher From a

money

rates

of inflation,

other

periods.

higher

and

FIGURE 20.1 and

Inflation

Growth America, Latin

countries

with higher rates of growth in their money supplies also tended to have higher

rates of inflation 1995 and 2007.

between

has been found

in

30

1995-2007.

American

and this relationship

countries

other

35

Money

Latin

in

in

Venezuela

\342\200\242

& 25

c0

S 20 infl. al nuu

Paraguay

c

<

Peru 1

5

\\

A \342\200\242*Argentina \342\200\242 \302\253k

^

Chile

1

1

1

1

I

I

10

15

20

25

30

35

Annual

Source:

World

WorldBank,

The economist by

saying,

see later that,

increase in

Development

the

is always

money

(%)

the

summarized

of money.

But over

can

arise

relationship

inflation-money

and everywhere a monetary

over short periods,inflation supply

growth

I

40

Indicators.

Milton Friedman

\"Inflation

Uruguay \342\200\242Brazil

Bolivia^

5

)

.

^Colombia

phenomenon.\"

from

We

will

sources other than an

a longer period,and

particularly

for

CENTRAL BANKS, THE MONEY

SUPPLY, AND

PRICES

583

Friedman's dictum is certainly correct:Therate of inflation of the money supply are closely related. The existenceof a close link between money supply and pricesshould make intuitive sense. Imagine a situation in which the available of supply goods and servicesis approximately fixed. Then the more cash (say, dollars) that people the more they will be able to bid up the prices of the fixed supply of goods hold, and services. to the of goods and Thus, a large money supply relative supply services(toomuch money chasing too few goods) tends to result in high prices. a rapidly growing supplyof money will lead to quickly rising prices\342\200\224 Likewise, and

severe inflations, the rate of growth

that

is, inflation.

more

VELOCITY

To explore the the

growth and inflation

of money

relationship

of velocity. money changes hands in

to introduce at which speed

the concept

useful

In

economics,

transactions

a bit

more

velocity

is a

in

involving

detail,

it

is

measure of

final goods

and

services.For example,a given dollar bill might pass from your hand to the grocer's when dollar you buy a quart of milk.The same may then pass from the grocer to a new car dealerwhen your grocer buys a car, and then from the car dealer to her doctor in exchange for medical services. The more quickly money circulates from one person to the next, the higher its velocity. More formally, velocity is defined as the number of times per year the typical dollar in the money supply is used to buy final goods or services, according to the

velocity a measure of the speed in at which money changes hands transactions final involving goods and services, or, equivalently, nominal GDP divided by the stock of money.

formula:

following

Nominal GDP

Velocity

Moneystock

*

and let M stand for the particular money stock being or M2). Nominal GDP (a measureof the total value of we transactions) equals the price level P times real GDP (Y). Usingthis notation, can write the definition of velocity as Let

V stand

considered

(for

for velocity

Ml

example,

PXY

V =

The higher

this

ratio,

the faster the

(20.3)

M dollar

\"typical\"

The Velocity What

is the

velocity of the U.S.money

is circulating.

of Money in the

U.S.

Economy

supply?

In 2010, Ml was $1,832.2 billion, M2 was and nominal GDP $8,816.4 billion, was $14,660.2 billion.We can use these data along with Equation 20.3 to find for both definitions of the For we have Ml, velocity money supply.

V

$14,660.2

$1,832.2 Similarly,

velocity

for

billion

billion

8.00.

M2 was

$14,660.2 billion

$8,816.4billion

1.66.

EXAMPLE

20.10

584

CHAPTER 20

MONEY,

AND THE

PRICES,

SYSTEM

FINANCIAL

the velocity of

can see that

You

sense:

the

Because

components

for transactions,each dollar

used more frequently the

than

A

creation of networksof payment holding less

We

have tended to

and thus

cash,

increasevelocity

use the definition of velocityto run. First, rewrite the definition sides of the equation by the money

can

long both

quantity

GDP.

money equals nominal

equation velocity

often

over\" more

time.

over

seehow of

money

M. This

are related

prices

20.3,

Equation

velocity,

stock

and

the

in

multiplying

by

yields

MXV = PXY. times

are

accounts,

checking

\"turns

INTHE LONG RUN

INFLATION

AND

MONEY

automated

allowed

have

methods

Ml

is advances in velocity. A leading example introduction of creditcards and debit cards or the teller machines (ATMs). These technologiesand to out their while people carry daily business

as the

such

technologies

of

determine

of factors

variety

payment

cash and

of M2.

dollar

average

such as

M2. This makes

than that of

is higher

Ml

of Ml,

(20.4)

The quantity Equation 20.4 is calledthe quantity equation. equation states that money times velocity nominal GDP. Because the is equals quantity equation a of the definition of it holds simply rewriting velocity, Equation 20.3, always

exactly.

and important because late nineteentheconomists used this to theorize early twentieth-century monetary relationship about the between money and prices. We can do the same thing here. relationship To keep things simple, imagine that V is determined current velocity by payment constant over the period we are technologiesand thus is approximately If we use a bar that real output Y is approximately constant. Likewise, considering. suppose over a variable to indicate that the variable is constant, we can rewrite the quantity

The

is historically

equation

quantity

as

equation

(20.5)

MXV=PX%

where we are treating

Now look at

Equation

the

increases

Reserve

V and

money

Y as fixed numbers. and imagine that

20.5

supply M

by

10

some reason the Federal V and Y are assumed Because percent. hold only if the price level P alsorises for

to fixed, Equation 20.5 can continue 10 That to the a 10 percent increase in is, according by percent. quantity equation, M in the money should cause a 10 increase the is, supply percent price level P, that an inflation of 10 percent. The intuition behind this conclusion is the one we mentioned at the beginning of this section. If the quantity of goods and services Y is approximately constant in that V also is an increase the of (and assuming constant), velocity supply money will lead to bid up the prices of the available and services. Thus, high people goods

to be

of money growth will tend to be associated with rates of inflation, which high is exactly what we observedin Figure 20.1. If high rates of money growth lead to inflation, why do countries allow their to rise rates of are the result money supplies quickly? Usually, rapid money growth

rates

of large government

countries

suffering

they

cannot

budget

raise

expenditures. In this money and usethis money

in

deficits.

circulation

Particularly

war or political sufficient taxes or

from

situation,

the

instability,

in developing governments

borrow enough from

government's

countries or

the

only recourse

public may

its bills. If the resulting increase in money is large enough, the result will be inflation. to pay

find that to cover their

sometimes

be the

to print amount

new of

585

SUMMARY

becomes so large that the only way to Sometimes, a country's budget deficit finance it is to print money. We can use Equation 20.5 to analyze the consequences of this policy.In this case, M grows at an extremely high rate leading P to rise at an which we discussed in Chapter 16. equally rapid rate.The result is hyperinflation, The Confederate States of America the Civil War and after World during Germany War I were in exactly this situation: They could not raise sufficient taxes to cover of paper money to pay needs, so they government spending printed large quantities for As 20.5 this resultedin government expenditures. Equation predicts,

in the

both

hyperinflations

and

Confederacy

Weimar

the

in

in Germany.

Republic

a way to stop hyperinflations: Reduce the Equation 20.5 also provides growth rate of the money supply. This is, of course, easier said than done. To accomplish the must somehow cut spending and/or raise taxes so that the this, government deficit can be financed rather than issue. The budget through borrowing money German government, for example, enacted reforms in late 1923 that made it difficult for the government to print money to cover its budget dificits. Inflation in slowed the months after the reform. The on the other dramatically Confederacy, was unable to its After the battles of and hand, stop hyperinflation. Gettysburg in it was clear that the would lose the war. 1863, Vicksburg Confederacy ultimately It could only sell bonds at exorbitant interest rates, and could not collecttaxes sincethe individual states controlled tax collections. Hyperinflation ended only

the

with

defeat

Confederacy's

sales

A

rate

high

of money growth

of money

amount

of available

in

goods and

supply while open-

supply.

generally leads to the

circulation,

PRICES

AND

open-market

through

the money

increase

the money

decrease

MONEYSUPPLY,

supply

money

purchases

Open-market

market

prices

the

banks control

Central operations.

1865.

April

BANKS, THE

CENTRAL

RECAP

in

higher

services.

The

inflation.

the public will

larger

bid up

the the

the speed at which money circulatesin payments for and services;equivalently it is equal to nominal GDP divided of money. A numerical value for velocity can be obtained V = (P X Y)/M, where V is velocity, P X Y is nominal equation

measures

Velocity

final goods by the stock from

the

GDP, and

M is the

money

supply.

equation states that money MX V = P X Y. The symbols, definition of velocity and thus

velocity equals nominal quantity equation is a If velocity restatement of the holds. and always are the that a constant, output approximately quantity equation implies in increase the leads to the same given percentage money supply in the price level. In other words,the rate increase of growth of the percentage the rate of inflation. money supply equals

The quantity

GDP,or, in

times

SUMMARY

The U.S. commercial

banking system banks

that

consists accept

businessesand use loans. Banksare the most als and

class

of institutions

of

thousands of from individu-

deposits those deposits important

called financial

to make of a example

intermediaries.Fi-

nancial intermediariesdevelop expertisein

evaluating

prospective borrowers, making it unnecessary small saversto do that on their own. (LOl) \342\200\242 Governments

ing

by

promise

and

businesses

can also

bonds or stocks. issuing to repay a debt, including

A

obtain

financ-

is a

bond

both

for

the

legal

principal

586

20

CHAPTER

MONEY,

PRICES,

AND

THE FINANCIAL SYSTEM

amount and regular interest or couponpayments. The of bonds decline when interest rates prices existing rise.A share of stock is a claimto partial ownership of a firm. The price of a stock depends positively on the dividend the stock is expected to pay and on the future on the expected price of the stock and negatively rate of return required by financial investors to hold in turn is the the stock. The requiredrate of return sum of the return on safe assets and the additional return to compensate financial investors for the required riskinessof stocks, called the risk premium. (L02) \342\200\242 The

broader measure

less convenient

to

Ml.

in

included

are part of the money deposits supply, of commercial banks and of bank affects the amount of money in the economy. depositors commercial banks create money Specifically, through rounds of lending and acceptingdeposits. multiple The money supply equals currency held by the public

\342\200\242 Because

bank

the behavior

the

in

financial

markets,

and

of

\342\200\242 The

in two information to ways. First, it provides savers about which of the many possible uses of their funds are likely to prove most productive and hence markets pay the highest return. Second,financial help savers share the risks of lending by permitting them to diversify their financial investments. (L03)

includes

and

currency

accounts.

checking

money

supply indirectly in several of these, called openbuys or sells government for currency held by banks or

ways. In the most important market operations,the Fed securities in

the

asset that can be used in making purchases. has three main functions: as a medium Money of exchange, as a unit of account, and as a store of In practice, value. it is difficult to measure the money since assets have some supply many money-like A relatively features. narrow measure of money is Ml,

which

of the United Statesis calledthe System, or the Fed for short.The Fed

the

affect

(L05)

system.

banking

bank

Reserve

can

exchange

(L06)

public.

is important

of the money supply run because the rate of growth

\342\200\242 Control

is any

Money

central

Federal

saving

\342\200\242

assets that are somewhat transactions than those

in

use

all the

includes

M2,

money,

(L04)

plus deposits

system, consisting of banks, bond stock markets, improves the allocation

of

plus additional

Ml

in

assets

and the rate of the particular, under in

the

in

the

long

supply

money

closely linked. In can be used to show that, a given percentage increase will lead to the same percentage are

inflation

quantity equation certain conditions,

supply

money

increasein

A

the

of

the

price

level. (LOG)

KEY TERMS bank

reserves

barter

fractional-reserve

(576)

bond (564)

Ml (574)

coupon

M2

payments

coupon

Federal

System

(the Fed) (580) financial

quantity

(562)

store of unit of

percent

(571)

reserve banking

open-marketoperations

(L02)

prices surge,

but

bonds remain stable.What

the

of government prices can you infer from the

(584)

(576)

velocity

(568)

(or equity) (566)

fund

in one year matures plans to sell a bond that and has a principal value of $1,000. Can he expect in the bond market for the bond? to receive $1,000

2. Stock

premium

(572)

Arjay

Explain.

stock

mutual

REVIEW

1.

risk

money 100

intermediaries

(564)

equation

reserve-depositratio (576)

(564) (580)

policy

monetary

(566)

Reserve

amount

principal

date

(581)

open-market sale (581)

medium of exchange(572)

rate (564)

purchase

open-market

(574)

maturation

(564)

diversification (569) dividend

banking

system (576)

(572)

value

(573)

account (572) (583)

(581)

QUESIIOHS

behavior of bond pricesabout of the increase in stock values?

the

two ways that the financial improve the allocation of saving.

3. Give

examples.

(L03)

possible

causes

(L02) system Illustrate

helps to with

587

PROBLEMS

is money?

4. What

though

it

pays

6.

hold money even people return than other financial

do

Why

a lower

5.

If

U.S. money

Describe

how this action Fed's objective.(LOG) and explain

the public switches from doing most of with shopping currency to using checks instead. the Fed takes no action, what will to the happen that

Suppose

its

operations.

open-market

assets?(L04)

to reduce the

wants

Fed

The

7. Usethe quantity growth and (L06)

supply? Explain.(LOl,L05)

national money

to

equation inflation

would

tend

to

using

supply

it would

what

accomplish

explain why be closely

money linked.

PROBLEMS Simon

newly issued by pays $60 to its holder at

The

bond

years and pays $1,060 upon its maturity a. What are the principal amount, the for Simon's bond? payment b. After receiving the second coupon

c.

if the

bond

his

10

percent?

below

Shares

in

Brothers

expected

to

pay

carries no risk? rate of interest carries no risk?

Grimm

c. If the safe rate

d. Repeat

|economics

of Simon's

price

bond after two years

the market interest rate

equals the

percent,

but

that

investing

in

is 3 percent? to expected pay a dividend,

risk

your

c, assuming is unchanged.

believe

you

is not

Grimm

that

consist

investments

and shares

is 10 percent and

premium

in

a

of U.S.

government bonds maturing

doing research in news items to following

company

start-up

in

10

pharmaceuticals.

would you expect each of the affect the value of assets? Explain your reasoning. (LOl) a. Interest rates of newly issued government bonds rise. b. Inflation is forecasted to be much lower than (Hint: previously expected Recall the Fisher effect from for simplicity that this 16.) Assume Chapter information doesnot affect your forecast of the dollar value of the pharmaceutical company's future dividends and stock price.

How

your

In parts cto f, remain

swings in

e. The

stock

the

market

new

However,

The

increase

drug.

the drug

financial investors'

to

concerns

own will

announces not

come

the development of to market for at least

years.

pharmaceutical

company announces that

year. f.

issued government bondsare assumed

start-up company whosestockyou

a valuable five

on newly

risk.

market

about

d. The

rates

interest

unchanged.

c. Large

connect\"

coupon

price

expected

financial

Your

years

the

manufacturers of gingerbread houses,are one year and to sell for $100 per share at that to share of Grimm: (LOl) willing pay today per in is 5 percent and you believe that investing

is 5

interest

of

a to

parts the

but

be

safe

the

rate, and

Graw Hill

(LOl)

year.

Grimm, Inc., a dividend of $5 in

time. How much should you a. If the safe rate of interest Grimm

the

even though

$1,000,

couponrate?

b. If

the coupon

term,

third

Mc

fer McGraw-Hill

fall

might

end of the

second

and

first

the

reason that

of a

you think

Can

the

at

of the

end

the

payment (at the end of the second year), bond market. What price can he expect one-year interest rate at that time is 3 percent? 8 percent?

to sellhis bond in

Simon decides for

Amalgamated Corporation, for

a bond,

purchases

$1,000.

federal

prescription drugs.

government

announces

it will

a system of

price

not pay controls

a dividendnext on

Visit

your mobile

store and

download

the Frank:

Study

Econ

app todayl

app

do,

the

588

CHAPTER

20

MONEY,

PRICES,

4.

AND

THE FINANCIAL SYSTEM

You

have

and are consideringbuying

to invest

$1,000

shares of two

companies,Donkeylnc

and

of the of Donkeylnc

combination

some

Shares

Elephantine.

are elected,an event you believe probability; pay a zero return. Shares if of will 8 the are elected(a 60 percent Elephantine pay percent Republicans will be zero otherwise. Either the Democrats or the probability), Republicans elected. (L02, L03) a. If your only concern is maximizing your average expectedreturn, with no for risk, how should you invest $1,000? regard your if you invest b. What is your expected return $500 in each stock? (Hint:

will

percent return if the Democrats

a 10

pay

a 40 percent

to have

what

Consider

possible

of

an investment

e. Devise an

outcome by

investment

and

win

that

probability

if the Republicans event occurs.)

$500 in each stock does not give the highest return. Why might you choose it anyway? at least a 4.4 percent return, strategy that guarantees that is

strategy

on your $1,000 doesnot depend

5. During World

the

party wins.

which

matter

no

investing

expected

average

d. Devise

Democrats

will be if the

return

your

win, then weight each

c. The strategy

the shares

otherwise

at

that is, one in which the return which party wins.

riskless, all on

several II, an Allied soldier named Robert Radford spent German A t times more than 50,000 years large prisoner-of-warcamp. about within the prisoners were held in the camp, with some freedom to move Radford later wrote an account of his He described compound. experiences. how an economydevelopedin the camp,in which traded food, prisoners and other items.Servicessuch as also were clothing, barbering exchanged. the prisoners began to use cigarettes(provided Lacking paper money, monthly the Red as Cross) made, by money. Priceswere quoted, and payments using War

in a

(L04)

cigarettes.

a. In Radford'sPOW money?

b. Why

do

you

other items c. Do

you

think

of value

functions

three

the

of

used cigarettesas money, as opposed to of chocolate or pairs of boots? would have been willing to accept prisoner

as squares

such

in exchange

cigarettes

fulfill

the prisoners

a nonsmoking

think

did cigarettes

how

camp,

for a

good or service

in

Radford's

camp?

Why or

not?

why

in the text (refer to Tables20.3to 20.7), the into (1) initially, Gorgonzolan central bank puts 5,000,000guilders in circulation of the used the and (instead 1,000,000 guilders (2) example) commercial banks desire to hold reserves of 20 percent of deposits (instead of the 10 in the original example). As in the text, assume that percent used the public holds no Show the consolidated balance sheets of commercialbanks currency. Gorgonzolan

6. Redo

the example

of Gorgonzola

that assuming

following instances. (L05) deposits (compare to Table 20.3). b. After one round of loans (compare to Table 20.4). c. After the first deposit of guilders (compare to Table 20.5). d. After two rounds of loans and redeposits (compareto Table 20.6). e. What are the final values of bank reserves, loans, deposits, and for

each

a. After

of the the

initial

the

money

supply?

7. Answer

a. Bank

each of the

following

reservesare 100,the

reserve-deposit

is 0.25.

ratio

(LOS) questions. holds 200

public

Find deposits

in currency,

and the

money

and the desired supply.

money supply is 500 and currency held by the public equals bank reserves. The desired ratio is 0.25. Find currency held by the reserve-deposit

b. The

public

and

bank

reserves.

c. The money supply Bank reservesare

is 1,250,

100.Find

of which the

desired

250 is currency reserve-deposit

held

ratio.

by the

public.

ANSWERS

8.

than

more

reserves

bank

increases

bank reserves by $1, the money supply rises extra money created when the central bank $1 is called the money multiplier. (L06)

bank increases $1. The amount of

a central

When

by

TO

CONCEPT

by

is generally why the money multiplier greater than 1. In what special case would it equal 1? b. The initial is $1,000, of which $500 is currency held by the money supply in money The desired public. reserve-deposit ratio is 0.2. Find the increase in associated with increases bank reserves of and What $10. $1, $5, supply in this economy? is the money multiplier c. Find a general rule for calculating the money multiplier. d. Suppose the Fed wanted to reduce the money multiplier, because it perhaps believes that change would it more control over the give precise money action could the Fed take to achieve its goal? supply. What

a. Explain

trillion,

a.

10.

is $2

Ml

Find

velocity

b. Show

real GDP is $8 trillion, nominal GDP is $10 and M2 is $5 trillion. (L06) trillion, for Ml and for M2. the quantity equation holds for both Ml and M2.

a country in

9. Consider

that

which

the following

Consider

hypothetical data for

supply

Money

Velocity

Real GDP

a.

Find

the

2013

1,000 8

1,050

12,000

and 2013.What

is the

rate of

between 2012 and 2013 if

b.

What

c.

2013 is 1,100 instead of 1,050? What is the rate of inflation between 2013 is 1,100 and output is 2013

(LOG)

8

12,000

the price level for 2012 two years? is the rate of inflation

2013:

and

2012

the

and 2013 if the

2012

is 12,600?

\342\226\240

between

inflation

in

supply

money

money supply

in

\342\226\240

CHECKS

CONCEPT

TO

ANSWERS

20.1

2012

have risen. To find the interest rate, prices fell, interest rates must investors are willing to pay only for a bond that $960 today will of $70 plus the principal amount of pay back $1,070 (a coupon payment $1,000)in one year. To find the one-year return, divide $1,070by $960 to get 1.115. Thus, the interest rate must have risen to 11.5 percent. (L02)

Since

bond

note that

bond

20.2 Theshareof

will be worth $81.00 in one year\342\200\224the sum of its expected the expected dividend. At an interest rate of 4 percent, its = $77.88. At an interest value is $81.00/1.04 rate of 8 percent, the today stock's current value is $81.00/1.08 = 75.00.Recallfrom 20.3 that, Example when the interest rate is 6 percent,the value of a share of FortuneCookie.com future

stock

and

price

is $76.42.Sincehigher

interest

about

to rise

interest

are

rates

20.3 Table 20.6 shows

percent,they

will

out the

keep remaining

lower stock stock

values, newsthat

market

to fall.

sheet of

guilders. Since banks have

1,000,000

imply

banks after two rounds of are and 2,710,000 guilders deposits

balance

At that point,

redeposits.

and lend

the

rates

should causethe

271,000

a desired

guilders (10 729,000

guilders.

reserve-deposit

percent

of

Loans

deposits)

(L02)

lending

and

reserves

ratio of

are

10

as reserves

to farmers

are now

CHECKS

589

590

CHAPTER

20

MONEY,

PRICES,

AND

THE FINANCIAL SYSTEM

guilders.

2,439,000

the

Eventually

into the banks, redeposited guilders and reserves of 1,000,000 be

accompanying table.

guilders lent to of deposits

729,000

banks

the

giving

guilders. The balancesheetis

Assets Loans to

1,000,000guilders

farmers

2,439,000

supply.

20.4 Becausethe

in the

guilders

guilders

that assets equal liabilities.The money 3,439,000 guilders. Currency held in the banks money

shown

3,439,000

Deposits

Notice the

as

Liabilities

(= reserves)

Currency

the farmers will 3,439,000

equals

supply

as reserves

deposits,

does not count

or in

(LOS)

no currency, the money supply equals bank deposits, bank reserves divided by the reserve-deposit ratio equal If bank reserves are 1,000,000 and the reserve-deposit (Equation 20.1). ratio is 0.05,then deposits equal 20,000,000 guilders, which is also the money reserves are 2,000,000 guilders and the reserve-deposit ratio is supply. If bank to 0.10, then the money supply and depositsare again 20,000,000 equal or

holds

public

turn

in

which

2,000,000/0.10.

(LOS)

20.5 If the central bank

sells 50 shekels

guilders,

currency,

the

of the public by 50 level of 1,000 shekels, banks, reducingbank

the public

reserves divided by

is 0.2,

The

money

public plus 750 shekels purchase

200

has reduced

to \"call

shekels

50

shekels to

deposits that, loans,

to the desired from commercial

150 shekels.The desired

must

150

equal

to reduce reducing

the money supply from

shekels

in

their deposits, their loans held by the

equals 1,000 shekels in currency or 1,750 shekels. Thus, the deposits,

supply in

holding

currency

in\"

in exchange for in the hands

of currency

amount

withdraw

so ultimately

have

bonds

government

0.2, or 750 shekels.(Note

the commercial banks will outstanding.)

will

from

reserves

ratio

reserve-deposit

of

reduce the shekels. To restore their is to

effect

immediate

open-market

2,000 to 1,750shekels.(LOG)

SEVEN

PART I

W

A

City, California, boasts that the Bay world's best climate. Redwood City's and rainfall are similar to that of

in Redwood

sign

the

has

town annual

9

temperature

U.S. cities, so on what

other

to many

attractive A

city

Redwood

summers place to

so

is

City

over

little

and

the

in

average yearly temperature as the winters are freezing and the would not be nearly so pleasant a

hot,

unbearably

Redwood

in

varies

many

City's

in winter

comfortable

where

but

City,

it

Area

mean

same

the

with

Redwood

weather

people because

year, being almost equally summer.

do

basis

The

claim?

their

make

boosters

RUN

SHORT

THE

#

IN

ECONOMY

THE

live.

An economy.

a period

Over

But

standards.

growth rate welfare as well. around

crucial determinant of averageliving short-term fluctuations of the economy's its long-run matter for economic average

In

economic

variables,

we

will

policymakers

and

hardship

including

output,

the

discuss for

recessions,

dissatisfaction.

of short-term

causes

the

explore

as

or negative create may significant In Part 7 we will

of slow

periods

particular,

known

growth,

economic

the performance of the or more, the economy's

is the

of growth

rate average

applies to of decades

idea

analogous

fluctuations

in

key

unemployment, and inflation, and available to government

options the economy.

stabilizing

Chapter 21 provides some necessarybackground fluctuations by describing their study of short-term the historical record of fluctuations characteristics,reviewing and placing

Chapters

22 through

short-term

policymakers.

Chapter

22

shows

how fluctuations

may lead to short-run fluctuations That chapter also explains how relating

policies

used

to

in

for

our

the

U.S.

the 2007-2009 recessioninto context. 24, we developa frameworkforthe analysis fluctuations and the options available to

economy, of

economic

stabilize

to government

in

in

output

changes

spending and

spending

aggregate

and in

In

employment. fiscal

policy\342\200\224

taxation\342\200\224can

be

on spending and output. Chapter 23 focuses

592

CHAPTER

21

SHORT-TERM ECONOMIC

FLUCTUATIONS

policy, a second tool 24 incorporates inflation

monetary Chapter

sources of inflation Chapter policymaking

through

25 in

24.

and

policies

the practices detail, using all of

discusses more

the

for

output

stabilizing

into

that

the

analysis,

can be

and

employment.

discussing

both the

used to controlit.Finally,

and pitfalls of macroeconomic the tools developed in

Chapters

21

I

CHAPTER

21

Economic

Short-Term

Fluctuations LEARNING

OBJECTIVES

After reading this chapter, you should be able to: *

LOI

\342\200\236

the

Identify

four

phases

of the business cycle and

the

explain

characteristics

primary

and

of recessions >

expansions.

L02 Use potential and

output

the output gap

analyze an

construction

among

Unemployment

workers rises substantially

during

recessions.

L03

\"Home \"As

Jobs

Sales and Vanish,

New

York Times tell the

through

its worst

story: From 2007 to

economic downturn

incomes fell; thousands Depression of the 1930s.Average of Americans lost their jobs, their health insurance, and even their homes; and governments at all levels struggled to deal with tax collections falling colliding with increased demands for public services like unemployment benefits and health care. In the preceding part of the book, we discussed the factors that determine since

long-run determine

the

relatively

effect on

the

Great

those factors growth. Over the broad sweepof history, success of a society.Indeed,over a span of 30, 50, or 100years, in the rate of economicgrowth small differences can have an enormous the standard of living. But even though the economic average person's

economic economic

is

unemployment.

Plummet.\"

Surge, and StocksFall Again.\" \"Steep Slide in Economy as Unsold GoodsPileUp.\" \"Fed Plans to Inject Another $1 Trillion to Aid the Economy.\" in '09.\" \"World Bank Says GlobalEconomy Will Shrink

passed

it

to cyclical

related

\"Energy Prices

headlines from The These 2009, the U.S. economy

natural

of unemployment

and show how

Prices Continue to Plummet.\" Motel Rooms BecomeHome.\"

Markets

Stock

\"Global

cycle.

Define the rate

economy's

in the

position business

to

L04

law

Okun's

Apply

to analyze the relationship

output

the

between

gap

and

cyclical

unemployment.

L05

Discuss the basic

differencesbetween how

the

economy

operates in the run versus the

shor long

run.

CHAPTER 21

594

SHORT-TERM

FLUCTUATIONS

ECONOMIC

determinant of living (long-run economic conditions) is the ultimate in in the economic \"weather\" fluctuations economic (short-run changes A good long-run growth are also important. record is not much consolation

\"climate\" standards, conditions)

to a workerwho This

has

her job,

lost

chapter begins our

her health insurance, or even of

study

her

home.

in economic

fluctuations with some

short-term

activity,

as business cycles. We will start background on the and characteristics of these economic and a nd downs, place the current history ups recession in context. We next develop concepts that allow us to measure the severity of businesscycles. These concepts allow us to analyze short-run economic from activity known

commonly

in output to changes in unemployment. different perspectives, and to link fluctuations we introduce a verbal of a basic model of booms and recessions. Finally, description in the chapters that This will set the stage for the formal analysiswe will develop follow. Throughout this chapter those that we will connect the data we (and follow), examine and the theories we develop to the recession that began in late 2007.

EXPANSIONS 21.1 shows the path of real GDPin the United States since 1929. As you can Figure the of real GDP is not see, smooth; the bumps and wiggles growth path always in GDP, to short of faster or slower correspond periods growth.These fluctuations AND

RECESSIONS

with similar

along

known as business

business cyclesshort-term in GDP and

fluctuations

other

variables

recession

period

in

a (or contract/on) the economy

which

is growing at a rate below

significantly

normal

depression a particularly or protracted recession

21.1 Fluctuations in U.S. GDP, 1929-2010.

severe

fluctuations

in

variables

other

such

as unemployment,

cycles.

economy is growing at a rate significantly below normal is called a recessionor a contraction.An extremely severe or protracted recession is called a depression.You should be able to pick out the Great Depressionin Figure the sharp initial decline between 1929 and 1933. But you also 21.1, particularly can see that the U.S. economy was volatile in the mid-1970s and the early 1980s, in 1973-1975 with serious recessions and 1981-1982. A moderate recession in 1990-1991. occurred The next recession did not begin for another 10 years, the in without a recession U.S. was short and longest period history. It, too, relatively 2001 and ending eight months later.The beginning of the mild, beginning in March in which the

A period

recession

current

in

is clearly

2007

visible

in

Figure

21.1.

FIGURE

Real

GDP

smoothly

not grow has speedups

but

(expansions or slowdowns

Real

does

^13,000

co 12,000

=

2001

\342\200\224.

/

recession

11,000

'\342\226\240*

(recessions or

9,000 \302\243

depressions).

recession

2007-2009

14,000

and

booms)

are

10,000

1990-1991 recession

o

8,000

*

7000

1981-1982recession

5,000

Q

4,000

2

ff

1973-1975 recession\342\200\224,Jl/

\302\2516,000

&

,

/

\342\226\240

~~

-

3,000 _

Great

Depression

World

|\342\200\224

begins i

S 2,000

^^^

War

II

^^^

Real GDP

^^y^

/ 1,000:/11111111111111111 0 o lo o 11111111111111111111111111111111111111111111111111111111111111111111 LOOLOOLOOLOOLOOLOOLOo uo

c VI

cft

CO

O)

CO

O)

^-LOLOcocor^r^cocooooOi0)0)0)0)0)0)0)0)0)0)0)000

<*\342\226\240

O)

Year

Source:

Bureau of Economic

Analysis,

www.bea.gov.

RECESSIONS

AND

595

EXPANSIONS

21.1

TABLE

U.S. Recessions

Peak date

since 1929

1929

Aug.

May 1937

June

Feb. 1945

Oct. 1945

1938

II

May

Aug. 1957

Apr. 1958

8

Feb. 1961

10

I960

Apr.

1954

Dec. 1969

Nov.

Nov. 1973

Mar. 1975

Jan.

1980

July

July 1981 1990

July

10

II

1970

16 6

1980

Nov. 1982

16

Mar. 1991

8

Mar. 2001

Nov.

Dec. 2007

June 2009

8

2001

real

18

GDP

(%)

Duration of

subsequent expansion(months)

-28.8

19.0 3.9 5.9 5.5 6.8 6.7 5.9 8.5 7.6 9.7 7.5 5.8 10.0

8

July 1953

Change in

24.9

13

Oct. 1949

1948

Nov.

rate (%)

43

1933

Mar.

unemployment

(months)

(end)

(beginning)

Highest

Duration

date

Trough

50

-5.5

80

-8.5

37

-1.4

45

-1.2

39

-1.7 2.3

106

24

0.1

36

-I.I

58

-0.3

12

-2.1

92

-0.9

120

73

0.8

-4.1

Notes:Unemployment

rate is the annual rate. Peak and trough dates from the National Bureau of Economic Research.Unemployment real GDP data from Historical Statistics rate is the of the United States and the Economic Report of the President. Unemployment annual rate for the trough year or the subsequent year, whichever is higher. Change in annual real GDP is measured from the peak year to the trough year, except that the entry for the 1945 recession is the 1945-1946 change in real GDP, the entry for the 1980 recessionis the 1979-1980 and the 2007 entry is for 2007-2009. change, the entry for 2001 is the 2000-2001 change, and

Sources: Peak and trough United States and Economic

dates, National Bureau of Report of the President.

Economic

Research;

unemployment

and real GDP, Historical

of the

Statistics

of a recession, often cited by reporters, is a period for at least two consecutive This definition is not quarters. a bad rule of thumb, as real GDP usually does fall during recessions. However, economists would real GDP growth is well many argue that periods in which below normal, not should be counted as recessions. Indeed, though actually negative, real GDP fell in only one quarter during the 2001 recession.Another with problem on GDP for recessions is that GDP data can be relying figures dating substantially sometimes to determine revised, years after the fact. In practice, when trying whether a recession is in progress, economists look at a variety of economicdata, An

during which

not

just

informal

definition

real

GDP falls

GDP.

lists the beginning and endingdates of U.S. recessions since 1929, in months) as well as the duration of each. The table also gives the (length, highest unemployment rate recorded each recession and the during percentage in real GDP. (Ignore the last column of the table for now.) The beginning change of a recession is called the peak becauseit represents the high point of economic peak the beginning to a downturn. The end of a w hich marks the low recession; the high recession, activity prior point of economic activity to a is called the The dates of economic activity prior recovery, trough. peaks and troughs Bureau of downturn reported in Table 21.1 were determined by the National Economic Research (NBER), a nonprofit that has been a major organization Table 21.1

sourceof research on

short-term

1920. The NBERis not a

newsmedia and and

troughs.

the

economic

government

government

as

fluctuations but it is

since its founding in

agency, usually treated by the the \"official\" arbiter of the dates of peaks

trough the low activity

the

point prior

end

of a point prior

of to a

of a recession;

of economic to a recovery

596

21

CHAPTER

FLUCTUATIONS

SHORT-TERM ECONOMIC

\"Please stand by for a series of tones. The first indicates the end the the second indicates recession, official of prosperity, and the third the return of the recession.\"

Table 21.1 shows

1929, by far the longest and most severe the Great Depression. to the NBER, the According in two months before the famous stockmarket 1929, Depression began August crashin October and lasted until March 1933. Between 1933 and 1937, 1929, the economygrew fairly rapidly, so technically the period was not a recession, remained although unemployment very high at close to 20 percentof the recession

the

in

workforce.

In

United

since

that,

States was

the nation

1937-1938,

economic recovery from World War II at the end of reflecting

21.1),

Figure equipment

and

was

hit

by

another

did

the 1941.

Depression The economy

significant

not come until boomed from

recession.

U.S.

entry

Full

into

1941 to 1945 (see

wartime production of military

the enormous

supplies.

contrast to the 1930s, U.S.recessions from the 1940s the through 2000s were between 6 and 16 months from to short, early relatively peak As Table 21.1 the two most severe recessions to shows, 2007, trough. prior those of 1973-1975and 1981-1982, lasted 16 months as opposed to the 43-monthduration of the Great Depression. The 2007-2009 recession was the In sharp

longestsince

World

from peak to

War

II,

lasting

trough. Unemployment

rates

quite high by today's standards, but rate

unemployment

the

is growing

economy

prorate

significantly

boom protracted

in which

a period

expansion

above

a particularly expansion

at a normal

strong

and

recorded

18 months

during

they

with

during were low

the Great

GDP

these

4.1 percent falling three recessions were

compared

to the

25 percent

Depression.

in which the economy is The opposite of a recessionis an expansion\342\200\224a period A at a rate that is above normal. growing significantly particularly strong and tracted expansion is calleda boom.In the United States, strong expansions occurred and 1991-2001, with 1933-1937, 1961-1969, 1982-1990, during 1995-2000 On average, ex(see Figure 21.1). exceptionally strong growth during have been much than recessions. The final column of Table 21.1 pansions longer

in months, of U.S. expansionssince 1929.As you can see in 1961-1969 expansionlasted 106 months; the 1982-1990 expansion, 92 months.The longestexpansionof all began in March 1991, at the trough of the 1990-1991 recession. This expansion lasted 120 months, a full 10 years, until a new recession began in March 2001. shows

the

duration,

the table, the

RECESSIONS AND

we know

do

How

The Business

a recession

began

EXAMPLE 21.1

Recession

2007?

December

of the National Bureau in December 2007. What

Cycle Dating Committee

determined that choose

recession began in

that a

2007

the

Calling

of EconomicResearch led

the

to

committee

date?

that

within the National Cycle Dating Committee is the group Research that determines recession dates.The determination of whether and when a recession has begun involves intensive statistical analysis, mixed in with a significant amount of human The committee judgment. typically relies heavily on a small set of statistical indicators that measure the overall of the economy. It prefers indicators that are available because strength monthly about they are available quickly and may provide relatively precise information the timing of peaks and troughs. Four of the most indicators used by the important

Business

The

Bureau

Economic

of

are:

committee \342\226\240 Industrial

\342\226\240 Nonfarm

(the number

employment

received

income

after-tax

Securitypayments. Each of these indicators measures movements tend to coincidewith

factories and mines.

by

of people at

overall

aspect of

the

like Social

transfers

economy.

in the

movements

of agriculture).

outside

work

excluding

households,

a different the

trade.

Because

economy,

they

their are

indicators.

coincident

called

measures the output of

wholesale trade, and retail

in manufacturing,

sales

\342\226\240 Total

\342\226\240 Real

which

production,

more or less together. During the Normally the coincidentindicatorsmove current recession,two of the indicators showed the same pattern: employment and after-tax income. Both of these measurespeaked in December 2007. Industrial production was the next to peak, in January 2008. Real manufacturing and wholesale/retail salespeakedlast, in June 2008. Thus the business cycle peak was

easy

relatively

SOME

to identify.

FACTS ABOUT SHORT-TERM

ECONOMICFLUCTUATIONS Table

and

21.1

Figure

21.1 show only

have beena feature expansion the late eighteenth century. Karl Marx and recession which

fluctuations,

of 1848. In the fluctuations for

more

they

called

are

felt

been

throughout

the economy.

global impact. For instance, the

Great

are

not

limited

Indeed, Depression

the

to a few

to these

short-term

industries or regions may have

largest

fluctuations

of the

1930s affected nearly

alsowere economies, and the 1973-1975 and 1981-1982 recessions felt outside the United States.The 2007-2009 recession w as worldwide widely felt in 2011 and beyond. scope, and its effects are still being which shows 21.2, Figure growth rates of real GDPover the period 2002-2010 for Canada, Germany,Japan,the United and the United States, illustrates Kingdom, in this You can see that all five countries the point. sample plunged into a recession the

of

Manifesto

Communist

their

studying

a century.

periods

since at least

Engels referred

Friedrich

and

United States,economistshave

than

economies

industrial

of

\"commercial crises,\" in

Expansions and recessionsusually but

twentieth-century data, but

EXPANSIONS

a

all

world's

in

597

598

CHAPTER21

FLUCTUATIONS

ECONOMIC

SHORT-TERM

Germany

4.00

3.00

6

Unjted

/

I

Canada

S{a{es

2.00^c:

Q

X

1.00 0

-1.00

Japan

United

-2.00

Kingdom

-3.00

-4.00

v

-5.00

I -6.00 -7.00 CM

I CO

O

O

O

o

CM

CM

CM

O

CM

CD

O

o

O

o

o

CM

CM

o

CO

o

o

o

CM

CM

o

o

o

o

CM

Year

21.2

FIGURE

Real GDP Growth Annual

rates

growth

countries

Five five

recession

into

fell

in

for

Major major

in 2008 and

Economic Report of

Source:

Countries,

the

2002-2010. countries show

industrialized

remained there February

President,

into

that

all of

these

2009.

2011, Table B112,www.gpoaccess.

gov/eop.

in 2008 and sunk deeper there in 2009. ended for all of these economiessometime

is a key

Unemployment

unemployment rate typically

indicator rises

The in of

sharply

2010

data suggest

that

the

recession

2009. economic

short-term

during

recessions and

fluctuations.

The

recovers (although

17) shows the U.S. expansions. Figure 17.8 (in Chapter rate since 1960. You should be ableto the recessions unemployment identify by noting the sharp peaks in the unemployment rate in those years. Recall from 17 Chapter that the part of unemployment that is associated with recessions is called cyclical more

slowly)

during

in unemployment, increase labor market conditions recessions. For generally during example, during recessions, real wages more workers are less grow slowly, likely to receive promotionsor bonuses,and new entrants to the labor force (such as have a much tougher graduates) this

Beyond

unemployment.

worsen

time

college

attractive

finding

jobs.

durable Generally, industries that produce goods such as cars, houses,and capital are more affected than others recessions and booms. In contrast, equipment by industries that services and nondurable like food are much less sensitive to provide goods short-term fluctuations. an automobile worker or a construction worker is far Thus, more likely to losehis or her job in a recession than is a barber or a baker. Like follows a typical pattern in recessionsand unemployment, inflation it is not so defined. 21.3 shows the U.S. expansions, though sharply Figure in inflation rate since the of recession are indicated 1960; figure, periods by shaded

vertical bars.As in

can see, recessions tend to be followed soon you of inflation. For example, the recession of 1981-1982 in inflation. Furthermore, many\342\200\224though reduction not

rate

the

a sharp

behavior fully

been

have

recessions

in

of

preceded

inflation

Chapters

during

24 and

25.

by increases expansions

in

inflation,

as Figure

and recessions will

by a decline was followed by

after

all\342\200\224postwar

The be discussedmore 21.3 shows.

RECESSIONS

U.S.

14.00

recessionare indicated

^ 8.00 4.00

declined

that

inflation

recessionsof

1990-1991,2001,and

0.00

oc\\i^-(ocooc\\i<^-

O

CM ^\" CD CO O O O O toCM Oo oooo CM CM CM CM CM

COCOCOCOCOO)0)0)0)0)

0)0)0)0)0)0)0)0)0)0)0)0)0)0)0)0)0)0)0)0)

O

Year

Source:Economic

of the

Report

President,February

2010,

Table B-64. www.gpoaccess.gov/eop/.

SOME FACTS ABOUT SHORT-TERM

RECAP

ECONOMIC

FLUCTUATIONS

is a

A recession An

period in

which

is a

more slowly than

is growing

output

or boom,

expansion,

more quickly than normal.

period in

which

The sharpest in

occurred

1973-1975,

occurred

recessions

Depression in

length

Expansions and affecting

also

are

expansions) to predict.

difficult

(and

widespread

sometimes

mild

are

global)

and industries.

regions

Unemployment rises sharply during

initial

the

recessions

and

(recessions thus

recessionshave

most

(which is called

and 2007-2009. Two relatively and 2001.

Short-term economicfluctuations and

its end

expansion)

Severe

1929-1933.

1981-1982, in 1990-1991

and severity,

and

United Stateswas

history of the

in the

recession

of the Great

is growing

output

The beginning of a recessionis calledthe peak, corresponds to the beginningof the subsequent the trough.

a recession

during

and falls, usually

more

an expansion.

Durable goods industries are more affected than other industries. Servicesand nondurable

sensitiveto ups and

downs

Recessions tend to

be followed

preceded

Note

2007-2009, and rose prior to many of those recessions.

2.00

slowly,

bars.

1960-1961, 1969-1970, 1980, 1973-1975, 1981-1982,

6.00

impacts,

by

the shaded vertical

following the

#o

in irregular

1960-2010.

since I960 is measured by the change in the CPI, and periods of

Sho.oo

phase

21.3

Inflation,

U.S.inflation

Inflation

12.00

normal.

599

EXPANSIONS

FIGURE

16.00

|

AND

by an increase

in the

in

inflation.

by

expansions goods

and recessions industries are less

economy. by

a decline

in inflation

and are

often

CHAPTER 21

600

SHORT-TERM

FLUCTUATIONS

ECONOMIC

CYCLICAL

AND

GAPS

OUTPUT

UNEMPLOYMENT a particular recessionor boom is \"big\" or \"small\"? The to both economistswho study business cycles and policymakers who must formulate to economic fluctuations. responses or expansion is one in which and the unemployment Intuitively, a \"big\" recession output rate deviate from their normal or trend levels.In this section we will significantly to be more precise about this idea the concept of the output attempt by introducing is from its normal level at a particular time. We gap, which measures how far output also will revisit the idea of cyclical or the deviation of unemployment unemployment, from its normal level. Finally, we will examine how these two concepts are related. tell whether

we

can

How

answer to

this

OUTPUT

POTENTIAL

The conceptof potent/al

V* (or

output,

expansions

potent/a/ GDP or fullemployment maximum

of output economy

output)

amount

sustainable

(real GDP)that can produce

Note

can produce. an

sustainable amount

periods These greater-than-normal of

time,

(real GDP)

output

simply the

at

economy of

rates for limited its potential output.

greater-than-normal

temporarily

an

that

amount

maximum

exceed

cannot be sustainedindefinitely, cannot work overtime every weekand machinery occasionally utilization

workers

because

partly

output

potential

of

is not

and labor can be utilized capital a country's actual output can

Because

output.

that

for thinking about GDP or full-employment

point

starting

output, also called potential

Potential

output, is the maximum the

is a useful

output

potential

recessions.

and

is important

question

however,

rates,

down for maintenanceand repairs. is not a fixed number but grows over time, reflecting increases in output both the amounts of available capital and labor and their 21.4 productivity. Figure for the United States from 1949to 2010. this presents potential output Compare graph with the data on actual real GDP shown in Figure 21.1. Notice that is potential output in the economy's much smoother than actual output; this reflects the fact that increases as human (such productive capacity are due to factors capital) that grow relatively over time. Potential therefore smoothly output grows relatively smoothly as well. does a nation's actual sometimes and Why output grow quickly sometimes slowly, as shown for the United States in Figure 21.1? there are two Logically, be shut

must

Potential

FIGURE

21.4

U.S. Potential

1949-2010. Potential

output

grows more real GDP.

smoothly than Compare these Figure 21.1.

16,000

Output,

data

| 14,000 rf

12,000

o

10,000

with \342\226\240n

o oo (2005 DP

o

oo

u rt

4,000

$

2,000

0

0

c c

i

i

i

i

i

i

1954

1959

1964

1969

1974

r^

i

i

i

i

i

i

1989

1994

1999

2004

2009

co

Year Source:

Federal Reserve Bank

of St. Louis

FRED

database,

http://research.stlouisfed.org/fred2.

OUTPUT GAPS

AND

CYCLICAL

601

UNEMPLOYMENT

possibilities: First, changes in the rate of output growth may reflect changes in the rate at which the country's potential output is increasing. For example, unfavorable weather conditions,such as a severe drought, would reduce the rate of potential output growth in an agricultural economy, and a decline in the rate of technological innovation might reduce the rate of potential output growth in an industrial the assumption that the country is using its resources at normal rates,so economy. Under that actual output equals potential output, a significant slowdown in potential would tend to result in recession. new technologies, increased output growth Similarly, in or a that swells the labor force could capital investment, surge immigration in potential output, and hence an economic produce unusually brisk growth boom. in the rate of of are Undoubtedly, changes growth potential output part of the In for and recessions. the United for States, explanation expansions example,the in part by new economic boom of the second half of the 1990s was propelled information such as the Internet. And the severe slowdown in Japan during technologies the decade of the 1990s reflectedin part a reduction in the growth of potential output, in from factors such as slower the labor force and capital arising growth Japanese in the growth stock.When changes in the rate of GDP growth reflect rate of changes in the a re those discussed 18. potential output, appropriate policy responses Chapter In particular, when a recessionresults from in potential output, the slowing growth government's best responseis to try to promote saving, investment, technological human and other activities that support innovation, formation, capital growth. THE

OUTPUT

GAP

economicfluctuations is that actual For potential output. example,potential output may be but for some reason the and labor resources growing normally, economy's capital may not be fully utilized, so that actual is significantly below the level of potential output This low level of output, from underutilization of economic resources, output. resulting would generally be interpreted as a recession. Alternatively, and labor may capital be working much harder than normal\342\200\224firms workers on overtime, for may put that actual a boom. example\342\200\224so output expands beyond potential output, creating At any point in time, the difference between potential and actual output output is called the output gap. Unfortunately, we cannot measure the output gap by in time the difference between real GDP and potential output at a point simply taking since both are growing over time. For instance, a difference of $100 billion between actual and potential GDP of $2 trillion output is large compared to potential in the size of the but small (roughly potential output early 1950s), comparedto in $15trillion of potential output (about the level of potential 2009.) output To accurately measure the output gap for a particular year, we needto difference between actual and potential GDPwith the economy's compare the potential GDP in that year. We therefore calculate the output gap as a percentageof potentialoutput. let Y* be the symbol for potential at a point in time, Specifically, output and Y will continue to stand for real GDP at a point in time. We can express the output gap as follows: A

second

output does

possible explanation not always equal

for short-term

Output gap

X

being utilized at above normal a rapidly. Thus, positive output gap is referred to are

the difference

gap

between

the

actual

economy's

output and its potential output, relative to potential output, at in time point

100%.

21.5 shows the output for the U.S. from 1949 to 2010.You'll notice Figure gap that sometimes the output is for the is gap negative; example, output gap quite large in the early 1980s and in the late 2000s. This reflects the severerecessions the U.S. A from 1981 to 1983 and from 2007 to 2010. economy experienced negative output gap is a situation in which actual is below and resources are not output potential being fully so it is called a recessionarygap.Similarly, when actual utilized, output is above potential,resources

output

rates and the economy as an expansionary gap.

is expanding

gap a

recessionary output potential output

gap

expansionary

output actual

negative

gap, which occurs output exceeds (Y < Y*)

gap,

which

output

potential

output

when actual

a positive

when than

occurs

is higher (Y >

Y*)

a

602

CHAPTER

21

FLUCTUATIONS

SHORT-TERM ECONOMIC

FIGURE 21.5

The Output

Gap

in the

U.S., 1949-2010.

Source:Authors'

Policymakers

problems. It is not economy:

there

When

utilized,

and

using data from

calculations

generally view both to

difficult

is a

and 21.4.

recessionarygaps

recessionary gap, capital

and

and

for

the

are not being

resources

labor

are belowmaximum

as

gaps

expansionary

gap is bad news

a recessionary

see why

and employment

output

21.1

Figures

fully

levels.

sustainable

an expansionary gap is unsustainable, for a more subtle reason: What's after all, problem by policymakers wrong, with having higher output and employment, even if it is temporary? A prolonged In addition

to the fact that

it is

considereda

expansionary gap is

prices.Thus,

an

gap

expansionary

when

because,

problematic

products that significantly exceeds their

faced

sustainable

in

for their

demand

tend to

firms

capacity,

results

typically

a

with

increased

raise

which

inflation,

in the longer run. (We discuss the genesis reduces the efficiency of the economy of in more detail in Chapter inflation 25.) it is recessionary or Thus, whenever an output gap exists, whether have an incentive to to eliminate the actual expansionary, policymakers try gap by returning In to the next three we will discuss both how output potential. chapters output have for stabilizing the economy\342\200\224that gaps arise and the tools that policymakers actual output into line with potential is, bringing output.

THE NATURAL RATE OF

UNEMPLOYMENTAND

CYCLICAL

UNEMPLOYMENT

Whether actual

recessions

output

least grows are

Efficiency

O

falls

arise because below potential,

more slowly),

particularly

implying

frustrating

of slower growth they

bring

reduced

bad

in

potential

times. In either

output

or because

case, output

living standards. Recessionary

for policymakers,

however, becausethey

falls

gaps

output

imply

(or at

that

the

economy has the capacityto producemore,but for some reason available resources are in that they not being fully utilized. Recessionary gaps violate the Efficiency Principle reduce the total economic the worse off. unnecessarily pie, making typical person An indicator of the low utilization of resources recessions is important during the unemployment rate. In general, a high unemployment rate means that labor

NATURAL

THE

RATE OF

resources are not being fully utilized, so that output has fallen belowpotential (a the same an low unemployment rate suggests recessionary gap). By logic, unusually that labor is being utilized at an unsustainably actual high rate, so that output exceeds potential output (an expansionary gap). To better understand the relationship between the output gap and unemployment, recall from Chapter 17 the three broad types of unemployment: frictional structural and cyclical unemployment. Frictional unemployment unemployment, unemployment, is the short-term with the matching of workersand unemployment that is associated Some amount of frictional is jobs. unemployment necessaryfor the labor market to in function a is the efficiently dynamic, changing economy. Structural unemployment and chronic that occurs even when the is long-term unemployment economy producing at its normal rate. Structural unemployment often resultswhen workers' skills are outmoded and do not meet the needs of employers\342\200\224so, for example, steelworkers may become structurally as the steel industry into a long-term decline, unemployed goes unlessthose workerscan retrain to find jobs in growing industries. Finally, cyclical is the extra that occurs unemployment unemployment during periods of recession. Unlikecyclical which is present only during recessions, unemployment, frictional and structural unemployment unemployment are always presentin the labor even when the is Economists call the part of market, economy operating normally. the total unemployment rate that is attributable to frictional and structural the natural rate of unemployment. Put another way, the natural rate of unemployment is the rate that when unemployment unemployment prevails cyclical unemployment is zero, so that the economy has neither a recessionary nor an expansionary as u*. output gap. We will denote the natural rate of unemployment which is the difference between the total Cyclical unemployment, unemployment u is the actual rate and the natural rate, can thus be expressed as u \342\200\224 where z/*, In a recession, rate and u* denotes the natural rate of unemployment. unemployment u exceeds the natural unemployment rate u'% so the actual unemployment rate u \342\200\224 cyclicalunemployment, When the economy experiencesan u*, is positive. in the actual rate is lower than the natural so contrast, rate, expansionary gap, unemployment that cyclical unemployment is negative.Negative cyclical unemployment corresponds to a situation in which labor is being used at an unsustainably level, so that high actual unemployment has dipped below its usual frictional and structural levels. The the

was

Why

2000s

late

rate of

natural

than

in

late

the

Natural

unemployment so much

Rate

of Unemployment

lower

in the

U.S.

1970s?

to the CongressionalBudget Office, which estimates the regularly in the United States, the natural rate fell steadily from 6.3 percent force in 1979 to about 4.8 percentin 2007.1 Some 4 that remained close to for several economists, noting unemployment percent years around the turn of the millennium, have argued for an even lower natural rate, was the U.S. natural rate of unemployment so perhaps as low as 4.5 percent. Why in the late 1970s? much lower in the late 2000s than

According natural rate

of unemployment of the labor

The natural rate frictional

of

unemployment

reduced

unemployment,

structural

may

have

fallen because

unemployment,

explaindeclinesin both types of is based on the changingage structure promising suggestion ideas have

been advanced to

force.2 The

average

age

of U.S.

workers

is rising, reflecting

A

variety

unemployment.

the

Fiscal Years 2008 to Office, The Budget and Outlook: Budget online at www.cbo.gov. 2SeeRobert Rate So Much Lower?\" Shinier, \"Why Is the U.S. Unemployment 1998. eds., NBER Macroeconomics Annual, J. Rotemberg, Congressional

of reduced

or both. of

the

aging

of

One

U.S. labor of the baby

2017, January

2008,

available

in B.

rate

natural

u*

the

part

of unemployment, of the total rate

unemployment

attributable to structural equivalently,

that is

Bernanke and

and

frictional

unemployment; the

unemployment

rate that prevails when unemployment

the economy

is zero, has

recessionary nor expansionary

cyclical

so that

neither an

output

EXAMPLE 21.2

the

during

603

CYCLICAL UNEMPLOYMENT

AND

UNEMPLOYMENT

gap

a

CHAPTER 21

604

SHORT-TERM

FLUCTUATIONS

ECONOMIC

force aged generation. Indeed, over the past 25 years, the share of the labor 16-24 has fallen from about 25 percent to about 15 percent.Sinceyounger workersare more of the labor prone to unemployment than older workers,the aging force may help to explain the overall decline in unemployment.

boom

are young workers more likely to be unemployed? in their twenties, older workersare much

Why

workers

teenagers and

term, stable jobs. In time

Because

they

frictional workers, so

long-

hold short-term jobs, career, or because particular

to a they are not ready to commit labor market is interrupted by schooling or military service. more workersaremore than others often, younger change jobs prone also have fewer on than older skills, unemployment. They average,

because

perhaps their

likely

to hold

tend to

workers

younger

contrast,

to

Compared more

in the

more structural

experience

may

they

As

unemployment.

declines. natural rate of

gain experience, however, Another possible explanation for the declining that labor markets have becomemore efficient at matching

reducing both

of unemployment

risk

their

workers

to

age and

workers

unemployment

is

with jobs, thereby

and structural For example, agencies that unemployment. in the United States in have become much more arrange temporary help commonplace recent the these make are intended to be years. Although placements agencies often become when an and worker discover that a temporary, they permanent employer match has been made. Online which allow workers to particularly good job services, search for jobs nationally and even internationally, also are becoming increasingly in the time must and by creating important. By reducing people spend unemployment more lasting matches between workers and jobs,temporary online job help agencies, and similar innovations have reduced the natural rate of services, may unemployment.3 frictional

LAW

OKUN'S

observedthat

We have already

is positive cyclical unemployment gap, negative when there is an expansionary A more quantitative gap, and zero when there is no output gap. relationship between and the output gap is given by a rule of thumb called cyclical unemployment Okun's law, after Arthur one of President Kennedy's chief economic Okun, advisers.According to Okun's of cyclical law, each extra percentagepoint in the output gap, unemployment is associated with about a 2 percentagepoint increase measured in relation to potential output. So, for example,if cyclical unemployment increases from 1 percent to 2 percentof the labor force, the recessionary gap will increase from 2 percent to 4 percentof potential GDP. We can also express Okun's law as an equation. Using our expression for the output gap, we have

when the

Okun's

law

each

extra

percentage point of cyclical unemployment

is associated

with about a 2 percentage in the output increase point in relation to gap, measured potential

output

has

economy

by

X

The following examplefurther EXAMPLE

21.3

definition,

a recessionary

=

100%

-2

Okun's

illustrates

Okun's Law and the OutputGapin

the

How is Okun'slaw

data?

The table belowpresents unemployment economy

3For \"The

in

rate,

four

and

selected

a detailed

High-Pressure (1999), pp. 1-88.

to real-world

applied data

potential

(u

X

- u*

Law.

U.S.

Economy

on the actual unemployment rate, the GDP (in billions of 2005 dollars) for

natural

the

U.S.

years.

analysis of

factors

U.S. Labor

affecting

Market of

the natural

rate, see Lawrence

the

Brookings

1990s,\"

Katz and Alan Krueger, 1 Papers on Economic Activity

OKUN'S

Year

u

1995 2000

2005

2010

y*

u*

5.6%

5.3%

4.0

5.0

10,880.7

5.1 9.6

5.0

12,576.3

5.2

14,017.1

9,216.4

was 0.3 percent of the labor force u'\\ cyclical unemployment, u Okun's the times that (5.6% 5.3%). Applying law, output gap for 1995was \342\200\2242 or \342\200\2240.6 of Potential was estimated to percentage, percent potential output. output be $9,216.4billion, so the value of the output gap for that was billion. $55.3 year 2000 was near the end of an expansion and the actual unemployment rate was below the natural rate. Specifically,cyclical was \342\200\2241.0 unemployment percent; using Okun's law this means that the output gap was 2.0 percent and the U.S. economy's In

\342\200\224

1995,

\342\200\224

more than it typically would have beenin 2000. 2010 give a senseof the depth of the most recent recession. Cyclical rose to 4.4 percent, implying an output Thus, unemployment gap of \342\200\2248.8 percent. to Okun's about billion less than $616.8 law, the U.S. economywas producing according it would had all resources been There were about 309 produce fully employed. in the United States in 2010, million people so Okun's law implies that average incomes in could have been almost 2010\342\200\224about $2,000 higher (i.e., per capita GDP) $8,000 for a family of four\342\200\224had the economy not been operating below potential. Thus and cyclical have significant costs, a conclusion that output gaps unemployment the concern that the and have about recessions. justifies public policymakers

output was

first

the

21.1

CHECK

CONCEPT In

$217.6 billion

data for

The

of 201 I, the

quarter

CongressionalBudget 5.2 percent. By what first

quarter

U.S.unemployment that the

estimated

Office

did actual

percentage

GDP

was

rate

of unemployment

from

GDP

differ

The

9.8 percent.

rate natural

potential

was the

in

of 201 I?

The Federal Reserve's Slowingof the U.S.Economy the Federal Reserve act to slow

Why did As

in Chapter

noted

that

change

U.S. economy.Why economy

in

20, monetary

the level

1999

the

Federal

money

estimates.

rates

risk

of future

In 1997 typically caused

offsetby

of the

performance the

productivity

the

United

States fell

in 1997,

inflation.

and 1998the by rapidly

in

negative according to Congressional Okun's law indicates that growing negative cyclical it an signal an increasing expansionary gap, and with

sometime

unemployment increased

Reserve\342\200\224actions

and 2000?

becoming

Office

Budget

the

and 2000?

measures to slowdown

Throughout the 1990s, cyclical unemployment dramatically,

Federal

the

supply\342\200\224affect

Reserve take

in 1999

economy

policy decisionsof

of the nation's

did

the

down

EXAMPLE

Federal

Reserve

argued

expanding output gains and international

and

that the

falling

competition,

pressures

inflationary

unemployment leaving

rates were being inflation

rates

lower

than expected. Becauseinflation remained low during this period\342\200\224despite a small but Federal Reserve did little to eliminate the growing expansionary gap\342\200\224the gap. as the actual 1999 However, unemployment rate continued to fall throughout and early 2000, the expansionarygap continued to widen, the Federal Reserve causing

21.4

LAW

605

606

CHAPTER

21

FLUCTUATIONS

SHORT-TERM ECONOMIC

to grow

imbalance between actual

concerned about the growing GDP and the threat of potential increasinginflation. took actions in 1999 and 2000 to slow the growth

potential

how the

increasingly

into

closer

output

do this).

can

Fed

and restrain inflation economy\"4 stalled and fell into economy

and take policy

Potential

give

2000.

By early

is the

the

in

2001, however,

U.S.

the

to reverse course the growing recessionary gap.

at eliminating

Reserve

Federal

UNEMPLOYMENT

CYCLICAL

AND

overall balance

to \"promote

helped

throughout

OUTPUT GAPS

RECAP

will

recession, leading the

aimed

measures

(we

alignment

The Fed's actions

and

the Federal Reserve response, of output and actual and bring more details in Chapter 23 about In

amount of output (real The output gap is the difference between the economy's actual output and its potential output, relative to potential output, at a point in time. When actual output is below actual potential, the resulting output gap is called a recessionarygap.When is above potential, the differenceis calledan expansionary output gap. A while an expansionary recessionary gap reflectsa wasteof resources, gap threatens to ignite inflation; have an incentive to try hence, policymakers to eliminate both types of output gaps.

output

GDP) that

The

an

can produce.

u* is the sum

of unemployment

rate

natural

structural

sustainable

maximum

economy

rates. It is

unemployment

observed when

the

the

is operating

economy

of

rate

at a

of

that is

unemployment

normal level,

u \342\200\224 z/*, is the difference between the actual the natural rate of unemployment u*. Cyclical

unemployment, u and rate

Cyclical unemployment

is positive when there is a recessionary unemployment gap,negative is an expansionary gap, and zero when there is no output

there

Okun's law relatescyclical to this rule of thumb, each

unemployment

percentage

about a

with

associated

is

unemployment

output gap, measured in

causes

discussed

possible

First, growth changes technological

output

in

progress.

Second,

may be higher output

recessionary

gaps

in

cyclical

2 percentagepoint output.

OCCUR?

FLUCTUATIONS

itself

of available even

or lower than

may slow

capital

if potential potential

and

output

real

can

vary,

4Testimonyof monetary 17, 2000.

and

we

section, GDP

growth.

down or speedup, reflecting labor

and

in

is growing

output\342\200\224that

is,

the

pace

of actual

normally,

or

expansionary

may develop.

18, we discussedsomeof the reasons that growth in the options that policymakers have for stimulating potential output. But we have not yet addressed the question of how In Chapter

output

in the

increase

PARABLE

output

potential

growth rates

in the

when

gap.

gap. According

the output

point increase

of recession and expansion?In the preceding reasons for slowdowns and speedupsin

periods

two

and

to potential

relation

DO SHORT-TERM

A PREVIEW AND A What

no

with

gap.

output

WHY

and

frictional

the

potential

growth output

in gaps

Chairman Alan Greenspan, The Federal Reserve's semiannual report on the economy and Committee on Banking and Financial Services, U.S. House of Representatives, February online at www.federalreserve.gov/boarddocs/hh/2000/February/Testimony.htm.

policy, Available

WHY DO

OCCUR?

A

or what policymakers should do in response. The causes and cures will be a of the next three Here is a brief output gaps major topic chapters. preview of the main conclusions of those chapters:

of

can

1.

FLUCTUATIONS

SHORT-TERM

arise

in which

a world

In

demanded

and

supplied

However, for many immediately is not

to balance prices adjusted immediately for all goods and services, output gaps and services, the assumption that goods

realistic.Instead,many

firms

adjust

the quantities would not exist. will

prices

the prices

adjust

of their

In particular, rather than changing prices with every in demand, firms tend to adjust to changesin demand in the short run the quantity of output they produce and sell. This of by varying type behavior is known as \"meeting the demand\" at a preset price. output

periodically.

only

variation

2. Becausein

changes

preset prices, affect

to meet the demand for

is low

spending

for

their

decide to

customers

that

amount

the

in

total

When

output.

firms tend

run

short

the

some

spend

will

may fall

output

reason,

at

output

below potential output; conversely, when spendingis high, output rise may above potential output. In other words, changesin economywide spending are the primary cause of output gaps.Thus, government can help to policies eliminate output gaps by influencing total For example, the spending. government can affect total spending directly simply by changing its own level of

purchases.

3. Although

firms tend to meet demand in

to do

so indefinitely.

output,

firms

If

will eventually

demand exceedspotential aggressively,

prices

(a recessionary reducing

prices,

adjust (an

output

spurring

gap), firms

short

the

demand

customer

their

run, they to

prices

expansionary

be willing

not

will

to differ from

continues

eliminate

potential

output

gap), firms

will

gaps. If their

raise

inflation. If demand falls below potential will raise their prices less aggressivelyor

output even

cut

inflation.

4. Over the longer run,

bring production

price changesby

firms

eliminate

any

output

gap and

with the

economy's potential output. Thus, the sense that it operates to eliminate economy output in over time. Because of this the long run actual gaps self-correcting tendency, is determined output equals potential output, so that output by the economy's In rather than the rate of the run, total productive capacity by spending. long influences the rate of inflation. spending only back

into

line

is \"self-correcting\"

in the

will become clearer as we proceedthrough the next chapters. Before the details of the analysis, though, let's consideran example that illustrates the links between spending and output in the short and long run. You can refer backto this example to understand better (and this entire section) in order the material in the next three chapters.

These

ideas

into

plunging

AL'S ICE

CREAM STORE: ATALE

SHORT-RUN

FLUCTUATIONS

cream store producesgourmet

ABOUT

ice cream on the premises and sells it determines the amount of ice creamthat Al directly produces on or of the productive capacity, potentialoutput, is one factor. A l's of ice cream shop important Specifically, potential output and labor depends on the amount of capital (number of ice creammakers) of that he and on the of that (number workers) employs, productivity capital and labor.Although Al's potential output usually changes rather slowly, on if an ice cream maker breaks occasion it can fluctuate significantly\342\200\224for example,

Al's ice

to

down

or

the public. What a daily basis? The

Al contracts

the flu.

PREVIEW

AND

A

PARABLE

607

608

CHAPTER

21

FLUCTUATIONS

SHORT-TERM ECONOMIC

The main source of day-to-day variations in Al's ice cream production, however, is not changes in potential but fluctuations in the demand for ice cream by output the public. Some of these fluctuations in spending occur predictably over the course of the day (more demand in the afternoon than in the morning, for example), the week (more demandon weekends),or the year (more demand in the summer).

Other changesin demand are less regular\342\200\224more demand on a hot day than a cool in or when a is the store. Some demand are hard for one, parade passingby changes Al to interpret: For example, a surge in demand for rocky road ice cream on one could reflect a permanent change in consumer or it might tastes, particular Tuesday be a one-time event. random, just How should Al react to theseebbs and flows in the demand for icecream?The basic model that we introduced in Chapter 3, if applied to the supply-and-demand market for icecream,would that the of ice cream should predict price changewith in the demand for ice cream.For should rise every change example,prices just after the movie theater next door to Al's shop lets out on Friday night, and they should fall on unusually when most would a hot cider to cold, blustery days, people prefer an ice cream cone.Indeed,taken the and demand model of Chapter literally, supply 3 predicts that ice cream pricesshould almost moment to moment. change Imagine Al in front of his shop like an auctioneer,calling out in an effort to standing prices

determine how many people are willing to buy Of course, we do not expectto seethis

owner.Pricesetting for

market

retail

setting

grain

markets,

reasonis up

the market

such as

auction for

the market

for

costs

it

an ice

cream store

markets, such as the

the normal

is not

cream.

doing

by

occur in some

benefits of

price!

behavior

procedure

Why this difference?

of

hiring

so, and

an

auctioneer

sometimes

in

most

The basic and

they do not. In

many buyers and sellersgathertogetherin trade large volumes of standardized goods

example,

the

to place at the same time In (bushelsof that kind of to situation, an auction is an efficient grain). way determine prices and balance the quantities supplied and demanded.In an ice cream and threes at random times store, by contrast, customers come in by twos the Some want some and some sodas. With small shakes, cones, throughout day. numbers of customers and a low sales volume at any given time, the costs in selling involved ice cream by auction are much than the benefits of greater

same

O

ice

for

economic

exceed the

grain,

in fact

stock market, but the

sometimes

that

an

by

or the

does

auction

each

at

allowing pricesto vary

with

demand.

in the demand store manager, deal with changes Al, for ice cream? Observation suggeststhat he begins by setting prices based on the best information he has about the demand for his product and the costs of production. Perhaps he prints a menu or makesa the prices. Then, up sign announcing over a periodof time, he will keep his prices fixed and serve as many customers as want to buy (up to the point where he runs out of ice cream or room in the store at these prices). This behavior is what we call \"meeting the demand\" at preset prices, and it implies in the short the amount of ice cream Al produces and sells run, that, is determined by the demand for his products. However,in the long run, the situation is quite different. Suppose,for example, that Al's ice cream earns a city wide for its freshness and flavor. reputation Day Al observes in after day lines his store. His ice cream maker is overtaxed, as are long his and his table space. There can no longer be any doubt that at current employees Al is the of ice cream the wants to consume exceeds what prices, quantity public able and willing to supply on a normal basis (his potential the output). Expanding store is an attractive possibility, but not one (we assume) that is immediately

So how

feasible.

What

does

will

the

ice cream

Al do?

Al will earn Certainly one thing Al can do is raise his prices. At higher prices, will ice cream the higher profits. Moreover,raising prices bring quantity of ice cream demandedcloserto Al's normal production capacity\342\200\224his potential output. rises to its equilibrium Indeed, when the price of Al's icecream finally level, the

DO

WHY

actual

shop's

will equal its

output

cream prices adjust to determined

potential output. Thus, over level,

equilibrium

This example illustrates in of course, that we must except,

way the links of this story

a simple think

amount

and the

output.

potential

by

their

FLUCTUATIONS OCCUR?A

SHORT-TERM

the

AND A

ice

run, is

long is sold

that

PREVIEW

between spendingand output\342\200\224 as applying to the whole there is an important difference

is that single business. The key point run and the long run. In the short run, producersoften choose not to change their prices, but rather to meet the demand at preset prices.Because is determined role output by demand, in the short run total spending plays a central in determining the level of economicactivity. Al's ice cream store Thus, enjoys a boom on an unusually hot day, when the demand for ice cream is strong, while an in cold an ice cream recession. But the unseasonably day brings long run, prices economy,

to a

not

between the

short

the levels, and output equals potential Thus, output. with which are used are the inputs productivity they primary in the long run, as we saw in Chapter determinants of economic 18. activity in in total affects the short the run its main effects run, Although spending output long are on prices.

adjust

their

to

market-clearing

quantities of

the

and

The Economic Naturalist21.1 \342\226\240m Why

Co. test

Coca-Cola

did

is hot?

According to

a vending machine that

NewYorkTimes

The

When the

that

machines

vending

them the

to

capability

company'schairman

sensor. the weather is hot?

a temperature

the demand for refreshing of this variation advantage

is hot,

weather

their market-clearing price. To

Coca-ColaCo.has

28, 1999, p. CI),

(October

vending machine that includes want a vending machine that \"knows\" when a soda

tested

weather

the

when

\"knows\"

would

Why

drinks

soft

in consumer

take

quietly

Coca-Cola

rises, increasing demand, the

Coca-Cola tested were equippedwith a computer chip that gave soda prices automatically when the temperature climbs. The and chief executive, M. Douglas Ivester, described in an interview raise

how the desire for a cold drink increases a sports during championship final held in the summer heat.\"So it is fair that it should be more expensive,\" Ivester was quoted as \"The machine will make this automatic.\" saying. simply process Company officials in numerous other which machine could be made dependent suggested ways vending prices on demand. For example, machines could be programmed to reduce prices during off-

peak hours or

at

machines.

low-traffic

in a way analogous are priced to the way vending machines,cold drinks Al prices his ice cream: A price is set, and demand is met at the preset price until the machine runs out of soda.The weather-sensitive machine illustrates how vending in the future. increased computing power Indeed, technology may change pricing practices and access to the Internet already have allowed some firms, such as airline companies, to In traditional

changepricesalmost practice of meeting On the other

to fully

illustrate the barriers

are more costly must

decide

than

machines.Second,in complaining

complaints

sensitively

the extra tests,

early

they

take

and concerns with

changing

unfair

price

pricing

model. profits

with in practice.

advantage

variable

pricing

reacted

of thirsty make

\"smart\" First,

whether

deciding

Conceivably,

the

machines

also

be obsolete.

someday

may

many consumers

about \"fairness\"

demand.

In

from

in demand.

variations

experiments

flexible

standard

the

whether that

at a preset Coca-Cola's

hand,

to

in response

continuously demand

vending the

to use justify

negatively

customers.

companies

less

vending machines

new

them, the

to In

company

cost of the the new machines, extra

the

practice,

willing

to

customer vary

prices

PARABLE

609

SHORT-TERM ECONOMIC

21

CHAPTER

610

FLUCTUATIONS

SUMMARY \342\200\242 Real

grow smoothly. Periodsin

does not

GDP

is growing at a rate significantly economy normal are called recessions; periods in

1929 and

\342\200\242 The

1933, strong

particularly

Recessions

of a recession is called the peak the high point of economic to a downturn. The end of a recession, which

activityprior

ending

later

10 years

exactly

in

2001

Cyclicalunemployment,

and may

the economy rises

Unemployment

Durable

sharply industries

goods to

sensitive

and

recessions

nondurable goodsindustries \342\200\242 Potential

of

amount

output

produce.The difference

are

less

sensitive.

(real

the

full-

of

about

with

states

to the output each extra

that

is

unemployment

cyclical

percentage point increasein in relation to potential measured a 2

next

short-run

that influence

economy's

its potential output, relative to output potential at a point in time is called the output output, When is below potential, the gap is called gap. output

In

changes

will

economy will influence

government policies that spending may help to eliminate the long run, however, firms' price period,

aggregate gaps.

output

and

actual

is related which

and

maximum sustainable GDP) that an economy can between

of unemployment

several chapters, our study of recessions will focus on the role of expansions economyIf wide firms spending. adjust prices only in the meantime produce enough output to periodically,and will lead meet demand, then fluctuations in spending to fluctuations in output over the short run. During

\342\200\242 In the

(LOl)

GDP or

law,

the output gap, output. (L04)

is the

output,

employment

associated

or shortly after a recession. tend to be particularly booms, whereas servicesand

called potential

also

output,

in

to forecast.

even

fall during

to

tends

inflation

are irregular hard

part

(L03)

unemployment

gap by Okun's percentagepoint

are typically felt throughout be global in scope. during recessions, while

recessions

and

Expansions

thus

rate.

unemployment Cyclical

and are

severity,

the

associated with recessions and expansions, the total rate less the natural equals unemployment

\342\200\242

fluctuations

economic and

length

the

to fric-

that is

recession began.(LOl) \342\200\242 Short-term

of

to to

tional and structural unemployment. Equivalently, the natural rate of unemployment is the rate of that exists when the output gap is zero. unemployment

a new

when

part

rate

natural

total

activity prior to a Since World War II, shorter on average

March

of unemployment is the rate that is attributable unemployment

\342\200\242 The

point recovery, is calledthe trough. U.S. recessionshave been much than booms, lasting between6 and 16 months. The in boom U.S. with the longest period history began in March 1991, end of the 1990-1991 recession economic

of

because potential output is or because actual output is

below potential.Becauserecessionary gaps represent resources and expansionary gaps threaten create have an incentive inflation, policymakers (LOl) try to eliminate both types of gap.

it represents

marks the low

slowly

unusually

potential, gap.

expansionary

wasted

beginning

because

either

occur

can

growing

the

like

recession,

the

which above

is above

output

the difference

below

A severe or protracted expansions. long decline that occurred between is called a depression, while a is called a boom. (LOl) expansion

called

are

normal

a rate significantly

is growing at

economy

a recessionarygap; when is called an

which

the

eliminate

output

gaps\342\200\224that

total

\"self-correct\"\342\200\224and

only

the

rate of

is, the

spending

will

inflation. (LOS)

KEY TERMS

boom

Okun's

(596)

business

(594)

cycles

depression expansionary

u*

(603)

gap

rate of

output gap

recession

potential

(601)

unemployment,

output,

(or contraction)

recessionarygap

(601)

peak (595)

(594)

expansion (596) natural

law (604)

trough Y* (or

GDP or

full-employment

output)

(600)

potential

(595)

(601)

(594)

611

PROBLEMS

REVIEW

QUESTIONS

recession and expansion.What are the and ending points of a recession called?In the United States, which have been longer postwar on average: recessionsor expansions?(LOl)

4. How is

each of the following to be affected likely rate, the by a recession:the natural unemployment rate, the cyclical unemployment rate, the inflation poll ratings of the president? (LOl, L03)

is likely to see its profits reducedthe a recession: an automobile producer, a manufacturer of boots and shoes, or a janitorial service? Which is likely to see its profits reduced

5.

1. Define beginning

2.

firm

Which

in

most

least?

the

potential output. Is it

3. Define economy

to

an amount

produce

6.

When

false:

the

If what

natural is the

is 2

potential output,

zero. Explain. (L04) rate of unemployment is 5 percent, total rate of unemployment if output is

2 percentbelow an

for

possible

output equals

rate is

unemployment

potential

percent above

greater than potential

output?

potential output?

What

if

output

(L04)

(LOl)

Explain.

output?

the

(LOl)

Explain.

or

True

PROBLEMS

1. Using

Table 21.1,

maximum

duration

find

the

duration,

average

of expansions or shorter on

in

the

United

the minimum duration, and States since 1929. Are

the

tendency for

getting longer average any recessions? (LOl) long expansionsto be followed by long 2. From the homepage of the Bureau of EconomicAnalysis (www.bea.gov) obtain data for U.S. real GDP from three recessions: 1981-1982, quarterly 1990-1991, and 2001. (LOl) a. How many quarters of negative real GDP growth occurred in each recession? if any, of the recessions satisfied the b. Which, informal criterion that a recession must have two consecutive quarters of negative GDP growth? expansions

over

time?

Is there

below are data on real GDPand potential GDP for the United States for in billions of 2005 dollars.For each year, calculate the 2000-2010, GDP and state whether the gap is a output gap as a percentageof potential Also calculate the year-to-year recessionarygap or an expansionary gap. growth rates of real GDP. Identify the recessions that occurred during this

3. Given the

years

period?(LOl) Year

Real

PotentialGDP

GDP

2000

11,226.0

10,880.7

2001

11,347.2

11,278.1

2002

11,553.0

11,652.3

2003

11,840.7

11,992.0

2004

12,263.8

12,292.1

2005

12,638.4

12,576.3

2006

12,976.2

2007

13,228.9

12,874.8 13,193.4

2008

13,228.8

13,507.8

2009

12,880.6

13,782.0

2010

13,248.2

14,017.1

Source:

Potential

GDP,

Congressional

Budget

Office;

real

GDP, www.bea.gov.

\302\253-conned: |ECONOMICS

McGraw-Hill

Visit your mobile app store and download the Frank: Study Econ app today!

612

CHAPTER

21

SHORT-TERM ECONOMIC

FLUCTUATIONS

4. From the homepage of

Statistics (www.bls.gov),obtain

of Labor

Bureau

the

available

recent

most

the

data on

the

for

rate

unemployment

workers

16-19 and workersaged20or over. How do they differ? What are someof reasons for the difference? How doesthis difference relate to the decline in overall natural rate of unemployment since 1980?(L03)

5.

Okun's

Using

law,

fill in the four

data are hypothetical. (L04) Real

Potential

GDP

2012

7,840

2013

8,100

2014

(c)

2015

6.

GDP ($ billions)

($ billions)

Year

a.

Output

gaps

table

Actual

unemployment

rate (%)

rate (%) 6 5

(a)

5

8,200

4.5

8,250

5

4 (d)

identify the incorrect statement.(LOS) by inflationary pressures generated by

are caused

of government policy. b. A low aggregate spending can make output c. When is high, output may rise above spending d. Government policies can help to eliminate

the the

below. The

Natural

(b)

8,415

the

in

unemployment

8,000

the following,

Of

pieces of missing data

aged

the

unintended

side effects

-

TO CONCEPT

ANSWERS

21.1

The natural

actual rate

potential

unemployment by

4.6

output

fall below

to

output

potential output. output.

potential

gaps.

CHECKS -

rate in the

first

quarter

percent. Applying Okun's by 9.2 percent. (L04)

of 2011

exceeded the

law, actual output

fell

below

CHAPTER|22

I

Output,

Spending,

Fiscal

and

i irv i^x

Policy

LEARNING

OBJECTIVES

After

this chapter,

you

LOI

5 fllW

reading

to:

be able

should

the

Identify

key

of the basic

assumption Keynesian

explain how the

i* i

\342\200\224 =

\342\200\224

\342\200\224

i

by firms.

made

L02 Discuss the

l

\302\273

affects

this

production

decisions

_

and

model

i

determinants

\342\226\240

investment

of planned and

aggregate

spending

consumption

and how are

these concepts to develop a

used

model of planned aggregateexpenditure.

L03

using graphs

Analyze, and

how

numbers,

an

economy reachesshortrun

How are consumer

GDP related?

and

spending

hen one of the authors of this book was a small boy, he usedto spend some time every summer with his grandparents, who lived a few hours LA^ ^^^^\342\204\242 from his home. A favorite activity of his during these visits was to a summer on the front with his spend evening porch grandmother, listening to her stories.

L04

Cy^F!

Grandma had spent the early years of her marriage worst part of the Great Depression.In one of

during the

remarked that, at that time, to be able to buy her children

where she and they grandson

new

fell

her

and a

apart, thought

shoes?\"

family this

in

the

New

been a

it had

to

satisfaction

\"Why

didn't

their

parents

just

buy

Grandma explained,\"nobody \"Because,\"

had

have

the money.

Most

aggregate

planned

can cause

a changein

short-run

multiplier.

them

of

the

output

equilibrium

L05

why the

Explain

that

useful as a policy,

fiscal policy is stabilization

and discuss

in applying

any

money

down.\" to

buy

that fiscal

in real-world shoes.\"

basic

model

Keynesian suggests

qualifications

to close

change in

she

he demanded.

didn't \"They couldn't,\"said Grandma. \"They fathers had lost their jobs because of the Depression.\" \"What kind of jobs did they have?\" in worked the shoe had factories, which \"They did the factories close down?\" \"Why

Show how a

her

pair of shoesevery year. In the small town many children had to wear their shoesuntil and girls went to school barefoot.Her boys

was scandalous:

Keynesian

expenditure

England,

reminiscences,

model.

and how this is related to the income-expenditure

a new

lived,

few unlucky

mid-1930s,

in

her

in the

equilibrium

basic

the arise

policy

situations.

614

CHAPTER

22

SPENDING,

OUTPUT, AND

POLICY

FISCAL

The grandsonwas was

there

that

shoes.

without

six or

seven years

old at

badly wrong and shoe workers with couldn't the shoe factories just

something

with

Grandma's

factories

shoe

boarded-up

only

Why

children so badly

needed? He madehis

point

but even he could see logic. On the one side were no jobs; on the other, children and the shoes the open produce the

quite

time,

but Grandma just

firmly,

shrugged and said it didn't work that way. The story of the closed-down shoe factories illustrates in a microcosm the cost In to society of a recessionary an with a available gap. economy recessionary gap, could be used to produce valuable and services, resources, which in principle goods are instead allowed to lie fallow. This waste of resources lowers the economy's and economic welfare, compared to its potential. output

Grandma'saccountalso suggests

how such an unfortunate situation might owners and other Suppose factory producers,being reluctant to accumulate unsold on their to satisfy shelves, produce just enough output goods the demand for their products. And for some the reason, that, suppose public's to spend declines. If spending declines, factories will respond willingnessor ability their production (because they don't want to produce goods they can't by cutting and off workers who are no longer needed.And because the workers sell) by laying who are laid off will lose most of their income\342\200\224a particularly serious loss in the in the before insurance was 1930s, days government-sponsored unemployment must reduce their own As their factories declines, common\342\200\224they spending. spending

about.

come

will

Efficiency

O

reduce

their

spending\342\200\224and

production on, in a

so

of productive capacity\342\200\224the

again,

laying

off

more

workers,

who

vicious circle.In this scenario,the factories

have

not lost their

turn

in

problem

ability

to

reduce

their

is not

a lack

produce\342\200\224but

to support the normal level of production. insufficient spending in aggregate spending may The idea that a decline cause to fall below output was one of the of John Maynard Keynes potential output key insights (pronounced a highly influential British economist of the first half of the twentieth \"canes\,") or model, of how recessions and century.1 The goal of this chapter is to presenta theory, rather

expansionsmay

arise

aA brief biography

of Keynes

in aggregate spending, along the lines first from fluctuations This which we call the basic Keynesian model, is also model, suggested by Keynes. known as the Keynesian cross, after the diagram that is used to illustrate the theory. We with a brief discussion of the key assumptions of the basic Keynesian begin model.We then turn to the important concept of total, or aggregate, planned We show how, in the short run, the rate of aggregate spending in the economy. to determine the level of which can be greater than or less spending helps output, In than other on the level of spending, the words, depending potential output. an \"Too little\" leads to a economy may develop output gap. spending recessionary output gap, while \"too much\" creates an expansionary output gap. An of the basic Keynesian model is that that implication government policies affect the level of spendingcan be used to reduce or eliminate output gaps. Policies usedin this way are called stabilization policies. Keynes himself for the argued active use of fiscal policy\342\200\224policy to and taxes\342\200\224to relating government spending In eliminate and stabilize the the latter of this output gaps economy. part chapter, we'll show why Keynes thought fiscal policy could help to stabilize the economy, and discuss the usefulness of fiscal as a stabilization tool. policy in the previous chapter, the basic As we mentioned model is not a Keynesian or realistic model of the since it complete entirely economy, applies only to the short which firms do not their but instead meet the relatively period during adjust prices demand at t his model is an essential forthcoming preset prices. Nevertheless, building block of leading current theories of short-run economic fluctuations and stabilization we'll extend the basic Keynesianmodelto policies. In the next two chapters, incorporate and other important features of the economy. monetary policy, inflation,

maynard.

shtml.

is available

at www.bbc.co.uk/history/historic_figures/keynes_john_

THE

MODEL'S

KEYNESIAN

THE

MODEL'S

KEYNESIAN

CRUCIAL ASSUMPTION: FIRMS

MEET

DEMAND

AT

615

PRICES

PRESET

CRUCIAL

FIRMS MEET DEMAND

ASSUMPTION:

AT

PRICES

PRESET

Keynesian modelis built on a key assumption: In the short run, firms meet the demand do not respond to every for their products at preset prices.Firms in the demand for their their Instead, change products by changing prices. they typically set a pricefor some period, then meet the demand at that price. By

The basic

we mean that firms produce just enough to satisfy their that have been set.2 in order to As we will their see, the assumption that firms vary production meet demand at preset prices implies that fluctuations in spending will have powerful effects on the nation's real GDP. The assumptionthat, over short periods of time, firms meet the demand for Think of the stores where you their products at preset pricesis generally realistic. The of a of does not fluctuate from moment to moment shop. price pair jeans to the number of customers who enter the store or the latest news about according the of denim. the store a and sells Instead, price posts price jeans to any customer who wants to buy at that price, at least until the store runs out of stock. Similarly, the corner pizza restaurant may leave the price of its large pie unchanged for months or longer, allowing its pizza to be determined by the number of production customers who want to buy at the preset price. Firms do not normally their prices frequently because change doing so would be In the case of Economists refer to the costs of as menu costs. costly. changing prices the pizza restaurant, the menu cost is literally that\342\200\224the cost of just printing up a new menu when the store faces the cost of remarking all prices change. Similarly, clothing its merchandise if the manager But menu costs also include other changes prices. may kinds of costs\342\200\224for example, the cost of doing a market to determine what survey to and the cost of customers about price charge informing price changes. Menu costs will not prevent firms from changing their As we prices indefinitely. saw in the case of Al's ice cream store (in the previous too an chapter), great imbalance between demand and supply, as reflected by a difference between sales and If will lead firms to their no one is buying potential output, eventually change prices. for at some the store will mark down its jeans, example, point clothing jeans prices. Or if the pizza restaurant becomes the local hot spot, with a line of customers the manager will raise the price of a large pie. stretching out the door, eventually Like other economic the decision to change reflects a costdecisions, many prices if the benefit of doing so\342\200\224thefact that benefit comparison: Pricesshould be changed in line with sales will be brought more the firm's normal production capacity\342\200\224 nearly the menu costs associated with the outweighs making change. As we have stressed,the in basic model this will Keynesian developed chapter ignores the fact that prices and therefore should be as to the short run. eventually adjust, interpreted applying the \"meeting customers at

demand,\" the prices

The Will

new technologies

Impact

of New

Technologies on Menu Costs

eliminate menu costs?

on the assumption that menu costs are sufficiently large to changing market adjusting prices immediately in response conditions. However, in many new have eliminated or industries, technologies reduced the direct costs of For the use of bar greatly changing prices. example, Keynesian

theory

to prevent

firms

2Obviously,

firms

is based

from

can only

their capacity

to produce.

producers have

unused

meet the For that

capacity.

forthcoming

reason, the

demand Keynesian

up to the point where they reach the limit of of this chapter is relevant only when

analysis

menu costs

the

costs

changing prices

a

EXAMPLE

Cost-Benefit

22.1

of

CHAPTER22

616

SPENDING,

AND FISCAL POLICY

OUTPUT,

codes to KLINES

grocery

\"You lower

thought fares?

r-

-

we would offer How insensitive.\"

prices

with

label on each can of

soup

just

technologies, allowsa

a few

keystrokes, without of bread. Airlines

or loaf

having use

computer

travelers

two

5

with scanner

together

products,

to change

software to implement complex pricing strategies,under which on the same flight to Milwaukee different fares, may pay very on whether travelers and on how far in depending they are business or vacation advance their were booked. Online retailers such as booksellers have the flights to their of customer and even individual customer, ability vary prices by type by while other Internet-based such as eBay and Priceline allow for companies in the previous negotiationover the price of each individual purchase. As we discussed Naturalist Coca-Cola with a vending 21.1), chapter, (Economic experimented machine that varied the of a soft drink to the outdoor automatically price according more when the weather was hot. temperature, charging Will in the direct costs of changing these reductions make the Keynesian prices which assumes that firms meet demand at to the theory, preset prices, lessrelevant real world? It's possible, but it is unlikely that new technologies will completely sophisticated

X-

manager

the price

to change

4

individual

identify

store

of changing prices anytime soon. Gathering the information conditions needed to set the profit-maximizing the price\342\200\224including the costs of the or and the service, prices charged by competitors, producing good demand for the remain for firms. Another cost of likely product\342\200\224will costly is the use of valuable managerial time and attention needed to make changingprices A informed decisions. more subtle cost of pricing changing prices\342\200\224particularly costs

the

eliminate

market

about

lead regular customersto rethink

raising prices\342\200\224is that doing so may of suppliers and decideto searchfor

planned aggregate expenditure

(PAE)

planned spending on and services

goods

total

model,

Keynesian

simple

amount that people as planned aggregate

choice

their

deal elsewhere.

EXPENDITURE

AGGREGATE

PLANNED

In the

a better

output

at each point in time is determined by the want to spend\342\200\224what we will refer to

the economy

throughout

Specifically,

expenditure.

aggregate expenditure

planned

and services. planned spending on final goods The four components of spendingon final goods

(PAE)

is total

final in

Chapter

expenditure, or simply consumption goods and services. Examples of

1. Consumption final

on

households

spending on

food, clothes,and

like automobilesand office

(residential

buildings

also are

investment)

of

final

and

government

such

4. Net

the

on consumer

included in

investment.3

hardware,

equipment

and local include

purchases

for the

space

services of government employees such as soldiers, and workers. Recall from Chapter 15 that transfer payments and insurance and interest on security benefits unemployment debt are not included in government purchases.

police,

exports (NX) equal exportsminus goods

and

services to

imports.

Exports

are sales

of

foreigners. Imports are purchasesby

discussed earlier, we use \"investment\" here to mean spending housing, and equipment, which is not the same as financial important to keep in mind. factories,

are

durable goods

office

as social government

domesticallyproduced

3As we

by

expenditure

domestic firms on new capital goods, such as by and equipment. Spending on new housesand and increases in inventories investment) (inventory

and hospitals,military

new schools program,

and

entertainment

is spending

state, purchases (G) are purchasesby federal, goods and services. Examples of government

Government governments

(C), consumption

furniture.

factories,

buildings,

apartment

the

were introduced

services

(I) is spending

2. Investment

3.

and

15:

on new capital goods such as This distinction is

investment.

AGGREGATE

PLANNED

of goods and servicesproducedabroadthat I, and G but must now be subtracted because they represent domestic Net exports therefore represent the net production. domestic goods and servicesby foreigners. residents

domestic included

four types

these

Together,

the rest of

the

of spending\342\200\224by to

world\342\200\224sum

firms,

households,

or aggregate,

total,

been

have

in C,

EXPENDITURE

not

do

demand

for

the government,

and

spending.

PLANNED SPENDING VERSUSACTUAL SPENDING or output is determined by planned aggregate expenditure, Could ever differ from actual planned spending, planned spending answer is yes. The most important case is that of a firm that sells either spending?The less or more of its product than expected. As we noted in Chapter additions to 15, in a firm's warehouse the stocks of goodssitting are treated in official government statistics as inventory investment by the firm. In effect, government statisticians assume that the firm buys its unsold output from itself; they then count those purchases as part of the firm's investment spending.4 so that part of Suppose,then, that a firm's actual sales are less than expected, In this case, the firm's actual what it had planned to sell remains in the warehouse. the unexpected increases in its inventory, is greater than its investment, including If this is true for which did not include the added planned investment, inventory. > will I P the as a we find that where the firm's planned whole, P, economy equals In

the

model,

Keynesian

short.

for

including planned

investment,

their inventories

than

investment,

is,

that

they

than

In that

expected?

investment

and actual

planned

P. The

I <

investment.

inventory

sell more output

if firms

What

following examplegives

is the

difference between planned investment Kite Co.

Fly-by-Night

expects sales of

will

be

will

less

a numerical

versus Actual

Planned What

add less to than planned illustration.

case, firms

and

produces $5,000,000worth

of

actual kites

Investment

investment?

the year. It

during

to year, leaving $200,000 worth of kites be stored in the warehouse for future sale. During the year, adds Fly-by-Night in new production equipment as part of an expansion $1,000,000 plan. Fly-by P, thus Night's plannedinvestment, equals its purchases of new production equipment ($1,000,000) its for a total ($200,000), plus planned additions to inventory of $1,200,000 in planned investment. The company's planned investment does not

dependon how

kites to its

investment,

inventory output

than

planned,

sells only instead

inventory

investment

actual

it actually

much

If Fly-by-Night

the

for

$4,800,000

sells.

of the

$200,000

equals the $1,000,000 in so I = $1,400,000. We actual investment exceeds

If Fly-by-Night has $4,800,000 inventory, just as planned. In this case, I =

Finally,

to add to investment

its

4For

planned

if Fly-by-Night inventory.

Its

(including

the

investment

sales,

actual

GDP, treating production

planned investment then

and

(I >

P).

it will add

$200,000 in investment are the planned

to

kites same:

$1,200,000.

sells $5,000,000 investment inventory new equipment) will

the purposes of measuring of ensuring that actual

advantage

in

P =

of $1,200,000

in of kites, it will add $400,000 worth originally planned. In this case, new equipment plus the $400,000 in see that, when the firm sells less

worth

$4,600,000

worth of kites, it will have will be zero, and its total equal

(I < P).

$1,000,000,

which

no output actual

is less

unsold output as being purchased by its producer and actual expenditure are equal.

than

has the

EXAMPLE

22.2

CHAPTER

618

22

SPENDING,

AND FISCAL POLICY

OUTPUT,

assumptions, we can define following equation: With these

PAE

Equation 22.1 says

=

C +

NX.

G +

+

V>

expenditure

aggregate

planned

by the

(22.1)

is the sum of planned and firms, governments, spending by households, foreigners. To our analysis keep simple, we will assume that planned spending equals actual spending for households, the and foreigners. This is a reasonable government, assumption and does not affect the basic analysis. It also allows us to avoid using to distinguish between planned versus actual superscripts consumption, government or net purchases, exports. that

expenditure

aggregate

planned

CONSUMER SPENDING ANDTHEECONOMY of planned aggregate expenditure is consumption spending. consumer mentioned, already spending includes household purchasesof goods such as groceries and clothing; servicessuch as health care, concerts, and college and consumer durables such as and home tuition; cars, furniture, Thus, computers. in a wide range of consumers' willingness to spend affects sales and profitability

The

component

largest

As

industries.

purchases

consumption,

but home

than

which

household

homes are classifiedas investment, channel purchases representanother through of new

(Households'

rather

decisions affect total

spending.)

factors determine how much people plan to spend on consumer in a given period? While and services factors are relevant, a particularly many determinant is their or after-tax, important disposable, income.All else being equal, the higher the private sector'sdisposable the higher will be the level of income,

goods

What

consumption spending. and

Figure

22.1

real

disposable

point on the are indicated combination

22.1

FIGURE

The

point

on this real

aggregate

figure

a combination

of

consumption

and aggregate real disposable income for a specific year

between 1960and Note

the strong

relationship

consumption

in

the

relationship

income.

2010

10;000.0 L-

Function, 1960-2010. Each

graph

11 000.0 i-

U.S. Consumption

represents

of

the relationship between real consumptionexpenditures income in the United States for the period 1960-2010. Each to a between 1960 and 2010 (selected corresponds year years The position of each point is determined by the figure). between aggregate consumption and disposable

shows

2010. positive

between

and disposable

9;

000.0

i-

8

000.0

L-

000.0

i-

000.0

L-

000.0

i-

000.0

L-

000.0

i-

o

\342\226\240D

O

o

C

2005.

\342\200\242\"*

2000.\342\200\242

1995,

1990#,

1985

\342\200\242\342\200\242**

1980

#o

Q.

1970

1965..**

E

3(/> C O

U

000.0

L-

000.0

L

o.o] 0

Source:

Economic

_L

_L

_L

1975

_L

Report

_L

3,000 4,000 5,000 Disposableincome

1,000 2,000

of the President, February

J_ 6,000 (2005 2011,

_L

_L

7,000 8,000 dollars,

_L

_L

J

9,00010,00011,000

billions)

Table B-31.

www.gpoaccess.gov/eop.

PLANNED

We can write

a linear

this

between

relationship

This equation

C+

might

consumption function. The consumption \342\200\224 (C) to disposable income (Y T) and

spending

affect

household

spending.

Let's look at the consumption equation contains two terms, C and

represented by not related to (i.e.,autonomous C is

suppose

more and save

to consume

In

this

C will

case,

income has not can

We Suppose,

home for

a

called

at

increase and

\342\200\224

T).

(mpc)(Y

The

The

factors

right

consumption

increase

function

between

relationship

and

spending

its

determinants, in particular, income disposable

is consumption

changes

will

the

consumption of the

side

of consumption that is

amount

consumption since it

consumption

function

all other

in disposable income. For example, about the future, so that they wanted optimistic level of their current income. any given disposable

from)

more less

more carefully.

function

autonomous

became

consumers

(22.2)

T).

(mpc)(Y-

as the

is known

consumption

that

income as

equation5

C=

relates

and disposable

consumption

619

EXPENDITURE

AGGREGATE

even

though

disposable

autonomous consumption spending

consumption

not related to

the

level

that is of

disposable income

changed.

imagine

other factors that there is a

that

could

affect

autonomous

consumption.

boom in the stock market or a sharp increasein example, consumers feel wealthier, and hence more inclined to spend, prices, making level of current given disposable income.This effect could be captured by for

C increases. or stock prices that made Likewise, a fall in home prices feel poorer and less inclined to spend would be represented by a in C. Economists in asset prices on decrease refer to the effects of changes in autonomous consumption via changes effect. consumption as the wealth that

assuming

consumers

Finally, consumption also takes account of the effects that real In particular, higher real interest rates will interest rates have on consumption. make it more expensive to buy consumer durables on credit and so households consume less and save more. C would thus decrease and consumption will fall may A even though disposable income has not changed. The is also true: opposite in real interest decline rates will lower costs and the cost of borrowing opportunity and so households increase their autonomous and saving, may consumption

autonomous

therefore

total

their

the

did

decline

Wealth

in U.S.

stock market

values

from

2000-2002

Effects

affect

consumption spending?

2000 to October 2002, the U.S. stock market suffered a 49 percent as measured by the Standard and Poor's 500 stock index,a widely drop referenced benchmark of U.S. stock performance. According to MIT economist owned $13.3 trillion of corporate stockin JamesPoterba,U.S.households roughly If households' 2000.6 stock market holdings reflect those of the Standard and Poor's stock index,the 49 percent drop in the value of the stock market out wiped in trillion of household wealth two to $6.5 approximately years. According in economic modelsbased on historical a dollar's decrease household experience, in stock wealth reduces consumer spending by 3 to 7 cents per year, so the reduction market wealth had the potential to reduce overall consumer spending by $195 billion to $455 3 to 7 percent. Yet, real consumption billion, a drop of approximately continued to rise from 2000 2002. spending through Why did this happen? From

March

in

5You

value

should

equations. 6SeeTable

review the

material

effect

changes

households' their

of to affect prices wealth and thus the tendency

in asset

consumption

spending

spending.

consumption

Understanding How

wealth

in the

appendix to

1 in James M. Poterba, \"Stock Market 2000), Perspectives 14 (Spring pp. 99-118.

Chapter

1 if

you don't

regularly

Wealth and Consumption,\"Journal

work

with linear of Economic

EXAMPLE 22.3

620

22

CHAPTER

SPENDING,

OUTPUT, AND

FISCAL

POLICY

the start

of a recessionin

overall consumption spending of reasons. First, consumers'real after-tax income continued to grow into the fall of 2001, helping to maintain consumer Furthermore, strong spending despite the drop in the stock market. 2001 and into the Federal Reserve significantly reduced 2002, throughout early interest rates; we'lldiscuss how the Federal Reserve does this in the next chapter. As we discussed,a reduction in interest rates helps to promote consumer spending, on durable consumers' especially goods such as automobiles, by reducing costs. rose this borrowing Finally, housing prices significantly during period, increasing consumers'housing wealth and partially offsetting their decline in stock-related wealth. Data on repeat house salesthat measure the price of individual houses that are sold and resold over time indicate that rose by 20.1 percent housing prices between the first quarter of 2000 and the third of 2002.7 The total market quarter in 2000, value of household real estate was about $12 trillion so house price added about about 37 $2.4 trillion to household wealth, offsetting appreciation percent of the decline in stock market wealth during this period.8 Despite

remained strong during

marginal

propensity to

consume (mpc) the by which

income

disposable

rises

0 <

on the

side

right

of disposable income,Y to consume (mpc),a fixed number, current disposable income rises by the effect

amount

consumption rises when

we assume that

term

second

The

$ I;

by

mpc <

I

will

therefore realisticto than

0 (an

(the

increase

increase we

Mathematically,

that

assume

in income

in consumption can summarize

Figure 22.2 shows a spending (C) on the vertical

which rises when by consumption The intuition behind the marginal If people receive an extra dollar of dollar and save the rest. That is, their than the full dollar of extra income. It is

one

but

increase,

the

amount

dollar.

marginal

propensity

in leads to an increase will be less than the full these assumptions as 0

and disposable

to consume is greater but less than 1

consumption)

in income).

increase

< mpc

<

1.

with

function,

consumption

hypothetical

axis

\342\200\224

(mpc)(Y T), measures The marginal propensity

of Equation 22.2, T, on consumption.

is the

part of the by less

consume

will

they

consumption

2001,

a variety

\342\200\224

propensityto consumeis straightforward:

income,

March

for

2000-2002

income on the

consumption

horizontal

FIGURE 22.2 A Consumption

Function. The consumption relates

function

spending (C) to disposable income,

(Y

T). The

function

autonomous

consumption

(C) line

equals

#c '\342\226\2405 Q_ i/>

consumption

the

Consumption function

w>

c V

\342\200\224

vertical intercept of the

and

^^

u

consumption

is

of the

slope the marginal

propensity to consume

C

#0

'\342\200\242C

Q.

^^^

Ic

Y

Slope

=

mpc

C

0 U

(mpc).

0

Disposable income

7U.S. Office of Federal Housing Enterprise Oversight continued to rise from 2003 through mid-2006. 8Federal Reserve of Board, Flow of Funds Accounts

Y\342\200\224T

(OFHEO),

the

United

www.ofheo.gov. House prices States,

www.federalreserve.gov.

axis.

PLANNED

AGGREGATE

EXPENDITURE

of the consumption function on the vertical axis equals and the of the function (C) consumption slope consumption equals the to consume To see how this fits marginal propensity (mpc). consumptionfunction 22.2 to 22.1 shows the between (which reality, compare Figure Figure relationship and real disposable income.) Our aggregate real consumptionexpenditures theoretical fits with the actual between relationship clearly relationship disposable The intercept

autonomous

and

income

consumption.

AND OUTPUT

EXPENDITURE

AGGREGATE

PLANNED

an important element of her and As income, among production, spending. the shoe in Grandma's factories town reduced production, the incomes of both factory workers and factory owners fell. Workers' incomes fell as the number of hours of work per week were reduced (a common practiceduring the as workers were Depression), laid off, or as wages were cut. Factory owners'incomefell as profits declined. in turn, forced both workers and factory Reduced owners to curtail their incomes, in led to still lower and further reductions income. spending\342\200\224which production This vicious circle led the economy further and further into recession. The logicof Grandma's has two story key elements: (1) declinesin production in declines the income received (which imply by producers) lead to reduced in in In and reductions lead to declines and income. (2) spending spending production this we look at the first of the the effects of and section, part story, production income on spending. We return later in this chapter to the effects of spendingon

to Grandma's

back

Thinking

story involved the

Why do changes

The consumption

source

basic

spending

aggregate

Let'sexamine

ways. We

see the

will

relationship

see its

can

in

this

In a

relates

which

Because

relationship.

spending,

consumption dependson output

Y,

whole depends on output. in two the link between planned aggregate expenditureand output with a numerical so that begin by working specific example you can we will the on a so that Next, clearly. plot relationship graph you as a

general shape and start

is the

affect planned aggregate spending? consumption to disposable income,is the consumption spending C is a large part of

and because

working

Planned

Linking What

that

income

and

production

function,

of

aggregate

planned

recall

income.

and

production

reminiscences,

links

with

these concepts

function

consumption

C =

620 + 0.8(Y-

graphs.

to Output

Expenditure

Aggregate

relationship between planned aggregateexpenditure

particular economy,the

using

and

output?

is

T),

function C equals 620 and the 0.8. Also, marginal propensity mpc equals supposethat we are given that = Ip investment 220, planned spending government purchases G = 300, net = = NX 250. 20, and taxes T exports Recall the definition of planned aggregate expenditure, Equation 22.1: so

that

the intercept

term

in

the

consumption

to consume

PAE

+ IP +

G+

NX.

numerical equation

for we planned aggregate expenditure, for each of its four The first expressions components. component + is defined by the consumption function, C = spending,consumption, T = 250, we can substitute for T to write the consumption Since

To

find a

= C

numerical

620

need to

find

of 0.8(Y

\342\200\224

T).

function as

EXAMPLE

22.4

621

SPENDING, OUTPUT,AND

22

CHAPTER

622

POLICY

FISCAL

C =

620 + 0.8(Y \342\200\224 Now 250). plug this expression for C into above to get planned aggregate expenditure = [620

PAE

can substitute

we

Similarly,

government purchases G, PAE = To simplify all

together

-

numerical values

the given net

and

G+

+ Ip +

250)]

exports

of

investment

P,

NX.

planned

definition

into the

NX

of

of

planned

to get

expenditure

aggregate

+ 0.8(Y

definition

the

[620 +

this equation, first the terms that don't

PAE =

-

0.8(Y

that

note

250)]

+ 220

+ 300 +

0.8(Y

- 250)

= 0.8Y - 200,then

depend on output

(620 - 200+

= 960 +

Y The

add

is

result

+ 0.8Y

+ 20)

+ 300

220

20.

0.8Y.

shows the relationshipbetween planned aggregate numerical example. Note that, according to this equation, a $1 increasein Y leads to an increase in PAE of (0.8)($1), or 80 cents. The reason for this is that the marginal propensityto consume, mpc,in this example is 0.8. Hence, a $1 increasein income raises consumption spending by 80 cents. Sinceconsumption is a component of total planned spending,total rises spending by 80 cents as well. final

The

expression

expenditure and

in this

output

The specific equation we expenditure

aggregate output autonomous

the

expenditure

portion of planned aggregate that is independent expenditure

of output

expenditure In the

aggregate expenditure. term

a part

and

(Y)

and

number, does

portion of planned expenditure output

the

expenditure

aggregate

that depends

Y

on

is equal to not vary when

output varies.

22.3

Figure

expenditure the relationship showing

between expenditure

planned

aggregate

and output

portion

of planned

induced expenditure.

(Y) is called

on

= graph of the equation PAE of 960 and a intercept slopeof

is a

a vertical

with

relationship betweenplanned

line

the

contrast,

By

aggregate expenditure depends output In the equationabove,inducedexpenditureequals 0.8Y, the second term in the Notethat the numerical value of expression for planned aggregate expenditure. induced expenditure depends, by definition, on the numerical value taken by Autonomous and induced output. expenditure expenditure together equal planned aggregateexpenditure. line

line a

into two

be divided

that

induced

point: Planned

a general

illustrates

developed

parts, a part that depends on that is independent of output. The portion of planned that is independent of output is called autonomous autonomous equation above, expenditure is the constant 960. This portion of planned spending, being a fixed

can

calledthe

There First,

the

expenditure

expenditure line intercept

is

0.8.

expenditure

aggregate

+ 0.8

is a straight which shows the line, and output graphically, is Y,

which

This

line.

are three properties of the of this line is equal to slope

specificnumerical

960

line that

expenditure the

marginal

propensity The

slope of the to the marginal propensity to consume.Second, the vertical to autonomous for our T his also expenditure example. point example.

This

point

holds

are important to note. to consume for our

in

general:

is equal equal

more generally: The vertical of the expenditure intercept autonomous expenditure. Third, changes in autonomous

expenditure line: Increasesin

autonomous

line up while decreaseswill shift the in the rest of the chapter. these properties

expenditure

line

down.

line equals the

expenditure

will shift the

holds level

of

will shift the

expenditure We will apply all three of

SHORT-RUN

623

OUTPUT

EQUILIBRIUM

FIGURE 22.3

The Expenditure

PAE

e % iditu

line + 0.8/

Expenditure PAE =960

The line

PAE

referred

to as

line,

shows

planned

Slope

= 0.8

^^^

e DO

*

960

Planned

0

PLANNED AGGREGATE

RECAP Planned

aggregate expenditure and services. The four

goods

Y

Output

EXPENDITURE

(PAE) is total

plannedspending

of planned

components

on

final

spending are

investment (P), government purchases planned and net exports Planned investment differs from actual (NX). investment when firms' sales are different from what they expected, so that additions to inventory are different from (a component of investment) consumer

(C),

expenditure

(G),

what firms

anticipated.

The largestcomponentof expenditure,or

aggregate

consumption.

simply

after-tax,

income,

according

function,

stated

algebraically

than increase

more

by

as C

= C+

(mpc)(Y

disposable,or consumption

\342\200\224

T).

term

increase in

by an marginal

is consumer

in the function, C, captures factors other consumption income that affect consumer an disposable spending.For example, in housing or stock prices that makes households wealthier and thus to spend\342\200\224an effect called the wealth effect\342\200\224could be captured willing

constant

The

expenditure

Consumption depends on to a relationship known as the

propensity

which

consumption

Increases consumption expenditure, planned

aggregate expenditure.The

of output

SHORT-RUN

slope of the

C. The

to consume,

rises

the consumption function equals < < where 0 1. This is the amount mpc, mpc when disposable incomerisesby one dollar. cause equal increases in income, is part of plannedaggregate on output as well.The portion of planned

in output Y, which imply to rise. As consumption

spending depends that depends on output is called induced expenditure of planned aggregate expenditure that is independent portion

is autonomous

expenditure.

EQUILIBRIUM

OUTPUT

have defined planned aggregate expenditureand seen how it is the next task is to see how itself is determined. Recall the output, output In of the basic model: the short leave run, producers assumption Keynesian prices at preset levels and simply meet the demand that is forthcoming at those prices. In

Now

that

related

to

we

+ 0.8Y,

the expenditure the relationship of

aggregate

to output.

expei

Line. = 960

expenditure

624

22

CHAPTER

SPENDING,

OUTPUT, AND

other

short-run equilibrium output the level of output at which Y equals

output

during

are preset, firms produce during the short-run period in which prices is equal to planned aggregate expenditure.Accordingly, we define as the level of at which equilibrium output output output Y equals that

short-run

aggregate expenditure

planned

PAE:

planned

aggregate expenditure the

POLICY

words,

amount

an

FISCAL

Y =

PAE;

of output that prevails the period in which

PAE.

(22.3)

level

pricesare predetermined

Short-run in

which

equilibrium output is the level of prices are predetermined.

There are two approachesto finding

that

output

level

the

during the period

prevails

of short-run

equilibrium output

we can use a specific numerical to simple Keynesian example show where equilibrium output equals plannedspending.Thereare two ways to Y = PAE = 0, or we can manipulate do this: We can usea table to find where the Each method illustrates an about the basic equations directly. important point Keynesian model, so we apply both of them to the specificexamplewe introduced in the previous section. Second, we can add a line to our graph of the expenditure line to find short-run The is called the equilibrium output. resulting graph Keynesian cross since it involves two lines intersecting.This is technique quite useful for generalizingthe ideas we develop in the numerical example. in

model. First,

the

FINDING SHORT-RUNEQUILIBRIUM OUTPUT: APPROACH

NUMERICAL

Recall

that

determined

by the

our

in

(Example

example

previous

for

shows various

instance, the results levels

for

expenditure (PAE)

spendingis

equation

PAE = Thus,

22.4), planned

when Y = 4,000, of this calculation

960 + 0.8Y.

PAE

=

960

for different

= 4,160. Table 22.1 output; column 1 shows

+ 0.8(4,000) levels

of

and column 2 lists the levels of planned aggregate in column the different levels of output 1. given

of output

TABLE 22.1

Numerical Determinationof Short-Run (1)

Output

(2)

Planned

Y

aggregate PAE

=

960

Output

Equilibrium

expenditure + 0.8V

(3)

Y-

(4)

PAE

Y = PAE?

4,000

4,160

-160

No

4,200

4,320

-120

No

4,400

4,480

-80

No

4,600

4,640

-40

No

4,800

4,800

0

Yes

5,000

4,960

40

No

5,200

5,120

80

No

In Table

spending(which

22.1, notice that includes

since

consumption)

consumption

rises also.

rises with output,

Specifically,compare

total planned columns

1 and

time output rises by 200, planned 2, and see that every spending rises by only 160. in That is because the marginal to consume this propensity economy is 0.8, so that in added income raises consumption each dollar and planned spending by 80 cents.

SHORT-RUN

at which Y = PA\302\243, or, equilibrium output is the level of output \342\200\224 = 0. At this level of PAE actual investment will equal equivalently, output, investment and there will be no for to planned tendency output change. Lookingat Table we can see there is one level of that satisfies that condition, 22.1, only output Y = 4,800. At that level, output and planned aggregate expenditureare precisely so that producers are just meeting the demand for their goods and services. equal, In this economy, what would happen if output differed from its equilibrium value of 4,800?Suppose, for example, that output were 4,000. Looking at the second column of Table 22.1, you can see that, when output is 4,000, planned aggregate 960 + 0.8(4,000), or 4,160.Thus, if output is 4,000, firms are not expenditure equals to meet the demand. will find that, as sales exceedthe producing enough They amounts are their inventories of finished are being depleted by they producing, goods 160 and that actual investment per year, (including inventory investment) is less than investment. Under the planned assumption that firms are committed to meeting their customers' demand, firms will respond by expanding their production. Would to 4,160, the level of planned spendingfirms faced expanding production when was be The answer is no because of induced 4,000, output enough? expenditure. That income (wages and profits) rises is, as firms expand their output, aggregate in with which turn leads to levels of it, Indeed, if output higher consumption. expands to 4,160, planned spendingwill increase as well, to 960 + 0.8(4,160), or 4,288.So an level of 4,160 will still be insufficient to meet demand. As Table 22.1 shows, output will not be sufficient to meet until it expands to output planned aggregate expenditure its short-run value of 4,800. equilibrium if output What were initially greater than its equilibrium value\342\200\224say, 5,000? From Table 22.1, we can see that when output equals 5,000, planned spending than what firms are producing. So at an output level of equals only 4,960\342\200\224less firms will not sell all and will find that their merchandise 5,000, they produce, they in warehouses is piling up on store shelves and (actual investment, including is greater than planned investment). In response,firms will cut inventory investment, their production runs. As Table 22.1 shows, they will have to reduce production to its equilibrium value of 4,800 before output just matches planned spending. We can find short-run for equilibrium output directly by using the equation planned aggregate expenditure:

Short-run

Y

PAE

By definition, an

economy is in

=

short-run

equilibrium

Y =

So, using our equation for

+ 0.8Y

960

PAE. expenditure,

aggregate

planned

when

we have

Y=960 + 0.8Y for

Solving

Y, we

CONCEPT

have

CHECK

workingwith, IP

=

4,800,

the same

result we obtained using Table 22.1.

22.1

like Table 22.1 for an economy like the one we have been \342\200\224 that the consumption function is C = 820 + 0.7(Y T) and = = = G 600. 600, NX 200, and T short-run equilibrium output in this economy? (Hint:Try using values for

a table

Construct

that

Y

assuming =

600, is

What output

above

directly

using

Check your 5,000.) the equation for planned

answer

by

aggregate

finding

short-run

expenditure.

equilibrium

output

EQUILIBRIUM

OUTPUT

625

CHAPTER22

626

SPENDING,

OUTPUT,

AND FISCAL POLICY

FIGURE 22.4

Determination of Run

UJ
Short-

Q. V

Output

Equilibrium

Short-run

equilibrium

(4,800) is determined point

the \302\243,

intersection

is known

y

/ endi Q_

at

gre w>

*

as a

^^^

Jj^^

^^^A

^/ *^Y

960

V

c

A

y aS

\342\226\240o

Keynesian cross.

\342\231\246\342\231\246 \342\231\246

c Pla

yW

4,800

0

Output

SHORT-RUN

FINDING

22.4

shows

the economy horizontal axis

and

Y

OUTPUT:

EQUILIBRIUM

APPROACH

GRAPHICAL Figure

line

+ 0.8/

y^^^

Slope = 0.8

ite w>

Expenditure = 960 PAE

^^

A

X e

of

PAE

.Y=

\342\231\246#

itu

output

the expenditure line and the equilibrium condition = (Y PAE). This type of diagram

sy

&.

(Keynesian Cross).

s

the graphical

we analyzed

determination of short-run

numerically

above.

aggregate expenditure

planned

The figure contains two

lines.The blue

Output (PAE)

on

equilibrium

(Y) is plotted on the the vertical axis.

output

for

expenditure line, which we of output people want to purchaseat any from the origin, shows all of line, given level of output. The red dashed extending the points at which the variable on the horizontal axis (Y) equals the variable on the vertical axis (PAE). Since an economy is in short-run where Y = PAE, equilibrium the short-run equilibrium for our example must be somewhere along this line. At which particular point on the Y = PAE line will the economy be in short-run = PAE line and the in Y one the is on both the equilibrium? Only point figure expenditure line: E, where the two lines intersect.At point E, short-run point equilibrium which is the same value that we obtained 4,800, output equals using Table 22.1. if the economy What is above or below point \302\243? At levels of output higher than 4,800, output exceeds plannedaggregateexpenditure. Hence,firms will be more than can which will lead them to reduce their rate of sell, producing they will continue to reduce their until reaches production. They production output where at levels of 4,800, output equals planned aggregate expenditure.By contrast, In below exceeds that 4,800, plannedaggregateexpenditure output output. region, firms will not be producing enough to meet demand,and will tend to increase they

discussedearlier.This

the

shows

line

is the

amount

be equals 4,800, will firms on and services. producing enough satisfy planned spending goods in Figure 22.4 is calledthe Keynesian The diagram due to the fact that it cross, is a crosslike, graphical model of Keynes's basic ideas. The Keynesian cross shows how short-run graphically equilibrium output is determined in a world in which meet demand at producers predetermined prices.

their production. Only at

point

E, where

output

to just

CONCEPT

Use a

CHECK

Keynesian-cross

equilibrium

intercept and

output the

22.2

to show graphically the diagram for the economy described in Concept slope

of the

expenditure

line?

of short-run 22.1 .What are the

determination Check

PLANNED

SHORT-RUN

RECAP

is

output

specific sample economy,short-run or

numerically

627

which output

of output at

level

the

or, in symbols,

expenditure,

aggregate

AND THEOUTPUT GAP

OUTPUT

EQUILIBRIUM

Short-run equilibrium

equals planned

SPENDING

PAE.

can be

output

equilibrium

=

Y

For a

solved for

graphically.

solution is based on a diagram called the Keynesian cross. The Keynesian-crossdiagram includes two lines: a 45\302\260 line that represents the condition Y = PAE and the expenditure line, which shows the relationshipof planned aggregate expenditure to output. Short-run equilibrium is determined at the intersection of the two lines. If short-run output The graphical

equilibrium

exists.

gap

output

GAP

OUTPUT

ANDTHE

SPENDING

PLANNED

output, an

from potential

differs

output

to use the basic Keynesianmodelto show how insufficient to a recession. To illustrate the effects of spending changes on output, we will continue to work with the same we've worked with example throughout this chapter. We've shown that, in this economy, short-run equilibrium output equals 4,800. Let's now make the additional assumption that potential output in = Y* this also or so that initially there is no output 4,800, economy equals 4,800, from this of full let's how a fall in gap. Starting position employment, analyze now

We're

spendingcan

ready

lead

A

Why

a fall

does

Supposethat spend lessat by

level. To decline

in We

the

in

level

every

that

lead to

consumer

Figure 22.5 shows the

diagram.

Keynesian-cross

declinein

22.5

EXAMPLE

they begin to this change capture falls to a lower function, in turn implies a which

become about the future, pessimistic of current disposable income. We

effects of the

see the

a Recession

a recession?

constant term in the consumption suppose that C falls by 10 units, of 10 units. expenditure

specific, autonomous

Leads to

Spending

C, the

be

can

Planned

in

Fall

spending

planned

consumers

assuming

can lead to a recession.

expenditure

aggregate

planned

so

that

can

spending

on the

original

short-run

economy

using

equilibrium

FIGURE

jY=

PAE

22.5

A Decline Spending

-PAE

y

(2) Equilibrium moves toF

from

\342\231\246\342\231\246

^^

E

line 950 + 0.8/

Expenditure

\342\231\246# ^^^^^

PAE

/^^^^^

expenditure

Expenditure PAE = 960 + 0.8/ line

=

(1)A

|

T

aggrega CD

O

CO

O

0.

the

expenditure

line

down

line

expenditure

(2) the short-run moves from point from

\342\200\242 (3) Recessionary

gap

down;

equilibrium \302\243 to F;

output falls to 4,750; a

4,750

4,800

recessionary

/

y\\w>

0

decline in autonomous demand shifts aggregate (1) A

spend at any level of output shifts to

(3) equilibrium

*?

inned

n.

in consumers'

decline

willingness

the

\\^^^

a

Recession.

given

te

Planned

in

Leads to

created. 4,800 Y*

Output

Y

gap

of 50 is

628

CHAPTER

22

SPENDING,

OUTPUT, AND

of the

point

and the

FISCAL

POLICY

model

at (\302\243),

original

before, the

initial

expenditure value of

assumedalsocorresponds 10

of the 45\302\260line, along which Y = PAE, = 960 + 0.8Y. As line, representing the equation PAE short-run is which we have now 4,800, equilibrium output to potential Y*. output intersection

the

Originally, autonomous expenditurein causes it to fall to 950. Insteadof

units

this the

economy

was 960, planned

economy's

so a

declineof

being

spending

described by the equation PAE = 960 + 0.8Y, as initially, it is now given by PAE = 950 + 0.8Y. What in Figure 22.5? does this change imply for the graph Since the intercept of the expenditure line (equal to autonomous expenditure)has in consumer spending will be to decreased from 960 to 950, the effect of the decline shift the expenditure line down in parallel fashion, by 10 units. Figure 22.5 indicates this downward shift in the expenditure line.The new short-run is equilibrium point at point F, where the new, lower expenditure line intersects the Y = PAE line. Point F is to the left of the original equilibrium point E, so we can see that F is fallen from their initial levels. Since output at point output and spending have in lower than potential output, we see that the fall consumer has 4,800, spending in resulted in a recessionary the More from a gap economy. generally, starting in situation of full employment (where output equals potential output), any decline autonomous leads to a recession. expenditure

how 22.5? To answer this large is the recessionary gap in Figure can use Table 22.2, which is in the same form as Table 22.1.The key = is that in Table 22.2 planned aggregate expenditureis given by PAE in 0.8 Y, rather than by PAE = 960 + as Table 22.1. Y,

Numerically,

we

question, difference

950 +

0.8

TABLE 22.2

Determination of Short-Run Equilibrium (1)

Output

(2)

Planned aggregate

Y

=

PAE

4,600

4,650

950

Output

expenditure

+ 0.8V

a Fall in Spending

after

(3)

Y-PAE

(4) Y

= PAE?

4,630

-30

No

4,670 4,710

-20

No Yes

4,750

4,750

-10 0

4,800

4,790

10

No

4,850

4,830

20

No

4,900

4,870

30

No

4,950

4,910

40

No

5,000

4,950

50

No

4,700

No

the first column of the table shows alternative possible values the second column shows the levels of planned aggregate PAE in the first column. Notice that expenditure the 4,800, implied by each value of output in value of short-run equilibrium found Table is no an 22.1, output longer is 4,800, planned spending is and equilibrium; when output output planned

As

of output

in

Table

22.1,

Y, and

4,790,so

spending aggregate

are not equal.

expenditure,

As

short-run

the

table

following the decline in output is 4,750, the only

shows,

equilibrium

planned

value of

output

SPENDING AND THEOUTPUT GAP

PLANNED

Y =

for which

PAE. Thus, a drop of

a 50-unit declinein

short-run

in autonomous expenditure has ledto If full-employment output. output is \342\200\224 = 50 units. 22.5 is 4,800 4,750 Figure

units

10

equilibrium

4,800, then the recessionarygap shown in CONCEPT CHECK 22.3 In

the

of 4,800.

output

is 5

unemployment u*

above, we Suppose that,

described

economy

potential

percent.

recessionarygap

appears?

The example that autonomous

gap of 50, relative rate of economy, the natural What will the actual unemployment rate be (Hint: Recall Okun's law from the last chapter.)

we

to

in this

worked through showed that from a decreased willingness of

just

arising

expenditure,

a recessionary

found

a declinein to

consumers

spend,

recessionary gap. The in autonomous same conclusionapplies to declines expenditure arising from other sources. firms become disillusioned with new Suppose, for instance, that In terms of the and cut back their planned investment in new technologies equipment. in planned of firms to invest can be interpreted as a decline model, this reluctance investment spending Ip.Under our that planned investment spending assumption is given and does not depend on output, planned investment is part of autonomous investment expenditure. So a declinein planned spending depresses autonomous the same way that a decline in the expenditure and output, in precisely autonomous part of consumption spending does. Similar conclusions apply to declinesin other of autonomous and components expenditure, such as government purchases net exports, as we will see in later applications. causes short-run equilibrium output

to

after the

fall

and

opens

up a

CONCEPT CHECK 22.4 rather raises

Example 22.5, except assume that consumers about the future. As a result, C rises by 10 value expenditure by 10 units. Find the numerical

of analysis confident

the

Repeat

less

than

autonomous

in

turn

of the

gap.

expansionary output

The did the

How

more

become units, which

deep Japanese

Japanese

recessionof the 1990s affect

Recession the

rest

of the 1990s of East

Asia?

slump. Japan's economic but of policymakersin other problems only Japanese East Asian countries, such as Thailand and did East Asian Singapore. Why policymakers about the effects of the on their own economies? worry Japanese slump

During the 1990s, Japan were

the

Although

in many

a major

economies

ways, one of

the

a prolonged

suffered

not

concern

most

economic

of the

of Japan and its East Asian neighbors links is through trade. important

are

intertwined

Much of

the

been basedon the development of export industries, and over the years Japan has been the most important customer for East Asian in When the the households and firms 1990s, goods. economy slumped Japanese reduced their purchases of imported goods sharply. This fall in demand dealt a of other East Asian countries. major blowto the export industries Not just the owners and workers of export industries wereaffected, as though; in in and industries so did domestic the East fell, wages profits export spending Asian nations. The declines in domestic reduced sales at home as well as spending the East Asian economies. In terms of the model, the abroad, further weakening economic

success

of East

Asia has

EXAMPLE

22.6

629

630

22

CHAPTER

SPENDING,

OUTPUT, AND

POLICY

FISCAL

in exports to Japan reducednet exports NX, East Asian countries. The fall in autonomous much like that shown in Figure 22.5. gap,

decline

recessionary

is not the only country on its trading partners.

Japan major

impact

autonomous

and thus

expenditure, in

led to

expenditure

whose economicups Becausethe United

have had a most important

downs

and

is the

States

a

in 2001 and Mexico, the U.S. recession that trading partner of both Canada began in Canada led to declining exports and recessions and Mexico as well.East Asia, which also was hurt States, exports high-tech goods to the United by the U.S in with GDP countries such as Economic recession, Singaporedropping sharply. growth rebounded throughout most of East Asia after 2001, largely because of increased demand for exports to the United States and China.

EXAMPLE

22.7

The

What

price bubblethat The

recession.

borrowers and

lenders

United

of 2006;

summer

the

state

The

highest average annual rate

of

American

in

increase

a primary

cause

homes rose at

of the

a spectacular

rate

attracted both

this phenomenon

to profit from

wished

who

This

States?

2006 is

price of American

was unprecedented

of affairs

the

in

in summer

burst

average

late 1990s until

from the

recession

2007-2009

the

caused

The house current

of 2007-2009

Recession

U.S.

the record realestateboom.

as shown in Figure 22.6. history, in house was the prices previously

1976 to 1979, when house prices rose 4.7 percent per year. By contrast, from 2001 to 2006, average house rose by an average of 8.2 percent prices per year. This number masksthe fact that over the period the rate of increase itself in and peaking at an annual rate of 12 percent rose, starting at 4 percent in 2001

spikeof

2004-2005.

250

^^ o

o II

200

A

A / 1

O o*

00

^.^

// 11

/

x 150

J/ /


#c Q

u

\342\200\242C 100

^1*^

s\\

^

yv

\302\253-*\302\253^ __ \" \342\226\240 \302\273\302\273W^^^^ ^^

s\\*~. ^*\302\273*t* y

11 w

*\\

%#*\342\200\242 \342\200\242\342\200\242\342\226\240

Q. V i/> 3 O

f

50

rt

V

$>

#

#

N#

N#

Year

&

&

& &

<j&
(by quarter)

FIGURE 22.6 Data, 1953 to 201I. Quarterly Source:Robert J. Shiller, data underlying Figure 2.1 of The SubprimeSolution, available at www.econ.yale.edu/~shiller/data.htm.

Index of

House

Prices,

PLANNED

can use the rule of At the growth rates house doubles in 15 to

We context. of

a

72, discussed

years,

accelerated,however,

dropped by

from

6 percent and between

about

by

the

May 2007

house doublesin about than

ever

before.

at first fell gradually, 2007. The decline May 2009 the average home price

Prices

2006.

July

2006

July

of a

price

average

and 100 percentfaster

home pricepeakedin

The average declining

the

50 percent

is, between

that

18, to put these numbers in and 1980s, the average price at the growth rates experienced

Chapter 1970s

experienced 19 years.By contrast,

in the recent housepriceboom,

10

in in

SPENDING

through

and February

20 percent.

over

The bursting of the housing bubbleand the financial market crisis it induced in two ways. caused both businesses and households to cut backon their spending the financial market made it difficult for businesses to borrow First, disruptions funds for investment and for consumers to borrow funds for spending purchasing crisis increased the level of uncertainty housing and automobiles. Second,the financial about the future, which led to a reductionin autonomous or spending spending,

independent of output.

represented as a downward shift in the planned in line as shown 22.7. At point \302\243, aggregate expenditure (PAE) Figure and are both to Y*. After the planned spending output equal potential output line shifts is less than actual the natural down, planned spending expenditure output; of businesses i s to reduce until their meets demand response production output again can be

situation

this

Analytically,

(seen as the movement from point

in a

recession,

with

below

output

Okun's law tells us

that

\302\243 to

point

potential. has

unemployment

F in Figure

is

the economy 22.7). At \302\243, since is below Further, output potential, now risen above the natural rate.

PAE

.Y=

UJ PA

expenditure

E

ite CO

\\^

\\.

\\^^^

c

T

agg ed

^f

Plann A^\302\260

THE

(2)

22.7

of the

down

gap

Recessionary

Y*

FIGURE

line

/

0

The End

(1) A decline in autonomous shifts the spending

expenditure

1/

/

^

[

Output

Y

HousePriceBubble.

MULTIPLIER

In Table

22.2 and

Figure

22.5,

we

was only expenditure fell by 50 units. Why did a relatively in lead to a much fall larger output? autonomous

a case analyzed 10 units, and yet modest

initial

in

which

short-run decline

the

initial

equilibrium in consumer

decline

in

output

spending

The reason the impact on output was greater than the initial change in spending is the \"vicious circle\" effect suggestedby Grandma's reminiscences about the Great in a fall consumer not reduces the sales of Depression. Specifically, spending only

AND THE

OUTPUT GAP

631

632

22

CHAPTER

SPENDING,

OUTPUT, AND

POLICY

FISCAL

the incomes of workers and ownersin the goods directly; it also reduces that produce consumer goods. As their incomes fall, these workers and owners reduce their which reduces the and incomes of other capital spending, output in in in the And these reductions income lead to still further cuts producers economy. consumer

industries

spending. to a

lead

greater than the The effect income-expenditure multiplier effect of a one-unit increase

the in

autonomous

short-run

expenditure

on

output

equilibrium

successiverounds of

Ultimately, these decrease in planned

in spending

change

on short-run

short. In our

exampleeconomy,

autonomous

expenditure

the

same direction. The

significantly

larger

idea that

how

determines

the

short-run

An

be?

will

for

multiplier

output

equilibrium

may lead to a

in spending

the multiplier

large

in

1-unitchangein

equilibrium output is a key feature

in short-run

Keynesian model. What

or

That is, each

5-unit change in a change

increase

one-unit

multiplier,

is 5.

multiplier

to a

output

may

is significantly

that

process.

of a

output

equilibrium

leads

in the

change

the

started

that

the income-expenditure

is called

autonomous expenditure

and

expenditure

aggregate

and income

in spending

declines

of

basic

the

factor is the

important

will marginal propensity to consume(mpc).If the mpc is large, then falls in income cause people to reduce their and the effect will then spending sharply, multiplier also be large. If the marginal propensity to consumeis small, then people will not reduce spending so much when income and the falls, multiplier also will be small. The appendix to this chapter providesmore detail on the multiplier.

PLANNED SPENDING ANDTHE OUTPUTGAP

RECAP

in autonomous

Increases

expenditure

the

shift

expenditure

line upward,

increasing short-run equilibrium output; decreasesin autonomous shift the expenditure line downward, leading to declinesin expenditure short-run

equilibrium

drive actual output

Decreases

output.

below potential

the

them to

spend more,raising

and producers,

so on.

According to the policies

government policies that are used to affect planned aggregate with

expenditure,

of eliminating

the objective gaps

output

expansionary

policies actions

government

policy

intended to

increaseplanned

spending

and output

policy

designed to spending

reduce planned

and output

leads

of other

inadequate

model,

recessions, policymakers are used to affect planned

spending find

ways

is an important cause to stimulate planned

aggregate expenditure,with

the

actions objective output gaps, are calledstabilization policies. Policy intended to increase planned spendingand output are called expansionary policies; taken when the economy is in recession. It expansionarypolicy actions are normally is also possible, as we have for the to be with seen, \"overheated,\" economy output of an expansionary greater than potential output (an expansionary gap).The risk gap, as we will see in more detail later, is that it may lead to an increase in inflation. To offset an expansionary gap, policymakerswill try to reduce spending and output. are policy actions intended to reduceplanned and Contractionary policies spending of eliminating

output. government

which

producers,

and spending

incomes

must

spending. Policiesthat

The two

contractionary policies actions

leads to a expenditure reflecting the working of The multiplier arises because a given

RECESSIONS

basic Keynesian

To fight

recessions.

that

of recessions.

output,

raises the incomes of the

AND

POLICY

FISCAL

of

in spending

increase

expenditure

a source

autonomous

equilibrium multiplier.

income-expenditure

initial

stabilization

short-run

are

output

Generally,a one-unit changein larger change in

autonomous

in

We

policy.

short-run

focus

major tools of

discussed

monetary

on how

long-run

stabilization

policy

monetary

policy in Chapter

fiscal policy

can

be

are monetary

policy in Chapter

23. For the rest of this

used

to influence

policy and

20 and

will

chapter,

fiscal

analyze we will

spending in the basic

FISCAL

Keynesian model. Fiscalpolicy government

spends

how changesin how variations taken

actions

revenue

it

collects.

affect

spending

about how We

short-run

much the

fiscal

by looking at then examine output,

will start

spending and output.We will then that began in 2007 and examinethe fiscal policy and Obama administrations. also affect

can

taxes

the recession by the Bush

on

in

focus

government in

to decisions

refers

much tax

how

and

POLICY

decisions

policy

how much

the

spends and how much revenue it collects

spending represent one of the two main the other decisionsabout taxesand transfer policy, being in payments. himself felt that were Keynes changes government purchases the most effective tool for or probably reducing eliminating output gaps. His basic argument was Government of goods and straightforward: purchases a of services,being component planned aggregate expenditure, directly affect If total are caused by too much or too little total spending. output gaps then the can spending, government help to guide the economytoward full employment by its own level of spending. Keynes's views seemed to be changing vindicated by the events of the 1930s, notably the fact that the Depression did in not end until increased their the governments greatly military spending latter part of the decade. about

Decisions

components

government

fiscal

of

Gap

Recessionary the

can

How

goods and

government

In our exampleeconomy, creates output

an output

eliminate

services?

we

found

gap by

its purchases

changing

of

in consumer a drop of 10 units spending can the government eliminate the its of and by changing purchases goods

that

a recessionary gap of 50 units. gap and restore full employment

How

G?

services

PAE = 960 + Planned aggregate expenditure was given Y, so by the equation in that autonomous 960. The 10-unit C a 10-unit expenditure equaled drop implied in that sample to 950. Because the multiplier drop in autonomous expenditure, resulted in turn in a 5, this 10-unit decline in autonomous economy equaled expenditure 50-unit decline in short-run equilibrium output.

0.8

To offset

assumptionthat

the

of the

consumption decline, the

purchases

are part

value,

original

are simply given

purchases

government

government government

effects

autonomous expenditureto its

to restore

of

autonomous

autonomous purchases change from 950 to expenditure

and do not depend

expenditure,

expenditure

government

960. Under

have

would

our on

and changes

one-for-one. Thus, to

output, in

increase

increase 960, the government shouldsimply its purchases 10 units on defense (for by example, by increasing spending military road construction). model, this increase in According to the basic Keynesian government should return autonomous purchases expenditure and, hence,output autonomous

their

original

or

to

levels.

The effect of

in government increase purchases is shown graphically in in the 10-unit decline the autonomous of Figure component consumption the is at with a 50-unit F, spending, economy point recessionary gap. A 10-unit in government purchases raises autonomous increase expenditure by 10 units, the of the line 10 units and the raising intercept expenditure by causing expenditure line in parallel to shift upward fashion. The economy returns to point E, where short= = Y* run and the output (Y 4,800) equilibrium output equals potential output 22.8.

the

After

gap has beeneliminated.

about

government

PURCHASES AND PLANNED SPENDING

GOVERNMENT

633

AND RECESSIONS

EXAMPLE 22.8

tax

22

CHAPTER

634

SPENDING,

AND FISCAL POLICY

OUTPUT,

FIGURE 22.8

= PAE

Y \342\231\246

in

Increase

An

Purchases

Government

UJ
Eliminates a

a.

3

C

at point F, with a recessionary gap of 50;(2) a in

increase

10-unit

autonomous

10 units,

expenditure

\342\226\240o 960

V

new

c

where

output

^^Z,

8P

line up; (3) the equilibrium is at point

^^^? *^jyy _^^

<^

950

rt

^r

^^^

/

Expenditure pae = 950+

(2) An

^v

^

+ 0.8y

960

line o.sy

increase in government shifts the

purchases

p

line

expenditure

upward

s

\342\231\246\342\231\246

0.

equals

^\\^

f^^^^

00

by

S

i\\ \\\302\243^*\\

line

Expenditure = PAE

^y^\\^^ \342\231\246 y

\\

toE

\302\243

expenditure

E,

from F

*CO

the

shifting

Equilibrium

(3)

moves

a. X

government purchases raises

/

/

+J

is initially

economy

(l)The

S

\302\243

RecessionaryGap.

f j>

1/(1) Recessionary gap

/

potential output. The output gap has been eliminated.

^

yV5\302\260

0

4,800

4,750

Output

Y

y*

CHECK 22.5

CONCEPT Concept

Check

rather than change in

less

In

Show

EXAMPLE

22.9

your

22.4, you

of Military

Does

spending

antiwar

your business,

son.\" but

spending

stepped-up government or depression.

to

eliminate

an

gap.

expansionary

Does

bore the

planned

spending

message

economic

could be

purchases military

Economy

the economy?

stimulate

Keynesian model, increasesin

the

on

Spending

from the 1960s poster War itself poses too many military

output

expansionary

be used

become more Discuss how a gap.

consumers

which

graphically.

analysis

The Impact

An

an

could

purchases

government

military

considered the case in leading to

confident,

may

a

and

matter.

different

stimulate

is good

business. Invest

costs to According

be good to the

basic from

expenditure resulting bring an economy out of a recession demand? aggregate

aggregate

help

\"War

human

as a share of GDP from 1940 to Figure 22.9 shows U.S.military spending The shaded areas in the figure to of recession as correspond periods shownin Table 21.1. Note the spike that occurred during World War II (1941reached as well as 1945), when military spending nearly 38 percent of U.S.GDP, in military the surge during the Korean War Smaller increases (1950-1953). to GDP occurred at the peak of the Vietnam War in 1967-1969, spending relative the of the and the wars in Afghanistan 1980s, during Reagan military buildup during and Iraq. 22.9 some support for the idea that expanded Figure provides military spending in aggregate tends to promote growth demand. The clearest case is the World War II which massive the U.S. to recover era, during military spending helped economy from the Great The U.S. unemployment rate fell from 17.2 percent of Depression. 2 percent the workforce in 1939 (when defense spending was less than of GDP) to

2010.

RECESSIONS

FISCAL POLICY AND

22.9

FIGURE

U.S. Military

Expenditures of

as a Share

1940-2010.

GDP,

Military expenditures as a of GDP rose during

share

World

War

II,

the

Korean

War, the Vietnam War, and the Reagan military buildup of the early 1980s. Increased military spending is often with an expanding economy and declining

associated

unemploymentThe

shaded

areas indicate periods of

recession.

Source:Bureau

of Economic

Analysis, www.bea.gov.

1.2 percent in 1944 (when defense spending was greater than 37 percent of GDP). Two brief recessions,in 1945 and 1948-1949, followed the end of the war and the At the time, though, many feared that the sharp decline in military spending. people war's end would bring a resumption of the Great Depression, so the relative mildness of the two postwar recessions was something of a relief. Increases in defense also were spending during the post-World War II period associated with economic The Korean War of 1950-1953 occurred expansions. with a strong expansion, during which the unemployment rate dropped simultaneously from 5.9 percent in 1949 to 2.9 percent in 1953. A recession began in 1954, the year after the armistice was signed,though had not yet declined much. military spending

Economic expansionsalsooccurredduring 1960s and the Reagan buildup of the 1980s. for

spending

government

purchases\342\200\224in

services of

military

this

military

on a

buildup

in

the

smaller scale, increased

mildness

case,

personnel\342\200\224can

Vietnam-era Finally,

and Iraq security and the wars in Afghanistan of the U.S. recession in 2001 and the in These episodes support the idea that increases

homeland

probably contributed to the relative strength of the subsequentrecovery. government

the

help

of weapons, to stimulate

other

military

supplies,

and

the

the economy.

TAXES, TRANSFERS, AND AGGREGATESPENDING Fiscal refers to the decisions governments make about how much to spend policy in and tax. We have seenhow affect short-run changes government spending we turn our attention to tax policy and its effects. output. Now, In Chapter19we defined net taxes (T) in the following way: T =

Total taxes \342\200\224 Transfer

Tax policy, as part

payments

\342\200\224

interest

Government

payments.

of net taxes: total parts are made payments. payments, recall, payments by the to the for which no current or servicesare received. government public, goods of transfer are unemployment insurance benefits, SocialSecurity Examples payments and income support payments to farmers. benefits,

taxes and

transfer

of

fiscal

policy,

Transfer

involves

the

first

two

635

636

CHAPTER

22

SPENDING, OUTPUT,AND

POLICY

FISCAL

*

\302\273 t

.y^V

I

*CS

-4

*\"-\342\226\240*,

\\

u$

\\ \\

\302\251<

my voyage will not only forge a new route to the the East but also create over three thousand new jobs\"

'Your

majesty,

The basic Keynesian model implies in the level of taxes or transfers changes

expenditureand directly.

Instead

sector.

Recall

like changes in government purchases, be used to affect planned aggregate

output gaps. Unlike changes in government in taxes or transfers do not affect planned spending

changes

indirectly, by changing disposable income in the private income is equal to Y \342\200\224 T. Net taxes will fall by one disposable taxes are cut by one or transfers are increased by one. According to work

they

that

if either

unit

can

eliminate

thus

however,

purchases,

that,

of

spices

the consumption function, when disposableincomerises,households should spend more. Thus, a tax cut or increasein transfers should increase planned aggregate in taxes or a cut in transfers, expenditure. Likewise,an increase by lowering will households' disposable tend to lower plannedspending. income,

EXAMPLE

22.10

a Tax

Using How

the

can

Cut to Close a RecessionaryGap eliminate

government

an output

gap by

taxes?

cutting

in consumer spending of 10 units that this recessionary gap could be in eliminated a 10-unit increase by government purchases. Suppose that, instead of fiscal decided to stimulate increasinggovernment purchases, policymakers consumer the level of tax collections. how much should they spending by changing By taxes to eliminate the change output gap? A common first guess is that policymakers should cut taxes by 10, but that In our creates

hypothetical economy,an initial gap of 50 units. We

a recessionary

their constant

this

their

each

Why?

0.8, so that units

by

10 units,

units

is the at

consumption

of the tax cut

enough

to

return

spending

increase

households

level of output

assumed to taxes at

T by

10 units,

only 8 units.

An increase to its

in

the

10 units. To households to level. However, if

output \342\200\224

made

fallen

induce

must each

have

Y\342\200\224thatis,

marginal propensity to consume in our example increases by only 0.8 times the amount of the

is saved.) output

by

that

reduction

each

raising disposable income Y

level of output Y will The reason is that the

(The rest is not

by 10

the consumption function is recessionary gap, the change in consumption spending by 10 units

taxes T are cut consumption at

recessionary gap

spending

consumption term C in

increase

cut.

of the

source

eliminate

showed

correct. Let'sseewhy.

guess is not The

drop

in

autonomous

full-employment

expenditure

level,

in

this

is tax

of eight

example.

FISCAL POLICY AND

To raise consumption spendingby cut taxes by 12.5 \342\200\224 Y 12.5 units at each income, T, by will increase by the marginal propensity or by 0.8(12.5) = 10. Thus, income,

10

instead

must

policymakers

at each level of output, This will raise the level

units

units.

level of

output

Y. Consequently,

RECESSIONS

fiscal

of disposable consumption

to consume times the increase in disposable a tax cut of 12.5 will households to spur increase their 10 units at each level of consumption by output. in Table These changes are illustrated 22.3. Following the initial 10-unit drop in consumer spending, the equilibrium level of output fell to 4,750. When net taxes are to their initial level of column 3 illustrates that income 250, equal disposable equals \342\200\224 = 250 the consumption 4,750 4,500. After the drop in consumer spending, function becomes C = 610 + 0.8(Y \342\200\224 when Y = 4,750 and T = 250, T). Thus, = = consumption will 610 + 0.8(4,750 250) 610+ 0.8(4,500) 4,210, as shown in equal column 4. If taxes are cut by 12.5 to 237.5, disposable income at that level of output = will rise by 12.5 to 4,750 \342\200\224 237.5 at that level of 4,512.5. Consumption output - 237.5)= 4,220.This = 10 so that will rise by 0.8(12.5) C = 610 + 0.8(4^750 in C and will bring increase will just offset the initial 10-unit decrease the economy back to full employment. Note the same result could be obtainedby that, since T refers to net taxes, transfer 12.5 units. Because households spend0.8times any increasing payments by in transfer payments they receive, this policyalso would increase raise consumption 10 units at level of spending by any output. TABLE 22.3

Reduction

Initial Effect of a

in

taxes

Net

Y-T 4,500

4,210

4,750

237.5

4,512.5

4,220

units.

of the tax cut is identical to the effect of the increase in shown in Figure 22.8. Becauseit leads to a 10-unit increase level of output, the tax cut shifts the expenditure line up by is attained at point E in Figure where output again 22.8,

effect

the

purchases, at any

consumption

Equilibrium

equals potential

output.

22.6

CHECK

CONCEPT In

a particular

economy, situation

initial

an

Describe two

in

ways

the

gap. Assume

marginal

a 20-unit increase in planned investment moved the economy with no output with an expansionary gap. gap to a situation which fiscal policy could be used to offset this expansionary to consume propensity equals 0.5.

The Economic Growth and TaxRelief did

Why

the

householdsin On

May

Reconciliation

The

Consumption 6IO + 0.8(y-T)

250

Graphically,

from

(4)

income

4,750

government

10

(3) Disposable

T

Y

12.5

of

(2)

(I) Output

in

Taxes

EGTRRA

send out

millions

of

$300

and

EXAMPLE 22.11

of 2001

$600 checks

to

2001?

25, 2001, Act

government

federal

Act

Reconciliation

Congress passedthe

(EGTRRA) made

Economic

of 2001, which President cuts in income significant

and Tax

Growth

Relief

on June 7. George signed tax rates and also provided for W.

Bush

638

CHAPTER 22

SPENDING,

AND FISCAL POLICY

OUTPUT,

married

for in

August

rebate checksof

up to $300 for individual taxpayers and up to $600 a return. Millions of families received these checks taxpayers filing joint and September with about billion. $38 2001, payments totaling

one-time tax

the 2001 recession was not officially \"declared\" until November the National Bureau of Economic Research announced that the (when in recession had there was clear evidence 2001 that the March), begun by spring was and the tax rebate economy slowing. Congress president hoped that, by sending checks to households,they could stimulate and avoid recession. spending perhaps In retrospect, the of the tax rebate was quite since the economy and timing good, consumer confidence were further buffeted the terrorist attacks on New York by and on 2001. City Washington September 11, Did the tax rebates have their intended effect of stimulating consumer In in a economists found that households 2006, spending? study published spent about two-thirds of their rebates within six months of receiving them.9 This suggests that the rebate had a substantial effect on consumer which held up spending, well the last of 2001 and into 2002. remarkably during quarter Although

2001

FISCAL

POLICY

AND THE

RECESSION OF 2007-2009

important part of the U.S. government's response to the Obama proposed and obtained congressional for packages of tax cuts, tax rebates,and spending increases approval designed to bolster between the two policies illustrate how fiscal policy private spending.The differences under two presidents can have a different the same ultimate emphasis yet goal. The Economic Stimulus Act of 2008 was enactedduring the last year of the Bush administration.The act calledfor roughly $100 billion in tax cuts and rebates in spending increases, spread over and billion the course of 2008 and early $60 2009. By contrast, the American and Reinvestment Act of 2009, Recovery passed the first month of the Obama consisted of $200 administration, during roughly in additional billion tax cuts and $600 billion government spending. Thus, the 2008act was composed of roughly while the % tax cuts and % spending increases, 2009 act had Va tax cuts and % spending increases. The CongressionalBudget Office the effectiveness of both (CBO) analyzed and found that had the effects our basic model programs they Keynesian predicts. the CBO estimated that the 2008 \"raised the Specifically, legislation growth of in the second and third [of 2008] by 2.3 percent and 0.2 percent, consumption quarters in but reduced it 1.0 respectively, by percent the fourth quarter, when the distribution of the rebates ended.\" Similarly, the CBO found that real GDPwas 1.2to 3.2percent in in the fourth the third of 2009 and 1.5 to 3.5 percent higher higher quarter percent than would it would have been without the 2009 act.10 quarter tax cuts while the other put more weight on Why did one presidentemphasize in increases? This is a to which we cannot do this spending deep question, justice in how book. The disparity mostly boils down to differences each administration viewed the effects of tax cuts and spending increases on long-run rather growth than on short-run output. It also depends on problems that economists have in the identifiedwith fiscal policy in general. We discuss thesedifficulties more generally next section. Fiscal

latest

policy

recession.

has

been an

Presidents

Bush and

S. Johnson, and Nicholas S. Souleles, \"HouseholdExpenditure and the Jonathan A. Parker, Income Tax Rebates of 2001,\" American Economic Review, December 2006, pp 1589-1610. 10The studies are \"Did the 2008 Tax Rebates Stimulate Short-Term Growth?\", \"Estimated Impact of the American and Economic Recovery and Reinvestment Act on Employment Output as of September Act on Employment and 2009,\" and \"Estimated Impact of the American Recovery and Reinvestment Economic Output from October 2009 through December 2009.\"All three studies are available at 9David

www.cbo.gov/publications/collections/collections.cfm?collect=12.

FISCAL POLICY AS A STABILIZATION

POLICY AS A

FISCAL THREE

639

TOOL: THREE QUALIFICATIONS

TOOL:

STABILIZATION

QUALIFICATIONS

The basic Keynesian

can eliminate

gaps.

output

models

economic

complicated than

lead you to might But as is often the

model

about the use of

fiscal

policy

that

case,

the

use of fiscal precise world is more

use of fiscal

policy

real

suggest. We close the chapter as a stabilization tool.

Fiscal Policy and the SupplySide on the

think

three

with

qualifications

planned aggregate expenditure. may affect potential output as well as plannedaggregate On the spending side, for example, expenditure. in public investments schools can play a major capital such as roads, airports, and role in the growth of potential output, as we discussedin Chapter 18. On the other side of the ledger, tax and transfer programs may well affect the incentives, and thus the economic Some critics of the Keynesian behavior, of households and firms. theory have gone so far as to argue that the only effects of fiscal policy that matter are effects on potential output. This was essentially the view of the so-called and journalists whose influence reached a supply-siders, a group of economists the first Reagan term (1981-1985). Mosteconomistsnow high point during agree focused

have

We

would

economists

most

However,

that

fiscal policy

affects both

The

Problem

of Deficits

A

the

budget

government's

policy

fiscal

and

policymakers

to avoid large and persistent

is the need that

that

plannedspending

for fiscal

consideration

second

to affect

policy

agree

of government

policies

from Chapter

Recall

deficits.

deficit is the excess

stabilization

about

thinking

budget

output.

potential

spending

over

19

tax

Sustained government deficits can be harmful because they reduce in turn reduces investment in new capital which goods\342\200\224an important source of long-run economic growth. The needto keepdeficits under control may make increasing spendingor cutting taxes to fight a slowdown a lessattractive both economically and politically. option, The policiesof both the Bush and Obama administrations,for instance, contributed to large and rising budget deficits.It may be the case that the large budget deficits, and the increased debt resulting from these deficits,couldmake future administrations hesitant to apply fiscal policy during the next economic downturn. collections. national

saving,

The Relative The

third

about the use of fiscal is that fiscal policy is not policy to be useful for stabilization.Our exampleshave implicitly

qualification enough

flexible

always

Inflexibility of FiscalPolicy

in the government can change spendingor taxes relatively quickly in to eliminate output gaps. In reality, or taxes changes government spending must a lengthy which reduces the ability of usually go through legislative process, fiscal policy to respond in a timely to economic conditions. For way example, tax changes be submitted to budget and proposed by the president must typically 18 months or more before into effect. Congress they go Another factor that limits the of fiscal policy is that fiscal flexibility

that

assumed

order

policymakers

objectives besides stabilizing aggregate spending,from national defense to providing income to the poor. adequate support the need to the national defense if, say, happens strengthen requires an in government but the need to contain spending, planned aggregate have

many

other

an

ensuring What increase expenditure

a decrease

requires

to resolve through the This

lack

spending view

fiscal

than

in government

political process.

of flexibility means the basic Keynesian

policy

as an

spending? Such conflicts

that

fiscal

be difficult

automatic

provisions

is often

policy

model suggests. in

less useful for stabilizing

Nevertheless, most economists

important stabilizing force, for

presence of automatic stabilizers,provisions

can

the

two

law

reasons.

The first is the

that imply

automatic

stabilizers

in the

law

that

imply automatic increases government spending or

decreases in taxes output declines

when

in

real

640

CHAPTER

22

SPENDING,

OUTPUT, AND

FISCAL

POLICY

in spending or decreases

in government

increases

example,somegovernment communities

spending

when the unemployment rate reachesa also respond automaticallyto output gaps:

automatically transfer

and

Taxes

payments

declines, income tax collectionsfall while unemployment insurance payments action

explicit

by

tax collections

when real output declines. For as \"recession aid\"; it flows to

taxes

is earmarked

(because

benefits

welfare

and

automatic

These

Congress.

taxable

households'

changes

help to increaseplanned

in

certainlevel. GDP

When

incomes

fall)

rise\342\200\224allwithout

any

and

spending

government

recessions and reduce it spending during in the inherent the during expansions, delays legislative process. The second reason that fiscal is an important stabilizing force is that, policy fiscal policy may be difficult to change although quickly, it may still be useful for with of recession. The Great dealing prolonged episodes Depressionof the 1930s and the Japanese slump of the 1990s are two cases in point. The recession of 2007-2009 21 that this is the longest recession since is another example;recallfrom Chapter World War II. However, because of the relative lack of flexibility of fiscal policy in modern first to stabilize economies, governments attempt aggregatespending without

monetary

through

RECAP

that will

be enactedfar more changes can be made

policy can

Monetary

policy.

fiscal policy due to the fact by the Federal Reserve. We

policy

monetary

detail

this in more

examine

in

the

next

than

quickly immediately

chapter.

PLANNEDSPENDING

FISCAL POLICYAND

consists of two tools for affecting total and eliminating policy spending and (2) changes in taxes or output gaps: (1) changesin government purchases in government transfer payments. An increase purchases increases in taxes or an increase in autonomous expenditure by an equal amount. A reduction transfer increases autonomous payments expenditure by an amount equal to in taxes or increase the marginal propensity to consumetimes the reduction in transfers. The ultimate effect of a fiscal on short-run policy change equilibrium output the change in autonomous times the equals expenditure Fiscal

Accordingly,

if the

purchases, a cut in

taxes,

multiplier.

economy is in or an increase

the spending and eliminate There are three important \342\226\240 Changes

in taxes

can

transfers

gap.

recessionary

programs and

households

fiscal policy.

regarding

qualifications

and transfer

economic behavior of

in

increase in government be used to stimulate

an

recession,

affect

may

must weigh the short-run effects of deficits; possibility of large and persistentbudget

relatively

in spending and taxation slow and inflexible.

and

incentives

firms;

\342\226\240 Governments

\342\226\240 Changes

the

take time

and

fiscal

thus

policy

against

fiscal policy

the

can be

SUMMARY

The basic Keynesian model shows how fluctuations in planned aggregate expenditure, or total planned

they

typically

the

demand

spending,can causeactual

to differ from output little output. spending leads to a too much recessionary output gap; spending creates an This model relies on the expansionary output gap. crucialassumption that firms do not respond to in demand every change by changing prices. Instead, potential

Too

\342\200\242 Planned

set a price for some period,then forthcoming at that price. (LOl)

aggregate

spendingon final total

components

of

investment,

government

investment

may

meet

is total planned expenditure and services. The four

goods

spending purchases,

differ

are consumption, and net exports. Actual from planned investment

KEY

firms may sell a greater or lesseramount than they expected. If firms production

because their

lessthan

expected,

they

goods to

to add more And because

for example, than

inventory

forced

are

they

of

sell

additions to inventory as in of this case actual investment investment, part is greater than investment) (including inventory

planned investment.

(L02)

summarizes the income and consumption relationshipbetween disposable rises spending. The amount by which consumption when disposable income rises by one dollar is called the marginal propensity to consume(mpc). The to consume is always greater than marginal propensity zero but less than one. (L02)

\342\200\242 The

raises planned aggregate

in real output

expenditure,sincehigher output

more.

equivalently,

consume

can be autonomous

expenditure

aggregate two

into

(and,

encourages households to

income)

Planned

down

components:

broken

the

expenditure is

independent of

portion

Autonomous expenditure. of is portion planned spending that of output; induced expenditure is the that depends on output. (L02) spending

prices are fixed, short-run is the level of output that equilibrium output just equals planned aggregate expenditure. Short-run can be determined equilibrium numerically by a table that alternative values of output and the compares level of output and planned spendingimplied by each by using equations. Short-run equilibrium output also can be determined graphically in a Keynesiancross diagram. (L03)

\342\200\242 In the

in

Changes

changesin if the particular,

fall

in

recessionary

will

in which

period

\342\200\242

autonomous short-run

autonomous

create

will lead In output.

expenditure

equilibrium

is

economy gap

increase

spending, and

is called the expenditure the

raises

it also

turn increase their

who in producers, so on. Hence the

of

incomes

multiplier is greater

than

increase in autonomous raise short-run equilibrium output by

A one-dollar

one:

expendituretends

to

more than

one

dollar.

\342\200\242 To eliminate employment, the

(L04)

at

initially

a rise

in

employment,

will create

expenditure

and

full

autonomous

an expansionary

gap. The

to a

a

The two major types of decisions

spend and so

in

increase

transfer

spending amount equal to the consume times the cut in taxes by an

to

\342\200\242 Three fiscal

must qualifications as a stabilization

by

be made

policy

affect

may

output

potential

spending.Second,large

to the use of

tool. First, fiscal policy as well as aggregate

and

persistent

government

and budget deficits reduce national saving the need to keep deficits under control may use of expansionary fiscal policies.Finally, in fiscal policy must go through changes

legislative

process, to

flexible enough However,

law that spending

growth; the

limit

because a lengthy

fiscal policy is not always for short-run stabilization.

be useful

automatic automatic

imply

in the stabilizers\342\200\224provisions in government increases

or reductions in taxes

declines\342\200\224can

or

Higher consumer spending,in equilibrium output. (L05)

in transfers. raises short-run

increase turn,

at

consumption

raising

output

propensity

marginal

a cut in taxes or an increases the public's

payments

income,

disposable

in

expenditure

to reduce or eliminatea

Similarly,

gap.

increase

autonomous

be used

it can

policies. are

policy. Fiscal policy refers to about how much to

raises

recessionary

full

policy

make governments tax. For example, an

purchases

directly,

stabilization

fiscal

and

policy

monetary the

restore

stabilization

employs

overcome

delays to some extentand

expenditure amount

gaps and

output government

each level of

induced

expenditure and

equilibrium output in autonomous

multiplier. not only raises spendingdirectly,

government

higher

autonomous

in

function

consumption

\342\200\242 An increase

short-run

expenditure raises

An

anticipated. are counted

increase

a one-unit

which

641

TERMS

the

problem contribute

when

output

of legislative to

economic

stability. (LOS)

KEY TERMS automatic

autonomous

stabilizers

fiscal policy

(639)

consumption

(619)

autonomous expenditure(622) consumption

function

(619)

policies (632)

contractionary

expansionary policies(632) expenditure

line

(622)

planned aggregate expenditure

(633)

income-expenditure induced

(PAE)

short-run

(632)

multiplier

expenditure

(622)

marginal propensity to (mpc)

menu

(615)

equilibrium

(624)

stabilization policies(632) wealth

(620)

costs

consume

output

(616)

effect

(619)

CHAPTER22

642

AND FISCAL POLICY

OUTPUT,

SPENDING,

RHItW

1. What

is the

model? one

a

is to

accept the view

of the basic Keynesian assumption is needed

that

spending

aggregate

6. Sketchthe if

words the

is

graphed

expenditure,induced

(LOl)

changes

example of a good or service very frequently and one

changes

relatively

Give an

whose

Define

planned

aggregate

Explain spendingcan

5. Sketch

how

and list its expenditure planned spending change

Illustrate

a graph

of the

the

8. Define the

and actual with an example. (LOl)

9. The

labeling

function,

propensity output?

equilibrium

axes of the graph. Discussthe economic meaning of (a) a movement from left to right along the graph of the consumption function and (b) a parallel upward shift of the consumption function. Give an of a factor that could leadto a parallel example upward shift of the consumption function. (LOl)

In economic

multiplier.

one?

than

terms,

one

purchases

of

involving 50 units,

increased

the other

is

a tax

cut of

planned Why? (L04)

more

policy to

of fiscal

use

the

stabilizethe economy

government

involving

by more?

10. Discussthreereasonswhy

alternative

stimulate

will

policy

expenditure

aggregate

is the

why

(L04)

government is considering two

policies,

50 units. Which

the

L04)

(L03,

chapter.

greater

multiplier

consumption

short-run

the Keynesian-crossdiagram,illustrate of the 2007-2009 recession discussed

throughout

spending

planned

differ.

cause

main

does components. Why when output changes? (LOl)

4.

the marginal

expenditure,

7. Using the

for

accounts

autonomous

determine

(L03)

whose price

What

infrequently.

price

the

only this diagram,

Given

diagram.

to consume, and

the difference? (LOl)

3.

the

in

in Explain two lines

diagram.

Keynesian-cross

economic significance of

how could you

economic

short-term

behind

force

driving

fluctuations.

2.

key assumption why this

Explain

QUESTIONS

than

complicated

suggested by the basic Keynesian

model.

(LOS)

PROBIEMS 1. Acme

|ECONOMICS

in

of goods this year and is planning to purchase$1,500,000 of the year, the company during the year. At the beginning in its warehouse. Find actual investment and inventory if Acme actually sells

new

entire

equipment

has $500,000in planned

investment

a. $3,850,000 worth c. $4,200,00worth

Visit your mobile app store and download the Frank: Study Econ app today!

of

of

$4,000,000worth It also

production.

goods.

worth of

b. $4,000,000 McGraw-Hill

is producing

Manufacturing

expects to sellits

B-connect

goods.

goods.

that Acme's situation is similar Assuming these three cases is output equal to short-run

to

that

of other

firms,

output?

equilibrium

on before-taxincome,taxespaid, and consumption in various Simpson family years are given below. (LOl)

2. Data

Taxes

Before-tax

income

paid

3,000

20,000

27,000

3,500

21,350

28,000

3,700

22,070

30,000

4,000

23,600

$32,000

and

for the

and

find

their household's

to consume.

propensity

b. How much

of

Consumption spending($)

($)

Simpsons'consumption function

which

spending

25,000

a. Graph the marginal

($)

in

(LOl)

would you they

paid

expect

taxes

the

Simpsons

of $5,000?

to consume if their

income was

c. Homer Simpsonwins

As a result, the Simpson family at each level of after-tax income. consumption by $1,000 does not includethe How does this (\"Income\" prize money.) change affect the graph of their consumption function? How does it affect their marginal

3.

An

a

prize.

lottery

its

increases

to consume?

propensity

equations: (L02)

by the following

is described

economy

C= 1,800 +

T)

0.6(Y-

Ip = 900

G = 1,500 =

NX

100

T =

a. Find

b. Find

a numerical equation autonomous

4. For the

c.

9,000

and induced

expenditure

economy described in

a table like Table possible valuesfor short-run

for this economy

is 2.5. Find

in government in tax

decrease

A

their

at

spending

recession. is 4.

original

4, take as given on short-run

that

the

equilibrium

spending from 900 to

800.

full

economy the

LOS)

(L04,

a. How large is the recessionary gap b. By how much would the government

after the fall in planned have to change its

to full

investment?

purchases to restore

employment? much would the government have to change taxes? in balance, that the with Suppose government's budget is initially A government spending to taxes collected. law forbids the equal balanced-budget from a deficit. Is there that fiscal government running anything in this economy, assuming they policymakers could do to restore full employment do not want to violate the balanced-budget law? the

An

effect

economy?

from 1,500 to 1,600. from 1,500 to 1,400 (leaving government

value). investment at

3 and the

of this

but a decrease in planned employment, of autonomous (a component expenditure) pushesthe Assume that the mpc of this economy is 0.75 and that

is initially

economy

multiplier

7.

Consider

ranging from

purchases

collections

in planned

decrease

A

into

d.*

economy.

output.

equilibrium

output

in Problems

described

economy

increase

An

investment

c.

short-run

the determination of the Keynesian-cross diagram. What is the output rate gap for this economy? If the natural unemployment is 4 percent, what is the actual unemployment rate for (Hint: Use Okun's law.)

purchases

An

this

8,200 to 9,000. short-run equilibrium output for this economy

output of (L04)

6.

find

equilibrium

Show

multiplier

c.

expenditure

in

3: (L03)

Problem

22.1 to

to output.

expenditure

using

5. For the

a. b.

aggregate

planned

linking

a. Construct

b.

1,500

=

Y*

economy

Alternatively,

economy

by

how

is described by the

following equations:

C = 40 + Ip =

70

G = 120

NX= 10

T= 150

Y*

=

580

0.8(Y-

T)

644

CHAPTER22

SPENDING,

AND FISCAL POLICY

OUTPUT,

The multiplier

this

in

b. c.

economy is fairly much

how

eliminate

(L04, LOS) planned aggregate

relating

equation

to find the value of short-run to full employment.) would government purchases

a table

Construct

By

is 5.

economy

a. Find a numerical output.

(Hint: The

output.

equilibrium

close

gap? By how much

output

any

expenditure to

effects of thesefiscal

d. Repeat c assuming part e. Showyour results for 8.*An economy is described

changes

policy

have to change in order to would taxeshave to change? Show the in a Keynesian-cross diagram.

that Y* =630. parts b through d on by the following =

C

a Keynesian-cross diagram.

equations: (L03, L04, LOS)

+ 0.5(Y-

3,000

T)

Ip = 1,500

G = 2,500 =

NX

T = =

Y*

a. For this multiplier,

b.

economy,

short-run this

Illustrate

c. Calculate

the

find

equilibrium economy's amount

the

200

2,000 12,000 following:

autonomous

the

expenditure,

output, and the output gap. short-run equilibrium on a Keynesian-crossdiagram. to by which autonomous expenditure would have

to eliminate the output change gap. d. Suppose that the government decided to taxes. By how much must taxes be reduced in

closethe

output

order

to do

gap

by reducing

this?

9.*An

has zero net exports. Otherwise, it is identical to the economy economy described in Problem 7. (L03, L04, LOS) a. Find short-run equilibrium output. b. Economic recovery abroadincreasesthe demand for the country's exports; as a result,NX rises to 100. What happens to short-run equilibrium output? c. Repeat part b, but this time assume that foreign economiesare slowing, = \342\200\224100. NX demand for the country's exports, so that (A negative reducingthe value of net exports means that exports are less than imports.) d. How do your results help to explain the tendency of recessionsand expansions

*Denotes

more

to

First

we need

PAE

to

output then

to

find an equation that relates planned aggregate expenditure Y We start with the definition of planned aggregate in the problem substitute the numerical values given

PAE =

C + Ip

+

G +

= [820 + 0.7(Y

= 1,800+

NX -

600)1

+ 600

(column

1).

+ 600 + 200

0.7Y.

this relationship, we construct a table trial and error is necessary to find an appropriate

Using

\342\226\240

CHECKS

CONCEPT

TO

ANSWERS

expenditure and

countries?

difficult problem.

\342\226\240

22.1

across

spread

analogousto Table

22.1.

range of guesses

Some

for output

ANSWERS TO CONCEPTCHECKS

of Short-Run

Determination (1)

Output

Equilibrium

(3)

(2)

Planned

Output Y

expenditure

aggregate

+ 0.7/

= 1,800

PAE

(4)

Y-PAE

Y

= PAE1

5,000

5,300

-300

No

5,200

5,440

-240

No

5,400

5,580

-180

No

5,600

5,720

-120

No

5,800

5,860

-60

No

0

6,000

6,000

6,200

6,140

60

No

6,400

6,280

120

No

6,600

6,420

180

No

Yes

Short-run equilibrium output equals 6,000,as that is the only level of output Y = PAE. Using the equation satisfies the condition for planned in equilibrium we have Y = 1,800 + 0.7Y. Solving for Y, aggregate expenditure, we find that Y = 6,000, just as we found the table. (L02, L03) using that

22.2 The graph =

Y

6,000.

Notice that the

equals

the

of

determination

the

shows

The intercept

equals to propensity

autonomous

intercept

marginal

short-run

of the expenditure line

equilibrium output, and its slope is 0.7. expenditure and the slope

is 1,800

consume. (L03)

#Y=

PAE

2 3

>

'\"5

Expenditure

PAE=

c

Q. X Q)

line

1,800 +

0.7Y

= 0.7

Slope

n w>

1

800

c

c

/V5\302\260

6,000

22.3

This problem is an application The recessionary gap in this

Output

of Okun's example

is

Y

law, introduced \342\200\22450/4,800,

or

in

about

the

last

chapter.

\342\200\2241.04 percent,

is one-half of the output. By Okun's law, cyclical unemployment or 0.52 output gap (multiplied by \342\200\2241), percent. As the natural rate of is 5 percent, the total unemployment rate after the recessionary unemployment gap 5.52 percent. (L04) appears will be approximately

of potential

22 A

This

10

expenditure

raises line

reverse of the

is just the

exercise units

by

autonomous

10 units.

10 units, leading to an

in the text. An increase and hence the intercept of

expenditure

The expenditure line increase

in C

analysis

in output

of

the

shifts up, in parallel fashion, by and an expansionary output gap. As

645

646

CHAPTER

22

SPENDING,

AND FISCAL POLICY

OUTPUT,

falls

output analyzed that

PAE

970

50

by

here. To

in the

units verify

text,

by 50

rises

it

short-run

that

equilibrium

units, to 4,850, in the case output equals 4,850, note

in autonomous expenditure implies that + 0.8 Y. When Y = 4,850, then PAE = rises from 960 + 0.8 Y to 970 = = + 0.8(4,850) 4,850,sothat we have Y PAE. (L04) of

increase

an

10 units

22.5 In ConceptCheck22.4we autonomous

expenditure

a 10-unit the intercept

that

saw

hence

and

increase in C

of the

increases line

expenditure

by

in parallel The expenditureline shifts upward, fashion, by 10 units, to an To offset this leading expansionary output gap. gap, the government should reduce its purchases by 10 units, returning autonomous expenditure to its original level. The expenditureline shifts back down to its original to its initial level. The graph is position, restoringoutput full-employment

10 units.

just

reverse

the

the increasein reduction

in

22.6 The 20-unit autonomous

of Figure consumption

Since

line being

(back to point

(L04,

\302\243) by

shifted up by

the

offsetting

L05)

is a 20-unit increase in to an even greater increasein short-run

investment

will lead

To offset the

fiscalpolicy,the

Alternatively, spending.

planned

which

expenditure

down

purchases.

increasein output.

by means of

the

with

and

government

expenditure,

equilibrium

22.8,

20-unit increasein

government

it could raise taxes the mpc = 0.5, to

can

reduce

autonomous

its purchases

expenditure 20 units. by

(or cut transfers) to reduce consumption

reduceconsumption

spending

by 20

units

to increase taxes (or reduce output, government 40 units. At each level of a 40-unit tax increase will transfers) by output, reduce disposableincomeby 40 units and cause consumers to reducetheir = 20 the units, as needed to eliminate spending by 0.5 X 40 expansionary output gap. (L04, LOS) at each

level of

the

will need

||

APPENDIX

I

The Multiplier Basic

the

in

Model

Keynesian

on the example economy used throughout the a more of the chapter completeexplanation income-expenditure T multiplier in the basic Keynesian model. In the chapter, we saw that a a decline in short-run drop in autonomous expenditure of 10 units caused in spending. equilibrium of 50 five times as as the initial units, output great change in the this is 5. Hence, multiplier example To seewhy this multiplier effect occurs, note that the initial decrease of 10 in consumer in the constant term of the (more precisely, spending consumption his

builds

appendix

to give

function, C) has two effects. First, the fall in consumer spending directly reduces in 10 units. the fall also Second, planned aggregate expenditureby spending firm reduces 10 units the incomes of and owners) of by producers(workers consumer Since the to consumeis the of 0.8, producers goods. marginal propensity consumer

goods will times their income other

producers

times their

cut

continues

process

of

income

10 + 8 + The three dots indicate effect

of the

decrease

10[1 This

expression

highlights

round is 0.8 times the propensity

marginal

round

of

spending.

the

that

initial

+ 0.8

+ 5.12

6.4

series

6.4

lead

0.8

and so on. In principle, spending and

+

of

10 in consumer

-.

of reductions continues indefinitely. also can be written as

The

in consumption

+ (0.8)2 +

(0.8)3 +

\342\200\242\342\200\242\342\200\242].

the fact that the

spending

by 6.4, or still other

reductions are added,the

reduction

initial

spending

many rounds of

quite small. and spending

become

spending of the

on planned

effect

after

although

indefinitely,

spending is

total

their consumption spending by 8, or 0.8 in spending cuts the income of reduction

by 8 units, leading them to reducetheir loss of 8. These income reductionsof their spending by 5.12, or 0.8 times 6.4,

income reductions,the effects When all these \"rounds\" total

This

10.

income

to

producers

this

reduce

therefore

loss of

in the

to consume out

spending that takes place previous round (0.8) becausethat

of

the

income

generated

in each is the

by the previous

648

CHAPTER

22 APPENDIX

THE

IN THE BASIC KEYNESIAN

MULTIPLIER

algebraic relationship, which 1, is

A useful but

than

less

1+X set x = 0.8, this

If we

X1 +

+

*

=

a similar

By

to propensity

the

in

multiplier

consume

x'

= 10

lof-V)

X

V0.27

effect of

5

the

decline

in

= 50.

earlier calculation, which showed that short-run from 4,800 to 4,750. a general analysis, we also can find algebraic expression for the basic Keynesian model. Recallingthat is the marginal mpc out of disposable income, we know that a one-unit increase in

output fell

equilibrium

1

with our

is consistent

answer

This

than 0

\342\200\242\342\200\242 \342\200\224

+

implies

) VI - 0.8/

x greater

number

any

that the total deand and output is

formula

lo(,

X3

applies to

1

on aggregate

spending

consumption

MODEL

50

by

units,

raises spending and income by one unit in the first round; expenditure by = = round; by mpc X mpc mpc X 1 mpc units in the second mpc1 units in the third = round; by mpc X mpc1 round; and so on. Thus, the total mpc3 units in the fourth in autonomous effect on short-run equilibrium output of a one-unit increase autonomous

expenditure

is given

by

1 + Applying

can rewrite

the this

algebraic expression

+

mpc3

\342\200\242\342\200\242\342\200\242.

formula given above, and recalling that 0 < mpc < 1, in a basic Keynesianmodelwith as 1/(1 \342\200\224 Thus, mpc).

to consume

propensity that if mpc = 0.8 then the multiplier we found marginal

mpc + mpc1 +

1/(1

of mpc, the

\342\200\224

mpc)

=

1/(1

numerically above.

multiplier \342\200\224

0.8)

=

1/(1 equals 5, which is the

\342\200\224

mpc).

we a

Note

same value of

I

CHAPTER

| 23

Reserve

Federal

the

and

Policy

Monetary

LEARNING OBJECTIVES After

this

reading

you should be LOI

chapter,

able to: structure

the

Describe

and responsibilities of

the FederalReserve

E

System.

L02

in

V:

*-

'-a.

TT-r-

the

rate

\302\253

how changes

Analyze

federal

funds

real

interest

and

rates affect

planned

expenditure

aggregate

and the short-run level

equilibrium

How

does the Federal

Reserve affect

and output

spending

in

the

short

output.

run?

L03 inancial market participants and commentators go to remarkable lengths to try to predict the actions of the FederalReserve. For a while, the CNBC financial news program Box reported the Squawk regularly on what commentators called the Greenspan Briefcase Indicator. The idea was to spot the Fed chairman at that time, Alan on his way to meet with the Federal Greenspan, Open Market Committee, the group that determines U.S. monetary policy. If Greenspan's briefcasewas packedfull, presumably with macroeconomic data and analyses,the was that the Fed to A interest rates. slim briefcase meant no guess planned change in rates

change \"It

was

was likely. 17 out right

of the

first

20

Hainesnoted,\"but

times,\"

the program's

anchor Mark

it has a built-in self-destruct mechanism becauseGreenspan briefcase. He can make it wrong or right. He has never publicly [own] packs t he but we have reason to believe that he knows about acknowledged indicator, it. We have to considerthe fact that he wants us to stop doing it because the last two times the briefcasehas beenwrong, and that's disturbing.\"1 The Briefcase Indicatoris but one example of the close public scrutiny that the chairman of the Federal Reserve and other face. monetary policymakers Every

his

aRobert

H. Frank, \"Safety

in Numbers,\"

The New

York

Times

Magazine,

of

November 28,1999, p. 35.

Show

the

how

demand

for money and the supply of money interactto

determine

equilibrium rate.

interest

L04

the

nominal

Discuss how the

Fed uses its control supply

nominal

ability

to

the money to

influence

and real

interest rates.

650

CHAPTER

23

MONETARY POLICY AND

THE FEDERAL

RESERVE

from a member of the Board of every congressional testimony, every interview is closely for clues about the future course of monetary policy. The analyzed reason for the intense public interest in the Federal Reserve's decisions about monetary the level of interest rates\342\200\224isthat those decisions have policy\342\200\224and especially in general. importantimplications both for financial markets and for the economy

speech,

Governors

In this chapter, we examine the workings of monetary policy, one of the two of other fiscal stabilization major types policy. (The type, policy, was discussed in the last chapter.) As we saw in the last chapter, stabilization policies are government policies that are meant to influence plannedaggregateexpenditure,with the of Both of stabilization and goal eliminating output gaps. types policy, monetary and have been useful at various times. However,monetary fiscal, are important which can be changed quickly by a decisionof the Federal Reserve's Federal policy, Market Committee is more flexible and (FOMC), Open responsive than fiscal policy,

be changed

can

which

circumstances,

only

Under normal

by Congress.

more activelyin

is used

policy

policy to help stabilize the

than fiscal

action

legislative

by

monetary

therefore,

United

the

States

economy.

the Federal Reserve as an institution: how begin this chapter by studying it came to be, how it responded to banking and how it panics early in its history, functions we look how affects short-run Next, today. monetary policy output. in nominal interest rates, which how changes the Fed Specifically, we first examine

We

affect real interest rates, which affect decisions. We then spending our analysis of the basic Keynesian model in the previous and chapter show how, in the short run, changes in real interest rates change planned spending and thus short-run equilibrium output. We then look at some of the details of more monetary policy by examining closely the relationship betweenchangesin the

can influence,

build on

discussed

first

central

of the

bank

responsibilities.

country's central see in this the level

chapter

of interest

the Federal Reserve in Chapter 20. Recall that the Fed is the in general have two main United States, and that central banks are for which means that a First, they responsible monetary policy, bank determines how much money circulatesin the economy. We'll that this responsibility implies that Federal Reserve actions affect in the

rates

economy as

in general,

banks

government agencies,

central

responsibilities

for the oversight and

central banksplay

during

periods of

other

have

particular,

financial

of

regulation

crisis in

important

In particular,

markets.

markets.

financial

OFTHE FEDERAL

AND STRUCTURE

Reserve System

Federal

Congress a government whose

well. Second,alongwith

and the Fed in

SYSTEM

RESERVE

The

roles

important

HISTORY

THE

rates.

interest

nominal

in

RESERVE

FEDERAL

THE We

and changes

supply

money

in

and

1913,

agency.

principal

operations

began

objective

operation

in

is making as

economic

Like

banks,

a profit,

central

growth,

Reserve all central

Federal

the

1914.

commercial

Unlike

promoting publicgoals such of financial

was created by

which are banks

Act, passed by banks, the Fed is businesses

private

like the

low inflation,

Fed focus on

and

the

smooth

markets.

The FederalReserve

banks,

Act established a system of 12 regional FederalReserve with a geographical area calleda FederalReserve district. that the establishment of Federal Reserve banks around the hoped ensure that different regions were representedin the national In fact, the regional Feds regularly in their assess economic conditions

each

Congress countrywould policymaking process.

districts and Reserve

banks

commercial

associated

report this also

banks

information

provide in

their

to policymakers

various services, district.

in Washington.

Regional Federal

such as check-clearing services,

to

the

THE

'Ym sorry, sir, but

At the its

by

Board

professional

the

up for

in Washington,

is located

appointed by

Senate,

the

to 14-year

reappointment members

Board

know you Fed\"

national level, the leadership of the Federal of Governors. The Board of Governors,

staff,

who are

I don't believe to call us the

years. The Fed

president

of

us well

Reserve together

other

every

as chairman chairman, along with to serve

enough

System is provided a large

with

D.C. The Boardconsists of seven governors, the United States, subjectto confirmation by

terms. The terms are staggeredso that year. of the

651

RESERVE

FEDERAL

one

governor

comes

The president also appoints one of these the Board of Governors for a term of four of the is secretary Treasury, probably one

leadership of the

Fed, consisting

of seven by the

the

of Governors

Board

governors president to

14-year

appointed staggered

terms

most powerful economic policymakers in the U.S. government, after the Recent such as Paul Volcker and Alan have been chairmen, president. Greenspan, of

the

two

regarded

highly

and

influential.

about monetary policy are made by a 12-membercommittee called the Federal Open Market Committee (or FOMC).The FOMC consists of the seven Fed governors, the president of the Federal Reserve Bank of NewYork, and four of the presidents of the other regional Federal Reserve banks, who serve on a rotating basis. The FOMC meets approximately eight times a year to review the state of the and to determine economy monetary policy. Decisions

THE

FED'S

STABILIZING FINANCIAL MARKETS:

PANICS

BANKING

of the Fed in 1913 was promoted by a series of financial market crises both the markets themselves and the U.S. economy as a whole.The was that the Fed would be ableto eliminate or at least control Congress

The creation that disrupted

hope of

ROLE IN

Market Committee (FOMC)the

Federal Open committee

that makes

concerning

monetary

decisions policy

652

23

CHAPTER

THE FEDERAL

MONETARY POLICY AND

crises.

such

panic

banking

news or

which imminent

bankruptcy

or more banks depositors to their

a situation

in

rumors of the leads rush

of one bank to withdraw

funds

bank

depositors

disruptive

during the nineteenth

States

panic, news

a banking

In

centuries.

United

the

more banksleads

perhaps the most

panics were

Banking

financial crisis in

RESERVE

or rumors to rush

of

the

imminent

and early

of recurrent

type

twentieth

bankruptcy

of one

or

to withdraw their funds.

factor that makes banking panics panics occur? An important is the existence of fractional-reserve As we discussedin Chapter 20, possible banking. in a fractional-reserve banking system, like that of the United States and all other industrialized bank reserves are less than which means that banks countries, deposits, if they were all to decideto do not keep enough cash on hand to pay off depositors withdraw their at one time. Normally this is not a problem, as only a small deposits if a of to withdraw their funds on But percentage depositors attempt any given day. rumor circulates that one or more banks are in financial trouble and may go Since bank reserves are bankrupt, depositors may panic, lining up to demand their money. do

Why

banking

a sufficiently severe panic could lead even deposits, financially healthy banks to run out of cash, forcing them into bankruptcy and closure.(Think of the scene in the movie Ifs a Wonderful when tries to convince his Life George Bailey not to withdraw all of their and close their accounts.) depositors deposits The Federal Reserve was established in response to a particularly severe in that occurred 1907. The Fed was with two tools to bankingpanic equipped principal

less than

try

to

or moderate

prevent

supervise and regulate in

confidence

banks,

banking panics. First, the

banks.

hoped

the

that

be less prone to panic,if

and thus

keepinga closewatch

It was

Fed

public people

was

the power to have greater that the Fed was

given

would knew

Second, the Fed was allowedto make loans to banks. The idea was that, a during panic, banks could borrow cash from the Fed with which to pay off the need to close. depositors, avoiding No banking occurred between when the Fed was established, and 1914, panics 1930. between 1930 and 1933, the United States the worst However, experienced in its history. Economic historians agree and most protracted seriesof banking panics that much of the blame for this should be placed on the Fed, which neither panic the of the nor acted to contain it. appreciated severity problem aggressively enough

EXAMPLE 23.1

on

bankers'

activities.

The Banking Panicsof 1930-1933 and

the

How did the

Depression affect the

banking

panics

during

the Great

Money

Supply money

supply?

in the United States occurred during the banking panics ever experienced of the Great between 1930 and 1933. this early stages Depression, During period, to close. This approximately one-third of the banks in the United States were forced of the was an reason that the near-collapse banking system probably important in was so severe. With fewer banks it was difficult for Depression many operation, very small businesses and consumers during the 1930s to obtain credit. Another early effect of the banking panics was to greatly reduce the nation's money supply. important

The

worst

During of

the

risk

prior to the

a banking to keep panic, people are afraid deposits in a bank because that the bank will go bankrupt and their money will be lost (this was introduction of federal deposit insurance, discussed below).During the

bank depositors withdrew their money from banks, These withdrawals reduced bank reserves. Recall from holding 20 that each extra dollar of held the adds to the $1 Chapter currency by public but each extra dollar of bank reserves translates into several dollars money supply; in a fractional-reserve banking system each dollar of of because money supply reserves can \"support\" several dollars in bank Thus, the public's deposits. withdrawals from which increased currency holdings by the public but reduced banks, in the total money supply bank reserves by an equal amount, led to a net decrease 1930-1933

period, many instead. currency

(currency plus deposits).

withdrawals addition, fearing banking panics and the associated increased their desired reserve-deposit ratios, which reduced

In

by the

depositors, banks quantity of

that

could be

reserve-deposit

ratios

deposits

change in

supported by any also tended

given

of bank

level

to reduce the

reserves. This

supply.

money

on currency holdings by the public, the reserve-deposit ratio,bank in and the for selected datesare shown Table 23.1. Notice reserves, money supply in the amount of currency held by the public the increase over the period and in the reserve-deposit ratio, as well as the decline in bank reserves in 1931. The last column shows that the U.S. money supply dropped by about one-third between Data

December1929and

1933.

December

TABLE 23.1

Key U.S. Monetary Statistics,1929-1933

Reserve-deposit

Currency

held

by

ratio

public

Bank

Money

reserves

supply

December

1929

3.85

0.075

3.15

45.9

December

1930

3.79

0.082

3.31

44.1

December 1931

4.59

0.095

3.11

37.3

December1932

4.82

0.109

3.18

34.0

4.85

0.133

3.45

30.8

1933

December

Note:Data Source:

Friedman

1863-1960(Princeton,

Recall

the

on currency,

Milton

Equation

this

money

supply

are in

Anna J. Schwartz, A Monetary History A-l. NJ: Princeton University Press, 1963),Table

billions

of dollars.

of the United States,

20.1:

Bank deposits = Using

and the

base,

monetary

and

equation,

(Bank

we can

reserve-deposit

reserves)/(Desired

see

that

increases

in currency

ratio).

holdings

by

the

reserve-deposit ratio both tend to reducethe money supply. These effects were so powerful in 1930-1933 that the nation's money supply, shown in the fourth column of Table 23.1, droppedprecipitously, even though and bank taken rose the period. reserves, currency holdings separately,actually during increases

public and

in the

CONCEPT CHECK 23.1 between the money supply supply = Currency held by + Bank reserves/Desired reserve-depositratio). Would the money supply have in 193 l-l 933 if the public had stopped withdrawing after December 1930 deposits held by the public had remained at its December 1930 level? currency the

Using

and

data

from Table 23.1, confirm is consistent with

its determinants

public fallen

so that

CONCEPT

CHECK

that

Equation

the

relationship

20.2 (Money

23.2

fell from $44.1 billion to $37.3 billion over According to Table23.1,the U.S. money supply did use open-market the course of 1931.The Fed 1931 to replenish purchases during Find (a) the quantity bank reserves in the face of depositor withdrawals. of reserves that the Fed injected into the economy in 1931 and (b) the quantity of reserves the Fed would have had to add to the economy to keepthe money supply unchanged from 1930, that ratios for each year remained as assuming public currency holdings and reserve-deposit in the table. Why has the Fed been criticized for being too timid in 1931 ? reported

654

CHAPTER

23

MONETARY POLICY AND

under

insurance which the

a system

government

that depositors guarantees not lose any money even if

their

bank

goes

bankrupt

will

RESERVE

failed to

the Fed

When

deposit

THE FEDERAL

decided to look at other tuted a system of deposit government guarantees than

of less

deposits

stop the banking

of the 1930s, policymakers panics for strategies controlling panics. In 1934 Congressinstiinsurance. Under a system of deposit the

insurance,

under

depositors\342\200\224specifically,

get their money

will

they

$100,000\342\200\224that

current

insurance eliminates the

rules,

back

those even

with

if

bankrupt. Deposit people their deposits when rumors circulate that the bank is in financial in the bud. Indeed, sincedepositinsurancewas trouble, which instituted, nips panics the United States has had no significant banking panics. bank

goes

for

incentive

the

to

withdraw

insurance is not a perfect solution to the problem of drawback is that when deposit insurance is in force, banking panics. know are what to their bank, and depositors they protected no matter happens become unconcerned about whether their bank is making prudent they completely loans.This situation can lead to reckless behavior by banksor other insured in intermediaries. For and loan associations example, during the 1980s, many savings the United States went bankrupt, in part because of reckless lending and financial investments. Like banks, so the U.S. insurance, savings and loans have deposit deposit

Unfortunately,

An important

government had to pay savings

This action ultimately cost U.S. such occurrences,the prevent

POLICY

depositors

hundreds

taxpayers

and

Reserve

Federal

examine banksto makesure they MONETARY

loan

and

are

full

value

of their

deposits.

of billions of dollars. To try to other government regulators

prudently.

lending

AND

the

ECONOMIC

FLUCTUATIONS policy can be used to eliminate output gaps and is relatively straightforward. As we will see in this section, planned aggregate expenditure is affected by the level of the real in the economy. Specifically,a lower real interest rate encourages interestrate prevailing real interest rate higher planned spending by households and firms, while a higher reduces spending. By adjusting the real interest rate, the Fed can move planned in the desired direction. Under the assumption of the basic Keynesian spending model that firms produce just enough goods and servicesto meet the demand for their output, the Fed's stabilization of planned leads to stabilization of spending

We

how

examine

now

stabilize the

monetary

The

economy.

basic idea

and as well. aggregate output employment The Fed can control the economy's nominal the

supply.

money

we'll look at

how

rate

interest

rate affect

in

planned spendingand

Through

its control

output.

equilibrium

FED CONTROLTHE

THE

CAN

the

interest rate through its control of We will analyze how it does this later in the chapter; for now, control of the nominal interest rate leadsto control of the real short run. We'll then look at how changesin the real interest

REAL INTEREST RATE?

of the money supply, the

Fed can control the

economy's

important economic decisions,such as the decisions to save and invest, on the real interest rate. To affect those the Fed decisions, depend must exert some control over the real interest rate. Most economists believe that the Fed can control the real interest rate, at least for some period.To see why, recall the definition of the real interest rate from rate.

nominalinterest

Chapter

But many

16:

r = i The The

real interest rate Fed can control

determine the

money

\342\200\224

it.

r equals the nominal interest rate i minus the rate of inflation it. the nominal interest rate quite precisely its ability to through inflation appears to change relatively Furthermore, supply.

MONETARY

slowly discuss

to

Fed by

POLICY AND

ECONOMICFLUCTUATIONS

655

to changes in policy or economic conditions, for reasons we will tends to adjust slowly, actions by the chapter. Becauseinflation the nominal interest rate lead the real interest rate to change change generally in response in the next the

about

same amount.

the Fed can set the real interest rate appears to contradict our in 19. we concluded that the real interest rate is There, analysis Chapter in new capital determined by the condition that national saving must investment equal This contradiction is rooted in a in the time goods. apparent difference frame being Because inflation does not adjust quickly, the Fed can control the real interest rate over the short run. In the long run, however\342\200\224that is, over periods of several years or more\342\200\224the inflation rate and other economic variables will adjust, and the balance of saving and investment will determine the real interest rate. Thus, the Fed's to influence consumption and investment its ability spending through control of the real interest rate is strongestin the short run.

The idea that

considered.

THE IN

ROLE OF

MONETARY

THE FEDERALFUNDSRATE POLICY

thousands of interest rates and other financial data are easily available, rate that is perhaps most closelywatched by the public, politicians, the markets is the federal funds rate. media, and the financial The federal funds rate is the interest rate commercial banks each other for charge loans. For example, a bank that has insufficient very short-term (usually overnight) reserves to meet its legal reserve requirements borrow reserves for a few days might from a bank that has extra reserves. Despite its name, the federal funds rate is not an official government interest rate and is not connected to the federal government. Because the market for loans between commercial banks is tiny compared to some other financial markets, such as the market for government bonds, one might the federal funds rate to be of little interest to anyone other than the managers expect of commercial banks. But enormous attention is paid to this interest rate because, in terms of the over most of the past 40 years, the Fed has expressedits policies federal funds rate. Indeed, at the close of every of the Federal Open Market meeting whether the federal funds rate will be increased, Committee, the Fed announces or left unchanged. The Fed alsomay indicate the likely direction of future decreased, in the federal funds rate. Thus, more than other financial variable, changes any changes in the federal funds rate indicate the Fed's plans for monetary policy.2 nominal interest rate over Why does the Fed choose to focus on this particular all others? As we saw in Chapter 20, in practice the Fed affects the money supply Because open-market through its control of bank reserves. operations directly affect the of bank reserves, the Fed's control over the federal funds rate is supply the Fed wants the federal funds rate to fall, it particularly tight. If, for example, conducts open-market purchases, which increasereserves,until the federal funds rate falls to the new desired level. However, if Fed officials chose to do so, they in terms could of another probably signal their intended policiesjust as effectively short-term nominal interest rate, such as the rate on short-term government debt. of the federal funds rate from January 1970 Figure 23.1 showsthe behavior 2011. As you can see, the Fed has allowed this interest rate to vary through May in response to economic conditions. considerably In reality, not rates are seen in the just one but many thousands of interest Because interest rates tend to move us to speak of the economy. together (allowing interest an action by the Fed to change the federal funds rate generally causes rate), other interest ratesto changein the same direction. However, the tendency of other interest rates (suchas the long-term bond rate or the rate on bonds government

Although the

interest

Federal Open Market Committee'sannouncements www.federalreserve.gov. 2The

are available

on the

Federal

Reserve's

website,

rate the interest rate that commercial banks

federal funds each

charge short-term

because

loans;

sets federal

its

other

for very

overnight) the Fed frequently

(usually

policy

in terms

funds rate, this

closely watched

markets

in

of the rate is

financial

656

23

CHAPTER

MONETARY POLICY AND

THE FEDERAL

RESERVE

23.1

FIGURE

The Federal

Funds

Rate,

1970-2011.

The federal funds rate is the interest rate commercial banks each other for charge loans.

short-term

It is closely

watched becausethe

Fed

its policies in expresses terms of the federal funds

allowed the to vary response to

The Fed has

rate. federal

funds rate

considerably

in

economicconditions.

1978

1974

1970

1982

1986 1990 1994 1998

2002

2011

2006

Year

Source:

issued only

other interest funds

not

rates

rate\342\200\224afact

THE REAL the

output which

be

may

that

somewhat

complicates

INTEREST

as the federal funds

direction

In practice,then, the

less precise than

the Fed's

Fed's

its control

rate is of

control

of the

federal

policymaking.

EXPENDITURE

AGGREGATE

PLANNED

In

to move in the same an exact relationship.

by corporations) a tendency,

Bank of St. Louis, http://research.stlouisfed.org/fred2.

Reserve

Federal

AND

RATE

last chapter, we saw how planned spending is affected by changes in real Y. Changes in output affect the private sector's disposable income (Y \342\200\224 T), in turn influences consumption spending\342\200\224a relationship the captured by

consumption function. A

variable that has potentially important effectson real interest rate r. aggregate expenditure In Chapter both the saving 19, we saw that the real interest rate influences decisions of households and the investment behaviorof firms. For households, the effect of a higher real interest rate is to increasethe reward for saving, which leads householdsto if they consume save more.3 At a given level of income, households can save more only less. Thus, saying that a higher real interest rate increasessaving is the same as saying that a higher real interest rate reducesconsumption at each level of income. spending The idea that higher real interest rates reduce household spendingmakes intuitive sense. for example, about people's willingness to buy consumer durables Think, such as automobiles or furniture. Purchases of consumer durables, which are part of are often financed from a credit bank, union, consumption spending, by borrowing or finance finance company. When the real interest rate rises,the monthly charges associated with the purchase of a car or a piano are higher, and become less people or able to make the purchase. Thus, a higher real interest rate reduces willing to on consumer constant income people's willingness spend goods, holding disposable and other factors that affect consumption. second

is the

Besides discourages

real interest rate a new car rises, financing

When

reducing

firms

from

consumption spending, a higher real interest rate also making capital investments. As in the case of a consumer

the

becomes more expensive fewer cars are purchased.

and

3Because

savings empirical

a higher real interest rate also reduces the amount households must put aside to reach a However, target, a higher real interest rate could theoretically increase or decreasesaving. evidence real interest rates have a modest positive effect on saving. suggests that higher

given

MONETARY POLICY

AND

ECONOMIC

FLUCTUATIONS

a piano, when a rise in the real interest rate increases reconsider their plans to invest. For example, financing may firm when the cost a be upgrading computer system may profitable for a manufacturing of the system can be financed at a real interest rate of 3 percent. by borrowing if the real interest rate rises to 6 the cost of funds to However, percent,doubling the firm, the same upgrade may not be profitable and the firm may choose not to invest. We also should remember that residential investment\342\200\224the of building houses and apartment buildings\342\200\224is also part of investment spending. Higher in the form of higher mortgage rates, certainly interest this kind of rates, discourage car or

a buying firms costs,

of

thinking

investment spending as well.4

is that, at any given level of output, both consumption investment decline when the real interest rate increases. planned spending in a fall the real interest rate tendsto stimulate and Conversely, consumption investment costs. spending by reducing financing The

conclusion

spendingand

Planned Aggregate Expenditure and the How does the

interestrate affect

certain economy,

In a

the

f

=

spending are given

of planned

components C=

expenditure?

aggregate

planned

640

+ 0.8(Y-

250

-

Rate

Interest

Real

by

T) - 400r,

600r,

G = 300, =

NX

20,

T =

This economy is similar except

the

now

that

\342\200\224

400r,

interestrate,

planned the

real

example,

implies

that a

1 percentagepoint

to 5 percent\342\200\224that 400(0.01) = 4 units. Similarly,

by

investment

interest

in the

term

final

the

4 percent

from

spending

one we worked with rate r is allowedto affect

the

to

real interest

planned investment. For consumption,

250.

tells us that in this example, rate lowers planned investment

a by

chapter

previous

and

consumption

equation describing

.05\342\200\224reduces

the

real

consumption

in the

equation for 1 percentage point increasein term

final

the

the

both

(0.01)increasein

.04 to

is, from

in

600(0.01)

= 6 units.

Thus, the

overall effect of a 1 percentage point increase in the real interest rate is to lower planned aggregate expenditureby 10 units, the sum of the effectson consumption \342\200\224 and investment. As in the earlier examples, disposable income (Y T) is assumed to affect consumption spendingthrough a marginal to consume of 0.8 propensity T the first and net and taxes G, NX, (see equation), government purchases exports are assumedto be fixed numbers. To find a numerical equation that describes the relationship of planned in to we can as the last with the (PAE) aggregate expenditure output, begin chapter definition of general planned aggregate expenditure: PAE = Substituting each describing

type PAE

4We

discussed

remember this

C+P

for the four components of of spending, we get =

[640

+ 0.8(

Y

-

250)

-

+

G

+ NX.

using

expenditure,

-

400r] + [250

600rJ

the equations

+

300

+ 20.

in Chapter 19. the relationship between the real interest rate and investment the section \"Investment and Capital Formation.\" material, you should review

If

you

do not

EXAMPLE

23.2

657

658

CHAPTER

23

MONETARY

POLICY

AND THE

first term

The

RESERVE

FEDERAL

side of this equation is the expression T = 250; the second bracketed term

the right

on

brackets

in

using the fact

for

is consumption, and the last two terms to the assumed numerical investment; planned correspond If we simplify this values of government purchases and net exports. and equation Y the terms that do not on and the terms that do group together depend output

depend on output, PAE

=

we

[(640

or, simplifying

get

- 0.8 X

-

250

23.1, the term

In Equation

=

equals

output,

EXAMPLE 23.3

is autonomous does

that

the

0.8

Rate

Now, suppose

that

23.1

Equation

the

Fed

short-run

sets the

+ 0.8Y,

0.8Y.

(23.1)

expenditure, the portion of on output. Noticethat in this real interest rate r. Induced on

Setting

r =

Output

Equilibrium

output?

equilibrium

real interest rate

depend

does

at

5 percent.

0.05

[1,010

- 1,000(0.05)] +

0.8Y.

we get

Simplifying,

PAE = the

real

interest

rate is

induced expenditure is 0.8Y. equals

+ 20j

gives

PAE =

that

not depend

Short-Run

and

interestrate affect

when

300

expenditure depends on the of planned aggregate expenditure that portion Y in this example.

How does the

So,

l,000r] +

autonomous

The Real Interest

in

-

[1,010

brackets

in

plannedaggregateexpenditure expenditure,

- 600r) +

+ (250

400r)

further,

PAE

example

taxes

that

planned

could now apply the

5 percent,autonomous

Short-run

aggregate tabular

960 + 0.8Y.

equilibrium

spending. To find

method

used in the

expenditure

output short-run

is 960

is the level equilibrium

and

of output

output,

we

last chapter,comparing alternative

of output with the planned aggregate expenditureat that level of output. Short-run equilibrium output would be determined as the value of output such that or output just equals spending,

values

Y

=

PAE.

when we comparethis example with the example economy we see that the for previous chapter, equation planned aggregate = 960 + we found there. Thus, Table 22.1, expenditure,PAE 0.8Y, is identical to what as well, and we get the same answer for short-run appliesto this example equilibrium output, which is Y = 4,800. Short-run equilibrium output also can be found graphically, using the from the last Keynesian-crossdiagram chapter. Again, since the equation for in is the same as 22.4 planned aggregate output Chapter 22, Figure applies well here. equally However, in

the

conveniently,

AND ECONOMIC

POLICY

MONETARY

CONCEPT CHECK23.3 the

For

economy

3 percent rather between

values

in Example 23.3, suppose the Fed sets the real interest rate at at 5 percent. Find short-run equilibrium output. (Hint: Consider 4,500 and 5,500.) than

FIGHTS

THE FED

RECESSION

A

now demonstrated

We have

i r

the

that

interest rate and equilibrium

following

holds between the

relationship

real

output:

=>-t planned C and

I =>-

planned

t PAE

=>>

(via

the

multiplier)

t

Y.

in the real interest rate causesincreasesin both decrease planned consumption and planned investment, which lead to an increasein planned The spending. in shortincrease in planned leads, through the multiplier, to an increase spending run equilibrium output. Similarly,

A

t r

and

consumption

The

increase

is, an

That

planned C and

=> i

short-run

in

affects

relationships are the economic

short-run

usedto fight

(via

the

multiplier)

i

Y.

planned spending.

a decreasein

output.

equilibrium

These two

=>>

rate causes decreases in both which lead to a decreasein planned leads, through the multiplier, to

spending

planned

i PAE

interest

investment,

planned

decrease

real

the

in

I =>-

planned

a recession;

activity. then we

key

Let's will

to understanding how analyze

first

turn

to how

how monetary policy monetary policy can

the Fed

can fight

be

inflation.

in which real output faces a recessionary situation gap\342\200\224a and planned spendingis \"too low.\" To fight a recessionary the real interest rate, stimulating and gap, the consumption in planned investment spending. to the we have this increase According theory developed, will cause to the to full rise, restoring spending output economy employment. in the previous Let's build on the example we worked through section. Y* that As the Fed has set the real before, Suppose potential output equals 5,000. in interest rate to 5 The this is 5. equal percent. multiplier economy We showed earlier short-run that, with the real interest rate at 5 percent, equilibrium for this is Potential is so the output 4,800. 5,000, output economy output = 200. B ecause actual is below Y*) equals 5,000 4,800 gap (Y output this faces a To the the Fed should potential, recession, economy recessionary gap. fight lower the real interest rate, raising until aggregate expenditure output reaches the level. That the Fed's is to increase 5,000, is, full-employment objective output Because the multiplier equals 5, to increase the Fed must by 200. output by 200,

the economy potential output, Fed should reduce

Suppose

is below

increase autonomous expenditureby 200/5 = 40 units. By how much should the Fed reduce the real interest rate to increase autonomous expenditure by 40 units? Autonomous expenditure in this economy is \342\200\224 as can see from [1,010 l,000r], you Equation 23.1, so that each percentage

expenditure by 1,000 X (0.01) = 10 units. To increaseautonomous real expenditure by 40, then, the Fed shouldlower the interest rate by 4 percentage points, from 5 percent to 1 percent. In summary, to eliminate the recessionary gap of 200, the Fed should lower the real interest rate from 5 percent to 1 percent.Notice that the Fed's decrease in the real point

reduction

interest rate

r increases

in

autonomous

output, as economiclogic suggests. 23.2. The policy graphically in Figure reduction in the real interest rate raises planned spendingat each level of output, the line upward. When the real interest rate equals1 percent, shifting expenditure the line intersects the Y = PAE line at Y = 5,000, so that output and expenditure increases

short-run

The Fed'srecession-fighting

potential output

are

equal.

equilibrium

is shown

FLUCTUATIONS

659

660

CHAPTER23

MONETARY

AND THE

POLICY

RESERVE

FEDERAL

PAE

Y= UJ

##

2

. (3) Equilibrium

ure

moves from

dit

/ /

F

E to

c

#*^^^|

F\\

^^(r=1%) line

Expenditure

^^^

(r =

f^^\\^^

Q_

line

Expenditure

5%)

X Q V

rE

^^7

Si

^^ C

c J2

j>

\\

//

/

line

CL

z

r

upward

\342\200\242 (I) Recessionary

/

reduction in the expenditure

(2) A ^ shifts

gap

i\342\200\224*\342\200\224^ \\_

0

\342\200\224\342\226\2721 5,000

4,800

Output

Y

)r

23.2

FIGURE

The Fed Fights a The is (I) economy

Recession.

with a recessionary gap of 200;(2) the initially at point \302\243, the real interest rate from 5 percent to I percent, shifting the line the new is at where F, expenditure up; (3) equilibrium point output equals potential outputThe output gap has been eliminated.

reduces

Fed

CHECK 23.4

CONCEPT

Supposethat as

take

EXAMPLE

23.4

in Example 23.3 potential output the Fed cut the real interest rate is 5. given that the multiplier

is 4,850

should

much

and the TerroristAttacks

The Fed How did

in

the Fed respondto recession and

The U.S. economy

began

Research, a recessionbegan

2001,

to seriousproblems

The Fed

in the

first

than 5,000. By You

full employment?

how may

2001 terrorist

the fall

rather

of

2000,

attacks with National

in 2001?

investment Bureau

in

high-tech

of Economic

2001. To make matters worse, on September11, York City and Washington shocked the nation and led travel and financial industries, among others. in March

on New

attacks

terrorist

in the

restore

particularly sharply. According to the

falling

equipment

slowing

to

began

to respond to growing evidence of an economic slowdown the federal funds rate stood at about 6.5 percent. dramatic move was a surprise cut of 0.5 percentage in January between 2001, regularly scheduled meetingsof the Committee. Further rate cuts followed, and by July the funds

of 2000. At the time, (See Figure 23.1.) The Fed'smost

at the end

funds rate Open Market

in the

point

Federal

rate was

below 4 percent.By

summer's

end,

however,

there was

still

considerable

of the economic slowdown. uncertainty The picture changed suddenly on September11, 2001,when the terrorist attacks on the World Trade Centerand the Pentagon killed almost 3,000 people. The terrorist attacks economic as well as human costs. The imposed great about

physicaldamage

and financial

the likely severity

was in the billions of dollars, and many offices area had to close.The Fed, in its role as supervisor of the worked hard to assist in the restoration of normal operations in

in lower

businesses system,

in the

Manhattan

POLICY AND

MONETARY

ECONOMICFLUCTUATIONS

the financial district of New York City. (The FederalReserve Bank of New York, which actually conductsopen-marketoperations, is only a block from the site of the World Trade conditions Center.) The Fed also tried to ease financial by the federal funds rate to as low as 1.25 temporarily lowering percentin the week the attack. following In the weeks and months following September11,the Fed turned its attention from the direct of the attack to the indirect effects on impact possible the U.S. economy. The Fed was worriedthat consumers, nervous about the with the ongoing future, would severely cut back their spending; together weakness in investment, a fall in consumption could spending sharply worsen the recession. To stimulate spending,the Fed continued to cut the federal

funds rate.

officially ended in

recession

the

time

the

By

percent, 4.5 percentagepoints number of factors made the 2001 recessionrelatively President Bush's tax cuts and increasedgovernment homeland

defense.

and

security

November 2001, the than

lower short

A

including for

agree that

Fed's

the

the

and

recession

the

funds

earlier.

a year and mild,

expenditures

most economists

Nevertheless,

helped to moderatethe impact of

actions

quick

attacks.

11 September

THE To

at 2.0

was

rate

FED

FIGHTS

point

we have

this

considering

our is an

inflation

and hence actual

focused on the problem next chapter, we will For now we will simply

In the

inflation.

incorporated into

INFLATION

analysis.

expansionary

output

of stabilizing output, without see how inflation can be note

that

one important cause of planned spending,

in which

gap\342\200\224asituation

potential output. When an expansionary gap the demand for their exceeds their normal rate of exists, output production. firms be content to meet this excess demand at previously Although may determined prices for some time, if the high demand persists, they ultimately will firms

their

raise

find

eliminate

of an

that

spurring inflation.

prices,

Becausean

exceeds

output,

gap

expansionary

gaps

expansionary

expansionary

as well

tends to lead to inflation, the Fed moves to as recessionary gaps.The procedurefor getting in which

gap\342\200\224asituation

output is \"too

high\"

rid

to

relative

of that for fighting a recessionary gap, a situation in which is \"too low.\" As we have the cure for a seen, output recessionarygap is to reduce the real interest rate, an action that stimulates planned spending and increases The cure for an is to raise the real interest rate, output. expansionary gap which reduces consumption and plannedinvestment the cost of by raising The fall in planned spending leads in turn to a decline in output and borrowing. resulting to a reduction in inflationary pressures. let's now assume that above, Using the same example economy we've analyzed is rather than At the initial real interest rate of 4,600 5,000. potential output 5 percent,short-run is so this 4,800, equilibrium output economy has an of 200. expansionary gap potential

by

output\342\200\224is

the

reverse

As before, the multiplier 200, the Fed needs to

From Equation 23.1, we \342\200\224

so that

in

this

economy

reduce autonomous know

that

is 5.

expenditure

autonomous

each percentage

Hence, to reducetotal by

expenditure

200/5 in

point (0.01)increasein

this

output

= 40

units.

is economy real interest

[1,010 l,000r], rate lowers autonomous expenditureby 10 units (1,000 X 0.01). We conclude that to eliminate the inflationary the Fed should raise the real interest rate by gap, 4 percentage points (0.04),from 5 percent to 9 percent. The higher real interest

rate will

reduce

planned

aggregate

expenditure

output, 4,600, eliminating inflationary

and output to the

pressures.

the

level

of potential

661

662

CHAPTER

23

MONETARY POLICY

THE FEDERAL

AND

RESERVE

Y= PAE

S/

Q)

PAE

/

iditur

exper

/

(3) Equilibrium

y

moves from

^^^^

\\J^^

^0^^

line

Expenditure

. (r=5%)

^^

line

(r = 9%) Expenditure

EtoG gate

f

^^ aggre^

i i i i

!

Planned

in r increase shifts the expenditure line downward

\\ \\ (2) An

\\^^^^^

(1) Expansionary gap

y

f 0

Output

4,800

4,600

Y

Y* FIGURE

23.3

The Fed

Fights

Inflation.

at point \302\243, with an expansionary gap of 200;(2) the (I)The economy is initially Fed increases the real interest rate from 5 percent to 9 percent, shifting the line down; (3) the new equilibrium is at point G, where output expenditure

equals potential

the

The

effects

real

interest

point E

in

the

of the

outputThe

output

Fed's

inflation-fighting

rate at 5

percent,

where

figure,

output, the Fed raises the real slows consumption and investment At

new

the

eliminated

the

the expansionary

fjjj

eliminated.

in Figure

the

4,800. To reduce planned 9 percent. The higher

rate to

interest

moving

spending,

output

gap,

and,

the expenditure

equals

rate\342\200\224acontractionary

output

shown intersects

are line

expenditure

output equals

interest

real

been

policy

point G, actual

equilibrium

The Fed'sraising

the

gap has

potential

=

With

line at

spending

and

interest

rate

real

line downward. at 4,600. output thus

of inflation.

Jlf^-J

**.nt<*Vr

\"Personally,

23.3. PAE

action\342\200\224has

policy

with it, the threat

Y

I liked

this roller Reserve

coaster a lot better before the got bold of it.\"

Board

Federal

\302\251<

MONETARY

the

did

Why

ECONOMICFLUCTUATIONS

EXAMPLE

Rates

Interest

Raising

POLICY AND

Fed raise

interest rates

2004

in

and

2005?

in June 2004 when it increased the monetary policy 1.0 to 1.25 percent.(SeeFigure It continued to tighten 23.1.) the federal funds rate by one-quarter percentat each successive by raising meeting of the Federal Open Market Committee. after more than two 2006, By August the federal funds rate was 5.25 percent. did the Fed begin years of tightening, Why

The Fed federal

began tightening rate

funds

from

increasing the funds rate Because

2004?

in

that began

the recovery

in

2001

November

was slower than

normal

and marked by weak job growth, the Fed kept reducingthe funds rate until it reached 1.0 percent in June 2003. Once the recovery took hold,however, this very low rate was no longer necessary. While had not risen as much during employment the as it had in previous real GDP grew at a rate of nearly 6 recoveries, recovery in the second half of 2003 and 4.4 2004. Furthermore, percent during by percent 2004 the unemployment rate had fallen to 5.6 percent, not far above most by June estimates of the natural rate of unemployment. Although inflation to rise in began in most of the increase was due to the oil and the rate of 2004, sharp run-up prices, inflation remained low. the Fed to raise the Nevertheless, excluding energy began federal funds rate in order to prevent the emergenceof an expansionary gap, which would result in higher inflation. the Fed's rate increases couldbe viewed as a Thus, inflation. Had the Fed waited until inflation problem could have emerged, federal funds rate by even more than it

strike against future a significant appeared,

preemptive expansionary gap

might have had to

raisethe

and

the Fed

did.

the economy as a whole, but they have a markets. The introduction to this chapter noted the tremendous lengths financial market will go to in an participants to anticipate Federal Reserve policy changes. The EconomicNaturalist 23.1 attempt illustrates the type of information financial investors look it is so for, and why important to them.

The Fed's

interest rate

an

important

particularly

policiesaffect

on financial

effect

The Economic Naturalist23.1 does

Why

of inflation

market participants is increasing or is

Financial

inflation

Why

news

does bad news

Investors in

about

watch higher

stock

the

hurt

than

inflation

inflation

extremely

often causes expected hurt the stock market?

worry about

closely.

A report

stock pricesto

fall

that

sharply.

inflation because of its likely on impact understand that the when faced with Fed, policy. signs of an expansionary to raise interest rates in an attempt to reduce planned gap, is likely and \"cool down\" the economy. This type of contractionary action hurts spending policy stock prices in two ways. First, it slows down economic the activity, reducing expected in the stock market. Lower salesand profits of companies whose shares are traded reduce the dividends those firms are likely to pay their shareholders. profits,in turn, real interest rates reduce the value of stocks by increasing the Second, higher in in return for stocks. We saw 20 that an increase the return required holding Chapter financial investors require in order to hold stocks lowers current stock prices. Intuitively, if interest rates rise, interest-bearing alternatives to stocks such as newly issued will become government bonds more attractive to investors, the demand for, and reducing

Federal Reserve

hence

the

the

financial

markets

data on

market?

Financial

price of, stocks.

investors

v)jj^

23.5

664

CHAPTER

23

MONETARY POLICY AND

THE FEDERAL

RESPOND

RESERVE

FEDERAL

THE

SHOULD

RESERVE

TO CHANGES IN ASSETPRICES? Reserve's

Federal

The

inflation low. In have

economists

and

conditions

prompted

and

gaps

keeping

strategy. However,

it

attention

should

discussion.

this

For

a successful

Fed's focus on general economic to asset prices aswell.Thestock pay of the late 1990s and the housing bubble of the 2000s have

bust

and

been

has

to question the

started recently have argued that

boom

market

been on reducing output

focus has

primary

most instances,this

Federal Reserve and its chairman

many credit the

example,

for

Alan Greenspan,

effective

policymaking

monetary

at

the

set the stage

that

time,

for

and rising asset prices throughout the 1990s, growth especially the second half of the decade. Between 1995 and March 2000, the during January 500 stock market index rose by a record-breaking 233 percent and the U.S. S&P a business the stock Indeed, economy enjoyed record-long cycle expansion. economic

sustained

market's

rise helped

sustained

strong,

turn

promoted

economic

further

to fuel additional

expansion.

as stock

prices fell sharply some people questioned whether

However, peak,

view, overly

optimistic

that eventually burst could not support the Federal

Reserve,

and prices the resulting

stock and

to constrain

rates

interest

preemptivelyraised

in the the

as

2000

two years

Federal

Reserve

investors' \"irrational

in

which

after their

March

2000

should have In this

exuberance.\"5

a speculative run-up in stock prices firms' began to realize that earnings Earlier intervention the being paid. by slowed down the dramatic increase in the resulting stock market \"crash\"

led to

sentiment

investor

in

consumerspending,

investors

stock pricesthat were critics argued, would have therefore could have prevented loss of consumer wealth.

Alan defended the Fed's monetary Greenspan late out that it is very difficult to 1990s, pointing policymakingperformance in asset of assets to unsustainable levels\342\200\224\"until after identify bubbles\342\200\224surges prices if such the fact\342\200\224that is, when its bursting confirm(s) its existence.\"6 Even a speculative bubble could be identified, Greenspan noted, the Federal Reserve could have done little\342\200\224short of \"inducing a substantial contraction in economic activity\"\342\200\224to At

in August

a symposium

in

2002,

the

from driving up stock prices. Indeed, Greenspan that a well-timed incremental could have been claimed, tightening calibrated to prevent the late 1990s bubble is almost surely an illusion.\" Rather, the Federal Reservewas focusing as early as 1999 on policies that would the \"mitigate fallout when it occurs ease the transition to the next and, hopefully, expansion.\"7 investors'

prevent

\"the

speculation

notion

Greenspan'sremarks

highlight

two

basic problems

with

using

monetary

policy

First, doing so presupposesthat the Federal financial market professionalsat identifying when asset In are relative to the asset's value. prices inappropriately high, underlying practice, about the stock market that is not also however, the Fed does not have information if the available to private-sector investors.Second,even Fed were sure that a \"bubble\" is not a tool for existed, monetary policy very good addressing the problem. The Fed could try to lower stock pricesby raising the federal funds rate and But if this policy led to a recessionand slowing the economy. rising unemployment, in the first the outcome would be preciselythe one that the Fed was trying to avoid in For these the Fed monitors conditions the stock reasons, although market, place. in to address \"bubbles\" Reserve is better than

5Fed

markets.

asset

Chairman Alan Greenspan in a December 5,1996,

behavior

mentioned the possibility of \"irrational exuberance\" investor driving speech,which is available online at www.federalreserve.gov/boarddocs/

speeches/1996/19961205.htm. 6The

text

of Greenspan's

speech is

available

online

at www.federalreserve.gov/boarddocs/speeches/

2002/20020830/default.htm.

7Tbe Federal

before the Available

Reserve's

Semiannual

Committeeon online

Banking

on Monetary Policy, testimony of Chairman Report and Financial Services,U.S.House of Representatives,

at www.federalreserve.gov/boarddocs/hh/1999/July/Testimony.htm.

Alan

Greenspan

July 22,1999.

THE FEDERAL

when

setting monetary stock

than

as

prices

they

bubble.\"

have started to questionwhether these before the current recession.Specifically,

home As

spending. The view the

through

and

the bubble

try to prevent of a consequences to

the

in

interest

real

investment

planned

Fed is able to

rate, the

difficult,

the

first

effects

place. difficult

decreases

less

of a

in

residential

collapsing

Now, after living it is to clean up

the role

reconsidering

of monetary

ECONOMY

POLICYANDTHE

MONETARY

An increase and

seriously

of

asset bubbles.

in preventing

RECAP

are

led to

effects

wealth on consumption if not impossible, to spot

reduced

the

are

unemployment

prices

mitigate

in

as \"the

that the

fact

bubble, and seeinghow

after a bubblepops,economists

policy

was

better to

it was

that

it

house

of

effects

was that

of

growth

rapid

referred to

the direct

both through

2008

before

asset price bubbles, than

declinein

22, the

the

sharp rise in 2007 and 2008. prices during

the

is,

are as

problems

increasesin

in house

declines

swift

and through the indirect

construction

bubble

by

in Chapter expenditure

aggregate

planned

two

commonly

and steep

of this bubble popping, that followed

was prices we discussed

is now

2006

in output

declines

Deep

the result

clearly

and output, rather

spending,

inflation,

seemed

house prices between1999and housing

on

focuses

themselves.

Economists serious

policy it

RESERVE

rate reduces

spending. influence

Through planned

both consumption spending of the real interest

its control

spending

and short-run

equilibrium output.

To fight a recession (a recessionaryoutput the Fed lowers the gap), real interest rate, stimulating and planned spending output. Conversely, to fight the threat of inflation (an expansionary output the Fed gap), raises the real interest rate, reducing plannedspending and output.

Reserve has not typically used monetary policy to affect the Fed has focusedon prices. keepingpricesstable and output near potential. The experience of the stock market bubble of the late 1990stends to support this course of action, but the housing bubble of the 2000s provides evidence against it.

The Federal asset

Rather,

THE FEDERAL RESERVEAND

\342\200\224

Reserve Systemin

20, we focused on the Chapter that the of and checking is, money supply, quantity currency the public. the nation's is Determining money supply the primary task of monetary policymakers. But if you follow the economic news regularly, you a bit foreign may find the idea that the Fed's job is to control the money supply because the news media nearly always focus on the Fed's decisions about interest rates. Indeed, the announcement the Fed makes after each meeting of the Federal

When

we introduced

Fed's control of accounts held by

Open Market

term

the Federal

RATES

INTEREST

interest

the

Committee nearly

rate,

always

the federal funds

concerns

its plan

rate, discussedearlier in

for a particular this

chapter.

short-

contradiction between the two ways of looking at control of the money supply or as the setting of interest rates. As monetary policy\342\200\224as we will see in this section, the Fed changes the money to control the supply nominal interest rate. Thus, controlling the money supply and controlling the nominal interest rate are two sides of the same coin: Any value of the money chosen supply the Fed a for the nominal interest and vice versa. rate, by implies specificsetting The reason for this close connection is that the nominal interest rate is effectively Actually,

there is no

AND

INTEREST

RATES

665

CHAPTER

666

23

MONETARY

POLICY

the

AND THE

RESERVE

FEDERAL

of holding

\"price\"

controlling the

money (or, more of

quantity

money

supplied

its

accurately,

opportunity

to the economy, the

cost).

So, by

Fed alsocontrols

money (the nominal interest rate). how the Fed determines interest rates,we will look first at the market for money, with the demand side of that market. We will beginning see that given the demand for money the the Fed can control interest by public, rates by changing the amount of money it supplies. the

\"price\" To

THE

better

of holding understand

Money

refers to the

usable

in transactions.

estate\342\200\224in

of

way

other

holding

words,

if

allocation

portfolio the

decision

to hold

which

demand

decision the forms

firm

in

one's wealth

for money the an individual

of wealth

amount

or

about

chooses

to hold

in

the

form of money

Cost-Benefit

O

he

wished,

set

such as cash and checking accounts,that are is also a store of like or real value, stocks, bonds, Money a type of financial asset.As a financial asset, money is a of

assets,

wealth.

Anyone who

wishes to

MONEY

FOR

DEMAND

hold that

has some wealth wealth.

For

hold all $10,000

in

determine the form in which he or she if has wealth of he could, $10,000, example, Larry in the cash. Or he could hold $5,000 of his wealth must

in government form of cash and $5,000 bonds. Or he couldhold $1,000in cash, in in a and $5,000 in rare $2,000 bonds, checking account, $2,000 government there are thousands of different real and financial assets to choose Indeed, stamps. in all of which can be held different amounts and so Larry's from, combinations, choicesare virtually infinite. The decision about the forms in which to hold one's wealth is calledthe portfolio allocation decision. What determines the particular mix of assets that Larry or another wealth holderwill choose? All else being equal, people generally to hold assets that prefer to a return and do not too much risk. they expect pay high carry They also may try to reduce the overall risk they face through is, by owning a diversification\342\200\224that of different assets.8 own some real such as a car or a assets, variety Many people because services or and often a home, shelter) they provide (transportation in in financial return increase as when the of a home rises a real (an value, price strong estate market). Here we do not needto analyze the entire allocation decision, but portfolio one of the decision about how much of one'swealth to hold only part it\342\200\224namely, in the form of money and The amount of wealth an (cash checking accounts). individual chooses to hold in the form of money is that individual's demand for money, if sometimes calledan individual's So liquidity preference. Larry decided to hold in his entire the form of his demand for $10,000 cash, money would be $10,000. if he were to hold $1,000 in cash, in But a $2,000 checking account, $2,000 in in and rare his demand for money would be bonds, $5,000 government stamps, in in cash the his account. $3,000\342\200\224that is, $1,000 $2,000 only plus checking How much money shouldan individual choose to hold? (or household) the Cost-Benefit an individual should increasehis or her Applying Principle, money so long as the extra benefit of doing so exceeds the extra cost. As we saw holdings only in Chapter 20, the principal benefit of holding money is its usefulness in carrying out transactions. shares of his stock, car, and his furniture are all valuable Larry's but he cannot use them to or pay his rent. He can make assets, buy groceries routine payments cash or his Because of its using checking account, however. usefulness in will almost want to hold some of his transactions, daily Larry certainly in the form of money. Furthermore, if Larry wealth is a high-income individual, he will probably choose to hold more money than someone with a lower income would becausehe is likely to spend more and carry out more transactions than the low-income person. from and Larry'sbenefit holding money is also affected by the technological financial sophistication of the society he lives in. For example, in the United States, 8We

examined

risk, return, and

asset diversification

in Chapter

20.

THE FEDERAL

such as

RESERVE

than

more

In

half\342\200\224ofthe

any

total

money

stock.

THAT AFFECT THE DEMAND

FACTORS

MONEY

household

or business, the

circumstances.

thousands

hand than

businesses

and

individuals

interest

affect

choose

probably

depend on a variety of retail businessthat serves to have more money on

will

money

a high-volume

and pays employeesmonthly.

vary considerably

factors hold,threemacroeconomic

nominal

demand for

For

example, of customers each day will firm that bills clients a legal

individual

in

the

rate, real output, and the

the

amount

demand

price level.

But

of money they

for money quite

while

choose to

broadly: the

(i). We have seen that the interest rate paid on cost government bonds, determines the opportunity of holding money. The higher the nominal interest rate, the greater prevailing the cost of holding money, and hence the less individuals opportunity money and businesses will demand.

\342\226\240 The

nominal

alternatives

to

RATES

of money

amount

MACROECONOMIC

FOR

INTEREST

credit cards,debit

and ATM machines have generally cards, need to transactions, people carry out routine In the United the demand for at decreasing public's money given levels of income. States in 1960, for example, money holdings in the form of cash and checking account balances (the monetary aggregate Ml) were about 28 percentof GDP. By 2009 that ratio had fallen to about 9 percent of GDP. is an Although money extremely useful asset, there is also a costto holding an cost\342\200\224that arises from the fact that most money\342\200\224more precisely, opportunity forms of money pay little or no interest. Cashpays zero interest, and most checking accounts pay either no interest or very low rates. For the sake of simplicity, we will In contrast, most assume that the nominal interest rate on money is zero. A bond, for alternative such as bonds or a nominal return. assets, stocks, pay positive a fixed amount of interest each to the while stocks pay holder, example, pays period in value (capital gains). dividends and also may increase The cost of holding arises because, in order to hold an extra dollar of money in the form of money, a person must wealth reduce by one dollar the amount of in the form of higher-yieldingassets,such wealth held as bonds or stocks. The cost of is measured the interest rate that could have opportunity holding money by been earned if the person had chosen to hold interest-bearingassets instead of All else the the nominal interest the the rate, money. being equal, higher higher cost of holding opportunity money, and hence the less money people will choose to hold. We have been talking about the demand for money but by individuals, businesses also hold money to carry out transactions with customers and to pay workers and The same general factors that determine individuals' suppliers. money demand also affect the demand for money by businesses. That is, in choosing how much money to hold, a business,like an individual, will compare the benefits of for use in transactions with the cost of holding a nonholding money opportunity asset. we will not differentiate between the money held interest-bearing Although in individuals and the held businesses by money by discussing money demand, you in the U.S. economy, businesses hold a significant should be aware that portion\342\200\224

developments

reducedthe

AND

interest rate such as

money,

What do we mean by the nominal interest rate? As we have discussed, there are thousands of different each with its own interest rate of So assets, (rate return). can we really talk about the nominal interest rate? The answer is that, while there are many different assets, each with its own interest rate, the rates corresponding if the on those assets tend to rise and fall together. This is to be expectedbecause interest rates on some assetswereto rise sharply while the rates on other assets investors would flock to the assets paying high rates and refuse declined,financial

Innovations

such

as ATM

machines have reduced the amount of money that people need to hold for routine transactions.

667

668

MONETARY POLICY AND

23

CHAPTER

THE FEDERAL

RESERVE

the assets paying low rates. So,although there are many different interest rates in practice, of the level of interest rates speaking general usually does make sense.In this book,when we talk about the nominal interest rate, what we have in mind is some average measureof interest rates. The nominal interest rate is a macroeconomic factor that affects the cost of A macroeconomic factor that affects the of holding money. benefit holding

to buy

is:

money

in aggregate or output (Y). An increase real income or output\342\200\224 for example, by real GDP\342\200\224raises the quantity of goods and services that people and businesses want to buy and sell. When the economy enters a boom, for example, do more shopping and stores have more people customers. To accommodate the increase in transactions, both individuals and businesses need to hold more money. Thus real output raises the higher income

\342\226\240 Real

as

measured,

for

demand

A second \342\226\240 The

money.

macroeconomic factor affecting (or

higher

benefit

of holding

money is:

level (P). The higher the prices of goods and services, the or euros) are needed to make a given set of transactions. with a higher demand for money. price level is associated

price

dollars

the

yen,

more Thus, a

of teenagers go out for a movie and snacks on Saturday five times as much cash as their parents did 25 years night, they Because the of movie tickets and ago. prices popcorn have risen steeply over 25 years, more money more is needed to pay for a Saturday night is, (that dollars) date than in the past. By the way, the fact that prices are higher today doesnot in the past because nominal wages and that are worse off today than imply people In general, however, higher pricesdo imply salariesalso have risen substantially. in cash or in a that need to keep a greater number of dollars available, people Today,

when need

checking

THE

For the

a curve

curve

demand

money

the relationship between the aggregate

that shows

of

an

increase

est rate nity

cost

which money demand

rate

interest

nominal

in the

quantity

the

M and

demanded

money

/;

because

nominal

increasesthe

inter-

opportu-

of holding money,

reduces the demanded, curve

quantity

of

the money slopes

down

a couple probably

account.

MONEY

DEMAND CURVE

policymaking, economists are most interestedin the demand for money. The interaction of the aggregate aggregate, demand for money, determined the and the of by public, supply money, which is set in the determines the nominal interest rate that the economy. Fed, by prevails The economywide demandfor money can be represented graphically by the demand curve The demand curve relates the ag(seeFigure 23.4). money money M of demanded to the nominal interest rate /\". The gregate quantity money quantity in of money demanded M is a nominal measured dollars (or yen, or euros, quantity, in the nominal interest rate independing on the country).Becausean increase creases the opportunity cost of holding money, which reduces the quantity of the demand curve down. demanded, money money slopes If we think of the nominal interest rate as the \"price\" (more precisely, the opporof money people want to hold as the \"quantunity cost) of money and the amount the demand curve is curve for a good or tity,\" money analogousto the demand service. As with a standard demand curve, the fact that a higher of price money leads in to demand less of it is the downward of the demand curve. people captured slope For a given nominal interest rate, any change that makes people want to hold will more money shift the money demand curve to the right, and any change that makes want to hold less will shift the demand curve to the people money money in left. Thus, as in a standard demand curve, factors other than the price of changes nominal interest cause the demand curve for to shift. We rate) money (the money have identified two macroeconomic factors other than the nominal interest already rate that affect the economywide demand for money: real output and the price in either level. Becausean increase of these variables increasesthe demand for of monetary or economywide,

purposes

THE

FEDERAL

RESERVE

AND

669

RATES

INTEREST

23.4

FIGURE

The Money Demand

Curve.

The

demand nominal

the

economywide

for money to interest rate.

Because an nominal

curve

demand

money

relates the

increase

the

in the

rate raises

interest

of

cost

opportunity

holding money, the money demand curve slopes down.

money, Similarly,

it

the money The the

affect

the money in real output

shifts

a fall

demand curve

money demand or benefit

cost

demand curve rightward, as shown in or the general pricelevel reduces money

curve also may of holding money,

shift such

by

potential

demand,

shifting

in response to other changes that as the technological and financial

advances we mentioned earlier.For example,the source

23.5.

leftward.

reduced the amount of money wide money demand curve another

Figure

people to

the

of shifts

in

introduction

of ATM

machines

and thus shifted the economyleft. The Economic Naturalist 23.2 describes the demand for money, holdings of U.S.dollars choose

to hold

foreigners.

FIGURE 23.5 A Shift in the Money Demand Curve. At a given nominal interest rate, any change that makes

peoplewant in

the

in real

general

hold more

to

money\342\200\224such

as an

increase

price

level

GDP\342\200\224will shift

money demand the right.

curve

or

the to

670

CHAPTER

23

MONETARY POLICY AND

\302\261Wr

THE FEDERAL

The

Economic

Why

does

RESERVE

Naturalist

23.2

\342\200\224^

the

Argentine hold

average

more U.S.dollarsthan

the

average

U.S.

citizen?

Estimates are that the person,which is higher

of U.S. dollars circulating than the per capita dollar

value

in Argentina in the

holdings

exceeds $1,000 United States. A

per

to the former SovietUnion, countries, including those that once belonged in U.S. currency\342\200\224more large quantities of dollars.In all, as much as $300 billion than half the total amount issued\342\200\224may be circulating outside the borders of the United States. Why do Argentines and other non-U.S. residents hold so many dollars? other

number of

hold

also

U.S. residents and businesses hold dollars primarily for transaction purposes, rather as a store of value. As a store of value, interest-bearing bonds and dividend-paying stocks are a better choice for Americans than zero-interest money. But this is not the case for the citizens of other countries, particularly nations that are necessarily or politically unstable. Argentina, for example, endured many of high and economically years in the erratic inflation 1970s and 1980s,which eroded the value of financial sharply

than

denominated

investments

began stable

saving

in value Argentina's

country

in Argentine pesos. Lacking form of U.S.currency, which they

than peso-denominated assets. use of dollars became officially

better

alternatives,

correctly

recognized

believed in

1990.

many Argentines

to be In

that

more year,

the

which U.S. monetary system, called a currency board, under board pesos by law traded freely one for one.Under the currency in their wallets for became accustomed to carrying U.S. dollars

a new

instituted

dollars and system,

in the

Argentine

Argentines

pesos. However, in 2001 Argentina's monetary as the currency board system broke down, the peso the dollar, and inflation returned. the plummeted in value Consequently, the next few years. Argentinian demand for dollarsincreasedduring Some countries,including a number formed as a result of the breakup of the Soviet not only high inflation but political instability and uncertainty as well. Union, have endured In a politically volatile environment, citizens face the risk that their savings, including their bank will be confiscated or heavily taxed deposits, by the government. Often they conclude that a hidden cache of U.S.dollars is the safest way to hold wealth. Indeed, an in $ 100 bills can be stored in a suitcase. estimated The ability to hold such wealth $ I million in a relatively small container is one reasonwhy international most notably drug criminals, hold so many bills. Now that the European currency, the euro, dealers, $100 allegedly which is worth more than $ I, can be held in the form of a 500-euro banknote, it has been suggested that drug dealers and other cash-hoarders may switch to holding 500-euro bills in even smaller suitcases. If they decline. do, the demand for dollars would transaction problems

purposes,

returned

SUPPLY

THE

with

along with a vengeance, relative to

OF

MONEY

AND MONEY

MARKET

EQUILIBRIUM

Where money As

we

there is demand, can supply be far behind? As we have seen, the supply of is controlled the central bank\342\200\224in the United States, the Federal Reserve. by in Chapter 20, the Fed's primary discussed tool for controlling the money

to increase the supply is open-market operations.For example, money supply, the Fed can use newly created to bonds from the (an money buy government public into circulation. open-market purchase), which puts the new money Figure 23.6 shows the demand for and the supply of money in a single The nominal interest rate is on the vertical axis,and the nominal of diagram. quantity is on the horizontal axis. As we have because a seen, money (in dollars) higher nominal interest rate increases the opportunity cost of holding the money money, demand curve slopesdownward. And because the Fed fixes the supply of money,

THE

FEDERAL

RESERVE

INTEREST

AND

23.6

FIGURE

Equilibrium supply curve

Equilibrium

MS

where

\\e

demand curve ^\342\200\242\342\226\240\342\226\240^Ivloney

M

0

MD

M'

Money

the money supply curve as a vertical line that intercepts the of chosen the denoted M. Fed, quantity money by As in standard and demand analysis, equilibrium in the market for supply E occurs at the intersection of the and demand shown as curves, money supply point in Figure 23.6. The equilibrium amount of money in circulation, M, is simply the amount of money the Fed chooses to supply. The equilibrium nominal interest rate i is the interest rate at which the quantity of money demanded by the public, as determined by the money demand curve, equals the fixed supply of money made available by

drawn

have

the

axis

at the

Fed.

how the market

for reaches it is helpful to money equilibrium, interest rates and the market relationship price of bonds that was introduced in Chapter 20: The prices of existing bondsare inversely related to the current interest rate. Higherinterest rates lower bond and lower imply prices, interest rates this between interest rates imply higher bond prices. With relationship and bond pricesin mind, let's ask what happens if, say, the nominal interest rate is below the equilibrium level in the market for money\342\200\224for example, at a initially value such as V in Figure 23.6. At that interest demanded rate, the public's quantity of money is M', which is greater than the actual amount of money in circulation, if the amount to M. How will the and firms\342\200\224react of equal public\342\200\224households hold is less than would like? To increase their of money they they holdings money, people will try to sell some of the interest-bearing assetsthey hold, such as bonds. But if everyone is trying to sell bonds and there are no willing then all the buyers, to reduce bond will achieve is to drive down the of bonds, attempt holdings price in the same way that a glut of apples will drive down the price of apples. A fall in the price of bonds, however, is equivalent to an increase in interest rates. the collective to increase its bonds Thus, public's attempt money holdings by selling and other interest-bearing assets, which has the effect of lowering bond prices,also market interest rates. As interest rates rise,the quantity of money implies higher demanded the will decline a movement by public (represented by right-to-left along the will demand as the desire to sell bonds. when the interest rate curve), money Only reaches its equilibrium value, / in Figure 23.6, will people be content to hold the of money and other assets that are actually available in the economy. quantities

To understand

recall the

public equals

of money

amount

nominal

interest

equates

the supply of and

demand for

Nominal

horizontal

\302\243,

for

supplied by the Federal Reserve. The equilibrium

interest

we

the demand by the

money

the

the

at point

occurs

money

rate

in

for Money. in the market for

Market Money

671

RATES

between

rate,

money,

which

is /.

672

CHAPTER

23

THE FEDERAL

MONETARY POLICY AND

Describe the

in the

process

adjustment

than below

rather

above

its

market for money if

rate

interest

nominal

the

happens to the price of

What

equilibrium?

AND SUPPLY

DEMAND

MONEY

RECAP

value.

equilibrium

money market adjusts toward

as the

bonds

23.5

CHECK

CONCEPT

is initially

RESERVE

as a whole,the demand for money is the amount of wealth and businesses chooseto hold in the form of cost of holding money is measured by the nominal money. The opportunity interest rate i, which is the return that could be earned on alternative assets such as bonds. The benefit of holding is its usefulness in transactions. money

\342\226\240 For

the economy

that

households,

individuals,

in real

\342\226\240 Increases

GDP (Y) or the

of transactionsand

thus

the

price level

ATM machines, that

benefits of holding money. \342\226\240 The

money

and

technological

by

volume for money. The

the nominal

raise

demand

economywide

also is affected money such as the introduction of innovations, for

demand

(P)

financial the

affect

or

costs

curve relates the economywidedemand for money to in the nominal interest rate interest rate. Becausean increase cost of holding money, the money demand curve opportunity demand

the nominal

raisesthe

downward.

slopes

in factors

\342\226\240 Changes

for money

demand

in

increases shifting

the

the

nominal interest rate

money

demand

curve to the

that

curve. For

GDP or the price level raise the demand demand curve to the right, whereas

demand

money \342\226\240 In the

real

money

other than the

can shift

for

affect

the

example, money,

decreasesshift

the

left.

for money, the money the fact that a higher nominal

market

demandcurve

slopes

downward,

increases the of holding of money opportunity cost money and thus reduces the amount curve is vertical at the quantity people want to hold. The money supply of money that the Fed chooses to supply.The equilibrium nominal interestrate i is the interest rate at which the quantity of money demanded by the public made available equals the fixed supply of money by the Fed. reflecting

HOW

THE FED CONTROLS

interest rate

THE NOMINAL

RATE

INTEREST

section by noting that the public and the press usually talk about of decisions about the nominal interest rate rather than the Fed themselves describe their money supply. Indeed, policymakers usually plans in terms of a specific value for the interest rate. We now have the necessary to understand how the Fed translates the ability to determine the background into control of the nominal interest rate.The Fedcan control economy's money supply in the three discount money supply ways: through open-market operations, window lending, and directly affecting bank reserves.

We began this

Fed policy in

terms

OPEN-MARKET OPERATIONS in the 23.6 showed that the nominal interest rate is determined Figure by equilibrium market for money. Let'ssupposethat for some reason the Fed decidesto lower the interestrate. As we will see, to lower the interest of rate, the Fed must increasethe supply in as we saw is created 20, money, which, Chapter usually accomplished by using newly bonds from the public (an open-marketpurchase). money to purchasegovernment

HOW

THE

FED CONTROLS

THE NOMINAL

RATE

INTEREST

FIGURE 23.7

The Fed Lowersthe \\

MS'

MS

Fed

can

rate \342\200\224\342\226\272

by

increase from YE

MtoM'

***^

nominal MD

M^M'

Money

of such an increase in the money Figure 23.7 shows the effects supply by the Fed. If the initial is M, then equilibrium in the money market occurs money supply at point E in the figure, and the equilibrium nominal interest rate is i. Now suppose the Fed, by means of open-market purchasesof bonds, increases the money supply toM'. This increasein the money supply shifts the vertical money supply curve to in the money market from point E to point the right, which shifts the equilibrium F. Note that at point F the equilibrium nominal interest rate has declined,from i to /\"'. The nominal interest rate must decline if the public is to be persuaded to hold the extra that has been injected into the economy. money To understand what happens in financial markets when the Fed expands the recall once again the inverse relationship between interest rates and money supply, the of bonds. To increase the money the Fed typically buys price supply, government bonds from the public. However, if households and firms are initially satisfied with their asset holdings, they will be willing to sell bonds only at a price that is That drive is, the Fed's bond purchaseswill higher than the initial price. up the bond price of bonds in the open market. But we know that higher prices imply lower interest rates.Thus, the Fed's bond purchases lower the prevailing nominal interest

rate.

scenario unfolds if the Fed decides to raise interest rates.To raise Fed must reduce the money supply.Reduction of the money supply sale\342\200\224the sale of government bonds to may be accomplishedby an open-market the public in exchange for money.9 (The Fed keeps a large inventory of government bonds, acquired through previous open-market purchases,for use in open-market to sell bonds on the open market, the Fed will drive operations.) But in the attempt down the price of bonds. Given the inverse between the price of bonds relationship and the interest is equivalent to a rise in the interest rate, the fall in bond prices rate. In terms of money demand and money supply, the higher interest rate is the public to hold lessmoney. necessary to persuade A similar

interest

rates,

the

9The sale of existing government bonds by the Federal Reserve in an open-market sale should not be confused with the sale of newly issued government bonds by the Treasury when it finances government sales reduce the money do budget deficits.Whereas open-market supply, Treasury sales of new bonds not affect the money supply. The difference arises because the Federal Reserve does not put the money

it receivesin an open-market sale back into circulation, contrast, the Treasury puts the money it receivesfrom as it purchases goods and services.

leaving less money for the public to hold. In newly issued bonds back into circulation

selling

/to/'.

the

given

curve,

an

money supply shifts the

point

money market lowering

0

in the

equilibrium

\\F

interest the supply

increasing

of money. For demand money

interest

Nominal

lower the nominal

equilibrium rate

Rate.

Interest

Nominal

The

in the

from

\302\243 to F,

the equilibrium interest rate from

673

674

CHAPTER

23

MONETARY

AND THE

POLICY

FEDERAL

RESERVE

control of the interest rate is not separate If Fed officials choose to set the nominal interest money supply. rate at a particular can do so the level, they only by setting money supply at a level consistentwith the target interest rate. The Fed cannot set the interest rate and the money supply independently,sincefor any given money demand curve, a particular interest rate implies a particular size of the money supply, and vice versa. Sincemonetary actions can be policy expressed in terms of either the interest rate or the money supply, why does the Fed (and almost every other central bank) choose to communicate its policy decisionsto the public to the by referring nominal interest rate rather than the money supply? One reason,which we analyzed the main effects of monetary policy on both the economy and earlier, is that financial markets are exerted the interest rate is through interest rates. Consequently, often the best summary of the overall of the Fed's actions. Another reason impact for focusing on interest rates is that they are more familiar to the public than the in interest rates can be monitored the financial money supply. Finally, continuously markets, which makes the effects of Fed policies on interest rates easy to observe. in the economy By contrast, measuring the amount of money requires collecting data on bank deposits,with the consequence that several weeks may before pass and the know how Fed actions have affected the policymakers public precisely money supply.

As Figures control

from

DISCOUNT

23.7

23.6 and

LENDING

WINDOW

The Fed controlsthe money

hence the nominal interest rate, However, the Fed can changethe money with two other tools that it uses much less frequently. One tool is called supply discount window Recall from Chapter 20 that the cash or assets held lending. for the purpose of meeting depositor withdrawals are by a commercialbank calledits reserves. Its desired amount of reserves is equal to its deposits desired reserve-deposit 20.1. When an ratio, as impliedby Equation multiplied by the individual commercial bank has insufficient it may choose to borrow reserves, reservesfrom the Fed. For historical reasons, lending of reserves by the Federal Reserve to commercialbanks is called discount window lending. The interest rate that the Fed charges commercial banks that borrow reservesis calledthe discount rate. Loans of reserves by the Fed directly increase the quantity of in the reserves banking system, leading ultimately to increasesin bank deposits and the money supply. Be careful not to confuse the discount rate and the federal funds rate. The discount rate is the interest rate commercial banks pay to the Fed; the federal funds rate is the interest rate commercial banks charge each other for short-term loans. using

primarily by

discount

window

lending

of reserves

the

lending by the

Federal Reserve to

commercial

banks

discount

rate

credit rate)

(or primary the

rate

interest

that the Fed charges commercial banks to borrow reserves

RESERVE

ON As

open-market

we

commercial

set

by

AND

REQUIREMENTS

showed

in Chapter on

three

hold, the supply of bank

reserverequirements

and

supply,

operations.

INTEREST PAID

RESERVES

supply depends

the Fed,the minimum values of the ratio of bank reserves to bank deposits that commercial banks are allowed to maintain

illustrate,

of the

banks.

The

20

(in

factors:

particular,

Equation

the amount

reserves,and the

20.2),

the economy's

of currency the

reserve-deposit

ratio

public

maintained

money

chooses

to

by

ratio is equal to total bank reserves divided reserve-deposit banks all of their as t he reserves, reserve-deposit kept deposits

by

total deposits. If ratio would be 100 percent, and banks would not make any loans. As banks lend out more of their deposits, the reserve-deposit ratio falls. Within a certain banks are free to set the reserve-deposit range, commercial ratio they want to maintain. However,Congressgranted the Fed the power to set minimum values of the reserve-deposit ratio for commercial banks.The values of the reserve-deposit ratio set by the Fed are called legally required reserve requirements.

FED CONTROLS

THE

HOW

THE NOMINAL

the Changes in reserve requirements can be used to affect money supply, in the Fed does not use them this For although usually way. example,suppose that commercial banks are maintaining a legally mandated minimum 3 percent If ratio. the Fed wants to the it could reserve-deposit expand money supply, 2 reduce reserves of This would allow banks to to, say, required percent deposits.

lend a greaterportion of

their

wanted to make new

generate additionaldeposits,as we ratio reserve-deposit on the other Suppose,

wide

and keep

deposits

reserves. If banks

as required

hand, the Fedwanted

supply. In October2008,the reserves.

Specifically,

deposits,

Reserve

Federal

to at

economyto rise.

supply. If commercial banks

the money

contract

which

would

the

in

supply

of deposits,

ratio

Fed began paying

the

to

5 percent

reserve-deposit

of loans and

contraction

to a

lead

20. A decline

would therefore causethe money

deposits

new loans

these

loans,

in Chapter

saw

the Fedraised requiredreservesto, say,

would needto raisetheir

a smaller percentageof

least 5

percent.This

would

decrease

would

the money

added a new way of affecting bank interest on requiredreserve balances and over and above the required amount) held

reserve balances (i.e.,reserves banks at the Federal Reserve.Before October2008,these balances by earned no interest, and thus banks had an incentive to keep these amounts to a minimum and loan out as much as they could above their legal reserves. Put another \"The interest rate paid on requiredreserve balances is determined way, by the Board and is intended to eliminate the tax that reserve effectively implicit requirements used to impose on depository institutions.\"10 This for gives the Fed another tool to control the money supply. Suppose, that the Federal Reserve wants to decrease the It can increase example, money supply. the interest rate paid on reserves,thus increasing the reserve-deposit ratio since banks will want to hold more of these interest-bearingreserves relative to more loans that earn similar interest rates. This will cause the risky money supply to on excess

commercial

decreaseand

raise

the

economy

in

the

economy

will be an

this

that

more

generally.

important monetary policy tool

next few years.The Fed

over the

recovers

rates

interest

nominal

Many observers believe

substantially

as

the

increased

the current bonds and other recession, mostly by exchanging money supply during financial assets held by banks for increased reserve balances held at the Fed. As the economy recovers,the banks will start to draw down their reserve balances and lend out these funds, causing the money to increase through the money-multiplier supply The Fed can slow down this the interest rate it pays on process. process by increasing reserves and thereby discouragingbanksfrom their reserves into loans. turning

THE FEDERAL

RECAP

The Federal Reserve supply of

RESERVE

the

controls

An open-market

money.

nominal

reserves,or a reduction in

interest rate

purchase of government

money supply and lowers the equilibrium in discount window lending, a decreasein reserve

requirements

by

the

changing bonds

interest rate. interest rate paid will have the

nominal the

RATES

INTEREST

AND

increases An

the

increase

on required same effect.

bonds reduces the money in discount interest as will a decrease rate, supply in the interest rate paid on requiredreserves, window lending, an increase or in reserve requirements. The Fed can prevent in an increase the changes demand for from affecting the nominal interest rate by adjusting the money

Conversely, an

and increases

quantity

10See

\"Interest

reqresbalances.htm.

of

sale

open-market

money

on Required

of government

the nominal

supplied

appropriately.

Balancesand

Excess

Balances\" at

www.federalreserve.gov/monetarypolicy/

INTEREST

RATE

675

CHAPTER 23

676

AND THE

POLICY

MONETARY

RESERVE

FEDERAL

SUMMARY \342\200\242 The

output. The Fed's ultimate

United Statesis calledthe Reserve or the Fed for short. The System, two main responsibilities are making monetary which means determining how much money

Federal

Fed's policy,

of the

bank

central

will circulate in regulating financial in

Created

the

of the original purposes of the was to help eliminate or control

Reserve

banking panic is an episode in spurred by news or rumors of the imminent of one or more banks,rush to bankruptcy withdraw their deposits from the banking system. Because banks do not keep enough reserveson hand to pay off all depositors, even a financially healthy bank can run out of cash during a panic and be depositors,

\342\200\242 In the

run, the Fed can control the real well as the nominal interest rate. real interest rate equals the nominal minus the inflation rate, and because

rate

the inflation rate adjusts relatively can changethe real interest rate nominal interest rate. In the long and

investment

federal which rate, banks charge each funds

for

balance of saving

very

aggregate

\342\200\242 The

Reserve's

because

in

changes

actions real

the

short-term

and

consumption

by increasing the reduce

output. Conversely,by

rate, the

Fed can stimulate and

expenditure

and

reducing

the

planned

raise

thereby

short-run

short-run

Fed

banking panic (652) of

Governors

(of the

Federal Reserve System) (651) for

money

(666)

deposit insurance

(654)

demand

interest rate by

the nominal

(shifting the money supply increase the nominal interest

supply

supply

(shifting

the

(L04)

Reserve has three tools it can use to money supply.The first is open-market in which the Fed purchasesor sells in order to increase (via purchases) bonds

or decrease (via Thus,

second

can

the money sales) supply. The window lending, in which borrow additional reserves from the Fed. involves bank reserves directly, affecting

discount

is

commercial banks

The third

either by changing reserverequirementsor interest rate paid on reserve balancesheld at adjustingthe

interest

aggregate

equilibrium

KET

Board

operations,

equilibrium real

money

Federal

government

borrowing,

investment.

real interest rate, the

spending

planned

planned

cost

change the

in the

increase

in the

(L03)

curve to the right) or rate by reducing the money money supply curve to the left).

affect the economy interest rate affect

an planned spending.For example, real interest rate raises the cost of

is determined in the both a demand side

relates money demand curve of demandedto the quantity money

can reduce the

(LOl, L04)

Federal

reducing

Fed

increasing

\342\200\242 The \342\200\242 The

has

side. The

supply.

money

targets most closely is the is the rate commercial

other

loans.

slowly, the Fed by changing the run, the real

19). The nominal

Chapter

(see

the Fed

that

rate

interest

by the

is determined

rate

interest

the

real

of holding money, which reduces the quantity the demand curve demanded, money money slopes down. Factors other than the nominal interestrate that affect the demand for money (such as the price level of real to GDP) will shift the demand curve the right or left. The supplycurve for is money vertical at the value of the money supply set by the Fed. Money market equilibrium occurs at the nominal interest rate at which money demand equalsthe

as

the

Since interest

a supply

raise the

of

short rate

interest

which

money,

and

will

an

nominal interestrate.Because an increase nominal interest rate increasesthe opportunity

close.(LOl)

forced to

rate

interest

market for

Fed

the

L04)

(LOl,

nominal

\342\200\242 The

A

panics.

banking

which

low inflation. To

the Fed will

gap,

output

expansionary interest rate.

banks.

especially

markets,

gaps

output

to

are

objectives

maintain

eliminate a recessionaryoutput gap, lower the real interest rate.To eliminate

and

overseeing

and

one

1914,

Federal

and

economy,

eliminate

Fed.

the

(L04)

TERMS

discount rate (674) discount

window

federal funds rate

Federal OpenMarket (FOMC)

(651)

curve (668)

money demand

lending

(674)

(655) Committee

portfolio

allocation

primary credit reserve

requirements

decision

rate (674) (674)

(666)

677

PROBLEMS

REVIEW

real interest rate

1. Why does the

Give

expenditure?

aggregate

affect

QUESIIDHS

Show graphically

planned

(L02)

examples.

interestrate?

2. The Fed faces a recessionarygap.How would you expect it to respond? Explain step by step how its to affect the economy. (L02) policy change is likely

3. The

Under

action.

effect

bonds

by

action be

does an

real

open-market purchaseof rates?

Fed have on nominal interest terms of (a) the effect of the purchase

the

in

prices and (b) the

supply of

most appropriate? What would you interest rate, the real expect to happen to the nominal interest rate, and the money supply? (LOl, L03)

policy

What

bond

the

(L04)

Discuss

to take a contractionary policy what circumstances would this type of

decides

Fed

Fed controls

Fed control the

the

how

Can the

rate.

nominalinterest

effect of

the

purchase

on

on the

money. (L04)

PROBLEMS

1.

The

Act, System was created by the Federal Reserve passed Like all central banks, began operations in 1914. Which of the following statements about the agency.

Reserve

Federal

Congress

in

and

1913,

Fed is a government is false?

(LOl)

a. The Fed has the

and regulate

to supervise

power

b. The Fed'sgoals are to promote economicgrowth, and watch over a smooth operationof financial c. The

Fed is the

d. The Fed is allowedto make a profit 2.

An

C = 2,600+ Ip

=

low

maintain

inflation,

markets.

Ss?

banks.

McGraw-Hill

Visit

equations: -

0.8(Y

T)

and

- 10,000r

Study

- 10,000r

2,000

G = 1,800 =

NX

0

T = 3,000

The real

interest

a. Find a output.

b. Usinga table

c. Show 3. For the

your

(or

graphically

described

decimal,is 0.10 (that

expenditure

(LOl) to

short-run equilibrium output.

using the Keynesian-cross

in Problem

10 percent).

is,

aggregate

planned

diagram.

2 above, supposethat

output

potential

12,000. (LOl) real

rate should the Fed set to bring the multiplier may take as given that a for the case in which potential output the real interest rate you found in part

interest You

employment?

b. Repeat part c.*Showthat equal to plannedinvestment result showsthat the real in the

as a

solve for

algebra),

result

economy

Y* equals

a. What

expressed

rate,

numerical equationrelating

market

Review the *Denotesmore difficult

for saving when

material

problem.

the

when

on national

the

economy

saving

in

the

to full

economy

for this

economy is 5.

Y* equals 9,000. a sets national saving

is at potential

economy

rate must

interest

be consistentwith is at full

Chapter

|ECONOMICS

banks.

commercial

by the following

is described

economy

like

connect

&r

Fed

last resort.\"

of

\"lender

by

the

19).

output. This equilibrium

employment.

{Hint:

your mobile app store the Frank:

download Econ

app today!

678

CHAPTER 23

MONETARY

POLICY

AND THE

set of

is another

4.* Here

RESERVE

FEDERAL

C = 14,400+ =

Ip

an economy:

describing

equations

8,000

-

0.5(Y

T)

(L02)

- 40,000r

- 20,000r

G = 7,800 =

NX

1,800

T = 8,000 =

Y*

40,000

a numerical equation relating to output planned aggregate expenditure and to the real interest rate. b. At what value should the Fed set the real interest rate to eliminateany to the value of potential output (Hint: Set output Y equal output gap? in the equation above given you found in part a. Then solve for the real interestrate that also sets planned aggregate expenditure equal to a. Find

potentialoutput.)

the heavy Christmas shoppingseason, salesof retail stores, rise firms, and other merchants (L03) significantly. a. What would you expect to happen to the money demand curve Christmas season? Show graphically. b. If the Fed took no action, what would happen to nominal

c. In fact, nominal the

Christmas. The

following

rates do not change significantly to deliberate Fed policy.Explain

can ensurethat

table

nominal

interest

Total benefit

($)

700

35 47 57

800

65

900

71

600

1,000

75

1,100

11

1,200

11

money will

Uma

hold

on average

if the

*

Denotes

graphically

holding

money

of additional

more difficult problem.

holdings

with

the opportunity

money holdings.)

($)

nominal interest rate is her money holding to

9 percent?5 percent?3 percent?Assume that she wants bea multiple of $100. (Hint: Make a table comparing the interest,

fourth

stable around

remain

benefits of

500

additional $100 in

show

(L03)

Average money holdings

How much

and

rates

Uma's estimated annual

shows

of money:

differentamounts

forgone

rates

interest

the

in

interest

year, due

how the Fed

6.

the

during

Christmas?

around quarter of

sales

online

5. During

extra

benefit

cost, in

terms

of each of

ANSWERSTO CONCEPT CHECKS

for

demand

b. Grocery

stores

stocks.

nominal

credit cards in payment. become concerned about increasingriskinessof

to accept

begin

using a

reasoning

supply-and-demandgraph of

the

market.

money

L04)

(L03,

\342\200\242

date in

for each

directly

Verify

,

Money supply

Currency

=

held

For example, for

Bank reserves :\342\200\224 : :\342\200\224 Desired reserve-depositratio

H

.

by public

December

that

23.1

Table

can check that

we

1929,

\342\226\240

CHECKS

CONCEPT

TO

ANSWERS

23.1

selling

rate

interest

your

charge for

scenarios described in Problem 7, what will happen to the if the Fed does not change the money supply? Explain

of the

each

For

economywide

the commission

down

forces

brokers

investors

c. Financial

to affect the

following

or stocks.

of bonds

holdings

the

(L03)

Explain.

money?

a. Competition among

8.

each of

would you expect

7. How

45.9 = 3.85 +

3.15/0.075.

3.79, as in 3.79

1933

December

1930,

1.06) had been left would have been 3.45

difference in

been

(4.85

\342\200\224

December

the money supply would have The money supply would still have fallen had not increased their holdings of

1930 and 1933 if people only by about half as much. (LOl)

between but

currency,

the

bank reserves

+ 1.06= 4.51and

= 37.7.

(4.51/0.133)

and that

Then

banks.

the

in

1933 had

in December

public

than 4.85,

rather

=

been 3.79 +

23.2

held by the

the currency

that

Suppose

of 1931, currency holdings by the public rose by $0.80 reserves fell overall by only $0.20 billion. Thus, the Fed must have replaced $0.60 billion of lost reserves during the year through openmarket purchases.Currency at the end of 1931 were billion. holdings To have kept the money supply at the December 1930 value of $44.1billion, the Fed would have had to ensure that bank $44.1 billion \342\200\224 deposits equaled or $39.51 billion. As the reserve-deposit ratio in 1931 was $4.59 billion, Over

billion,

course

the

bank

but

$4.59

0.095, this would have

$3.75 billion,

billion.

Thus,

increase

keepthe If

r =

and

bank

increasing

money

0.03, then

0.8Y,

supply

from

consumption

0.8(

is P = 250 -

is given

PAE

= C

+

IP

= 980+ short-run

22.1.

+

G +

did.

250)

had

Fed has

The

to

been

was neededto

400(0.03)= 428

600(0.03) =

+

232.

Planned

NX + 232

+ 300

+ 20

0.8Y.

equilibrium output, we can construct a table analogousto some trial and error is necessary to find an appropriate

As usual,

range of guessesfor

Fed would have

by

= (428 + 0.8Y)

Table

of $3.11

1931

December

reserves by only about half what falling. (LOl) Y is C = 640 +

investment

planned

expenditure

aggregate

To find

in

billion), or

of 0.095($39.51

reserves

actual value

to the

to keep the money supply from falling, the bank reserves by $0.64 billion more than it

criticized for 23.3

bank

required

compared

output

(column

1).

679

680

CHAPTER

23

MONETARY POLICY AND

THE FEDERAL

RESERVE

of Short-Run

Determination (1)

Output

Equilibrium

(2)

Planned

Output Y

PAE

(4)

(3)

aggregate = 980

expenditure

+ 0.8V

Y-PAE

Y

= PAE1

4,500

4,580

-80

No

4,600

4,660

-60

No

4,700

4,740

-40

No

4,800

4,820

No

4,900

4,900

-20 0

Yes

5,000 5,100

4,980

20

No

5,060

40

No

5,200

5,140

60

No

5,300

5,220

80

No

5,400

5,300

100

No

5,380

120

No

5,500

Short-run equilibrium output equals 4,900, as that Y = PAE. satisfies the condition

is the

only level

of output

that

The answer can be obtained solving for short-run equilibrium

0.8

Y

and

quickly by simply Y. Remembering output

more

for PAE,

substituting

we get

Y= 980+ Y(l

- 0.8) Y

23

A

So lowering the

real

run

output

equilibrium

setting Y = PAE and that PAE = 980 +

0.8Y

= 980 =

980/0.2

= 4,900.

rate from 5 percent to 3 percentincreasesshortfrom 4,800 to 4,900. (L02)

interest

real interest rate is 5 percent, output is 4,800. Each percentage point the real interest rate increases autonomous expenditure by 10 units. Since the multiplier in this model is 5, to raise output by 50 units, the real interest rate should be cut by 1 percentage point, from 5 percent to 4 percent. the output Increasing output by 50 units, to 4,850, eliminates gap. (L02)

When

the

reduction

23.5 If the

in

interest rate is above its equilibrium value, then are people more than would like. To their holding money they bring money holdings assets such down, they will use some of their money to buy interest-bearing as bonds. If everyone is trying to buy bonds, however, the price of bonds in bond prices is equivalent to a fall in market will be bid up. An increase interest rates. As interest rates fall, people will be willing to hold more interest rates will fall enough that people are content to money. Eventually nominal

hold the amount be

in equilibrium.

of

money

(L03)

supplied

by the

Fed, and the money market will

CHAPTER|24

I

Demand,

Aggregate

Supply,

Aggregate

Business

and

Cycles V-

\\

OBJECTIVES

After

this chapter, able to:

you

\\

>:^

LEARNING

reading be

should

LOI

Definethe demand

aggregate

curve, explain

it slopes

why

downward,

and

explain

why

aggreg

te

it shifts.

L02

\"V5

Definethe

supply curve,

f

and

I

^1 do changes

in

house

affect consumer

prices

spending and

the

In

25

years.

The depth

output and

high

U.S.

economy

aggregatedemand X

of the recession,as measured

unemployment,

along

its worst

with

by

recession in such as

factors

the financial

panic

lost that

the world in fall 2008, has led some to call it the Great Recession. through Three significant events are usually cited as causes of the Great Recession. burst in July 2006 and First, the largest house price bubble in American history home fell 30 percent in the next 18 months. Higher home values average prices allowed households to increase their consumption, and when the housing bubble swept

burst,

the

through product

consumer spending

of

the

United

collapsing

dropped as well.Second,

and Europe in fall 2008. house price bubble, but it

States

the crisis, economy. Interestrates spiked during for investment impossible for firms to borrowfunds shock sent the price of oil to its highest level in instance, gaspricesreachedhistoric highs, hitting United States.

a

financial

panic

swept

The panic was in part a effects on the independent and even making it difficult

had

spending. Third, an oil price In summer 2008, for

history.

$4 per

and the

curve

economy?

entered

it

Show how the

aggregate supply

curve

determine

output

the

December 2007, the

upward, why

explain

shifts.

L03

How

explain

it slopes

why

gallon throughout the

and

rate over

inflation

the business cycle.

L04

how

Analyze

economy

the

adjusts to

expansionaryand gaps

recessionary

relate concept

this

to

the

of a self-

correctingeconomy.

and

-

CHAPTER 24

682

AGGREGATE

AGGREGATE

DEMAND,

SUPPLY,

AND

BUSINESS CYCLES

In this chapter, factors trigger a deep recession? we develop the model. This model aggregate demand-aggregate supply (AD-AS) provides a framework for the causes of the Great Recession and evaluating possible helps us in understand business more We build the model three First, we cycles generally. steps. in demand a that connects it to the of the develop aggregate way analysis previous 22 and 23) on planned aggregate expenditure, two chapters(Chapters and output, the inflation and their with fiscal and rate, relationships monetary policy. Second, we develop aggregate supply by lookingat how firms make price-setting decisions in in the demand for their reaction to changes we put aggregate Third, products. demand and aggregatesupply together to seehow output and the inflation rate are determined simultaneously. Once we have a working understanding of the aggregate demand-aggregate supply model, we can put the model to work analyzing business cyclesand how stabilization their effects. examining policy can be used to mitigate Along the way, we will close attention to the events of the few and how these events led pay past years did these

How

to the

THE

Great Recession.

AGGREGATE

MODEL: A

BRIEF

DEMAND-AGGREGATE

SUPPLY

OVERVIEW

demand-aggregate supply (AD-AS)model is one of the most useful It has two distinct advantages over the basic Keynesian in both output and the inflation model. First, we can use it to analyze fluctuations rate. In the basic Keynesian model we could not explainchangesin inflation since our basic assumption was that the level remained fixed. the basic Second, price model is a model of the short run, while the AD-AS model Keynesian applies to both the short run and the long run. (AD-AS) Figure 24.1 shows the aggregatedemand-aggregate supply This is the tool we will use to apply the AD-AS model to real-world diagram. situations. The current inflation rate it is on the vertical axis and the current level of output Y is on the horizontal axis. The aggregatedemand curve (AD) shows the relationship between planned spending and the inflation rate, holding all other factors constant. The aggregate supply (AS) curve showsthe relationship

The aggregate

models

FIGURE

in

macroeconomics.

24.1

The Aggregate

Demand-Aggregate Supply

>

Aggregate

supply

(AS)

Diagram.

The aggregate demand

(AD)

slopes downward because a fall in the inflation

curve

rate

causes an increase

in

planned spending and output. The aggregate supply (AS) curve

is upward sloping because an in the quantity increase of output supplied causes an in the inflation increase rate. The economy is in long-run equilibrium because the AD and AS curves intersect at the level of potential GDP Y*

\302\243

C

o

1

c >

Y*

Output

Y

Aggregate

demand

(AD)

THE AGGREGATE DEMAND

683

CURVE

FIGURE 24.2 Short-Run Equilibrium. The \302\243

\\ \\

rt

X.

/

x

&.

c

N^

0

3 ^1

at>^x

M-

\302\243 a>

\\y

\\f

SJ

k. r\\.

+j

2 C

0

^.

N

^

k

/

k

Output

(a) Recessionary

\\ \\>AD

Y*

Y*

gap

(b)

Expansionary

Y gap

the amount of output firms want to produce and the inflation Y* is shown in order to all other factors constant.Potential holding output between

measure

shown in Figure 24.1 is in long-run equilibrium. An economy is in AD when the and AS curves intersect at long-run equilibrium potential output Y*. in a long-run equilibrium is called the expected The inflation rate inflation rate ire since this is the inflation rate that consumers, and businesses, government believe Figure 24.2 showsan economy that is above or 24.1

short-run

in

economy out of long-run with Figure 24.2. Similarly,

aggregate supplycan move

the

equilibrium.

and AS curves intersectat

below potential.Shifts

can push the Figure

in

where the AD

a situation

comparing

economy

either

the AD

equilibrium. changes

from

A short-run a level of real GDP

curve or AS curve can see this

You

in aggregate

a short-run

output

y,

output

Y*

is above

potential (b), there gap of

level

potential

a

equilibrium

long-run

situation in which AS curves intersect output y*

the AD and at potential

(or

by

demand

and

short-run

a

equilibrium

where the AD and AS curves intersect at a level of real GDP that is above or below situation

potential

equilibrium toward a

is how we can usethe AD-AS model to explain business cycles: shifts and AS curves push the economy out of long-run equilibrium, and shifts AD and AS curves bring the economyback as In the next two

This AD the

in

panel

equilibrium.

long-run

the

is below

long run.

in the

prevail

both)

Y,

output y*. In

gaps.

output

equilibrium is

(a),

panel

rate,

The economy

will

output

is an expansionary because the current

Y^

Output

In

level

there is a recessionary gap because the current level of

*MD

Y

AS curve

output.

potential

^^

Inf

|N

the

intersect at an output that is below or above

r

-\342\200\224-^

^^

,v4S

the AD

when

curve and

A

a/

/

x

3 ^1

\302\243

X

>

\\

is in short-run

economy

equilibrium

^>AS

in

well.

behind the AD curve and the AS curve sections, through so that understand are the that separately you why they shaped way they are and shift. We can then the AD-AS modelto real-world situations like why they apply we

the

THE

Great

the reasoning

work

Recession.

DEMAND

AGGREGATE

CURVE

The aggregate demand(AD)

curve shows the amount of output consumers, firms, customers abroad want to government, purchase at each inflation rate, In AD curve showsthat, as the all other factors constant. the holding particular, inflation rate the of demanded rises, falls, quantity planned spending and output AD other factors constant. 24.3 shows a curve. holding Figure typical We need to answer two questions about the AD curve:

and

\342\226\240 Why \342\226\240 What

does

the AD

factors

curve slope downward?

shift the

AD curve?

aggregate

demand

curve a curve that amount of output

(AD) shows

the

consumers,

firms, government, and customers abroad want to purchase each

other

inflation

rate,

holding

factors constant

all

at

AGGREGATE

SUPPLY,

AND

CYCLES

BUSINESS

24.3

FIGURE

Demand

The Aggregate (AD)

AGGREGATE DEMAND,

24

CHAPTER

684

Curve.

The AD

curve slopes

decrease

a

because

downward in

inflation

the

rate

increases planned consumption,

investment,

and net exports, short-run

causing

output

to rise.

Aggregate demand

'2

'1

Output

AD CURVE

Y

SLOPE DOWNWARD?

an increase in slopes downward because, holding all else constant, rate it causes planned consumption C, investment Ip, and net exports in decreased to fall, resulting levels of planned spendingPAE and short-run Y. We can express this relationship as follows: curve

AD

The

THE

DOES

WHY

(AD)

inflation

the

NX output

177

I planned

=>

have

We

Specifically,

C, Jp, and

NX =>>

I PAE

=>>

the

(via

worked through the last three parts already we defined planned aggregate expenditure(PAE) = C

PAE

Lower levelsof

+

Jp

+

G +

I

multiplier) of

this

Y.

relationship.

as

NX.

investment, government spending, or net In the two exports planned spending. previous chapters,we used the basic in model to show that a decrease the Keynesian planned spending leads,through in to a decrease short-run We can thus focus on the multiplier, equilibrium output. between the inflation rate and the componentsof planned relationship spending, knowing that a change in any of these components results in a change in short-run output. (For the moment, we ignore government as it is mostly determined by elected spending in government officials. We return to the effectsof changes spending below.) planned

consumption,

reduce

The

the Federal spending are connected through In rule. when inflation the Federal rises, monetary policy particular, Reserve increases the real interest rate, and a higher real interest rate causes and net to fall. when inflation investment, falls, the consumption, exports Similarly, Federal Reserve decreasesthe real interest rate, and a lower real interest rate causes and net exports to rise. investment, consumption, inflation

rate

and

planned

Reserve's

The Fed's MonetaryPolicyRule monetary policy

rule

that describes how a central bank, like the Fed, takes action in response to changes in the state of the economy a rule

A

policy

monetary

response

to changes

We will rises, decreases

work

rule describes how a central in the state of the economy.

with

a particularly

bank, like

monetary

simple

increases the real interest rate, and real interest rate. In symbols, we have

the Fed the

177

=>

t r and

i

tt

=>

when

i r.

the

Fed,

takes

policy rule: When inflation

action inflation

falls, the Fed

in

AGGREGATE

THE

DEMAND

CURVE

685

in the previous chapter but We actually developedthis relationship did not call in rule.1 Let's review this order to understand the Fed behaves this analysis why AD We will also see the curve is downward. way. why sloped One of the primary responsibilities of the Fed is to maintain a low and stable in recent years, the Fed has tried to keepinflation in rate of inflation. For example, the United States in the range of 2 to 3 percent.How does the Fed carry out this responsibility? By using monetary policy to minimize output gaps. In particular, when the inflation rate tt rises due to an expansionary gap, the Federal Reserve increases the real interest rate r in order to reduce consumption C and investment I. in consumption Decrease and investment reduce plannedaggregateexpenditure PAE the multiplier process, this leads to a decreasein equilibrium and, through Y falls relative to Y. The output output gap starts to closeas actual output potentialoutput Y*. In symbols, we have

it a

1tt

t r

=>

=> i

=> i r =>t

opens,

response

between

in the

connection betweeninflation

PAE => (via the

I=>t

planned

connection

of changes

terms

in

C and

planned

now made the

We have

change

real interest and

output:

we have

chains,

logic

i Y.

multiplier)

inflation falls. The Federal Reservereacts the real interest rate, causingconsumption, by decreasing equilibrium output to rise. In symbols,we have

and

investment,

made a

i PAE => (via the

in inflation

fall

i tt

I =>

planned

a recessionarygap

Similarly, when

to the

planned C and

t Y.

multiplier)

in inflation

rate. Notice that

and the Fed's we

have

also

using the endpoints

of the

two

Ttt^IY and

We

thus

have

shown

that the AD curve must

downward

as shown

in

Figure

24.3.

THE AD CURVE?

SHIFT

FACTORS

WHAT

slope

demand curve shows how the amount of planned spendingand output the inflation rate, holding all other factors constant. We need to examine these other factors to understand how and why they cause the AD curve to shift. Before we dive into the details, we need some terminology. We did this in curve for a single market and Chapter 3, when we introducedthe demand in the quantity between a change demanded and a change in demand. distinguished in the AD curve. We define a change in aggregate we need to focus on shifts Here, demand as a shift of the AD curve.

The

aggregate

with

varies

Specifically, an AD

curve,

and

This is illustrated in demand. to Figure Demand

increase in

a decrease

We will use

in

24.4

Figure this

language

24.4 throughout

is a rightward shift in the leftward shift of the AD curve. for both an increase and a decreasein aggregate the rest of the chapter, and we will refer through

this

demand

aggregate

aggregate

demand

is a

section.

Shocks

in output (e.g., consumption is a function Planned spending is affected by changes of real GDP), and the inflation rate (e.g., consumptionand investment rise or fall aSeethe sections\"The

Fed Fights a

Recession\"and

\"The

Fed Fights Inflation\"

in Chapter

23.

change

a shift

in aggregate of the

AD curve

demand

686

CHAPTER

24

AGGREGATE

DEMAND, AGGREGATE

SUPPLY,

AND

CYCLES

BUSINESS

AD,

FIGURE 24.4 A Change in Aggregate A change in aggregate

Demand. demand

is a shift of the

rate). However, real wealth output

domestic residents Changes

the

spending that are by changes in output

inflation

rate

EXAMPLE 24.1

demand,

aggregate

and panel (b) shows

inflation

not

spending

and consumers'

confidence

consumer

even if there

has been no change in

rate. Decreased business confidenceor new technological lead firms to decrease or increasetheir planned investment.

willingness of foreigners to purchasedomesticgoodsor of foreign goods will affect the planned level of net exports. in planned in output that are not causedby changes or the spending rate are calleddemand shocks. These events are termed shocks because to purchase

not anticipated by households, businesses, government, or foreign buyers those entities made their decisions about plannedspending.Further, since demand shocks affect planned spending, they affect short-run as well and output therefore increase or decrease demand. demandshocksare one Thus, aggregate causeof shifts in the AD curve. were

they

or

or lowering the real interest or the inflation rate can have an

by raising

than output

in the

Changes

in

inflation

other

consumption

may

opportunities

planned

in

For example, changesin

affect

inflation

the

or

factors

many

on spending.

effect

caused

an increase

shows

(a)

reacts to a change in

the Fed

when

demand shockschanges

Panel

curve.

AD

demand.

in aggregate

a decrease

when

House Prices

an increase

Does

Suppose that

2006

the

in

the

U.S.

in

and

aggregate

demand?

Go to in

house

planned

aggregate

Figure 24.4(a) and house

affect

prices

average price of This will increase

consumption

increase

Shocks

Demand

and

prices

homes begins to rise,as it did between 1999 and real household wealth and therefore cause expenditure to rise as well.How does this affect

start

with

causes planned

pricesincreases

curve

aggregate

shifts demand.

from

output

Y1

and

rate

inflation

expenditure to rise, which

output as well. Real GDPthereforemoves remains at irv Since we chose ttx arbitrarily,

rate and the AD

demand?

aggregate

from

ADX to

Y1 to output

Y2

while

increases

ADr Hence, an

in

irv The turn

raises

rate at every inflation the

inflation

increasein house

THE AGGREGATE DEMAND

The house

becausethe

price increase in

has the opposite

shock

demandshock

Example

shifts to the

curve

AD

effect and

as

right

is called a positive 24.1(a) a result of the shock. A negative curve

AD

the

shifts

to the left.

demand

This is shown in

24.4(b).

Figure

CHECK

CONCEPT

Suppose over

the

Explain

your

24.1

become

that

firms

next

year or so. Is this

extremely a demand

pessimistic about their business prospects shock? If so, is it positive or negative?

reasoning.

Stabilization

Policy

Stabilization policies are

expenditurewith

the

to affect

planned aggregate gaps. Recall that the two and monetary policy policy. Fiscal government spends and how much used

policies

government

of eliminating

objective

output

tools of stabilization policy are fiscal how much the policy refers to decisionsabout tax revenue it collects. Monetary policy refers to decisionsabout the size of the money supply and hence the level of interest rates in the economy. in fiscal policy and monetary Stabilization and changes policy in general, affects aggregate demand and shifts the AD curve. The Great policy in particular, Recession has seen active use of both fiscal and monetary policy, so it is worth taking a moment to understand how each affects demand. aggregate major

Fiscal the

affects

Policy: Changes of government

level

spending and output. in

to decrease

order

inflation

given

in

Government

For example,suppose that the budget deficit.This will

rate and

shift

and Taxes

Spending

purchases and taxescollectedand

the

curve

AD

the government cause

spending

thus

Fiscal policy influences

total

reduces its spending to decrease at any

to the left [as shown in AD curve to the right.

Figure

24.4(b)].

in government spending shift the in taxes also shift AD curve. Suppose that the the cuts Changes government to increase taxes; recall that this raises households' disposable income, leading them their consumption level of consumption spending. The higher spending causes an increasein planned and real GDR This processworks at any given inflation spending rate, so a tax cut causes the AD curve to shift to the right as shown in Figure 24.4(a). Increases

have the opposite effect: Disposable output fall, and the AD curve shifts to the left as

Tax increases

Monetary Inflation

We

Policy: Changes in earlier

that

down. In

this

demonstrated curve slopes

the

Real the

income in

Interest

Fed's

falls, consumption

and

24.4(b).

Figure

Rate without

monetary

Changes

in

policy rule is the reason

assumed that the Fed that the Fed increased the real interest rate when inflation rose above 77* and decreased the real interest rate when inflation fell below 77*. The Fed is, however, free to change the real interest rate even when inflation is stable. There are two possible reasonswhy the Feb might do this. The first reason is that the Fed may decide to change its current target for the inflation rate. For instance, suppose the Fed considers its current target rate of inflation to be too high. To reduce inflation, the Fed needs to reduce planned of Figure 24.4(b), this spendingand output by increasing the real interest rate. In terms means that, at an inflation rate such as ttv output will fall from Y1 to Y2. We chose in the Fed's inflation the inflation rate tt1 arbitrarily, so this means that a reduction AD will shift the curve to the left. target in which Now considera situation the Fed realizes that its current target rate of inflation is too low. The Fed can now stimulate the real interest spending by decreasing rate. Using Figure 24.4(a), this means that, at inflation rate ttv output will rise from Yt to rate tt1 arbitrarily, so we have Y2. As in the previous casewe chosethe inflation demonstrated that an increase in the Fed's inflation will shift the AD curve to the right. target AD

why

the

had

a target

rate

of

inflation

77* and

analysis,

we implicitly

CURVE

687

CHAPTER 24

688

AGGREGATE

AGGREGATE

DEMAND,

BUSINESS CYCLES

AND

SUPPLY,

The second reason the Fed may interest rates is that it is concerned change about the level of output itself relative to potential. For example, if the Fed believes that the current level of output is too low (e.g., the economy is in a deep recession), it can decrease the real interest rate and cause consumption, investment, and output to

once again, with

This corresponds,

rise.

Stabilization Policy:SummarizingIts Effects

summarize how the stabilization policy.

There

are

on

24.4(a). Let's

Demand

Aggregate

government aggregate demand through that the wants to increaseaggregate demand. First, suppose government in three tools it can employ or combination with one (alone another):

\342\226\240 Increase \342\226\240 Cut

in Figure

situation

the

influence

can

spending;

government

taxes;

Second, if

the

rate.

real interest

the

\342\226\240 Decrease

wants

government

to decrease

aggregate demand,it

has

also

three

options: \342\226\240 Decrease \342\226\240 Raise

spending;

government taxes;

real interest

the

\342\226\240 Increase

rate.

THEAGGREGATE

RECAP

The aggregate

demand (AD)

curve

(AD)

shows

and customers

government,

consumers, firms,

DEMAND

CURVE

the amount of output abroad want to purchaseat

inflation

rate, holding all other

factors constant.

The AD

curve

downward

because of the

rule:

Higher

slopes

inflation

leads the Fed to

reduces spending and thus

shocks (changes in

Demand

changes

in

shocks

shift

shift the

planned

AD

Fed's monetary

real

interest

policy

rate,

which

output.

equilibrium

that

spending

inflation rate) shift the AD curve to the right curve to the left.

or the

output

shocks

demand

short-run

raise the

each

the

AD while

are not caused curve. Positive negative

by

demand

Stabilization policy,that

to close is, the use of fiscal and monetary policy of government output gaps, shifts the AD curve. Higherlevels spending, lower taxes, and lower interest rates all increaseaggregate demand, while rates

decreased government all decrease aggregate

THE AGGREGATE So far, we have

supply

aggregate

between relationship output firms

the

shows

(AS) the

the amount

want to

inflation rate,

factors constant

curve

of

produce and holding

all other

higher

interest

SUPPLY CURVE

the aggregate demand (AD) curve. The AD curve we developed in the last two chapters. Specifically, reasoning the basic Keynesian model tells us that, at a given price level, planned aggregate must equal short-run equilibrium The AD curve builds on this expenditure output. model and shows that when the inflation rate rises,the level of planned aggregate and short-run and when the inflation rate falls, planned falls, expenditure output and rise. spending output This leaves us with an important, unanswered question: What factors causethe In rate to rise or this we section, develop the aggregate supply (AS) inflation fall? curve to help us answer this question. The AS curve shows the relationship between embodies

a curve that

spending, higher taxes, and

demand.

the

focused

economic

on

THE

AGGREGATE

SUPPLY CURVE

FIGURE 24.5 /AS

+J rt

-e

The AS curve slopes upward because, when firms increase their output, the inflation

*A

rate rises.

#0

\"-M

.2 M-C

y

sx

TT2

--/o y*

y2

the level of output all other factors we

curve,

Just questions \342\226\240 Why \342\226\240 What

When assumption:

typical

we

the

AD

shown

as we did with the aggregate about the AS curve: the AS

does causes

first In

That is, firms

Vi

to produce and the worked

have

curve in

through

to analyze

Figure

demand

inflation

the

why

holding

rate,

the details

of the AS rate rises

inflation

24.5.

(AD) curve,

we must

answer

two

curve slope upward?

the AS

curve to

shift?

AS CURVE

THE

DOES

WHY

firms want

use it along with AS curve is

can

and falls. A

GDP)

(real

constant. Once we

SLOPE UPWARD?

developed the basic Keynesianmodel (Chapter short run, firms meet the demand for their

the

22),

products

we made

a key

at preset

prices.

for their products by respond to changes in the demand their firms set their for some changing prices. Rather, many prices period and then meet the demand at those prices.We argued that this assumption is generally realisticover short of time due to a phenomenon known as menu costs. Menu costs refer to periods in order to change their the fact that firms must incur costs we prices. Examples gave in Chapter 22 included the case of a restaurant, where the menu cost is literally the cost of printing up a new menu, and the cost a clothing store faceswhen it has to retag all its merchandise or reprogram its computer when the managerchangesprices. We can now relax the assumption that firms sell all of their output at preset and examine the between and the inflation rate. To do prices relationship output we must look at two reasons this exists: inflation this, important why relationship do

inertia and

output

Inflation

Inertia

not

always

gaps.

Physicists have noted that

to keep moving at a constant speed and some outside force\342\200\224a refer to as upon by tendency they to observers have noted that inflation economics, many concept in the sense that it tends to remain roughly constant as long as the is at and there are no external shocksto the price level. economy potential output Economists refer to this phenomenon as inflation inertia. If the rate of inflation in one year is 2 percent, it may be 3 percent or even 4 percentin the next year. But unless the nation experiencesvery unusual economic inflation is conditions, \342\200\2242 in to rise to 6 or 8 or fall to the unlikely percent percent percent following year. This relatively behavior contrasts the behavior of economic sluggish sharply with

direction unless it is inertia.Applying this seems to be inertial,

acted

a body

will tend

Supply

(AS) Curve.

/xe j /\\ y

1*1 \302\243
=

The Aggregate

689

690

CHAPTER24

AGGREGATE

AGGREGATE

DEMAND,

BUSINESS CYCLES

AND

SUPPLY,

such as stock pricesor commodity to day day. For example,oil pricesmight a year and then fall 20 percentover the inflation rate has generally remained in

variables

answer

To

play an important public's

industrial adjust relatively slowly in modern we must consider two closely related factors that the inflation rate: the behavior of the determining and the existence of long-term and price contracts. wage

role in

expectations

inflation

Let'sfirst

Inflation Expectations In

inflation.

today'sexpectations rate. Suppose,

of inflation of

the

consider

they

expect

inflation

future

for example,that

office

to prevail

may help worker

the

to

determine

sellerstake

few years. As

next

in

about

expectations

public's

wages and prices, both buyers and

future

negotiating

the rate

account

rise

tend to this question,

inflation

does

Why economies?

can change rapidly from 20 of by percent over the course next year. Yet since about 1992, the U.S. the range of 2-4 percent per year. which

prices,

well

inflation

future

the

Fred and his

into

a result,

boss Colleen agree that in his real wage percent

year justifies an increase of 2 or dollar,wage increaseshould they agree on? If Fred believes that inflation is likely to be 3 percentover the next year, he will ask for a in 2 in his real wage. increase his nominal to obtain a increase 5-percent wage percent If Colleen agrees that inflation is likely to be 3 percent,she should be willing to go along with a 5 percent nominal increase, knowing that it implies only a 2 percent increasein Fred's real wage. Thus, the rate at which Fred and Colleenexpectprices to rise affects the rate at which at least one price\342\200\224Fred's nominal rises. wage\342\200\224actually A similar dynamic affects the contracts for production other than labor. inputs For example,if Colleen is negotiating with her officesupply company, the prices she will agree to pay for next year's deliveries of copy paper and stapleswill depend on what she expects the inflation rate to be. If Colleen anticipates that the price of office and services, and that supplies will not change relative to the prices of other goods the general inflation rate will be 3 percent, then she should be willing to agree to a in if increase the of office On the other she hand, 3-percent price supplies. expects the inflation rate to be 6 then she will to 6 general percent, agree pay percent more for and next that a nominal increase of 6 percent copy paper staples year, knowing in no the of office relative to other implies change price supplies goods and services. the the rate of the more nominal then, inflation, Economywide, higher expected if and the cost of other will tend to rise. But and other costsof wages inputs wages in to firms will have to raise inflation, production grow rapidly response expected their prices rapidly as well in order to cover their costs. Thus, a high rate of inflation tends to lead to a high rate of actual inflation. Similarly, if expected expected inflation is low, leading and other coststo riserelatively actual wages slowly, inflation should be low as well. Fred's for

this past

performance

year. What

next

nominal,

CONCEPT CHECK24.2 that

Assume

employers

and workers

agree

that

real

wages

should

rise

by

2 percent

next year.

a.

If

b.

If

is expected

inflation

next

wages

is expected

inflation

will

inflation

The inflation

raises

to nominal

happen

c. Useyour

answers will

conclusion the

to be

2 percentnext

what

year,

will happen

to

nominal

year?

affect

that

question

from the

4 percentnext wages next year?

to be

year,

rather

than 2

percent,

parts a and b to explain how an increase following year's actual rate of inflation.

actual inflation is partially of what determines inflation

determined expectations.

by

what

in expected

expected

To a

great extent,

691

SUPPLY CURVE

AGGREGATE

THE

FIGURE 24.6 A

Low

Inflation.

in

inflation

costs

production

they

Low expected

wages and other

to

inflation

future. As a result, they agree in to accept small increases wages and in the prices of the goods and services

\\

increase

Slow

leads people in the

inflation

expect low

/

Low

and

Expected inflation

Low

of Low

Circle

Virtuous

Inflation

which

supply,

keeps

inflation\342\200\224and

expected

inflation\342\200\224low.

In a

way,

high

inflation

similar leads

people to expect high inflation,

which

to produce

are influenced

expectations

people's

low and stablefor

time,

their

by

recent

are likely

people

has been low.

If inflation

experience.

to expectit

to

to be

continue

has recently been high, people will expect it to continue to be high. been unpredictable, alternating between low and high levels, the tend to be volatile, rising or falling with news or expectations will likewise

if inflation

But If

some

inflation

public's

has

economic conditionsor economic policy. illustrates tend to schematically how low and stableinflation may be self-perpetuating. As the figure shows, if inflation has been low for some time, in nominal Increase people will continue to expect low inflation. wages and other rumors about

24.6

Figure

productioncosts thus cover costs,then actual turn

will

low

promote

will

to be small. If firms raise prices will be low, as expected.This

tend

inflation

perpetuating the

inflation,

expected

only low

enough

to

rate

in

actual circle.\"

\"virtuous

A inflation: logic applies in reverse in an economywith high in rate leads the public to expecthigh inflation, resulting 24.6 higher increases in nominal wages and other productioncosts.As Figure this in turn contributes to a high rate of actual inflation, and so demonstrates, in the determination of on in a vicious circle.This role of inflation expectations and price increases often seems to adjust wage helps to explain why inflation The

same

inflation

high

persistently

slowly.

Long-termWage and PriceContractsThe wage

is strengthened

inertia

inflation

and

contracts.

price

three years into firms

pay

the

for parts

union

inflation

by

Union wage

future.

Likewise,

serve

to

role

contracts,for

often

cover

several

often

example,

that set the

extend

in

for

prices manufacturing

years.

in\" wage and price increasesthat depend the contractswere signed.For example, a environment is much more likely to demand a the life of the contract than would a union in

\"build

at the time

expectations in a high-inflation

negotiating

rapid increase an economy in

of inflation

expectations key element, the existence of long-term

contracts

and raw materials

Long-term contracts on

a second

over are stable. prices To summarize, in the absence of external shocks, inflation tends to remain in low-inflation stable over time\342\200\224at least industrial economies like that relatively of the United States. In other words, inflation is inertial (or, as some people put it, I nflation tends to be inertial for two main reasons. The first is the \"sticky\.") A behavior of people's of inflation. low inflation rate leads expectations people to expect in

nominal

which

wages

high

in turn inflation.

tends

692

CHAPTER

24

AGGREGATE

AGGREGATE

DEMAND,

low inflation

the

in

future,

increases.Similarly,

a high

future, resulting which

is the second

Figure

inflation rate

wage and

stable over

effects of people'sinflation

contracts,

price

time. Long-term

expectations.

the

why

Federal

the

Reserve

has a strong incentive to

maintain

economy.

and Inflation

Gaps

Output

in

to be

tends

24.3

discuss

24.6,

Using

a low

existence of long-term

by the

reason inflation

CHECK

CONCEPT

which results in reduced for wage and price pressure in the inflation rate leads people to expecthigh inflation in increases and The effects of rapid wages prices.

in the

to build

tend

contracts

more

in

reinforced

are

expectations

BUSINESS CYCLES

AND

SUPPLY,

Just as a physical

will change speed if it is acted on by outside so forces, An important can change the rate of inflation. factor influencing 21 as the the rate of inflation is the output gap, which we defined in Chapter difference between the economy's actual output and its potential relative to output, potentialoutput, at a point in time. At a particular time, the level of short-run equilibrium various

object

forces

economic

to equal the

long-run productive capacity, or the case. exceed necessarily Output may potential output, rise to an expansionary giving gap, or it may fall short of potential output, producing in each of these three a recessionary to inflation gap. Let's consider what happens cases: n o an and a possible output gap, expansionary gap, recessionarygap.

output

may happen But

potentialoutput.

No

economy's

that is not

Gap:

Output

Y = Y* If

actual

output

equals

output,

potential

there

is no

When

the

gap is zero,

then

by

in the output gap. output sense that their sales equal their maximum sustainable production rates.As a result, firms have no incentive to either reduce or increase their prices relativeto the prices of other goods and services.However, the fact that firms are satisfiedwith their sales does not imply that inflation\342\200\224the rate of change in the overall price level\342\200\224iszero. To see why, let's go backto the idea of inflation inertia. Suppose that inflation has recently been steady at 3 percentper year, so that the public has come to expect an inflation rate of 3 percent per year. If the public's inflation expectations are in the wage and price increases agreedto in long-term reflected then firms contracts, will find their labor and materials costs are rising at 3 percent per year. To cover their firms will need to raise their 3 costs, prices by percent per year.Note that if all firms are increasing their prices by 3 percent per year, the relative prices of various in and services the the goods economy\342\200\224say, price of ice cream relative to the price of a taxi ride\342\200\224will not change. the economywide rate of inflation Nevertheless, in 3 the same as We conclude that, if the output gap equals percent, previous years. is zero, the rate of inflation will tend to remain the same. definition

firms

are

satisfied

Gap: Y > Y* Suppose now that an expansionary gap exists, so that exceed their maximum sustainable production rates.As we might the quantity demanded exceeds the quantity firms desire expect in situations in which to supply, firms will ultimately to increase their relative To do respond by trying prices. in If will increase their more than the increase their costs. all firms so, they prices by behave this way, then the inflation rate will begin to rise more rapidly than before. Thus, when an expansionary gap exists,the rate of inflation will tend to increase. most

Expansionary firms' sales

RecessionaryGap:Y

<

if a recessionary gap exists,firms will be to and will have an capacity produce, they so they can sell more. In this case, firms will raise in costs, as determined by cover their increases fully

Y* Finally,

their selling an amount less than incentive to cut their relative prices

less than needed to inflation rate. As a result, when a existing inflation will tend to decrease.

their prices the

recessionarygap exists,the

rate

of

AGGREGATE

THE

THE AS CURVE:GRAPHICAL ANALYSIS

DERIVING We

can

inflation

now derive the AS curve when there are output

have learned

the

in

by

(it) =

Expectedinflation

inflation

than

inertia,

inflation inertia is Let's begin

caused by an output gap.

on the right-hand sideof the equation as expected inflation, cause of because, as we discussed above, the primary

first term

the

label

we

what

summarize

(it6)

in inflation

+ Change

rather

of

and the behavior

inertia

inflation

combining

gaps. In particular, we can

equation:

following

Current inflation

We

agents' expectationsof where

situation

the

with

inflation

Current

(77^)

inflation.

future

there is no

= Expected inflation

show this situation as point A in Figure 24.7. Next, has an expansionary gap. In this situation, the inflation in the economy plus some additional amount of inertia

economy being above

output

potential

Current inflation

(tt2)

level, that

Then,

gap.

output

We

(it6).

suppose

the

that

will be

rate

amount

economy

equal to

caused

the

by the

is, inflation

> Expected

(it6).

r

7T2

C

^3

/

24.7

Deriving

the AS Curve.

point

output is equal

/ rc

inflation

Y*

Y2

B in

Figure

inflation

Current inflation is

lower than

encourages

reduce

firms

inflation rate.

WHAT

inflation

to

Points A, level

CAUSES

(77-3)

expected

Finally,

suppose

that

there

is a

recessionary

<

inflation

Expected

because

inflation

their prices and thus C in Figure 24.7 B, and of ire.

puts thus

(ire). the recessionary gap on the pressure out the AS curve at the

downward trace

THE AS CURVETO SHIFT?

(AS) curve shows the relationship betweenthe amount supply firms want to all other factors rate, holding output produce and the inflation constant. As we did with the AD curve, we next needto examinetheseother factors and understand how and why cause the AS curve to shift. they

The

aggregate

to expected

77e).

At point

tt3 is

of

8,

so

C,

potential, so below its

is below

expected level.

Y^

case,

Current

expected

24.7.

=

output is above potential, inflation tt2 is above its level. At point expected output

This is shown as point

and so

inflation

(77,

to

is equal

A, output

potential

inflation

A

O

FIGURE

At

TB

/

gap.In this

693

SUPPLY CURVE

694

CHAPTER

24

AGGREGATE

AGGREGATE

DEMAND,

AND

SUPPLY,

BUSINESS CYCLES

AS2

ASA > >AS2

\302\243

\302\243

v

^^r

^r J* L.

^

&.

C

c

3 *i

3 ^1

0

^r

S^^r

S^

C

M-

C

I I I

^

(a)

Increase

FIGURE 24.8 A Change in Aggregate A change in aggregate

change

a decrease

in aggregate of the AS

curve

^r

jf'

^r

^r

^r

^r

,^r

I I I

Y1

Output

in aggregate

(b) Decrease

supply

Supply. supply is a shift of the AS curve.

Panel

(a) shows

an increase

in

in

^r

_^r

Jf'

Y2

Y

asa

^r^r

^S <^^

I I I

Y2

in aggregate

supply

^r

I I I

Output

a shift

^T

0

M-

shows

y

Y supply

aggregate

aggregate

supply; panel

(b)

supply.

in aggregate we need to coversometerms.A change demand, Just as with aggregate An in is a shift of the AS curve. increase is a shift supply aggregate supply rightward in the AS curve and a decreasein aggregate is shown a leftward shift of supply by the AS curve. Both cases are shown in Figure 24.8.

Resources

in Available

Changes

and Technology

the resources rate, firms can increasetheir capacity any given by increasing in have available for This is shown The 24.8(a). they production. Figure economy rate natural begins at output Y1 and inflation ir^ firms then hire more labor,capital, or some combination of all three. This allows firms to increase their resources, output from Y1 to Y2 while the inflation rate remains at 7r1. Our choice of tt1 was entirely inflation

At

so the same reasoning applies to any inflation rate we choose, meaning that the AS curve shifts out when firms have more resourcesavailable to them. on aggregate Changes in technology have the same effect supply as changes in

arbitrary,

entire

For

resources.

example,

suppose

more machines, a manufacturer more

efficiently.

sell its

production

the AS

shift

of hiring a figures way to its can produce more that,

instead

out

more workers or purchasing use its workersand machines

This means that the using at the same prices as before.In general,technological

same

resources,

and

improvements

curve outward.

Changes in Inflation Expectations

earlier how inflation expectations are formed and how either a virtuous or reinforces these inflation cycle expectations.(SeeFigure 24.6.) Why might expectations change? What happens to the AS curve when inflation expectations change? industries Suppose that wages and pricesin certain begin to rise faster than workersand firms thought to be they would rise.This will cause the actual rate of inflation than what was and can lead to revise their higher expected people upward expected rate of inflation. Figure 24.9 showswhat to the AS curve when expected happens inflation rises. inflation is Originally, AS1 is the AS curve for the economyand expected at 7Ter After inflation inflation is at the entire AS curve rise, expected expectations 77e2; thus shifts because output gaps still have the same effect on actual inflation. upward

We

discussed

vicious

THE

24.9

FIGURE 1

AS2

695

SUPPLY CURVE

AGGREGATE

An Increase

in

Expected

Inflation.

An increase inflation

w/ S ^ei

shifts

1

expected to 7Te2

77*,

the AS curve

upward. in

a decrease

Similarly,

/>

in

from

would

expected inflation the AS curve down.

shift

'/\\ y*

Draw

being sure to labelthe current level be affected if inflation fall? expectations

AS curve,

an

AS curve

the

24.4

CHECK

CONCEPT

inflation. How

of expected

will

Shocks

Inflation

the inflation rate is a shockthat directly affects an inflation shock. An inflation shock is a sudden change in the normal behavior of inflation, unrelated to the nation's output gap. A in increase the of for r aises the of large price imported oil, example, price gasoline, oil or services heating oil, and other fuels, as well as of goods made with using oil. A famous of an inflation shock is the sudden increase in the price of oil example in In that took the 1970s. late at the time of the Yom 1973, place early Kippur War between Israel and a coalition of Arab nations, the Organization of Petroleum Countries of crude oil to the (OPEC) dramatically cut its supplies Exporting in industrializednations, world oil a matter of months. The sharp increase quadrupling prices

The second factor prices, which we

in and

oil

prices services

oil price

can

that

was quickly transferred to the price of gasoline, that were heavily dependent on oil, such as air

increase,together

contributed

affect

to as

refer

will

to a

agricultural shortages in the overall U.S. inflation

rise

and goods of the

effects

The

that increased the

with

significant

heating oil, travel.

price

of

food,

in 1974.

rate

inflation shock that causes an increase in inflation, like the large rise in oil in is called an inflation shock and shifts the AS curve left. An 1973, prices negative in oil prices that inflation shock that reduces inflation, such as the sharp decline occurred in 1986, is called a positive inflation shock and shifts the AS curve right.

An

THE

RECAP

The aggregatesupply of

amount

all other

output

gap

potential, is above

(AS)

firms

curve

want to

factors constant.

The AS curve between

SUPPLY (AS) CURVE

AGGREGATE

upward

slopes actual

output

shows

the relationship

produce and the

inflation

because actual inflation and potential output: When

actual inflation is below expectedinflation,

potential, actual

inflation

is above

expected

between the rate,

holding

is relatedto the output and

when

inflation.

is below

output

change

a sudden

shock

inflation in

of inflation,

the

normal

unrelated

nation's output

gap

behavior to the

696

24

CHAPTER

AGGREGATE

DEMAND, AGGREGATE

SUPPLY,

AND

and technology,and changes in

in available resources shift the AS curve.

\342\226\240 Changes

inflation

shocks

\342\226\240 Inflation

curve to the

left

also shift the AS and

CYCLES

BUSINESS

curve. Negativeinflation

positive inflation shocks

the

Now that you understand the basics of the AD curve and the them together to analyze business cycles. Specifically, we will to answer two questions:

1. 2. Is We

the

are

What

a role

there

the

address

causes of

fundamental

for stabilization

first question

in

shift

shocks

AS curve

to the

the AS right.

CYCLES

BUSINESS

UNDERSTANDING

shift

expected

AS use

we can put AD-AS model

curve the

business cycles?

policy? section

this

and then

ask the second in

the

following

section. 24.1 and 24.2. Figure 24.1 shows the economy in long-run Y* is at and the inflation rate is at its expected level7Ter equilibrium: Output potential in 24.2 shows the short-run with a Figure economy equilibrium, panel (a) illustrating and an The \"What recessionary gap panel (b) displaying expansionary gap. question are the fundamental causes of business cycles?\"can thus be rephrased as follows: What factors move the economy from the situation in Figure 24.1 to one of the in Figure in the AD curve and the AS scenarios 24.2? The short answer is that shifts curve push the economy out of long-run and into either a recessionary equilibrium in turn. or an We examine each of these gap expansionary gap. possibilities

Let's

to

return

24.10

illustrates

how shifts

FIGURE

24.10

Demand

Shocks

The

economy

shock

demand (from right,

77e

to

AD

left and to

the

CURVE

curve cause business cycles.Figure 24.10(a) opening a recessionary gap. By contrast, right and opens an expansionarygap.

and Business Cycles.

begins in long-run equilibrium shifts the AD curve to the

77,). Panel

increasing

the

in

curve shifting to the Figure 24.10(b), the AD curve shifts the AD

shows

IN THE AD

SHIFTS

SHOCKS:

DEMAND Figure

Figures

(b) shows

both output

(from

in each

an expansionary Y* to

panel. Panel (a) shows a recessionary gap:A negative both output (from Y* to Y,) and the inflation rate A AD demand shock shifts the curve to the gap: positive

left, reducing

Y^ and the

inflation

rate

(from

77e

to

77,).

in

UNDERSTANDING BUSINESSCYCLES

the AD curve to shift and the economy out of longpush in identified three earlier this demand equilibrium? possibilities chapter: in in fiscal and Economists have shocks, changes policy, changes monetary policy. found that demand shocks are the most common causeof business that are cycles induced by AD shifts. The following example illustrates this point. cause

would

What

We

run

The Impactofthe did

How

the U.S.economy?

bubble affect

dot-com

the

EXAMPLE 24.2

U.S. Economy

the

on

Bubble

Dot-Com

stock market boom that took place between 1995 and of the boom was new stockissues by Internet such as Netscape.com, AOL.com, and Amazon.com. The Standard and companies Poor's 500 stock index approximately doubledduring this (S&P) period, leading to a large increasein household wealth. This led to an increase in aggregate demand like that shown in Figure and an expansionary gap. 24.10(b)

The

was a

bubble

dot-com

2000. One of

the

forces

driving

The dot-com bubble during the dot-com

reaped

greatly reduced.The result Figure

24.10(a),

INFLATION

bubble had beenwiped was

caused

that

2000. By fall 2002,

in March

burst

2001

the

demand, like

in aggregate

a decrease

most

of

the

gains

wealth was

household

and

out

in

shown

that

recession.

SHOCKS: SHIFTS IN THE AS

CURVE

in Figure 24.11. AS curve can also causebusiness as shown cycles, shows the AS curve to the left and 24.11(a) Figure shifting opening a recessionary Shifts

in the

gap,while

24.11(b)

Figure

the AS curve

shows

to

shifting

the

right

and opening an

expansionary gap.

(a) Negative

Y Output (b) Positive inflation

Y

Output

shock

inflation

shock

FIGURE24.il

Inflation

Shocks and Business Cycles.

begins in long-run shock shifts the AS curve (from 77e to 77,). Panel (b) shows

The

economy

inflation

right,

increasing

output

in each

equilibrium

to the

left,

reducing

an expansionary

(from Y* to

Y^

and

gap:

reducing

panel.

(a) shows

Panel

output

A positive

the

inflation

a recessionary

(from Y* to Y,) and

demand shock rate

(from

77e

gap:A increasing the

shifts

to

77,).

the

negative inflation

AS curve

rate

to the

697

698

CHAPTER24

AGGREGATE

AGGREGATE

DEMAND,

in available inflation

Changes inflation

and

rate,

Economists have in the AS curve.

EXAMPLE 24.3

found

BUSINESS CYCLES

AND

SUPPLY,

resources and technology,changesin the expected shocks are reasons why the AS curve might shift. that shocks are the most causes of shifts price frequent

The ImpactofOilPrices How did oil pricesaffect

the

U.S.

the

on

in

Figure

and again

in

early

1970s and

1980s?

rapid increases in the in the first case and shocks:

price

of

in

oil,

in

doubled

then

supply

aggregate

the economy into

pushing

24.11(a), 1980.

in the

U.S. economy

The U.S.experienced two \"oil shocks,\" 1973-74 and 1979. The price of oil tripled the second. Both of theseacted as inflation as shown

Economy

recessions in

decreased, 1973

late

of crude oil reacheda peak in early 1982. It then fell by 50 percent and 1986, providing a positive inflation shock to the U.S. economy. rose this inflation Aggregate supply during period: first, reversing the negative in Figure shocks of the 1970s [i.e., shifting the AS curve to the right and 24.11(b)] then pushing the AS curve out further once the economy returned to potential. The price between 1982

USING THE AD-AS Examples 24.2 and

how

illustrate

24.3

business cycles. Let's summarize

world

then apply them

to the

CYCLES

BUSINESS

STUDY

MODELTO

the AD-AS model can be applied to in we followed these steps examples

the

real-

and

Recession.

Great

Five Steps for Using the AD-AS Model to Study Business Cycles In Examples 24.2 and 24.3, an event such as a stockmarket boom or an oil price shock occurredand we traced out the effect of that event on the economy's output and inflation rate. We can generalize our analysis in the following five steps:

Drawa diagram

Step I:

24.1. Be sure to Figure is at potential output Y*

like

where output

equilibrium,

expected rate ire.

mark the and

the

long-run

economy's

inflation

rate is at its

the event affects the AD curve, the AS curve, or both. This is Step 2: Ask whether where knowing the factors that shift the AD and AS curves pays off. You can write down the factors that shift the AD curve (demand shocks, fiscal policy, monetary resources and technology, changes in policy) and the AS curve (changesin available the expected inflation rate, inflation shocks), assign the event to one of the ask what direction the event shifts the relevant curve. categories,then

Step 3: Shift the curve(s) in the appropriate directions). Step 4: Find the new short-run equilibrium. to the original long-run Step 5: Comparethe new short-run equilibrium equilibrium.

U.S.

2009,

inflation

rate

AD-AS

Using In

fell

from

We can events

to compare the new with the expected

sure

Be

new inflation

are

to Analyze

now use the often

inflation

with

output

potential

output

and the

rate.

the Great Recession

real GDP was roughly 2.7 percent in 2007 to

most

level of

AD-AS

cited as

8 percent \342\200\2240.7 percent

below

potential

output. Core

in 2009.

model to understand the Great Recession.Three causes: the declinein housepricesthat began in

UNDERSTANDING BUSINESSCYCLES

,vAS \302\243

V1 CC TT-i

V^

C

\302\253*\342\200\242 ^V >

H\\v4D2

YA

Output

y

U.S. economy

(a)

Output in

2007

Y*

Y

2008 through

(b) August

June

2009

24.12

FIGURE

The Great Recession. Panel (a) shows the U.S.economyin recession

into

(from point

A

to

long-run equilibrium at point A Panel (b) shows the economy moving point 8). Declining house pricesand a financial crisis caused consumption, to a demand shock that shifted the AD curve to the left (AD, to fall, leading

and net exports to investment, fell to and the inflation rate 77, was below its expected rate 77e. The AD2).Output Y, the picture becausethe sharp increase in oil prices from early 2007 to mid-2008 was in oil prices from mid-2008 to early 2009.

mid-2006, and the

the sharp increase in the price of oil from early 2007 through worldwide financial panic in fall 2008. Here are the five steps:

Step I: Draw The economy

a diagram

Step 2: Ask decline

in

shocks. household aggregate

2007

in

like Figure is at point A.

(a) of

panel

offset

mid-2008,

Figure 24.12.

event affects the AD curve, the AS curve, or both. The and the worldwide financial panic were negative demand

the

whether

house

prices We have already referred to declinesin house which leads to a fall in consumption wealth, demand. The worldwide financial panic

on

of its effects

because

24.1. This is shown in

AS curve

steeplyincreasedthe

investment

rates

interest

spending.

charged

In

as causing a decline in and a decrease in spending

prices

was a negative particular,

on corporate

shock

demand

the financial

crisis

loans.This led directly

to

a

demand. spending and a decreasein aggregate oil approximatelydoubled between 2007 and August January 2008. From 2008 to oil September January 2009, however, prices approximately returned to their January 2007 levels.The U.S.economy, a therefore, experienced in inflation shock and a decrease between 2007 negative aggregate supply early and mid-2008,then a positive inflation shock and an increase in aggregate supply

fall in investment The price of

from

mid-2008

Step

3: Shift the curve(s)

shocksshifted but

the

amount, so the Step

AD

the

movement from the left

early

through

ADX

Figure

the

appropriate

direction(s).

to the left; this is shown in to AD2. The negative inflation shock inflation shock shifted the AS curve curve

positive AS curve

4: Find the new

point B in

in

2009.

remained

roughly where

short-run equilibrium.

24.12(b).

The

it

was

new

The negative Figure

24.12(b)

shifted the to the

AS

demand by the to

curve

right by an equal

in 2007.

short-run

equilibrium

is

does

not

by the rapid

shift

in

decline

699

700

CHAPTER24

AGGREGATE

AGGREGATE

DEMAND,

BUSINESS CYCLES

AND

SUPPLY,

new short-run equilibrium to the original long-run A B in Figure 24.12(b). Actual moved from to economy point point the actual inflation rate in output in 2009, Yv is below potential output Y* and is below the inflation rate ire. 2009, expected 7Tp Recession is a story of negative demand shocks. Thus, the story of the Great The bursting of the housing bubbleand the financial crisis of 2008 reduced 5: Compare the

Step

The

equilibrium.

and

demand

aggregate

the price of macroeconomic

oil may

the economy into a deep recession. The been important at the microeconomic did not have a lasting impact.

pushed have

level

they

in

fluctuations

level,

the

at

but

UNDERSTANDINGBUSINESS CYCLES

RECAP Business

cycles

are caused

by shifts

in

and aggregate

demand

aggregate

supply.

The primary

demand

of aggregate

causes

frequent causesof aggregate The AD-AS modelcan be used to five-stepprocess: the most

the

\342\226\240 Show

economy how

\342\226\240 Identify

in long-run

the

AD and/or AS

\342\226\240 Find

the

economy's the

was the

declining house pricesand

the

in

while

shocks.

by applying

cycles

a

the

fashion;

appropriate

equilibrium;

equilibrium with the initial long-run and the inflation rate were affected.

result

of

two

financial

2008

demand

negative

shocks:

panic.

ECONOMY

SELF-CORRECTING

THE

shocks,

are inflation

business

study

new short-run

new short-run how output

Recession

Great

The

demand

equilibrium;

curves

show

to

equilibrium

are

shifts

and/or AS curves are affected;

the AD

\342\226\240 Shift

\342\226\240 Compare

shifts

supply

AND

STABILIZATION POLICY fiscal and monetary policy to bring economiesout of down economies that are operatingabove potential output. effects of both types of policiesusing the AD-AS model. We will

Governments recessions

can

apply

to

or

slow

the

study

We find

of the shock that caused the recessions (i.e., a demand shockversus matters greatly in how governments respond. to stabilization need to look at how However, before we turn policy, we first if the government the economy will behave does not engage in stabilization policy. It turns out that this is a critical element in understanding how governments should use stabilization policy. the nature

that an

inflation

shock)

THE SELF-CORRECTING ECONOMY In

the

basic

Keynesian

more componentsof spending, or net exports) policies

are

crucial

model, an output planned

GDP

will

not

be eliminated

(consumption, The model implies that

spending

change.

to closing output

could sit below potential

gap

gaps.

indefinitely.

Without

stabilization

investment, fiscal

and

unless one

or

government

monetary the economy policy,

THE SELF-CORRECTING ECONOMY

We built the basic Keynesian the demand for their products

AND

assumption: Firms meet In the AD-AS model,we relaxed prices. this the level can and inflation can rise or fall due now, assumption; price vary to shifts in aggregate demand and aggregate This is a supply. very important difference betweenthe basic Keynesian model and the AD-AS model because, when the price level is no longer fixed, output gaps can be closedthrough rising or falling inflation. This is known as the economy'sself-correcting property. a crucial

on

model

at fixed

Expansionary

that

Figure 24.13 expansionary

illustrates how an economy gap. The economy is initially

inflation

actual

and

gap sinceactual The AD curve in the

shocks.

indefinitely,

Gap

this

At

irv

point,

in

with

equilibrium

Since the AD

not

does

curve

economicsbehind

as

how will long-run must shift

move,

AS curve

the

the

rapidly

chapter, shift

inflation

mechanism

through which the economy to long-run

both the actual

and expectedrates

An

of

adjusts from expansionary

to rise

inflation

their high demand by raising prices costs are rising. Specifically,supposethat

their

than

equilibrium.

more

to

respond

actual most firms will see that

is above

output

be

to

irx

is the

changes in workers' the AS curve, and

equilibrium

causes firms

potential output; this excess demand for their

experiencing

that

means

box,

Adjustment

products

their

to

to rise faster

than

\"slow increase

the

Higher expected inflation shifts wages and productioncosts begin that is, we change the box marked and other production costs\" to \"faster

in

explains Remember

before; wages

why inflation the Fed's

interest rate and spendingwill to long-run

rises, but monetary

why

A

Recessionary gap.

The

actual

with

equilibrium,

to expectedinflation

so that

ttv At this

AS, to

as expected AS2

actual

inflation

policy

rule

the

long-run

economy

adjustment

to

move

inflation costs

production

inflation

potential

moves along the from

to potential

short-run output

Fed the real

the

rises,

AD

curve

equilibrium Y* and

actual

tt2.

a recessionary

of inflation

in

gap is similar to that to a recessionary response

for

curve

there

an

gap is shown

with

and

outputY,

is an

shifts to rises

output

the

Y* and

from

its monetary rate as

fall

as inflation

moves along the AD at output

left

and causes

The Fed follows the real interest

so spending

equilibrium

Fed will increase

the

the economy thus

As

point, inflation

to rise.

in wages

increases

equilibrium

and increases

rises, and

output fall to

actual

rises,

output equal

Gap

The economy's adjustment expansionary

fall

does

policy rule:

falls while inflation is rising.We

inflation equal

to an Expansionary Gap. is initially in

left as

increases the real interest rate. So,as inflation and output

inflation

rises

Actual production costs.\"The circleis now complete: continuesto rise, causing expected inflation to rise, causingwagesand to increase at a faster rate. This

economy

and

inflation

and other

output?

The

expansionary gap. The AS

inflation.\"

expected

\"higher

the AS curve

24.13

FIGURE

firms

prices. This will increase the one to another is price relative but the general level of prices is rising at a faster rate. rising This is just the beginning of the story. Go to Figure 24.6 If we change and look at the box marked \"low inflation.\" this box to \"higher inflation\" and follow the clockwise arrow to the next we will \"low expected inflation\" to change they will respond by raising inflation rate since not just

and

inflation

falling

shift?

this

discussed earlier in

and firms' expectations about

gap

Y1

or

greater than potential output Y*. at AD1 as long asthere is no change policy rule and there are no demand

the left from ASX to AS2 and inflation must rise from does the AS curve shift to the left? What tt2. But why

is the

actual output

rising

is an expansionary

there

to

short-run

an

begins

remain

equilibrium be restored?Graphically,

this

with

it

Y1 is

output

will

Fed's monetary

As we

when

over time

adjusts

property the output gaps will not last but will be closed by

self-correcting fact

An

701

POLICY

STABILIZATION

inflation

curve ttt

to

24

CHAPTER

702

AGGREGATE DEMAND,

AGGREGATE

AND

SUPPLY,

CYCLES

BUSINESS

24.14. Again, the economy is initially with actual equilibrium output Y1 and actual inflation At this there is a point, recessionary gap since actual 7Tr is less than output potential output Y*. The AD curve Yx will remain at ADX as long as there is no change in the Fed's

graphically

in

Figure

in

AS,

AS?

policy rule and there are no demand shocks. the case with an expansionary gap, the AS in curve must this case to the from shift, right AS1 to AS2, to close the gap as long as the AD curve is stable.Inflation will fall from tt1 to tt2 as workers' and firms' expectations about inflation fall due to the recessionary gap. (Again, as in the case of an expansionary gap,Figure24.6is helpful. monetary As

ir1

\302\261 TT2

1 AD,

3^

FIGURE

YA

Y*

Output

Y

In this inflation

costs.) Actual output will rise from Yx its potential output Y* because the Fed will follow rule and lower the real interest rate as inflation monetary policy increased levels of consumption and falls, stimulating

Adjustment to a RecessionaryGap. economy

and

inflation

gap.

The

is initially in

r At this AS curve shifts 77

inflation

equilibrium

point, there to the right

with

output

Y,

a recessionary

is

from AS,

to

AS2

investment

as

actual inflation to fall. expected The Fed follows its monetary rule and decreases policy the real interest rate as inflation falls, so spending and rise as inflation falls and the output economy moves AD the curve to at output along long-run equilibrium Y*

and

inflation

case, lower inflation causeslower expected this in turn slows the growth of wages and other

production

24.14

The

and

was

falls

and

to

spending.

causes

A

ROLE

FOR

Our analysis important

in

irT

of Figures 24.13 and

general

correcting

STABILIZATION

the

real interest

24.14

an

makes

The economy tends to point: In run. other words, given long

output gaps tend to or fiscal policy monetary time,

POLICY?

disappear without (other than the

rate embodiedin

the

be selfenough

in

changes

change

Fed's

policy

in the

rule).

while recessionary inflation, Expansionary output gaps are eliminated by rising are eliminated inflation. This result contrasts output gaps by falling sharply with the basic which does not includea mechanism. model, Keynesian self-correcting in results is explained by the fact that the basic Keynesian model The difference concentrates on the short-run period,during which do not adjust, and prices in prices and inflation that occur over doesnot take into accountthe changes a period.

longer

Does the

economy's tendencyto self-correct imply

that

aggressive

monetary

and fiscal policies are not needed to stabilizeoutput? The answer to this question depends crucially on the speed with which the self-correction If self-correction process takes takes place very slowly, so that actual place. output differs from potential for protracted periods,then active use of monetary and if fiscal policycan help to stabilize But self-correction is then output. rapid, active

stabilization

and

uncertainties returns

economy

are probably not justified in most cases,given the lags if the that are involved in policymakingin practice.Indeed, to full employment then attempts by policymakers to quickly,

policies

stabilize spending and

end up doing more harm than for output may good, actual to \"overshoot\" example, by causing output potential output. The speedwith which a particular economy corrects itself depends on a of factors, the prevalence of long-termcontractsand the variety including and of a reasonable efficiency flexibility product and labor markets.However, conclusion is that the greater the initial output gap, the longer the economy's of self-correction will take. This observationsuggeststhat stabilization process should not be used actively to try to eliminate policies relatively small output in but that be useful gaps, they may quite remedyinglarge gaps\342\200\224for example, when the unemployment rate is exceptionallyhigh.We will return to these issues in

the

next

chapter.

KEY

AD-AS ANDTHE

RECAP

SELF-CORRECTING ECONOMY

to bring the economy into long-run equilibrium Inflation rises economy's self-correctingtendency). eliminate an expansionary gap and falls to eliminate a recessionary gap.

Inflation

gradually

adjusts

called the

(a phenomenon

to

703

TERMS

The more rapid the stabilization

policies to

attempts

self-correction

to

eliminate

eliminate

output gap is large than

output when

need for active In gaps. practice, policymakers' the less

process,

output gaps are more it is small.

likely

to

when the

be helpful

SUMMARY \342\200\242 The

shows the consumers, firms, government, and demand

aggregate

of output

(AD) curve

holding all

AS curve

the

to purchase at each inflation rate, factors constant. It slopes downward because of the Fed's monetary policy rule: leads the Fed to raise the real interest Higherinflation which reduces spending and thus short-run rate, equilibrium Demand shocks (changes in planned output. that are not caused by changes in output or spending the inflation rate) shift the AD curve: Positive demand shocks shift the AD curve to the right, while negative demand shocks shift the AD curve to the left. Stabilizationpolicy also shifts the AD curve. (LOl) customers abroad

to the

AS curve

amount

left,

want

the

other

aggregate supply (AS) curve shows the between the amount of output firms want to relationship and the inflation rate, holding all other produce factors constant. It slopes upward because actual inflation is related to the gap between actual output and potential is below output: When output potential, actual inflation is below expected inflation, and when is above inflation is above output potential, actual in inflation. available resources expected Changes and technology and changes in the expected inflation rate shift the AS curve. Inflation shocks also shift the AS curve: Negative inflation shocks shift the

\342\200\242 Business

aggregate demand

aggregate the

most

are

inflation

\342\200\242 The

frequent

AD-AS

cycles

positive

are caused

cycles and

demand

and

inflation shocks

by shifts

in

aggregate

supply. The primary causes of shifts are demand shocks, while causes of aggregate supply shifts

shocks.

(L03)

model

can be

used to study business

a five-step process: (L03) applying in long-run equilibrium; the economy

by

1. Show

2. Identify how the

AD

and/or

AS

curves

the

appropriate

Shift

the

AD

and/or

AS curves

in

fashion;

4. Find the economy's new short-run equilibrium; the new short-run equilibrium with 5. Compare initial and

long-run equilibrium to show how the inflation rate were affected.

demand

absence of stabilization policy,output will gaps be closed through the economy's self-correcting need to engage in active stabilization property. The policy depends on the size of the output gap and the nature of the shock that created the output gap. (L04)

\342\200\242 In the

(AS)

in aggregate

curve

(688)

demand (685)

supply

aggregate

demand shocks

(683)

aggregate supply change

change in

(AD)

the

output

KET TERMS curve

are

affected;

3.

\342\200\242 The

aggregate

shift

to the right. (LOl)

(686)

inflation

shock

long-run

equilibrium

(695)

(683)

(694)

monetary policy rule (684) self-correcting

property

(701)

short-run

equilibrium

(683)

704

AGGREGATE

24

CHAPTER

DEMAND, AGGREGATE

SUPPLY,

REVIEW

1. What two demand

2.

variablesare related by curve?

(AD)

inflation

rate

affect

and

cause

the

the

a.

AD curve: An

increase

each of

why

the

relationship is this

How

inflation.

AS curve?

4. Sketch an

affects

following

the

Discuss

short-run

on

this

gaps and captured in the

output

depicting an economy in Discuss how the economy over a period of time equilibrium use of stabilization and show policy,

AD-AS

diagram

equilibrium.

without the

purchases.

between

relationship

(LOl)

reaches long-run

in government

the

(L03,

diagram.

L04)

investment spending by about the future. optimism Fed's inflation target.

in planned

caused

firms

the

in

(LOl)

increase

A decrease

3.

aggregate

(LOl)

b. A tax increase.

c. An

the

why changes

CYCLES

BUSINESS

QUESTIONS

the components of planned spending AD curve to slope downward.

and

how

State

Explain

AND

by in

the

PROBLEMS Mc

Graw Hill

connect\"

|ECONOMICS

1. Explain how and why each of the following events affectsthe AD in consumer a. An increase confidence leads to higher consumption b. The government reduces income taxes.

2.

a. The Fed raisesits target b. Oil pricesdrop sharply. Fed raises its

3. The

Visit

your mobile

store and

Econ

Study

4. Suppose that Assuming

rate to

of

Use

inflation.

equilibrium.

long-run

cuts taxes

the

AS curve.

(LOl)

in

an AD-AS

and

the

inflation

diagram to rate.

showthe

Assume

the

(L01-L04) response

to a

recessionary

gap,

but

cut is not put in place for 18 months. and the inflation objective is to return output use an AD-AS to illustrate how this levels, long-run diagram to be might actually prove counterproductive. (L01-L04)

their

policy action

5.

the

the

(LOl) spending.

of inflation.

effects on output

government of legislative delays that the government's

because

app todayl

of the following events affects rate

target rate

long-run

economy starts in

app

download

the Frank:

and

short-run

McGraw-Hill

why each

and

how

Explain

curve.

the tax

increase in oil prices both creates an inflation shock reduces to and, time, potential output. Use an AD-AS diagram show the effects of the oil price increase on output and the inflation rate in the short run and the long run in the following two cases: (L01-L04) a. The government does not engage in stabilization policy. b. The government cuts taxes and increases government spending. same

the

at

6. An

a permanent

that

Suppose

in recession. Using an AD-AS diagram, show how the to long-run equilibrium under each of the following policies. in terms of output loss and Discuss the costs and benefits of each approach is initially

economy

returns

economy inflation.

a. The

b. The

(L01-L04)

Fed raises its target policy

monetary

7. Suppose the in

house

a.

Explain

rate

Fed doesnot changeits

of inflation. target

rate

of inflation

in long-run Now, due to a decline equilibrium. reduce their consumption spending. (L04) in consumer spending affects the AD curve.

economy is initially

prices, how

consumers the decline

how your answer to part a affects the equilibrium. Use an AD-AS diagram to illustrate your

b. Explain

and follows its current

rule.

economy's answer.

short-run

ANSWERS TO

c. Now, in

the decline

to

addition

consumer

in

that the

suppose

spending,

CONCEPTCHECKS

inflation shock, economy experiences a negative i. Explain how the adverse inflation shock affects the AS curve, ii. Discuss,using AD-AS diagrams, what choices the government now must make

8. True or

regarding

stabilization

false:The economy's

stabilization

spending.

This

investment

spending

to decreasetheir investment in demand becausethe decrease

will cause firms

will decrease aggregate is not associated with

in the

a change

demand decreases,businessespessimism

since aggregate

\342\226\240

CHECKS

CONCEPT

TO

ANSWERS

the future

about

Pessimism

in one

Explain

' 24.1

makes active use of to three paragraphs.(L04)

tendency

self-correcting

unnecessary.

policy

policy.

rate.

inflation

And,

to be

is considered

a

negative demand shock.(LOl)

24.2a.

If

a 2 expecting

to be

is expected

inflation

percent

increase

for, a 4 percentincreasein If inflation is expected to

b.

workerswill wages.

If wage

c.

expect,

to cover their

real

be 4

they

a 6

will

percent increase

than 2

in

to increase the to

and ask

expect,

wages. year, rather

increased costs,leading

are

workers

next

percent

need

will

and

then

wages,

nominal

their

ask for,

and

costs rise,firms

services

2 percentnext year

their

in

their

prices of their an increase

percent, nominal

goods

and

in inflation. be faced with

In part b, when expectedinflation 4 percent, was firms will in in increases nominal than when larger wages part a, expectedinflation 2 was we can firms to raise only percent. Thus, expect prices by more when expectedinflation is 4 percent than when expected inflation is 2 percent.

From this example, we can concludethat lead to higher inflation. (LOl)

24.3

increased

inflationary

expectations

tend to stay in this high-inflation and the existence of long-term expectations if will and while the inflation rate is low, the economy wage pricecontracts, likewise tend to stay in this low-inflation state for similar reasons. However, in sincehigh inflation rates impose economic costs on society,as pointed out the Federal Reservehas an incentive to avoid the 16, Chapter high-inflation state by keeping inflation which low, helps to maintain people's expectations of low inflation and leads to lower future inflation rates\342\200\224perpetuating the \"virtuous circle\" illustrated in Figure 24.6. (LOl) If

the

state

24.4 The shifts

inflation

rate is

high,

due to

of

graph should look the downward.

the

(LOl)

will economy inflation high

same

as

Figure

24.9 except that the AS

curve

705

CHAPTER|25

I

Macroeconomic

Policy n

I

economics

and

policy.

policymakers

worked

We

cut taxes,

spending,

government

in active

t

ary gap

' ./*-?'!...\302\273\302\273

to

precision

of

In

i7L

.

-

*

?'\342\226\240

its full

in the

-

*

V \"

LOI Discussthe

' -\342\200\236.

-

-..-.... -\\

v-*

the Fed in and

'

\"*

*

\"

L02

.

accelerating

be

to

aBen

respond

has

\342\204\242*

to

tempted

appropriate

an unreliable

unpredictably

S. Bernanke,

anchored

\342\200\224 -

.

;

\"The Logic

and

credibility ^

l

*

of Monetary

boarddocs/speeches/2004/20041202/default.htm.

a delay

L03

Policy,\"

a foggy windshield, and a tendency accelerator or the brake.\"1

to the

December

2, 2004,

www.federalreserve.gov/

keeping

:

Describe how fiscal policy

speedometer,

in

bank

low.

inflation

times,

with

central

expectations and

the driver of a car can safely control Is managing the economy like driving a car? it. She can steer it around obstacles. She can accelerate when the car is sluggish going up hills or if it needs an extra boost to pass another car.And she can step on the brake if the car is hill if too fast down a or a hazard lies ahead. going macroeconomic Unfortunately, conducting policy is much more difficult than a car. The driver of a car knows where she is at all driving typically exactly times. She alsoknows her destination and can clearly see the road ahead. She has in control over the and wheel. most brake, accelerator, precise steering Finally, she knows from how and when the car will to her instances, experience respond actions.The real-world on the other is more because hand, economy, complex the economic has less information and control than the driver of a policymaker car. As one of us wrote, \"if making is like a then the car, monetary policy driving

car is one that

roles the

by

inflationary

economy as an automobile and the policymaker as its driver. By judiciously steering, braking, or the

shocks.

the

Explain

played

of the

at

shocks

inflation

\\

macroeconomic

might

response

to demand

mm

-

policy

available to

options

\"

policymaking.

analyzing

policy, one think

'

'T* *

short run. While those examples are useful in how fiscal and moneunderstanding works, they overstate the tary policy level

,%tl_ .t

in

and restore output

employment

OBJECTIVES

After reading this chapter, you should be able to:

\342\226\240.

..

or

policy a specificrecession-

monetary

to eliminate

order

LEARNING fiscal

examples showing how much would have to increase

through

engage

basic

the

underlying

monetary

we

four chapters,

last

the

have analyzed

can affect

both

aggregate demand and aggregate

L04

Address economic

as much science.

supply. why

macro-

policy is an art as a

708

CHAPTER 25

MACROECONOMICPOLICY

we we use the First, this

In

chapter,

both

examine

will

the art

and science of

macroeconomic

in the face of policy we focus on inflation and aggregate supply. Second, describe the ways in which be made more effective. we Third, monetary policy might examine the effects of fiscal on and how must policy potential output policymakers the consequences of fiscal policy on both the short-run and the long-run weigh of the we return to the Is performance economy. Finally, question: macroeconomic policy.

shocksto aggregate

art

an

policy

AD-ASmodel to and

demand

or a

science?

OF

IS THE ROLE

WHAT

analyze

stabilization

STABILIZATIONPOLICY? In

the

previous chapter, fact that output

we discussed the

economy'sself-correctingproperty, which

but will be closed by rising or Does the economy's tendency to self-correctimply that and fiscal policies are not neededto stabilize The aggressive monetary output? answer to this question depends crucially on the speed with which the self-correction If self-correction takes actual process takes place very slowly, so that output differs from potential for protractedperiods,then active use of monetary and fiscal is the

will

not

last

indefinitely

rates.

inflation

falling

gaps

place.

policy can help to stabilize output.

On the

probably

other

hand,

if self-correction is rapid, active the lags and uncertainties in Chapter 22 we identified these

not justified given

stabilization that

are

involved

policies

are

in

types of problems as they policy.) Indeed, if the economy returns to full employment quickly, then attempts by policymakers to stabilize spendingand output may end up doing more harm than good, for example, by causing actual output to go beyond policymaking.

(For

example,

to fiscal

apply

potentialoutput.

a particular economy correctsitself depends on a contracts and the includingthe prevalenceof long-term and of product and labor markets. Specifically, the selfefficiency flexibility mechanism assumes that firms change their prices and/or alter their correcting costs in response to output gaps. However, long-term contracts and market imperfectionscan slow this process and cause output gaps to persist for long The

variety

speed

with which

of factors,

of time. In general, economists have longerit will take the economy's

periods

to long-runequilibrium. shouldnot be used actively that the

they Great

may be quite Recession.

This to

that the greater the initial output gap, the self-correction process to return the economy observation that stabilization policies suggests try to eliminate relatively small output gaps, but found

useful in remedying largegaps suchas the onecreatedby

in considering The underlying causes of the output gap are also important the role of stabilization policy.In particular, stabilization affects the economy in policy different on whether the economy was hit by a demand shock or a ways depending

priceshock.

STABILIZATION POLICY

AND

DEMAND

SHOCKS

demand shock knocks the economy out of its longinto a illustrates this situation. 24.10(a) equilibrium deep recession;Figure Notice that a negative demand shock pushes the inflation rate below its expected tt{ level7Te. In the absence of stabilization policy the economy's self-correcting mechanismwill drive the AS curve downward and reestablisha long-run at a equilibrium

Suppose

that a

run

lower expected

large negative and

price level.

IS THE ROLE

WHAT

The

self-correcting years in

or even

months

the

OF

STABILIZATION

709

POLICY?

process could take many case of a large output gap.

the fiscal this, it can employ government recognizes or monetary policy to increaseaggregatedemand and the back to This bring economy long-run equilibrium. is shown in Figure 25.1. As we discussed in the previouschapter,the government can increase demand in two ways. aggregate

If

and the

Congress

First,

fiscal

expansionary

president can undertake

government spending increases increased

planned spendingdirectly

the

(through

and indirectly

spending)

government

This

cuts.

tax

and

will increase

of

a combination

through

policy

induced (through increasedconsumption by lower taxes and increased disposableincome).Second,the

can

Reserve

Federal

policy. This will investment

increased

expansionary

apply

interest

lower

spending,

monetary

stimulate rates, and increase planned

25.1

FIGURE

spending and output. Thus, in the caseof a negative demand the shock, active stabilization policyreturns to the and level that economy output price prevailed

The

before

that

Stabilization

77,.The

the recession.

fiscal

current

prevailed policy

Policy and Negative Demand Shocks. recession at output Y, and inflation rate inflation rate is below its expected level 77e before the recession.In this case, expansionary is in a

economy

and/or

expansionary monetary

applied without causing

Federal Response to

the 2001Recession

federal government respondto the 2001recession?

did the

How

22.11 and 23.4 using the basic Keynesof the AD-AS model. Recallthat the of the dot-com bubble was the cause of the 2001 recession. bursting primary This was a negative demand shock that shifted the AD curve to the left, as in B in of The tax rebate checks sent out 2001 increased point Figure 24.10(a). households' disposableincomeand increased as in point B of demand, aggregate this

addressed

We

ian model.

question

Let's revisit

in

it

in Examples the context

Figure 25.1.

TheFederalReserve no changein inflation

interest rates even though there had been lowering 2000. But, as we discussedin Example the 23.4, September terrorist attacks the Fed into a more active 2001, 11, prodded response. By November 2001, the federal funds rate was 4.5 percentage pointslower than it had in been one year earlier, an increase both consumer and business stimulating fiscal to increase aggregate spending.Expansionary monetary policy worked with policy began

in late

demand and push the

economy

STABILIZATION

POLICY AND INFLATIONSHOCKS

As

we've choice

difficult

inflation expansionary

may

seen, shocks in aggregate between inflation and

toward

potential

demand do not the

stability

of

output.

requirethe

output.

Fed

However,

a shocks to

to make

dilemma. If the Fed maintains the initial target the or rate, economy may experience a protracted recessionary to hasten the return to potential GDP,it If, on the other hand, it wants gap. supply

aggregate

back

have

do

create

such a

to change the inflation

target.

policy

inflation.

EXAMPLE

25.1

can

be

CHAPTER

710

MACROECONOMIC

25

POLICY

AS,

f*

\\s

\\

V\302\256 ^w

/

\302\251

f

3 v~*

\302\243 ^3

c

0 TTp

i____N

^1

X

V\\D2

>AD1

yt

y2

Output

25.2

FIGURE

an inflation Shock. Accommodating in equilibrium The economy is initially with output Y, equal the Fed's long-run inflation (7) An adverse inflation target. increase to

Y2.

inflation

in

The Fed

(2)

inflation

target to

lowers the potential

y

real output

by following the monetary accommodates the inflation

773

shock

this is the

inflation

rate

by loosening that workers and

rate at every

inflation

rate

and shifts

since

interest

policy

to potential output and inflation and 77, equal to expected inflation shifts the AS curve from AS, to AST The Fed responds to the rule and increasing the real interest rate; this causes output to fall from Y, shock

Yr AS does

not

shift

again since

the

the Fed's action

AD

monetary firms

to the

curve

ratifies

Specifically,

policy.

expect

the Fed

after the

adverse

from

AD, to

right

the increase

in

raises

AD2

the

shockThe

inflation

and

output

long-run

Fed thus returns to

expectations.

inflationary

in Figures 25.2 and 25.3.In both this dilemma the figures, in long-run equilibrium with to output equal potential output Y1 and inflation to inflation and the Fed's inflation equal expected long-run target. 7r{ An adverse inflation shock then shifts in the AS curve from to each figure. AS^ AS2 in inflation by following the monetary policy rule The Fedresponds to the increase in the real interest rate causes and increasingthe real interest the increase rate; We

economy

illustrate

is initially

spending

planned

Now,

to decline

with the economy

and output falls from Y, in a recession at output

Fed faces a choice:engagein funds rate in order to increase rule and bring inflation back

active

monetary

to Y2

Y2. and

policy\342\200\224that

inflation is,

reduce

rate 772, the the federal

its monetary aggregate demand\342\200\224or follow policy to irv Figure 25.2 showsthe consequences for if the Fed loosens monetary policy. Specifically, the Fed raises output and inflation the long-run inflation target to ttv the level of inflation that workers and firms when the economy returns to potential output. The Fedthus lowers the real expect interest rate at each level of inflation and shifts the AD curve to the right, from to As the AD curve shifts to the right, the inflation rate rises towards the AD1 ADr

Fed's new long-run

inflation

down

target,

iry

The rise in inflation validates the new level of expectedinflation workers tt3: and firms expect inflation to continue rising,so they for faster increases in push and prices, which drives actual and expectedinflation towards wages ttv The AS curve thus remains at AS2 and the economy eventually returns to potential output the new, higher long-run inflation rate iry Consequently,the higher rate caused by the adverse inflation shock will be sustained and, in fact,

with

accommodating policythat

allows the

shock to occur

policy a effects of a

by

the

allows

Fed's

monetary

policy.

Economists use the term accommodating the effects of a shock to occur.In this

policy example,

to describe the

Fed's

inflation

increased

a policy that accommodating

IS THE ROLE

WHAT

Maintaining Low Inflation

The economy

and

inflation

the

inflationary

raises

to be

with

output

equal

Y,

adverse inflation interest rates in response (7) An

inflation

the

after

firms reduce

and

is restored

equilibrium

long-run

their

inflationary

at the Fed's long-run

well.

to decrease output

shock

inflation

to potential output and inflation and 77, equal to expected inflation shifts the AS curve from AS, to AS2.The Fed keeps the long-run to the adverse inflation shock. (2) Inflation 772 is lower than what shock

shock (773),so workers

continues until expectations are reduced to 77, as This process

right.

allow the

is to

equilibrium target.

and

77,

inflation

expect

the AS curve to

policy

the

in

run and

short

of the long run. There are two important implications Fed's accommodating policy. First, in the short run, the economy experiences a

inflation

in

the

periodof an

short

run and the and

recession

in output

increase

inflation caused

higher

inflation

with

rising

by

the

even higher.

economy returns to potential output, where it began, A possibly rate. shorter and shallower recessionis

inflation run

shock,

spending

Second, but

now

paid

in

the

followed

by

run, the

long

has a higher a higher long-

for with

rate.

inflation

inflation shock is for the Fed to To do the Fed must keep the this, long-run target, 771. real interest rate above the long-run level and not lower it as when it target accommodates the adverse inflation shock. Figure 25.3 illustratesthis situation. The therefore remains at for a time than when the Fed economy longer Y2 accommodates the shock\342\200\224that caused by the adverse inflation shock is is, the recession than when the Fed lowers interest rates. longer The Fed'swillingness to keep interest rates high, and to not close the will will convince workers and firms that inflation not rise to the level they recessionary gap, inflation therefore starts to fall and the AS curve starts to expected, iry Expected shift back toward Note how the Fed will react: As the AS curve shifts to the AS^.

The alternative

stickto the

right,

the

rule and

to accommodating the

actual

adverse

inflation

current

inflation rate

fall

will

and

lower the real interest rate. The

the Fed

will

lower

real

the

follow

interest

monetary

rate

will

policy increase

and output and reduce the recessionary gap and, eventually, the to and the level of inflation, economy potential output original 771. In deciding which of these two policy alternatives to follow, the Fed might like if it did not to know how long it would take for the economy to return to potential

planned

POLICY?

Inflation Shock.

an Adverse

after

is initially in

the Fed's long-run inflation at target

77,

STABILIZATION

25.3

FIGURE

people

OF

spending will

change monetary

return

policy.

The

answer

supply curve shifts down when

an

depends on the

adverse

inflation

speed with shock

which

creates a

the

aggregate

recessionary

expectations, inflation

shifting of

target

712

CHAPTER

25

POLICY

MACROECONOMIC

gap. If the AS curve rate

inflation the

other

the AS

to increase the

when

expectations of

future

change

even

people's inflation if inflation

do not rises

temporarily

any

very

a

slowly, the

the target be short. If, on

to

likely

keep

probably

Fed

be

may

more

inclined

recession.

the

which

lengthy

aggregate

wage increasesand firms will be less likely to raise prices.The second will be eliminated, the aggregate supply line will shift back to more and will return to more Because rapidly, output potential quickly. any AS1 recession will be shorter if inflationary are anchored, the Fed also will expectations be comfortable rate keeping the target inflation unchanged. on the other the Fed has accommodated If, hand, frequently higher inflation in the past, expectations of inflation If rates not be anchored. the may public believes the Fed will raise the target inflation of future inflation will be rate, expectations Workers will then demand increases and firms will raise higher. larger wage prices inflation

of

more rapidly. In that event, slowly, and the return to

stakein

^

will

to avoid

rate

inflation

more

recession

inflationary round

^Jf

down

shifts

the Fed is

supply curve shifts back down shock of following depends partly on the public's expectation how the Fed will act. If people are confident that the Fed will maintain the original their of future inflation will not change even if rate, target inflation expectations If this is the case, we describepeople's inflation rises temporarily. of expectations inflation as being anchored. When an adverse inflation shock increases inflation, believe that the Fed will act to ensure that peoplewith anchored expectations inflation quickly falls back to the initial level. Workers will then be less likely to ask for an

anchoredinflationary

curve

the speed with adverse inflation

Ironically,

expectations

target

quickly,

at 7r1 because

unchanged

hand,

down

shifts

How

was

After

reaching

inflation

for the rest range

in

most

in the

levels

How was

years.

will

the

in

1980s? late

1970s and

3.2 percent in 1983, In the 1990s, inflation

to

decade.

the

of

it

aggregate supply line will shift down more will be prolonged. Thus, the Fed has a maintain its original target inflation rate.

25.1

conquered

double-digit fell all the way

States

employment

that

public

Naturalist

Economic

United

the

convincing

short-run

the full

inflation

conquered

13.5percentin

and it fell

in the

remained even

in

lower,

1980,

the in

2-5 the

inflation

in the

percent range 2-3 percent

1980s?

in the The person who was most directly responsible for the conquest of inflation Federal Reserve'schairman, PaulVolcker. an unusual and secret Following the Federal Market Committee Saturday meeting he called on October 6, 1979, Open to a The results of this agreed adopt strongly anti-inflationary monetary policy. policy in on the U.S. are shown Table which includes selected macroeco25.1, change economy nomic data for the period 1978-1985.

1980s was the

The data

First, as

of inflation

in Table

our model

25.1

our

fit

predicts,

in

the

analysis of anti-inflationary monetary policy quite well. short run the Fed's maintenance of its low target rate

to accommodate inflation shocks led to a recession. In followed the Fed's action in 1979, a short one in 1980 and a deeper in real GDP was negative in 1980 and 1982, and one in 1981 -1982. Note that growth the in rate rose at 9.7 1982. Nominal and real unemployment significantly, peaking percent interest rates also rose,a direct effect of the shift in monetary policy. Inflation, however, did All not much the 1979-1981. these results are consistent respond during period

fact,

two

with

the

and

its unwillingness

recessions

short-run

analysis

in

Figure

25.3.

had changed By 1983, however, the situation markedly. The economy had recovered, with strong growth in real GDP in 1983-1985. In 1984 the unemployment rate, which tends to lag the recovery, began to decline. Interest rates remained relatively high, perhaps other factors besides monetary policy. Most and reflecting significantly, inflation fell in 1982-1983 stabilized at a much lower level. Inflation has remained low in the United States ever since.

WHAT

TABLE 25.1

U.S. Macroeconomic

Nominal

Year

Unemployment

5.5

1979

3.2

1980

1981

-0.2 2.5

1982

-2.0

1983

4.3

1984

7.3

1985

3.8

Source: Economic the authors.

Report

rate

6.1 5.8 7.1 7.6 9.7 9.6 7.5 7.2 of the

rate

(%)

interest

caused

Great

the

0.7

11.4

9.7

-1.7

13.5

11.6 14.4 12.9 10.5

-1.9

10.3 6.2 3.2 4.3 3.6

growth in Figure

cr

cr

cr

o i^

LO CD CD

lo

CD

CD

and inflation 25.4, the

cr

cr o

lo

(DO CD

Year FIGURE

4.1 6.7 7.3

11.9 9.6

7.6

6.0

calculations

Volatility

Between 1985and 2007 Source: Bureau of Economic

25.2

Naturalist

(DO CD

and

cr

o

CD CD

less volatile

much

were

in the

variability

cr

LO CD CD

oocr

growth

cr

o

C\\J

oC\\J

o

GDP. was a dramatic

of Real

there

Analysis

reduction

(www.bea.gov).

in the

volatility of

real

cr

o

quarter

GDP.

than

rate of

lo

o

25.4

The Changing

by

Moderation?

From 1985to 2007, both real GDP were prior to 1985. As shown

CD

(%)

8.3

President (www.gpoaccess.gov/eop) and

they

cr oCD

rate

(%)

7.6

Economic What

STABILIZATION

Real

interest

Inflation

rate (%)

real GDP

1978

OF

Data, 1978-1985

in

Growth

IS THE ROLE

C\\J

^

*i

POLICY?

713

CHAPTER25 MACROECONOMICPOLICY

714

was about

GDP

real

so

decline

But

macroeconomic

market

improves

to

to

has been more

reduced variability

off

by anchoring

not

for

responsible

changesin

the

of

inventories,

an

increased

to changes

in

in

output. If output

potential

the

inflationary

following

doing

keep inflation low, even so may impose short-run

economic

costs

can

discussed,

just

Fed have

efforts

that

structural

These

output.

and other

that improved the changes include better and toward manufacturing capital flows.

of these

from

international

POLICY

create

expectations

an

inflation

Fed,were largely changes included

features

structural

away

of the

to actions

inflation

in

and not the

economy,

shocks

in

demand,

aggregate

and

potential (such

as inflation inflation

and

are anchored, however, the return shock will occur more rapidly.

the Fed can determinewhether effects on inflation and can act

an

By

inflation

accordingly.

saw

in the

last two

EconomicNaturalist

examples,

macroeconomic

if inflationary expectations are anchored.But what determines whether are anchored? Most economists believe that it depends expectations on the credibility of monetary which is the degree to which the public policy, believes the central bank's promises to keep inflation even if doing so may low, performance

promises to

as we have

in

CREDIBILITY

AND

the public bank's

to

Prior

shocks to to rein attempts to

EXPECTATIONS

INFLATIONARY

we

monetary

inflation.

rising.These

be applied to return to output rate. Shocksto aggregate supply Fed to choose between maintaining

monitoring the core rate of inflation, shock has led to any second-round

the central

and

response

from

shocks.Someexamples

spending

monetary policy can to its long-run expected

stabilizing

believes

in

variability

the

in

THE ROLE OF STABILIZATION

shocks), however,force to

reduced

deregulation, the shift openness to trade and

and

inflation

the

practices,

to absorb

management

In response

of monetary policy

to rise

which,

changes

variability

business

economy

RECAP

to which

output

too.3

attribute

reduced

services, and

fiscal

employment

especially

policy,

in both

keep inflation

expectations, output,

structural

that

technology,

of the

ability

efforts to

inflationary

inflation, but most economists

only

While

degree

inflation

allowed

and

and firms.

better macroeconomic

that

in its

consistent

Fed, others believe

credibility

stable output

households

and aggregate supply.This was followed by periodic in monetary that followed.These swings policy from ease to tightness in both output and inflation. Since the early 1980s,however,the volatility

inflation

contributed

the

risks. More

confronting

for the economy. It easier, and reduces

planning

demand

aggregate

As

business

and

inflation

managing

believe

economists

Many

economic

uncertainty

policy, was responsible for the 1981, the Federal Reserve often

stabilize

United

the

in

benefits

numerous

has

volatility

makes

functioning,

the resources devoted reduce the economic

paid

rate of inflation States

the

addition,

volatility

markedly?

Reduced

the

macroeconomic

did

why

1985.In

prior to

it was

of what

half

by two-thirds.2

declined

may

be improved

impose short-run

economic

costs.

if

2OHvier J.

A. Simon, \"The Long and Large Decline in U.S. Output Volatility,\" who have taken statistics Activity, No. 1 (2001),pp. 135-64.Students know that scientists generally use the variance of a variable (or its square root, called the standard to measure its variability. deviation) 3Ben Bernanke, \"The Great Moderation,\" 20, 2004, www.federalreserve.gov/boarddocs/ February Blanchard

Brookings Papers

and John on Economic

speeches/2004/20040220/default.htm.

EXPECTATIONS

INFLATIONARY

AND

715

CREDIBILITY

of credibility was illustrated in our earlier analysis of an In that case, the Fed's credibility as an inflation-fighter the second-round effects of inflation and hastened the return to full preempted at the rate of inflation. Economists have identified several employment original institutional characteristics that may affect the credibility of the central bank's pronouncements to keep inflation low and thus its ability to do so. These include the of central bank independence, the announcement of explicit inflation degree and the establishment of a for inflation. targets, reputation fighting The

importance

shock.

inflation

adverse

The credibility of

may

policy

monetary

short-term

from

insulated

INDEPENDENCE

BANK

CENTRAL

be enhanced if

central bankersare

a condition

considerations,

political

is

that

sometimes

bank independence. Independent central banks will be better able to take a long-term view of the economy. In particular, they can pursueantiinflation policy when it is necessary, even if it leads to a temporary recession. Elected politicians, on the other face frequent reelections, and they be hand, may to overexpand swayed by short-term political considerationsto allow the economy in the long run. Because of its enhanced credibility, at the cost of higher inflation an independent central bank may find it easier to anchor the public's expectationsof the duration of any inflationary or recessionarygap and inflation, reducing as central

to

referred

economic

overall

promoting

stability.

contribute to a central possible factors, we list four: Various factors

\342\226\240 The

of appointments

length

more independentif

to be

if the

especially

cannot

legislators

or veto

considered

are

banks

are appointed for long terms, or group of single president

bankers a

them

bank's actions are subjectto frequent interference, review, branch. Central banks are consideredto be more are not subject to frequent interference or review.

central

the

legislative if their actions

by

independent

finance the

deficit

national to

obligation

bank has the

central

the

\342\226\240 Whether

central

the many

Among

independence.

to the central bank. Central their

are staggered so that all at once.

terms

replace

the

\342\226\240 Whether

bank's

do so

by

reduces a

obligation, as it

does

in some

to

countries,

buying newly issued government

central bank'sindependence.

bonds.The

to which the central bank's budget is controlledby the legislative or degree executive branch of government. Central banks are considered to be more if they are allowed to set and control their own independent budgets.

\342\226\240 The

Reserve is generally considered to be a relatively independent seven members of the Federal Reserve are appointed to staggered in contrast terms of 14 years, to the members of the U.S. House of Representatives, the president, and membersof the Senate, who must face reelection every two, four, and six years, respectively.Although to the Fed's Board of Governors appointments must be approved Reserve is subject to general by the Senate, and the Federal the the actions of the Fed are not subject to review, oversight by Congress, daily policy or veto either the or branches of executive,legislative, approval, by judicial government. Finally, the Fed is under no obligation to finance the national deficit, and it controls its own budget. On the other hand, the law that created the Fed (the

The

U.S. Federal

central

bank.

The

Federal Reserve Act) decisions

does

by the legislative

is explicit in

not

explicitly

and executive

prohibit branches

interference

central banking laws of many evidence Empirical supports the proposition that countries of their central banks. Countries whose central independence have lower rates of inflation. More the independent importantly, the

in

policy

monetary

This prohibition

of government. other countries.

should

foster

the

banks are more lower

inflation

does

central bank when

dence are

insulated

indepencentral bankers from short-term

political considerations and allowed to take a long-term of the

economy

are

view

716

CHAPTER

25

POLICY

MACROECONOMIC

to comeat

not appear

to most

studies. leads

independence

By to

credible in

countries

those

bank

TARGET

more

are

expectations

as more

is perceived

bank

central

greater

INFLATION

NUMERICAL

A

believe that

Some economists

or higher unemployment, according

a central bank's credibility, enhancing better overall economic outcomes.

ANNOUNCING central

of lower output

cost

the

firmly anchored in which the

and the central bank

announces an explicit, numerical introduced target for inflation. We have already in our discussion of the monetary of a target rate of inflation rule. policy central banks must have an idea of the inflation rate Generally speaking, they would like to achieve in order to make sensible policy. The more controversial central banks should announce their target inflation rate to the question is whether that a numerical for public. Proponents argue announcing target long-run the idea

then

and

inflation,

to it,

sticking

increase

will

expectations. Many central banks publicly

Canada,

for

its inflation

announcing

began

example,

inflation

their

announce

better anchor inflation

and

credibility

target.

target

1991.

in

The Bank of Since

1995,

has been2 percent.In March the Bank of England's inflation 2011, 2 was and the Central Bank of Brazil's target percent, target was 4.5 percent. Other central banksprovide a range for their target rather than, or in addition to, a single number. The Bank of Israel and the Reserve Bank of New Zealand,for in Chile the both had a 1-3 percent target range as of March 2011; example, 2-4 was range percent. Central banks that announce their targets typically provide additional that target

to

information

the

public.

This information

forecasts

their

include

may

real

of inflation,

GDP, and other variables, as well as some discussion of the specific policies that will be needed to meet their targets. Advocates believe that announcing inflation and them with information enhances the targets accompanying supporting central bank and reduces uncertainty households and firms. credibility of the among This helps to anchor inflationary inflation and maintain low, expectations, keep full

employment.

that it makes sense for a central bank to announcea long-run in that the central bank is ableto control the rate of inflation would not make sensefor a central bank to announce a long-run

Note target,

run. It

real GDP factors the

(such

or employment becausethesevariables are as productivity and the supply of labor) that

determined not

are

inflation

in the

long

target

for

by a host of under the control

of

bank.

central

an inflation target is announced, the central bank may choose to adhere A or it be more flexible. central bank that sets a strict target tries strictly, may to meet the target all the time without for the for regard consequences output. As we have this at when the is beset by seen, policy keeps output potential economy in if but it result a recession the central bank acts to spendingshocks, may eliminate even the initial bulge in inflation a shock to aggregate supply such following Once

to it

as an

shock.

inflation

In practice, flexible inflation

on average over supply

in

all

virtually

targeters\342\200\224they

a long

a way

central

period

monetary

policy

uncertainty

allows

themselves from putting

the

prestige

of both

to

to the

run or

long to aggregate

In these inflation rate in target and

gaps

output

correspond

targets

shocks

short-term

are

target

inflation.

rule.

Advocates of announcing

reduces uncertainty

while responding

takes account

that

cases, the announcedinflation the

try

that announce an inflation their inflation target in the

banks to hit

in

explicit

financial

numerical

markets

targets

and among

more effectively,save

believe that this practice

the public.Reduced

resources used to protect market inflation, unexpected improve functioning. By of the central bank behindits commitment to meet the target, the

people

to plan

and

the

EXPECTATIONS

INFLATIONARY

AND

CREDIBILITY

also believe that explicit inflation targets enhancethe central bank's and anchor inflation credibility expectations. that it has been successful in both Supportersof inflation targets emphasize advocates

They believe

countries.

industrialized

and

developing

that

in Brazil,

targets

explicit

Chile, Mexico, and Peru are one important reason why the central banks in nine of the most populousLatin American countries were able to reduce their inflation rates in the 1980s from 160 percent per year and 235 percent during the first half of the 1990s to only 13 percent per year in 1995-1999 and less than 8 percent in the period 2000-2004.4 that do not announce an banks, such as the FederalReserve, in to the still have a or mind when explicit target public may target range Instead of announcing a specific number to the public,however, making policy. these banks state that they are interested in keeping inflation low, typically without believe defining exactly what that means. Proponentsof this approach that a system of publicly announced is too rigid and may reduce the targets of the central bank to deal with circumstances. flexibility unexpected They worry that having an explicit inflation target may lead the central bank to pay too much attention to inflation and not enough attention to stabilizing output and maintaining full employment. of Finally, opponents explicit inflation for the United States emphasize that the Fed has achievedgoodresults targeting without a the having publicly announced target. They suggestfollowing adage \"If it ain't broke, don't fix it.\"

Those central

Inflation

The

Why

the

shouldn't

inflation

Becausecentral banks that the

seem

often

target be state

that

logical long-run target

for

zero? they are inflation

in

favor

is 0

of stable

believe

prices,

it

would

percent. However,most

that an inflation target of zero is too low, announce an explicit inflation choose values target usually zero. Why shouldn't the inflation be zero? target economists

Target

and that

central are

low

banks that but above

been offered. First, because hitting the target at all times is inflation of 0 increases the risk that the impossible practice, target percent will of deflation The economy experience periods (negative inflation). deflationary in the of the United States in the 1930s and, more recently, in Japan experiences illustrate that deflation can be difficult to once it and it can lead 1990s, starts, stop in if to painful and declines real it to GDP, especially people persistent expect continue. an Many policymakers prefer to reduce the risk of deflation by choosing inflation above 0 target percent. Second, there are times when the Fed may wish to counteract negative shocks to the economy with a negative real interest rate, but this that inflation be requires than zero. Recall that the real interest rate is to the nominal interest greater equal rate minus the rate of inflation. a real interest rate Thus, negative requiressetting a nominal interest rate less than inflation. If inflation is zero (or less than zero), real interest rate would require a negative nominal interest rate. however, a negative But the federal funds rate cannot fall below zero because banks would rather keep their reserves than lend them out at a negative nominal interest rate. Consequently, reasons

Several

have

an

in

a negative

real interest rate must

4Ben Bernanke,

\"Inflation

in Latin

boarddocs/speeches/2005/20050211/default.htm.

be

accompanied

America: A New

Era?\"

by inflation

February

11, 2005,

greater

than

zero.

www.federalreserve.gov/

EXAMPLE 25.2

717

CHAPTER

718

MACROECONOMIC

25

POLICY

as we saw in Chapter of inflation tend to

Third,

measures

percentagepoint.Consequently, inflation (that is, \"true\" of inflation of at

rates

believe

to \"grease\"our economicengine. The technological industries

and

change

or

occupations

some

the

least 1 percent.

economists

some

Finally,

of

evidence suggests that the conventional \"true\" rate of inflation by about one if the Fed wanted to maintain \"true\" price stability 0 percent), this would require conventionally measured 16,

overstate

shifts in product to fall in an

small amount

that a

in Chapter

analysis

inflation

of

17 indicated

is necessary that

demand may require real wages in some efficiently operating economy, even when

real

industries and occupationsare rising.If inflation is positive, a wages worker's real will fall whenever her nominal rises less than the rate of wage wage by inflation. If, for example, her nominal wage rises by 4 percent but prices rise by 5 percent, her real wage (that is, the amount of goods and servicesshecan buy with will fall. If, however, inflation is 0 percentand prices her earnings) are not in if the which a worker's real can fall is her nominal changing, only way wage wage itself falls. Some evidence resist cuts in their suggests that workers will strenuously nominal wages.5They seem to be less resistant to having their nominal wages rise a smaller than inflation even reduces their real by percent though this, too, wage. inflation can the to reduce real Consequently, provide \"grease\" required wages in some industries and achieve economic efficiency.6Criticsof the \"grease\" theory, that workers will become less resistant to nominal wage cuts at however, argue In a low inflation low or zero rates of inflation. environment, nominal wage very cuts would,of necessity, be more common and workers would get usedto the idea. in other

BANK

CENTRAL

REPUTATION

Ultimately, credibility can be won bank's

central

inflation is

hawk someonewho even

inflation,

cost

in

reduced

output and employment inflation is

not

dove

strongly

achieving and inflation

someone who committed to maintaining

low

or an

hawk\"

to achieving and

committed

maintaining low some short-run

at

performance

\"inflation dove.\" An

achieving and maintaining output and employment. ted

and

maintained

will depend partly low An

inflation

hawk

as being

is someone

an

and maintaining Inflation hawks believe that

\"inflation

who is committed to

cost in

even at some short-run inflation, dove is someone who is not strongly

inflation

to achieving

and a

only by performance,

on its reputation

low

reduced commit-

inflation.

and stable inflation allows the economy to grow more rapidly in the long run and therefore will be worth the possible shortrun cost. Somewhat paradoxically,inflation hawks also may achieve more stable output and employment, even in the short run. Central banks that have acquired as an inflation hawk will find it easier to anchor inflationary expectareputations tions. As we have learned, anchored expectations reducethe inflationary of impact an inflation shock by minimizing the second-round effects of that shock. Recall that anchored also increase the speed with which short-run expectations shifts down following an adverse inflation shock or demand shock. aggregate supply that is viewed as an Consequently, by anchoring expectations,a central bank inflation hawk at potential GDP, even in the may be better able to stabilizeoutput short

low

run.

But how bankers

central

does a central acquire

bank

acquire

this reputation

a reputation as an inflation hawk? only after conducting monetary policy the can select people to president

hawk. Sometimes, however, on the Fed who already have acquired reputations their professional or academic backgrounds. Jimmy an inflation

5Thisdoes not

as inflation

Carter's

hawks,

based

appointment

Some like

serve on of

mean that nominal wages never fall. Many workers in the airline industry, for example, to accept lower nominal wages as their employerscompete with newer low-cost airlines such as Southwest and Jet Blue. 6GeorgeA. Akerlof, William T. Dickens, and George L.Perry, \"The Macroeconomics of Low Inflation,\" No. 1 (1996), pp. 1-76. Brookings Papers on EconomicActivity, have

had

FISCAL POLICY AND

as chair of famous exampleof

Paul Volcker

the

is a

a chair

we discussed in to the Fed with

, which

coming

25.1,

a well-established

AND INFLATIONARYEXPECTATIONS

RECAP

Naturalist

Economic

SIDE

hawk.

an inflation

reputationas

Fed

THE SUPPLY

CREDIBILITY

of inflation are performance may be improved if expectations anchored. Anchored expectations,in turn, depend on the extent to which a central bank's anti-inflation as credible. Several pronouncements are viewed institutional characteristics may help to enhance a central bank's credibility: the extent to which the central bank is independent from the executive and the announcement of a numerical legislative branches of the government, inflation and the reputation of the central bank as an \"inflation hawk.\" target, Macroeconomic

So far,

we to

attention

of fiscal

SUPPLY

ANDTHE

POLICY

FISCAL

have

focused

fiscal

policy.

policy and its effects. Now,we turn our 22 and 24 we focused on the Chapters

on monetary Recall that in

and

spending

policy\342\200\224government

SIDE

taxes\342\200\224in

the

determination

role

of increased

demand. We saw, for example, that aggregate government or lower taxes can the spending expand economy by increasing aggregate demand. However, most economists that fiscal affect the economy's policies In general, demand. productive capacity, or potential output, as well as aggregate a supply-sidepolicy is a policy that affects potential output side\" of (the \"supply in the economy). As we discuss here, fiscal policies are often supply-side policies and

aggregate expenditure

agree

this sense.

For example,government

spending,as we is

interstate transportation, potential

well as an

output.

already

influence

behavior,

discussed.

However, highway

public they

capital also

may

increase aggregate increase

the

output. system, begun under President a case in point: By lowering the costs of long-distance made the U.S. economy more productive and increased highways on public capital may be a supply-side Thus, spending policy as

interstate

on aggregate

Government tax and transfer economic

on

expenditures

The

potential

economy's Eisenhower,

have

of households

demand. programs

and firms.

affect

To the

the incentives, extent

that

and

changes

thus

the

in behavior

in

also have supply-side potential output, tax and transfer programs A lower effects. tax rate on interest income (asopposedto all income), for example, in increase to save for the as we saw 19. future, may people's willingness Chapter lower a nd thus weaker Although greater saving implies consumption expenditures in demand in the short run, greater saving also leadsto more investment aggregate the long run and a faster rate of capital formation in the economy. As a result, turn

affect

will more rapidly. potential output grow Tax and transfer also affect potential output by affecting the supply of policies labor. For example,lowertax rates on earnings increase may potential output by that Tom earns $10 per inducing people to workmorehours.To illustrate, suppose hour before taxes and his tax rate is 40 percent.Thus, for each hour he works, Tom earns $10;pays 40 percent of $10, or $4, in taxes; and takes home $6 in after-tax Tom's situation is depicted in the first line of Table 25.2. Now suppose his earnings. If Tom's tax rate is reduced to 30 percent. before-tax rate remains wage equal to his taxes on each hour of work fall to 30 of or and he takes $10, $10, $3, percent in home $7 in after-tax as illustrated the second line of Table 25.2. earnings, in Tom's tax rate from a reduction 40 percent to 30 percent increaseshis Consequently, after-tax from to hour. $6 $7 wage per

supply-side

policy

that affects potential

a policy output

719

CHAPTER

720

25

MACROECONOMIC

POLICY

25.2

TABLE

a Reduction in

Effects of

The

Pretaxwage $10

rate

Tax 40%

on Tom's

Rates

Tax

(

=

in tax rates Reductions and reduce the amount of

Rates

Taxes paid

After-tax wage

$4

$6

$3

$7

0.40)

30% ( = 0.30)

$10

Aftei^Tax Wage

number of hours people want to work to at home television they spend watching and doing chores because the opportunity cost of staying home has risen. Tom's cost of an additional hour of for is equal television, example, opportunity watching to the amount of after-tax he could have earned that hour, which earnings during has risen from $6 to $7.

Cost-Benefit marginal

tax

rate

O

one

average divided

comparing

the Cost-Benefit benefits with the therefore,

Principle, individuals make decisionsby extra costs. In examining the effects of tax rates economists focus on people's marginal tax rate

on the marginal or extra dollar of

tax rate

is the

which

want

time

rise when before-taxincomerises by

which taxes

one

income,

dollar.

tax rate can

dollar

tax rate by total

extra

the

on economicincentives,

the

amount by which taxes rise when before-tax income rises by

to

According

the

increase

may

total

before-tax

taxes

or the amount by Someone's marginal

differ from his average tax rate, which is calculated considerably by his total taxes his total before-tax income to obtain the of dividing by percentage before-tax income he pays in taxes. there was no differencebetweenTom's marginal and tax rates Although average in Table in this is not true for most as we show Check 25.1. In 25.2, people, Concept

2007

collected

taxes

total

percent

of U.S. GDP, and

depend

on

incomes

Most

income. are

that

greater

state, and

by federal,

these

of

many

taxes,

Americans, however, than 30 percent.

localgovernments such as

face marginal

were

30

about

property taxes, do not tax

rates

on their

CONCEPT CHECK25.1 he has to pays no taxes on the first $ 10,000 of his income. Suppose,however, of 20 percent on any additional income. Thus, if he earns $1 1,000, he pays

Tom

Suppose

taxes

pay

-

0.20($I5,000

rates

- $ 10,000)= $200 in taxes. Similarly, if he earns $ 15,000, he $10,000) = $1,000in taxes. Calculate Tom's average and marginal earns $5,000, $ I 1,000, and $ 15,000.

I 1,000

0.20($

if

he

tax Changes in marginal besides the number

decision

decision

rates of

may affect worked.

hours

other aspects of For example,

labor

the

consider a

pays

tax

supply

student's

the time and money necessaryto becomea in human the return to that investment perspective, will is the extra income that the student be able to earn as a doctor, capital relative to what he or she might earn without a medical degree. If the marginal tax rate on earningsis high, the economicincentive to become a doctor will be and the student decide not to make that investment. lower, Likewise,a may lower marginaltax rate increases the incentive for people to be entrepreneurial and to take risks\342\200\224for example, their own companies\342\200\224since by starting they know that they will be able to keep a largerportion of the returns to their an

From

efforts.

As

we

of economic

In Figure

to

whether

about

doctor.

invest

economic

discussed

in Chapter

18, entrepreneurship

is an important

source

growth.

25.5 we illustrate one scenarioin

rates increasesboth

aggregate

demand

and

which

aggregate

in marginal

a cut

supply.

As

before,

the

tax tax

FISCAL

POLICY

AND THE

SUPPLY

721

SIDE

\302\256

tt rate

Inflation

>vQ

ADA

V\\D2

Y2

Y1

Output

Y

25.5

FIGURE

Effects of Tax

on Aggregate Demand and AggregateSupply. to potential output and inflation economy equilibrium output Y, equal 77, equal to expected inflation A in AD the Fed's long-run inflation reduction tax rates shifts the curve from to ADT (2) If the supply-side target. (T) AD^ effects of the tax-rate reduction are strong, inflation remains at 77, and output rises from Y, to Y2. The Potential

is initially in

The

cut

shifts

the

aggregate

Rate

Reductions

with

demand curve to the

also increasespotential increasein both the short run and the

however, the tax cut also

we

will increase drawn

have

the case.

right, from

output.

As a

AD1

to

result, real

AD2.

Now,

output will

run. Whether the rate of inflation long size of the two shifts. For simplicity, depends on the relative them so that inflation remains constant, but this need not be

that tax rates affect economicbehavior, the direction of the effects can be controversial. In our earlier example,we showed that a decline in Tom's tax rate implies an increase in in Tom's after-tax wage gives his after-tax wage rate. As we mentioned, the increase him an incentive to work more hours and to watch less television because the cost of watching television instead of workinghas risen.On the other opportunity tax rate also might increase his after-tax wage to such hand, the reduction in Tom's an extent that he may feel that he can afford to work even fewer hours and still pay his bills.7 Empirical studiesof the labor market suggest that the responsiveness of an individual's labor supply to changesin taxes depends on many factors, women have sex, marital status, and education. For example,married including age, been more traditionally likely to move in and out of the labor force and appearto be in after-tax wages than are their more responsive to changes who have husbands, in the labor market on a full-time basis even when historically tended to remain tax rates change. While Americans many may be dismayed by what they consider to be high have considerably higher marginal tax rates.In the taxes, Europeans generally we examine the claim that the higher marginal tax rates in Europe following example, are responsible for the fact that the typical European works many fewer hours each economists

Although

agree

magnitude and

sometimes

even the

year than

the

American.

7Students who substitution and

typical

have

taken

income effects.

introductory

microeconomics

may

recognize

this as an example

of

and

CHAPTER 25

m

MACROECONOMICPOLICY

The Economic Naturalist

The

average

Not

only

American

As indicated in worked 100/64 =

American

hours.

more

more hours

than

\342\200\224

100)/100

hours

more

many

average workweeklonger have fewer holidays, retire

Europeans.

(104

works

hours than Europeans?

is the

vacations,

percent

work more

Americans

do

Why

25.3

Table

in America,

and experience

later,

25.3,

than the average Western European. but Americans generally take fewer

the period

during

less

than

unemployment

1993-1996,the

average

1.56times as many hours as the average Italian, or 56 \342\200\224 = 33 worked Similarly, the average American (100 75)/75 percent the average German.The average Japanese, on the other hand, worked = 4 percent more hours than the average American. Why?

TABLE 25.3

Hours Worked per Personand

Marginal

Tax

Hours worked per person per relative to the U.S.(U.S.=

Country

Rates,

1993-1996

year 100)

tax

Marginal

Japan

104

37%

United States

100

40

88

44

Canada

88

52

Germany

75

59

France

68

59

Italy

64

64

United

Kingdom

Source: Edward Federal

Reserve

C. Prescott,

\"Why

Bank of Minneapolis

Do Americans Quarterly

Work So Much

Review,

July 2004,

More

Than

pp. 2-13.

rate

Europeans?\"

found that most of these differences can be explained by the tax rates on labor income these countries.8 The marginal among Japanese, for worked the most and had the lowest tax rate of 37 example, marginal percent, while the Italians worked the least and had the highest marginal tax rate of 64 percent.Moreover, the period 1970-1974, when the tax rates in Europe were much closer during marginal Edward

variation

Prescott

in

to those

in the United as the average States, the average European worked as much in marginal tax rates in Europe American. Prescott concludes that reductions would increase both labor and considerably supply potential output. Most economists tax rates help to explain agree that higher why continental Europeans work fewer hours than Americans, but many note that there are other explanations as well. These explanations include unionization rates and Europe's higher government regulations that limit workweeks and the number of hours that stores may remain open. The differences in work-hours also may be related to more generous socialsecurity the systems supporting in the sick and and those who retire countries.9 disabled, unemployed, early many European Some observersalso have suggested that Europeans simply have a greater taste for in leisure and the \"good life\" than Americans do. However, as Prescott points out, people in most European countries worked much hours the other longer past (when, among than that the underlying things, tax rates were lower) they do today, which suggests

taxes on consumption as well as income. and Taxes,\" London Schoolof Economics Centre for Economic PerformanceDiscussion Paper No. 634, May 2004, and Alberto Alesina, Edward Glaeser,and Bruce Sacerdote, \"Work and Leisurein the U.S. and Europe:Why So Different?\" National Bureau of Economic Research 2005. Working Paper No. April 8Prescott's

marginal

9Stephen Nickell,

tax rates

\"Employment

11278,

include

POLICYMAKING:

preferencesof in

to the

related

and Americans

Europeans

increase

in

rates.10

tax

different.Yet, the decrease countries is only weakly

be all that

not

may

among a larger sample

over time

worked

hours

of

European

remains a controversialissue.

Clearly, this

If lower tax rates tend to increase potential output, why not reduce taxes to zero? The answer is that, ultimately, can be government expenditures paid for only taxes. Of the can run a deficit for a course, while, borrowing through government in taxes. But to cover the difference between what it spends and what it collects in deficits can be harmful reduce national as we saw 19), (they may saving, Chapter and in any case the government's borrowing eventually must be repaid with future in the long run, taxes shouldbe set at a level commensurate taxes. with the Thus, rate of government's spending. The important as well as message is that fiscal policy can affect potential ouptut in demand. fiscal officials should take Thus, making aggregate policy, government into account not only the need to stabilize demand but also the effects aggregate likely of government taxes, and transfers on the economy'sproductive spending, capacity.

FISCAL

RECAP

A

is a

policy

supply-side

policies

affect

policy

aggregate

affects

that

but

demand,

may

as

capital\342\200\224such

and

airports,

roads,

may increase potential

but also

expenditure

aggregate

output. Fiscal be supply-side policies.

potential

also

they

Government expenditureson public schools\342\200\224increase

SUPPLY SIDE

POLICY ANDTHE

output.

tax and

Government

economic behavior, of People may more

hours,

risks, all

of

transfer programs affect

respond to reductions in investing more

which

contribute

in

to greater

of tax

POLICYMAKING:

their

education,

changes on labor supply Fiscal policymakers should take into tax decisionson potential as output effect

the

and thus the

incentives,

firms.

and

households

marginal and taking

tax rates

by

working

more entrepreneurial

potential output. The size of

account

well as

the

controversial.

somewhat

remains

the effects of spending and on aggregate demand.

ART OR SCIENCE?

would require each of the following: (1) accurate policy of the current state of the of the future of (2) knowledge knowledge economy, path the economy if no policy changesare implemented, the value of (3) precise potentialoutput to determine the existence and size of any output gap, (4) complete and immediate control over the tools of fiscal and monetary and (5) knowledge policy, of how and when the economy will respond to changes in policy. macroeconomic

Perfect

macroeconomic is far Unfortunately, policy in reality levels of many macroeconomic indicators such known until several months later, and even after that they

revisions. Becausepolicymakers state

from

this

as real GDP

current

of the economy,

10Olivier

Blanchard,

(2004),pp. 3-26.

do may

not

\"The Economic

Future

they

not

have very

be able

are

The

ideal. often

subject

precise knowledge of

are

not

to multiple the

current

to act decisively.

of Europe,\"

Journal of Economic

Perspectives

18, No. 1

ART OR SCIENCE?

723

724

CHAPTER

25

POLICY

MACROECONOMIC

are often unsure about the future of the economy if no path If will are the move to its changes implemented. economy potential level in the future in the absence of any policy it will be changes, unnecessary and often for policymakers to act now to eliminate an output gap. Instead of hastening the policymakers

Further,

policy near unwise

move backto full

employment,

reversal

a policy

necessitating

in

Economists are also unsure about rate of unemployment. For macroeconomic policy was often too natural

during

and hence Even

inside lag (of macroeconomic the delay between the policy) date a policy change is needed and the date it is implemented

to implement

because

1970s

the

may lead the economy to overshoot, potentially destabilizing the economy. the exact levels of potential output and the most economists now believe that example,

policy changes future and

the

(and, hence, too inflationary) overestimated the potential level of output

expansionary

policymakers

underestimated the natural rate of when policy changes are needed,it the

policy

appropriate

unemployment.

take a long time for policymakers The inside lag of macroeconomic changes. date a policy change is needed and the date can

refers to the delay between the policy that policy change is implemented. During this

must recognize

advisers correct policy

policy change

a persistent

that

The policymakers change. and implement it.

The inside lag for monetary fiscal policy.Oncemonetary federal funds rate, they only

period,the

output

policymakers'

economic

gap exists and determine the

must then accept the

desirability

of that

is substantially shorter than the inside lag for in the the of a policymakers accept desirability change have to wait until the next of the Federal meeting Open Market committee. Since this committee meets eight times per year, the maximum seven weeks. In urgent the committee has been known to act situations, delay is about in conference calls between And once the committee decides to change during meetings. the federal funds rate, the Federal ReserveBank of New York almost immediately conducts the sufficient to move the rate to its desired level. open-market operations The insidelag for fiscal policy, on the other hand, is considerablylonger.After the president a change in tax rates or government spending, both houses proposes of

Congress

or

one

both

must

approve

of the houses

policy

process can take a long time, especiallywhen of Congressare controlledby the opposing political in for these delays is that the exact form of a change it. This

party. One of the reasons taxes or government spendingcan vary

or businesstaxes be cut? Should

increased?Even has

after

signed the bill,

it

Congress sometimes

considerably.

defense

spending

has approved takes a long

Should income taxes personal or spending on education be

the policy change and the time to implement the tax

make the additional expenditures.

president

changes

or

only an approximate idea of the exact output effect with change policy. marginal propensity to consume is not known in and need not be the same for all income. Fed certainty changes Similarly, have idea of the effect of a given change in the real policymakers only an approximate interest rate on planned spending.Economists have constructed statistical models of the economy that track the historical performance of the economy reasonably well.Yet these same statistical models have often yieldeddisappointing and unreliable forecasts of the future path of the economy. Part of the problem is that it is in the economy, such as difficult to predict the values of the exogenous variables Finally,

of a

economists

have

The

in

rates. In addition, the economic structure of the over time. The extent to which investment occasionally changes to changing real interest rates, for example,has varied over time. responds both fiscal and are never sure about the Furthermore, monetary policymakers will of time before the effects on occur. The outside lag of length planned spending macroeconomicpolicy refers to the delay between the date a policy change is implemented and the date by which most of its effects on the economy have occurred. fiscal has a longer inside lag than Although policy monetary policy, its outside lag may be shorter. Changesin government have an immediate effecton real GDP spending and the economy, the effects continue into the future. although multiplier Similarly, households often respond to tax cuts by increasing their consumption expenditures government

spending

or tax

economy itself

outside lag policy)

the

(of macroeconomic delay between

the date a policy

change

is

and the date by implemented which most of its effects on the economy have occurred

immediately. On

the

other

hand,

investment

responds

more slowly when the Fed

725

SUMMARY

the real

changes

businesses

Because our

alsowill

interest rate

look at before

sincethe

building

knowledgeof

a new the

is one

rate

interest

or

factory

among an

buying

is imperfect,

economy

factors

many

that

new machine.

expensive

policymaking at its best

of our aggregate supply-aggregate demand model, how much or how fast the policymakers exactly aggregate demand will curve to policy changes.They also don't know how fast the curve shifts when exceeds its aggregatesupply up output potential level or how fast it shifts down if output is less than potential. were more confident about their to During the 1960s, economists ability maintain output at its potential level using the appropriate monetary and fiscal policies. They believed they could compute the size of output gaps, and devise policiesto eliminate these gaps. Many also believed they could easily predictthe future path of the economy under alternate and they were comfortable scenarios, policy the economy. implementing frequent policy changes in order to \"fine-tune\" Finally, many economists mistakenly thought could deliver a permanently higher policymakers level of output with just a bit more inflation. The of the past few decadeshas made economistsmore humble, experience even about an output gap. Some economistsbelieve that we are at identifying potential when the rate is 4.5 while others believe the output unemployment percent, natural rate of unemployment is as high as 5.5 or even 6.0 percent. Consequently, whenever the actual unemployment rate lies between 4.5 and 6 percent, some economiststhink they see a recessionary gap while others seean expansionary gap. Because of these uncertainties, macroeconomic tend to proceed policymakers avoids rates and rarely cautiously. The Fed, for example, large changes in interest raises or lowersthe federal funds rate more than one-half of a percentagepoint 5 percent to 5.5 percent, for example) at any one time. Indeed, the (from typical in the interest rate is of a change one-quarter percentage point. Similarly, policymakers are now less likely to try to \"fine-tune\" the economy. Is macroeconomicpolicymaking an art or a science, then? In practice it appears to be both. Scientific analyses,such as the development of detailed statistical models of the economy, have proved useful in making But human policy. judgment based on be

In terms

imperfect.

don't know shift in response

long experience\342\200\224what

has

role in successful

crucial

RECAP

been

called

the

macroeconomic

of

\"art\"

policymaking and is likely

ART POLICYMAKING:

OR

to

continue

policy\342\200\224plays

to do

a

so.

SCIENCE?

and inexact science. Policymakers policymaking is a difficult do not knowthe precise state of the economy, the future of the economy path if no policy changesare implemented, or the precise level of potential output. also have control over policy instruments and imprecise They imperfect of the effects of The existence of inside and knowledge any policy changes. outsidelags makes policymaking even more difficult. Consequently, macroeconomicpolicymaking is an art as well as a science.

Macroeconomic

\342\226\240

\342\226\240

SUMMARY

Changes

demand can be tion

to

in exogenous the spending shift curve. In response, fiscaland monetary

applied to return its long-run

output

aggregate policy

and infla-

to potential

expected rate. (LOl)

are anchored, expectations an inflation output following

taining

shocks inflation

force

the Fed

to choose between

and

stabilizing

output. If

inflationary

main-

to

return

shock

will

potential more

occur

rapidly. (LOl) \342\200\242 Anchored

Inflation

the

economic may

reduce

inflationary

expectations

will improve

performance long run and also in the volatility of output and inflation

in the

CHAPTER 25

726

run. Inflationary expectations are more if the central bank's policies anchored as credible and the public believes

short

the

are

rates

viewed

the central bank'spromises to keep

and

(L02) bank's

credibility

it is

political considerations and is of the long-term view economy. Credibility also may be enhanced if the central bank publicly announces a numerical inflation target and if it has a reputation as an insulated

from short-term allowed to take a

\"inflation hawk.\"

spending

well as on aggregatedemand. \342\200\242 Economists between

policy is a policy policies affect may be supply-side

supply-side

but

Fiscal also

they

on

Governmentexpenditures

but

expenditure

aggregate

output. Government affect

incentives

the

to

respond

may

public also

(710)

credibility

expectations (712) rate

average

central bank

few

inflation

inside

(720)

independence (715)

decades,

lag (of

to

the

\"fine-tune\"

(L04)

economy.

of monetary

knowledge During the past have become

imprecise

any policy changes. economic policymakers

of

more humble about their ability

\342\226\240

TERMS

hawk

and

instruments

policy

of the effects

inflation dove (718)

inflationary

the precise

know

not

over

tax and transfer programs of households and firms. People in their marginal tax reductions

policy

tax

that the analogy and managing the economyis a car, macroeconomic driving

is an inexact science.Policymakers state of the economy, the future path of the economy if no policy changes are implemented, or the precise level of potential In addition, they have imperfect control output.

affects

that

KIT

anchored

(L03)

recognize

a car

a poor one.Unlike

aggregate demand, policies. capital increase may increase potential

\342\226\240

accommodating

now driving

of as

policymaking do

potentialoutput.

tax

and

(L02)

\342\200\242 A

controversial. Fiscal into account the effects decisions on aggregate supply

take

should

policymakers

may be enhancedif

risks,

entrepreneurial

somewhat

remains

supply

\342\200\242 A central

taking

more in

hours, investing more

all of which contributeto greaterpotential output. The size of the effect of tax changes on labor

low.

inflation

more

working

by

education,

be

to

likely

MACROECONOMICPOLICY

policy (714)

outside lag

(718)

policy)

macroeconomic

rate

tax

marginal

(720)

(of macroeconomic

(724)

policy

supply-side

(719)

policy) (724)

REVIEW QUESTIONS 1.

there

Suppose

is an

increase

in

taxes.

What

saving

2. How policy,

early interest

investment?

equals

does the

like

that

1980s, rate

in

(LOl) of a

tighter monetary conducted by the Volcker Fed in the affect output, inflation, and the real the short run? In the long run? (LOl) adoption

effect

shock?

4.

increase on

output

in oil

prices. and inflation in

factors

What

independence? What independent central

6. How

inflation

adverse

and inflationary expectations cost of an adverse inflation

anchored

are

how do they reduce shock? (LOl)

5.

faced

\"dilemma\"

(LOl)

What

affect

3. Supposethereis a sudden What will be the

the short run? What is the by the Fed as a result of the

is the

short-run effect on output, inflation, and the real interest rate, assuming any supply-side effects are minimal? What will be the effect in the long run if the Fed chooses to adjust its target real interest rate to the new long-run real interest rate at which

the

a central bank's the benefits of having an

determine are bank?

(LOl)

does a reduction in

both

(L03)

aggregate

demand

the

marginal

tax rate

and aggregate

supply?

PROBLEMS

727

PROBLEMS

the economy

Suppose

a loosermonetary rate.

is initially

in

its long-run

Fed adopts

and the

equilibrium

long-run

raises

and

policy

target

inflation

the

for

| ECONOMICS

the U\"\302\243*l Econ

Suppose the economy is initially shock.

inflation

favorable

in

and experiences

equilibrium

long-run

a McGraw-Hill

(LOl)

a. Explain how the AS curve is affected in the short run. b. Use your result for part a along with an AD-AS diagram to illustrate and in both what will happen to output and inflation the short run and the explain inflation shock. long run if the Fed accommodates the favorable c. Use your result for part a along with an AD-AS diagram to illustrate in both and what will happen to output and inflation the short explain run and the long run if the Fed does not accommodate the favorable shock.

inflation

the economy suppose

Suppose house

prices,

(LOl)

how

Explain

to

in

initially

Due to a declinein equilibrium. reduce their consumptionspending.

long-run

that consumers

spending affects the

in consumer

decline

the

in consumer

decline

the

and

is

Fed does not change its monetary

b. If the

explain

rule,

policy

AD

curve.

Fed react

will the

how

Use an AD-AS diagram to

spending?

illustrate

answer.

your

c. Now, in addition to the decline in consumer that the spending, suppose inflation shock. economy experiences an adverse i. Explain how the adverse inflation shock affects the AS curve, ii. Discuss,using AD-AS diagrams, what choices the Fed now must make or not it should regarding monetary policy. (Hint: Think about whether there is a

Suppose

core

the

policy.)

monetary

tighten

If

large increasein

rate

oil or food prices. (LOl) remains unchanged, what might

of inflation

about inflationary expectations and shock?

inflation

How

might

b. If the core rate about

What are the the

Suppose

a. Usea

graph

to output effects of aggregate

like

it respond?

rises what substantially, and the second-round expectations might it respond? of having that make a

tax rate. Figure

might the

effects of

Fed infer the

an independent central bank? Describethe central bank independent.(LOl) in long-run equilibrium and the government

(L03)

25.5

Fed infer of the

the

effects

second-round

the

inflation

is initially

economy

the marginal

reduces

cuts

advantages

features

institutional

b. How

of

inflationary shock? How

inflation

to illustrate

and inflation in both the tax cuts are stronger

short

the on

and explain what will run and the long run demand

aggregate

happen if the

than on

supply.

would your conclusions are stronger

using a Using

connect*

Hill

long run.

a.

Graw

(LOl)

a. Explain how this change in monetary will affect the AD curve. policy b. Use your result for part a along with an AD-AS diagram to illustrate and in both what will happen to output and inflation the short run and explain

a.

Mc

the

graph like Figure theory

in

a be

affected if the effects on

aggregate

demand?

of the

tax

Explain

25.5.

presented in this chapter,

more anti-inflationary unpopular. (L04) a tighter,

part

on aggregate supply than

monetary

explain why policy

might

the

adoption

be politically

of

Visit your mobile app store and download

the

Frank:

Econ

app

Study todayl

728

CHAPTER 25

MACROECONOMICPOLICY

8.

Explain inexact

the recognition that macroeconomic policymakingis an your recommended policy response to the following

how

affects

science

situations:(L04)

a.

b.

Your

of the

estimate

natural

actual unemployment rate Your

of the

estimate

natural

actual unemployment rate

-

TO

ANSWER

25.1

If

Tom

earned

0 percent.If

CONCEPT

$5,000, he

earned

rate of

unemployment

is

5 percent,

and the

rate of

unemployment

is

5 percent,

and the

is 5.5percent. is 8 percent.

CHECK

-

he would pay no taxes,so his average tax rate would be $5,001, he would still pay no taxes, so his marginal tax

also would be 0 percent. - $10,000) = $200in If Tomearned $11,000,he would ($11,000 pay 0.20 = so his average tax rate would be $200/$l taxes, 1,000 0.018, or 1.8 percent. If his income rose by $1 so that he earned $11,001, his taxes would be 0.20 - $10,000) = $200.20. in he would an additional $0.20 ($11,001 Thus, pay taxes and his marginal tax rate would be 20 percent. If Tom earned $15,000, he would pay 0.20 ($15,000 $10,000) = $1,000 = in taxes, and his average tax rate would be $1,000/$15,0000.067, or 6.7 percent. If his income rose by $1 to $15,001, he would pay an additional $0.20in so his marginal tax rate would still be 20 percent. (L03) taxes, rate

EIGHT

PART

THE

INTERNATIONAL

ECONOMY of

One

the

\"globalization\"

of recent decadesis the mid-1980s, the

Since the

economies.

national

of

trends

economic

defining

value of internationaltrade has increased at nearly twice the rate of world GDP, and the volumeof internationalfinancial transactions has at many times that rate. Froma expanded the long-run perspective, rapidly increasing integration of

national economies see Before World War I, Great we

international

economic

our own, with

\"globalized\" as or

immediacy

that recent

communicationsand

international nineteenth-century

far-seeing

have

imparted

the

by

revolutionary changes

transportation

as nearly trade

ways

many

be astonished

would

banker

merchant

in

extensive

most

But even the

and lending.

was

unprecedented: of an

center

the

was

that

system

not

is

today

Britain

to

of

sense

in

international

economic relations. For example, and the teleconferencing Internet now permit people on oppositesidesofthe globe to conduct

business

\"face-to-face\"

negotiations

and transactions.

We introduced internationaldimensionsof the economy

at

book already (for example,in our discussion points 2 and our of comparative advantage and trade in Chapter analysisof the labor market effects of globalization in Chapter 17). in international 26 focuses on two additional Chapter topics economics.The first topic is the exchange rate;understanding the in this

several

rate

exchange patterns

international

domestic international its

domestic

capital

since

is important

of trade.

trade

The second in

capital

We

capital

flows

and

formation

a key

plays

topic

is

international

goods,

formation.

it

the

role

in

relationship

capital

determining

among

flows,

and

determinants of show how a country can augment by borrowing from abroad. will focus

on the

CHAPTER|26

Rates,

Exchange

International

and

Trade,

Flows

Capital

LEARNING

OBJECTIVES

After reading this chapter, you should be able to:

LOI

nominal

the

Define

rate

exchange the

discuss

and

advantages

of

and disadvantages

flexible versusfixed rates.

exchange

L02 Jf41

S

,.

-tot

t'^

Use

to

demand

-?

the

L03

v

318i4270|i|jf^ ^

H.

exchange

is determined

Define the real summarize

exchange

rate,

the

law

of one

and

understand

rates

exchange

in the

short

long run?

and

run

L04

power the

relationship

domestic

between

wo Americans

visiting

London

were

over their problems

commiserating

morning

and quid, it's

pence,

bob,

it took

me 20 minutes

to

driving

figure

me

crazy,\"

out how

said the

The second American wasmoreupbeat.\"Actually,\" had at all.\" my new system, I haven't any problems The first American looked interested. \"What's your \"Well,\" replied the second, \"now, driver all the English money I have. And exactly right every time!\"

he

the

said,

new

American.

you

balance to

\"This

the trade net

trade

understand

domestic

how

driver.\" \"since I adopted taxi

saving,

balance,and inflows are

capital

related. system?\"

a taxi, I just give the believe it, I have got the fare

I take

whenever would

first

much to pay

the

and

saving

understanding English currency. \"Pounds,shillings, tuppence,thrup-

parity

long-

exchange rate.

the

Use

price, how

determines

run real

What determines

in

run.

short

purchasing

,ir \"//*

how

analyze

nominal

rate the

and

supply

currencies\342\200\224and the value of foreign Dealing with unfamiliar translating money into dollars\342\200\224is a problem every international traveler faces.1The traveler's

L05

the

Analyze

factors

that determine international

and how affect

capital

these

domestic

flows flows

saving

and the domestic real British money today is less complicated to understand than suggested by the introductory the British switched to a decimal monetary system, under which each pound is worth 100 pence.At that time, the traditional British a pound equaled 20 shillings and system, under which each shilling equaled 12 pence,was abandoned. aHowever,

story.

In

1971

interest rate.

732

CHAPTER

26

EXCHANGE RATES, INTERNATIONAL

problem country's

AND CAPITAL FLOWS

TRADE,

is complicated by the fact that trades for money another\342\200\224may

British

can buy

Japanese yen,

rubles,

over

vary

may

The economicconsequences of variable than their impact on travel and tourism, foreign

dollar

U.S.

of

competitiveness

which

part

depend

investments heavily dependent on financial

This

start

rates are much broader exchange however. For example, the on the prices of U.S. goods in terms of on the exchange rate betweenthe

U.S.

the prices Americans pay for imported Likewise, value of the dollar relative to the currenciesof

goods. Exchange rates also made across national borders. countries

trade

international

and

discusses

chapter

exchange

of

majority

have a significant

rate may

rates, international trade, and effects on the broader economy.We

their

the nominal

by introducing

flows\342\200\224the

capital

exchange and

flows,

capital

the

in

of are

that

For

nations\342\200\224fluctuations

the

value

the

affect

economicimpact. international

one the number of Thus, dollars that a U.S. dollar at which

rates

in part on the produce those

goods depend countries that

the world's

in

turn

in

currencies.

those

and

depends

exports

currencies,

unpredictably.

change

or Australian sometimes time, quite a lot.

Russian

pounds,

rates\342\200\224the

exchange

exchange

will

one of how

which

at

rate

rate\342\200\224the

Next we will turn to the question short run. Exchange rates may be divided into two broad categories: flexibleand fixed. The value of a flexible exchange rate is determinedfreely in the market for national currencies, known as the the value of a fixed exchangerate is set foreign exchangemarket.In contrast, the at a constant level. We show that a country's by government monetary in a role the exchange rate. policy plays particularly important determining Furthermore,in an open economy with a flexible exchangerate, the exchange rate becomes a tool of monetary policy,in much the same way as the real national

for another.

trades

currency

exchange rates are determined

in

the

rate.

interest

rates becausemostcountries allow market rate. small and However, exchange many fix economies their so we will also consider the rates, developing exchange relative merits of fixed and flexible exchange rates. We close our discussion of rates the real rate\342\200\224the rate at which one exchange by introducing exchange how exchange rates are country's goods trade for another's\342\200\224and discussing determinedin the long run. in goods and services, and trade Finally, we examine data on U.S.international in how trade and services is connected with international analyze goods directly We

forces

focus on flexible exchange to determine their nominal

capital flows.

States, foreign

Specifically,we analyze provides

saving

of financing capital

means

how

for many

countries, including the United

domesticsaving

supplement to

an important

formation.

economic benefits of trade between nations in goods, services, similar to the benefits of trade within a nation. In both cases,trade services permits greater specializationand efficiency, whereas trade

financial investors to earn higher returns while providing between capital projects. However, there is a difference services, yen,

be\342\200\224whereas

So, for

pesos,

assets within a or whatever the between

trade

example, if an

manufactured

trade

and

dollars

in

South

for the

nations American

Korea,

nation

normally

country's

official

funds

two

the

involves a form

resident

she (or

Korean currency,calledthe

the won.

automobile The

Korean

goods

and

in assets allows for worthwhile

cases. Trade

in

single currency\342\200\224

different

to purchase

wants

more likely,

in

of money

usually involves dealing in

are

and assets

The

dollars,

a

RATES

EXCHANGE

goods,

as

happens

to

currencies.

an automobile dealer) must first car manufacturer

26.1

TABLE

Nominal

Rates for

Exchange

the U.S.Dollar

0.619

United Kingdom (pound)

Canada (Canadian Mexico

(peso)

Source:

use

won.

in

1.402 March

14, 2011.

a U.S.

RATES

traded for

can be

simply the

exchange rate, between

each

For

two

yen, the per

nominal

is called the currencies.

other the

U.S. dollar can be exchangedfor 90 Japanese the U.S. and Japanese currenciesis 90 yen

between

in

dollarsand

shares.

currencies

more

or

if one

example,

two

which

exchangerate, rate

0.012

an Argentine who wants to purchaseshares first trade his Argentine pesos for

Similarly,

EXCHANGE at

81.647

Release H.10 for

must (a U.S. financial asset) the dollars to purchase the

NOMINAL

The rate

1.024

0.083

0.713

Statistical

Reserve

Federal

is then paid company

0.977

Union (euro)

European

1.616

11.996

dollar)

(yen)

Japan

U.S.. dollars/foreign currency

Foreign

currency/U.S.dollar

Country

then

dollar.

nominal exchange Each country has

nominal

rate

rate

exchange at

can be

which traded

for

each other

nominal which its rates, one corresponding to each currency exchange against own currency is traded. Thus, the dollar's value can be quoted in terms of English or dozens of other currencies. rubles, pounds, Swedish kronor, Israelishekels,Russian Table 26.1 gives exchange rates between the dollar and five other important in New York City on March 14, 2011. currencies as of the close of business As Table 26.1 an important point to keep in mind about exchange rates: illustrates, either as the amount of foreign currency neededto purchase They can be expressed one U.S. dollar (left column) or as the number of U.S. dollars needed to purchase

one unit

the

of

currency

foreign

rate are

exchange

(right column).

equivalent: Each is the

These two ways of the

reciprocal

of

expressing

other.

Rates

Exchange is the

What

rate between

exchange

pound?

use the data in Table 26.1 to find the exchange rate between any pair table. For example,suppose that the exchange you need to find between the British pound and the Canadian dollar. The table tells us that we one U.S. dollar for 0.977 Canadian dollars; it also tells us that we can purchase one U.S. dollar for 0.619 British pound. This implies that

can also

We

of countries

rate can

buy

in the

Thus, two

terms

we can ways.

the

find

First,

of British

= 0.619

by

British

rate between British out how much one both sides of the dividing

exchange

we can

pounds

1 Canadian

dollars

Canadian

0.977

in

the Canadiandollarand the British

find

dollar =

*

British

pound

pound.

pounds and Canadian dollars in Canadian dollar is worth above equation by 0.977: 0.634

British pound.

the

two currencies

many

the

733

RATES

EXCHANGE

EXAMPLE 26.1

734

26

CHAPTER

EXCHANGE

TRADE, AND

INTERNATIONAL

RATES,

divide both

we can

Alternatively,

1 British

From the

\342\200\236 ^^

of

the

first

dollars =

Canadian

St. Louis

1.578 Canadian dollars.

Federal http://research.stlouisfed.org/fred2), find or

of a newspaper FRED database,

an

online

of the value of the U.S.dollar quotations against and the Japanese yen. Based on these data,

recent

by 0.619:

equation

26.1

businesssection

Reserve Bank

sides of

0.619

CHECK

CONCEPT

0.977

=

pound F

CAPITALFLOWS

Canadian dollar,

the find

source

(try the

British pound, the exchange rate (a) the Canadian dollar and

the

and the Canadian dollar and (b) between the yen. Express exchange rates you derive in two ways (e.g., both Canadian dollar and as Canadian dollars per pound). the

between

pound

the

2010.

Figure 26.1 shows the nominal exchange Rather than showing the value of the

rate for the relative

dollar

as

pounds

U.S. dollar from to

that

of

per

1973

such as the Japanese yen or the British pound, the figure expresses dollar as an average of its values against other major currencies. This average value of the dollar is measured relativeto a basevalue of 100 in 1973. of 120 for the dollar in a particular the So, for example,a value year implies that in that dollar was 20 percent more valuable relative to other currencies, year, major than it was in 1973. You can see from Figure 26.1 that the dollar's value has fluctuated over time, in sometimes the and sometimesdecreasing(as (as 1980-1985) increasing period in An increase in the value of a currency relative to 1985-1987 and 2002-2008). other currenciesis known as an appreciation; a decline in the value of a currency relative to other currenciesis calleda depreciation. So we can say that the dollar in in 1980-1985 and 1985-1987 and 2002-2008. appreciated depreciated We will use the symbol e to stand for a country's nominal exchange rate. Table 26.1 shows that we can express the exchange rate as either foreign currency units per unit of domestic currency or vice versa. The choice is arbitrary, but it is important foreign currency,

the

appreciation an

increase

of a

value

other

currency currencies

in the

relative

a decrease in

depreciation

value of a currency other currencies

relative

to

the to

FIGURE 26.1

of the

value

The U.S.Nominal

160

Rate,

140

Exchange

1973-2010.

This figure shows the value of the dollar as an average of other major to a base currencies, value of 100 in 1973. its

values

to

an individual

against

relative

CO cx>

lo

N a

r^

N a

a>

i-

a

CO

N

a

co

CO

a

lo

co

r^

a) o^

co co o^

i-

a> o^

co

lo

co lo r^ a>o O O OtoCM Oo oCM o oo CM CM CMCM t-

Q

Year

Source:

Federal ReserveBank

of St.

Louis,

FRED

database,

http://research.stlouisfed.org/fred2.

735

EXCHANGE RATES

because you need to

Thus, we

define

domestic

currency

e as

be consistentwhenever the number

of

units

analyzing exchange rates. that each unit of foreign currency we treat the United States as the e is the number \"foreign\" country, you

of

are

will buy. For example, if country and Japan as the of Japaneseyen that one U.S. dollar will buy. The advantage of defining the nominal in rate this that an increase e to an exchange way implies corresponds or a strengthening, of the home currency sinceeachunit of domestic appreciation, currency will then buy more units of foreign currency. Similarly, a decreasein e implies or weakening, of the home currency sinceeach unit of domestic depreciation, or

\"home\"

currency

\"domestic\"

fewer

will buy

Figure 26.1 shows

the

that

constant

isn't

but

foreign

currency.

RATES rate between the U.S. dollar and other exchange varies continually. Indeed,changesin the value of

FIXED

FLEXIBLEVERSUS currencies

of

units

EXCHANGE

in the occur daily, hourly, even minute by minute. Such fluctuations are normal for countries like the United which have States, currency a flexible or floating exchange rate. The value of a flexible rate is not exchange in fixed but varies to the and demand for the officially according supply currency the foreign exchange market\342\200\224the market on which currencies of various nations are traded for one another. We will discuss the factors that determine the supply and demand for currenciesshortly. Some countries do not allow their currency values to vary with market conditions but instead maintain a fixed exchange rate.The value of a fixed exchange rate is set by official government policy. (A government that establishes a fixed determines the exchange rate's value independently, but exchangerate typically sometimesexchangeratesareset according to an agreement among a number of fix in Some countries their rates terms of the U.S. dollar governments.) exchange for but there are other (Hong Kong, example), possibilities. Many African countries fix the value of their currencies in terms of the euro, the currency of the Union. U nder the which countries used until its standard, European gold many in terms of the Great values were fixed collapse during Depression, currency ounces of gold.

the dollar value of a

We

focus

will

RATES BE

EXCHANGE

SHOULD

on the

case of

for most countries.However, many

countries, Should

the

two systems,

been

especially

countries

adopt

we

will

flexibleexchangeratessince an

Fixedexchangerateshave

FIXED OR FLEXIBLE?

alternative

approach important historically

quite

it

is the

major issues: (1) the effects (2) the effects of the exchange

on two

case

exchange rate. and are still used in

small or developing nations. fixed or flexible exchange rates? In

focus

relevant

is to fix an

briefly

of the

comparing

exchange

rate system on monetary and rate system on policy trade and economicintegration. The type of exchange rate a country has strongly affects the central bank's A to use to stabilize the flexible rate ability monetary policy economy. exchange the of on demand. actually strengthens impact monetary policy aggregate rate prevents policymakers from However, a fixed exchange using monetary policy to stabilize the economy becausethey must instead use it to keep the exchange rate's market value at its official value. equilibrium In large economieslikethat of the United States, giving up the power to stabilize the domestic via monetary policy makes little sense. Thus, economy large in economies should nearly always employ a flexibleexchangerate.However, An small economies, this have some benefits. case giving up power may interesting

exchange rate an rate whose value is exchange not officially fixed but varies

flexible

according to the demand for the

supply

and

currency

in

the foreign exchange market foreign

exchange

market

on which

various

nations

market the currencies of are traded for

one another rate exchange rate whose exchange

fixed

set by

official

government

an value

is

policy

736

CHAPTER26

EXCHANGE

RATES,

TRADE, AND CAPITALFLOWS

INTERNATIONAL

a one-to-one period 1991-2001maintained and the U.S. dollar. to 1991 exchange peso Although prior had suffered of while the was Argentina periods hyperinflation, peso pegged to the dollar, Argentina's inflation rate that of the United essentially equaled is

which for the

of Argentina,

that

rate between its

States.

its

tying

By

monetary policy,Argentina inflationary

Reserve.

the Federal

to repay its international let

and

the

float. The

peso

up

giving

instead placed itself

not yet

fully

avoiding the

would not be able its fixed exchangerate

an

experienced

The

of

\"umbrella\"

the

under

Argentina

recovered.

to set its

freedom

the

itself to

commit

peso depreciated,and

it has

which

from

crisis

economic

to

in 2002, investors' fears that Argentina debts forced to abandon Argentina

early

Unfortunately,

dollar and

attempted

past, and

of the

policies

to the

currency

is that a

lesson

fixed

in a small economy if other policiesare exchangerate alonecannot stop inflation not sound as well. Large fiscal deficits financed by foreign borrowing ultimately

into crisis.

pushed Argentina

The second important

economic

effect of the exchangerate on trade and of fixed exchange rates argue that fixed rates

is the

issue

Proponents

integration.

international trade and cross-bordereconomic cooperation by reducing about future uncertainty exchange rates. For example,a firm that is considering building up its export business knowsthat its potential profits will depend on the future value of its own country's currency relative to the currencies of the

promote

to

countries

Under a

it exports.

which

home currency

fluctuates

with

flexible-exchange-rate regime,the in supply

changes

and demand

of the

value

and is therefore

Such uncertainty may make the firm reluctant to expand its export business.Supporters of fixed rates argue that if the exchange rate is about the future fixed, exchange officially uncertainty exchange rate is to

difficult

far in advance.

predict

reducedor

eliminated.

underscored

with this argument, which has been problem by episodes the East Asian crisis of the late 1990s and the Argentine crisis, is that fixed rates are not to remain fixed forever. do not exchange guaranteed Although they fluctuate from day to day as flexiblerates fixed rate that is set exchange One

like

do, a

above the market'sequilibrium to unpredictably

exchange

and sudden fall in the Thai currency

a large in

instance,

may lead suddenly and the value of the country's currency. For over 67 percent (the baht) depreciatedby is trying to forecast the exchangerate 10years if the exchange rate is fixed as if uncertainty rate

1997,

just two weeks. Thus, a firm that into the future may face as much

in it

is flexible.

The potential a more adoption

The EURO: A Since World War economic

of

instability

fixed

radical solution to the problem of a common currency.

cooperation

rates exchange of uncertainty

has led somecountries to about exchange rates:

for Europe Currency the nations of western II, Europehave worked and trade themselves. among European

try the

Common

to increase

leaders recognized

more

and integrated European economy wouldbe and productive more with the U.S. than a one. As perhaps competitive economy fragmented in of this these countries established fixed rates the 1970s effort, part exchange under the auspices of a system called the European Monetary System the EMS did not prove stable. Numerous devaluations of the Unfortunately, various currencies occurred, and in 1992 severe problems their maintaining rates forced several nations, including Great Britain, to abandon the exchange that

a unified

(EMS).

fixed-exchange-rate

system.

In the

December

European

One of the

1991, Community

major

the Netherlands, the member countries of to a known as the Maastricht agreed pact Treaty. the treaty, which took effect in November 1993,

in Maastricht

provisions

(EC) of

in

EXCHANGE RATE DETERMINATION

countries would strive to adopt 11 western European nations,

the member

was

1999,

1,

January

Italy, adopted a common currency,

the

called

currency. Effective

a common

France,

including

euro.

In several

and

Germany,

stages,

the

euro

franc, the German mark, the Italian lira, and other national currencies. The was completed in early when the old currencies were 2002, process eliminated and euros. completely replaced by The advent of the euro means that Europeans no longer have to change currencieswhen with other European countries, much as Americans from trading differentstates can trade with each other without that a \"New York dollar\" worrying will in value relative to a \"California dollar.\" The euro has to change helped promote trade and cooperation while eliminating the necessity of individual European countries maintaining fixed rates. exchange Since so many countries now have a common currency, also European they need to have a common monetary The EC members that policy. agreed European of a new European Central Bank monetary policy would be put under the control in Frankfurt, Germany. The ECB,in institution located (ECB),a multinational French

the

replaced

become

has

effect,

a singlemonetary

policy in

respond

Europe

(such

due to

countries (such as Germany)

The former

monetary different

policy for many economic

conditions,

so

of them. For example,in recent Greece, Ireland, Portugal, and Spain)

to all as

large government

have

concerned

been

would prefer an

of countries

set

face

may

cannot

crises

financial

faced

have

a single

having

different countries

countries

some

years,

problemwith

is that

differentcountries

Fed.\"

\"Europe's

One potential

budget

about

easier monetary

while

deficits,

other

increases in inflation. policy,

while

the

of tighter monetary policy.Becausethe ECB argue can choose only a single monetary for all the countries using the euro, policy conflicts of interest arise the member nations of the European Union, and may among the International Monetary Fund has had to aid countries such as Greece, Ireland, latter

and

directly.

Portugal

NOMINAL EXCHANGE

RECAP The

nominal

which

the

nominal of

in favor

would

countries

between two currencies is the rate at traded for each other.Moreprecisely, the rate e for any given is the number of units country that can be bought for one unit of the domestic rate

exchange

can be

currencies

exchange currency

foreign

RATES

currency. An

is an

appreciation

currencies(a rise in (a fall

in

increase e);

in

the

a depreciation

value

is a

of a

currency relative to other

decline in

a currency's

value

e).

rate can be either flexible\342\200\224meaning that it varies freely in to and demand for the the according supply currency foreign exchange market\342\200\224or that its value is established by official fixed, meaning

An

exchange

government policy.

RATE

EXCHANGE

INTHE

SHORT

DETERMINATION

RUN

see the States, exchange rates, such as the United currencies change continually. What determines the value of the nominal exchange rate at any point in time? In this section, we use supply Countries

international

that

values

have

flexible

of their

IN THE

SHORT

RUN

737

738

CHAPTER

26

EXCHANGE

RATES,

INTERNATIONAL

TRADE, AND CAPITALFLOWS

and demand for the short run. Later analysis to answer this question in the long run. we discuss the determination of exchangerates

A SUPPLY

in

the

chapter

AND DEMANDANALYSIS

we analyze the foreign exchangemarket and discuss the factors that of and demand for and thus the U.S. dollars, supply exchange rate.As we will see, dollars are demanded in the foreign market who exchange by foreigners seek to purchase U.S. goods,services, and assets. dollars are Similarly, supplied by U.S.residents who need foreign currencies to buy foreign services, and goods, assets. The market equilibrium exchange rate is the value of the dollar that equates the number of dollars supplied and demandedin the foreign exchange market. In Chapter 23, Before proceeding,we needto be careful about our terminology. we analyzed how the supply of money (controlled by the Fed) and the demand for determine the nominal interest rate. However, the of money by the public supply in the domestic in and demand for money as that are economy, presented chapter, not equivalent to the supply and demand for dollars in the foreign exchange market. The market is the market in which the currencies of various foreign exchange In

this

section,

the

affect

nations are traded for one another. market is not the same as the money of dollars U.S. householdsand firms the

for dollars

demand

domestic demand

for

currencies seek to

in

the

money,

The supply of dollars to the foreign exchange set by the Fed; rather, it is the number supply offer to trade for other currencies.Likewise,

foreign

but

exchange

is the

is not the

market

number

of

holders

dollars

same as the of foreign

buy.

the distinction, keep in mind that, while the Fed determines the in of dollars available the U.S. supply economy, a dollar is not suppliedto the market until a holder of such as an American household dollars, foreign exchange or firm, offers to trade it for foreign currency. understand

To

total

The Supply of Dollars who

Anyone

holds

are buried

dollars

exchange market. In

the

practice,however,

market

exchange

foreign

from an international bank to a is a potential supplier of backyard,

dollars, in

are U.S.

the

principal

households and firms.

Russian citizen to the

dollars

suppliers

of dollars

whose

foreign

to the

household or firm want to supply dollars in exchange for firm There are two reasons. a U.S. household or First, foreign currency? major may need foreign to purchase a U.S. currency foreign goods or services.For example, automobile importer may need yen to purchase Japanese cars,or an American tourist need a U.S. household or Second, may yen to make purchasesin Tokyo. firm need to assets. For an may foreign currency purchase foreign example, Americanmutual fund may wish to acquire stocksissued or an by Japanese companies, individual U.S. saver may want to purchase Japanese government bonds. Because Japaneseassets are priced in yen, the U.S. household or firm will need to trade dollars for yen to acquire these assets. The supply of dollars to the foreign exchange market is illustrated by the in will in curve 26.2. We focus on the market which dollars upward-sloping Figure are traded for Japanese yen, but bear in mind that similar markets exist for every other axis of the figure shows the pair of traded currencies. The vertical would

Why

a U.S.

U.S.-Japaneseexchangerateas measured purchased

traded

with in

the

each

dollar.

yen-dollar

The horizontal

by

the

number

axis shows the

of yen number

that

can

of dollars

be

being

market.

The supply curve for dollarsis upward-sloping, that the more yen indicating each dollarcan buy, the more dollars people are willing to supply to the foreign market. At for and exchange Why? given prices Japanese goods, services, assets, the more yen a dollar can buy, the cheaper those goods, services, and assetswill be in dollar

terms.

DETERMINATION

RATE

EXCHANGE

IN

THE

26.2

FIGURE

The

The

supply

the

Market.

Yen-Dollar of dollars

Demand

Supply and

for Dollarsin Supply

739

SHORT RUN

of dollars

to the

market

exchange

foreign

is

upward-sloping because an in the number of yen increase offered for each dollar makes and Japanese goods,services, assets more attractive to U.S.

the demand

Similarly,

buyers.

for dollars

is downward-

holders of yen

sloping because

Demand

for dollars

will be

less willing

dollars the they

Quantity of dollars traded

are in terms

market

to buy

more expensive

equilibrium

of yen. exchange

The

rate

e* equates the quantities of dollars supplied and demanded.

The

of the

Impact

How does

Exchange Rate on the

the exchangerate affect

Suppose a video game dollar price of the video

the

costs

5,000 yen game will be

5,000 yen If, however, the yen

video game that

price of

costs

5,000

If lower

dollar priceswill

will

Japanese increase the

yen

induce

Demand

X

of imported and

Japan

$1/100

rises to in yen Japan will $1/200

yen

yen

goods?

a dollar

can

buy

100

yen;

the

= $50.2

200 yen, the then

EXAMPLE

Goods

Imported

dollar

price

of the

same

be

= $25.

to increase their total dollar assets, a higher yen-dollar exchangerate

Americans

goods, services, and supply of dollars to the

curve for dollarsis upward-sloping. The

X

in

a dollar

5,000

expenditureson

price

Priceof

foreign

exchange

market.

Thus, the supply

for Dollars

demanders of dollars are those who Most demanders of dollarsin the yendollar market are Japanese householdsand firms, although anyone who happens to hold yen is free to trade them for dollars.Why demand dollars? The reasons for and acquiring dollarsare analogousto those for acquiring yen. First, households firms that hold yen will demand dollars so that can purchase U.S. goods and they

In the yen-dollar

wish

to acquire

exchange

foreign

dollars

in

exchange

market, for yen.

100

that an exchange rate of one dollar per 100 yen is the same as yen per dollar. We it the first way in this example so that the yen will cancel when we perform the multiplication are left with the dollar price. 2Recall

are writing and we

26.2

740

EXCHANGE

26

CHAPTER

a Japanese firm example, to pay the required

For

services.

American

university

the

acquire

must pay

dollars

necessary

and firms

only

The firm or in exchange.

dollars.

in

yen

offering

by

U.S.-produced

fees, and a Japanesestudent

tuition

to purchase U.S.assets.The

in order

dollars

demand

to license

wants

that

dollars

needs

software

CAPITALFLOWS

TRADE, AND

INTERNATIONAL

RATES,

in an

studying

the student can Second, households of

purchase

of Microsoft stock by by a Japanese company or the acquisition fund are two Japanese pension examples. The demand curve for dollars will be downward-sloping, as illustrated 26.2. The of dollars demanded will be low when dollarsare Figure quantity estate

Hawaiian real

EXAMPLE

The Impact of the

26.3

the

does

How

and

of yen

terms

in

expensive

licensing fee for a pieceof U.S.-produced business 200 yen to buy $1, the software

the

Suppose

Japanese

$30 If, however,the

$30

the

As

to the

attractive

services, and assetsand

mentioned

means

of the exchange the

value

equilibrium

exchange rate rate that

quantities

supplied

the

and

of

equates the currency

demanded

foreign exchange market

in the

the

equals

supplied

demand for

and assets

respond by more

become cheaper U.S. goods,

more

buying

dollars.

States maintains a flexible, or floating, dollar is determined by the forces exchange market. In Figure 26.2, the equilibrium

foreign

dollars

of dollars

in the

rate at which the

exchange

yen-dollar

quantity

exchange rate is not

value of the

a

3,000 yen.

exchange

of the

value

the

that

and demand in the the dollar is e*, the market

costs

same software

price of the

yen

services,

goods,

demanding

thereby

the

the United

earlier,

which

rate,

U.S.

falls,

Japanese. They

it

Japanese

6,000 yen.3

=

yen/$l

is $30. If

software

will cost the

Equilibrium Value of the Dollar

The Market As

=

yen/$l

100

X

per dollar

yen price

more

and

200

of a dollar falls to 100 yen, United States will then be

price

in the

$30

costs

that

X

Goods

the priceof exportedgoods?

rate affect

exchange

in

of yen.

terms

in

of Exported

Price

the

on

Rate

Exchange

are cheap

dollars

when

high

a

but

constant

foreign exchange

with

changes

shifts

dollars

of

quantity

demanded. In general, the

of supply value of

market in the

market.

equilibrium

supply

of and

CHANGES IN THE SUPPLYOF DOLLARS to

order

people supply dollars Japanese goods,

that

Recall

purchase

of U.S. households and therefore

will

that

will

right,

firms

Japanese

acquire

foreign

dollars to the foreign of dollars, shifting the

affect

goods, services, exchange supply

market

exchange

assets.Factorsthat

the

in

desire

and assets

market. Some factors curve for dollars to the

dollars

to

the

this calculation, multiplication

for Japanese goods. For example,suppose some popular new consumerelectronics. To

that

preference

produce

needed to

3In

to

yen-dollar

include:

\342\226\240 An increased

the

firms

the supply of increase the supply affect

to the

services, and

buy

these

foreign

goods,

importers

will

increase

their

the dollars

cancel

Japanese the yen

supply

of

exchange market.

we use the we are

and

American

acquire

yen-per-dollar with the

left

exchange

price

in

yen.

rate so that

when

we perform

\342\226\240 An increase

incomes

in U.S. real GDP.An increase of Americans, allowing them

services (recall the

discussedin

22). Some part

Chapter

of goods

form

the

take

goods,Americans

between

relationship

will

more dollars

raise

Supplying

dollars,

yen.

FIGURE

26.3

THE

the

goods and and income we

in consumption

increase

buy more

To

Japan.

741

IN

more

consume

consumption

of this

imported from

supply

real GDP will

in U.S. to

SHORT RUN

RATE DETERMINATION

EXCHANGE

to acquire the

'

will

j

Japanese

necessary

yen.

n in real interest rate on Japaneseassets or a decrease _* the real interest rate on U.S.assets.Recall that U.S. households and | \302\247 firms as acquire yen in order to purchase Japanese assetsas well and services. With other factors, such as risk,held the constant, goods jl the \302\247 (or the lower higher the real interest rate paid on Japaneseassets \302\251 real interest rate paid on U.S. assets),the more assets AmerJapanese icans will choose to hold. To purchaseadditional U.S. assets, Japanese households and firms will more dollars to the foreign exchangemarket. supply

in the

\342\226\240 An increase

demanding

goods, a lower U.S.GDP, a lower real real interest rate on U.S. assets will reduce the number of yen Americans need, in turn reducing their supply of dollars to the foreign exchange market and shifting the supply curve for dollars to the left. for example, that Japanese firms come to dominate the video game Suppose, in the with that are more and realistic than those market, games exciting produced United States. All else being equal, how will this change affect the relative value of the yen and the dollar? reduced

Conversely,

rate on

interest

for Japanese

demand

Japaneseassets,or a higher

The increasedquality

video

of Japanese

games

increase

will

the

demand

for the

video games acquire the yen necessaryto buy more Japanese will U.S. more dollars to the market. As games, importers supply foreign exchange In 26.3 the increased of dollars will reduce the value of the dollar. shows, Figure supply other words, a dollar will buy fewer yen than it did before. At the same time, the yen in value: A given number of yen will buy more dollars than will increase it did before. in

the

United

States. To

An Increase

of Dollars

S

/

\\

ate &.

Japanese

w>

Americans

\\

-C

u

/\342\200\224>\342\226\272

/

X

V

/

\\e/

e* \302\253

the

exchange

market to

^r

.^r

>-

yen they

foreign

need to

^^\"^D

dollar in terms market equilibrium 0

CONCEPT The

United

economic

Quantity

of dollars

the exchange e*toe*'.

traded

CHECK 26.2 States weakness

goes into a recession, and likely to affect the value

real

GDP

falls. All

of the dollar?

acquire buy

the

curve for games. The supply dollars shifts from S to S', the value of the lowering

le*' JV

for

video games forces to supply more

dollars to the

\"c

Supply

Increased U.S.demand

Q c rt

the

Dollar.

of the

Value

S

in

Lowers the

else equal, how is this

of yen.The

rate

value

of

falls from

742

CHAPTER

26

EXCHANGE

TRADE, AND

INTERNATIONAL

RATES,

The factors that

FOR DOLLARS

DEMAND

IN THE

CHANGES

CAPITALFLOWS

the demand for dollars in the foreign market, exchange demand curve, are analogousto the factors that affect the the demand for dollars include: supply of dollars. Factorsthat will increase

and

change

dollar

the

shift

thus

increased

\342\226\240 An

preference

Japanese airlines American

in real demand

more

goods by

For

customers.

foreign

aircraft are

U.S.-built

example,

superior to others,and

in their fleets. To of American-made planes airlines would demand more dollarson the Japanese

buy

market.

increase

thus

that

the number

planes,

exchange

foreign \342\226\240 An

might

to expand

decide the

for U.S. find

GDP abroad, which

for imports from the

implieshigher incomesabroad, and

United States.

in the real interest rate on U.S.assets in the real interest or a reduction rate on Japaneseassets, which would make U.S. assets more attractive to foreign savers. To acquire U.S.assets,Japanese savers would demand more dollars.

\342\226\240 An increase

DOES A STRONG CURRENCYIMPLY and the public sometimestake meaning that its value

Politicians

is \"strong,\"

currency rising.

sign of

sometimes

policymakers

Likewise,

A

in the

pride in

terms

view a

economic failure.

ECONOMY?

STRONG

fact

of other

that

their

currencies

depreciating (\"weak\")

national

is high

or

as a

currency

there is no simple connectionbetween popular impression, of its economy. For example, country's currency and the strength 26.1 shows that the value of the U.S. dollar relative to other major Figure in 1973 than in the year 2007, though U.S. economic performance currencies was greater was better in 2007 than in 1973, a period of deep recessionand rising considerably inflation. the one period shown in Figure 26.1 during which the dollar rose Indeed, in was a time of recessionand high unemployment markedly in value, 1980-1985, the United States. One reasona strong currency does not necessarily imply a strong economy is that an appreciating currency (an increasein e) tends to hurt a country's net if the dollar strengthens against the yen For (that is, if a dollar exports. example, buys more yen than before), Japanese goods will become cheaper in terms of dollars. The result rather than may be that Americans prefer to buy Japanese goods a stronger dollar implies that each Likewise, goods produced at home. yen buys fewer dollars, so exported U.S.goodsbecome more to Japanese expensive consumers. As U.S. goods become more expensive in terms of yen, the willingness of Japaneseconsumersto buy U.S. exports declines. A strong dollar therefore may lower sales and profits for U.S. industries that as well as for U.S. imply export, industries automobile that compete with firms for (like manufacturers) foreign the domestic U.S. market. the

Contrary

to

strength

of a

Of the the

important

policy

interest

that

factors

many

most

Monetary

AND

POLICY

MONETARY

affects

rate.

is the the

could

THE

EXCHANGE a country's

influence

RATE

exchange rate, among

central bank. monetary policy the country's rate its effect on the exchange primarily through of

real

inflation and tightens U.S. monetary Suppose the Fed is concernedabout in The effects of this on the value of the dollar policy response. policy change are shown in Figure 26.4. Beforethe policy the value of change, equilibrium the exchangerate is e*, at the intersection of supply curve S and the demand D (point E in the figure). The tightening of monetary curve raises the policy domestic U.S. real interestrate r, making U.S. assets, such as bonds, more attractive to both foreign and American financial investors.The increased willingness

RATE DETERMINATION

EXCHANGE

743

SHORT RUN

THE

IN

FIGURE 26.4 A

of

Tightening

Monetary

Policy

Strengthens the

Dollar.

monetary policy in United States raises the

Tighter the

real interest

domestic

the

increasing

U.S. assets by foreign American savers. An demand

increased

rate,

demand

for and

for U.S.

assets by foreigners increases the demand for dollars, shifting the demand curve from D to D'. An rightward demand

increased

assets

by

American

decreases the

supply

for U.S. savers of

shifting the supply curve to the left. The exchange rate appreciates from e* to e*'. dollars,

of foreign demand

the

to

investors

buy

investors to

supply of dollars and equilibrium

from

moves

In short, dollars

and

a tightening

U.S.

of

assets,

monetary

such as

This would weaken Americans

more

buy

The appreciation of

the

dollar the

real interest

which

policy,

for dollars

decreases

the

S to S'. The value of the

equilibrium

Fed

Fed raises the

both

to

rate sharply

to the surge in

hopes

By similar

real interest rate, would

and foreigners. supply of dollars (as

the

dollar to depreciate. of the 1980s and the depreciation

2007 were primarily

responded

for

Americans

increase

but

demand

to appreciate.

dollar

reduces the

assets), causing the in the first half

dollar

the

2002 and the

by the

bonds, less attractive

foreign of

policy

monetary

demand

the

between

policy.In particular, raising

market

the

of dollars, causing the

the supply

reduces

and

F,

American

assets)

curve leftward from

supply

point

of

to e*'.

e*

logic, an easingof make

E to

point

dollarrises from

D''. The willingness (and presumablyfewer foreign from D to

the

shifts

for dollars, shifting

the demand

increases

assets

U.S.

buy

curve rightward more U.S. assets

the in

of reducing

of U.S.

result

in the

inflation

aggregate

monetary

late 1970s

by

demand and

real interest rate in the United States rose to more than 5 percent in 1983 and 1984 Attracted these savers (seeFigure 16.3). by high real returns, U.S. and foreign rushed to buy U.S. assets, driving the value of the dollar up significantly. The Fed's to bring down inflation was successful.By the middle of the 1980s, the Fed attempt As

pressures.

inflationary

from negative values

in

a result, the and 1980

1979

wasableto easeU.S.monetary

policy.

reduced the demand for U.S. assets, fell back almost to its 1980level.

The resulting decline and thus for dollars, at

in

the

which

interest rate the dollar point

real

26.1 shows that the dollar depreciated substantially starting are several reasons for this depreciation, but we will focus on two. First, the U.S. economygrew faster this period than that of most of the during countries to which it exports and the (Canada, Mexico, Japan). Consequently, aswe discussed in Chapter 23, (to pay for imports) increased.Second, supply of dollars the Fed reducedthe federal funds rate from 6 percent in early 2001 to 1 percent Similarly,

in early

Figure

2002. There

744

CHAPTER

26

EXCHANGE

TRADE, AND

INTERNATIONAL

RATES,

CAPITALFLOWS

in June 2003 and kept it at 1 percent until June 2004. Although the steep decline in in the federal funds rate wasnot accompanied declines by equal long-term nominal and real interest rates,they, too, fell. All else equal, the decline in U.S. real interest rates reduced the attractiveness of U.S. bonds to both Americans and foreigners. the supply of dollars rose and the demand for dollars fell, Consequently, to the of the dollar. contributing depreciation

The Exchange Rate as a Toolof Monetary Policy In a closed economy, monetary policy affects demand aggregate solely through the real interest rate. For example,by raising the real interest rate, a tight monetary reduces consumption and investment spending. In an open economy with a policy flexible exchange rate, the exchange rate serves as another channel for monetary one that reinforces the effects of the real interest rate. policy, To illustrate, supposethat policymakers are concerned about inflation and decide to restrain demand. To do increase the real interest rate, so, they aggregate and investment as But, reducing consumption spending. Figure 26.4 shows,the real interest rate also increases the demand for dollars and reduces the higher in turn, further of the dollar to T he dollars, dollar, supply causing appreciate. stronger reduces aggregate demand.Why? As we saw in discussing the exchange rate, a strongerdollarreducesthe cost of imported goods, thereby increasing imports.It also makes U.S. exports more costly to foreign buyers,which tends to reduce exports.

net

that

Recall

exports\342\200\224or

exports

minus

one

imports\342\200\224is

of the

four

Thus, by reducing exports and increasing imports,a components aggregate dollar (more stronger precisely, a higher exchange rate) reducesaggregatedemand.4 In sum, when the exchange rate is flexible, a tighter monetary policy reduces net exports (through a stronger as well as and investment dollar) consumption a real interest an easier rate). Conversely, spending (through higher monetary the dollar and stimulates net exports, reinforcing the effect of the policy weakens lower real interest rate on consumption and investment relative to Thus, spending. the case of a closedeconomy we studied is more earlier, monetary policy effective demand.

of

rate. in the early 1980s under Fed ChairmanVolcker policy illustrates the effect of monetary policy on net exports. As we discussed above, Volcker's were a major reason for the 50 percent appreciation of the dollar tight-money policies In 1980-1985. 1980 and the United States a trade 1981, during enjoyed surplus, with in that exceeded to a exports modestly imports. Largely response stronger dollar, the U.S.trade balance fell into deficit after 1981. By the end of 1985, the U.S. trade deficit in less than half a decade. was about 3 percent of GDP,a substantial shift in

an

open

economy

The tightening

a flexible

with

RATE

EXCHANGE

RECAP

SHORT

IN THE Supply

exchange

of monetary

and

determination

DETERMINATION

RUN

analysis is a useful tool of the exchangerate. U.S.households

demand

for

short-run supply dollars the

studying and

firms

to the foreign exchange market to acquire foreign currencies, which they need to purchase demand foreign goods, services,and assets.Foreigners in the foreign exchange market to purchaseU.S.goods,services, dollars and assets. The market equilibrium exchange rate the quantities of equates dollars suppliedand demandedin the foreign exchange market.

are temporarily foreign currencies

4We

assuming

are not

that

changing.

the prices of

U.S. goods in

dollars

and the

prices of foreign

goods

in

EXCHANGE

DETERMINATION

RATE

IN THE

LONG

RUN

preference for foreign goods, an increasein U.S. real GDP, an in the real interest rate on foreign assets,or a decrease real interest rate on U.S. assets will increase the supply of dollars on the foreign the value of the dollar.An increased for market, exchange lowering preference in the U.S. goods by foreigners, an increase in real GDP abroad, an increase in the real interest rate on real interest rate on U.S.assets, or a decrease

\342\226\240 An increased

increase in

\342\226\240 A tight

the demand for

will increase

assets

foreign

the

dollars,raising

the

value

dollar.

of the

the demand for rate, policy raises the real interest increasing A of dollars, and strengthening the dollar. supply reinforces the effects of tight monetary policy on aggregate

monetary

dollars, reducingthe strongerdollar spending by

demand.

aggregate

the real interest

lowers

policy

Conversely,

rate, weakening the dollar.

RATE DETERMINATION IN

EXCHANGE

THE

a component of

net exports,

reducing

an easy monetary

RUN

LONG

rates are determined in the long run. In section, we discusshow exchange our short-run analysis,we assumedthat both the dollar price of U.S. goodsand the the price of Sony PlayStations foreign currency price of foreign goods(for example, in yen) did not change. In discussing the long run, we relax this The assumption. we use to discuss the determination of the rate is called theory long-run exchange the of purchasing we must first theory power parity. In order to explainthis theory, introduce the real exchangerate.

In this

THE

RATE

EXCHANGE

REAL

The nominal

exchange rate

tells

foreign currency.As we will see average domesticgood or service

in terms us the price of the domestic currency of a in this section, the real exchangerate is the price of the in terms of the average foreigngood or service.

Should

acquire a large identified

two

specifications. with

the

you

number

countries of manufacture, should

you To

good or an

are in charge that is planning to of new computers. The company'scomputer has specialist one Japanese-made and one U.S.-made,that meet the necessary models, Since the two models are essentially equivalent, the company will buy the one lower price. However, since the computers are pricedin the currencies of the

that

Suppose

Good

Imported

importedgood? of purchasing for a U.S.corporation

a domestic

purchase

you

versus

a Domestic

Purchasing

the

decide to

your

complete

nominal exchange models in terms of

Suppose

that

price

assignment,

rate between the the currencies of

a U.S.-made

is not

comparison

to determine accept it\342\200\224is

which

you will need dollar their

computer

straightforward.

Your

mission\342\200\224

of the two models is cheaper.

two piecesof

costs $2,400,

and a similar

the

information:

the yen and the prices countries of manufacture. and

of

the

Japanese-made

two

242,000 yen. If the nominal exchangerate is 110yen per dollar, which computer is the better buy? To make this price comparison, we must measure the of both computers in terms of the same currency. To make the prices in dollars, we first convert the Japanese computer's comparison priceinto dollars. \302\245 The price in terms of Japanese yen is \302\245242,000 (the symbol means and \"yen\,") we are told that \302\245110 = the dollar $1. As we did earlier, we find price of the Japanese computer by observing that, for any good or service, computer

costs

Price in

yen

= Price

in dollars

X

Value

of dollar

in terms

of yen.

EXAMPLE 26.4

745

746

CHAPTER

26

EXCHANGE RATES, INTERNATIONAL

the value

that

Note Making

of a dollar in

terms

and solving,

substitution

this

AND CAPITAL FLOWS

TRADE,

of yen

we get

is just the yen-dollar

in yen

Price

Price in

dollars

exchange rate.

Yen-dollar exchange rate \302\245242,000

=

$2,200.

\302\245110/$1

Notice the

that

the

so it

ratio,

yen

appears

symbol

than the U.S. computer at

in

the

both

Our conclusionis

cancels out.

$2,200,

$2,400.TheJapanesecomputer

or $200 is the

better

numerator

and the denominator of computer is cheaper price of the U.S. computer,

the Japanese

that

less than deal.

the

CONCEPT CHECK 26.3 Using

the

Japanese

same and

information

American

presented

computers

by

in

compare the prices of yen. prices in terms

26.4,

Example

expressing

both

of the

The fact

firm would that the was cheaper implied that Japanese computer your in choose it over the U.S.-made computer. In general, a country's ability to compete international markets depends in part on the prices of its goods and servicesrelative to the prices of foreign goods and services, when the prices are measured in a In the hypothetical common currency. of the and U.S. computers, the example Japanese of the domestic relative to the of the (U.S.) price good price foreign (Japanese) good is $2,400/$2,200, or 1.09.So the U.S. computer is 9 percent more expensivethan the Japanese computer, putting the U.S. product at a competitive disadvantage. More generally, economists ask whether on average the goods and services are expensive relative to the goods and services producedby a particular country

real exchange rate the price of the average domesticgood or service relative to the price of the average foreign good or

service,when

prices terms

expressed common currency in

are of a

This question can be answeredby the country's real produced by other countries. rate. a real rate is the of the exchange Specifically, country's exchange price average domestic good or service relative to the price of the average foreign or service, good when prices are expressedin terms of a common currency. To obtain a formula for the real exchange rate, recall that e equals the nominal P rate number of units of and that (the dollar) exchange foreign currency per the domestic as for the consumer level, measured, equals price example, by price index. We will use P as a measure of the price of the \"average\" domestic good or service.Similarly, let Pf equal the foreign price level.We will use Pf as the measure

of the \"average\" foreign good or service. price The real exchangerate equals the of the average domestic good or price servicerelative to the price of the average foreign or service. It would not good be correct,however, to define the real exchange rate as the ratio P/Pf because the two price levels are expressedin different currencies. As we saw in our example of U.S.versus to convert foreign prices into dollars, we Japanese computers, must divide the foreign the price by exchange rate. By this rule, the price in dollars of the average or service equals Pf/e. Now we can write the foreign good real exchange rate as

of the

Price of Real

exchange

rate

Price of

Pf/e

foreign

domestic good good,

in dollars

RATE

EXCHANGE

To

this

simplify

expression,

and denominator

the numerator

multiply

Real exchange rate

by

eP

DETERMINATION

e to

IN

THE

747

LONG RUN

get

(26.1)

for the real exchange rate. let's apply it to the situation we analyzed in Example 26.4. For the sake of argument, that computers are the only good produced imagine by the United States and Japan, so the real exchange rate becomes just the price of U.S. relative to Japanese the nominal computers computers. In that example, exchange rate e was \302\245110/$1, the domestic price P (of a computer) was and the foreign price $2,400, Pf was \302\245242,000. 26.1, we get Applying Equation formula

is the

which

To

this

check

formula,

Real exchangerate (for

computers)

=

X

(\302\245110/$1)

$2,400

\302\245242,000

_ \302\245264,000 ~ \302\245242,000

=

is the same answer we got earlier. The real exchange rate is an important

1.09,

which

economic variable. It

incorporates both

and services across exchange rate and the relative prices of goods countries: When the real exchange rate is high, domestic are on average more goods than expensive foreign goods (when priced in the same currency). A high real exchange rate implies that domestic will have difficulty to other countries producers exporting while foreign goods will sell well in the home (domestic goods will be \"overpriced\,") the

nominal

to goods at home). country (becauseimported goodsare cheaprelative produced Sincea high real exchange rate tends to reduce exportsand increase imports, we conclude that net will tend to be low when the real exchange rate is exports high. Conversely, if the real exchangerate is low, then the home country will find it easier to export (because its goodsare pricedbelow those of foreign competitors), while domestic residentswill buy fewer imports (because imports are expensive relative to domestic when the real goods). Thus, net exports will tend to be high exchange rate is low.

In our earlier analysis,we

showed

how

an increase

in

the

nominal

exchange

and exports more expensiveto foreigners 26.1 shows that an increase in by making imports cheaper for Americans.Equation e also will increase the real exchange rate, all other things equal, most notably, the ratio P/Pf.And an increase in the real exchange rate will again reduce net exports.

rate e will

reduce

A SIMPLE POWER

net

exports

by making

THEORY OF EXCHANGERATES:

PARITY

PURCHASING

(PPP)

The most basictheory of how nominal exchange rates are determined in the long run is called purchasing power parity, or PPP. To understand this theory, we must first discuss a market equilibrium economic concept,calledthe law of one price. if transportation The law of one pricestates that costs are relativelysmall, the of an traded must be the same in all locations. For price internationally commodity if costs are not too the of a bushel of wheat example, transportation large, price in to be the same and Australia. Note that this India, ought Bombay, Sydney, in condition implies that the real exchange rate must one the equal long run. that were not the case. For that the price of wheat in instance, imagine Suppose in In were half the that case, grain merchants would Sydney only price Bombay.

law

of one

transportation costs

price

the price of an traded same

if

are relatively small, internationally

commodity must in all locations

be the

748

CHAPTER

26

EXCHANGE

sold at

could be

Equilibrium

O

to

CAPITALFLOWS

in Sydney and ship it to Bombay, where it of As wheat left price purchase. Sydney, reducing the in Sydney would rise, while the wheat inflow of wheat

incentive

a strong

have

TRADE, AND

INTERNATIONAL

RATES,

wheat

buy

the

double

local supply, the price of into Bombay would reducethe price in Bombay. market According to the Equilibrium Principle(Chapter3),the international for wheat would return to equilibrium only when to unexploited opportunities in had been when the of wheat profit eliminated\342\200\224specifically, only prices Sydney and in Bombay became equal or nearly the difference being less than (with equal the cost of transporting wheat from Australia to India). Let's look at a specific example.

EXAMPLE

26.5

The Relationship between GoodsPricesand How isthe priceof wheat

Supposethat in

Bombay.

must

the

equal

costs 5 Australian one priceholds for

law of

rate betweenAustralia must be the same

and

in both

price of

Indian

by

5, we

per

Exchange

Rate

rate?

dollars

in Sydney

what

wheat, so that

= 150

dollars

rupees.

get

1 Australian

Thus, the

Real

and 150 rupees is the nominal wheat, exchange India? Because the market value of a bushel of wheat we know that the Australian of wheat locations, price

5 Australian

Dividing

real exchange

of wheat

a bushel

If the

to the

related

the

nominal

= 30

dollars

rate between

exchange

Indian rupees.

Australia and India shouldbe 30 rupees

dollar.

Australian

Alternatively,

exchange rate will

if we

use Equation 26.1 and

the

PPP

assumption

that the real

one,

equal

eP_

and =150

pf/P

Indian

= 30 Indian

rupees/5 rupees

per

Australian dollars 1 Australian dollar.

CONCEPT CHECK26.4 The

of gold Sweden.

price

Stockholm, exchange

the theory that nominal rates are determined exchange as necessaryfor the law of one (PPP)

price to

hold

between

If

the

per ounce in

law of

the concept of purchasing powerparity. to According nominal rates are determined (PPP) power parity theory, exchange as necessaryfor the law of one price to hold. A in the useful of the PPP theory is that, particularly prediction long run, the currencies of countries that experience will tend to significant inflation depreciate. To see why, let's extend our analysis of the price of wheat in India and Australia. These

purchasing power parity

rate

New York and 2,500 kronor per ounce in one price holds for gold,what is the nominal the U.S. dollar and the Swedish krona?

is $300

examples

the purchasing

illustrate

RATE

EXCHANGE

Power Parity

Purchasing does inflation

How

affect the

DETERMINATION

IN

LONG RUN

THE

26.6

EXAMPLE

real exchangerate?

in experiences significant inflation so that the price of a bushel of wheat rises from 150 to 300rupees.Australia has no inflation, so the price of wheat in Sydney If the law of one priceholds remains unchanged at 5 Australian dollars. for what will happen to the nominal exchangerate between Australia and India? wheat, We know that the market value of a bushel of wheat must be the same in both India

Suppose

Bombay

locations.

Therefore,

5 Australian

dollars

= 300

rupees.

Equivalently,

1 Australian The nominal exchangerate

inflation, the nominal

example, inflation Conversely,

Australia,

dollar

is now

exchange rate

= 60

rupees.

60 rupees per Australian 30 rupees per Australian

to depreciateagainst inflation, has seen its currency

has

caused

with

no

dollar.

was

the rupee

the

So, in

this

dollar.

Australian

against

appreciate

India's

Before

dollar.

the rupee.

This link betweeninflation and makes economic sense. Inflation depreciation that a nation's is market. implies currency losing purchasing powerin the domestic rate that the nation's is Analogously, exchange depreciationimplies currency losing markets. purchasing powerin international 26.5 shows annual rates of inflation and nominal Figure exchange rate for the 10 South American countries from 1995 to 2004.5 depreciation largest 26.5

FIGURE

35

\342\200\242 Ecuador

Inflation and Currency

Depreciationin

T 30 (%/yez Ol

South

America,

1995-2004.

The

annual

rates

and

nominal

of inflation rate

exchange

(relative to the U.S. dollar) in the 10 largest South American countries varied considerably during 1995-2004. High inflation depreciation

O \342\200\242 Venezuela ^preciation

dc

Ol

Argentina \342\200\242

1 rate

was associatedwith

Uruguay

\342\200\242 \342\200\242 Paraguay

O

\\

\342\200\242Colombia

exchange Ecuador

Brazil

#Bolivia

ExchangeOl

Chile 1

1

20

10

1

I

1

30

40

50

Inflation (%/year)

Source:International

Monetary

the Ecuador, to the period

1995-2000.

5Since refer

tenth

country,

Fund, International

adopted

Financial

Statistics,

the U.S. dollar as its currency

and authors'

calculations.

in 2000, the data for

Ecuador

rapid nominal

rate. (Data to the

refer

1995-2000.)

\302\251\342\200\242Peru

0

of the

depreciation

for period

749

750

CHAPTER

26

EXCHANGE

as the annual rate

is measured

Inflation

CAPITALFLOWS

TRADE, AND

INTERNATIONAL

RATES,

index; depreciation is measured

relative

of change in to the

the

country's

U.S. dollar.

As

you

varied greatly among South American

consumer can

price

see, inflation

countries the period. For example, during two percentage points of the inflation rate of the United States, while Venezuela's inflation was 33 percent per year. 26.5 shows with that, as the PPP theory implies,countries Figure higher inflation during the 1995-2004 tended to t he most period experience rapid depreciation of their currencies.

Chile'sinflation

was

rate

within

OFTHE PPP THEORY

SHORTCOMINGS

studies have found that the PPP theory is useful for predicting Empirical changes in nominal exchange rates over the relatively long run. In particular, this theory helps to explain the tendency of countries with inflation to experience depreciation high of their exchange as shown in Figure 26.5. the theory is less rates, However, in predicting successful short-run movements in exchange rates. A particularly dramatic failure of the PPP theory occurred in the United

1980s. Figure 26.1 shows that, between 1980and the 1985, early U.S. dollar rosenearly 50 percent relative to the currencies of U.S. This strong appreciation was followed trading partners. by an even more rapid PPP could explain this rollerdepreciation during 1986 and 1987. theory if inflation in coasterbehavior were far lower in the United States than only U.S. trading from 1986 to 1987. In partners from 1980 to 1985, and far higher in the United States and its trading partners inflation was similar fact,

States in

the

of the

value

throughout both

periods.

theory work less well in the short run than the long run? law of one price,which that the price of an says must be the same in all locations. The law of one internationally traded commodity well for goods such as grain or gold, which are standardized price works commodities that are traded widely. However, not all goodsand services are traded and not all goods are standardized commodities. internationally, and services are not traded internationally because the Many goods does the PPP

Why

Recall that

this

theory

relies on the

law of one price\342\200\224that transportation costs are relatively For example, for Indians to export haircuts to Australia, barber to Australia every time a Sydney they would need to transport an Indian residentdesireda trim. Becausetransportation costs haircuts from being prevent if traded internationally, the law of one price does not apply to them. Thus, even in India, the price of haircuts in Australia were double the price of haircuts market in the short run. (Over forces would not necessarilyforce pricestoward equality the to Australia.) Other examples run, some Indian barbers might long emigrate the

assumptionunderlying small\342\200\224does

hold.

not

of nontradedgoodsand

construction materials

(whose

is low

agricultural

land, buildings, heavy

relative to their transportation costs),and

foods.

perishable

highly

are

services

value

A some products use nontraded goodsand services as inputs: McDonald's hamburger servedin Moscow has both a tradable component (frozen hamburger and a nontradable patties) component (the labor of counter In general, the greater the share of nontraded and services in a workers). goods nation's output, the lesspreciselythe PPP theory will apply to the country's In addition,

exchangerate.6 second

The

apply is 6Trade

that

barriers,

one country same way

reason not

all

the law

of one price and

internationally

traded

the

PPP

theory

goods and

sometimes

servicesare

fail to

perfectly

such as tariffs and quotas, also increase the costs associated with shipping goods from reduce the applicability of the law of one price in much the Thus, trade barriers transportation costs do.

to another. that physical

TRADE

THE

standardized

commodities,

BALANCE AND

NET CAPITAL

751

INFLOWS

like grain or gold.For example, U.S.-made automobiles

automobiles are not and other features. As a

identical; they differ in styling, one result, somepeoplestrongly horsepower, reliability, prefer nation's cars to the other's. Thus, if Japanese cars cost 10 percent more than American cars, U.S. automobile flood the Japanese market exports will not necessarily will still prefer Japanese-made cars even sincemany Japanese at a 10 percent premium. Of course, there are limits to how far prices can diverge before people will switch to the cheaper product. But the law of one price, and hence the PPP theory, will not apply exactly to nonstandardized goods. and

Japanese-made

RATE

EXCHANGE

RECAP

IN THE

LONG

DETERMINATION

RUN

rate is the price of the average domestic good or service of the or service,when prices price average foreign good in terms of a common currency. A useful are expressed formula for the real exchange rate is eP/Pf, where e is the nominal exchangerate, P is the domestic price level, and Pf is the foreign price level. real

The

exchange

relative to

the

in the

increase

An

becoming more

exportsand

rate tends The

real exchange

expensiverelative

stimulate

imports.

to increasenet

foreign

goods,

domestic

a decline

Conversely,

goods

which tends in

the

real

are

to reduce

exchange

exports.

of

basic theory

most

rate impliesthat to

nominal

rate

exchange

in the

determination

of one price. (PPP), long run, purchasing powerparity The law of one price states that if transportation costs are relatively the price of an internationally traded commodity must be the same small, in all locations. According to the PPP theory, the nominal exchange rate betweentwo currencies can be found by setting the price of a traded in one to the of the same commodity currency equal price commodity in the second expressed currency. is based

A

useful

that

of the

prediction

PPP theory inflation

significant

experience

is that

the

will tend

on the law

currencies

of countries

to depreciate over

the

long

in the short run. The the PPP theory doesnot work well fact that many goods and services are nontraded,and that not all traded of the law of one price, goods are standardized,reducesthe applicability and hence of the PPP theory.

run.

However,

value

lessthe

trade

the term 15, we introduced Chapter less the value of its exports imports. An

exports lessthe value

net exports (NX), equivalent

term

the

for the

of a

country's value of a country's

value

trade balance.Becauseexportsneed in not each or the trade balance (or net exports) need equal imports quarter year, If not always zero. the trade balance is equal positive in a particular period so that the value of exports exceeds the value of imports, a country is said to have a trade for that to the value of its minus the value of its surplus period equal exports

imports. If

the

trade

the country is said

of

imports

balance

to have

value of its exports.

its

a trade

is the

or

year)

CAPITALINFLOWS In

period (quarter

a particular

BALANCE AND NET

THE TRADE

(or net exports) of a country's exports value of its imports in

balance

trade the

is negative, with than exports, imports greater deficit equal to the value of its imports minus the

when exports

surplus

exceed imports,

the

between the

exports imports

exceed between imports

exports

country's

value of its

and

the

in

a given

trade deficit

difference of a

value

when

period imports

exports, the difference the value of a country's and the value of its in

a given

period

752

EXCHANGE

26

CHAPTER

RATES,

TRADE, AND

INTERNATIONAL

CAPITALFLOWS

18

16

n

Imports/GDP

y 14 12

\342\226\240g

O 00

tage

Exports/GDP

4

K

\302\2432

0

i

i

i

i

CD

O) cd O}

CM

lO

O}

O}

I

c3

C\302\243 3

0}

cd

O}

1963

r^

iii

I

i

i-^-r^OCOCDOCM cococoo)0)0)0)0

r^

1978

m

o

0)0)0)0)0)0)0)0

i

i

co o

o io

oCM o CM CM

Year

26.6

FIGURE

Balance, 1960-2010.

The U.S.Trade This

figure

U.S. exports

shows

1970s, the United

Source:

line

showsthe

represents two

the

imports

exceed

and

imports

as a percentage

a trade deficit,

run

with

imports

of GDP.Since the exceeding

late

exports.

Analysis, www.bea.gov.

components

U.S. exports

as a percentageof between

has

of Economic

Bureau

Figure 26.6 blue

States

balance since1960.The red line, U.S. imports GDP; exceed imports, the vertical distance

of the

U.S. trade

as a percentageof

the

GDP. When exports lines gives the U.S. trade surplusas a percentageof GDP. When the vertical distance between the two lines represents the exports,

U.S.

trade deficit. Figure 26.6 shows

first that international trade has become an increasingly in In 1960, U.S. the decades. important part economy past several only 5 percent of U.S. GDP was exported, and the value of imports 4.3 equaled percent of U.S. GDP. By 2008, almost 13 percent of U.S. was sold production abroad and imports were over 17 percent of U.S. GDP. The steep declinein in 2009 was the result of the worldwide and recession that began imports exports in in late 2008 and late 2007 and spread from the U.S.to the rest of the world

of the

early 2009.

Purchasesor sales of

(which international

flows

capital

purchases or salesof real and financial assets across borders

international

capital

inflows

purchases of

domesticassetsby households

capital

and

outflows

of foreign assets households and

foreign

firms

purchases by domestic firms

net capital inflows inflows minus capital

capital

outflows

borders)

are

economically

known

are

real

and

equivalent

financial

to lending

international borders and borrowing acrossinternational

assets across

as international capital flows.From the the United States, purchases of domestic

perspective

of a

assets (U.S.) domestic by

by assets inflows; purchases of foreign (U.S.) households and firms are called capital outflows. To remember theseterms, it may in\" to the that capital inflows represent funds \"flowing help to keep in mind savers domestic while outflows are funds assets), country(foreign buying capital out\" of the savers The difference assets). \"flowing country (domestic buying foreign between the two flows is expressed as net capital inflows\342\200\224capital inflows minus outflows. capital The trade balancerepresentsthe difference between the value of goods and servicesexportedby a country and the value of goodsand services imported by the Net inflows the difference between of country. capital represent purchases domestic assets and purchases of foreign assets residents. There by foreigners by domestic link between these two imbalances:In any given is a preciseand very important the trade balance and net capital inflows sum to zero. It's convenient to period, write this as an relationship equation: particular

foreigners

country, are

called

say

capital

NX + KI = 0,

(26.2)

INTERNATIONAL

NX is

where

The

inflows.

true

the trade balance (i.e.,net given

relationship

26.2 is an

by Equation

for net

capital it is

that

meaning

identity,

Japanese company do with

can a

at

automobile priced

an

The U.S.

$20,000.

dollars?

U.S.

U.S. residentpurchases

that a

Suppose

Inflows

Net Capital

and

Balance

Trade

good,

imported

buyer pays by

say, a Japanese that the Japanese

so

check

car

in an account in a U.S. bank. $20,000 What will the Japanese manufacturer do with this $20,000? Basically, there are two possibilities.First, the Japanese company may use the $20,000 to buy U.S.or Hawaiian produced goods and services, such as U.S.-manufactured parts vacations for its executives. In this case, the United States has $20,000 in exports to balance the $20,000 automobile import. Becauseexportsequal the U.S. imports, holds

now

manufacturer

car

trade balance is

unaffected by thesetransactions

Becauseno assets are is, KI = 0). So under

or sold,

bought this

scenario,

zero, as

stated

(for

these

NX =

transactions,

0).

there are no capital inflows or outflows (that the condition that the trade balance plus net

is satisfied. 26.2, might use the $20,000 to acquire U.S. assets such as a U.S. Treasury bond or someland to a manufacturing adjacent plant it in the United States. In this owns the United States compiles a trade deficit of case, = because the $20,000 car import is not offset by an export (that $20,000 is, NX \342\200\224 And there is a corresponding capital inflow of $20,000, the $20,000). reflecting inflows

capital

equals

the

Alternatively,

the Japanese

by

in

Equation

car producer

Japanese

purchase of a U.S.asset

company

(that

is, KI

=

$20,000). Once

again,

and net capital inflows sum to zero and Equation 26.2 is satisfied. In fact, there is a third possibility, which is that the Japanese car company might the United States. For example,the swap its dollars to some other party outside in exchange for trade its dollars to another Japanesefirm or individual company might the of the dollars would then have the same two Japanese yen. However, acquirer the

balance

trade

options as the so that

car

company\342\200\224to

the equality

buy

U.S.

of net capital inflows

goods

and services or acquire U.S.assets\342\200\224 deficit would continueto hold.

the trade

and

This between the trade balance and net capital inflows makes an relationship at their peril: A country with a trade important point that policymakers ignore deficit also must be receiving 26.2 tells us that if capital inflows. That is, Equation a trade deficit exists it must be true that net capital inflows (that is, NX < 0), then are positive (i.e., KI > 0). Thus, that aim to restrict trade in goods and policies reduce the trade deficit, have a clearcost sincethey will reduce services, and thus the flow of international capital.

INTERNATIONAL Like

FLOWS

definition.7

by

What

KI stands

and

exports)

CAPITAL

the

of goods

production

necessarily restrictedby savings

might

or starting

be

located

a small

national

CAPITAL FLOWS and services,saving boundaries.

far from

businessin

U.S. soil, in

Poland.

and

The most

Likewise,

investment

opportunities

productive use of

to build a the best way for

helping

a U.S.

are not citizen's

factory in Thailand a Brazilian saverto

26.2 is not quite correct. The current account (CA)consists of net exports plus net technically, Equation factor income (that is, the net flow of income on investments abroad) plus international transfers (that is, nonmarket transfers from citizens of one country to citizens of another). Thus, the precise relationship is CA + KI = 0. However, net factor income plus international transfers are less than 10 percent of the current account. Since it will make the discussioneasier, it is better to use net exports in Equation 26.2 rather than the current account.

EXAMPLE

26.7

754

CHAPTER

26

EXCHANGE

TRADE, AND

INTERNATIONAL

RATES,

CAPITALFLOWS

and reduce her riskscouldbe to hold bonds and stocks from a Over time, extensivefinancial markets have developed to in cross-border and Financial markets which borrowers and permit borrowing lending. lenders are residentsof different countries are called international financial markets. in at International financial markets differ from domestic financial markets least one important Unlike a domestic financial an transaction, respect: assets

her

diversify

countries.

of different

number

transaction is subject to the laws and regulations of at least two the that is home to the lender and the country that is home to countries, country the borrower. the size and of international financial markets depend Thus, vitality on the degree of political and economic cooperation among countries.For financial

international

the

example,during

relatively

centuries,

at the time the

Britain, international

peaceful decades of the markets were

financial

international

world's

finance

international

both

substantially reduced

remarkably highly

for use around the

years 1914-1945, two world wars

turbulent

and early

nineteenth

economic

dominant

its savings

dispatching

lender,

late

and

the

a major the

during

globe.

However,

Great

Depression

trade in

and international

Great

developed.

was

power,

twentieth

and

goods

The extent of international finance and trade returned to the levels in the late nineteenth in achieved the 1980s. century only In thinking about international financial it is useful to understand that markets, is to a real or financial and asset, lending economically equivalent acquiring is to a real or financial asset. For borrowing economically equivalent selling example, savers lend to companiesby purchasing stocks or bonds, which are financial assets for the lender and financial liabilities for the borrowing firms. to Similarly, lending a government is accomplished in practice a bond\342\200\224a by acquiring government financial asset for the lender and a financial for the borrower, in this case liability the government. Savers also can provide funds real assets such as land; by acquiring if I purchase I a parcel of land from am not you, though making a loan in the usual I am with funds that can use for sense, providing you you consuming or investing. In lieu of interest or dividends from a bond or a stock, I receive the rental value of the land that I purchased. From a macroeconomic perspective,international flows play two capital in important roles. as we discussed earlier this allow countries to run First, chapter, they trade a trade deficit is matched net inflows and a trade imbalances; by capital is matched net outflows. (Recall 26.2.) Second, they allow surplus by capital Equation services.

countries whoseproductive fill in

savings to

this second

the gap

investment

by

borrowing

are greater

opportunities from

abroad.

The rest

of this

Capital inflows are would

Why

Americans The

on

focuses

chapter

role.

THE DETERMINANTSOF INTERNATIONAL outflows

domestic

than

FLOWS

CAPITAL

are purchasesof

domestic assets by foreigners, while capital of assets domestic residents. This begs the question: purchases foreign by want to U.S. would assets,and, conversely, foreigners acquire why

want to

basic

acquire assetsabroad?

that determine the

factors

or foreign, are return with other factors

and

risk.

attractiveness of

Financial

(such as the degreeof

held constant,a higher

investors risk

and

any

seek

asset,

high

the returns

real

either

domestic

returns;

thus,

available abroad)

real interest rate in the home country promotes capital domestic assets more attractive to foreigners. by making By the same token, a higher real interest rate in the home country reduces capital outflows by their at home. Thus, all else being inducing domesticresidentsto invest savings a real interest rate at home increases net equal, higher capital inflows. Conversely, a low real interest rate at home tends to reduce net capital inflows (by increasing net capital outflows), as financial investors look abroad for better opportunities. 26.7 shows the relationship between a country's net capital inflows and Figure in the real rate of interest that When the domestic real interest prevailing country.

inflows

755

CAPITAL FLOWS

INTERNATIONAL

26.7

FIGURE

Net Capital Inflows and the Real Interest Rate.

1

v.

Net

inflows

capital

Kl

K/<0 r

outflows

interest

rate

country

will

assets,

Kl>0

r

Net

inflows.

capital

inflows

\302\273tic

induce

to

assets,

foreign

the higher

capital inflows are positive of foreign assets). purchases

is high, net domestic

capital inflows The interest

rate.

of domestic assets interest rate is low, net

(that is, the country experiences net capital outflows). negative of risk on capital flows is the opposite of the effect of the real in the riskiness of domestic For a given real interest rate, an increase net as foreigners become less willing to buy the inflows, capital

assets, and

domestic savers becomemoreinclined

example, politicalinstability, to reduce net capital inflows.

which

tends

increasein an

purchases the real

capital

are

country's

assets. For country,

when

be net

effect

assets reduces home

(foreign But

will

KL

inflows

exceed

reducing

all else being equal, the higher the domestic real interest rate r,

Kl

inflows

buy

outflows.Thus,

capital

0

Net capital

for

incentive

domestic savers to

Domes

in

country also

reducesthe

rate

domestic

buy

increasing capital A high real rate

home

the

returns

a high real in the home

abroad,

foreigners

inter

the real

and

available

Net capital

est

the degree

constant

Holding

of risk

increase

to the left.

risk

on

in risk

capital

flows:

reduces net

At

each

Figure

value

to buy foreign the risk of investing in a 26.8 shows the effect of an

increases

of the

capital inflows, shifting

domestic real interest the

capital

inflows

rate,

curve

26.8

FIGURE

An Increase

Risk

in

Net Capital

Reduces Inflows.

increase in the riskiness of domesticassets,arising, for

An

example, political

from an increase instability,

in

reduces

the willingness of foreign and domestic savers to hold assets. The supply inflows declines at value of the domestic

domestic

of capital each real Kl

interest curve

rate, shifting

to the

left.

the

756

CHAPTER

26

EXCHANGE

INTERNATIONAL

RATES,

TRADE, AND CAPITALFLOWS

26.5

CHECK

CONCEPT

For given real interest rate and riskiness in the home country, how would you in real interest rates abroad? net capital inflows to be affected by an increase your answer graphically.

International investment.

we

As

the

increasing

reduce the

flows have a close relationship to domesticsaving and capital will see next, capital inflows the domestic augment saving pool, funds available for investment in physical while capital outflows capital,

economic growth the

derive

To

from Chapter four

total

G+

C+

we subtract

NX

both

from

+

saw

in the

substitution

that

national

the sum (I),

identity,

government

we have

obtain

to

identity

= L

saving S is equal to

Y

\342\200\224 \342\200\224

C

G.

If we

make

recall that Equation 26.2 describesthe NX and net capital inflows KI. In particular, = 0. This also can zero, or NX + KI equals

Now

in

this

preceding equation, we obtain

S-NX = L

this substitution

of the

NX.

sides of the

Y-C-G-NX

In Chapter19we

this

out

recall

investment,

equal

(C), investment

consumption

net exports(NX).Writing

Y=C + I+G Next,

and

output

of expenditure:

(G), and

Thus capital inflows can help outflows, to restrain it.

and capital

a country,

within

among capital inflows, saving, or income Y must always

relationship

15 that

components

purchases

available for investment.

of saving

amount

to promote

Show

AND CAPITAL INFLOWS

INVESTMENT,

SAVING,

expect

the

above

equation, S +

we

(26.3)

relationship

the trade be written

the trade

balance

that

find

KI =

between

balance plus capital inflows If we make as KI = \342\200\224NX.

L

(26.4)

a key result, says that the sum of national saving S and net capital in new capital goods, I. In abroad KI must domestic investment equal in an open economy, the pool of saving other words, available for domestic investment includes not only national of the domestic and saving (the saving private but funds from savers abroad as well. public sectors) In Chapter 19,we introduced the saving-investment diagram, which shows that, in a closed economy, the supply of saving must equal the demand for saving. A similar the of saving in an open diagram applies to an open economy, exceptthat supply includes net inflows as well as domestic economy capital saving. 26.4,

Equation

inflows

from

26.9 shows the open-economy version of the saving-investment Figure diagram. The domestic real interest rate is shown on the vertical axis and saving and investment flows on the horizontal axis. As in a closed economy, the downward-sloping curve J showsthe demand for funds by firms that want to make capital investments. The curve marked S + KI shows the total supply of saving, S and including both domestic saving

net capital

inflows

abroad

from

both domesticsaving Figure 26.9 shows,the

KI. Since

the total amount of saving supplied to the amount of saving demanded equal

that

sets

a higher

domestic real interest rate increases the S + KI curve is upward-sloping. As rate in an open economy, r*, is the level net capital inflows from abroad) (including for purposes of domestic capital investment.

net capital inflows, real interest equilibrium

and

INTERNATIONAL

757

CAPITAL FLOWS

FIGURE 26.9

The Saving-Investment for an

Diagram V

S+

\\ \\

+J rt

\\

&.

\\

\\\\

+j

I/) Q) &. Q)

\\

J Xx

\\

\\X

+J

\\

#c 73 r* Q) &.

#y

'\342\200\242C I/) Q)

^^^ ^^

^^r

^r

//

/

m

Kl

of saving in economy is the sum of national saving S and net inflows K/. An increase capital in the domestic real interest rate will increase both S and K/. The domestic demand for

/

an open

/S

\\

V

^^

saving

^/

E

0

curve and

Saving

for purposes is shown

labeled

equilibrium r* sets the

investment

real interest supply

saving, including

capital

equal to

the

domesticdemand

26.9 also

indicates how net capital inflows

benefit

can

of foreign

an economy. A have a larger

capital lower real interest rate and a higher rate of in new capital than it otherwise investment would. The United States and Canada in both benefited from inflows of the large capital early stages of their economic as do countries Because development, many developing today. capital inflows tend to react very sensitively to risk, an implication is that countries that are politically stable and safeguard the rights of foreign investors will attract more foreign capital and thus grow more quickly than countries without those characteristics. country pool of total

that

attracts

occur because other countries

hence,

RATE AND

trade

causes

What

significant

and,

saving

SAVING

THE

amounts

deficits?

both a

flows

will

THE TRADE DEFICIT

Stories

the

in

media

a country produces inferior goods trade restrictions impose unfair

sometimes claim that trade deficits no one wants to buy or because on imports. Despite the popularity of that

these explanations,however, there is little support for them in either economic theory or evidence. For example,the United States has a large trade deficit with but China, no one would claim U.S. are inferior to Chinese A nd goods generally goods. many countries

developing

have

significant

trading partners, tend to imposethe

Economists argue that, of unfair

existence

rather

deficits

trade

stringent

than

the quality

trade restrictions,

a low rate

cause of trade deficits. We

balance

have in

already Equation

even though they, restrictions on

more

of

of a

NX.

than

their

country'sexportsor the

national

seen the relationship between national = NX S \342\200\224 26.3, I, which we rewrite as

S- I =

rather

trade.

saving saving

is the primary and

the trade

(26.5)

Equation 26.5, if we hold domestic investment (I) constant, a high saving S implies a high level of net exports NX, while a low level if a country's of national of net exports. Furthermore, saving implies a low level < national is less than its or S then 26.5 investment, I, saving Equation implies that net exports NX will be negative. That is, the country will have a trade deficit. The

to According rate of national

by the

/.The

total

inflows,

Figure

of capital

investment

Q

0

Open

Economy. The total supply

for

rate

of

saving.

CHAPTER26

758

EXCHANGE

RATES,

INTERNATIONAL

conclusion

from

Equation

saving tends to

national national

TRADE, AND CAPITALFLOWS

is associated

saving

26.5 is that, holding

domestic investment

be associatedwith a trade with a trade surplus(NX

deficit >

low

constant,

(NX < 0), and

high

0).

to be associatedwith a trade deficit? in rate is one which households and the saving governmenthave relative to domestic income and Since part high spending rates, production. of the spendingof households and the government is devoted to imported we goods, would expect a low-saving,high-spending to have a volume of economy high imports. consumes a large proportion of its domestic Furthermore, a low-savingeconomy the quantity of goods and servicesavailable for export. With high production, reducing and low a will a trade deficit. imports exports, low-saving economy experience A country with a trade deficit also must be receiving capital inflows. (Recall that Equation 26.2 tells us that if a trade deficit exists,NX < 0, then it must be true that net capital inflows are positive, KI > 0.)Isa low national rate also saving consistent with the existence of net capital inflows?The answeris yes. A country with a low national rate will not have sufficient saving of its own to finance saving Why does

A country

with

a low rate a low

of national

saving tend

national

be many Thus, there likely will good investment available to to capital inflows. Equivacountry foreign savers,leading a of domestic will tend to drive the domestic real interest lently, shortage saving up which attracts flows from abroad. rate, capital

investment.

domestic

in opportunities

the

U.S. TradeDeficit

EXAMPLE 26.8

U.S. trade

is the

Why

deficit so large?

until the mid-1970s. 26.6, U.S. trade was more or lessin balance the United States has run large trade deficits, particularly in the mid-1980s and since the latter part of the 1990s. Indeed,in 2006 and 2007 the trade deficit equaled 5.7 percent of U.S. GDP. Why is the U.S. trade deficit so large?

As

shown

by Figure

Sincethe late 1970s,however,

Figure

26.10 shows national saving, and the trade balance for the investment, from 1960 to 2010 (all measuredrelative to GDP). Note that the

States

United

trade balance

has been negative

that

trade deficits

Note

also

saving, as requiredby

national

26.10 National Saving,

since

the

late

1970s, indicating

correspond to periods in Equation

which

a trade deficit.

exceeds

investment

26.5.

FIGURE

25

Investment, and the Balance

Trade

United States, Since

National

has fallen below

domestic implying

Investment/GDP

1960-2010.

1970s, U.S. national

the

saving

in the

saving/GDP

investment,

a significant

trade

deficit.

Trade balance/GDP -10

o

CD CD

CD CD

CO CD CD

CM Is-CD

CD CD

O

CO CD

^1\" 00 CD

Year Source:

Bureau of Economic

Analysis,

www.bea.gov.

00 00

CD

CM CD CD

CD CD CD

O

O

O

CM

_L ^1-

I 00

oCM

CM CM

o

I

O

o j: o o

INTERNATIONAL

U.S.

national

1970s,

early period.

However,

One factor government deficits

U.S.trade

saving and investment

and, hence, the U.S. national contributed

that

of the

U.S. trade

were roughly

era. Because investment

did not

the

saving decline

1960s and

during that and 1980s. was the large as much as saving, the

to zero

close

saving fell sharply during to the decline in national

in the

balance

in

balancewas

late

1970s

1980s, coming under control only when of 1990-1991. and investment both during Saving recovered during the 1990s, but in the latter of the national 1990s, part saving dropped This time the federal government wasnot at fault since its budget showed a again. the fall in national saving reflecteda declinein private Rather, healthy surplus. the result of a Much of the saving, powerful upsurge in consumption spending. in consumption increase was for and which services, spending imported goods increased the trade deficit. In 2002, however, the federal government again began to have large budget deficits. This reduced national saving even more and led to a recordtrade deficit in 2006 (as a percentage of GDP). Is the U.S. trade deficit a problem?The trade deficit that the United implies States is relying heavily on foreign and net inflows to finance its saving capital domestic formation. These loans must be with capital foreign ultimately repaid interest. If the foreign savings are well invested and the U.S. economy grows, if economic in the United repayment will not pose a problem.However, growth in States slackens,repaying the lenders will impose an economicburden foreign investment

the

deficit

in the

ballooned

the recession

fell

future.

i.

' \342\200\242*> '\342\226\240':

>

c^\\

i

iJ

V

... \"But

RECAP

were

'\342\226\240\342\226\240\302\273\342\200\242 -j

!

just talking about buying this country's trade confronting not

INTERNATIONAL BALANCE

OF

a car\342\200\224we're talking deficit

with

about

Japan\"

CAPITAL FLOWS AND THE

TRADE

Purchases or sales of assetsacrossborders are called international capital in (say) the United States borrows flows. If a person,firm, or government from we say that there is a capital inflow into the United States. abroad, In this case, foreign savers are acquiring U.S. assets.If a person, firm, or government in the United States lends to someone abroad, thereby a foreign there has been a capital outflow from asset, we say that acquiring

CAPITAL FLOWS

759

26

CHAPTER

760

EXCHANGE

TRADE, AND CAPITALFLOWS

INTERNATIONAL

RATES,

States

United

the

country. Net capital

to the foreign

capital inflows

country equal

to

inflows

a given

outflows.

minus

it must imports more goods and servicesthan it exports, to cover the difference. Likewise, a country that exports more than it imports will lend the difference to foreigners.Thus, as a KI matter of accounting, the trade balance NX and net capital inflows must sum to zero in every period.

\342\226\240 If a

country

borrow

abroad

\342\226\240 The

funds

domestic investment in new capital goods from abroad. saving and net capital inflows

available for of domestic

sum

the

equal

the

domesticcountry,

inflows

Capital

lowerthe risk of investing the capital inflows benefit an economy by providing

the return and the

The higher

capital investment, but in new

investing

lenders.

will be

greater

capital

a burden

become

can

they

goods are

to

insufficient

in the from

returns

if the

pay

abroad.

for

funds

more

back

from

the foreign

cause of a trade deficit is a low national saving rate. A saves little and spends a lot will tend to import a greater of goods and services than it is able to export. At the same time, quantity the country's low saving rate a need for more foreign implies borrowing to finance domestic investment spending.

\342\226\240 An

important that country

-

\342\226\240

SUMMARY

rate is flexible, exchange increases the demand for the

the

\342\200\242 When

policy

a tight

assets,or a decreasein

monetary

reduces

currency,

currency, and causesit to appreciate. of the currency reinforces the effects on demand tight monetary policy aggregate by reducing net exports. Conversely, easy monetary policy

the supply of The stronger

lowersthe real interest

currency,

which

\342\200\242 The

nominal

in turn

is the rate

A rise in

other.

each

for

appreciation;a

the value

a

of

in the

decline

depreciation.(LOl) and

\342\200\242

Supply

the

studying

demand analysis determination of

is a useful tool exchange rates in

currency

is supplied

wish to acquire foreign foreign

goods,

the

preference

for

GDP, an

foreign

increase

in

to

currencies

goods, the

residents who

by domestic

and assets.

services,

\342\200\242 The real domestic

An

an increase real

interest

(LOl)

rate is the price of the average exchange or service relative to the price of the good or service, when prices foreign good in terms of a common currency. The

expressed for

equilibrium exchange rate, alsocalled the market value of the exchange rate, equilibrium the of the currency supplied and equates quantities demandedin the foreign exchange market. (LOl) \342\200\242 A

its value.

increase

average

run. The

short

thus

currency

currencies is calledan value of a currency is calleda

to other

relative

two currencies can be traded

currencies

the

which

the

weakens

net exports. (LOl)

rate between

exchange at

and

rate

stimulates

the real interest rate on increase the supply of a currency on the foreign exchange market and thus lower its A currency value. is demanded by foreigners who wish to purchasedomestic and assets. services, goods, An increased for domestic goods by preference in real GDP abroad, an increase an increase foreigners, in the domestic real interest rate, or a decreasein the real interest rate all will increase the demand foreign for the currency on the foreign market and exchange

all will

assets

domestic

exchange rate incorporatesboth

countries.

An

implies

domestic

that

moreexpensive

to reduce a decline

Conversely,

to increasenet

are becoming goods and services, and increase imports. exports in the real exchange rate tends

goods

relative

tends

which

nominal

the relative levels of pricesamong in the real exchange rate increase

and

rate

exchange

the

are real

exports.

and services

to foreign

(L03)

purchase

increased in

the

\342\200\242 A basic

domestic

rate on

foreign

theory

determination

(PPP)

in

the

theory,

of nominal

exchange rate

long run, the purchasing power parity is based on the law of one price. The

REVIEW

are

price states that

of one

law

small,

relatively

traded

must

commodity

if

the price be

rate of national saving is the primary trade deficits. A low-saving, high-spending

costs

transportation

same in all

likely to import more than also consumesmore of its

PPP theory, we can find the rate between two currenciesby exchange the of a setting price commodity in one of the currenciesequal to the price of the commodity in locations.

to the

According

nominal

the second currency.The PPP theory that the currencies of countries predicts

leaving less

correctly that

balance

country country. production,

is It

domestic

Finally, a

low-saving country

deficit.

is

rate, which attracts sum of the trade

interest

real

level capital inflows is zero, a high inflows always accompaniesa largetrade

net

and

net capital

of

(L04)

run.

the real interest rate in a country, and higher the lower the risk of investing the higher its there, net capital inflows.The availability of capital inflows a country's expands pool of saving, allowing

\342\200\242 The

changesin exchangerates.(L03) \342\200\242 The

for

export. to have a high

likely

inflation

significant

the

in

of

a high-saving

net capital inflows. Becausethe

will tend to depreciate the fact that many goods However, long and services are not traded internationally, and that not all traded goods are standardized,makes the PPP theory less useful for explaining short-run experience

cause

\342\200\242 A low

of an internationally the

761

QUESTIONS

trade

or net

balance,

less the

exports

country's

exports, is the value value

of

its

for more domesticinvestment and increased A drawback to using capital inflows

a

of

growth.

in a

imports

domestic

finance

particular period. Exports neednot equal imports in each period. If exports exceed imports,the difference is called a trade surplus, and if imports exceed the difference is called a trade exports,

formation

capital

returns to capital (interestand foreign

financial

residents.

to

is that the

dividends)

accrue

to

investors rather than domestic

(LOS)

deficit.(L04)

KEY TERMS (734)

appreciation

inflows

capital

fixed

one

price

rate (735)

the

(PPP) (748)

real exchange rate (746)

(747)

flexible exchange

rate

exchange

net capital inflows

rate (735)

nominal

exchange

balance

trade

(751)

trade deficit

(738)

(751)

trade surplus(751)

(752) rate

power parity

purchasing

(735)

market equilibrium value of

(734)

exchange

of

law

market

capital flows (752)

internationl

capital outflows (752) depreciation

exchange

foreign

(752)

(733)

REVIEW QUESTIONS 1.

rate, how exchange policy (a lower real interest

a flexible

Under

of monetary

the value

of the exchange rate?

Does

does an rate)

this

employment? Explain.

in

4. Define nominal

rate. Howarethe

the

5. Explain with

(LOl)

do U.S. householdsand firms supply dollars to the foreign exchangemarket? do Why in the foreign exchange foreigners demand dollars

country's net

2. Why

market?

(LOl)

3. Japanese Mexican pesos

yen trade at 110 yen per dollar and trade at 10 pesos per dollar.What

in

rate

exchange two

concepts

and real exchange related? (LOl, L03)

in any period,

why,

inflows

the yen and the

(LOl)

ways.

equal

its trade

a

deficit.

(L04)

6.

How

are

capital

to domestic investment (L04)

is the

two

examples

capital

between

rate

exchange

peso?Express

affect

change

the exchange rate tend to weakenor strengthen effect of the monetary ease on output and

nominal

easing

or outflows

inflows in

new

capital

related goods?

762

CHAPTER

26

EXCHANGE RATES, INTERNATIONAL

AND CAPITAL FLOWS

TRADE,

PROBLEMS

follows an

1. If the government

Mc

Graw

flexible,which

connect\"

of

the

easy

monetary

will likely

following

policy and the exchange rate is be the result? (LOl)

a. A falling real interest rate but higher net exports. b. A higher real interest rate but lower net exports. c. A strong currency that helps stimulate exports. d. Increases in the demand for the currency and decreasesin

|ECONOMICS

the

of the

supply

currency.

2. Usingthe

McGraw-Hill

Mexican

Visit

your mobile

store and

Study

app todayl

and

change if of the yen

download

the Frank: Econ

app

in Table 26.1, the Japanese the peso appreciates the dollar against data

peso

3.

find the nominal rate between the exchange yen. Express in two ways. How do your answers the dollar while the value by 10 percent against remains unchanged? (LOl)

of champagne costs 20 euros.(LOl) rate is 0.8 euro per dollar, so that a dollar can 0.8 the champagne cost in the United States? euro, how much will buy b. If the euro-dollar rate rises to 1 euro per dollar, how much will exchange the champagne cost in the United States? in c. If an increase in the euro-dollar rate leads to an increase exchange Americans' dollar on French champagne, what will happen to the expenditures amount of dollars suppliedto the foreign market as the euro-dollar exchange

a.

euro-dollar

the

If

bottle

a French

Suppose

exchange

exchange rate rises?

4.

Consider

a.

the

If

European

eurodollar

what

will happen

demandedin

would each of

a. U.S.stocks

are

the

following

c.

perceived

investments.

computer

European

East

aware

0.8

so

that

iPod cost

euro per

in

it costs

a

France?

dollar, how

much

will

the

to French purchases of foreign

exchange

and

iPods

market

the

as the

as

be likely having

to affect the become

value

of the

much riskier

dollar, all

financial

switch from U.S.-produced software to software and other nations. grow, international financial investors become high-return investment opportunities in the region. firms

in India, Israel, Asian economies

produced As

to

the

falls?

rate

exchange

else being equal? Explain.(LOl)

b.

will

France?

in

of dollars

amount

costs $240. (LOl) rate is 1 euro per dollar,

a dollar, how much exchange rate falls

euro-dollar

iPod cost

c. Consequently,

5. How

exchange

to buy

1 euro

b. If the the

iPod that

an Apple euro-dollar

of

new

many

last year and this year, the CPI in Blueland rose from 100 to 110 and rose from 100 to 105. Blueland's unit, the blue, currency was worth $1 (U.S.)last year and is worth 90 cents (U.S.)this year. Redland's 50 cents 45 cents (U.S.) last year and is worth currency unit, the red, was worth (U.S.) this year. Find the percentage change from last year to this year in Blueland's nominalexchange rate with Redland and in Blueland's real exchange rate with Redland. (Treat Blueland as the home country.) Relative to Redland, do you expect Blueland's exports to be helped or hurt by these changes in exchange rates?

6. Between the

CPI

in Redland

(LOl, L03)

7.

A

British-made

automobile

is priced

at

\302\24320,000

(20,000

British

pounds).

trades for $1.50 in comparable U.S.-madecar costs $26,000.One pound market. Find the real rate from the foreign exchange exchange perspective the United States and from the of Great Britain. Which perspective country's cars are more competitively priced? (L03)

A the

of

ANSWERS

do eachof

8. How deficit and

identity

outflows for

United

the

balance plus net

trade

the

that

affect (1) the

transactions

following

inflows or

(2) capital

case the

trade surplusor Show

States?

capital

CONCEPT

inflows

in

that

equals

each

zero

(L04)

applies.

a. A

to b.

the

TO

buy

U.S.

firm

uses

firm

proceeds from a

equipment

drilling

Israel.

She uses the

Israeli shekelsreceived

sale of

oil

to the

United States

to buy

debt.

government

c. A Mexican

oil

to

Israeli company. uses proceeds from its

in an

stock

Mexican

A

sells software

U.S. exporter

from its sale U.S. firm.

of oil to the

United

States

to buy

9. Usea diagram like 26.9 to show the effects of each of the following on Figure the real interest rate and capital investment of a country that is a net borrower abroad.

from

(L05)

a. Investment

b.

The

opportunities budget

government

the

in

deficit

country

improve

owing to

new technologies.

rises.

c. Domestic citizens decideto save more. d. Foreign investors believe that the riskinessof

lending

to

increased.

\342\226\240

ANSWERS

TO

CONCEPT

the country

has

CHECKS

depending on when the data are obtained. (LOl) in U.S. GDP reduces consumer incomesand 26.2 A decline hence As imports. Americans are purchasing fewer fewer dollars to the imports, they supply so the supply curve for dollars shifts to the left. market, foreign exchange Reduced supply raisesthe market value of the dollar. (LOl) equilibrium 26.1

will vary,

Answers

26.3 The dollar price of

U.S. computer is $2,400, and eachdollar is equal to the of the U.S. is Therefore, (110 yen/dollar) X yen price computer or The of the is 242,000 yen. ($2,400), 264,000 yen. price Japanese computer the conclusion that the model is doesnot on Thus, Japanese cheaper depend in which the comparison is made.(L03) the currency Since the law of one price holdsfor gold, its price per ounce must be the same in New York and Stockholm: the

110 yen.

26A

$300 = 2,500kronor. Dividing

sides by

both

300, we get

$1 = 8.33kronor. 8.33 kronor per dollar.(L03) 26.5An increase in the real interest rate abroad increasesthe relative attractiveness of foreign financial investments to both foreign and domestic savers. Net real capital inflows to the home country will fall at each level of the domestic interest rate. The supply curve of net capital inflows shifts left, as in Figure So

the

26.8.

exchange

(L04,

rate is

LOS)

\342\226\240

CHECKS

763

G

LOSSARY

B

A

Absolute

advantage.

over another task than the

if

other

A

The difference

between a

revenue and its explicit costs. in which Adverse selection. The pattern

purchaseddisproportionately costly for companiesto

insurance tends to be those who are most

by

firms,

customers abroad want

to

purchase

the

shows

that

curve

A

and government, at each inflation

all other factors constant. (AS) curve. A curve that Aggregate supply between the amount of output relationship

produce and

inflation

the

want

firms

holding

rate,

the

shows

to

from

future

rises

do

inflation

even

change

in the value

An increase

of a currency

Autonomous

Average benefit. an

The portion

that is independent

expenditure

Average cost. activity

The

The total

divided

of

n units

by n. cost

of undertaking

n units

of

of an

before-tax

income. total

Average

Total cost divided Variable

cost

by total

divided

an

leaving

value is

the

of to staggered

consisting

Fed,

president

both

including

usually

or coupon,

interest,

and the

output. by total

expansion.

in GDP

largest

dollar

for

a good.

pay

between the price he or she actually

and other the

amount

buyer's

pays.

c

Capitalgood.

A

production of

assets

of foreign

and firms. of firms that

of

table.

from

earning

of existing

value

the

Purchases

coalition

Central bank insulated

of domestic

by

foreign

and firms.

the purpose the

services.

Purchases

households

Cash on

good

goods and

Capital outflows. A

of existing assets. that is used in the

value

the

long-lived

other

Capital losses.Decreasesin

gains

cost (ATC).

Average variable cost (AVC). output.

surplus.

Capital gains. Increasesin

Cartel. total

of the

by

fluctuations

be willing to The difference

would

Capital inflows.

employed worker. by

player receives

expected

and protracted

strong

particularly

reservation price

by n.

Average labor productivity. Output per Average tax rate. Total taxes divided

A

households

of undertaking

whose

gamble

to repay a debt, legal promise the principal amount and regular

Buyer's

aggregate

planned

of output.

benefit

total

divided

activity

A

The leadership

Governors.

buyer

in government spending or decreasesin real output declines. consumption. Consumption spending that is to the level of disposable income.

expenditure.

gamble.

variables. Buyer's reservation price.The

increases

related

goods

strategies

purpose of

for the

Businesscycles.Short-term

when

not

the

each payoffs of strategies.

the

Bond. A Boom.

of value

Autonomous

entering

payments.

that one owns. in which buyers information. Situations and Asymmetric sellers are not equally well informed about the characteristics of goods and services for sale in the marketplace. Attainable point. Any combination of goods that can be produced using available resources. currently in the law that imply Automatic stabilizers. Provisions automatic

game. The players,

player, and

each

positive.

relative

currencies.

to other

Assets. Anything

from

firms

or servicesfor other

14-year terms.

if inflation

bank

leads

inheritance.

temporarily.

Appreciation.

taxes

of a

elements

Boardof

When people's not

of the

rumors

their funds.

of goods

trade

seven governors appointed

expectations.

inflationary

expectationsof

withdrawals

banks

that prevents

for each possiblecombination done Bequest saving. Saving

direct toward

news or

in which

of one or more

force

or services.

Basic

depositor

market.

Barter. The direct

are underserved.

that

markets

in prices price. Changes overcrowded markets and

of meeting

to withdraw

rush

Any

entry.

Better-than-fair of

function

resourcesaway Anchored

Barrier to

factors

other

all

constant.

Allocative

depositors to

by commercial

held

assets

similar

purpose

payments.

available to

holding

the

Banking panic. A situation imminent bankruptcy

a new

consumers,

output

total

firm's

insure.

(AD) curve.

demand

amount of

rate,

banks for

unit's assets and

economic

date.

Bank reserves.Cash or of a

and

profit.

of an

list

a specific

liabilities on

occur.

Accounting

Aggregate

a

to perform

allows the effects

that

policy

sheet. A

Balance

advantage

person.

policy.

Accommodating

shockto

One person has an absolute he or she takes fewer hours

an

assets. by

domestic

agree to restrict output

economic

An economic

assets

for

profit.

metaphor for unexploited

exchange.

independence. When

from

allowedto

central

bankers

are

political considerations and are long-term view of the economy.

short-term take

a

G-l

G-2

GLOSSARY

A shift of the AD curve. A shift of the AS curve. Change in demand. A shift of the entire demand curve. Changein the quantity demanded. A movement along the demand curve that occurs in response to a change in

demand.

in aggregate

Change

Changein

price.

Change

the

in

supply

A movement along

supplied.

quantity curve that

occurs

in

to

response

a change

of the

sale

and

purchase

to the

solutions

Collective

A good

good.

Commitment

can

or

service

low,

least some

to at

that,

Commitment achieve

A way of changing incentives so as to empty threats or promisescredible. A situation in which people cannot problem. their goals because of an inability to make credible

device.

or promises.

threats

Comparative advantage. One person has a comparative advantage over another if his or her opportunity cost of performing a task is lower than the other person's

opportunity cost.

Compensating wage attractiveness of

a job's

Complements.Two an increase

in the

price of one

the other

for

all

Constant (or parameter).A Constant returns to scale. have constant returns

changedby

causes

(or

The payment of but on

deposit

a given

A

scale

not

only

accumulated

is fixed

that

production

to

a

interest

previously quantity

if

in consumption a leftward shift in decrease causes a

proportion,

value.

in

process if, when all

on the interest.

is said to

inputs are output changes by the

proportion.

and entertainment. function.

The

between

relationship

determinants,

in

particular,

disposable income.

See Recession.

Contraction.

to reduceplanned Core rate of inflation. energy and food.

Cost-plusregulation. cover the

Government

policies.

Contractionary

regulated explicit opportunity

owners.

the policy. The degree to which the central bank's promises to keep inflation

so may impose short-run

if doing

even

policy actions

and output. rate of increase of

designed

spending The

all

prices

except

A method of regulation under which firm is permitted to chargeprices that costs of production plus a markup to cover cost of resources provided by the firm's

economic

spending).

discrimination. The to pay more for a product favored group, even if the

Cyclical unemployment.

of

willingness

produced quality extra

The

occurs during

by

consumers

members

of the

of a

product is

unemployment

that

of recession.

periods

D

Deadweight loss. The

in economic surplus that of a adoption policy. Decision tree (or game tree). A diagram that describes the possible moves in a game in sequence and lists the that correspond to each possiblecombination payoffs reduction

from

results

of moves.

(a nominal

Deflating nominal

quantity

express the

Deflation. and

A

quantity

situation

services

are

The of dividing a process by a price index (such as the CPI) to in real terms.

quantity).

in which falling

over

the prices of time so that

most inflation

goods is

negative.

curve. A schedule or graph showing the quantity of that buyers wish to buy at each price. Demand for money. The amount of wealth an individual or firm chooses to hold in the form of money. in planned Demand shocks. Changes spending that are not in caused or the inflation rate. by changes output Dependent variable. A variable in an equation whose value is in the determined variable by the value taken by another equation. Deposit insurance.A system under which the government that will not lose any money even guarantees depositors if their bank goes bankrupt. A decrease in the value of a currency relative to Depreciation. other currencies. severe or protracted recession. Depression. A particularly Demand

a good

and its

consumption spending

amount

principal

the

to take an action that is in the promise. A promise to keep. promiser's interest Credible threat. A threat to take an action that is in the threatener's interest to carry out. of demand. The percentage by which the Cross-price elasticity quantity demanded of the first good changes in response in the price of the second. to a 1 percentchange out. Government leads to Crowding borrowing that firms to cancel higher interest rates, causing private of planned investment projects (i.e., the tendency increased government deficits to reduce investment

wage

Consumer price index (CPI).For any period, a measure of the cost in that period of a standard basket of goods and servicesrelative to the cost of the same basket of goods and servicesin a fixed year, called the base year. Consumer surplus. The differencebetween a buyer's reservation for a product and the price actually price paid. Consumption expenditure (or consumption). Spending by households on goods and servicessuch as food, clothing, Consumption

the

is

a bond

of monetary

unaffected.

are complements

goods

interest.

original

the

rate times

when

are equal to of the bond.

Credible

the

reflects

positive\342\200\224that

the

costs.

working conditions.

the demand curve rightward shift). Compound

in the

difference

A

differential.

made to

payments

payments

coupon

Customer

or

rate\342\200\224negative

annual

the

publicbelieves

excludable.

but

interest

Regular

The interest rate promised

rate.

coupon

the

externalities.

or

be costly

fake.

payments.

issued;

in

otherwise

same

to

Coupon

activities that perform arrive at efficient always

problems caused by

degree,is nonrival

if

difficult

must

signal

bondholder.

to

right

cause externalities,they

make

to a potential rival, a

Credibility

Change in supply. A shift of the entire supply curve. Coase theorem. If at no cost peoplecan negotiate

information

communicate

credibly

Coupon

the

price.

principle. To

Costly-to-fake

supply.

aggregate

G-3

GLOSSARY

to capital.

returns

Diminishing amount

adds to

of capital

other

in

inputs

an additional

less

unit

production.

the

greater less each

the

of labor already employed, the additional worker adds to production. discourse. The theory that people who Disappearing political a position may remain silent because support speaking out would create a risk of being misunderstood. Discount rate (or primary credit rate). The interest rate that the Fed charges commercial banks to borrow reserves. Discountwindow The lending of reserves by the lending. Federal Reserve to commercialbanks. Discouragedworkers. People who say they would like to have a job but have not made an effort to find one in the past four weeks. Diversification. The practice of spreading one'swealth over a of different financial investments to reduce variety overallrisk.

A regular

each sharethat

the other

Dominated

players

Duration. The length

choose.

a game

in

strategy available to a

Earned-incometax credit (EITC).A income workers receivecredits tax. See

Economic

loss.

Economic

profit (or

under which lowpolicy on their federal income

(or shortage).The

profit

less than

zero.

costs.

implicit

rate

of a

gap. actual

when

A

normal.

is higher

output

gap, which

output

positive

than

occurs output

potential

Y*).

Government policy actions intended planned spending and output. value of a gamble. The sum of the possible Expected outcomes of the gamble multiplied by their respective probabilities. Expenditure line. A line showing the relationship between and output. planned aggregate expenditure costs. The actual payments a firm makes to its Explicit policies.

Expansionary

factors of production and External benefit (or positive received

other

suppliers.

other

by people

who

those

than

of an

benefit

A

externality).

pursue

activity.

cost

External

falls

that

(or negative externality). on people other than

A cost

of an

who

those

activity

the

pursue

activity.

cost or

An external

of an

benefit

activity.

payment for a factor of the owner's reservation price,the the owner would not the supply

part

which

below

quantity

price

of the

exceeds

that

production

price

above

significantly

Externality.

rent. That

the

when

below the equilibrium price. See Economicprofit. Excess (or surplus). The amount supply by which quantity demanded when the price of supplied exceeds quantity the exceeds the equilibrium price. good at a Expansion.A period in which the economy is growing

excess profit). The difference between a total revenue and the sum of its explicit and

firm's

by which

amount

supplied

quantity

good lies Excess profit.

the that is

demand

good.

exceeds

demanded

activity

Efficiency.

economic

An

player

spell.

unemployment

price and

and

supply

to increase

strategy.

of an

Economicefficiency.

matter

others.

The

quantity.

of the

all

in which by

Stock.

See

Excess demand

(Y>

payoff no

a higher

yields

other

Any

strategy.

has a dominant

Economic

curves for the

own.

they

strategy. One that

Dominant

who

quantity

for

by stockholders

received

payment

within

price and equilibrium at the intersection

Equilibrium

Expansionary

Dividend.

economic enterprises. that describes the expression or more variables.

or unchanging situation a system are canceled

A balanced

forces at work

Equity.

two

between

relationship Equilibrium.

over another.

create new

mathematical

A

an

by

preference

arbitrary

of workers

who

People

Entrepreneurs. Equation.

quantity

what

employer for one group

and

of capital

An

discrimination.

Employer

the

the greater

then

to labor. If the amount use is held constant, then

returns

Diminishing

of labor and

amount

the

If

is held constant, inputs employed of capital already in use, the

other

factor.

Economic surplus. The

of taking

benefit

an action

minus

The

Economics. conditions

of

study

of scarcity

how

make choices under of those choices

people

and of the

results

for society.

Economiesof

returns to scale. A condition that occurs when all goods and services are produced and consumed at their respective socially optimal levels. if no Efficient (or Pareto efficient). A situation is efficient chang e is possible that will help some people without (or

Efficiency

Efficient

See Increasing

scale.

economic

efficiency).

others.

harming

point.

currently

production.An goodor service.

production

its price

of

combination

Any

resources

available of the

Elastic. The demand

Fair

financial

Federal

do

not

one good without

goods allow

for

which

in in the

an increase

a reduction

other.

a good is elastic with respect elasticity of demand is greater than

to price

for

1.

federal

in the production

of a banks

very short-term (usually overnight) Fed frequently sets its policy in terms this rate is closely watched in rate,

for

funds

markets.

Open

committee

used

whose expectedvalue is zero. rate. The interest rate that commercial

charge eachother loans; becausethe of the

input

A gamble

gamble.

Federal funds

Market Committee (or FOMC).The makes decisions concerning monetary

that

policy.

Federal

the production of

if

Factor of

cost.

its

Reserve System

United

Final goods

(or the

Fed).

The central

bank of

the

States.

or services.Goodsor services

consumed

by the

ultimate user; becausethey are the end products of the of GDP. production process, they are counted as part Financial intermediaries. Firms that extend credit to borrowers using funds raised from savers.

G-4

GLOSSARY

insurance

First-dollar

Insurance

coverage.

expenses generated

insured

the

by

that

all

pays

Fiscal policy. Decisions about how much the government and how much tax revenue it collects. spends Fisher effect. The tendency for nominal interest rates be high when inflation is high and low when inflation

says

stockof

payments made to

of all

factors of production.

Fixed exchange rate. An

to

An

input

whose

be alteredin the short run. Flexible exchange rate. An exchange demand

and

cannot

quantity

The

by

practice

who

all buyers

to

obstacle.

some

A

extremely

the inflation rate is

which

in

situation

high.

whose

rate

jobs. See

output.

i

competitive

Imperfectly

market. Flow. A measure that is defined per unit of time. on which currencies of Foreign exchange market. Themarket various nations are traded for one another. in Fractional-reserve banking system. A banking system which bank reserves are lessthan so that the deposits reserve-depositratio is less than 100 percent. An incentive Free-riderproblem. problem in which too little of a good or service is produced because nonpayers cannot be excluded from using it. Frictional The short-term unemployment unemployment. associated with the process of matching workers with Full-employment

capital.

set by

value is fixed but varies according to the supply for the currency in the foreign exchange

officially

overcome

fixed

firm's

whose value is

rate

exchange

the

proportional

policy.

government

Fixed factor of production. not

human

be

will

determination that to his or her

of pay

theory

method of price discrimination. which a seller offers a discount

Hyperinflation.

The sum

official

capital theory. A a worker's wage

Hurdle

is low.

Fixed cost.

Human

activity.

Potential

output,

Y*.

has at

firm (or

least some control

price setter). A

firm

that

price of

market

the

over

its

product.

Implicit

The

costs.

supplied by Income effect.

goodthat

the

the

resources

owners.

The change

results

of

costs

opportunity

firm's

the

in

because

demanded of a the price of a good

quantity

a change in

changes the Income elasticity

buyer's purchasing power. of demand. The percentage a by which to a good's quantity demanded changes in response 1 percent change in income. The effect of a Income-expenditure multiplier (or multiplier). one-unit increase in autonomous on shortexpenditure run

output.

equilibrium

A returns to scale (or economies of scale). is said to have returns to production process increasing scale if, when all inputs are changed by a given proportion,output changes by more than that proportion. variable. A variable in an equation whose value Independent determines the value taken by another variable in the Increasing

equation.

G

Gametree. SeeDecision

tree.

budget deficit. The excessof government over tax collections (G \342\200\224 T). spending Government budget surplus. The excessof government \342\200\224 collections over government (T G); the spending

period by

Government

government

surplus

budget

tax

for which by the government in return or services are received, nor do they goods interest paid on the government debt. made

current

include

Gross domestic product goods and services

(GDP).

value of the

The market

produced in

final

during a given

a country

period.

H Head tax. A

tax

collects the

that

same amount

from

every

taxpayer.

Health maintenance physicians

families

that

(HMO).

organization

provides

for a fixed

health annual

A group

services to

individuals

of and

fee.

such as education, capital. An amalgam of factors work habits, training, experience, intelligence, energy, and initiative that affects the value of a trustworthiness,

Human

worker's marginal

product.

equal to

a nominal the

price index.Indexing the

nominal

quantity

quantity

prevents

each

increase

percentage

in

the purchasing

from being

eroded

by

inflation.

The portion of planned expenditure. aggregate that Y. expenditure depends on output Inefficient of goods for which point. Any combination available resources enable an increase in the currently Induced

equals public saving.

Purchasesby federal, state, and local of final and services; government governments goods purchases do not include transfer payments, which are no

power of

amount

an

a specified

Government purchases.

payments

The practice of increasing

Indexing.

of

production

production

one good without of the other.

a reduction

in

the

Inelastic. The demand

for a good is inelastic with to respect 1. price if its price elasticity of demand is lessthan Inferior curve shifts leftward good. A good whose demand when the incomes of buyers increase and rightward when the incomes of buyers decrease. Inflation dove. Someone who is not strongly committed to and maintaining low inflation. achieving Inflation hawk. Someone who is committed to achieving and low inflation, evenat someshort-run cost in maintaining reduced output and employment. bonds. Bonds that pay a nominal interest Inflation-protected

year equal to a fixed real rate plus the actual that year. during Inflation shock. A sudden change in the normal behavior of unrelated to the nation's output inflation, gap. In-kind transfer. A payment made not in the form of cash but in the form of a good or service. rate

each

rate of

inflation

G-5

GLOSSARY

Inside lag (of macroeconomicpolicy). The the date a policy change is needed and

implemented. Intermediate

goods

assets across

financial

Spending

primarily

capital

Invisible hand

theory.

theory that

Smith's

Adam

self-interested

buyers

before-tax

will

of resources.

Marginal

additional

Labor union. the

Law of

of workers

A group

do

of doing it

for any

additional

gained from consuming an

utility

of a good to diminish beyond some point.

unit

Law of diminishing

the

as

of

price

of an

of

the

tends

information

Liabilities. The debts

factor.

A firm's

must

commodity

to reduce

the

average

as

such

checking

M2. All the

all

the

variable.

are

in which output

the AD and

AS

Y*.

outstanding

and

balances

held

in

accounts.

assets in

state

between

and the

plus

some additional

assets that

are

in making payments but at greater cost or inconvenience than currency or checks. Macroeconomics. The study of the performance of national economies and the policies that use to try governments to improve that performance. in total benefit that Marginal benefit. The increase results from out one additional unit of an carrying

the

of the asset

interest rate. raise the price of a the

good

principal

of a bond

prices.

changing

of individual for

economy. can be

that

A

the

under

choice

and

of prices

behavior

used in that

curve

making

purchases.

shows the

relationship

the aggregate quantity of money demanded M nominal interest rate /\"; because an increase in the rate

interest

increases

the

opportunity

cost

of

holding money, quantity of money demanded, the money demand curve slopes down. An industry structure in which a Monopolistic competition. number of firms produce slightly differentiated large productsthat are reasonably close substitutes for one another. Moral hazard. The tendency of people to expend less effort those goods that are insured theft or protecting against damage. which

See

reduces

the

multiplier. that sells shares in intermediary itself to the public, then uses the funds raised to buy a wide variety of financial assets.

Multiplier.

Ml

market.

markets. Determination of the nation's money supply. rule. A rule that describes how a central Fed, takes action in response to changes in

Money demand curve.

Mutual

usable

activity.

policy

nominal

length that

sufficient

M currency

policy.

Money. Any

meet

supplied

currency

in individual

bank, like

of

quality

of

The study its implications

quantities

the

another's legislative proposals. of Long run. A period of time firm's factors of production Long-run equilibrium. A situation curves intersect at potential

The sum of

and

the

whose benefit level declines additional income. asset used in purchasing goods and

An

The costs

Monetary

Life-cycle saving. Saving long-term objectives of a home. retirement, college attendance, or the purchase one Logrolling. The practice whereby legislators support to

recipient

Monetary of how

explanation

owes.

one

scarcity

at

program

earns

services.

small,

the

exchange to

ability

A benefit

costs.

of

and

buyers

The exchange

rate.

exchange

sales. date at which

Medium of exchange. Menu

of the

all

quantities

respective

foreign

be repaid.

as the

their

See Nominal

The

date.

Maturation

or

buyers

all its

losing

Microeconomics.

are relatively

costs

sale.

goods offered for

eventually

good

variable

the

internationally traded

be the same in all locations. Lemons model. George Akerlof's asymmetric

rate.

power.

Means-tested.

relationship

of a good or service produced and amount of a variable factor required to produceit; law says that when some factors of production are

the

in

Market

without

increases

the

equates

when

a market

in

the quantities

Market interest

will

fixed, increased production requires ever-largerincreasesin Law of one price. If transportation the

that

and demanded

additional

consumption

A property

returns.

the

rate

the amount

between

the

The tendency for

utility.

price.

Market equilibrium value

collectively

bargain

rises.

marginal

diminishing

who

wages and working conditions. less of what they want to do as

better

for

demand. People cost

market

good. good consists of all

good.

Occurs equilibrium. sellers are satisfied with

unemployed

economy.

with employers

Law of

and

utility gained from

unit of a

market that

dollar.

one

by

Market

number of employed

The total

force.

people in the

Ml.

rises

The

additional

sellers of

L

income

utility.

an consuming

Market. The Labor

a

Marginal propensity to consume (mpc). The amount by which consumption rises when income rises disposable < 1. by $1; we assume that 0 < mpc in revenue. The a firm's total revenue that Marginal change results from a one-unit change in output. tax rate. The amount taxes rise when Marginal by which

actions

the

sellers

and

most efficient allocation

in the

result

goods and services,

on final

goods.

of independent,

often

borders.

international

firms

by

product of labor (MP). The additional output firm gets by employing one additional unit of labor.

in

the production of final goods and services and therefore not counted as part of GDP. International flows. Purchases or sales of real and capital Investment.

total cost that results from unit of an activity.

in

one additional

out

carrying

Marginal

servicesusedup

Goods or

or services.

it is

date

the

The increase

Marginal cost.

between

delay

fund.

Income-expenditure

A financial

N

Nash

equilibrium. the

Any

combination

each player's choice other players' choices.

which

is his

of strategy or her

choices

best choice,

given

in

G-6

GLOSSARY

National

Natural

of the

The saving

saving.

GDP less consumption purchases of goodsand

or Y

services,

A monopoly

monopoly.

economy, equal to and government

entire

expenditures

\342\200\224 \342\200\224

results

that

C

G.

from

economies

of scale (increasing returns to scale). Natural rate of unemployment, u*. The part of the total rate that is attributable to frictional and unemployment structural unemployment; equivalently, the unemployment rate that prevails when cyclical unemployment is a recessionary nor an zero, so the economy has neither

would

government

Net

Net exports.

See External (NIT). A

by

cost.

under which the each every citizen a cash payment additional tax on earned income.

grant

year, financed inflows. capital

Nominal

gap.

output

expansionary

Negative externality. income tax Negative

an

minus

minus

outflows.

capital

(See also

imports.

The rate at

rate.

exchange

Trade balance.) can

currencies

two

which

asset.

price. The absolute quantity. A quantity current dollar value.

price of a goodin

Nominal

Nonexcludable good.

excludenonpayers

Nonrival good. A does not diminish

dollar

terms.

in terms of

is measured

that

its

of buyers

incomes

difficult, or costly, to

cost

of the

firm's owners, equal to economic profit; Normal profit

by

minus

the

resources

economic

should behave.

One

principle.

that

profit

accounting

=

- Economicprofit.

profit Normative

says

Accounting how

people

o law.

Okun's

unemployment

increase

potential

Oligopoly. An perfect

100

extra percentage point of cyclical with about a 2 percentagepoint in the output gap, measured in relation to

Each

output. industry

structure

reserve banking.

in which a small number that are either close or

A

situation

in which

reservesequal 100percent of their deposits. Open-market operations. Open-marketpurchases

of

banks'

from

the

the

supply

public

of

purchase

Fed for the bank reserves and the by the

open-

of government purpose money

bonds

of increasing supply.

sale. The saleby the Fed of government bonds to the public for the purpose of reducing bank reserves and the money supply.

Open-market

actual

economy's

output at a point

potential

in

time,

policy). The delay between implemented and the date by which most of its effects on the economy have occurred. Outsourcing.A term increasingly used to connote having services performed by low-wage workers overseas. date

the

p Constant.

See

See Efficient.

Pareto efficient.

The percentage

rate.

Participation in

population

the labor

force

(that

or looking

either

employed A matrix.

of the

working-age

is, the

percentage

that is

for work).

in a game table that describes the payoffs for each possiblecombination of strategies. Peak. The beginning of a recession; the high point of economic activity to a downturn. prior A threshold Perfect hurdle. that completely segregatesbuyers whose reservation prices lie above it from others whose reservation prices lie below it, imposing no cost on those Payoff

jump

the hurdle.

Perfectly competitive of the

market.

has significant

market

A

in which

influence on

the

no market

price

product.

A firm that charges each her reservation price. elastic demand. Demand is perfectly elastic with Perfectly to price if price elasticity of demand is infinite. respect elastic is elastic with respect Perfectly supply. Supply perfectly to price if elasticity of supply is infinite. inelastic demand. Demand is perfectly inelastic with Perfectly respect to price if price elasticity of demand is zero. inelastic inelastic with Perfectly supply. Supply is perfectly is zero. respect to price if elasticity Personal Responsibility Act. The 1996 federal law that transferred responsibility for welfare programs from the federal level to the state leveland placeda five-year lifetime limit on payment of AFDC benefits to any given monopolist.

discriminating

Perfectly

his or

exactly

buyer

recipient.

Planned

aggregate

Pork

(PAE).

expenditure

Total

planned

goods and services. A public expenditure barrel that is larger than spending. the total benefit it creates but that is favored by a legislatorbecause his or her constituents benefit from the more than their share of the expenditure by resulting extra

and

market sales.

Open-market purchase.The

the

between

combination

Y5:-)/Y^.

final

on spending

substitutes.

percent

to

lag (of macroeconomic a policy change is

Outside

is associated

firms produce products

large

(Y-

individual supplier

decrease.

Normal profit. The opportunity supplied

its

and

output

whose

good

The difference

Output gap.

who

that is good from consuming.

A

one person consumption by its availability for others. Normal good. A good whose demand curve shifts rightward when the incomes of buyers increase and leftward when the

Optimal combination of goods. The affordable that yields the highest total utility.

Parameter.

be traded for each other. A measure of GDP in which Nominal GDP. the quantities produced are valued at current-year prices; nominal GDP measures the current dollar value of production. Nominal interest rate (or market interest The annual rate). in increase the nominal value of a financial percentage Nominal

be forgone

must

what

activity.

system

Capital inflows

Exports

an

undertake

of

The value

cost.

Opportunity

taxes.

Portfolio allocation decision. The decision about the forms in which to hold one's wealth. in which Positional arms control agreement. An agreement contestants attempt to limit mutually offsetting investments

in performance

Positional arms investments in

race. A

enhancement. of mutually offsetting enhancement that is stimulated

series

performance a positional externality.

by

G-7

GLOSSARY

externality. This occurs when person's performancereducesthe

Positional

another's

relative

performance.

principle. One

economic

Positive

reward

reward depends on

in which

situations

in

in one of

increase

an

expected

that

how

predicts

people

behave.

will

externality. See External output, Y* (or potential

Positive Potential

output). The

an

The

threshold. federal

can produce.

income belowwhich a family as poor.

level of

for

Saving

saving.

loss of a

the

no

or a medical

job

emergency.

Price ceiling. A

allowable

maximum

different prices

Price elasticity

for

of a good or service

a 1 percent change in

supplied price.

Price index.

of the

measure

A

from

results

change in quantity

average price of a given

such as the CPI. setter. See Imperfectly competitive Price taker. A firm that has no influence which it sells its product. credit rate. See Discount rate. Primary Price

The amount

amount.

Prisoner's dilemma. dominant payoffs

each

and when

than

smaller

are

the

saving.

The saving of to the after-tax

economy is

equal

minus

consumption

saving

business

and

reservation

seller's

had

the

has

sector of the

of the private sector

price exceeds

which

by

curve. A

in producing

the

graph

of one

it.

Profit-maximizing

maximize the

firm.

firm

A

whose

between

difference

primary goal is to its total revenues and

costs.

total

firm. A

Profitable

firm

total

whose

revenue exceeds

its

total

cost.

Progressive in

taxes

tax. One in which the proportion rises as income rises.

Proportional income tax. the

same

proportion

One

of

their

under

which

incomes

of income paid all taxpayers

in taxes.

X

times velocity

equals

nominal

Y

The

inflation.

price level, as

goodsso that

highly.

resulting played a dominated

private

Money

= P

annual percentage rate of change in measured, for example,by the CPI. Rational person. Someonewith well-defined goals who tries to fulfill those goals as best he or she can. Rational rule. Spending should be allocatedacross spending the

a

it, the

income

amount

M X V

the

pay

marginal

utility per dollar is

the

same

good.

function

scarce goods to

that describes the that can be produced for good of the other good. every possible level of production Profit. The total revenue a firm receives from the sale of its all costs\342\200\224explicit and implicit\342\200\224incurred product minus

maximum amount

and nonexcludable.

R

Rate of

Rationing

price.

Production possibilities

nonrival

equation. GDP:

lent.

saving.

Producer surplus. The

can easily be

for which

Q Quantity

price at

\342\200\224 T \342\200\224 (Y C); private expenditures broken down into household

saving can be further

both

for each

each player

plays

each

if

over

strategy.

Private

and

of

class

firm.

originally

in which

A game

strategy,

for which nonpayers

One

each unit consumed by one person means one less unit available for others. Pure public good. A good or servicethat, to a high degree, is

in

to the price of the same goods or servicesrelative goods or services in a base year. Price level. A measure of the overall level of prices at a particular point in time as measuredby a price index

Principal

substitutes. good.

excluded

buyers

to a 1 percentchange

in response

occurs

that

that

its price. The percentage

of supply.

Price elasticity

close

private

good or service. The percentage change in the

demand.

of

law.

by

different

good

the same

essentially

demanded

quantity

price, specified

The practice of charging

Price discrimination.

A

nonrival

is both

Pure

against

protection

as the

such

setbacks

unexpected

economy

classifies

government

Precautionary

or full-employment amount of output

GDP sustainable

maximum

(real GDP)that Poverty

benefit.

or service that, to at least somedegree, and nonexcludable. Public The saving of the government sector is equal to saving. net tax payments minus government purchases (T \342\200\224 G). that nominal Purchasing power parity (PPP). The theory as necessary for the law of exchange rates are determined one price to hold. Pure commons One for which nonpayers cannot good. easily be excluded and for which each unit consumed by one for others. person means one less unit available Pure monopoly. The only supplier of a unique product with

Public good.

of price.

Changes

in

those consumers who

prices value

distribute them

most

rate. The price of the average domestic exchange good or service relative to the price of the average foreign in terms or service, when prices are expressed of a good common currency. Real GDP.A measure of GDP in which the quantities produced are valued at the prices in a base year rather than at current prices; real GDP measuresthe actual physical volume of production. Real interest rate. The annual percentage increase in the of a financial asset; the real interest rate purchasing power on any asset equals the nominal interest rate on that asset minus the inflation rate. Real price. The dollar price of a good relative to the average dollar price of all other goods. Real quantity. A quantity that is measured in physical in terms of quantities terms\342\200\224for example, of goods and services. Real wage. The wage paid to workers measured in terms of purchasing power; the real wage for any given period is calculated by dividing the nominal (dollar) wage by the CPI for that period. A period in which the economy Recession(or contraction). is below normal. growing at a rate significantly Recessionary gap. A negative output gap, which occurs when exceeds actual output (Y < Y*). potential output Real

G-8

GLOSSARY

paid in Relative

The

price. comparison

to the The

to win

firms

which

under

the proportion

A standard

prisoner's

players repeatedly. Reserverequirements. Set by the Fed, the minimum values of the ratio of bank reserves to bank deposits that commercial banks are allowed to maintain. ratio. Bank reserves divided by deposits. Reserve-deposit Rise. See Slope. Risk The rate of return that financial investors require premium. to hold risky assets minus the rate of return on safe assets. Risk-averse Someone who would refuse person. any fair gamble. Risk-neutral person. Someonewho would accept any gamble that is fair or better. See

Run.

Two

Substitutes.

is

economy

if an are substitutes in consumption of one causes a rightward shift in the the other (or if a decrease causes a

goods

shift).

effect. The change

Substitution

a good that

because

results

A graph

curve.

good

of

demanded

quantity

or from

changes.

good

recovery at

a

moment

the

or schedule showing the quantity to sell at each price. policy that affects potential output.

of a

wish

sellers

that

the

in

buyers switch to

substitutes when the price of the Sunk cost. A cost that is beyond decision must be made. Supply

the

rate.

increase in the price demand curve for leftward

even when

exists

that

a normal

at producing

dilemma

the same

confronts

The long-term and chronic

unemployment.

unemployment

a prize.

Repeated prisoner's dilemma. that

Structural

as income

declines

taxes

Rent-seeking.

of income rises. price of a specificgoodor service in prices of other goods and services. efforts of peopleor socially unproductive

A tax

tax.

Regressive

A

Supply-side

policy.

Surplus.

See Excess

supply.

Slope. T for the repeated prisoner's dilemma in cooperate on the first move, then mimic their last move on each successive move. partner's cost. The sum of all payments made to the firm's fixed

A

Tit-for-tat.

s

which

Current income minus spending on current needs. rate. divided income. Saving Saving by Self-correcting property. The fact that output gaps will not last inflation. indefinitely, but will be closed by rising or falling Seller's reservation for price. The smallest dollar amount which a seller would be willing to sell an additional unit, generally equal to marginal cost. Seller'ssurplus. The difference between the price receivedby the seller and his or her reservation price. Short run. A period of time short that at least sufficiently someof the firm's factors of production are fixed. Short-run equilibrium. A situation where the AD and AS curves intersect at a level of real GDP that is above or Saving.

Total

Total

Total

output.

equilibrium

at

in

the

which

demand. Shortage. SeeExcess

that

technological change. Technological change affects the marginal products of higher-skilled

workers

workers.

Slope.In

differently

a straight

from

of lower-skilled

those

line, the ratio

they

travels

between

of the

vertical

any two

distance

its

When

reservation

buyer's

exports

in a given When

between the its imports Tragedy of the has

a given

period. The

its

to zero.

Transfer payments.

Payments

for which it

for a resource that

tendency

used until

to be

value of

imports, the difference exports and the value of

exceed

of a country's

commons.

no price

imports

country's

difference

the

and the

period.

exports

value in

exceed exports,

imports

the value of a

Trade surplus.

benefit

marginal

makes to

the government

receives no

current

falls the

or services

goods

in return.

Trough. The end

the low

a recession;

of

of

point

economic

activity prior to a recovery.

u Unattainable

Any

point.

be produced

Unemployment

continuously

Unit elastic. Unit

of account.

during

of

cannot

resources.

available

unemployed

which an

individual

people is

unemployed.

The demand

to price if

of goods that

combination

using currently rate. The number

divided by the labor force. Unemployment spell. A period

belong.

Stock. A measure that is defined at a point in time. A claim to partial ownership Stock (or equity). of a firm. Store of value. An asset that serves as a meansof holding wealth.

the

(quarter or year).

Trade deficit.

the to the

to

and the seller's reservation price. Trade balance (or net exports). The value of a country's exports lessthe value of its imports in a particular period

public

(rise) straight points distance (run). corresponding horizontal The quantity of a good that results Socially optimal quantity. in the maximum possible economic from surplus and consuming the good. producing Stabilization Government policies. policies that are used to affect planned aggregate expenditure, with the objective of eliminating output gaps. Statistical discrimination. The of making practice judgments about the quality of people, goods, or services based on the characteristics of the groups to which line

expenditure. between the

difference

that

amount

is equal

price

which

PAE;

Total

See The

surplus.

between

The level of output output Y equals planned aggregate expenditure level of output that prevails during the period are prices predetermined.

Skill-biased

and variable factors of production. = Total revenue. The dollar expenditure consumers spend on a product (P X Q) dollar amount that sellers receive.

Totalrevenue.

belowpotential.

Short-run

strategy

players

its price

for a good is unit elastic with respect elasticity of demand equals 1.

A basic

measure of economic

value.

G-9

GLOSSARY

V

Vertical For any firm, the market value minus the cost of inputs purchased

added.

Value

service

of marginal

Value

of

product

additional

the

of labor

unit of labor. that is free to quantity

from The

(VMP).

a firm

output

of its

gets

product or other firms.

dollar

A

of all payments variable factors of production. of production. altered in the short run. factor

Variable

be Velocity.

A

measure

of the

hands in transactions

or,

equivalently,

money.

The

Wealth.

Numerically,

X Y

whose

quantity

(P

which

final

GDP GDP,

to the

firm's

affect households'

can

X

and

measured.

liabilities.

changesin

asset to prices their consumption

thus

and

wealth

money

goods

divided

by the

M, where V M is the money

Y) /

changes

and services,

stock of supply

human

capital

in

Worker mobility. firms,

and

The

movement

large

of workers

differences

between jobs,

industries.

compensation. that provides benefits

job.

small

which into

in pay.

Workers'

is

in

One translate

market.

labor

Winner-take-all differences

involving

V =

made

of assets minus The tendency of

value

effect.

spending.

input

speed at

nominal

is nominal whose velocity is being P velocity,

An

the

equals

zero.

Wealth

cost. The sum

by

w

take a range of different

values.

Variable

variable

independent

one

additional Variable.

taken

value

the

line,

value

employing

by

intercept. In a straight variable when the

dependent

A

government

to workers

insurance

who are

injured

system on

the

#

PH

5: Ian Langsdon/EPA/ McGraw-Hill Companies,Inc./Barry Barker, 35: Kirk Weddle/Photodisc/GettyImages; photographer; 36 top:\302\251 of Robert Frank; 36 bottom: Courtesy Courtesy of Joe Jamail; 40: Bettmann/Corbis; 55: Courtesy of MacNeil/ Lehrer Productions; 61: ChinaFotoPress/Getty Images; 62 top: age fotostock/SuperStock; 62 bottom: JosephSohm/ Visions of America/Corbis; 64: Reunion des Musees Nationaux/Art Estate of Pablo Picasso/ Resource, NY. \302\251 Artists 65: Francis G. Mayer/ Rights Society (ARS), New York; Corbis.\302\251 Pollock-Krasner Foundation/Artists Rights Society New York; 97: Atamu Rahi/Iconotec.com;125:Ingram (ARS), Stock; 128: Photo courtesy the Waisman Publishing/Super Brain Imaging Lab, UW-Madison;138: Steve KRT/ Ringman 169: T. O'Keefe/ Newscom; 151: Robert Glusic/Getty Images; PhotoLink/Getty Images;179:David Zalubowski/AP Images; 215: Richard B. Levine/Newscom;251: Spencer Grant/ 279: Image Source/Getty Images; 300: Fabian PhotoEdit; Page

Landov;

C-0

3: Nick

Dolding/cultura/Corbis;

10: The

OTO

CREDITS

324: Paul Images; 307: Reed Saxon/AP Images; 333: Dan Buck/AFP/Getty Images; 326:AFP/Getty Images; Forer/Beateworks/Corbis; 334 left: AP Images; 334 right: Suzanne Vlamis/AP 342: John Duricka/AP Images; Images; 345: Peter Kramer/Getty Images; 354: David Young-Wolff/ 361: Image Source/Veer; 381: \302\251 2011 PhotoEdit; Getty Images; 387: VisionsofAmerica/JoeSohm/Getty Images; 415: Michael Ventura/PhotoEdit; 433: Bettmann/Corbis; 439: Photodisc/Getty Images; 467: Rob Crandall/The Image 501: Martin Works; Ruegner/Photodisc/Getty Images; 509: CourtesyEverett 531: Dave Bradley Collection; 561: Digital Vision/Getty Images; Photography/Getty Images; 572: Katherine 593: Ingram Publishing; Karnow/Corbis; 613: Werner Dieterich/Getty Images; 649: Jonathan Larsen/ 667: Cor bis RF; 681: Phillip Photolibrary; Spears/Getty 731: Maria Toutoudaki/ Images; 707: Ingram Publishing; 741: Getty Images; Stockbye/Punchstock. Bimmer/AP

D

N

Pagenumbers

by n

followed

and conspicuous consumption,

Ability,

Absolute

refer to

320-321

advantage

versus comparative advantage,

36

definition, 36

Absolute

dollar amounts, 8-9

Abstract

models,

7

notes. demand

curve diagram, 682-683 business cycle from shift in, 696-697 683 definition,

Anchored inflationary Antitrust laws harm from, 242

and

policy rule, 684-685 for downward slope, 684-685

242-243 vigorous enforcement, Apple Inc., 220, 516 Macintosh, 78, 156 Apple

Aggregate in AD-AS

shift factors demand

711 long-run implications, short-run implications, 711 Accounting profit, 182-183 compared to economic profit, 181 definition, 180 Acid rain, 400 Active learning, 16 Actual spending vs. planned spending, 617-618 101 Walter, AD-AS diagram, 682-683 Ad copy writers, 342 Adverse selection

Adams,

definition, 323 in private health insurance, 367 Advertising ad copy writers, 342 and brand switching, 261 of cigarettes illegal, 261-262 effect on demand curve, 261 TV vs. print media, 319-320 Advertising game, 252-255 531 Affordable Care Aesop,

Act of 2010,368 war, 540, 554, 634-635

Afghanistan AIDS epidemic, 502 Africa, demand Aggregate

of military spending on, 634-635 money, 668-669 demand - aggregate supply model Aggregate

impact for

aggregate aggregate

curve, 683-688 supply curve, 688-696 demand

of stabilization policy with demand shocks, 708-709

analysis

with

shocks, 709-714 for both long and short run, 682-683 Fed's response to recession of 2001, 709 683 long-run equilibrium, 682-683 overview,

and and

inflation

725

uncertainty, economy, 700-702 expansionary gap, 701 recessionary gap, 701-702 short-run 683 equilibrium, and stabilization policies, 702 to understand business cycle, 682 Great Recession, 698-700 analyzing policy

self-correcting

demand inflation steps,

shocks, 696-697 shocks, 697-698 698

734-735 in 1980s, 743 U.S. dollar 1980-1985, 750 Arbitrary wage gaps, 343 Arbitration agreements, 299 Appreciation,

of

policies, spending

Aggregate

710

definition,

685-687 687-688

shocks,

stabilization

alternative to, 711

of decline in,

effect

614

635-637 Aggregate supply curve in AD-AS diagram, 682-683 business cycle from shift in, 697-698 and changes, 693-695 in inflation, 694 in inflation 695 expectations, in resources and technology, 694 and

recessions,

688 of inflation shock,

reasons

for

graphical

Aristotle, 64 line production, 509 664-665 Asset prices, and Fed policy, 664-665 Assembly

Asset

of

costly-to-fake

322 elite educational credentials, well-dressed lawyers, 321 316 example,

examples,

227 123-124

midpoint formula, of multiplier, 648 profit maximization, 249-250 simultaneous equations, 32 and demand, 93-94 supply Allocative function of price, 184 and free entry and exit, 190-191 Amazon.com, 312, 697 Ambrose, Stephen E., 502, 514 American Airlines, 252-255, 268 American Cancer Society, 342 American Recovery and Reinvestment Act of

Analyze

Society

of

Plastic Surgeons,

prices, 307-308

over

model 316-318

moral hazard, 323-324 nature of, 315-316 statistical discrimination, Atari, 516

curve,

Online, 697 steroids, 297-298 This (film), 251, 265

320

definition, 316

525 George A., 316-317, 718n Alberto, 722n

Algebra

Anabolic

insurance,

haggling

Mexico City, 524-525 and Real GDP per person,

American

principle, 319-320 318-319 problem in trading, naturalist

auto

lemons

2009,638

as signal of ability,

320-321

economic

349

pollution

revenue

consumption

conspicuous

definition, 316

costs of advertising, 252-255 price discrimination, 239 of, 190-191 regulation

America

532

Asymmetric information adverse selection, 323

credibility

industry

marginal

576

banks,

definition,

supply shocks, 709-714 Aggregating by market values, 416-417 AIDS epidemic in Africa, 502 Aid to Families with Dependent Children,

Alesina,

bubbles,

Assets

710

upward slope analysis, 693

Aggregate

Akerlof,

736

board, 670 U.S. dollars circulating in., 670

690-691 expectations, inflation inertia, 689-690 long-term wage and price contracts, 691-692 692 output gaps and inflation, to show changes in rate of inflation, 688-689

Air

fixed exchange rate,

abandons currency

inflation

Airline

dollar

Argentina

definition, effect

712

expectations,

230-231

limitations,

monetary

reasons

policy

Accommodating

EX

301

ATMs,667 Braille

dots on,

321-323

18-19

AT&T,217,241 Attainable

point

definition, 43 illustration,

44

Auctions, 402-404 on eBay, 309-310 of pollution permits, 371-372 Automatic stabilizers, 639-640 Automobile industry car prices, 116-117 effect of gas prices on purchases, 138-139 heaters vs. satellite navigation, 18 as

oligopoly, 217 discrimination,

price

production

changes

238 over time, 482

1-2

INDEX

Automobile

industry\342\200\224Cont.

size of car engines, sports car market,

Automobile

check

139 263-265 for under-25 drivers,

insurance

322, 323 Autonomous

619

consumption, expenditure

Autonomous

definition, 622 effect of decline in, 628 effect of real interest rate on, 658 659 monetary policy to increase, and multiplier, 648 and recessionary gaps, 629 definition, 12 versus

benefit,

marginal cost

Average

13-14

definition, 12 and

of

economies

versus

scale,

221-222

cost, 12,13-14

marginal

labor productivity increase in, 502 506 definition,

Average

continuing

determinants, 508-519 515-517 509-511

entrepreneurship,

human capital, land and natural resources, 513 management,

physical political

capital, and

technology,

515-517 511-513

legal environment, 514-515

517-519

national growth comparisons 1990, 513 output per person, 507 role in economic growth, 506-508 in U.S. 1960-2009,508 vs. Bangladesh, 508 U.S. vs. Indonesia, 508 U.S.

Average tax rate, 720-723 total cost Average 161 definition,

162

example, and

cost curve,

maximum Robert,

Axelrod,

162-163 164-165

profit condition,

260

B

Babcock,L.,338n Babe Ruth baseball Balanced Balance

budget, sheet

card, 309-310

539

constructing, 532-533 definition,

532

Banifoot, Kosten, 12 Banking panics definition, 652 and deposit insurance, 654 in 1907, 652 between 1930 and 1933, 652-653 and origin of Fed, 651-562

reasonsfor,

Banking

652

system

access to credit, 564 576 assets, bank reserves, 576

in Japan in 1990s, 564 ease of payments, 563 as financial intermediaries, 562-566

Benefits of

281

actions,

fractional-reserve

to costs, 6 in proportion, 8-9 measured 10-11 relevant, Bennett, Danny, 251

help

Bennett,

crisis

compared

system, 576-578 with investment projects, 563

576 money creation by, 575-578 100 percent reserve banking, 576 reduced information gathering costs, 564 ratio, 576-578 reserve-deposit Bank of Canada, 716 Bank of England, 716 Bank of Israel, 716 Bank reserves, 576 and banking panics, 652 increased by open-market purchase, 581 interest paid on, 674-675 and money supply, 652-653 reduced by open-market sale, 581 of savings and loan Bankruptcy associations, 654 Barnes & Noble, 311-312 Barriers to entry definition and causes, 190 for monopolistic competition, 216 lacking Barriers to exit, 191 in monopolistic competition, 216 Barter

251, 252,

Tony,

Jeremy,

Bentham,

Bequest

263, 265

128-129

saving

542 in Japan, 543 Bernanke, Ben S., 603n, 707, 714n, 717n Better-than-fair gamble, 314 definition,

Bidding

402-403

in auctions,

phone companies, 403-404 Birkhaman, 35, 39 Blanchard, Olivier, 714n, 723n BMW, 18,126,140,321 Board of Governors, 651 564 Bondholders, by cell

selling in Bond

allocation informational

risk Bond

market, 565 565 of savings, 569-571 role, 569 and diversification, 569-571

bond

market,

sharing

prices

definition, 565 to interest

relation

rates,

565-566,

671

Bonds

definition, inefficiency

572

coupon

of, 572

coupon

Base

year for CPI, 441, 449 for GDP, 427 basket, 441 Base-year Basic elements of a game,

purchases

564

high-yield,

565

mutual

252-253

date, 564 565

and

planned

for, 571 amount, 564

funds

principal

shortvs. long-term, 565 tax treatment, 565 term of, 565 Bonds,

spending,

633-635

Book

Barry, 439, 440, 446 stores, 311-312

Boom

of 2007-2009, 638 and aggregate spending, taxes, transfers 635-638 fiscal policy as stabilization tool of budget deficits, 639 problem relative inflexibility, 639-640 recession

supply-side of economy, 639 policy role, 614 focus on short run, 702 615-616, 689 key assumption, 631-632, 647-648 multiplier, planned aggregate expenditures versus actual spending, 617-618 of, 616-617 components consumer spending, 618-621 and output, 621-623 planned spending and output gaps, 627-632 versus self-correcting economy, 700-701 short-run equilibrium output, 623-627 on taxes and transfer payments, 636 theories of short-term fluctuations, 614 Basket of goods and services base-year basket, 441 in CPI calculation, 440-441 fiscal

Baskin-Robbins,

definition,

municipal,

model, 614, 684 of AD-AS model, 682 advantage and defects of fiscal policy, 639-640 and Fed's stabilization policy, 654 fiscal policy and recessions, 632-638 government

payments, 564 rate, 564

maturation

Basic Keynesian

example, 162 and price, 185 total cost curve, 162 Average and economic profit, 185-189 and economies of scale, 221-222 and maximum profit condition, 164-165 Average utility vs. marginal utility, 137 Average variable cost definition, 161 Average variable

system, 575 advantage by specialization, 562

liabilities,

benefit

Average

payment

comparative

140

Baumol, William, 516 Bazerman, Max, 403 Beautiful Mind (film), 254n Beethoven, Ludwig von, 151 William W, Jr., 522n Behrens,

596 in stock market in 1990s, 664 Boskin Commission Report over, 450 controversy inflation overstated, 449 bias, 449 quality adjustment substitution bias, 449-450 Boston Red Sox, 39 Bracket creep, 453 Braille dots on ATMs, 18-19 Brands, and price elasticity, 100 Brand switching, 261 real GDP per person 1870-2008, 504-505 Brazil, Bread price subsidies, 204-206 Break-even calling volume, 31 Brin, Sergei, 515 British pound, 733-734 Browne, Harry, 388 share, determinant of price elasticity of Budget economic,

demand,

100

Buffett, Warren, 195,320 Bull market of 1990s, 535-536 Bureau of Economic Analysis, 426-428 Bureau of Labor Statistics attempts to correct CPI, 450

calculation of CPI, 441 estimates on discouraged data

for

workers,

488

survey

unemployment

2011, 484 rate 1960-2010, 485

unemployment

INDEX

George W., 540, 555, 637, 638 administration (2nd), 633, 639

Bush, Bush

Cycle Dating Committee, 597 cycles, 414; see also Expansion; Recessions AD-AS model for understanding, 682-700 causes of demand shocks, 696-697 inflation shocks, 697-698

Business Business

definition, 594 using AS-AD model to study, 698-700 Businesses, demand for money, 667 Business fixed investment, 422 Business saving, 538-539 of national saving, 541 component incentives for, 554 Buyers; see also Consumers; Customers effect on price and quantity, 64-67 and hurdle method of price discrimination,

235-237 in

competitive 65 effect,

perfectly

substitution

C gasoline

prices,

116

Proposition 13, 404 water shortage, 127-128 Camel cigarettes, 217, 342 Camerer, C, 338n limits, 299

spending

Campaign Canada effect hours

of U.S. recession of work, 722

nominal

Canada, Canadian

rate

exchange

real GDP growth

2007-2009, 630 for

dollar, 733

598 comparative advantage in, 40 dollar, 733-734 2002-2010,

Capital

creating,

522 returns

diminishing

to, 512

allowance, 453-454 depreciation formation, 522-523, 532 Capital and investment, 547-551 reliance on foreign savers for, 759 Capital gains, 534-536 Capital

definition, 535 effect on wealth, 535-536 from stocks, 566 tax rate reduction, 555 Capital goods business fixed investment, 422 definition,

418

511-512 enhancing productivity, as final goods, 418, 422 investment in, 522 in measuring GDP, 418-419 income, 425-426 Capital Capital

inflows

definition, 752 and real interest rate, 754-755 and saving and investment, 756-757 from trade deficit, 758

Carter

of Petroleum Exporting

260

Cash

advantages of, 573 cost of holding during inflation, 454 economizing on holding, 454 Cash on the table, 85 Cash rebates, 238 Casino economy, 455 Cell phone companies, 403-404 Central bank independence contributing factors, 715 definition and merits of, 715 Federal Reserve System, 715 and lower rate of inflation, 715-716 Central Bank of Brazil, 716 Central bank reputation as inflation dove, 717-718 as inflation hawk, 717-718 Central banks, 562; see also Federal Reserve System Bank of Canada, 716 Bank of England, 716 Bank of Israel, 716 Central Bank of Brazil, 716 of monetary policy, 714-719 credibility central bank independence, 715-716 reputation,

718-719

716-718 target rate announcements, effect of type of exchange rate, 735-736 Central Bank, 737 European making monetary policy, 581 monetary policy, 650 and money supply, 580-582 oversight of financial markets, 650 Reserve Bank of New Zealand, 716 Central planning, 519 abandoned in China, 64 versus markets, 63-64 Chain weighting, 42 8 n 217n Chamberlin, Edward, demand, 685 Change in aggregate in demand Change definition,

74-75

shift of demand curve, 75 in quantity demanded,

Change

Change in quantity supplied, definition, 75 Change in supply, 166 definition, 75 Chaplin, Charlie, 52-53 Character judgments, 272 Checks, 575

63

planning,

with, 326

relations

problems, 431 economic stagnation,

environmental

Jimmy, 717-718 361 administration,

Carter,

California

diplomatic

242

Countries,

of central

abandonment

definition, 257 Organization

217 Chevrolet Corvette, 263-265 Chevrolet, China

definition, 752 and real interest rate, 754-755 Capital punishment, 324-325 Carbon dioxide emissions, 372, 400 Carbon taxes, 372-373 Car heaters, 18 Andrew, 242, 515 Carnegie, Car prices vs. gas prices, 116-117 Cartel agreements payoff matrix, 259 to violate, 258 temptations unstable nature of, 257-260, 375

markets, 156

Buyer's reservation price definition, 66 and price ceilings, 203 in voluntary exchange, 85 Buyer's surplus, 85 Buying power; see also Purchasing power to maintain, 447-448 indexing of production workers 1970-2010, 447 sale of, 396 By-products,

50

Capitalist

Cartels,

307-308

information, income effect, 65 inadequate

investment

per worker, system, 64 losses, 534-536 Capital 535 definition, effect on wealth, 535-536 outflows Capital Capital

1-3

medieval

516-517

GDP growth, 431 real GDP per person 1870-2008, 504 U.S. trade deficit with, 757 real

Chung,

Ching-Fan

101

Choices vs. irrational, 15 under scarcity, 5-8 487 Chronically unemployed, 257 Chrysler Corporation, Churchill, Winston, 400 ban, 261-262 Cigarette advertising Civil War, hyperinflation during, 585 Class size cost-benefit analysis, 4-5 economics classes, 3-4 Clayton Antitrust Act, 242 Climate change, 372-373 Clinton, Bill, 53, 387 Closed economy, monetary policy, 744 rational

CNBC,

649

Coase, Ronald, 284 Coase theorem definition,

284

and externalities, 283-287

268 Coca-Cola, Coca-ColaCompany,

616

weather-sensitive vending machine, 609 Coincident indicators, 597 Collective bargaining, 341 Collective goods, 389 Commercial banks; see Banking system Commercial

crises,

597

Commitment device definition,

269

examples, 268-270 Commitment problems and changing incentives, 269-270 commitment device, 268-269 268 definition, preferences as solutions to, 271-272 and prisoner's dilemma, 268 in remote-office game, 268 when information search is costly, 314-315 seeTragedy of the commons Commons; Communication

complex, 55 in early America, 502 Communism in recovering from, 519 difficulty reasons for failure absence of free markets, 518-519 absence of property rights, 518 518 political/legal environment, Communist countries, former and remaining, 63 Communist Manifesto, 597 Companies

and elite educational

credentials, entry and exit, 190-191 157 imperfectly competitive, investment decisions, 548-549

320

free

74-75 166

perfectly profitable,

competitive, 156-157 161

shutdown condition, 161 unionized vs. nonunion, 341-342 Comparative advantage, 35-56 versus absolute advantage, 36

of banks, 562

1-4

INDEX

Comparative definition,

construction of, 440-441 definition, 440 deflating process, 444

advantage\342\200\224Cont.

36

economic

naturalist

baseball's .400 hitters, 39-40 video market, 41 digital free-trade

indexing on federal indexing procedures, 444 442-444 and inflation,

impact

cost, 36-41 exchange and opportunity from specialization and exchange, 46-49 and globalization, 479 and international trade, 53-55 of, 1-2, 37-40 principle production possibilities curve effect of individual productivity, 44-46 many-person economy, 47-49 shift factors, 49-53 two-person economy, 41-47 37-39 information, productivity

gains

of

sources

individual level, 40 national level, 40 noneconomic factors, 40-41 from specialization, 35 from technology, 514 usefulness of money, 572 Compensatory Competition

on economic profit, 191 unions, 491 statistical discrimination promoted by, 322-323 Competitive bidding on contracts, 241-242 effect

and

labor

wage, 336

equilibrium

Competitive Complements

of

111

demand,

75 on demand curve,

definition,

Complex communication, Compound interest

75-76 55

formula,

506

Computer

game

family's cost of living, 441-442 443 1929-1933,

Consumer

benefits

of trade, 480

price and choice of cars, 138-139 amount of information, 310-315 optimal

gas

reliance on middlemen, 308-310 to gather information, 308 strategies Consumer spending and economy, 618-621 and stock market decline 2000-2002, 619-620

17

102-103 320-321 Conspicuous consumption, Constant, 24 Constant returns to scale, 220 choice

Consumer

product

implications

income,

disposable

618-619

537 households, 614

versions, 308-309 of lemons model, 316-318

price index for inflation adjustments by deflating, 444-445 a nominal quantity, deflating

nondurable goods, 422 in planned aggregate expenditures, 615 bias, 449 quality adjustment relation to output gaps, 607-609 422

Consumer

and

bias,

449-450

function

619

income, 620-621 U.S. 1960-2010,618 tax vs. income tax, 554 Consumption Contraction, 594; see also Recessions disposable

of

Contractionary policy, 632 to end expansionary gap, 662 Convenience store locations, 267

Cook,

Philip

Copenhagen

J., 325n climate conference,

372

holders, 215 law, 190 Copyright source of market power, Copyrights, Core competencies, 54 Copyright

445-447

444-445 by indexing, indexing to maintain buying power, 447-448 base year, 440, 441 basket, 441 base-year Boskin Commission Report on inflation overstated, 449 bias, 449 quality adjustment substitution bias, 449-450 Bureau of Labor Statistics attempt to correct, 450 construction of, 441

advantages

applying,

goods, 422 of real interest rate on, 659 of tax cuts, 636-637

definition,

489 unemployment, classes, 3-4 of oligopoly, 217

university

Cost-benefit

expenditures 441-442

substitution Consumption

457, 585 Budget Office, 603, 638 Joint Committee on Taxation,

Congressional

CPI,

services,

investment in, 550 Confederate States of America, Congressional

Cost

insufficient,

Computers

social, 486 structural

autonomous, 619 sacrificed to capital formation, 522-523 versus saving, 544-545 Consumption, and utility, 129-131

219

Core rate of inflation, 444 Cornell University, 342 Corn market, economic profit in, 184-190 Corporateaccounting scandals, 571 196 Corporate earnings forecasters, bond issues, 564-565 Corporations, Cosmetic surgery, 301 Cost(s) of actions, 281 of advertising, 252-255 to benefits, 6 compared of economic growth

486

psychological,

of

422

Consumption,

and and

investment in capital goods, 522 and development costs, 523 of healthcare 1940-2009, 362 of holding money, 667 of inflation, 452-456 lower for Internet retailers, 308 in proportion, 8-9 measured of presidential campaigns, 299 of price changes, 615 of public goods and services, 417 relevant, 10-11 of research and development, 523 12 of space shuttle program, of unemployment economic, 486 frictional 488 unemployment, research

surplus

calculating, 142-145 to producer surplus, 170 compared definition, 142 with price ceilings, 201-202 with price subsidies, 205 producer surplus from, 237-238

by

with \"free\" software, invention of, 516

308

Reports,

Consumers

effect

purchase, 6 and outsourcing, 54-55

Computerization,

448-449

typical

effect

example, 505-506

among

and values

durable

505

definition,

budget,

price level vs. relative price, 452 as true measure of inflation, 448-450

Consumption

elasticity

cross-price effect

of

Consumer

wage differentials, 342-343 taxes on externalities, 289-290

Compensating

442

formula,

53

agreements, 54-55

outsourcing,

sacrificed to capital formation, 522-523 new capital, 522 creating consumption

principle/analysis, 5-8

1,16

computer game purchase, 6 economic surplus, 6 opportunity cost, 6-7 role of economic models, 7-8 Braille dots on ATMs, 18-19 buyer's reservation price, 66 and selling, 152 buying car heaters, 18 of class size, 4-5 and Coase theorem, 285-287 320-321 conspicuous consumption, in curbing pollution, 289 for decision making, 7-8 decision pitfalls failure to think at the margin, 10-14 ignoring implicit costs, 8-10 cost measurement, 8-9 improper definition,

4

economic growth, 523 toxic waste, 283-285 eliminating \"free\" software, 17-18 for gathering information, 310-311 and government policy, 432 government provision of public goods, 393 in health care delivery, 362-364 434 high school completion, holding money, 666-667 hours of work, 430 incentive principle, 15 for information search, 312-313 investment in capital goods, 547 investment in computers, 550 and law of demand, 126 marginal analysis in, 11-14 in marginal utility, 131 consumer surplus, 142-145 measuring monopolist'sprofit maximization decision rule, 227 and natural monopoly, 243 as normative economic principle, 15 and opportunity cost, 153

of outsourcing,

54 and tastes, 78 cost, 163-164 price and marginal and price elasticity of demand, 100 for production, 86 and profit-maximizing level of output, of public goods, 389-390 provision

and

preferences

160

INDEX

and rational spending rule, 135 for reducing amount of litter, 169 seats for infants in airplanes, 378 safety of saving, 543 of schooling, 510-511 Secret Service protection, 380-381 living expenses, 285-286 economic surplus, 286-287 splitting stock purchases, 567

out, 405 government budget deficits, Crystal, Billy, 251

supply of labor, 475 tax rates, 720 286-287 unequal rent amounts, workplace safety, 374-375 Costly-to-fake principle definition, 319 economic naturalist elite educational credentials, 320 TV advertising vs. print media, 319-320 Cost of living CPI as measure of, 441-442 merits of CPI on, 449-450

Currencies

241

definition,

with, 241 innovations

problems Cost-saving

hindered

by

cost-plus

regulation, 241

on economic profit, 194 impact Costs of production average total cost, 161 variable cost, 161 average basisof supply curve, 78 benefits to nonbuyers, 86 causing pollution, 86 computer game producers, 222-223 and cost-plus regulation, 241 input prices,

number

166

suppliers, 167 166 economies of scale, 220 of decrease on supply curve, 80 of increase on supply curve, 79 of new technology, 81

effect effect

of

fixed, 157

in market equilibrium, 86 and price determination, 75-76 114-118 price elasticity of supply, start-up costs, 221-224 157

variable,

Coupon payments, Coupon rate and

substitution

euro, 736-737 to strong economy, 742 board, Argentina, 670 Currency Customer discrimination, 343 489 Cyclical unemployment, decline in 1990s, 605 and natural rate of unemployment, 602-604 related

strength

Okun's law, 604-606 output gaps and, 600-602 in recession of 2007-2009, in recessions, 598

credit risk,

605

William,

Jr.,

486n

effect

225-227 monopolist, elastic, 106 inelastic, 106 perfectly vs. imperfect competition, perfect

effects

and

for

perfectly

Debtors

of interest rate changes, 459-460 of inflation, 455 Decision making; see also Game theory

with cost-benefit pitfalls

analysis,

7-8

in cost-benefit analysis

failure to think at

the margin,

10-14

costs, 9-10 8-9 measurement, 14

implicit

summary,

in uncertain environment, Decision tree

252

264

definition,

remote-office game, 265-266 264-265 sports car models, Defense, economies of scale in, 400 444

Deflating,

Deflation, 443 in Japan in 1990s, 717 in U.S. in 1930s, 717 rational

of interest rate changes, of inflation, 455 Credit risk, 565 Crime prevention, 380 effect

459-460

effects

Cross-price elasticity

of

demand,

origins,

and 111

99

influences on desire for the best, 127 peer influence, 126-127 tastes and preferences, 126 law of, 126 met at preset prices, 615-616 for needs vs. wants, 127 126-127

rationing,

shifts in,

125

83-84

price

218-219

85

controls,

price elasticity of demand, 105-106 private goods, 394 for public goods, 393-395 demanded and all costs, 125 quantity and for

inelastic,

Creditors

vs. market, 141-142 labor, 334, 471, 472

for

Credible

promise

66, 145

illicit

individual

716-718 target rate announcements, in trading, 318-319 Credibility problem

definition, 264-265 in remote-office game, 264-266 Credible threat, 264-265 Credit, access to, 564

79

find

interpretation, drugs, 97 and income effect, 65

rule, 137-140 spending of income differences, 140 role of substitution, 138-140

714

65-66

downward-sloping,

for

and consumer surplus, 142-145 economic naturalist California water shortages, 127-128 gas prices and car choice, 138-139 in Manhattan vs. Seattle, 138 housing size of car engines, 140 waiting in long lines, 140 effect of human capital differences, 340 elastic, 99 excess, 69-70

definition,

demand,

horizontal

128 Davidson, Richard, Deadweight loss caused by pollution, 281-282 of monopoly, 230 from taxation, 406 Death penalty opponents, 324-325

importance

565

in definition, 65 change

156-157 market equilibrium, 68-71 fluctuations and price volatility, 118

applying

definition, 564 on newly issued bonds, 564-565 short- vs. long-term bonds, 565 CPI; see Consumer price index Credibility of monetary policy central bank independence, 715-716 central bank reputation, 718-719

price, 66 75

reservation

buyer's and

rule, 132-135 135-137 128-131

effect,

utility concept, unit elastic, 99 Demand curve

to

Demand

564

spending

economic profit and, 184-190 effect of advertising, 261 effect of externalities, 281-283 effect of increase in cost of production, facing perfectly competitive firms,

603

negative,

improper

technology, effect

rational

734-735

ignoring

determinants

with

734-735

depreciation,

Darity,

regulation

for

appreciation,

D

449-450

overstating,

Cost-plus

554

Cuba, 63

shared

effect of shifts in, 189-190 stocks, 566-567 wants into translating income allocation, 131-134 income effect, 135-137 short-run

Crowding by

1-5

with rent shift

71-72

control, factors

complements, 75-76 78

expectations,

four rules governing, 82-83 income, 77-78 normal vs. inferior goods, 78 preferences and tastes, 78 substitutes, 76-77 shift of, 75 and

substitution

effect,

65

and total expenditure, 107-110 vertical interpretation, 66, 145, 199 Demand for dollars factors increasing, 742 to purchase U.S. assets, 740 to purchase U.S. goods, 739-740 Demand for labor reason for shifts in in economy, 471-472 in prices of output, 472-473 474-475 productivity improvements,

changes

increase

and

wages

demand diminishing example,

curve, 471, 472 returns, 470 471

productivity issue, 469-470 value of the marginal product, 470 Demand for money benefits of holding money, 666-667 by businesses, 667 cost-benefit principle, 666 and cost of holding money, 667 definition,

666

by individuals, 666-667 liquidity preference, 666 macro factors affecting nominal interest rate, 667-668

INDEX

1-6

for money\342\200\224Cont. price level, 668 real income and output, 668

Demand

disappointing

687

positive, 687 role of stabilization

policy, 708-709 fiscal policy, 709 expansionary expansionary monetary policy, 709 and shift in demand curve, 685-687 definition, 686 house prices,

686-687

Democrats, 387 Demonstration

effects

and low U.S. saving rate, 547 and saving, 546 DeNiro, Robert, 251 Agriculture, Household Food Survey, 350 Dependent variable, 24 unction and drawbacks, 654 Deposit insurance,

Department

of

Consumption

Deposits in

system, 576-578 allowance, 453-454

banking

Depreciation

(currency), dollar after 2002,

734-735

Depreciation of and

purchasing

748-750

parity,

relation to inflation, 748-750 in South America, 749 Thai baht, 736 U.S. dollar 1985-1987, 750 Depression, 594

of Great Depression, 596 of recessions, 595 of unemployment, 486-487 Dynamic labor market, 488

Income Tax Credit, 204, 352-354 see also Income; Wage entries over time, 446 comparison over time, 439-440 comparisons effects of inflation, 439-440 differences in explaining

marginal

Earnings;

utility

compensating discrimination

discrimination

Bureau definition,

of

workers Labor Statistics 487

estimates, 489

Discrimination in labor force 343 by customers, 343 by employers, from family socialization, 72 by landlords, Disposable

344

equilibrium principle, 339 capital theory, 339-340 344 job preferences, labor unions, 340-342 winner-take-all markets, 345-346 and

human

promoting

human capital, 519-520 and political environment, 521 research and development, 521 and investment, 520-521 saving and Fed policy in 1990s, 664 and labor market, 467 legal

of, 499 poorest countries, 521-522 of limits to, 523-525 question origin and

reasonsfor

investment per worker, 50 investment, 50 50-51 knowledge improvements, population growth, 50 rate, 50 savings 50-51 technology improvements, rise in living standards, 503-504 role of average labor productivity, 506-508 in growth rates, 504-506 small differences Economic Growth and Tax Relief Act of 2001, 637-638 Economic inequality, 431-432 Economic 729 integration, capital

losses

Asia effect of U.S. recession 2007-2009, financial crisis of 1990s, 736

Germany, 52 309-310, 616 Economic activities compared by location 430-431 nonmarket,

digital

consumption,

619

outsourcing,

630

and time, 426-429

Economic conditions over time cost of living, 440-442 interest rate and income differences, 439-440 purchasing power, 445-447 Economic costs of unemployment, 486 Economic data, 415 growth U.S.

costsof

since 1789,

advantage hitters, 39-40 video market, 41

free-trade

East

changes in

definition, 182 and invisible hand theory, 184-190 in monopolistic 217 competition, to, 184-190 response in short run, 189-190 Economic models, 7-8 Economic naturalism, 16-17 Economic naturalist asymmetric information auto insurance, 322 elite educational credentials, 320 well-dressed lawyers, 321 Braille dots on ATMs, 18-19 car heaters, 18 check-splitting, 401 baseball's

East

501-502

.400

agreements, 54-55

53

convenience store locations, 267 conventional health insurance, 366 and demand gas price and car choice, 138-139 in Manhattan vs. Seattle, 138 housing size of auto engines, 140 waiting in long lines, 140 water shortages, 127-128 disappearing political discourse silence of death penalty opponents, 324-325

silence of legalized drugs proponents, externalities free speech laws, 288 subsidies, 289 government Federal Reserve System dollars held in Argentina, 670 inflation and stock market, 663 free public education, 520

and

consumption expenditure, 618-619 620-621 marginal propensity to consume, Distribution of food in New York, 62

consumption

and

522-523

Diversification, 666 benefits of, 570 in bond and stock definition, 569

investment in

free-rider

research

book store failure, 311-312 knowledgeable sales clerks, 311 \"free\" software, 17-18

markets,

569-570

creating

determinants

sacrificed

to

capital

formation,

new capital, 522 capital goods, 522 and development, 523 of average labor productivity

entrepreneurship, 515-517

517-519

increasing

comparative

growth rate 1960-2010, 478-479 recent trends in inequality, 346-347 related to education, 468

Economic

income

autonomous

education, 344

eBay,

rate, 674

Discouraged

differentials, 342-343 in labor market, 343-344

513

management, 517-519 physical capital, 511-513 and legal environment, political technology, 514-515 factors

Dominant strategy for cartel agreements, 259 definition, 253 and equilibrium, 254 in prisoner's dilemma, 256-257 Dominated strategy, 253 Domingo, Placido, 127 Donation, funding by, 396 Dot-com bubble, 698, 709 Dow JonesIndustrial Average, 415 demand curve, 65-66 Downward-sloping and market power, 219 of monopolist, 226-227 Doyle, Arthur Conan, 9 326 Drug legalization, Dubin, Al, 561 Durable goods, 422, 537 effect of recessions on, 698

E

and income allocation, 131-134 law of, 130-131 Diminishing returns to capital, 512 returns to labor, 470 Diminishing Direct window lending, 674 Disappearing political discourse definition, 325 relations with China, 326 diplomatic economic naturalist silence of death penalty opponents, 323-325 silence of legalized drugs proponents, 326 Discount pricing, 242-243; see also Price Discount

555

263-265 Domestic product, 420 Dodge Viper,

131

graph,

and

tax rate reduction,

after 2000, 571

Earned

economic well-being, 433 obstacles to economic growth, 522 481 wage inequality, Dickens, William T., 718n Digital video market, 41 Diminishing

growth 567-568

capital, 509-511 and natural resources,

Economic

countries

Developing

expected,

land

Duration

743-744

power

566

definition,

decision, 666 portfolio allocation Demand shock and business cycles, 696-697 negative,

human

Dividends

problem

326

INDEX

GDP

of

schooling

in rich vs. poor countries, 430

nominal

and real GDP, 428

434

shorter workweek, impracticality

of

private

ownership

in public park, 295 blackberries shared milkshakes, 296 Intel cost patterns, 223 investment in computers, 550 invisible hand theory, 193 market

labor

earnings

of

342

of Renee Fleming, 345 unionized vs. nonunion firms, 341-342 low rate of inflation, 444 macroeconomic

policies

Great Moderation, 713-714 of 1980s, 712-713 hours, U.S. vs. Europe, 722-723 working in micro and macro levels of economy, 413 pooled incomes, 392

causes

of

inflation

pork-barrel legislation, 401-402 in price elasticity of demand luxury tax on yachts, 102-103 102 teenage smoking,

price elasticity of supply, 116-117 dilemma prisoner's cartel agreements, 257-260 shouting at parties, 262 TV cigarette advertising, 261-262 167-168 private market recycling,

public health and security Secret Service agents, 380-381 vaccination laws, 379-380 rise and decline of stock market, 571 378 safety seats for infants in airplanes, steroid use by football players, 297-298 in supply and demand 77-78 pay raises and rent increases, seasonal price movements, 84 term paper revisions, 81 terms for money, 561 too many earnings forecasters, 196 TV programming choices, 396-397 unstable cartel agreements, 257-260 weather-sensitive vending machine, 609 Economic principles, 1-2 Economic

182-183

corn market, 181

184-188

definition,

versus economic rent, 191 effect of entry on, 185-186 of cost-saving innovations, 194 impact for imperfect competition, 215, 216 and invisible hand theory, 184-190 in monopolistic 217 competition, monopoly, 242-243 not guaranteed for monopolist, 228-229 for oligopoly, 217 reasons for importance of, 182-183 response to, 184-190 in short run, 189-190 and types of profit, 180-181 Economic rent natural

definition,

191

versus economic example, 192 and

reservation

15-16

macroeconomics,

statistical

microeconomics, 15-16

strength

15

normative,

Affordable cost-benefit

Care Act of 2010,368 criteria, 362-364 a solution, 364-365

HMO revolution,

365-366

increased costs 1940-2009, 362 of private insurance, 367-368 problem third-party payment system, 362 Economic China, stagnation in medieval 516-517 Economic statistics, 415 Economic Stimulus Act of 2008, 638 Economic surplus, 95 consumer surplus, 142-145 definition, 6 effect of externalities, 282-283 effect of minimum wage on, 352-353 effects of better information, 309-310 from equilibrium price, 199 of pay-per-view TV, 397-398 impact impact of price subsidies on, 204-205 lost to taxation, 405-406 maximization of, 294-295 of perfectly discriminating monopolist, 235 with price ceilings, 202-203 without price ceilings, 201-202

producer surplus,

profit,

191-192

GDP as imperfect measure environmental quality, 431

real

nonmarket

431-432

Economists

agreement among, 64 former faith in fine-tuning,

opposition to

price

725

73

controls,

models, 724 tolerance of some inflation, 718 view of minimum wage, 351 statistical

Education

to develop human capital, 510-511 and economic well-being, 432-434 to increase human capital, 519-520 relation to earnings, 468

wage gap, 344 credentials, 320 Educational vouchers, 520 and

Educational

Efficiency

alternate

physical

goals to, 200

511

43

illustration, 44 Eight

64

high-income, 47n of military spending, 634-635 impact inflation as grease for, 718 interest in measuring, 415 in long-run 683 equilibrium, economic growth, 591 long-term 47n

Elastic

Crossings, demand

with

available

definition,

54 substitutes,

100

99

Elasticity, 95-124

cross-price elasticity definition,

of demand,

111-112

89

income elasticity of demand, 111-112 98-111 price elasticity of demand, price elasticity of supply, 112-118 relations to slope, 105 Elite educational credentials, 320 K., 101 Elzinga, Employed persons, 484 343 discrimination, Employee health insurance, 367 Employer-provided Employers

many-person, 47-49 mixed, 64

fear of exploitation by, 375 incentives to reduce workplace

607, 700-702 for production possibilities

capital, principle

definition, 86 and earned income tax credit, 353 and externalities, 284 labor market legislation, 491-492 and monopoly, 231 and recessionary gap, 602 transition aid, 481 Efficient point definition,

Economies/Economy benefit of net capital inflows, 757 benefit of unions for, 491 complexity of, 63 consumer spending in, 618-621 effect of changes on demand for labor, 471-472 effects of taxation, 405-406 variables, 724 exogenous

factors

monopoly, 240 fixed cost, 222

Efficiency

principle, 432 health and education, 432-434 rich vs. poor countries, 432-434

49-53

fixed cost, 222

natural

small

in

432

cost-benefit

shift

price, 191

in

196 forecasters, of price subsidies, 204-206 from globalization, 479 loss reduced by hurdle method, 239 and market equilibrium, 196-200

of goods and services, basic indicators, 433

self-correcting,

221-224

large

effect

availability

low-income,

41-47

unpredictability, 1 World War II, 596 during Economies of scale in defense, 400 definition, 220 of start-up costs, importance

earnings

well-being

free-market,

742

bases

GDP related to

time, 429-430 activities, 430-431 and income inequality, poverty quality of life, 431 revenue depletion, 431 431 underground economy,

of,

of, 199-200 definition, 86,197

170-172

producer surplus from, 237-238 and progressive tax, 393 split equally, 287 Economic value of work, 334-336 Economic

and strength

currency

in, 4

two-product,

classes, 4 of health care delivery

Economics

683 equilibrium, 591 fluctuations, models of, 724 of

trade-offs

positive, 15 Economics

short-run

short-term

leisure

profit

calculating, 181 in cartels, 258-259 central role of, 180-183 of cigarette makers, 261-262 compared to accounting profit, 181,

of

4

definition,

designing

ad copy writers,

earnings

in

in

Economics

directions

injuries,

377-378 curve,

reservation unionized

price for workers, 337 vs. nonunion, 341-342

1-8

INDEX

Employment for

of skill-biased 482-483

effect

labor, 337

technological

change,

productivity growth, 477-478 slowdown in wage growth, 478-479 Friedrich, 597 Engels, de facto world language, 40 English, 499 Entrepreneurial innovation, Entrepreneurship, 515-517 515

Jobs

of, 515

examples

favoring, 515-516 and Wozniak, 516

in China, and stagnation Entrepreneurship, source advantage, 40

516-517 of

comparative

free,

on price and profit, 190-191

185-186

long-run

Environmental

Environmental

safeguards,

523

Equations

solving simultaneous, straight-line demand

30-32

curve, 93 graph, 25-26 straight-line supply curve, 93 verbal description for constructing,

24-25 Equilibrium

definition, long-run,

68 683

market out of, 85 market tendency toward, 69-70 in money market, 670-671 real interest rate, 552 short-run,

683

Equilibrium

price

algebra of, 94 and cash on the table, 85-86 and decreased costs of production,

83-84 of substitutes, 76-77 of technology changes, 81 excess demand, 68 excess supply, 68 increased costs of production,

76-77

and and and information conveyed by, 85 market tendency toward, 69-70 no surplus-enhancing transactions in perfect competition, 218 regulations preventing, 85

Expansions

causes of, 606-609 in potential output, 600-601 changes felt throughout economy, 597 global impact, 597-598

competitive, 336 levels, 337-339 employment union wage, 340-341 566; see also Stock entries Equity, Euro, 670, 736-737 and

versus

Expectations determinant of supply, 167 effect on demand curve, 78 effect on supply curve, 81 Expected value of a gamble, 313-314 Expenditure line

Europe

financial panic, 681 hours of work, 722-723 saving, 546

Central

European

Monetary Union

common

currency,

debt crisis,

737

Bank, 737 System, 736

voluntary

80

of, 622-623 method; see GDP

costs, 180

Explicit Exports

definition, 423 effect of real exchange rate, 745-747 of exchange rates on prices, 740 impact External benefits, 279-280

External costs, 279-280 see also Positional externalities Externalities; Coase theorem, 283-287 cost-benefit principle, 285-287 279-280 on resource allocation, 281-283 on supply and demand, 281-283

definition, effect

legal

auction carbon

732

732 flexible vs. fixed, 735-737 on price of exports and imports, 739-740 impact in international trade, 732-733, 736 determination long-run for dollars, 742 changes in demand policy, 742-744 power parity theory,

real exchange rate, 745-747 of purchasing power shortcomings

747-750

Factors

strong

currency-strong

short-run

supply

jobs, 55

of production 157

definition,

economy

theory,

determination of dollars, 740-741 supply and demand analysis, 738-740

change in

25 In

Geraldine,

Face-to-face

parity,

of pollution permits, 371-372 taxes on pollution, 372-373

F Fabrikant,

750-751

283

compensatory taxes, 289-290 free speech laws, 288 subsidies, 289 government subsidies to producers, 290-291 in nature, 284 reciprocal of, 399 regulation and social efficiency, 284-285

flexible,

nominal, 734-735

resulting from, remedies, 287-289

inefficiency

85

consequences of variability, and euro, 736-737 fixed, 732

purchasing

at, 199

622

properties Expenditure

736-737

transactions, rates

monetary

79

definition,

effect

Exchange

policy, 632

601

economists' views, 602 and Fed policy 1999-2000, 605-606 Fed's response to, 685 inflation as, 661 interest rate to end, 661-663 raising and self-correcting economy, 701 and slope of aggregate supply curve, 692 from too much spending, 614 unsustainable, 602 Expansionary monetary policy, 709 Expansionary policies, 632

wage

European

policy, 709

contractionary

definition,

and comparative advantage, 36-41 and gains from specialization, 39

shifts,

effect

gap

Exchange

definition, 68 effect of complements, 75-76 effect of externalities, 281-283 effect of price controls on, 71-74 effect of price subsidies, 204-206 effect of simultaneous supply and demand effect

fiscal

Expansionary

and

Maastricht Treaty, 736-737 nominal exchange rate for dollar, 733 of monetary policy, 737 problem Excess demand definition, 69 markets with, 197-198 Excess profit, 181; see also Economic profit Excess supply definition, 69 markets with, 198

straight-line

Expansionary 195

definition, 68 effect of complements, 75-76 effect of externalities, 281-283 effect of price controls on, 71-74 effect of simultaneous supply and demand

European

94

simultaneous,

596 stages of, 595

quantity algebra of, 94

precautionary

from tables, 28-30 definition, 24 derived from graph, 26-27

constructed

187

supply curve,

long-run

Expansion,

Equilibrium

Equilibrium

supply curve, 187 quality, omitted from GDP, 431 Environmental regulation auction of pollution permits, 371-372 carbon taxes, 372-373 taxes, 369-371 pollution

and

and

market tendency toward, 69-70 total surplus, 87 maximizing

Entry effect

and unexploited opportunities, and wage differences, 339 ways to earn big payoff, 195

83-84 shifts, effect of substitutes,

190-191

free,

productive ability, 334-335 and public goods, 395 and recycling, 170 supermarket checkout lines, 193 tragedy of the commons, 294 and

of globalization, 479-481 of technological change, 481-483 labor supply in U.S., 479

factors

283

public education, 520 for gain, 187 opportunity

effects

early

for gain, 195

of inefficiencies,

free

effects

definition,

definition, 86 and end of opportunities examples

increase since 1970, 468-469 and market shifts, 338-339 curve of labor, 337-338 supply trends in

as tool of monetary policy, 744 tourists in United Kingdom, 731-732 241-242 Exclusive contracting, Exit effect of low price, 186

principle

Equilibrium

demand curve

742

and economies fixed,

of

scale, 220

158

variable, 158 in long run, 165 variable workers, in early 1900s, 374 Factory

INDEX

Fair

gamble, 314 socialization,

Family

300 Federal Express, 77 Federal funds rate, 665 definition, 655 versus discount rate, 674 from 1970 to 2011, 656 in 2004-2005, 663 raised role in monetary policy, 655-656 at time of terrorist attack, 660 Federal Open Market Committee, 649, 650, 724 of, 651 composition federal funds rate announcements, 655 federal funds rate cut in 2001, 660 and inflation of early 1980s, 712 raise in interest rates 2004-2005, 663 Federal Reserve Act of 1913, 650, 715 Federal Reserve Bank of New York, 651, 661, 724 Federal Reserve Bank of St. Louis, 734 Federal Reserve banks, 650 Federal Reserve districts, 650 Federal Reserve System, 562; see also Central banks accommodating policy, 710-711 actions to slow economy 605-606 1999-2000, anchored inflationary expectations, 712 avoidance of target rate announcement, 717 and banking panics, 651-654 Board of Governors, 649-650, 651 control of money supply discount window lending, 674 interest paid on reserves, 674-675 672-674 open-market operations, reserve 674-675 requirements, Fashion

norms,

580

definition,

650

districts,

economic

naturalist

held in Argentina, 670 inflation and stock market, 663 Federal Open Market Committee, 651 and Greenspan Briefcase Indicator, 649-650 and structure, 650-651 history interest rate deduction 2001-2002, 620 and interest rates, 665-672 demand for money, 666-668 federal funds rate, 665 money demand curve, 668-670 money supply and market equilibrium, dollars

670-671

money

low rate

monetary

determination, supply of inflation, 685

665

determining market in GDP, 417-420

651-654 of banks, 652

intermediate

versus

Fixed cost, 221

value

157

definition,

of, 224 with economies of scale,

increased large,

of, 417-419

importance

222-223 level of output, profit-maximizing small, with economies of scale, 222 Fixed exchange rate, 732 and

goods

and

services,

417-418 capital goods, 418, 422 added concept, 417-419

long-lived

abandoned

by

value

abandoned

by

735

Financial

assets, 532, 666

definition,

Financial

crisis/panic

effect

Asia, 736 in European Union, 737 demand shock, 699 negative in U.S. and Europe, 681 Financial intermediaries

effect

East

Financial

diversification

of,

569-570

markets, 551-552 2007, 631 Fed oversight of, 580 reaction to changes in money supply, Of

of

savings

by, 569-571

system, 562-564 bond market, 569-571 561 components,

definition,

Florida

exchange rates Light and Power

Forbes

36

Ford Motor Company, 217 Foreign aid, 522 Foreign assets, 738 market Foreign exchange definition, 735 in exchange market equilibrium rates,

650

recessions

Recovery and Reinvestment Act of

2009,638 Growth and Tax Relief Act of 2001, 637-638 Economic Stimulus Act of 2008, 638 Economic

output gaps by government purchases, 633-634 government purchases and planned spending, 633-634 of military spending, 634-635 impact recession of 2007-2009, 638 tax cuts to eliminate output gaps, 636-637 and aggregate spending, taxes, transfers, eliminating

Free-rider

639-640

problem, 639 inflexibility, 639-640 and supply-side of economy, 639 and supply-side economics, 719-723

738

supply and demand analysis changes in demand for dollars, 742 in supply of dollars, 740-741 changes demand for dollars, 739-740 effect of monetary policy, 742-743 market equilibrium value of dollar, 740 supply of dollars, 738-739 of dollars to, 738 supply market, 739 yen-dollar 738 Foreign goods and services, Forest, C. E., 372n Fox TV, 319-320 Fractional-reserve banking, 576-578, 652 hours of work, 722 France, Franchising, source of market power, 219-220 Robert H., 649n Frank, Free and open exchange of ideas, 517 Free entry, 190-191 Free exit, 190-191 Free-market system, 64 in communism, 518-519 absent Free public education, 520 problem

definition, 311

deficit

examples,

relative

and

Irving, 461 Ronald, 101 Fisher effect, 460-461

61-62

400 richest Americans,

Ford, Henry, 515

lag,

637-638 as stabilization tool and automatic stabilizers,

216

Company,

533 New York City,

supply,

633

709 724 less flexible than monetary policy, outside lag, 724-725

Fisher,

monetary policy, 744 exchange rate, 735; see also Flexible

definition,

expansionary,

Fisher,

Renee, 345

Floating

Food

and demand curve shift, 687-688 to eliminate output gaps, 614

American

allocated between two goods,

Flows contrasted with stock,533-534

improving savings allocation, 562 stock market, 569-571 of U.S., 551-552 Finder's fees, 72 Fine-tuning, 725 Firms; see Companies First Amendment, 288 First-dollar insurance coverage, 365 Fiscal policy, 632-633

and

income,

and

673

banking

inside

Fixed

system

allocation

rates, 735-737 of production, 157

factors

of inputs, 115 in fiscal policy, 639-640 lacking Flexible exchange rates, 732 735 definition, effect on central banks, 735-736 effect on trade, 736 versus fixed rate, 735-737

stocks, 566-568

Financial

735-736

Flexibility

Financial crisis

736

flexible

Fixed

Fleming,

569

risks,

160

131-134

423, 543

investments, 564-566

bonds,

Argentina, 736 United Kingdom,

on central banks, on trade, 736

versus

definition, 562 reasons for, 562-566

policy

and changes in asset prices, 664 control of interest rate, 654-655 federal funds rate, 655-656 to fight inflation, 661-663 to fight recession, 659-661 planned aggregate expenditures and real interest rate, 656-659 monetary policy rule, 684-685 581 open-market operations, of financial markets, 580 oversight public scrutiny of, 649-650 relative of, 715 independence to inflation of 1970s-80s, response 712-713 to inflation shock, 710-712 response response to recessionary gap 2001, 606 to recession of 2001, 709 response to terrorist attack, 660-661 response for monetary policy, 580 responsibility role in stabilizing financial markets, supervision

goods and services capital goods, 418-419 of users, 421-422 categories 417 definition,

Final

344

\"Free\"

311-312

goods, 389, 391 software with computers,

public

Free speech laws, 288 Free-trade agreements controversy over, 53

opposed

by

politicians,

480

17

I-10

INDEX

unemployment, 488-489 in economy, 603 and output gaps, 603 Friedman, Milton, 404, 520, 582-583, Thomas L., 467 Friedman, Full employment, to impediments health and safety regulations, 492 labor unions, 491 minimum wage laws, 490-491 insurance, 491-492 unemployment Full-employment output, 600

Positioning System, 521 Systems Model (MIT), 372-373 Glover, Paul, 573

Frictional

present

always

653

Global

leading

Global

reasons

Goldsmith, Arthur H., 486n Barbara A., 573n Good, Goods; see also Products allocating fixed income between two, 131-134 estimates of price elasticities, 101 normal, 78 not sensitive to

G from exchange, 46-47 from specialization, 46-47

Gains and

exchange, 39 51

real-world,

Gamble 314 of, 313-314

better-than-fair,

expected fair,

value

314

basic

252-253

elements,

dilemma

prisoner's

economics

cartels, 257-260 257

of

multiplayer,

260-262

repeated,

271

selfishness,

games, 263-266

sequential

solution to commitment problems, 271-272 strategic role of preferences, 270-271 timing in, 263-268 Game tree, 264 467 Gap between haves and have-nots, Garber, Peter, 524n Gasoline

price

versus car prices, 116-117 controls on, 72-73

increases,373

tax, pros and cons, 361-362 396 communities, Gates, Bill, 5, 54,138,191, 515 Gasoline Gated

General Motors, 238, 257 Germany

hours of work, 722 of 1923, 457, 585 hyperinflation post-World War II recovery, 510 real GDP growth 2002-2010, 598 real GDP per person 1870-2008,504 real GDP per person 1870-2008, Ghana, 504-505 Glaeser, Edward, 722n Global in, 467 economy, social conflicts Globalization,

729

adjusting to effects of need for transition aid, 481 worker mobility, 481 impact on labor market, 468 and increasing wage inequality, main benefits of, 479

479-481

expenditures

of fiscal policy on, 687 effect on recessions, 633-635 equal to government purchases, 633-634 government purchases, effect

539

cost-plusregulation,

in GDP, 432 in planned aggregate expenditures, 615 public capital, 537 Government saving calculating, 539-540 of national saving, 541 component Government-sponsored jobs, 354-355

critics of, 399

Graf, Steffi,

urged on, 404-405 enforcement of antitrust laws, 242-243 607 impact on total spending,

Graphs

changes,

limits on, 399 241

cutbacks

licensing lobbyists,

and

franchising

aggregate changes

by, 219-220

consumer federal

levels, 399-400

demand

power, 387 on use of force, 387 monopoly and natural monopoly exclusive contracting for, 241-242 240-241 ownership, regulation of, 241 military

of taxation, 405-406 power to tax, 387 of public goods provision 395 advantages, collective goods, 389 cost-benefit principle, 389-390 demand curve, 393-395 disadvantages of relying on, 395-396 for, 390-393 paying vs. private goods, 388-390 public pure common good, 389 pure public goods, 388-389 benefits, 390 unequal investment, 520-521 public question of size and power, 388 social safety net, 546 sources of inefficiency in pork-barrel legislation, 400-402 rent seeking, 402-404 subsidies to property owners, 289 for basic research, 521 support waste by, 404 Government bonds 460 inflation-protected, interest rates on, 459 Government borrowing, crowding out effect, Government budget balanced, 539 and public saving, 539-541 Government budget deficits crowding out effect, 554 definition, 540 effect of fiscal policy on, 639 effect on investment, 553-554 effect on real interest rate, 553-554 effect on saving, 553-554

297 supply curve, 693 in vertical intercept, 27-28

constructed

404

local, state, and

432

definition,

deriving

from tables, 28-30 surplus, 143-145 curve, 65 line from, 28-29 equations of straight

marginal utility, 131 of rent control, 72, 73 equation of a straight line, 25-26 diminishing effect

price, 68 excess demand, 69 excess supply, 67 interpretation of price elasticity 103-107 equilibrium

objects

original, 256-257

Government

Google Inc., 515 Gould, Stephen Jay, 40n Government abuse of powers, 387 constitutional

in equilibrium, 254 Game theory, 252-272 advertising game, 252-253 basic elements of games, 252-253 commitment problems, 268-270 credible threats and promises, 265-266 decision trees, 264-265 dominant strategy, 253 dominated strategy, 253 of moral sentiments, 270-271 impact Nash 254-255 equilibrium, matrix, 253 payoff

of, 540 in hyperinflation, 585 Government budget surplus, 539 resulting

impact of indexing on, 448-449 interest payments, 538 634-635 military spending, as recession aid, 640 transfer payments, 538 Government purchases, 539 to close recessionary gap, 633-634

price

combination,

bond issues,564-565

Games

recent history

98 134 socially optimal quantity, 86 Goods and services; see also Final goods and services; Intermediate goods and services availability of, 432 market values, 416-417 not in market, 417 optimal

Gains

78

inferior,

to inflation, 584 for, 540

changes

of

demand,

along straight-line demand

curve,

105-106 formula,

104

demand curve, 106 inelastic demand curve, 106 slope of demand curve, 105 pizza price controls, 74 of production possibilities curve, 45, 47, 48 164 profit,

perfectly

elastic

perfectly

profit maximization, 161-163 demanded vs. increase in demand, quantity rules on supply and demand shifts, 82 simultaneous supply and demand shifts, 70 supply and demand, supply curve, 67

405

75, 86 83

unregulated housing market, 71 Great Depression, 640; see also Recessions 652-653 banking panic of 1930-1933, and basic Keynesian model, 614 duration of, 596 effects of, 613-614 ended by World War II, 634-635 from insufficient spending, 614 and stabilization policies, 614 Great Moderation, 713-714 Great Recession, 681-682, 687, 700, 708 Greece, financial crisis, 737 Greenspan, Alan, 606n, 649, 651, 664 Briefcase Indicator, 649-650 Greenspan Gross domestic product, 413; seealso Nominal GDP; Real GDP

base year,

427

comparisons

over

time and place,

426-428

INDEX

computer

purchases

definition, 416

percent

550

of,

naturalist of nominal and real GDP, 428 in rich vs. poor countries, 434 schooling shorter workweek, 430

economic

directions

equation, 424 422-424, 425 components, method of measuring, 421-425 categories of users of goods and services,

expenditure expenditure

421-422 government

and

measure of output excluding intermediate goods and services, 417-418 final goods and services, 417-418 within a given country, 420 a given period, 420 during market value, 416-417 military spending percentage of, 634-635 omissions

quality, 431 417-419

leisure time, 429-430 economic activities, 430-431 in income inequality, 431-432 quality of life, 431 resource depletion, 431 430 underground economy, nonmarket poverty

relation to economic well-being availability of goods and services, 432 basic indicators, 433 health and education, 432-434 rich vs. poor nations, 432-433 three expressions of, 426 Gross domestic product per person and average labor productivity, 506-508 doubled

1960-2010,468 and share of population employed,

Grossman, Gene M., 524n Group characteristics, 323 Growth rates, small differences

506-508

in, 504-506

H 649

HBO, 389 Head

Holbrooke, Janet,

311-312 9

Holmes, Sherlock, Home equity loans, 546 Honda Accord, 317

Hoover,Herbert, 439

addition, 141-142 Horizontal interpretation of demand curve, 66,145 of supply curve, 67,172 Hospital stays, shorter, 363-364 Harold, 268 Hotelling, Hours of work shortened, 430 U.S.vs. Europe, 722-723 Household Food Consumption Survey, 350 Households 537 consumption expenditures, wealth and bull market of 1990s, 535-536 Household saving, 532, 538 of national saving, 541 component incentives for, 554 in U.S., 546-547 Housing bubble, 631, 664, 681 Housing market effect of rent controls, 62-63, 71-73 Manhattan vs. Seattle, 138 in New York City, 62 shortage Housing prices and demand shock, 686-687 growth 1999-2006, 665 increase after 2001, 620 in U.S. 1953-2011, 630-631 Houtthaker, H. S.,101 Horizontal

capital

analogous to assembly

432-434 impediment

benefit

to full

Health care delivery

definition,

physical capital, 510 line production, 509

of schooling, 339, 509

determinant

of

510-511

average

HMO revolution, 365-366 problems with private insurance, 367-368 third-party payment system, 362

productivity,

insurance

deductibles, 365 a solution, 363-364 designing 367

economic recovery of Germany and Japan, 519-520 policies to increase, in, 343 wage gap and differences and winner-take-all markets, 345-346 Human capital model, 331 Human capital theory, 339-340 457 Hungary, hyperinflation, Hurdle method of price discrimination airlines,

235

definition,

movie theaters, 239 and natural monopoly, 243 hurdle, 236-237 perfect producer surplus from, 238 reduction of efficiency loss, 239 temporary sales, 238 Hybrid goods, 389 Hyperinflation in Confederate states of America, 585 definition, 456 in Germany in 1923, 585 massive wealth redistribution, 457 means of stopping, 585 occurrences of, 457 result of government budget deficits, 585

I 242

IBM,

Ignorance, optimal level of, 311 Illicit drugs, 97-98 see also Market structure Imperfect competition; breakdown of invisible hand, 229-231 economic profit, 216 economies of scale, 221-224 of

forms

216-127 monopolistic competition, oligopoly, 217-218 216 pure monopoly, 231-240 price discrimination, 224-229 profit-maximizing monopolist, and public policy, 240-243 sourcesof market power, 219-221 costs, 221-224 start-up Imperfectly competitive firms, 157 to perfectly competitive firms, 216, compared 218-219 demand curve, 218-219 price setters, 215, 216 Imperfect price discrimination, 235 costs

Implicit

definition, 180-181 9-10

ignoring,

Implicit Imports

value,

opportunity

cost

as,

7

423 of real exchange rate, 745-747 of exchange rates on prices, 749 impact 1 Incentive principle, definition, effect

in

game, 254-255 cash on the table, 86 and credible threats, 265 15 definition, effect on supply, 78 and invisible hand, 180 in market equilibrium, 69-70 advertising

and

natural monopoly, 241 price controls, 204 and rent control, 72 and welfare payments, 349

and labor

509-511

Care Act of 2010,368 criteria shorter hospital stays, 363-364 third-party payment system, 362 costincreases 1940-2009, 362 a solution, 364-365 designing from economic growth, 504 Affordable cost-benefit

employer-provided,

336

credentials, 320 product of labor, 335-336 employers, 342

marginal by unionized

Human

Start, 519

Head taxes, 391, 393 Health and economic well-being, Health and safety regulations, employment, 492

Health

of prices on, educational

elite

and

goods and services,

565

Hiring effect

rates, 434

completion

bonds,

High-yield

47n

countries,

High school

options market values, 421-422 422 total expenditure,

intermediate

50n

High-income

measurement

environmental

organizations

definition, 365 economic naturalist, 366 operation of, 365-366 Heating oil, price ceiling on, 200-204 Hewlett-Packard, 516

investment, 422-423 net exports, 423-424 incomes of capital and labor, 425-426

Mark,

Health maintenance

Heston, Alan, 422 expenditures, purchases, 423

consumption

Haines,

first-dollar coverage, 365 problem with private policies, 367-368 reason for inflation in costs, 365 third-party payment system, 362, 363 waste caused by, 364, 365

239

auto sales, 238 book prices, 238 cash rebates, 238 consumer surplus from, 237-238 cost-benefit principle, 236

and

Incentives

in auctions,

402-403

cigarette advertising, 261-262 and commitment problems, 269-270 in economic system, 455 and

individual

vs. group, 262 see also Earnings; Wage entries of capital, 425-426 CEOs vs., typical workers, 432 effect on demand curve, 77-78

Income;

fixed, 131-134 of differences importance and

job safety, 375-377

in, 140

1-12

INDEX

Income\342\200\224Cont.

Inefficient

threshold, quintiles of, 346 poverty

Income

disparities,

Income

distribution

Inelastic

Inferior

65

vs. average utility, 137 and quantity demanded, 135-137

response to

price

elasticity

of

reduction, demand,

136-137 111

Income equality, 348 631-632, Income-expenditure multiplier, Income inequality, 331 and income sharing, 348 as moral problem, 347-348 of income 1940-2009, 346 quintiles Rawls on, 347-348 tax

versus

progressive,

tax, 554

393

proportional, 392 Income transfers, 203-204 and price subsidies, 206 Increasing marginal utility, 130-131 cost Increasing opportunity returns to capital, 512 diminishing diminishing returns to labor, 470 effect on supply curve, 79 investment decisions, 549 and physical capital, 511 and production possibilities curve, 49 and public goods, 395 returns to scale, 220 Increasing Independent variable, 24 Indexing, 444 definition,

448

impact on federal budget, 448-449 of labor contracts, 448 to maintain buying power, 447-448 of taxes, 453 real GDP per person 1870-2008, 504 India, Individual comparative advantage, 40 Individual demand curve, 141-142 and market equilibrium, 199 Individual Retirement Accounts, 520 Individual supply curve, 154-155 Induced 622 expenditure, Industrialized

countries

economic well-being, 433 factors leading to productivity growth, 477-478 in real wage, 477-478 increase Inefficiency,

230 572

of barter, government sources of 400-402 pork-barrel legislation, rent seeking, 402-404 of natural monopoly, 240 from externalities, 283-284 resulting

110-111

442

effect,

460-461

hyperinflation, 456-457 cost of imagined confusion, 451 popular price level vs. relative price, 451-452 and interest rate comparisons, 440 and interest rates Fisher effect, 460-461 real interest rate, 457-460

minimum wage not indexed for, 448 as monetary phenomenon, 582-583 and money in long run, 584-585 money supply growth in Latin America, 582 and output gaps expansionary gap, 692 no output gap, 692 recessionary gap, 692 over time, 440 and purchasing power parity, 748-750 in South America, 749 true costs of effect on long-term planning, 455-456 noise in price system, 452-453 shoe leather costs, 454 tax distortions, 453-454 455 unexpected wealth redistribution, in U.S. in 1970s-80s, 712-713 Inflation-adjusted quantities, 445 Inflation dove, 717-718 Inflation

expectations

aggregate supply curve shift and changes in, 694 and credibility of monetary policy, 714-719 in expansionary gap, 701 and inflation inertia, 690-691 shift in aggregate supply curve and in, 694 changes Inflation hawk, 717-718 Inflation

inertia

definition, 689 versus inflation

effect negative,

economic

variables, 689-690 690-691

expectations,

curve, 710

on aggregate supply 695

positive,

economists' tolerance of, 718 effect on real exchange rate, 749 effect on stock market, 663 as expansionary gap, 661 in expansions and recessions, 598-599 Fed policy 1999-2000, 605-506 Fed response to, 661-663 Fisher

consumption

cycle, 697-698 695

business

definition,

goods

definition,

647-648

recent trends, 346-347

Income

and

definition, 78 inelastic demand for, 111 Inflation; see also Rate of inflation AD-AS model to analyze, 682-683 basis of price comparisons over time, 439-440 Boskin Commission Report on CPI, 449-450 CPI adjustments for by deflating, 444-445 a nominal quantity, 445-447 deflating by indexing, 444-445 to maintain buying power, 447-448 indexing core, 444 and cost of holding cash, 454 cost to government of indexing, 448-49 to currency 748-750 depreciation,

marginal

Income

demand

definition, 99 for inferior goods, 111 with no available substitutes, 100 total expenditure and price increase, Infant mortality rates, 433

331, 333-334

effect

definition,

long-term

main

44

illustration,

350

changes over time, 347 Rawls on, 347-348 Income distribution methods combination of methods, 354-355 earned income tax credit, 352-354 in-kind transfers, 349 means-tested programs, 349-350 minimum wages, 351 income tax, 350-351 negative difficulties, 349 practical for the poor, 354 public employment welfare payments, 349 Income

wage and price contracts, 691-692 reasons for, 691-692 and slope of aggregate supply curve, 689-692 bonds, 460 Inflation-protected Inflation shock

point

definition, 43

of labor, 425-426 nominal vs. real, 445

695

and shift in aggregate supply curve, 695 stabilization policy, 709-714 accommodating policy, 710-711 anchored inflationary expectations, 712 causeof Great Moderation, 713-714 in 1980s, 712-713 Fed's response see also Asymmetric information disappearing political discourse, 324-326 effect on economic surplus, 309-310 in invisible hand theory, 308 amount of, 310-315 optimal provided by financial system, 562 308-310 provided by middlemen, from stock and bond markets, 569 to gather, 308 strategies Information and communication technologies, Information gathering, costs reduced by banks, 564 Information;

515

search

Information

commitment problems, 314-315 cost-benefit guidelines, 312-313 gamble inherent in, 313-314 benefit/cost of, 310 marginal Infrastructure,

In-kind transfers, Input prices

521 349

determinant of costs of production, effect on supply curve, 81 Inputs; see also Factors of production in corn market, 185 on price elasticity flexibility of, 115 mobility of, 115 substitutes, 115

effect

sourceof

of

supply

supply

power, 219 for, 220 bottleneck, 118

unique

and

substitutes

Inside

166

market

essential,

118

lag

of

fiscal policy, 724 monetary policy, 724 Insurance companies of

adverse selection, 323 and moral hazard, 323-324 statistical discrimination, 322, 323 Intel Corporation, 223 Interest compound,

505-506

538 government payments, simple, 505 Interest paid on reserves, 674-675 Interest rates; see also Nominal interest rate; Real interest rate and

bond prices,

and control Fisher

effect,

671 money supply, 665-666 460-461

of

formula

for compound interest, 506 inflation, 457-460 in economy, 655-656 many over time, 440 reduced by Fed 2001-2002, 620 relation to bond prices, 565-566 and supply of dollars, 741 Intergovernmental Panel of Climate Change, and

373

INDEX

Intermediate

definition,

excluded

attractive

outcomes, 187 fair outcomes, 187 breakdown under monopoly,

GDP, 417-419 versus final goods and services, 417-418 Internal Revenue Service, 350 call for abolition of, 388 International capital flows interest rate, 754-755 return and risk, 754-755 real

and domestic saving/investment, 756-757 and financial markets, 754 nature of, 753-754 roles of, 754 International Monetary Fund, 737 trade

advantage, 53-55, 479 of fixed or flexible rates, 736 on labor markets, 480-481

comparative

effect effect

rates, 732-733 exchange trade agreements, 480 free-trade agreements, 53 to U.S., 752 importance in value since 1980s, 729 increase international capital flows, 752, 753-760

and

highway

diminishing

Italy,

company

reasons

J Jamail, James,

547-549

520-521

and real interest rate, 549 real vs. financial, 423, 616n residential,

573 Life, 652

423

and value of the marginal product, 549 Investment/GDP ratio, 758 Investment spending and national saving, 537 Investors and interest rates, 459 irrational 664 exuberance, return and risk investments, 754-755 Invisible hand, 180 and corporate 196 earnings forecasts, and cost-saving 194 innovations, checkout lines, 193 supermarket and types of profit, 180 Invisible hand theory adjustments over time, 190 of full information, 308 assumption

definition, 484 size of, 55 Labor force participation by women, 479 Labor income, 425-426

of 1990s, 717 housing prices, 546 hours of work, 722 high

543 employment, exchange rate for dollar, 733 War II recovery, 510 post-World precautionary saving, 546

lifetime

discrimination in 343 by customers, 343 by employers, from family socialization, 344

real GDP growth 2002-2010, 598 real GDP per person 1870-2008,504 reasons for saving, 542-543 recessionof 1990s, 629-630 Jerry Springer show, 396-397 JetBlue Airways, 717n W Stanley, 65 Jevons,

dynamic,

face-to-face, 55 354-355

heterogeneous, 488 increase on number of, 468-469 less vulnerable to outsourcing, 55 losses and gains, 55 losses in boating industry, 103

efficiency of, 604 in, 375 competition matching jobs to skills, 488 national and international, 491 recent trends in inequality, 346-347

lack

375-377

of

recessions, 598 in, 338-339 and demand analysis, supply demand shifts, 471-475 during shifts

supply 8n

supply

India, 307 Lawrence, 604n Keeler, E. B., 365n Keeler, Wee Willie, 39-40 Kashmir,

wages

Katz,

318 School of Management, John E, 604n Kennedy, Key deposits, 72 John Maynard, 614, 633 Keynes, cross, 614, 627, 658; see also Keynesian Keynesian model Keillor,

Kellogg

Garrison, Graduate

definition,

626

339-346

increased

55

Daniel,

differences,

heterogeneous, 488

K Kahneman,

earnings

explaining

with risk exposure,344 worker choice and safety, Jobs, Steven, 516 Johnson, David S., 638n Junk bonds, 565 Jurassic Park, 78 Just-in-time systems, 517

488

and economic growth, 467 economic naturalist earnings of ad copy writers, 342 of Renee Fleming, 345 earnings unionized vs. nonunion firms, 341-342 economic surplus and minimum wage, 352 effect of globalization, 468 effect of minimum wage on, 351 effect of technological change, 468 effect of unions, 340-342 in, 337-339 equilibrium

Jobs government-sponsored,

rate, 485

market

Labor

nominal

rules-based,

force

Labor

of 1990s, 564

crisis

deflation

423

opportunities for foreign investors, 758 in planned aggregate 615 expenditures, vs. actual, 617 planned to promote, 520-521 policies and productivity growth, 50 public,

of, 470 marginal product nature of, 334 reservation price, 475 supply curve, 334-335, 337-338 and demand for, 469-471 wages Labor contracts of, 491 composition indexed for inflation, 448 not indexed for inflation, 455

Joe, 36 Bill, 40 LeBron, 118

banking

753

in computers, 550 definition, 422 effect of government budget deficits, 553-554 effect of new technologies, 552-553 effect of real interest rate, 551-552, 659 effects of recession 2007-2009, 631 inventory,

Hours,

158

481

low-skilled,

Japan

system, 718

for,

and

457 hyperinflation, hours of work, 722

James,

Intuit Corporation, 17 423 Inventory investments, Investment business fixed investment, 422 and capital formation, 547-551 in capital goods, 522 and capital inflows, 756-757 collective decisions on, 292-293

curve, 334, 337 returns to, 470 law of diminishing returns,

demand

Internet, 521 Interstate

L Labor

war, 540, 554, 634-635 financial crisis, 737 Irrational choices, 15 Irrational 664 exuberance,

Ithaca

inflows,

Simon, 415

Kuznets,

Ireland,

It's a Wonderful

53-55 outsourcing, strength of dollar, 744 trade balances, 751-752 trade balances and net capital trade deficit, 751 trade surplus, 751 and wage inequality, 481

in, 50-51 improvements Maiko, 543 n Korean War, 634-635 Koromvokis, Lee, 54 Alan B., 524n, 604n Krueger, Koga,

Iraq

Israel,

dates, 299

Knowledge,

292 workers, 487-488

part-time

free

and

229-231

resources,

unpriced

and

and

\"King

free

Involuntary

starting of Torts,\" 36

Kindergarten

entry and exit, 190-191 functions of price, 184 of free entry/exit, 190-191 importance lack of externalities in, 280 and market imperfections, 213 movement toward equilibrium, 188-190 response to profit or loss, 184-190 and

determinants

and

features

efficient

from

International

Kim, M., 344n

goods and services

417

403

Basic

469-477

labor, 475-476 shifts, 476 and demand for labor, 469-471 of

trends in growth in real wage in 20th century, 468 increased number of jobs, 468-469 increase in wage inequality, 468 slowed growth since 1970, 468 trends in real wages effect of globalization, 479-481 effects of technological change, 481-483 in industrialized countries, 477 productivity growth, 477-478 slowed in U.S. since 1970, 478-479

1-13

1-14

INDEX

Licensing, source of market power, 219-220 Liebowitz, A., 365n

Labor market\342\200\224Cont. two-tier,

468 352

unregulated,

winner-take-all markets, 345-346 worker mobility, 481 Labor productivity and entrepreneurs, 515 growth in U.S. since 1995, 514-515 Labor supply, 475-477; see also Demand for labor cost-benefit principle, 475 and income sharing, 348 nature of, 475 predicted slowdown, 479 reasons for increase in, 479 reservation price for working, 475 shifts in, 476 to work, 475-476 willingness Labor supply curve, 476

saving for buying a home, 546 541-542 definition, in Japan, 542-543

collective bargaining, 341 competition from nonunion 341-342

340 on earnings differences, 340-343 and employer-provided health insurance, to full employment, 491 impediment opponents opposition

367

Free Trade

rich

credit risk,

341-342

strike threat, 491 vs. leisure, 337-338

Lake

Wobegon

318

effect,

Land of average productivity growth, in Manhattan, 113 Late Show with David Letterman, 388 Latin America, inflation and money growth in, 582 Law of demand, 95 126 definition, determinant

513

prices

on Law

108

price increases, of diminishing marginal

utility

definition, 130-131 and income allocation, 131-134 Law of diminishing returns, 336-337 and curbing pollution, 289 definition,

158

and expanding output, 160 in long run, 165 not applicable Law of one price definition, 747 and purchasing power parity, 747-748 Law of supply, 165-166 Lawyers, conspicuous consumption by, 321 Least developed countries, economic well-being, 433 Legalized drug proponents, 326 Legislation

logrolling, pork-barrel,

402 400-402

Leisure time, 429-430 Lemons model, 316-318 LETS (local electronic trading system), 573 Letterman, David, 388 Levy, Frank, 54-55 Lewis and Clark expedition, 502 Lexus and the Olive Tree(Friedman), 467 Liabilities of banks, 576 definition,

Libertarian

532 Party,

Local government, 399-400 Location convenience stores, 267 and monopolistic competition, Loewenstein, G., 338n Logrolling,

402

London

Philharmonic

266-268

151 24-32

not applicable, 165 in, 584-585

returns

rate, 745-747 of purchasing power

parity, 750-

growth, 591, 593-594 683 equilibrium, supply curve, 187 planning, effect of inflation on, 455-456 economic

Long-run Long-run Long-term

487 Long-term unemployed, Long-term wage and price contracts, 691-692 LosAngeles Olympic Games of 1984, 333 Fruit Principle, 49 Low-Hanging Low-income countries, 47n Glenn, 325 Lowry, Low-skilled workers, 481 Low-wage foreign workers, 54 Lucas,

Robert

E., Jr., 499

Ludd, Ned, 482 Luddites, 482, 483 tax on yachts Luxury effect on sales, 98 102-103

repeal of, 103

time, 440 of, 15-16

over

definition

416

variables, Angus, 504

Magic:

The Gathering,

Magic

Cards, 213,

215

216

of

average

labor

515-517

productivity,

751 Long-run

economic conditions

Management, determinant

economy in, 702 of purchasing power parity in, 750 187-188 Long-run competitive equilibrium, of exchange rate Long-run determination purchasing power parity theory, 747-750 exchange

AD-AS model, 682-683 definition of, 413

League Baseball of .400 hitters, 39-40 rosterlimits, 299

success

imposed,

388

Orchestra,

724

lack

self-correcting

shortcomings

former

Major

telephone billing equation, Long-lived capital goods, 422 Long run

real

policy and supply side, 719-723 belief in fine-tuning, 725

fiscal

Maddison,

Long-distance

definition, 157 law of diminishing money and inflation

naturalist

causes of Great Moderation, 713-714 hours of work, U.S. vs. Europe, 722-723 inflation of 1980s, 712-713

Macroeconomic

564

404

Lobbyists,

Labor

banks,

by

economic

Macroeconomics,

565

evaluated

difficulty

Macroeconomics

Loans

increases,

of

output gaps, 725 inside lag, 724 outside lag, 724-725 requirements for perfection, 723 stabilization policies, 614, 632-633 to stopinflation in 1980s, 712-713 uncertainties of economists about natural rate of unemployment, about potential output, 724

503 economic

long-run

cause

identifying

growth, 591, 593-594 vs. poor countries, 521

from

Agreement, 53 role, 491 political productivity

156

666 Liquidity preference, Literacy rates, 433-434 285-287 Living expenses, Living standards effect of saving rate on, 544 and high saving rate, 555 improved by economic growth health care, 503 real GDP per person, 503-504 transportation,

stabilizers, 639-640 Great Moderation, 714 of conducting, 707

automatic

Limits to Growth (Meadowset al.),523 Limits to growth thesis with, 523-525 problems environmental issues, 523 market mechanisms, 524 ignoring environmental overlooking safeguards, 523 on, 523 report

effect

decline, 342 of, 491 to North American

policy;Monetary

social safety net, 546 expectancy, 433 Lifetime employment, Japan, 543

definition,

membership

policies, 414; see also Fiscal policy; Public policy accommodating policy, 710-711 as art or science, 723-725

Macroeconomic

and

firms,

for money,

667-668

Life

Linux,

Treaty, 736-737 factors in demand

Macroeconomic

Life-cycle

unions

Labor

M Maastricht

W. G., 365 Ashan, 101

Manning, Mansur,

buy-direct appeal, 309 productivity growth in, 151 economy, production possibilities

Manufacturers, Manufacturing, Many-person

curve in, 47-49 Mao Zedong, 326 Margin, failure to think at the, 10-14 Marginal analysis, and reservation price, 66 benefit

Marginal

versus

benefit,

average

definition,

11

equal to

marginal

of

information

12,13-14

cost, 86 search, 310

of SecretService shuttle cost

space Marginal

380-381 protection, program, 12-13

cost, 12, 13-14 11, 157 and economies of scale, 221-222 effect of reduction on supply curve, 80 effect of wage rates, 166

versus

average

definition,

of of

stays, 366 information search, hospital

of pollution price

310

abatement,

equal to,

289

163-165

of SecretService

380-381 protection, shuttle program, 12-13 cost curve, 162 Marginal and economic profit, 185-189 and maximum profit condition, 164-165 space

Marginal Marginal

physical product, 335 productivity, critique of, 347-348

1-15

INDEX

vs. society's interests, 195-196 social optimum, 195 with unexploited 195 opportunities, Market equilibrium exchange rate, 738 Market equilibrium value of exchange rate, 740 Market imperfections, 216 Market mechanisms, 524

product of labor, 470 definition, 335 and hiring, 335-336 short-run decline, 337 Marginal propensity to consume and disposable income, 620-621 effect of multiplier, 632 effect of tax cuts on, 636-637 and multiplier, 648 not known, 724

self-interest

Marginal

versus

Market

economies

of scale, 220 control over inputs, 219 government licensing and franchising,

revenue

Marginal

definition, 224

exclusive

225-227 monopolist, price discrimination, 233-234 revenue curve, for monopolist, Marginal tax rate, 720-723 Marginal Marginal utility; see also Diminishing for

219-220

and

226

marginal utility average utility, 137 130 definition, income effect, 136-137 substation effect, 136-137

versus

Market(s) in communism,

absent

518-519

failures, 196 and sellers in demand curve, 65-66 supply curve, 66-67

alleged buyers

versus central planning, 64-64 definition, 64 determination of prices, 64-65 effect of entry on economic profit, 185-186 with excess demand, 197-198 with excess supply, 198 fair outcomes, 187 116-117 gas vs. car prices, importance of free entry/exit, 190-191 efficient outcome, 187 long-run about, 197 misperceptions out of equilibrium, 85 Pareto efficiency, 197 price above equilibrium, 198-199 price below equilibrium, 197 of choice in, 179 range side, 152 supply tasks performed by, 197-200 69-70 tendency toward equilibrium, for wheat, 156 winner-take-all,

345-346

Market-clearing wage and real wage, 490 union wages higher than, 491 Market demand curve, 141-142,166 Market equilibrium bases of efficiency, 199 cost of preventing price adjustments price ceilings, 200-204 price subsidies, 204-206 68 of complements, 75-76 of price controls, 71-74 of substitutes, 76-77

definition, effect effect effect

efficiency, 196-200 for gain, 195 opportunities 68-71 equilibrium price and quantity, and excess demand, 69 and excess supply, 69 and individual demand curves, 199 information from equilibrium prices in, 85 in invisible hand theory, 188-190 total surplus, 87 maximizing and

end

of

with negative

power

definition, 219 sources of

externalities, not always ideal, 71 with positive externalities,

281-282

monopoly, 220 network economies, 220-221 219 patents and copyrights, Market shifts, 338-339 Market structure, forms of 216-217 monopolistic competition, oligopoly, 217-218 151-172 perfect competition, 216 pure monopoly, Market supply curve, 154-155 price along, 166 slope of, 155 Market value to calculate GDP, 417 over time, 427-428 changes of final goods and services, 419-420 of goods and services drawbacks of using, 417 ways of aggregating, 416-417 nonexistent for public goods, 417 Marlboro, 217 natural

Marquis,

Marshall,

definition, 564 length of, 565 Maximum profit condition, Mazda Miata, 316, 319

282-283

Global

580

and demand curve shift, determinant of exchange effect of type of exchange effect on exchange rates, exchange rate as tool of,

687-688 rates, 732, 742-744 rate, 735-736 742-744

744

709 federal funds rate, 655-656

163-165

2007-2009, 630

Heat, 118

740

714 664-665

expansionary,

exchange rate for dollar, 733 Mexico City, air pollution, 524-525

320,

712-713 Great Moderation,

definition,

nominal

15-16,

of monetary

discount window lending, 674 interest paid on reserves, 674-675 672-673 open-market operations, reserve 674-675 requirements, control of nominal interest rate, 654 control of real interest rate, 654-655

Mexico

Corporation,

of

changes in asset prices, control of money supply

615 new technologies, 615-616 Method of simultaneous equations, 32

Microsoft

Credibility

and

of

Microeconomics,

574

anti-inflationary,

definition,

Miami

101

supply

money

cause

Dennis L., 523n Meadows, Donella H., 523n Mean income, 346 Means-tested benefit programs, 349-350 374 Meatpacking plants of Chicago, Medicaid, 349, 362, 365 Medical records transcription, 53-54 Medicare, 362, 365, 546 Mediterranean Sea pollution, 296 Medium of exchange, 572 private money, 573 Mellon, Andrew, 242 Menu costs, 689

of U.S. recession

(film), 52-53

Joachim,

alternative to, 711 definition and implications, 710-711

Meadows,

effect

724

Times

accommodating

McDonald's,62

impact

634-635 impact on economy, by U.S.1940-2010,634-635 Minimum wage and economic surplus, 352-353 to full employment, 490-491 impediment level in U.S., 351 not indexed, 448 from, 351 unemployment Minorities, wage rates, 343 Mixed economies, 64 Mobility of inputs, 115 Models for earnings forecasting, 196

policy

Model, 372-373 Theater, 396-397 date

Maturation

308-310 123-124

definition and components, velocity of, 583-584 Monetary policy; see also

Systems Masterpiece

309-310

sales agent,

spending

Military

Ml

64 Technology,

of

source,

formula,

Midpoint

Moller,

Marx,

of

as information

statistical,

Marshall

Massachusetts Institute

economic role

Modern

M. S., 365n Alfred, 65, 75

Plan, 510 Karl, 52 on price determination, on recessions, 597

Middlemen

413 54,138,156,157,191,

to fight inflation, 661-663 to fight recession, 659-661 inside lag, 724 and interest rates, 665-672 control of nominal interest rate, 671-675 demand for money, 666-668 money demand curve, 668-670 money supply and market equilibrium, 670-671

to minimize output gaps, 685 more flexible than fiscal policy, 650 outside lag, 724-725 and real planned aggregate expenditures interest rate, 656-658 for European Union, 737 problem in addressing asset bubbles, 664-665 problem role of stabilization policy with demand shocks, 708-709 with inflation shocks, 709-714 and self-correcting economy, 708 as stabilization policy, 632-633 tightening in early 1980s, 744 Monetary policy rule, 684-685, 701 see also Demand for money Money; bank creation of, 575-578 versus barter, 572 574 brokerage accounts,

INDEX

1-16

572, 666 historical kinds of, 572 and inflation in long run, 584-585 of, 561 meanings measurements of, 573-574 medium of exchange, 572 definition,

M2 money

573

private,

584-585 quantity equation, store of value, 573 unit of account, 572-573 velocity of, 583-584 Money demand curve, 668-669 670 Money market equilibrium, Money supply and banking panic of 1930-1933, 652-653 in reserve-deposit ratio, 653 change credit card balances excluded, 574 with currency and deposits, 578-580 determination of, 575 effect of banks on, 575-578 effect of Christmas shopping, 579-580 effect of open market operations, 581-582 Fed control of and demand for money, 666-668 discount window lending, 674 interest paid on reserves, 674-675 money demand curve, 668-670 670-671 money market equilibrium, 672-674 open-market operations, reserve requirements, 674-675 setting interest rates, 665-666 and Fed control of reserves, 655 in Latin America, inflation 582 Ml money supply, 574 and money market equilibrium, 670 M2 money supply, 574 reaction of financial markets to changes in, 673 reduced to stop hyperinflation, 585 relation to prices, 582-583 role of central banks, 580-582 U.S. dollars, 738-739 Money supply curve, 671 Monopolist

perfectly discriminating, 235 price discrimination by, 232-240 profit

maximization,

Nash,

John, 254

Nash

equilibrium

and

game, 245-255

advertising

254

definition,

National

and Space Administration,

Aeronautics

12-13 Basketball Association, 118 299 National Bureau of Economic Research arbiter of recessions, 595 National

rosterlimits,

unemployment,

Negative

demand

shock,

513

603 699

689,

709 policy, 709

externalities

population density, 52 in, 35 poverty Nerd norms, 300 Net capital inflows benefit to economy, 757

steroid use,297-298

saving, 532 accounting identity, 536-537 aggregate spending components,

National

537

components,541

saving, 538-539 saving, 539 current income minus spending, 537 definition, effect of new technologies, 553 private public

and

537

purchases, 537 of, 536-538 and net capital inflows, 756 to increase, 554-555 policies government

measurement

capital, 537 saving and government budget, 539-541 rate in U.S. 1960-2010,538 and real interest rate, 655 reduced by government 553 budget deficits, ratio, 758 saving/GDP saving rate, cause of trade deficit, National Science Foundation, 521

National

757-758

47n

monopoly

and antitrust cable

laws,

television,

scale, 240 of, 240 network economies as source of, 220-221 price and marginal cost, 240 public policy for enforcement of antitrust laws, 242-243 of

inefficiency

241-242 contracting, government ownership, 240-241 government regulation, 241 Natural rate of unemployment and cyclical unemployment, 602-604 exclusive

definition, 752 and national saving, 756 and real interest rate, 754-755 and trade balance, 753 Net exports, 751 effect of real exchange rate, 747 and GDP, 432-434 and national saving, 536-537 in planned aggregate expenditures, 615-617 Net taxes, 538 Network economies, 220-221 Net worth, 532 New Division of Labor 54-55 (Levy & Murnane), Newhouse, J. P., 365n News Hour with Jim Lehrer, 54, 55 Newton, Isaac, 64

New York food

City

supply

and demand,

shortage,

housing

61-62

62

rent control, 62-63 Silicon Alley, 488 New York Stock Exchange, 566 New York Times, 115, 126, 444, 467, 593 Nickell, Stephen, 722n Nintendo, 222-223 Richard M., 326 Nixon, No-cash-on-the-table principle; see also

231, 242

240

regulation, 241 220 definition, economic profit, 242-243

economies

281-283

example, 280-281 and free speech laws, 288 amount not zero, 289 optional income tax, 350-351 Negative with jobs program, 354-355 inflation rate, 443 Negative inflation shock, 695 Negative Negative output gap, 601 Negotiation about externalities, 287-288 Nepal

Business Cycle Dating Committee, 597 on Great Depression, 596 on recession of 2001, 638, 660 National comparative advantage, 40 National Football League, 138

cost-plus

219-220

cyclical

280 effect on resource allocation,

Natural

sourcesof

127-128

Negative

growth,

definition,

N

low-income, 47n rich vs. poor, 432-434

deadweight loss of, 230 source of inefficiency in, 231

603-604

compensatory taxes, 289-290

high-income,

and antitrust laws, 230-231, 242-243 breakdown of invisible hand, 229-231

Needsvs. wants,

Negative

Nations

Monopoly

J. P., 515

571

funds,

determinant of average productivity exploitation of, 431 Natural selection, 17

dot-com bubble, and stabilization

345

National

economic profit, 217 importance of location, 266-268 barriers to entry, 216 lacking versus perfect competition, 216-217 differentiation product by, 216, 217

Morgan,

Mutual

296

public

216

market power control over inputs, 219 economies of scale, 220 government licensing and franchising, natural monopoly, 220 network economies, 220-221 219 patent and copyrights, Moral hazard definition, 323 and insurance companies, 323-324 Moral sentiments, 270-271

Natural

supply

definition and components, 574 velocity of, 583-584 Multinational environmental pollution, Multiplayer prisoner's dilemma, 257 631-632, 647-648 Multiplier, bonds, 565 Municipal Murnane, Richard, 54-55 Musicians,

than in 1990s, decline, 603-604 resources

reasonsfor

public

230

decision rule on output, 227-228 marginal revenue, 224-227 not guaranteed, 228-229 see also Game theory Monopolistic competition; definition,

definition, 603 lower in late 2000s

Morton Salt, 100 Movement along a demand curve, 75 Movie industry, price discrimination, 239

Money\342\200\224Cont.

Equilibrium principle

wage gap, 343 Lunch Principle, 4; see also Scarcity Noise in the price system, 452-453 Nominal exchange rate, 732 Canadian dollar and British pound, 733-734 and currency 734-735 appreciation, and currency 734-735 depreciation, 734 definition, national comparisons, 734

and

arbitrary

No Free

in U.S., 734 Nominal definition,

GDP, 583 427

moving in versus Nominal

direction, opposite real GDP, 426-429 income, 445

428

INDEX

Nominal and

interest rate, 457-460 control of money supply,

Oligopoly; see also Game theory cartel agreements, 257-260 cartels, 242, 258-259

665-666

definition, 458 for money, 667-668 654-655 over, 611-615 Fisher effect, 460-461 and

demand

Fed control Fed control

of,

formula, 458 and money demand in U.S. 1970-2010,459 Nominal price, 139 Nominal quantities

curve,

668-669

445

definition,

deflating, 445-447 over time, 446 earnings versus real quantities, 445 real quantity converted to, 447-448 real wages, 446-447 Nominal wage, 446-447 and inflation expectations, 690 lowered for airlines, 718 n resistance to cuts in, 717 Nondurable goods, 422 effect of recessions on, 698 Noneconomic factors in comparative advantage, 40-41 Nonexcludable public goods 388

definition,

pure common good, 389 Nonmarket activities, omitted from

GDP,

430-431

Nonpayers, Nonrival

means

of excluding,

396

collective goods, 389 definition, 388 Normal goods, 78 Normal

profit

definition, 181 more or less then, 184-190 earning Normative economic principle, 15 Norms

Output

of taste, 300-301 against vanity, 301 North American Free Trade Agreement, over, 53 controversy North Carolina Research Triangle, 488 North Korea, 52, 63

eliminated eliminated eliminating,

monetary

Okun's

581 effect on supply of reserves, 655 Open-market purchase, 672-673 581 definition, Open-market sale, 673

o

planned aggregate expenditures decline leading to recession, 627-628 determination of short-run equilibrium 628-629 output, of 1990s, 629-630 Japanese recession

U.S.recession

definition, 581

reasons

positive,

cost; see also Increasing

Opportunity

opportunity of activities, 9 all costs as, 7

cost

of capital investment, 549 and comparative advantage,

36-41

6

gains from specialization and exchange and implicit value, 7 in many-person economy, 48-49 and price discrimination, 233-235 in principle of comparative advantage, and supply, 152-154 and supply curve, 66-61 of time for schooling, 510-511 and tragedy of the commons,294

two-product economy, 43 of working less, 430 amount of information, Optimal 134 Optimal combination,

and, 47

39

definition,

377

Administration,

Offshore call centers, 55

Oil price of increase in,

effect

138-139

spike in 2001, 117 Oil prices 699 2007-2008, on U.S. economy, 698 increased by OPEC, 695 Oil price shocks, 681, 698 Oil reserves, 524 doubled impact

Oil supply

of 1979, 361

interruption Arthur, 503

Okun's law cyclical definition,

unemployment, 503

equation, 604 and output gap in

U.S.,

604-606

on, 54-55 foreign wages, 54 jobs less vulnerable to, 55 medical records example, 53-54

604-606

310-315

622

average

668

compensatory taxes on, 289-290 effect of decline in aggregate spending, 614 effect of externalities, 282 effect of increase on demand for labor, 473 effect of price discrimination, 232-235 to maximize profit, 224-229 expanded full-employment, 600 GDPas measure of, 416-421 and induced expenditure, 622 law of diminishing returns, 158 marginal product of labor, 335 market values, 416-417 maximum profit condition, 163-165 and planned aggregate expenditures,

621-623

profit-maximizing

reduced

by

socially

efficient

53 naturalist

and

682-683

expenditure, total cost, 161 variable cost, 161 average and benefit of holding money,

701

relation to aggregate spending, 614 relation to spending, 607-609 and self-correcting economy, 708 and slope of aggregate supply curve, 692 types of, 601-602 and unemployment, 602-604 in U.S. 1949-2010, 601-602 Output per person from increase in average labor productivity, in U.S. 1929-2010,503 in U.S. 1960-2009,507 Outside lag of fiscal policy, 724-725 of monetary policy, 724-725 Outsourcing of computerized tasks, 54-55 economic

Optimal level of ignorance, 311 of Petroleum Exporting Countries, Organization 117,260,695 Out of the labor market, 484 Output; see also Potential output; Short-run

autonomous

630-631 2007-2009, for short-term fluctuations, 601-602

formula, 701 195

unexploited, 195

and

367, 368, 638 Obama administration, 633, 639 Occupational Safety and Health Barack,

policy to minimize, 685 law, 604-606

and

Opportunities

buyer/seller awareness of, 156 for gain in market equilibrium,

payments, 530 monetary policy, 654 by stabilization policies, 632-633 602 by

fiscal policy to eliminate, 614 and inflation, 692 601 measuring, monetary policy to fight, 659-661

definition,

equilibrium output AD-AS model to analyze,

Obama,

gaps

causes and cures, 606-607 601 definition, effect on taxes and transfer

in

fashion, 300 nerd, 300

Okun,

of U.S.economy

economic profit, 217 examples, 217 and location in time, 268 333 Games, Los Angeles, Olympic Omerta code, 268, 269 100 percent reserve banking, 516 Online job services, 604 Open economy monetary policy, 744 saving-investment diagram, 155-151 670-671, 672-674 Open-market operations,

definition,

goods

to producers, 290-291 429 1929-2010,

subsidies

217

definition,

1-17

Larry, 515 24

Parameter,

Pareto,Vilfredo, 197 Pareto efficiency, 197 Parker, Jonathan A., 638n rate; see Labor force participation Participation rate Part-time workers, involuntary, 487-488 Patent protection, 220 and antitrust laws, 231 source of market power, 219 Patents, Payoff bases of, 252 in decision tree, 264-265 on relative performance, 297-298 depending and dominant strategy, 253 in prisoner's dilemma, 260 Payoff

matrix

in

advertising

game, 253 cartel agreements, 259 ban, 261 cigarette advertising 253 definition, for

with Nash equilibrium, 254-255 in prisoner's dilemma, 256

level, 159-160

486 unemployment, for monopolist,

P Page,

car differences, for steroid use, 298 sports

230

263

508

1-18

INDEX

Pay-per-view TV, 397-398 Pay raise, and rent increases, PBS evening news, 54-55 Peace Corps, 35

consumer spending, 618-621 in, 616 consumption expenditure

77-78

definition,

Peak, 595

Peer

on demand,

influences

126-127

117, 660-661

attack,

Pentagon

268

Pepsi,

PepsiCo, 319-320

net exportscomponent,

hurdle

Perfect

definition, 236 price, 236-237 Perfectly competitive firms compared to imperfectly competitive

and output, and output decline

reservation

firms,

Playstation,

acid rain, 400 auction of permits for, 371-372 carbon taxes on, 372-373 loss caused by, 281-282 deadweight effect on economic surplus, 282 limitations on discharge of, 288 cost of abatement, 369 marginal Mexico City, 524-525 multinational, 296 abatement not zero, 289 optimal from production, 86 and recycling, 168-169 socially optimal level, 289 taxation of, 369-371 toxic waste, 283-285

elastic

Poor,the

of price ceilings, 203 of price controls on, 73 effect of price subsidies, 204-206 income distribution for

George L., 718n arms control agreements, 299-301 Personal Responsibility Act of 1996, 349 Perry,

effect

Personal

effect

saving, 538 Iver, 31 In

combination

415

Pharmaceutical

companies,

patents owned

by,

Philip Morris, 261-262 Physical capital capital goods, 511-512 definition,

of

of methods, 354-355 income tax credit, 352-354

in-kind

transfers,

minimum negative

positional

positional

average

labor

productivity,

diminishing returns to capital, 512 effect of additional capital on output, 512 and efficiency, 511 human capital analogous to, 510 64

Pigou, A. C, 290 Pizza price ceiling, 73-74 Planned aggregate expenditures versus actual spending, 617-618 autonomous 622 expenditure,

349

programs, 349-350 wages, 351 income tax, 350-351

354 employment, welfare payments, 349 income transfers to, 203-204 waiting in long lines, 140 Poor countries and economic growth, 521-522 economic well-being, 432-434 Population density, in Nepal, 52 Population growth, 50 Pork-barrel legislation, 400-402 definition,

402

logrolling, 402 reasons for, 501-502

relative

performance,

arms control agreements, arms races, 299

299-301

norms, 299-301 demand shock, 689

social

15

Positive externalities 280 on resource allocation,

definition, effect

282-283

example, 280 subsidies to producers, 290-291 subsidies to property owners, 289 Positive inflation shock, 695 Potential GDP, 600 Potential output 600

characteristics,

definition, 600 of fiscal policy on, 639 to average output, 692 reasons for variations in, 600-601 recession and expansion explained effect equal

by

changes

in, 601 policy, 719-723 U.S. 1949-2010,600

supply-side of

James M., 619 431-432 Poverty, in Nepal, 35 Poverty line, in U.S. 2010, 431 threshold, 350 Poverty Poterba,

Poverty,

Precautionary

saving

definition, 542 in Japan, 543 U.S.

vs. Japan and Europe, 126

546

Preferences,

discerned in others, 272 effect on demand curve, 78 as ends in themselves, 271 in game theory impact of moral sentiments, 270-271 self-interest and selfishness, 271 solution to commitment problems, 271-272 Prescott, Edward C, 722 Presidential campaign costs, 299 President of the U.S., Secret Service protection,

380-381 Price(s);seealso of

public

511-513

Picasso,Pablo,

earned

means-tested

511

determinant

219

on

depending

payoff

Positive economic principle,

222-223

Pollution

389

William,

definition, 298

Positive

Point elasticity, 124 Polachek, S., 344n Political and legal environment determinants of average labor productivity free and open exchange of ideas, 517 and political instability, 517 well-defined property rights, 517 for economic growth, 521 and failure of communism, 518-519 Political instability, 517, 519 and desire to hold dollars, 670 Political process; see Government Pollock, Jackson, 64, 65

155

dates, 299

297-298

Plato, 64

demand curve, 106 elastic supply, 114 inelastic demand curve, 106 Perfectly Perfectly inelastic supply, 113 Perot, Ross, 53

Petty,

output, 624-627,

starting

kindergarten

norms, 299-301 roster limits, 299 arms races, 299 externalities

social

Positional

recession 2007-2009, 630-631 real interest rate, 564, 656-658 Planned spending, 614

Perfectly

Petersen,

mandatory

to recession, 627-628 recession of 1990s, 629-630

U.S.

Perfectly discriminating monopolist definition, 235 economic surplus, 235 reservation price, 235

Personal

financial crisis, 737 arms control agreements arbitration agreements, 299 campaign spending limits, 299 299 definition,

Positional

sports

and

standardized products, 156 well informed buyers and sellers, 156 Perfectly competitive supply, pure private

Perfectly

diversification, 666

Positional

equilibrium

decision

allocation 666

Portugal,

628-629

many buyers and sellers, 156 mobile resources, 156 as price takers, 156 230 maximization, profit in, 155-166 profit-maximization total cost, 161 average variable cost, 161 average choosing output level, 159-160 cost concepts, 158-159 demand curve, 155-156 graphing, 161-163 and law of supply, 165-166 maximum profit condition, 163-165 in short run, 157-158 production shutdown condition, 161

goods,

definition,

gaps leading

short-run

156

terminology,

616-617

621-623

Japanese

216,218-219 demand curve, 218-219 demand curve facing, 156-157 revenue, 224 marginal price takers, 194 Perfectly competitive markets and copyright holders, 215 definition,

616

expenditure line, 622-623 factors affecting, 685-686 government purchases in, 616 induced 622 expenditure, investment component, 616 and monetary policy rule, 684-685

Portfolio

Equilibrium price; Inflation; Rate inflation; Reservation price

above equilibrium level, 198-199 allocative function, 184 165-166 along market demand curve,

along market

curve, 166 supply average total cost, 185 below equilibrium level, 197

and

of bonds,565 and cash on the table, 85-86 and change in demand, 75 and change in quantity demanded, 74-75 changes over time, 426-428 and composition of workforce, 343

1-19

INDEX

CPI, 440-442 consumer surplus,

and and

costsof

Price

142-145

price

determination

of

over, 307-308

illicit

impact

law of demand, 126 of inflation, 444

and

low rate and

revenue

marginal

of

monopolist,

225-227 and market power, 219 menu costs, 615-616, 689 nominal quantities measured in, 445 in perfectly competitive firms, 156-157 predicting and explaining changes in four rules governing, 82-84 shift in demand curve, 75-78 shift in supply curve, 78-81

615-616

preset,

and

surplus, 170-172 bias, 449 adjustment function, 184 rationing real vs. nominal, 139 relation to money supply, 582-583 producer

quality

substitution substitution

84

economic economic

with, 202-203 without, 201-202

surplus

on equilibrium and efficiency, on heating oil, 200-204 on pizza, 73-74 effect

GDP measure

as

Price

excluding,

information, changes,

200-204

427

453

effect

on total expenditure,

110-111 Price controls

on gasoline, 72-73 and incentive principle, 204 opposed by economists, 73 pizza prices, 73-74 price ceilings, 200-204 price subsidies, 204-206 total surplus, 85 reducing on rent, 61-62, 71-73 rent control, 62-63, 71-73 waste caused by, 201, 202

taxpayers,

volatility

fluctuating

gasoline

demand prices,

whale harvesting limits on, 295 Private property laws, 295 Private provision of public goods disadvantages of relying on government, funding by donation, 396 means of excluding nonpayers, 396 396 private contracting, problems with, 398 sale of by-products, 396

curve,

116-117

118

national

of

saving, 538-539

538

incentives to Producers

increase,

554-555

compensatory

taxes on, 289-290

costly-to-fake

principle,

Producer

319-320

to, 290-291

subsidies

surplus

calculating, 170-172 to consumer compared definition, 170

surplus,

effect

170

171

graph,

price

choosing

453

395-396

saving

238

among versions of, 308-309 on supply of changes in prices of

other, 167 standardized,

156,194

takers,

harvesting

ceilings, 202 price discrimination, with price subsidies, 205 see also Goods Product(s);

on equilibrium and efficiency, 204-206 on economic surplus, 204-205 impact income transfers for, 206 waste from, 205 Price system, noise in, 452-453

Price

pollution, 296 on public land, 295-296 in international waters, 296

multinational

from

205

effect

Price

controlling timber

294-295

of

impracticality

with

relative

by

389

definition,

price, 451-452 616 Priceline.com, 250 Price-quantity combination, Price setters, 215-216 Price signals, distorted by inflation, Price subsidies

borne

pure,

Private health insurance, 367-368 Private money, 573 Private ownership economic surplus maximization, examples, 294

component

451

definition,

260-262

tit-for-tat strategy, 260-262 Private contracting, 396 Private goods jointly consumed, 392-393 390-391 joint purchases, market demand curve for, 394 versus public goods, 388-390

Private

perfectly elastic supply, 114 and perfectly inelastic supply, 113 and supply curve, 112-113 Price increases effect on hiring, 336 effect on total expenditure, 89 Price index, 442 Price level and benefit of holding money, 668 CPI as measure of, 440-442

versus

Price change

116

fluctuations,

of

and

73 surplus

curve

257

original, 256-257 matrix, 256 payoff repeated,

100

formula, 112

and substitution effect, 65,138 and supply curve, 66-67 total expenditure as function of, 109 unit of account, 572-573 value of marginal product, 335 Price ceilings definition,

curve, 105-106

inputs, 115 115 substitutes, input of inputs, 115 mobility time, 115-116 economic naturalist, 116-117

190 equilibrium, bias, 449-450 135-137 effect,

strategy,

multiplayer, demand

substitution possibilities, 100 time, 100 economic naturalist 102-103 luxury tax on yachts, 102 teenage smoking, formula, 104 vs. cars, 117 gasoline 103-107 graphical interpretation, formula, 123-124 midpoint and perfectly elastic demand curve, 106 and perfectly inelastic demand curve, 106 for pizza, 99 and quantity demanded, 98-99 estimates, 101 representative and total expenditure, 107-111 changes move in opposite directions, 107-110 move in same direction, 110-111 changes Price elasticity of supply 113 calculating graphically, definition, 112

flexibility

movements,

short-run

257 economic naturalist cartel agreements, 257-260 at parties, 262 shouting TV cigarette advertising, 261-262 economics of cartels, 257-260 investment choice, 257

98 share,

256

dominant

determinants

demand

dilemma

definition,

235 merits of, 237-238 with perfect hurdle, 236-237 relative effectiveness, 232 scratch and dent sales, 239 Price elasticity of demand

budget

of increasing opportunity cost, 49 individual supply curve, 155

Prisoner's

determinants

relative, 451-452 seasonal

and

imperfect,

definition,

advantage, 37-40

comparative 39

Principle

examples, 238-239 hurdle method, 235-237

calculating, 104 in straight-line changes

564

amount, of

definition,

appliance retailers, 239 ticket prices, 232 effect on output, 232-235

drugs, 97 of exchange rates on imports, 739 impact of exchange rats on exports, 740 in imperfectly competitive firms, 157 incentives in environmental regulation auction of pollution permits, 371-372 carbon taxes, 372-373 taxes on pollution, 369-371 income effect, 135-137 and income effect, 65 of land in Manhattan, 113 for

naturalist

movie

production theory, 64 value theory, 65 confusion, 64 widespread effect of increases on demand for labor, 472-473 to marginal cost, 163-165 equal haggling

Principal Principle

231

economic

preventing adjustments ceilings, 200-204 subsidies, 204-206

price

discrimination

definition,

156

Product clusters, 268 Product differentiation and location in time, 268 in monopolistic 216 competition, see also Costs of production Production; cost-benefit principle, 86 effect of changes in planned spending, of inputs, 115 flexibility law of diminishing returns, 158

621-623

INDEX

1-20

shutdown condition, 161

Production\342\200\224Cont.

and \"law\" of supply, 165-166 in long run, 157 market value vs. physical volume of inputs, 115 mobility in short run, 157-158

and of, 427

47 specialization, inputs, 115 118 bottlenecks, supply Production possibilities curve attainable point, 43-44 without

substitute

factors

knowledge population productivity

and

technology, growth, 50 growth, 49-50

two-product economy, point, 43-44 Productive ability, 334-335 for

50-51

41-47

unattainable

and demand for labor, 469-470 effect of changes in production possibilities

curve, 44-46 effect of improvements on demand for labor, 474-475 effect of unions on, 341-342 in manufacturing, 151 growth rate 1960-2010, 478-479 growth and increase in real wage, 477-478 reasons for growth in, 49-51 slow in services, 151 Product space, 268 Professional baseball, lack of .400 hitters, 39-40 sports

roster limits, 299 steroid use, 297-298 tennis, 297 Profit

from cigarette advertising 156 definition,

ban, 261

164 graphical measurement, and invisible hand, 180 quest for, 179-180 types of, 180-181 Profitable firm, 161 Profit maximization, 156 of, 249-250 algebra and cartel agreements, 257-260 for

monopolist

decision rule on output, 227-228 marginal revenue, 224-227 no guarantee of, 228-229 for monopoly vs. perfect competition, 230 in perfectly competitive markets, 155-166 average total cost, 151 variable cost, 151 average choosing output level, 159-160 cost concepts, 158-159 demand curve, 156-157 graphing, 161-163 and law of supply, 165-166 maximum profit condition, 163-165 short fun production, 157-158

comparisons over time, 445-447 effect of inflation, 454 in U.S., 430 increase and real interest rate, 459 Purchasing power parity theory

233-235 discrimination, level of output, 159-160

rights

absent in communism, 518 effect of private ownership, 294-295 396 gated communities, 399 government enforcement, 291 private property, tragedy

determination

388

demand curve for, 393-395 of, 388-393 government provision as individually consumed private goods, 392-393 market value of, 417 measuring nonexcludable, 388

Q

Quality of Quantity

over time, 426-428 and explaining changes four rules governing, 82-84 shift in demand curve, 75-78 shift in supply curve, 78-81 86 socially optimal,

changes

predicting

income effect,

396 by donation, of excluding nonpayers, 396 private contracting, problems with, 398 of by-products,

396

historical importance, 584 17 Quicken software, Quintiles of income, 346

396

common goods, 389 to pay for, 393

R

willingness

Public health and security cost-benefit principle, 380-381 crime prevention, 380 economic naturalist Secret Service agents, 380-381 vaccination laws, 379-380 cost, 380-381 increasing opportunity scarcity principle, 381 socially optimal expenditure, 379 Public investment, 520-521 Public policy, 331; see also Macroeconomic policies cost-benefit principle, 432 to increase human capital, 519-520 to increase national saving, 554-555 to promote saving and investment, 520-521 to support research and development, 521 Public saving of national component saving, 538, 539 539

equal to budget surplus, 539 and government budget, 539-541 means of increasing, 554-555 since 1970s, 541 negative reduced by government budget deficits, Purchase of foreign assets, 738 of foreign goods, 738 of U.S. assets, 740 of U.S. goods and services, 739-740

98-99

584

definition,

pure, 388-389

definition,

in

135-137

and price elasticity of demand, substitution effect, 135-137 Quantity equation

funding means

bias, 449 adjustment life, 431

Quality

Quantity demanded and demand curve, 125 effect of price increase, 98

395-396

pure

of, 750-751 short run vs. long run, 750 Pure common good, 389 Pure private good, 389 Pure public goods, 388-389 shortcomings

388

optimal quantity of, 393-398 paying for, 390-393 versus private goods, 388-390 private provision of of relying on government, disadvantage

sale

of exchange rates, 747-750 in U.S. in 1980s, 750 inflation and depreciation, 748-750 and law of one price, 747, 750 and nonstandardized commodities, 750-571 nontraded goods, 750 rate, 748 price of goods and real exchange failure

well-defined, 517 when private ownership is impractical, 295-296 and zoning laws, 399 tax, 392 Proportional Proportions, measuring in., 8-9 13, California, 404 Proposition costs of unemployment, 486 Psychological Public capital, 537 Public employment for the poor, 354-355 Public goods collective goods, 389 definition,

748

definition,

of unpriced resources, 292-294 of the commons, 292-294

nonrival,

Productivity

Professional

Property

problem

countries slow to specialize, 51-52 definition, 42 downward slope of, 43, 44 effect of individual productivity, 44-46 efficient point, 43-44 gains from specialization and exchange, 46-47 inefficient point, 43-44 for many-person economy, 47-49 of too much specialization, 52-53 possibility principle of increasing opportunity cost, 49 of, 36 purpose shift

price

Profit-maximizing

power

Purchasing

156

terminology,

Jorgen, 523n inflation, 416 444 annualized 2007-2010, 442-443 2006-2010, changes

Randers,

Rate

of

and

credibility of monetary 442

and

policy rule, 684-685

monetary

443

negative,

overstated, 718 price level vs. relative price, 451 444 short-run fluctuations, target rate, 687 in U.S. 1900-2010,443 in U.S. 1960-2010, 598-599 in U.S. 1970-2010,459 in U.S. 1978-1985,713 in U.S. in 1970s, 451 Rational choice, 15 Rational

person

definition, 5 in cost-benefit analysis, 8-14 pitfalls Rational spending rule for allocating fixed income, 132-134 definition,

553

policy, 715-716

definition,

135

formula, 135 importance

and

marginal

of income differences, utility, 132-135

price increase, 136 price reduction, 136-137 role of substitution, 138-140 and and

140

INDEX

raised to end expansionary gap, 661-663 reasons for raising in 2004-2005, 663 and saving, 543-545 uncertain as to effects of changes in, 724

125

Rationing,

of price, 184 Rationing function Ratio rise/run, 25-26 Reagan, Ronald W., 639 Real assets, 532 Real estate prices in Japan in 1980s, 564 Real exchange rate, 732 746 on exports and imports,

definition, effect

formula, 746-747 of domestic or purchase 745-746 Real GDP

747 goods,

imported

calculating

chain weighting, 428n by changes over time, 426-428 volatility of, 713-714 changing 427 definition, in definition of recession, 595 in U.S. 1929-2010, fluctuations 594

458

cure shift and changes in, 687-688 of international capital flows, 754-755 effect of government budget deficits, 553-554 effect of new technologies, 552-553 effect of surge on creditors and debtors, demand

determinant

459-460 effect on autonomous consumption, 619 effect on consumption and investment, 659 effect on exchange rates, 742-744 effect on investment decisions, 549 effect on planned aggregate 654 expenditures, effect on saving, 551-552 level, 552 equilibrium Fed control of, 654-655 to fight recession, 659-661 on and

458

inflation,

1975-2010, 458

457-460

bonds, 460 inflation-protected and monetary policy rule, 684-685 versus nominal rate, 458 and

planned aggregate expenditures and capital investments, 656-657

and

and effect effect

and

consumption

expenditure,

656

on firms, 656 on households, 656 short-run

by

of airline industry,

of cigarette in developing

expenditures,

629

601

633-634 by government purchases, by tax cuts, 636-637 Fed policy of 2001, 606 Fed's response to, 685, 711-712 monetary policy to deal with, 659

and and

equilibrium

output,

658

game

Rent control

self-correcting

and discrimination, 72 effect on quality of housing, finder's fees, 72 72 key deposits, misallocation from, 72

slope

in New York City, 62-63

economy, 701-702 of aggregate supply curve, 692 too little spending, 614

from

Recessions, 591, 596 big vs. small, 600 and Business Cycle Dating Committee, 597 causes of, 606-609 in potential output, 600-601 changes 489, 598 cyclical unemployment, duration,

duration

595

487 unemployment, on government budget, 540 fall in planned spending leading to, of

627-628 in Japan in 1990s, 629-630 in U.S. 2007-2009, 630-631 from Fed policy in early 1980s, 712-713 in 2001, 709 Fed's response felt throughout economy, 597 and fiscal policy contractionary policy, 632 expansionary policy, 632 and planned spending, government purchases 633-635

stabilization policies, 632 and aggregate taxes, transfers,

spending,

635-638 policy 2007-2009, 633 fiscal policy 2007-2009, 638

U.S. and

522

commitment problems in, 268 decision tree for, 265-266 role of preferences, 270-271

of

elimination

countries, 369-373

of externalities, 287-288 of natural monopoly, 241 safety seats for infants, 378 state vaccination laws, 379-380 of workplace safety, 374-378 zoning laws, 288, 295 Relative price defossion, 451 versus price level, 451-452 Remote-office

economists' views, 602 efficiency principle, 602

190-191 261-262

advertising,

environmental,

cure for, 661 autonomous

591

Regulation

impact, 597-598 definition, 595 in Japan in 1990s, 564 monetary policy to fight, 659-661 nature of, 1990-2009, 596 595 trough, global

bonds

government

457 hyperinflation, inflation, 455 Redwood City, California, tax, 392 Regressive by

quantity,

effect

definition, 458

formula,

Redistribution

recent trends in, 479-482 in recessions, 698 Recession aid, 640 Recessionary gap

definition,

167-168

price, 153 of wealth

Redemption

490 as price for labor, 469 and productivity, 478-479

from decline in

curve, 154-155

supply

168-169 pollution, by private market forces, Red Cross, 155 and

market-clearing,

growth in, 523 growth in major nations 2002-2010, 598 as imperfect measure of well-being, 429-432 measure of well-being inadequate environmental quality, 431 leisure time, 429-430 nonmarket activities, 430-431 and economic inequality, 431-432 poverty quality of life, 431 resource depletion, 431 431 underground economy, and increase in supply of dollars, 741 in opposite direction, 428 moves in early 1980s, 712-713 negative versus nominal GDP, 426-429 in U.S. 1978-1985, 713 Real GDP per person and air pollution, 525 from economic growth, 503-504 national 504-505 comparisons, Real income, 445 and benefit of holding money, 668 Real interest rate, 457-460 calculating,

in U.S. 1970-2010, 459 in U.S. 1978-1985, 713 Real price, 139 Real quantity converted to nominal 447-448 Real rate of return, 458, 545 Real wage, 446-447 decline since 1970, 468 growth in 20th century, 468 increase in, 151 and inflation expectations, 690

market

1-21

informal

and unemployment rate, 602-603 in U.S. 2007-2009, 593, 681-682 in U.S. since 1929, 595-596 Reconstructive surgery, 301 Recycling, 152-154 individual supply curve, 154

opposed

by

economists,

72

64

Rent seeking definition,

402

examples,

402-404

dilemma, 260-262 Repeated prisoner's Required rate of return, 567, 571 Research and development costs of, 523 fixed investment in, 224 to support, 521 policies Reservation price, 153 of buyer, 66 and consumer surplus, 142-145 and economic rent, 191 of employers for labor, 337 and hurdle method of price discrimination,

236-237 labor, 475

for of

perfectly

and

price

discriminating discrimination,

monopolist,

235

233-235

seller, 67 in voluntary exchange, 85 wants determinant of, 126 Reserve Bank of New Zealand, 716 ratio, 576-578, 653 Reserve-deposit of

674 Fed control over, 674-675 Reserve requirements, to control money supply, 674-675 Reserves; see Bank reserves definition,

Residential

investments, 423

Resourceallocation,

188 of externalities on, 280, 281-283 Resourcedepletion, omitted from GDP, 431 effect

Resources 156 shift in aggregate supply curve and changes in, 694 292-294 unpriced,

mobile,

INDEX

1-22

stores vs. Internet, 308 Retirement, saving for, 541-542 Retton, Mary Lou, 333 Return, determinant of international Retailers,

754-755 Revenue, smaller than variable cost, Rich countries economic well-being, 432-434 foreign aid from, 522

effect of

capital

flows,

role

of

average

labor

productivity,

of international 754-755 effect on capital flows, 755 in stock prices, 568-569 Risk and return, 666

Risk Risk Risk

flows,

rational

markets, 562 of bond and stock markets, 569-570 Books, Lambertville, NJ, 311-312

financial

RJR, 261-262 Robinson, Joan, 217n Rockefeller, John D., 242, 515

Roster limits, 299 J., 603n Rotemberg, Rules-based jobs, 55 Ruth, Babe, 440, 446, 549

s Salaries

Bruce, 722n

Sale

5

of professors,

396

of by-products, 309-310

Sales clerks, knowledgeable, Sanders,Harlan, 296

311

Satellite

18

navigation

scores, 322,

systems,

323

Saving

by financial system by Japanese banks, 562 562 providing information, risk sharing, 562 allocation by stock and bond markets, allocation

569-571 and capital formation, 532 and capital inflows, 756-757 versus 544-545 consumption, 532

definition,

533-534

importance of, 531 policies to promote, private, 538-539 public,

and real interest rate, 543-545

reasonsfor bequest

definition,

4

in health care delivery, 362 and optimal amount of litter, 169 and slope of production possibilities 101 Scarf, Herbert, Robert J., 630 Schiller, Anna J., 653 Schwartz, Scottish pin factory, 51 Scratch and dent sales, 239 Seale, James, 101 Search for information; see Information Sears Tower, 219 Seasonal price movements, 84 Secret Service agents, 380-381

curve, 43

saving, 542 542-543

life-cycle saving, 541-542 precautionary saving, 542 related to wealth, 534 self-control hypothesis, 545-546 and demand analysis, 551-552 supply target savers, 545 types of, 538-539 546-547 by U.S. households,

run

decline in marginal product decline of value of marginal

594-597 expansions, 598 Short-term unemployed, 487 Shoven, John, 101 Shutdown

condition,

Simon, Simple

Simultaneous

equations,

156

voluntary

growth,

422 category of consumption, effect of recessions on, 698 Street, 390 of population employed and average labor productivity, in U.S. 1960-2009,507

technological change, Dennis B., 325n 27-28

Share

definition, 25 of demand curve, 65-66 of individual supply curve, 155 of market supply curve, 155 of production possibilities curve, 43-46, 48 relation to elasticity, 105 of supply curve, 66-67 Small businesses, access to credit, 564 Smart for one, dumb for all behaviors, 86 Smith, Adam, 215, 216, 280, 292, 308 invisible hand theory, 188-190,190-191 quest for profit, 180 on society's interests, 195 on specialization, 51 Smith, Robert S., 377n Social costs of unemployment, 486 Social efficiency, and externalities, 284-285 Social forces, influence on demand, 126-127 Socially optimal expenditures on public health and security, 379 on

506-508

Sherman Antitrust Act, 242

factors for aggregate demand curve, 685-688 for aggregate supply curve, 693-695 Shifts in demand; see Demand

603n

151

Slope,

482-483

on prices,64

Sesame

Shift

94

method of, 32 solving, 30-32 Sinclair, Upton, 374

235-237

Services

City, 488

John R., 714n interest, 505

Skill-biased

exchange, 85 surplus, 85 industry, slow productivity

161

Alley, New York Silicon Valley, 488 Silver Blaze (Doyle), 9 Silicon

271

Robert,

and

unemployment,

costly-to-fake principle, 319-320 effect on price and quantity, 64-67 and hurdle method of price discrimination,

Shimer,

604-606 and cyclical unemployment, 600-602 for, 606-609

gaps

recessions

Slawson,

Service

policy, 654-665 rate of unemployment vs. cyclical rate,

natural

reasons

versus society's interests, 195-196

Seller's

598-599

monetary

output

policies with demand shocks, 708-709 with inflation shocks, 709-714 Self-interest, 180,271

perfectly competitive markets, Seller's reservation price, 67

337

602-604

297

in

337

Okun's law,

role of stabilization

Selfishness,

labor,

product,

demand met at preset prices, 615-616 economic profit or loss in, 189-190 rate determination, 738-744 exchange failure of purchasing power parity in, 750 focus of basic Keynesian model, 702 law of supply in, 165 Short-run 683 equilibrium, Short-run equilibrium output after fall in planned spending, 628-629 definition, 624 graphical approach, 626 and multiplier, 632 numerical 624-625 determination, and real interest rate, 658 Short-run equilibrium price, 190 Short-run shutdown condition, 161 Short-term economic fluctuations and basic Keynesian model, 614 business cycle, 594 versus depressions, 594 global impact, 597-598 historical data, 597-598 industries most affected, 598 and

search

of

157

inflation,

Self-control hypothesis and low U.S. saving rate, 547 and saving rate, 545-546 Self-correcting economy, 607 behind, 708 assumptions versus basic Keynesian model, 700-701 from expansionary gap, 701 in long run, 702 from recessionary gap, 701-702

in 520-521

539-541

in Japan,

assumption, 5 1,16

Sellers

demonstration effects, 546 effect of government budget deficits, 553-554 effect of new technologies, 552-553 effect of real interest rate, 551-552

as flow,

654

clean environment, 525 and comparative advantage, 36 costs of economic growth, 523

Seles,Monica,

Salesagents,

SAT

person principle,

Scarcity

Short

costs of inflation, 454 from price ceilings, 203

definition,

choices under, 5-8 fundamental fact of, 4

Risk sharing

Sacerdote,

rate

Scarcity

person, 314 person, 314 571 premium,

Rivergate

and government 554 budget deficits, 755-757 open economy, supply and demand analysis for saving, 551

506-508

capital

leather

Shortages,

definition, 532 in Japan, 542-543 and living standards, 555 and productivity growth, 50 and trade deficit, 757-759 of U.S. households, 546-547 and loan associations Savings bankruptcies,

neutral

function

553

Saving

averse

in

new technologies,

161

Risk

determinant

Shoe

diagram

Saving-investment

1-23

INDEX

level of pollution, 289 quantity, 86 optimal quantity of litter, 169 optimal quantity of public goods,

Socially Socially Socially

in auto

393-398

against

norms

of taste,

322

and

characteristics,

insurance

promoted by

rational

missing information, models, 724 Stein, Gerald, 311 Steroid use, 297-298

300-301

of

321

Society

ceilings to, 203-204 self-interest vs. interests of, 195-196 Software industry, 17 Sokolov, A. P., 372n Solmon, Paul, 54-55 Souleles, Michael S., 638n cost of price

Stock

Sunk cost

bull

example, 11

457

749

decline as economic power, financial crisis, 737 517 Spanish Inquisition,

517

Britney, 319-320

Spears,

Specialization

Adam Smith on, 51

aided by money, 572 in baseball, 40 from, 35 comparative advantage cost of failure, 46 gains from, 37-39, 46-47 from globalization, 479 Karl Marx on, 52 nations slow in, 51-52 and population density, 52 of too much, 52-53 possibility real-world gains and losses, 51 Steven, 78 Spielberg, car differences, Sprint, 217 Box, 649 Squawk Sports

263-265

applying theory of optimal pollution, 168-170 market recycling, 167-168 private

569-571

savings,

determinants

2000-2002,

policies, 614 632 definition, and demand curve shift fiscal policy changes, 687

policy changes, 687-688 policy, 632-633 monetary policy, 632-633 monetary policy flexibility, 650 on fiscal policy, 639-640 qualifications

monetary

fiscal

and

self-correcting

with demand with inflation

economy

shocks, 708-709 shocks, 709-714 versus 702 speed of self-correcting, summary of effects on demand curve, 688 Standard and Poor's 500 index, 535, 571,

619, 664 dot-com

and

Standardized

determination of, 566-567 factors affecting, 568 fall in 2000-2001, 664 future 568 determination, in Japan in 1980s, 564 and purchasers' expectations, and risk, 568-569

in

26-27

106 along, 105-106

policies, 519 countries,

522

developing

Structural

unemployment always present in economy, 603 costs of, 489 and economic change, 489 factors contributing to, 489 labor market features, 489 mismatch between skills and jobs, 489

and

gaps, 603

output

Subsidies

bubble, 698 750-751 commodities,

products, 156 of living, 432; seealso Living standards of scale, 221-224 costs, and economies Start-up State government, 399-400 State ownership of natural monopoly, 240-241 241 State regulation of natural monopoly,

to producers, 290-291 to property owners, 289 Substitute

Standard

Substitutes

vaccination

from graph,

of,

Strike threat, 491

Standardized

State

571

equation of, 25-26 demand curve to decline in elasticity,

price elasticity changes Structural

laws, 379-380

of opportunity cost, 152-154 of, 165-166 elastic, 114 perfectly inelastic, 113 perfectly market recycling, 167-168 private importance

producer surplus, 170-172 in, 83-84 Supply and demand, 61-94; see also Demand algebra of, 93-94

line

exceptions

166

excess, 69

shifts

definition, 566 dividends on, 566 mutual funds for, 571 required rate of return, 567, 571 risk premium, 571 risky investment, 568-569 in new company, shares 567-568 Stocks contrasted with flows, 533-534 Stone, P. H., 372n Stone, Richard, 415 Store of value, 573

Straight-line

technology,

167

and

Stocks

graphing

in prices of other products, expectations, 167 input prices, 166 number of suppliers, 167

change

law

deriving equation

Stabilization

of, 167

Supply

619-620 and dot-com bubble, 698 hurt by news of inflation, 663 informational role, 569 in early 2000s, 536 performance rise and fall 1990s-2000s, 571 risk sharing and diversification, 569-57\\

Straight

supply and number

Suppliers,

Stock prices

Spain

Bowl ads, 319-320

Super

of late 1990s, 571, 664 market of 1990s, 535-536

decline

10-11

definition,

boom

South America inflation and depreciation 1995-2004, Southwest Airlines, 717n Soviet Union, 63 reasons for failure, 518-519 Space shuttle program, 12-13

of

price supports, 402 Robert, 50n period in China, 516-517

Sung

market

allocation

rule, 138-140 to price reduction, 136-137

spending

response

Summers,

566

dividends,

marginal

Sugar

Stir oh, Kevin J., 515n Stock analysts, 196 Stockholders capital gains, 566

447-448, 448-449

65

definition,

322-323

449-450

bias, effect

vs. average utility, 137 and quantity demanded, 135-137

group

Statistical

Social

hyperinflation,

definition,

value

vanity, 301

safety net, 546 Social Security, 546 of benefits, indexing

322, 323

insurance,

companies, 322, 323 322-323 competition, silence of death penalty opponents, 325

norms, 299-301 fashion norms, 300 nerd norms, 300

Social

norms

Substitution Substitution

discrimination

Statistical

optimal optimal

Socially

inputs,

elasticity

definition,

76

determinant

Supply

115

cross-price

of

demand,

of price elasticity of demand, 100 effect on demand curve, 76-77

buyers and sellers, 64-67 buyer's reservation price, 66 demand curve, 65-66 economic naturalist 77-78 pay and rent increases, seasonal price movements, 84 term paper revisions, 81 effect of externalities on, 281-283 effect of simultaneous shifts in, 83-84 and equilibrium, 85-87 efficiency income effect, 65 market equilibrium, 68 substitution effect, 65 supply curve, 66-67 Supply and demand analysis central planning vs. markets, 63-64 in prices and quantities, 74-84 changes of foreign exchange market, 738-744 for illicit drugs, 97-98 of labor market, 469-477 demand shifts, 471-475 labor supply, 475-476 shifts, 476 supply and demand for labor, 469-471 wages minimum wage laws, 490 New York food supply, 61-62 price ceilings, 73-74 rent control effects, 62-63, 71-73 of saving, 551-552 118 bottlenecks, Supply

111

curve

definition, 66 economic profit and, 184-190 to find market equilibrium, 68-71 vs. car market, 117 gasoline horizontal 67, 172 interpretation, for illicit drugs, 97 individual vs. market, 154-155 for labor, 476

entries

INDEX

1-24

for public goods, 390-393 progressive tax, 393 tax, 392 proportional 13, California, 404 Proposition tax, 393 regressive to output gaps, 530 response and shift in aggregate demand curve, 687

curve\342\200\224Cont.

Supply

paying

of labor, 334-335 fruit principle, 67 low-hanging as marginal cost curve, 165 and organizational goals, 155 elastic, 114 perfectly inelastic, 113 perfectly price elasticity, 112-113 and production, 157-158 and profit-maximizing firms, 156 in recycling services, 153-154 with rent control, 71-72 shift factors and

Tax

legislation

average,

67,172,

interpretation,

199

factors

foreign assets, 738 foreign goods, 738 of labor; see Labor supply Supply Supply side of market, 152 Supply-side policy, 639 and average tax rate, 720-723 719 definition, purchase

constructing

equations

and

inflation rate, 687, 712 announcements avoided by Fed, 717 of announcements, 716-718 credibility additional information in, 716 of, 716 examples strict vs. flexible adherence to, 716 successes of, 717 too low at zero, 717-718 savers, 545 Target 126 on demand curve, norms of, 300-301

Tastes,

78

Taxation creep, 453 carbon taxes, 369-371 taxes, 289-290 compensatory consequences of, 405 bracket

from, 406 countries, 522 distortions from inflation, 453-454 Earned Income Tax Credit, 204 earned income tax credit, 352-354 effect of teenage smoking, 102 effect on boating industry, 102-103 effect on incentives, 405-406 effects on economy, 405-406

deadweight in developing

loss

government power, 387 head taxes, 391, 393 health insurance exemption, 367 on incentives, 718 impact income vs. consumption tax, 554 income tax, 350-351 negative as

objectsof, 405-406

Toxic waste, 283-285 Prius, 179 Toyota

reduced in

Trade

482-483

comparative

advantage

from,

514

determinant

of

labor

productivity,

average

514-515

graphs

from,

utility, 130

marginal

determinant of costs of production, 166 effect of changes on supply curve, 81 improvements in, 50-51 information and communication, 515 shift in aggregate supply curve and changes in, 694 U.S. productivity growth, 514-515 Teenage smoking, 102 729

Teleconferencing,

Television cigarette

ban, 261-262

advertising

397-398

pay-per-view,

programming choices, 396-397 advertising, 319-320 Temporary help agencies, 503 sales, 238 Temporary Term of bonds, 565 Terrorist attack of 2001,117, 638 Fed response to, 660-661 Thai currency depreciation, 736 Thaler, Richard, lln, 338n of the invisible hand; see Invisible Theory Television

theory

Trade barriers, Trade deficit

Timber

harvesting

on

system, 362, 363 public

land, 296

by NAFTA,

595 Amos, 8n Mark, 1

Two-product economy, production curve in, 41-47 Two-tier labor market, 468

Time

of price elasticity of demand, 100 determinant of price elasticity of supply, 115-116 economic conditions over, 439-440, 445-447 in game theory, 263-268 Timing, Titanic (film), 126 Tit-for-tat strategy, 260-262 Tjoa, Bill, 19 Total cost; see also Average total cost determinant

157

definition,

and

economies

varying,

Total

of scale, 221-222

12

expenditure,

effect of price

97 changes,

110-111

53

TurboTax, 17 Twain,

payment John, 62n

lowered

with China, 757 definition, 751 to capital inflows, 758 leading national saving rate as main cause of, 757-758 problem for capital formation, 759 and saving rate, 757-759 of U.S. in 1985, 744 Trade-offs, 4 between competing interests, 4 and economic surplus, 6 in opportunity cost, 6-7 Trade surplus, 751 of the commons Tragedy definition, 294 of unpriced resources, 292-294 problem Transactions buyer's surplus from, 85 seller's surplus from, 85 total surplus from, 85 Transfer payments, 432, 538 excluded from government purchases, 616 on incentives, 718 impact and recessions, 635-637 to output gaps, 530 response 491-492 unemployment insurance, Transition aid, 481 Transportation in early America, 502 from economic growth, 504

Tversky,

Tierney,

balance

components of, 752 definition, 751 of U.S. 1960-2010, 752, 758-759 of U.S. in 1980s, 744 Trade balance/GDP ratio, 758

Trough, hand

Thiel, Henri, 101 Third-party

129

maximizing,

Technology

Target

effect

and

and capital gains, 555 effect on hours of work, 720-723 720-722 marginal, dividends

and wage inequality, 481-483 workers opposed to, 482, 483

T 28-30

Total utility 720-722

skill-biased,

and fiscal policy, 719-723 interstate highway system, 719 and marginal tax rate, 720-723 taxation and transfers, 719-720 Szabo, Ecaterina, 333

Tables,

of 2001, 637-638 and recessions, 635-637

499 Technological advances/changes, effect on saving, investment, and real interest rate, 552-553 on labor market, 468 impact on menu costs, 615-616 impact of 19th and 20th centuries, 514

purchase

85

efficiency, 86 or decreasing, 86 increasing in market equilibrium, 87 and

early 2000s, 540 rebates, 638 Tax treatment of bonds, 565 Taylor, Lester, 101

738-739 decreasing, 741 increasing, 740-741

factors

gap, 636-637

recessionary

Tax

of dollars,

Supply

to to

on

surplus

definition,

Taxpolicy Taxrates

66-67

upward-sloping,

vertical

Total

cuts

to close

expectations, 81 four rules governing, 82-83 cost, 79-80 increasing opportunity input prices, 81 reduction of marginal cost, 80-81 technology changes, 81

of price increase, 89 108 equal to total revenue, as function of price, 109 and price elasticity of demand, 107-110 Total revenue, equal to total expenditure, 108 Total spending, 614 effect

U Unattainable

point

definition, 43 illustration,

44

431 Underground economy, Unemployed persons, 484 Unemployment among young workers, 503 487 chronically unemployed, costs of economic, 486 frictional 488 unemployment,

possibilities

1-25

INDEX

486

psychological,

bull

social, 486 structural

unemployment,

489

consumption

cyclical

and natural rate of unemployment,

602-604

Okun's law,

604-606

and, 600-602 485 duration of, 486-487 indicator of short-term fluctuations, 598

output

gaps

definition,

unemployed, 487

long-term

of

measures

Bureau

Labor Statistics survey, 484 of labor force, 484

of

definition

participation rate, 485 rate, 485 unemployment from minimum wage, 351, 490-491 relation to output gaps, 602-604 frictional unemployment, 603 structural unemployment, 603 short-term unemployed, 487 types of cyclical, 489 structural, 489 spell, 487 in U.S. 1960-2010,485 insurance,

impediment

to

full

491-492 employment, rate, 416 critics of measures of, 487

Unemployment

decline 1999-2000, 605-606 decline in World War II, 634-635 in recessions, 602-603 versus true rate workers, 487 discouraged involuntary part-time workers, 487-488 in U.S. 1978-1985, 713 in U.S. in 2004, 663 Unemployment spell, 487 85, 86 Unexploited opportunities, Union wage contracts, 691 Union wage premium, 341 United Airlines, 252-255, 268

United Kingdom abandons decimal hours

fixed exchange rate, 736 monetary system, 73In

of work, 722

nominal exchange rate for dollar, 733 real GDP growth 2002-2010, 598 real GDP per person 1870-2008,504 United Parcel Service, 77 United States Constitution, 399

United States

dollar

appreciation 1980-1985, 750 in early 1980s, 743 appreciation in Argentina, 670 circulating 750 1986-1987, depreciation after 2002, 743-744 depreciation fluctuations over time, 734 in foreign exchange market in demand, 742 changes in supply, 740-741 changes demand for dollars, 739-740 effect of monetary policy, 742-743 market equilibrium value, 740 of dollars, 738-739 supply nominal exchange rates for, 733, 734 trade and strength of, 744

1949-2010,

600

since 1929, 595-596 of population employed 1960-2009, shorter work hours, 430 size of labor force, 55 slowed by Fed in 1999-2000, 605-606 slowed growth of real wage, 478-479

572-573

292-294 Unpriced resources, Upward-sloping supply curve, 66-67 Used car sales, 316-319 Utility and consumption, 128-131 definition, 128 marginal utility, 130-131 vs. average, 137 marginal measuring,

128-129

annual

Utilometer,

average

inflation rate 2007-2010, 444 real GDP per person 1960-2009, 507 labor productivity 1960-2009, 507

128-129 Utils per hour, 129

Variable

cost, 221; seealso Average variable cost 157

definition,

revenue

than, 161 factors of production, Velocity of money smaller

157

Variable

definition, 583

616

25

of production possibilities curve, 47-48 Vertical interpretation of demand curve, 66, 145, 199 of supply curve, 67,172,199 of the U.S., Secret Service Vice-president 380-381 protection,

w 507

trade balance 1960-2010, 758-759 trade balances 752 1960-2010, trade deficit with China, 757 trends in income inequality, 346-347 unemployment rate 1960-2010, 485 of money, 583-584 velocity of production workers, 446 wages United States exchange rate, 738-744 United States House of Representatives, 373 United States Supreme Court, on free speech, 288 Unit elastic demand, 99

Unit of account,

24

Variable,

Video game industry, 222-223 Vietnam War, 634-635 Volcker, Paul, 651, 712, 719, 744

681-682

annualized

economy

595

recessions share

definition, 419 to determine market values, 419-420 by middlemen, 308-310 workers, 309 by productive Value of marginal product, 470 definition, 335 effect of labor unions, 340-342 investment decisions, 549 short-run decline, 337 Value theory of prices, 65 Vanity, norms against, 301

definition,

478-479

in U.S. 1929-2010, real GDP fluctuations real GDP growth 2002-2010, 598 real GDP per person 1870-2008, 504 real interest rate 1970-2010, 459 real wage trends, 477-478 recession of 2007-2009, 593, 630-631,

572-573

money,

Vertical intercept in, 27-28 changes

601-602 gapsl949-2010, output per person 1929-2010, 503 and outsourcing, 53-55 growth,

in

added

584 determining, quantity equation, 584 in U.S. economy, 583-584 machine, weather-sensitive, 609, Vending Verizon Communications, 217

output

output

Value

and

output 1929-2010, 429

productivity

expressed

Value,

factors

data 1978-1985, 713 statistics 1929-1933, 653 monetary national saving rate 1960-2010, 538 nominal exchange rate 1973-2010, 734 nominal interest rate 1970-2010, 460 Okun's law and output gap, 604-605

potential

laws, 379-380

Vaccination

decline in poverty, 431-432 deflation of 1930s, 717 earnings growth, 478-479 data 2011, 485 employment 596 1933-2001, expansions of GDP, 422-424, 425 expenditure components in digital video market, 41 failure failure of purchasing power parity in 1980s, 750 financial system, 551-552 hours of work, 722-723 bubble, 630-631 housing of dot-com bubble, 698 impact impact of oil prices, 698 importance of trade to, 752 inflation 598-599 1960-2010, inflation rate 1900-2010, 443 inflation rate 1970-2010, 460 labor productivity growth since 1995,

128 Utility maximization, and rational spending rule, 132-135 maximization model, 129-130 Utility

United States

V

macro

unemployment

Unemployment

of 1990s, 535-536 advantage in, 40 function 1960-2010, 618

514-515

488-489

frictional,

market

comparative

gap arbitrary,

Wage

343

customer

342-343

differentials,

compensating

discrimination,

differences

343

in human capital,

education, 344 effect of labor unions,

343, 344

and

340-342

343 employer discrimination, in human capital theory, 339-40 male-female earnings, 343-344 winner-take-all markets, 345-346 women and minorities, 343 worker preferences, 344 Wage inequality in developing countries, 481 from globalization, 479-481 increase in, 468 from international trade, 481 from skill-biased technological change, 482-483

from Wage

technological

change, 481-483

rates

342-343 compensating differentials, effect of unions, 340-342 effect on marginal cost, 166 income effect, 338 length of workweek, 338 lower for women and minorities, 343 minimum wage, 351 and quantity of leisure demanded, 337-338 union wage premium, 341

INDEX

1-26

see also Earnings; entries

Wages;

Equilibrium

wage;

and

for labor

demand

value effect effect

higher

of marginal product, 470 of globalization, 468 of technological change, 468 on supply curve, 80

power, 430 490-491

buying

market-clearing,

minimum wage, 490-491 not indexed for inflation, 455 and outsourcing, 54 of production workers 1970-2010, 447 of production workers 1979-2010, 446-447 real vs. nominal, 446-447 in two-tier labor market, 468 union wage, 491 Walmart,

431

Wants determinant

of

reservation

price, 126

needs, 127-128 for, 126 terminology translated into demand income between goods, allocating 131-135 income effect, 136-137 versus

rational

rules, 132-135 136-137 effect, 128-131 utility concept, Warner Brothers, 251, 252, 263, 265 spending

substitution

Harry, 561 DC, pay raises Washington, 77-78 Warren,

and rent increases,

Washington, George, 501, 502 Waste

government,

127-128

foreign, 54 to technological change, 482, 483 transition aid for, 481 two classes from minimum wage, 490 low-wage opposed

gains and losses, 534-536 definition, 532 as store of value, 573 money redistributed by hyperinflation, 457 redistribution by inflation, 455 related to saving, 534 Wealth, production of, 348 Wealth effect definition, 619 and stock market decline 2000-2002, 619-620 Wealth 64,180 of Nations (Smith), Weather-sensitive vending machine, 609, 616 Weimar Republic, 585 Welfare payments, 349 Welfare reform, 349 Well-defined property rights, 517 Whale waters, 296 harvesting in international John, 101 Whalley, Wheat market, 156 Williams, Ted, 39-40 to work, 508 Willingness Willis Tower, Chicago, 219, 220 Winehouse, Amy, 126 Winner-take-all markets, 345-346 Women labor force participation, 479 wage rates, 343 81 Word-processing technology, Work, economic value of marginal product of labor, 335 productive ability, 334-335 reservation price for hiring, 335-336 and demand curves, 334-335 supply value of marginal product, 335 Worker mobility, 375, 481 Workers

capital

404 in health care costs, 362 from price ceilings, 201-202 from price subsidies, 205 by

shortage,

capital

curve, 471, 472 returns, 470 diminishing 471 example, productivity issue, 469-470 demand

effect

Water

Wealth

Income

investment in, 50

heterogeneous, 488 part-time,

Workplace

487-488

Safety and 377

Occupational

Health

Administration,

environment, 375-376 income, 376-377 socially optimal level of, 375 Upton Sinclair's account of 1906, 374 and worker mobility, 375 and workers' choice, 376-377 in

perfectly

competitive

relative

and

workers'compensation,

377-378

Workweek, 429-430 shortening of, 338 Bank, 522 Trade Center attack, 117, 660-661 War II, 634-635

Workweek, World World World

Steven, 516

Wozniak,

Y Yachts

of tax on sales of, 98 of luxury tax, 102-103 of luxury tax, 103

effect

imposition repeal

market, 739 War, 695 Yosemite Concession Services Corporation, Yen-dollar

YomKippur

219-220

Yosemite

National

Z Zero inflation Zero

487 exploitation of, 375 discouraged,

involuntary

377-378 compensation, safety regulation cost-benefit principle, 374-375 financial incentives for employers, 377-378 and lack of labor market competition, 375

Workers'

Park, 219-220

rate, 717-718

tendency, 186-187 457 Zimbabwe, hyperinflation, Zimmerman, Dennis, 102n laws, 288, 295, 399 Zoning profit

^

ECONOMIST

AN

LIKE

THINK

rfpstudy Econ

Mobile

McGraw-Hill

is looking at your answer a host of interesting

Thinking

like

an economist

principles

can

help you

App

Have

seeing that economic everyday experiences.

and

surroundings

from

questions

Do

m-

surface all around and professional in this

learn

J\"

[

the

do

Why

this

this

book, Economic

way

of thinking.

Would you

Naturalist

will provide

examples

you

to

blind

elevator buttons

though

people

blind

people

public

roads.

dots

on the

then, do the

Why,

machines at

answer to this cost of producing

The

on

are

You

smooth buttons. types of

harder to

pose no keypads

If

use,there might

difficulty

with

for

fully

remarkable

automatic

teller

of daily

activity.

normal flow

things, they of automatic

patrons be

sighted

machines But even

been

have

require separate sets of molds of drive-up machines found buttons a reason to incur these extra costs.

users, the best

and

solution

cheapest

the

manufactured,

cost

the

than

and

of producing different Braille dots

But since the is to produce

f

>

*>

r

***

f

- +

tX V.

Cards

dots

\\

+ *

Quiz

the monthsof heaviest demand.

for price movements ticket Thus, prices

the demand for ticketsis highest By

contrast,

seasonal

seasonal variations because its supply

price in

while

consumption,

supply.

is highest

airline

tickets

are

others,

primarily the

to Europeare highest during

those

like sweet

during

result

the

of seasonal

summer

Mistakes & Pitfalls

Saved

Study Items

months because

forget.

Not

and feedback. \342\200\242

example, sure? Well,

key

it's

in

allow

that

self-quizzes

mistakes

Common

master

pesky formulas we do you calculate a

how

MGH Store

and pitfalls

the

app!

for more

practice

are included to help

concepts.

O

concepts

summer

For

increase?

Various

of months

on

lounging

by chapters.

for those

review

math

sometimes

\342\200\242

the

just

and definition from the

key term

customizable

are

Customizable

* \342\200\242

variations

months.

for sweet corn are primarily The price of sweet corn is lowest in the during those months. movements

go up during corn, go down?

Frank

to start, sitting on a bus, or

\342\200\242

to Europe,

tickets

for

and Bernanke's Principlesof Econ Study app that accompaniesyour to on the go... whether you study you're from

of every and

textbook,

Games

1

in

\342\200\242

Basic

\342\200\242

app

Study Econ mobile app include:

of the Flashcards

J

mobile study

couch.

percent

airline

allow

a class

for

a new

Review

only

Chapter

Seasonal

will

offer

The

edition.

\342\200\242

dots.

prices of some goods,like

graphs?

the

Math

Graph

Review

Summary

Why do the

textbook

Features

two

with

5th

the

to

proud economics

learning

Economics

waiting

pp

once the keypad molds dots is no higher

is

McGraw-Hill

cannot drive automobiles on teller machines install Braille

would

both

the

in the

Braille

with

Making

inventory.

keypads of walk-up

concepts?

for exams?

studying

with

automatic teller machineshave

locations?

is that

riddle

more

manufacturers

drive-up

buttons

on the

and

to participate can do many

when

efficient

more

students

Braille dots on

enable

be

and

in mind. mobile app was built student the go, and your study tools should be, too!

dots?

Braille

key terms

a

with

The Study Econ

on drive-up

buttons

keypad

like

was a

there

wished

more help understanding

need

you

first

like an economist?

to think

ready

you

with

to

course.

to practice

means

to

ability

will develop

throughout

Appearing

Are

you

world.The

situations

irrational

make sense of patterns and trends that in to future social your insights possibilities your rational explanations for odd or seemingly provide and application of the principles you will practice

enables you and then apply

an economist

like

Thinking

ever

you

fun way to learn

UNDERSTAND.

ANALYZE.

OBSERVE.

Econ

| Study

games more

help make and fun! engaging

which

learning key terms

and

result

Visit your mobile \"Study Econ\" and Economics 5th edition

app store downloadthe and

mobile

app.

try Frank

Study and

Econ Bernanke

today!

Search

Principles

of