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ies of scale long-run average total cost increases as output increases. (p. 562) disinflation the process of bringing down inflation that has become embedded in expectations. (p. 139) disposable income income plus government transfers minus taxes; the total amount of household income available to spend on consumption and saving. (p. 105) diversification investment in several different assets with unrelated, or independent, risks, so that the possible losses are independent events. (p. 225) dominant strategy in game theory, an action that is a player’s best action regardless of the action taken by the other player. (p. 646) duopolist one of the two firms in a duopoly. (p. 638) duopoly an oligopoly consisting of only two firms. (p. 638) economic aggregates economic measures that summarize data across different markets for goods, services, workers, and assets. (p. 5) economic growth an increase in the maximum amount of goods and services an economy can produce. (p. 13) economic profit a business’s revenue minus the opportunity cost of resources; usually less than the accounting profit. (p. 532) economics the study of scarcity and choice. (p. 2) G-4 G L O S S A R Y economies of scale long-run average total cost declines as output increases. (p. 562) economy a system for coordinating a society’s productive and consumptive activities. (p. 2) efficiency wages wages that employers set above the equilibrium wage rate as an incentive for workers to deliver better performance. (p. 130) efficiency-wage model a model in which some employers pay an aboveequilibrium wage as an incentive for better performance. (p. 714) efficient describes a market or economy that takes all opportunities to make some people better off without making other people worse off. (p. 17) elastic demand the price elasticity of demand is greater than 1. (p. 467) emissions tax a tax that depends on the amount of pollution a firm produces. (p. 732) employed people currently holding a job in the economy, either full time or part time. (p. 119) employment the total number of people currently employed for pay in the economy, either full-time or part-time. (p. 12) entrepreneurship the efforts of entrepreneurs in organizing resources for production, taking risks to create new enterprises, and innovating to develop new products and production processes. (
p. 3) environmental standards rules established by a government to protect the environment by specifying actions by producers and consumers. (p. 731) equilibrium an economic situation in which no individual would be better off doing something different. (p. 66) equilibrium exchange rate the exchange rate at which the quantity of a currency demanded in the foreign exchange market is equal to the quantity supplied. (p. 423) equilibrium price the price at which the market is in equilibrium, that is, the quantity of a good or service demanded equals the quantity of that good or service supplied; also referred to as the market-clearing price. (p. 66) equilibrium quantity the quantity of a good or service bought and sold at the equilibrium (or market-clearing) price. (p. 66) equilibrium value of the marginal product the additional value produced by the last unit of a factor employed in the factor market as a whole. (p. 712) excess capacity when firms produce less than the output at which average total cost is minimized; characteristic of monopolistically competitive firms. (p. 665) excess reserves a bank’s reserves over and above the reserves required by law or regulation. (p. 249) exchange market intervention government purchases or sales of currency in the foreign exchange market. (p. 432) exchange rate the price at which currencies trade, determined by the foreign exchange market. (p. 421) exchange rate regime a rule governing policy toward the exchange rate. (p. 431) excise tax a tax on sales of a particular good or service. (p. 499) excludable referring to a good, describes the case in which the supplier can prevent those who do not pay from consuming the good. (p. 743) expansion period of economic upturn in which output and employment are rising; most economic numbers are following their normal upward trend; also referred to as a recovery. (p. 10) expansionary fiscal policy fiscal policy that increases aggregate demand by increasing government purchases, decreasing taxes, or increasing transfers. (p. 205) expansionary monetary policy monetary policy that, through the lowering of the interest rate, increases aggregate demand and therefore output. (p. 310) explicit cost a cost that involves actually laying out money. (p. 530) exports goods and services sold to other countries. (p. 105) external benefit an uncompensated benefit that an individual or firm confers on others; also known as positive externalities. (p. 727) external cost an uncomp
ensated cost that an individual or firm imposes on others; also known as negative externalities. (p. 726) externalities external costs and external benefits. (p. 727) factor distribution of income the division of total income among labor, land, and capital. (p. 681) factor markets where resources, especially capital and labor, are bought and sold. (p. 103) federal funds market the financial market that allows banks that fall short of reserve requirements to borrow funds from banks with excess reserves. (p. 263) federal funds rate the interest rate at which funds are borrowed and lent in the federal funds market. (p. 263) fiat money a medium of exchange whose value derives entirely from its official status as a means of payment. (p. 234) final goods and services goods and services sold to the final, or end, user. (p. 106) financial account see balance of payments on the financial account. financial asset a paper claim that entitles the buyer to future income from the seller. Loans, stocks, bonds, and bank deposits are types of financial assets. (p. 224) financial intermediary an institution, such as a mutual fund, pension fund, life insurance company, or bank, that transforms the funds it gathers from many individuals into financial assets. (p. 227) financial markets the banking, stock, and bond markets, which channel private savings and foreign lending into investment spending, government borrowing, and foreign borrowing. (p. 105) financial risk uncertainty about future outcomes that involve financial losses and gains. (p. 225) firm an organization that produces goods and services for sale. (p. 103) fiscal policy the use of taxes, government transfers, or government purchases of goods and services to stabilize the economy. (p. 176) fiscal year the time period used for much of government accounting, running from October 1 to September 30. Fiscal years are labeled by the calendar year in which they end. (p. 300) Fisher effect the principle by which an increase in expected future inflation drives up the nominal interest rate, leaving the expected real interest rate unchanged. (p. 283) fixed cost cost that does not depend on the quantity of output produced. It is the cost of the fixed input. (p. 548) fixed exchange rate an exchange rate regime in which the government keeps the exchange rate against some other currency at or near a particular target. (p. 431) fixed input an input whose quantity is fixed for a period of time and cannot be
varied (for example, land). (p. 542) floating exchange rate an exchange rate regime in which the government lets the exchange rate go wherever the market takes it. (p. 431) foreign exchange controls licensing systems that limit the right of individuals to buy foreign currency. (p. 433) foreign exchange market the market in which currencies are traded. (p. 421) foreign exchange reserves stocks of foreign currency that governments can use to buy their own currency on the foreign exchange market. (p. 432) free entry and exit describes an industry that potential producers can easily enter or current producers can leave. (p. 570) free-rider problem when individuals have no incentive to pay for their own consumption of a good, they will take a “free ride” on anyone who does pay; a problem that with goods that are nonexcludable. (p. 745) frictional unemployment unemployment due to time workers spend in job search. (p. 127) gains from trade An economic principle that states that by dividing tasks and trading, people can get more of what they want through trade than they could if they tried to be selfsufficient. (p. 23) game theory the study of behavior in situations of interdependence. Used to explain the behavior of an oligopoly. (p. 644) GDP deflator a price measure for a given year that is equal to 100 times the ratio of nominal GDP to real GDP in that year. (p. 146) GDP per capita GDP divided by the size of the population; equivalent to the average GDP per person. (p. 115) Gini coefficient a number summarizes a country’s level of income inequality based on how unequally income is distributed across the quintiles. (p. 761) government borrowing the amount of funds borrowed by the government in financial markets to buy goods and services. (p. 105) government purchases of goods and services total purchases by federal, state, and local governments on goods and services. (p. 105) government transfers payments by the government to individuals for which no good or service is provided in return. (p. 105) gross domestic product (GDP) the total value of all final goods and services produced in the economy during a given period, usually a year. (p. 106) growth accounting estimates the contribution of each of the major factors (physical and human capital, labor, and technology) in the aggregate production function. (p. 378) Herfindahl–Hirschman Index,
or HHI is the square of each firm’s share of market sales summed over the industry. It gives a picture of the industry market structure. (p. 573) household a person or a group of people who share income. (p. 103) human capital the improvement in labor created by the education and knowledge embodied in the workforce. (pp. 373, 680) illiquid describes an asset that cannot be quickly converted into cash without much loss of value. (p. 226) implicit cost a cost that does not require the outlay of money; it is measured by the value, in dollar terms, of forgone benefits. (p. 530) implicit cost of capital the opportunity cost of the capital used by a business; that is the income that could have been realized had the capital been used in the next best alternative way. (p. 532) implicit liabilities spending promises made by governments that are effectively a debt despite the fact that they are not included in the usual debt statistics. In the United States, the largest implicit liabilities arise from Social Security and Medicare, which promise transfer payments to current and future retirees (Social Security) and to the elderly (Medicare). (p. 303) imports goods and services purchased from other countries. (p. 105) incentive anything that offers rewards to people who change their behavior. (p. 2-5 income effect the change in the quantity of a good consumed that results from the change in a consumer’s purchasing power due to the change in the price of the good. (p. 459) income-elastic demand when the income elasticity of demand for a good is greater than 1. (p. 476) income elasticity of demand the percent change in the quantity of a good demanded when a consumer’s income changes divided by the percent change in the consumer’s income. (p. 476) income-inelastic demand when the income elasticity of demand for a good is positive but less than 1. (p. 476) increasing returns to scale long-run average total cost declines as output increases (also referred to as economies of scale). (p. 562) indifference curve a contour line showing all consumption bundles that yield the same amount of total utility for an individual. (p. 789) indifference curve map a collection of indifference curves for a given individual that represents the individual’s entire utility function; each curve corresponds to a different total utility level. (p. 789)
individual choice the decision by an individual of what to do, which necessarily involves a decision of what not to do. (p. 2) individual consumer surplus the net gain to an individual buyer from the purchase of a good; equal to the difference between the buyer’s willingness to pay and the price paid. (p. 485) individual demand curve a graphical representation of the relationship between quantity demanded and price for an individual consumer. (p. 55) individual labor supply curve a graphical representation showing how the quantity of labor supplied by an individual depends on that individual’s wage rate. (p. 696) individual producer surplus the net gain to an individual seller from selling a good; equal to the difference between the price received and the seller’s cost. (p. 490) individual supply curve a graphical representation of the relationship between quantity supplied and price for an individual producer. (p. 63) G-6 G L O S S A R Y industry supply curve a graphical representation that shows the relationship between the price of a good and the total output of the industry for that good. (p. 599) inefficient allocation of sales among sellers a form of inefficiency in which sellers who would be willing to sell a good at the lowest price are not always those who actually manage to sell it; often the result of a price floor. (p. 84) inefficient allocation to consumers a form of inefficiency in which people who want a good badly and are willing to pay a high price don’t get it, and those who care relatively little about the good and are only willing to pay a low price do get it; often a result of a price ceiling. (p. 80) inefficiently high quality a form of inefficiency in which sellers offer high-quality goods at a high price even though buyers would prefer a lower quality at a lower price; often the result of a price floor. (p. 85) inefficiently low quality a form of inefficiency in which sellers offer lowquality goods at a low price even though buyers would prefer a higher quality at a higher price; often a result of a price ceiling. (p. 81) inelastic demand when the price elasticity of demand is less than 1. (p. 467) inferior good a good for which a rise in income decreases the demand for the good. (p. 54) inflation a rise in the overall price level. (p. 12) inflation rate the annual percent change in a price index—typically the
consumer price index. The inflation rate is positive when the aggregate price level is rising (inflation) and negative when the aggregate price level is falling (deflation). (p. 135) inflation targeting an approach to monetary policy that requires that the central bank try to keep the inflation rate near a predetermined target rate. (p. 312) inflation tax the reduction in the value of money held by the public caused by inflation. (p. 325) inflationary gap exists when aggregate output is above potential output. (p. 196) infrastructure physical capital, such as roads, power lines, ports, information networks, and other parts of an economy, that provides the underpinnings, or foundation, for economic activity. (p. 389) in-kind benefit a benefit given in the form of goods or services. (p. 768) input a good or service used to produce another good or service. (p. 62) interdependent the outcome (profit) of each firm depends on the actions of the other firms in the market. (p. 638) interest rate the price, calculated as a percentage of the amount borrowed, charged by lenders to borrowers for the use of their savings for one year. (p. 222) interest rate effect of a change in the aggregate price level the effect on consumer spending and investment spending caused by a change in the purchasing power of consumers’ money holdings when the aggregate price level changes. A rise (fall) in the aggregate price level decreases (increases) the purchasing power of consumers’ money holdings. In response, consumers try to increase (decrease) their money holdings, which drives up (down) interest rates, thereby decreasing (increasing) consumption and investment. (p. 174) intermediate goods and services goods and services, bought from one firm by another firm, that are inputs for production of final goods and services. (p. 106) internalize the externality when individuals take into account external costs and external benefits. (p. 728) inventories stocks of goods and raw materials held to satisfy future sales. (pp. 105, 168) inventory investment the value of the change in total inventories held in the economy during a given period. Unlike other types of investment spending, inventory investment can be negative, if inventories fall. (p. 168) investment bank a bank that trades in financial assets and is not covered by deposit insurance. (p. 257) investment spending spending on productive physical capital, such as machinery and construction of structures,
and on changes to inventories. (p. 106) job search when workers spend time looking for employment. (p. 127) labor the effort of workers. (p. 3) labor force the number of people who are either actively employed for pay or unemployed and actively looking for work; the sum of employment and unemployment. (pp. 12, 119) labor force participation rate the percentage of the population age 16 or older that is in the labor force. (p. 119) labor productivity (productivity) output per worker. (p. 372) land all resources that come from nature, such as minerals, timber, and petroleum. (p. 3) law of demand the principle that a higher price for a good or service, other things equal, leads people to demand a smaller quantity of that good or service. (p. 50) law of supply other things being equal, the price and quantity supplied of a good are positively related. (p. 60) leisure the time available for purposes other than earning money to buy marketed goods. (p. 696) leverage the degree to which a financial institution is financing its investments with borrowed funds. (p. 258) liability a requirement to pay income in the future. (p. 224) license gives its owner the right to supply a good or service. (p. 88) life insurance company a financial intermediary that sells policies guaranteeing a payment to a policyholder’s beneficiaries when the policyholder dies. (p. 228) liquid describes an asset that can be quickly converted into cash without much loss of value. (p. 226) liquidity preference model of the interest rate a model of the market for money in which the interest rate is determined by the supply and demand for money. (p. 273) liquidity trap a situation in which monetary policy is ineffective because nominal interest rates are up against the zero bound. (p. 339) loan a lending agreement between an individual lender and an individual borrower. Loans are usually tailored to the individual borrower’s needs and ability to pay but carry relatively high transaction costs. (p. 226-7 loanable funds market a hypothetical market in which the demand for funds is generated by borrowers and the supply of funds is provided by lenders. The market equilibrium determines the quantity and price, or interest rate, of loanable funds. (p. 277) loan-backed securities assets created by pooling individual loans and selling shares in that pool. (p. 227) long run the time period in which all inputs can be
varied. (p. 542) long-run aggregate supply curve a graphical representation of the relationship between the aggregate price level and the quantity of aggregate output supplied if all prices, including nominal wages, were fully flexible. The long-run aggregate supply curve is vertical because the aggregate price level has no effect on aggregate output in the long run; in the long run, aggregate output is determined by the economy’s potential output. (p. 184) long-run average total cost curve a graphical representation showing the relationship between output and average total cost when fixed cost has been chosen to minimize average total cost for each level of output. (p. 561) long-run industry supply curve a graphical representation that shows how quantity supplied responds to price once producers have had time to enter or exit the industry. (p. 603) long-run macroeconomic equilibrium a situation in which the short-run macroeconomic equilibrium is also on the long-run aggregate supply curve; so short-run equilibrium aggregate output is equal to potential output. (p. 194) long-run market equilibrium an economic balance in which, given sufficient time for producers to enter or exit an industry, the quantity supplied equals the quantity demanded. (p. 602) long-run Phillips curve a graphical representation of the relationship between unemployment and inflation in the long run after expectations of inflation have had time to adjust to experience. (p. 336) long-term interest rate the interest rate on financial assets that mature a number of years into the future. (p. 270) long-term reputation allows an individual to assure others that he or she isn’t concealing adverse private information. (p. 784) lump-sum taxes taxes that don’t depend on the taxpayer’s income. (pp. 211, 508) macroeconomic policy activism the use of monetary policy and fiscal policy to smooth out the business cycle. (p. 346) macroeconomics the branch of economics that is concerned with the overall ups and downs in the economy. (p. 5) marginal analysis the study of marginal decisions. (p. 3) marginal cost curve a graphical representation showing how the cost of producing one more unit depends on the quantity that has already been produced. (p. 538) marginal cost pricing occurs when regulators set a monopoly’s price equal to its marginal cost to achieve efficiency. (p. 757) marginal external benefit the addition to external benefits created by one more unit of the good. (p
. 738) marginal external cost the increase in external costs created by one more unit of a good. (p. 739) marginal factor cost of labor (MFCL) the additional cost of hiring an additional worker. The marginal factor cost of land and the marginal factor cost of capital are equivalent concepts. (p. 700) marginal private benefit the marginal benefit that accrues to consumers of a good, not including any external benefits. (p. 738) marginal private cost the marginal cost of producing a good, not including any external costs. (p. 739) marginal product the additional quantity of output produced by using one more unit of that input. (p. 543) marginal productivity theory of income distribution every factor of production is paid its equilibrium value of the marginal product. (p. 692) marginal propensity to consume (MPC) the increase in consumer spending when income rises by $1. Because consumers normally spend part but not all of an additional dollar of disposable income, MPC is between 0 and 1. (p. 159) marginal propensity to save (MPS) the increase in household savings when disposable income rises by $1. (p. 159) marginal rate of substitution (MRS) the ratio of the marginal utility of one good to the marginal utility of another. (p. 794) marginal revenue the change in total revenue generated by an additional unit of output. (p. 537) marginal revenue curve a graphical representation showing how marginal revenue varies as output varies. (p. 538) marginal revenue product of labor (MRPL) equals the marginal product of labor times the marginal revenue received from selling the additional output. The marginal revenue product of land and the marginal revenue product of capital are equivalent concepts. (p. 700) marginal social benefit of a good or activity the marginal benefit that accrues to consumers plus the marginal external benefit. (p. 738) marginal social benefit of pollution the additional gain to society as a whole from an additional unit of pollution. (p. 724) marginal social cost of a good or activity the marginal cost of production plus the marginal external cost. (p. 739) marginal social cost of pollution the additional cost imposed on society as a whole by an additional unit of pollution. (p. 724) marginal utility the change in total utility generated by consuming one additional unit of a good or service. (p. 513) marginal utility curve a graphical representation showing how marginal utility depends on the quantity of
a good or service consumed. (p. 513) marginal utility per dollar the additional utility from spending one more dollar on a good or service. (p. 518) marginally attached workers nonworking individuals who say they would like a job and have looked for work in the recent past but are not currently looking for work. (p. 120) market basket a hypothetical consumption bundle of consumer purchases of goods and services, used to measure changes in overall price level. (p. 142) market economy an economy in which decisions of individual producers and consumers largely determine what, how, and for whom to produce, with little government involvement in the decisions. (p. 2) G-8 G L O S S A R Y market share the fraction of the total industry output accounted for by a firm’s output. (p. 569) mean household income the average income across all households. (p. 765) means-tested program a program in which benefits are available only to individuals or families whose incomes fall below a certain level. (p. 768) median household income the income of the household lying in the middle of the income distribution. (p. 765) medium of exchange an asset that individuals acquire for the purpose of trading for goods and services rather than for their own consumption. (p. 232) menu cost the real cost of changing a listed price. (p. 137) merchandise trade balance (trade balance) the difference between a country’s exports and imports of goods alone—not including services. (p. 412) microeconomics the branch of economics that studies how people make decisions and how those decisions interact. (p. 5) midpoint method a technique for calculating the percent change in which changes in a variable are compared with the average, or midpoint, of the starting and final values. (p. 462) minimum-cost output the quantity of output at which average total cost is lowest—the bottom of the U-shaped average total cost curve. (p. 555) minimum wage a legal floor on the wage rate. The wage rate is the market price of labor. (p. 82) model a simplified representation of a real situation that is used to better understand real-life situations. (p. 14) monetarism a theory of business cycles, associated primarily with Milton Friedman, that asserts that GDP will grow steadily if the money supply grows steadily. (p. 348) monetary aggregate an overall measure of the money supply. The most common monetary aggregates
in the United States are M1, which includes currency in circulation, traveler’s checks, and checkable bank deposits, and M2, which includes M1 as well as near-moneys. (p. 234) monetary base the sum of currency in circulation and bank reserves. (p. 249) monetary neutrality the concept that changes in the money supply have no real effects on the economy in the long run and only result in a proportional change in the price level. (p. 317) monetary policy the central bank’s use of changes in the quantity of money or the interest rate to stabilize the economy (p. 177) monetary policy rule a formula that determines the central bank’s actions. (p. 349) money any asset that can easily be used to purchase goods and services. (p. 231) money demand curve a graphical representation of the negative relationship between the quantity of money demanded and the interest rate. The money demand curve slopes downward because, other things equal, a higher interest rate increases the opportunity cost of holding money. (p. 270) money multiplier the ratio of the money supply to the monetary base; indicates the total number of dollars created in the banking system by each $1 addition to the monetary base. (p. 250) money supply the total value of financial assets in the economy that are considered money. (p. 231) money supply curve a graphical representation of the relationship between the quantity of money supplied by the Federal Reserve and the interest rate. (p. 273) monopolist a firm that is the only producer of a good that has no close substitutes. (p. 571) monopolistic competition a market structure in which there are many competing firms in an industry, each firm sells a differentiated product, and there is free entry into and exit from the industry in the long run. (p. 575) monopoly an industry controlled by a monopolist. (p. 571) monopsonist a single buyer in a market. (p. 701) monopsony a market in which there is only one buyer. (p. 701) moral hazard the situation that can exist when an individual knows more about his or her own actions than other people do. This leads to a distortion of incentives to take care or to exert effort when someone else bears the costs of the lack of care or effort. (p. 785) movement along the demand curve a change in the quantity demanded of a good that results from a change in the price of that good. (
p. 51) movement along the supply curve a change in the quantity supplied of a good that results from a change in the price of that good. (p. 60) multiplier the ratio of total change in real GDP caused by an autonomous change in aggregate spending to the size of that autonomous change. (p. 160) mutual fund a financial intermediary that creates a stock portfolio by buying and holding shares in companies and then selling shares of this portfolio to individual investors. (p. 228) Nash equilibrium in game theory, the equilibrium that results when all players choose the action that maximizes their payoffs given the actions of other players, ignoring the effect of that action on the payoffs of other players; also known as noncooperative equilibrium. (p. 646) national income and product accounts an accounting of consumer spending, sales of producers, business investment spending, and other flows of money between different sectors of the economy; also referred to as national accounts. Calculated by the Bureau of Economic Analysis. (p. 102) national savings the sum of private savings and the government’s budget balance; the total amount of savings generated within the economy. (p. 223) natural monopoly a monopoly that exists when increasing returns to scale provide a large cost advantage to having all output produced by a single firm. (p. 571) natural rate hypothesis the hypothesis that the unemployment rate is stable in the long run at a particular natural rate. According to this hypothesis, attempts to lower the unemployment rate below the natural rate of unemployment will cause an ever-rising inflation rate. (p. 350) natural rate of unemployment the unemployment rate that arises from the effects of frictional plus structural unemployment. (p. 130) near-money a financial asset that can’t be directly used as a medium of exchange but can be readily converted into cash or checkable bank deposits. (p. 235) negative income tax a government program that supplements the income of low-income working families. (p. 769) net exports the difference between the value of exports and the value of imports. A positive value for net exports indicates that a country is a net exporter of goods and services; a negative value indicates that a country is a net importer of goods and services. (p. 108) net present value the present value of current and future benefits minus the present value of current and future costs. (p. 240) network externality when the value of a good to an individual is greater when more people also use the good
. (p. 739) new classical macroeconomics an approach to the business cycle that returns to the classical view that shifts in the aggregate demand curve affect only the aggregate price level, not aggregate output. (p. 351) new Keynesian economics theory that argues that market imperfections can lead to price stickiness for the economy as a whole. (p. 352) nominal GDP the value of all final goods and services produced in the economy during a given year, calculated using the prices current in the year in which the output is produced. (p. 114) nominal interest rate the interest rate actually paid for a loan, not adjusted for inflation. (p. 138) nominal wage the dollar amount of any given wage paid. (p. 180) nonaccelerating inflation rate of unemployment (NAIRU) the unemployment rate at which, other things equal, inflation does not change over time. (p. 336) noncooperative behavior actions by firms that ignore the effects of those actions on the profits of other firms. (p. 640) nonexcludable referring to a good, describes the case in which the supplier cannot prevent those who do not pay from consuming the good. (p. 743) nonprice competition competition in areas other than price to increase sales, such as new product features and advertising; especially engaged in by firms that have a tacit understanding not to compete on price. (p. 656) nonrival consumption referring to a good, describes the case in which the same unit can be consumed by more than one person at the same time. (p. 744) normal good a good for which a rise in income increases the demand for that good—the “normal” case. (p. 53) normal profit an economic profit equal to zero. It is an economic profit just high enough to keep a firm engaged in its current activity. (p. 534) normative economics the branch of economic analysis that makes prescriptions about the way the economy should work. (p. 6) oligopolist a firm in an industry with only a small number of producers. (p. 573) oligopoly an industry with only a small number of producers. (p. 573) open-market operation a purchase or sale of U.S. Treasury bills by the Federal Reserve, undertaken to change the monetary base, which in turn changes the money supply. (p. 264) opportunity cost the real cost of an item: what you must give up in order to get it.
(p. 3) optimal consumption bundle the consumption bundle that maximizes the consumer’s total utility given his or her budget constraint. (p. 515) optimal consumption rule when a consumer maximizes utility, the marginal utility per dollar spent must be the same for all goods and services in the consumption bundle. (p. 520) optimal output rule profit is maximized by producing the quantity of output at which the marginal revenue of the last unit produced is equal to its marginal cost. (p. 537) ordinary goods in a consumer’s utility function, those for which additional units of one good are required to compensate for fewer units of another, and vice versa; and for which the consumer experiences a diminishing marginal rate of substitution when substituting one good in place of another. (p. 795) other things equal assumption in the development of a model, the assumption that all relevant factors except the one under study remain unchanged. (p. 14) output the quality of goods and services produced. (p. 12-9 output gap the percentage difference between actual aggregate output and potential output. (p. 196) overuse the depletion of a common resource that occurs when individuals ignore the fact that their use depletes the amount of the resource remaining for others. (p. 749) patent a temporary monopoly given by the government to an inventor for the use or sale of an invention. (p. 572) payoff in game theory, the reward received by a player in a game (for example, the profit earned by an oligopolist). (p. 644) payoff matrix in game theory, a diagram that shows how the payoffs to each of the participants in a two-player game depend on the actions of both; a tool in analyzing interdependence. (p. 644) pension fund a type of mutual fund that holds assets in order to provide retirement income to its members. (p. 228) perfectly competitive industry an industry in which all producers are price-takers. (p. 569) perfectly competitive market a market in which all market participants are price-takers. (p. 568) perfectly elastic demand the case in which any price increase will cause the quantity demanded to drop to zero; the demand curve is a horizontal line. (p. 467) perfectly elastic supply the case in which even a tiny increase or reduction in the price will lead to very large changes in the quantity supplied, so that the price elasticity of supply is infinite; the
perfectly elastic supply curve is a horizontal line. (p. 479) perfectly inelastic demand the case in which the quantity demanded does not respond at all to changes in the price; the demand curve is a vertical line. (p. 466) perfectly inelastic supply the case in which the price elasticity of supply is zero, so that changes in the price of the good have no effect on the quantity supplied; the perfectly inelastic supply curve is a vertical line. (p. 478) perfect price discrimination a situation in which a monopolist charges each consumer his or her willingness to pay—the maximum that the consumer is willing to pay. (p. 627) G-10 G L O S S A R Y physical asset a claim on a tangible object that gives the owner the right to dispose of the object as he or she wishes. (p. 224) physical capital human-made goods such as buildings and machines used to produce other goods and services. (pp. 373, 680) Pigouvian subsidy a payment designed to encourage activities that yield external benefits. (p. 738) Pigouvian taxes taxes designed to reduce external costs. (p. 734) planned investment spending the investment spending that firms intend to undertake during a given period. Planned investment spending may differ from actual investment spending due to unplanned inventory investment. (p. 166) political business cycle a business cycle that results from the use of macroeconomic policy to serve political ends. (p. 351) positive economics the branch of economic analysis that describes the way the economy actually works. (p. 6) potential output the level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible. (p. 185) poverty rate the percentage of the population with incomes below the poverty threshold. (p. 761) poverty threshold the annual income below which a family is officially considered poor. (p. 761) present value the amount of money needed at the present time to produce, at the prevailing interest rate, a given amount of money at a specified future time. (p. 239) price ceiling the maximum price sellers are allowed to charge for a good or service; a form of price control. (p. 77) price controls legal restrictions on how high or low a market price may go. (p. 77) price discrimination charging different prices to different consumers for the same good. (p. 624) price floor the minimum price buyers are required to pay
for a good or service; a form of price control. (p. 77) price index a measure of the cost of purchasing a given market basket in a given year, where that cost is normal- ized so that it is equal to 100 in the selected base year; a measure of overall price level. (p. 143) price elasticity of demand the ratio of the percent change in the quantity demanded to the percent change in the price as we move along the demand curve (dropping the minus sign). (p. 460) price elasticity of supply a measure of the responsiveness of the quantity of a good supplied to the price of that good; the ratio of the percent change in the quantity supplied to the percent change in the price as we move along the supply curve. (p. 477) price leadership a pattern of behavior in which one firm sets its price and other firms in the industry follow. (p. 656) price regulation a limitation on the price that a monopolist is allowed to charge. (p. 619) price stability when the aggregate price level is changing only slowly. (p. 13) price-taking consumer a consumer whose actions have no effect on the market price of the good or service he or she buys. (p. 568) price-taking firm a firm whose actions have no effect on the market price of the good or service it sells. (p. 568) price-taking firm’s optimal output rule the profit of a price-taking firm is maximized by producing the quantity of output at which the market price is equal to the marginal cost of the last unit produced. (p. 585) price war a collapse of prices when tacit collusion breaks down. (p. 654) principle of diminishing marginal utility the proposition that each successive unit of a good or service consumed adds less to total utility than does the previous unit. (p. 513) principle of marginal analysis the proposition that the optimal quantity is the quantity at which marginal benefit is equal to marginal cost. (p. 537) prisoners’ dilemma a game based on two premises: (1) Each player has an incentive to choose an action that benefits itself at the other player’s expense; and (2) When both players act in this way, both are worse off than if they had acted cooperatively. (p. 645) private good a good that is both excludable and rival in consumption. (p. 743) private information information that some
people have that others do not. (p. 782) private savings disposable income minus consumer spending; disposable income that is not spent on consumption but rather goes into financial markets. (p. 105) producer price index (PPI) a measure of the cost of a typical basket of goods and services purchased by producers. Because these commodity prices respond quickly to changes in demand, the PPI is often regarded as a leading indicator of changes in the inflation rate. (p. 145) producer surplus a term often used to refer to either individual producer surplus or to total producer surplus. (p. 490) product differentiation the attempt by firms to convince buyers that their products are different from those of other firms in the industry. If firms can so convince buyers, they can charge a higher price. (p. 655) production possibilities curve illustrates the trade-offs facing an economy that produces only two goods; shows the maximum quantity of one good that can be produced for each possible quantity of the other good produced. (p. 16) production function the relationship between the quantity of inputs a firm uses and the quantity of output it produces. (p. 542) production possibilities curve shows the maximum quantity of one good that can be produced for each possible quantity of the other good produced. It illustrates the trade-offs facing an economy that produces only two goods. (p. 16) product markets where goods and services are bought and sold. (p. 103) progressive tax a tax that takes a larger share of the income of highincome taxpayers than of low-income taxpayers. (p. 499) property rights the rights of owners of valuable items, whether resources or goods, to dispose of those items as they choose. (p. 3) proportional tax a tax that is the same percentage of the tax base regardless of the taxpayer’s income or wealth. (p. 499-11 public debt government debt held by individuals and institutions outside the government. (p. 300) public good a good that is both nonexcludable and nonrival in consumption. (p. 745) public ownership when goods are supplied by the government or by a firm owned by the government to protect the interests of the consumer in response to natural monopoly. (p. 619) purchasing power parity (between two countries’ currencies) the nominal exchange rate at which a given basket of goods and services would cost the same amount in each country. (p. 427) quantity control (quota) an upper limit, set by the government, on
the quantity of some good that can be bought or sold; also referred to as a quota. (p. 88) quantity demanded the actual amount of a good or service consumers are willing to buy at some specific price. (p. 49) quantity supplied the actual amount of a good or service producers are willing to sell at some specific price. (p. 59) Quantity Theory of Money a theory that emphasizes the positive relationship between the price level and the money supply. It relies on the equation (M × V = P × Y). (p. 349) quota rent the earnings that accrue to the license-holder from ownership of the right to sell the good. (p. 91) rate of return (of an investment project) the profit earned on an investment project expressed as a percentage of its cost. (p. 278) rational expectations a theory of expectation formation that holds that individuals and firms make decisions optimally, using all available information. (p. 352) real business cycle theory a theory of business cycles that asserts that fluctuations in the growth rate of total factor productivity cause the business cycle. (p. 352) real exchange rate the exchange rate adjusted for international differences in aggregate price levels. (p. 425) real GDP the total value of all final goods and services produced in the economy during a given year, calculated using the prices of a selected base year. (p. 114) real income income divided by the price level. (p. 135) real interest rate the nominal interest rate minus the inflation rate. (p. 138) real wage the wage rate divided by the price level. (p. 135) recession a period of economic downturn when output and unemployment are falling; also referred to as a contraction. (p. 10) recessionary gap exists when aggregate output is below potential output. (p. 195) regressive tax a tax that takes a smaller share of the income of highincome taxpayers than of low-income taxpayers. (p. 499) relative price the ratio of the price of one good to the price of another. (p. 797) relative price rule at the optimal consumption bundle, the marginal rate of substitution of one good in place of another equal to their relative price. (p. 798) rental rate the cost, explicit or implicit, of using a unit of either land or capital for a given period of time. (p. 691) required reserve ratio the smallest fraction of deposits that the Federal Reserve allows banks to hold. (p. 244) research and
development (R & D) spending to create and implement new technologies. (p. 388) reserve ratio the fraction of bank deposits that a bank holds as reserves. In the United States, the minimum required reserve ratio is set by the Federal Reserve. (p. 244) reserve requirements rules set by the Federal Reserve that set the minimum reserve ratio for banks. For checkable bank deposits in the United States, the minimum reserve ratio is set at 10%. (p. 246) resource anything, such as land, labor, and capital, that can be used to produce something else; includes natural resources (from the physical environment) and human resources (labor, skill, intelligence). (p. 3) revaluation an increase in the value of a currency that is set under a fixed exchange rate regime. (p. 438) rival in consumption referring to a good, describes the case in which one unit cannot be consumed by more than one person at the same time. (p. 743) Rule of 70 a mathematical formula that states that the time it takes real GDP per capita, or any other variable that grows gradually over time, to double is approximately 70 divided by that variable’s annual growth rate. (p. 371) savings and loans (thrifts) deposittaking banks, usually specialized in issuing home loans. (p. 257) savings–investment spending identity an accounting fact that states that savings and investment spending are always equal for the economy as a whole. (p. 222) scarce in short supply; a resource is scarce when there is not enough of the resource available to satisfy all the various ways a society wants to use it. (p. 3) screening using observable information about people to make inferences about their private information; a way to reduce adverse selection. (p. 783) securitization the pooling of loans and mortgages made by a financial institution and the sale of shares in such a pool to other investors. (p. 259) self-correcting refers to the fact that in the long run, shocks to aggregate demand affect aggregate output in the short run, but not the long run. (p. 196) shoe-leather costs (of inflation) the increased costs of transactions caused by inflation. (p. 137) shortage the insufficiency of a good or service that occurs when the quantity demanded exceeds the quantity supplied; shortages occur when the price is below the equilibrium price. (p. 68) short run the time period in which at
least one input is fixed. (p. 542) short-run aggregate supply curve a graphical representation of the relationship between the aggregate price level and the quantity of aggregate output supplied that exists in the short run, the time period when many production costs can be taken as fixed. The short-run aggregate supply curve has a positive slope because a rise in the aggregate price level leads to a rise in profits, and therefore output, when production costs are fixed. (p. 181) short-run equilibrium aggregate output the quantity of aggregate output produced in short-run macroeconomic equilibrium. (p. 190) G-12 G L O S S A R Y short-run equilibrium aggregate price level the aggregate price level in shortrun macroeconomic equilibrium. (p. 190) short-run individual supply curve a graphical representation that shows how an individual producer’s profitmaximizing output quantity depends on the market price, taking fixed cost as given. (p. 594) short-run industry supply curve a graphical representation that shows how the quantity supplied by an industry depends on the market price, given a fixed number of producers. (p. 600) short-run macroeconomic equilibrium the point at which the quantity of aggregate output supplied is equal to the quantity demanded. (p. 190) short-run market equilibrium an economic balance that results when the quantity supplied equals the quantity demanded, taking the number of producers as given. (p. 601) short-run Phillips curve a graphical representation of the negative shortrun relationship between the unemployment rate and the inflation rate. (p. 331) short-term interest rate the interest rate on financial assets that mature within less than a year. (p. 269) shut-down price the price at which a firm ceases production in the short run because the price has fallen below the minimum average variable cost. (p. 593) signaling taking some action to establish credibility despite possessing private information; a way to reduce adverse selection. (p. 784) single-price monopolist a monopolist that offers its product to all consumers at the same price. (p. 624) social insurance government programs—like Social Security, Medicare, unemployment insurance, and food stamps—intended to protect families against economic hardship. (p. 204) socially optimal quantity of pollution the quantity of pollution that society would choose if all the costs and benefits of pollution were fully accounted for. (p. 725) specialization a situation in which different people each engage in the different task that he or
she is good at performing. (p. 23) stabilization policy the use of government policy to reduce the severity of recessions and to rein in excessively strong expansions. There are two main tools of stabilization policy: monetary policy and fiscal policy. (p. 199) stagflation the combination of inflation and falling aggregate output. (p. 193) standardized product output of different producers regarded by consumers as the same good; also referred to as a commodity. (p. 569) sticky wages nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of labor shortages. (p. 180) stock a share in the ownership of a company held by a shareholder. (p. 104) store of value an asset that is a means of holding purchasing power over time. (p. 232) strategic behavior actions taken by a firm that attempt to influence the future behavior of other firms. (p. 647) structural unemployment unemployment that results when there are more people seeking jobs in a labor market than there are jobs available at the current wage rate. (p. 128) subprime lending lending to home buyers who don’t meet the usual criteria for borrowing. (p. 259) substitutes pairs of goods for which a rise in the price of one of the goods leads to an increase in the demand for the other good. (p. 53) substitution effect the change in the quantity of a good demanded as the consumer substitutes the good that has become relatively cheaper for the good that has become relatively more expensive. (p. 458) sunk cost a cost that has already been incurred and is nonrecoverable. (p. 563) supply and demand model a model of how a competitive market works. (p. 48) supply curve a graphical representation of the supply schedule, showing the relationship between quantity supplied and price. (p. 59) supply price the price of a given quantity at which producers will supply that quantity. (p. 90) supply schedule a list or table showing how much of a good or service producers will supply at different prices. (p. 59) supply shock an event that shifts the short-run aggregate supply curve. A negative supply shock raises production costs and reduces the quantity supplied at any aggregate price level, shifting the curve leftward. A positive supply shock decreases production costs and increases the quantity supplied at any aggregate price level, shifting the curve rightward. (p. 192) surplus the excess of a good or service that occurs when the quantity
supplied exceeds the quantity demanded; surpluses occur when the price is above the equilibrium price. (p. 68) sustainable describes continued longrun economic growth in the face of the limited supply of natural resources and the impact of growth on the environment. (p. 391) T-account a simple tool that summarizes a business’s financial position by showing, in a single table, the business’s assets and liabilities, with assets on the left and liabilities on the right. (p. 243) tacit collusion cooperation among producers, without a formal agreement, to limit production and raise prices so as to raise one anothers’ profits. (p. 649) tangency condition on a graph of a consumer’s budget line and available indifference curves of available consumption bundles, the point at which an indifference curve and the budget line just touch. When the indifference curves have the typical convex shape, this point determines the optimal consumption bundle. (p. 796) target federal funds rate the Federal Reserve’s desired level for the federal funds rate. The Federal Reserve adjusts the money supply through the purchase and sale of Treasury bills until the actual rate equals the desired rate. (p. 307) tax incidence the distribution of the tax burden. (p. 502) Taylor rule for monetary policy a rule for setting the federal funds rate that takes into account both the inflation rate and the output gap. (p. 311) technology the technical means for the production of goods and services. (pp. 21, 373) in game theory, a strategy technology spillover an external benefit that results when knowledge spreads among individuals and firms. (p. 738) time allocation the decision about how many hours to spend on different activities, which leads to a decision about how much labor to supply. (p. 695) tit for tat that involves playing cooperatively at first, then doing whatever the other player did in the previous period. (p. 647) total consumer surplus the sum of the individual consumer surpluses of all the buyers of a good in a market. (p. 485) total cost the sum of the fixed cost and the variable cost of producing a quantity of output. (p. 548) total cost curve a graphical representation of the total cost, showing how total cost depends on the quantity of output. (p. 549) total factor productivity the amount of output that can be produced with a given amount of factor inputs. (p. 379) total producer surplus the
sum of the individual producer surpluses of all the sellers of a good in a market. (p. 490) total product curve a graphical representation of the production function, showing how the quantity of output depends on the quantity of the variable input for a given quantity of the fixed input. (p. 543) total revenue the total value of sales of a good or service (the price of the good or service multiplied by the quantity sold). (p. 468) total surplus the total net gain to consumers and producers from trading in a market; the sum of the consumer surplus and the producer surplus. (p. 495) tradable emissions permits licenses to emit limited quantities of pollutants that can be bought and sold by polluters. (p. 734) trade when individuals provide goods and services to others and receive goods and services in return. (p. 23) trade-off when you give up something in order to have something else. (p. 16) transaction costs the expenses of negotiating and executing a deal. (p. 225) underemployed people who work part time because they cannot find fulltime jobs. (p. 120) unemployed people who are actively looking for work but are not currently employed. (p. 119) unemployment the total number of people who are actively looking for work but aren’t currently employed. (p. 12) unemployment rate the percentage of the total number of people in the labor force who are unemployed, calculated as unemployment/(unemployment + employment). (pp. 12, 119) unions organizations of workers that try to raise wages and improve working conditions for their members by bargaining collectively. (p. 713) unit-elastic the price elasticity of demand is exactly 1. (p. 467) unit of account a measure used to set prices and make economic calculations. (p. 233) unit-of-account costs (of inflation) costs arising from the way inflation makes money a less reliable unit of measurement. (p. 137) unplanned inventory investment unplanned changes in inventories, which occur when actual sales are more or less than businesses expected; sales in excess of expectations result in negative unplanned inventory investment. (p. 169) U-shaped average total cost curve a distinctive graphical representation of the relationship between output and average total cost; the average total cost curve at first falls when output is low and then rises as output increases. (p. 553) util a unit of utility. (p. 512) utility (
of a consumer) a measure of the satisfaction derived from consumption of goods and services. (p. 511) value added (of a producer) the value of a producer’s sales minus the value of input purchases. (p. 107) value of the marginal product the value of the additional output generated by employing one more unit of a given factor, such as labor. (p. 684-13 value of the marginal product curve a graphical representation showing how the value of the marginal product of a factor depends on the quantity of the factor employed. (p. 684) variable cost a cost that depends on the quantity of output produced; the cost of the variable input. (p. 548) variable input an input whose quantity the firm can vary at any time (for example, labor). (p. 542) velocity of money the ratio of nominal GDP to the money supply. (p. 349) vicious cycle of deleveraging describes the sequence of events that takes place when a firm’s asset sales to cover losses produce negative balance sheet effects on other firms and force creditors to call in their loans, forcing sales of more assets and causing further declines in asset prices. (p. 258) wasted resources a form of inefficiency in which people expend money, effort, and time to cope with the shortages caused by a price ceiling. (p. 80) wealth (of a household) the value of accumulated savings. (p. 224) wealth effect of a change in the aggregate price level the effect on consumer spending caused by the change in the purchasing power of consumers’ assets when the aggregate price level changes. A rise in the aggregate price level decreases the purchasing power of consumers’ assets, so they decrease their consumption; a fall in the aggregate price level increases the purchasing power of consumers’ assets, so they increase their consumption. (p. 174) wedge the difference between the demand price of the quantity transacted and the supply price of the quantity transacted for a good when the supply of the good is legally restricted. Often created by a quota or a tax. (p. 91) willingness to pay the maximum price a consumer is prepared to pay for a good. (p. 483) zero bound the lower bound of zero on the nominal interest rate. (p. 339) zero-profit equilibrium an economic balance in which each firm makes zero profit at its profit-maximizing quantity. (p. 661) This page intentionally left blank Index A Absolute advantage,
27 Absolute value, 40 Accounting profit, 531–533, 539, 586 Actual investment spending, 169 Actual output, 185–186, 397 AD-AS model, 190–197 classic model of the price level, 322 demand shock, 191–197 economic policy, 199–207 inflation, 327 long-run economic growth, 399–400 long-run macroeconomic equilibrium, 194–196 short-run macroeconomic equilibrium, 190–191 supply shock, 192–194, 197 ADM (Archer Daniels Midland), 637 Administrative costs, 508 Advance purchase restrictions, 627 Adverse selection, 782–784 Advertising, product differentia- tion and brand names, 671–672 location differentiation, 669 quality differentiation, 669–670 role of, 670–671 style, type differentiation, 668–669 Africa, economic growth, 381–383 Aggregate consumption function, 164–166 Aggregate demand curve, 172–177 AD-AS model, 190–196 downward slope, 173–174 fiscal policy, 209 monetary policy, 309–310 movement along, 174 shifts of, 174–177, 444 Aggregate demand-aggregate supply model. See AD-AS model Aggregate output, 12, 112–115 actual, 186 aggregate demand curve, 172–173, 175 aggregate supply curve, 179, 181–188 Great Depression, 188 money supply increase, 316–317 output gap, 196 recessionary gap, 195 short-run equilibrium, 190–193 Aggregate price level, 142–143, 146 aggregate demand curve, 172–175, 177 aggregate supply curve, 179–188 change in, wealth/interest rate effects, 174 Great Depression, 188 long-run equilibrium, 194–196 Arab-Israeli war, 197 Archer Daniels Midland (ADM), 637 Argentina bank runs, 245 debt defaulting, 301, 305 economic growth, 369, 379–381 fixed exchange rate, 432, 435 natural resources, 378 Arms race, prisoners’ dilemma and, 649 money demand curve, Artificially scarce goods, 271–272 money supply, 316–317, 322 short-run equilibrium, 190–193 Aggregate production function, 374–378 Aggregate spending, 106 Aggregate supply curve, 179–187 AD-AS model, 190–196 long-run, 184–187 short-run, 179–184 Aggregate wealth, 166 Agricultural price floors, 82–84 Air Sunshine, 624–625 Airline industry oligopoly and, 641
–642 price discrimination, 624–627 regulation, 85 Allen, Paul, 227 Alternative input combinations, 706–707 American Economic Association, 1 American Economic Review, 8, 715 American Recovery and Reinvestment Act, 209, 213 Amtrak, monopolies and, 614 Antipoverty programs, United States, 768 effects of, 770–771 means-tested, 769 social security, 769 unemployment insurance, 769 Antitrust policy, 653, 754–755 Clayton Antitrust Act of 1914, 755–756 Federal Trade Commission Act of 1914, 756 natural monopoly and, 756–758 Sherman Antitrust Act of 1890, 755 Apartheid, economics of, 715 Appreciates, 420–424 751–752 Assets banks, 244 Federal Reserve, 264–265 financial, 224, 226–227 physical, 224 prices, macroeconomic policy, 358–359 ATC (average total cost curve), 553–554 ATMs, money demand curve and, 272–273 Australia monetary neutrality, 318 natural resources, 378 Automatic stabilizers, 161, 212, 298 Automobile industry exchange rate and, 427 inventories, 168, 170 Autonomous change in aggregate spending, 160, 209 Autonomous consumer spending, 162–164 AVC (average variable cost curve), 554 Average cost, 552–555, 564 Average cost pricing, 757 Average fixed cost, 553, 564 Average revenue, 586 Average total cost curve (ATC), 553–554 Average variable cost, 553, 564 Average variable cost curve (AVC), 554 B Bailey, George, 245 Balance of payments capital flows, 408–413 exchange rate, 419, 421–423 merchandise trade, 410–411 Balance of payments accounts, 408–413 Balance of payments on goods and services, 410 Balance of payments on the current account, 410–413, 436 Balance of payments on the financial account, 411–414 Balance sheet effect, 258 Bangladesh, clothing production, 27 Bank deposit, 224, 229, 248–249. See also Checkable bank deposit Bank failure, 245 Bank holidays, 256 Bank of England, 253, 358 Bank of Japan, 253, 341, 359 Bank reserves, 243 Bank run, 243, 245–246, 253–254 Banking system, 253–260 Banks, 228–229. See also Federal Reserve assets, liabilities, 244 central, 253, 310, 315–316, 318, 358 commercial, 257, 264–265
–167 436 Current disposable income, 161–164 I N D E X I-3 Current Population Survey, 119 Curve, in graph, 36–37 area, below or above, Depreciates, 420–424, 436 Depreciation, 398, 531–532 Depressions, 10–11. See also calculation, 41 horizontal and vertical, slopes of, 38 linear, slope of, 37–38 maximum and minimum points, 40–41 nonlinear, slope of, 39–40 Cyclical unemployment, 130, 328–329 Cyclically adjusted budget balance, 297–299 D Damon, Matt, 5 David, Paul, 379 De Beers, 570, 583, 609–613 Deadweight loss, 90, 92, 506–508, 618 Debt, 300–305. See also Federal debt default, 226, 301, 305 deflation, 338–339 in practice, 301–303 Debt deflation, 338–339 Debt-GDP ratio, 301–303 Decreasing returns to scale, 563 Deductible, 785 Default, 226, 301, 305 Deficit. See Budget deficit Deflation, 12–13, 139 debt, 338–339 effects, 339–341 Defoe, Daniel, 16 Delta (change in), 159 Demand curve, 49–56 consumer surplus and, 483–488 demand schedule, 49–50 individual, 55–56 market, 55 movement along, 51–52 price elasticity of demand and, 471–472 rightward versus leftward shifts, 52–53 shift effects, 71–72 shifts, 50–56, 444 Demand price, 89–90 Demand schedule, 49–50 Demand shock, 191–197 economic policy, 200 negative, 172, 194–195 positive, 194–195 short-run versus long-run effects, 194–195 versus supply shock, 193–194, 197 Demand-pull inflation, 327 Dependent variable, 35–36, 460 Deposit insurance, 246 Depositors, 228–229 Great Depression Derived demand, 681 Detroit Free Press, 124 Devaluation, 436–437 Differentiated product, in monopolistic competition, 575 Diminishing marginal rate of substitution, 795 Diminishing marginal utility, 513 Diminishing returns effect, 554 Diminishing returns to an input, 545 Diminishing returns to labor, 545 Diminishing returns to physical capital, 374–377 Disabled workers, 119 Discount rate, 263–264 Discount window, 246–247
, 263 Discouraged workers, 120 Discretionary fiscal policy, 212, 356–357 Discretionary monetary policy, 348, 357–359 Discrimination, income distri- bution and, 714–715 Diseconomies of scale, 562–563 Disinflation, 139, 327–329 costs of, 338 1980s, 337 Disposable income, 105 aggregate consumption function, 165–166 current, 161–164 future, 165 government budget, 204 MPC, MPS, 159–160 Diversification, 225, 227 Dividends, 108, 211 Dixies, 234 Dollar (U.S.) Euro comparison, 407 exchange rate, 419–426 history of, 234 Dominant strategy, 646 Dominant strategy equilibrium, 646 Double coincidence of wants, 232 Double-counting, 107–108 Duopolist, 638 Duopoly, 638–640 E Early childhood intervention, poverty and, 764 Earned Income Tax Credit (EITC), 769 East Asia “The Effects of Government economic growth, 380–382 human capital, 386 East Germany, structural unemployment, 132 ECB (European Central Bank), 253 Eckaus, Richard, 101 Economic aggregates, 5 Economic costs, 136–138 Economic growth, 13–14, 20–21, 366–371. See also Long-run economic growth Africa, 381–383 aggregate production function, 374–378 climate change, 392–393 comparing economies, 366–370 East Asia, 380–381 environment, 390–393 government, 387–389 growth rates, 369–370 Latin America, 381 long-run, sources, 370–371 natural resources, 378, 389–390 oil consumption, 391 rate differences, 385–389 real GDP per capita, 366–368 Rule of 70, 369 sustainability, 389–393 unemployment, 122–123 Economic inequality, 764–768 Economic insecurity, 768 Economic performance, measuring circular flow, 102–106 gross domestic product, 106–110, 112–116 inflation, 134–139, 142–147 national accounts, 102–110 price indexes, 142–147 unemployment, 118–124, 126–132 Taxes and Transfers on Income and Property” (U.S. Census Bureau), 770 Efficiency wages, 130, 714 Efficiency-wage model, 714 Efficient, 17–18 equity and, 499 market and, 496–499 Efficient in allocation, 18 Efficient in production, 18 Eisenhower,
Dwight David, 54 EITC (Earned Income Tax Credit), 769 Elastic, 466–471 Elasticity, 460 cross-price elasticity of demand, 475–476, 480 income elasticity of supply, 476, 480 midpoint method, 462–464 price discrimination and, 626 price elasticity of demand, 457, 460–463, 466–473, 480 price elasticity of supply, 477–480 Electricity, 379 Emissions tax, 732–734 Employed, 119 Employment, 12. See also Unemployment Energy Policy Act, 75, 596 England. See Britain Entrepreneurship, 3, 680 Environment, economic growth, 390–393 Environmental standards, 731–732 Equilibrium, 66–69 market, 67 shifts, 71–74 Equilibrium exchange rate, 421–423 Equilibrium interest rate, Economic policy. See also Fiscal policy; Monetary policy 273–274, 277–280 Equilibrium price, 66–69, AD-AS model, 199–207 demand shocks, 200 fiscal policy, 202–207 macroeconomic, 199–201 stabilization, 199–201 supply shocks, 200–201 Economic profit, 531–533, 539, 586 Economic theories. See Macroeconomic models Economics, 2, 6–8 Economies of scale, 562, 571 The Economist, 425–426 Economists, 7–8 Economy, 2 Edison, Thomas Alva, 387 Education, 374, 380–383, 386, 388 71–75 Equilibrium quantity, 66–67, 71–74 Equilibrium value of the marginal product, 712 An Essay on the Principle of Population (Malthus), 378, 546 Ethanol, supply and demand curve shifts and, 75 EU (European Union), 653 Euro, 134 creation of, 435–436 dollar comparison, 407 exchange rates, 419–423 Europe carbon dioxide emissions, 392 I-4 I N D E X Europe (continued) monetary neutrality, 318 unemployment benefits, 130 European Central Bank (ECB), 253 European Commission, 83 European Union (EU), 653 Excess capacity, 665 Excess demand. See Shortage Excess reserves, 249 Excess supply. See Surplus Exchange market intervention, 430–431 Exchange rate, 419–427. See also Foreign exchange market automobile industry, 427 balance of payments, 419, 421–423 Big Mac index, 425–426 equilibrium, 420–423 nominal, 423–426, 429 real, 423–425
Exchange Rate Mechanism, 436, 439 Exchange rate, policy devaluation, revaluation, 435–437 exchange market intervention, 430–431 fixed, 429–432, 435–437 floating, 429, 431–432, 437–438 foreign exchange controls, 431 foreign exchange reserves, 430–431 international business cycle, 438 macroeconomic, 435–439 Exchange rate regime, 429–432, 435–439 Excise tax, 499–500 cost of, 506–508 price elasticities and, 502–504 quantities and prices and, 500–502 revenue from, 505–506 Excludable, 743 Expanded circular-flow dia- gram, 103–106 Expansionary fiscal policy, 204–205, 209, 355–356 Expansionary monetary policy, 310, 355–356 Expansions, 10–11 Expectation changes aggregate demand curve, 175 demand curve, 54–55 supply curve, 63 Expected deflation, 339 Expected inflation, 333–336 Explicit cost, 530–531 Exports, 105–106, 108–109 External benefits, 726–727, 727 External cost, 726–727 Externalities, 727 pollution, economics of, 724–729 pollution, policies and, stock bubble, 359 target federal funds rate, 273, 307–309 unconventional policy, 359 U.S. Treasury, 324 average cost, 552–555 cost curves, 548–550 marginal cost, 550–552 marginal cost curve, slope, 556–557 731–736 Federal Reserve Bank of New minimum average total cost, private solutions to, 728–729 production, consumption and, 736–740 F Factor demand economy’s factors of production, 680–682 marginal productivity and, 682–688 shifts, in curve, 686–688 Factor distribution of income, 681–682 Factor income, 409–410, 681 Factor markets, 103, 679–680 Factor prices, 680–681 Factors of production, 3, 680 Fannie Mae, 257 Farm veterinary services, competition and, 65 Farming industry decline, in U.S., 477 implicit cost of, 533 perfect competition, 596 price floors, 82–84 FDIC (Federal Deposit Insurance Corporation), 229, 246 The Fed. See Federal Reserve Federal budget, 204 balance, 296–300 deficit, 296–305 future demands, 304 Federal debt, 300–304 problems with, 300–301 World War II, 303 Federal Deposit Insurance Corporation
(FDIC), 229, 246 Federal funds market, 263 Federal funds rate, 263, 307–313 Federal Open Market Committee, 255 economic contraction, expansion and, 313 money and interest rates, 273, 307, 309 Federal Reserve, 234–235, 295 assets, liabilities, 264–265 banks, 243–244, 246–247, 249–250 central bank targets, 358 financial crisis of 2008, 258–260 housing boom, 169, 258–259 monetary policy, interest rate, 307–313 money supply, 273–274 press release, 273 York, 255–256, 258 555–556 Federal Reserve Banks, 255–256 Federal Reserve Board, 134 Federal Reserve districts, 255–256 Federal Reserve System, 253–260, 262–266 counterfeit money, 265 creation, 253–255 discount rate, 263–264 effectiveness of, 256–257 functions of, 262–266 monetary policy, 262–266 open market operations, 264–266 reserve requirement, 263 structure of, 255–256 Treasury bills, 264–265, 324 Federal Trade Commission Act of 1914, 756 Fiat money, 234 Fidelity Investments, 228 Final buyers, 108 Final goods and services, 106–107 Finance, international. See Open economy Financial account, 411–414 Financial asset, 224, 226–227 Financial capital, 413 Financial crisis of 2008, 258–260 Financial intermediary, 227–229, 243 Financial markets, 105, 224, 277 Financial risk, 225 Financial sector banking, 243–251 Federal Reserve System, 253–260, 262–266 financial system, 224–229 interest rate models, 273–274, 277–286 loanable funds, 277–286 money, 231–235 money creation, 247–251 money market, 268–275 money, time value, 237–241 savings, investment, 222–224 Financial system, 224–229 financial assets, 224, 226–227 financial intermediaries, 227–229 liquidity, 225–226 risk, 225 transaction costs, 225 Firm, 103 Firm costs short-run versus long-run, 559–563 sunk costs, 563–565 First Street Bank, 244–248 Fiscal policy, 176–177, 202–207 aggregate demand curve, 209 budget balance, 296–300 contractionary, 204–206, 209 deficits, 296–305 demand/supply shocks, 200–201 discretionary, 212, 356–357 expansionary, 204–205, 209, 355–356 fixed money supply, 349 government spending, 202–205 lags, 206–207 long
-run implications, 300–305 macroeconomic theories, 356–357 versus monetary policy, 355–357 multiplier, 209–213 public debt, 300–302 taxes, 202–205 unemployment reduction, 356 Fiscal year, 300 Fisher effect, 283, 339 Fisher, Irving, 283, 338–339 Fixed cost, 548 concept and measures of, 564 in perfect competition, 595 short-run versus long-run and, 559–562 Fixed exchange rate, 429–432, 435–437 Fixed input, 542 Flat-bottomed paper bag, pro- ductivity and, 371 Floating exchange rate, 429, 431–432, 437–438 Florida, housing boom, 157 Flu vaccine, consumer demand, 457 Ford, Henry, 379, 670 Ford Motors U.K., 412 Foreign exchange. See Exchange rate Foreign exchange controls, 431 Foreign exchange market, 419–423, 444. See also Exchange rate equilibrium, 422–423 exchange rate, 419–427 Foreign exchange reserves, 430–432 Fossil fuel consumption, 392 Franc, 134, 436 France consumer price index, 145 economic growth, 369, 382 Euro, 134 government spending, tax revenue, 202 Freddie Mac, 257 Free entry and exit, 570, 575 Free-rider problem, 745 Frictional unemployment, 127–128, 130 Friedman, Milton, 165–166, inferior, 54, 460, 476 normal, 53, 460, 476 ordinary, 795 types of, 744 Government climate change, 393 economic growth, 387–389 human capital, 388 infrastructure, 387 intervention, 388–389 market failure and, 723 physical capital, 387–388 political stability, 388–389 price controls, 77–85 property rights, 388–389 quantity controls, 88–93 technology, 388 Government borrowing, 105, 333, 347–350, 355 202, 280 Government budget. See Federal budget Government debt. See also Federal debt defaulting, 301, 305 national accounts, 113 stock market crash, 175–176 Works Progress Administration, 212 World War II, 177, 346 world-wide influence, 438 Greece, national debt, 301 Greenhouse gas emissions, 392–393 Greenspan, Alan, 255, 358 Gross domestic product (GDP), 106–110 calculating, 107, 109 components of, 108–109 debt-GDP ratio, 301–303 domestically produced final goods and services, 107–108 double-counting, 107–108 final goods and services, 106–107 firms in the
economy, 108 GDP deflator, 146, 172–173, 188 Frisch, Ragnar, 343 Funny money, 221 Future disposable income, 165 G Gains from trade, 23–29, 232 Game theory, 644 prisoner’s dilemma, 644–647 repeated interaction, 647–649 tacit collusion, 647–649 Gates, Bill, 5, 227 GDP. See Gross domestic product GDP deflator, 146 aggregate demand, 172–173 Great Depression, 188 “GDP: One of the Great Inventions of the 20th Century” (Department of Commerce), 113 GDP per capita (Gross domestic product per capita), 115 General Motors, jobs, 126–127 The General Theory of Employment, Interest, and Money (Keynes), 344–347 Germany hyperinflation, 136, 325 marc, 436 real GDP per capita growth rate, 382 structural unemployment, 132 Giffen goods, 459–460 Gini coefficient, 765 Glass-Steagall Act, 256–257 Global savings glut, 416 Global warming, 392–393 GNP (gross national product), 412 Goods. See also Private goods; Public goods artificially scarce, 751–752 characteristics of, 743–744 Government deficits. See Budget government spending, deficit 209–210 Government policy. See also government spending, tax Economic policy; Fiscal policy; Monetary policy revenue, 202 versus gross national product, AD-AS curve, 194 aggregate demand curve, 176 unemployment rate, 132 Government purchases of goods and services, 105, 202–203, 205, 209–210 Government spending, 202–205 GDP, 209–210 tax revenue, 202 United States, 202–204 Government transfers, 105, 203–205, 210–211 Grains, price floors, 82–84 Graphs curves, 36–41 numerical, 42–44 perfect competition and, 590–596 two-variable graphs, 34–35 variables and economic mod- els, 34 Great Depression, 10 aggregate demand curve, 172 aggregate output, price level, 188 debt deflation, 339 deflation, 139 demand shock, 191–192 end of, 177, 346 Federal Reserve System, 256–257 GDP deflator, 188 Keynesian Revolution, 344–347 multiplier, 161 412 imports, exports, 105–106, 108–109 included/not included, 110 interpreting, 112–116 measuring, 106–108 net exports, 108–109 nominal, 114, 116 real, 112–116 versus real GDP, 113 U.S. per capita
, 460 Indexing to CPI, 147 India economic growth, 367–369, 374, 389 monetary neutrality, 318 Indifference curves, 787–790 budget line, slope of, 796–797 consumer choice and, 791–792 marginal rate of substitution, 792–795 preferences, choices and, 799–800 prices, marginal rate of substitution and, 797–799 properties of, 790–791 tangency condition, 795–796 Individual choice, 2 Individual consumer surplus, 485 hyperinflation, 136–137, investment spending, 325–327 inflation tax, 324–325 interest rates, 138–139 Israel, 136–137 level of prices, 134–138 loanable funds, 282–284 long-run Phillips curve, 335–336 measurement, calculation, 143–147 menu costs, 136–137 monetary policy, 310–313 money, 321–327 nonaccelerating inflation rate of unemployment, 336–337 output gap, unemployment rate, 328–329 Portugal, 101, 112 price indexes, 143–147 producer price index, 143, 167–168 loanable funds, 277–286 long run determination, 285–286 long-term, 270 monetary policy, Federal Reserve, 307–313 money, 273–275 money demand curve, 270–273 money supply changes, 317–319 opportunity cost, holding money, 268–270 short run determination, 284–285 short-term, 268–270 U.S. housing boom, 169 Interest rate effect of a change in the aggregate price level, 174 145–146 Interest rate models real exchange rate, 423–425 shoe-leather costs, 136–137 short-run Phillips curve, 331–335 stagflation, 193, 334 targeting, 312 unit-of-account costs, comparing, 284–286 liquidity preference, 273–274, 284–286 loanable funds, 277–286 long run determination, 285–286 short run determination, 284–285 Intermediate goods and serv- ices, 106–107 Internalize the externalities, 728 International business cycle, 438 International capital flows, 415–417 International finance. See Open economy International Monetary Fund, savings, 222–224 unplanned, 168–170 Ireland economic growth, 369 Giffen goods and, 459 infrastructure, 387 Israel, inflation, 136–137 Italy, economic growth, 382 It’s a Wonderful Life, 245 J Jackpots, present value and, 241 Japan Bank of Japan, 253, 341, 359 consumer price
274, 277–280 Fisher effect, 283 inflation, 138–139 28–29 exports/imports, 105 International transfers, 409–410, 412 Inventories, 105–106, 168–170 Inventory investment, 168–170 Investment banks, 257 Investment spending, 106, 157–160 capital flows, 413, 415–416 economic growth, 386 fluctuations, 167 Great Depression, 161 interest rate, 167–168 inventories, 168–170 planned, 166–167 production capacity, 168 real GDP, 168 surplus and, 488 Korea, monetary neutrality, 318 Kuwait, natural resources, 378 Kuznets, Simon, 113 Kydland, Finn, 353 L Labor, 3, 680 Labor force, 12, 119, 131 Labor force participation rate, 119 Labor market, 103, 128. See also Labor supply equilibrium in, 698–704 imperfect competition and, 703–704 perfect competition and, 700–703 product market, perfect competition and, 700 Labor market institutions, 131 Labor productivity, 370–371 Labor strike, 129 Labor supply shifts, of curve, 697–698 wages and, 696–697 work versus leisure, 695–696 Long-run aggregate supply curve (LRAS), 184–187, 444 classic model of the price level, 322–323 scenario analysis, 446–448 secondary effects, 441–442, 445–446 starting point, 441–443 structure for, 441–446 Labor supply curve, shifts of, long-run economic growth, Macroeconomic models I N D E X I-7 Marginal productivity theory of income distribution, 692–693, 711 discrimination, 714–715 efficiency wages, 714 market power, 713–714 objection to, 716–717 viability of, 717 wage disparities in practice, 715–716 wage inequality and, 711–713 Marginal propensity to consume (MPC), 159–160, 162–164 Marginal propensity to save (MPS), 159–160 Marginal rate of substitution (MRS), 792–795, 797–799 Marginal revenue, 537–538, 608–612 Marginal revenue curve, 538–539 Marginal revenue product, 703 Marginal revenue product of labor (MRPL), 700 Marginal social benefit of a good, 738 Marginal social benefit of pollution, 724–725 Marginal social cost of a 399–401 long-run macroeconomic equilibrium, 194 money supply increase, 316
–317 versus short-run, 186–187 Long-run average total cost, 562, 564 Long-run average total cost curve, 561–562 Long-run costs concepts and measures, 564 returns to scale, 562–563 versus short-run, 559–563 sunk costs, 563–564 Long-run economic growth, 365–371. See also Economic growth AD-AS model, 399–400 long-run aggregate supply curve, 399–401 macroeconomic models, 396–401 production possibilities curve, 396–400 productivity, 370–371 real GDP per capita, compar- ison, 379–383 classical, 343–344, 355–357 classical versus Keynesian, 345 Keynesian, 344–347, 355–357 modern consensus, 355–359 monetarism, 355–357 monetary policy versus fiscal policy, 355–357 natural rate hypothesis, 350–351 new classical economics, 351, 356 new Keynesian economics, 352, 356 political business cycle, 351 rational expectations, 352 real business cycle theory, 352–353 supply-side economics, 357 Macroeconomic policy activism, 346 Macroeconomics, 5 exchange rates, 435–439 five key questions, 355–359 international business cycle, 438 introduction, 10–14 long-run economic growth, good, 739–740 Marginal social cost of pollu- versus short-run fluctuations, 396–401 tion, 724 400–401 sources, 370–371 Long-run industry supply curve, 601–605 Long-run macroeconomic equilibrium, 194–196 Long-run market equilibri- um, 601–603, 605 Long-run Phillips curve (LRPS), 335–337 Long-Term Capital Management (LTCM), 258 Long-term interest rates, 270 Loss, 533 Lost Decade, 340–341 Lottery, present value and, 241 LRAS. See Long-run aggregate supply curve LTCM (Long-Term Capital Management), 258 Lucas, Robert, 352 Lump-sum tax, 211, 508 M M1, M2, 234–235, 243, 268 Macroeconomic analysis initial effects, 441–442, 445 long-run effects, 441–442, 445–446 pivotal event, 441–445 versus microeconomics, 5 open-economy, 407 policy, 199–201 Mad Money, 295 Maddison, Angus, 385 Malthus, Thomas, 378, 389 Marc, 436 Marginal analysis
, 3 Marginal benefit, 3, 537 Marginal cost, 3, 537, 550–552, 564 Marginal cost curve, 538–539, 554, 556–557 Marginal cost pricing, 757 Marginal decisions, 3 Marginal external benefit, 738 Marginal external cost, 739–740 Marginal factor cost, 703 Marginal factor cost of labor (MFCL), 700–702 Marginal physical product, 683 Marginal private benefit, 738 Marginal private cost, 739–740 Marginal product, 543 factor demand and, 684–686 value of, 682–684, 703 Marginal product of labor, 543–545, 682–683 Marginal utility, 513–514 Marginal utility curve, 513 Marginal utility per dollar, 518–521 Marginally attached workers, 120 Market basket, 142–145, 147, 425–426 Market, definition of, 48 Market demand curve, 55 Market economy, 2 Market equilibrium, 67 Market failure, government and, 723 Market power, 713–714 Market price, 67–69, 590–592 Market share, 569 Market structure, types of, 567–575 Market supply curve, 64 Market-clearing price, 66. See also Equilibrium price Martin, William McChesney, 255, 358 Mauritius, economic growth, 383 Maximum, of curve, 40 McCain, John, 393 McDonald’s, 54, 271–272 Big Mac index, 425–426 Montana, 124 697–698 Labor unions, 129–130 Laffer curve, 357 Land, 3 Land, capital markets and demand in, 690–691 equilibrium in, 692 marginal productivity theory, 692–693 supply in, 691–692 Latin America economic growth, 381–382 human capital, 386 transfer payments, 412 Law of demand, 50, 173 income effect, 459–460 substitution effect, 458–459 Law of supply, 60 LeBron, James, 4–5 Lehman Brothers, 260 Leisure, 696 Level of prices, 134–138 Leverage, 258 Liability, 224 banks, 244 Federal Reserve, 264–265 implicit, 303–304 License, 88 Lieberman, Joseph, 393 Life insurance company, 228 Life-cycle hypothesis, 166 The Limits to Growth (Club of Rome), 389 Linear curve, slope of, 37–38 Linear relationship, 36 Liquid, 226 Liquidity
, 225–226 Liquidity preference model of the interest rate, 273–274, 284–286 Liquidity trap, 339–340, 347 Lira, Turkey, 322 Loan, 224, 226 Loanable funds capital inflow, 281, 413–415 demand for, 278 demand shifts, 280–281, 444 financial account, 413–414 Fisher effect, 283 government borrowing, 280 inflation, 282–284 interest rates, 277–286 supply of, 279 supply shifts, 281–282, 444 Loanable funds market, 277–286, 413–414, 444 Loanable funds model, 413–414 Loan-backed securities, 227 Long run, 542 I-8 I N D E X McKinsey and Co., 370 MD (money demand curve), 270–273, 444 Mean household income, 765 Means-tested, 768 Means-tested programs, antipoverty, 768–769 Medallions, taxicabs, quantity controls, 88–93 Median household income, 765 Medicaid, 203–204, 303–304 Medicare, 203–204, 303–304 Medium of exchange, 232 Med-Stat, 457 Mega Millions, 241 Menu costs, 136–137 Merchandise trade balance, 410–411 Mexico peso, exchange rate, 423–426 tortilla prices, 75 inflation, 310–313 interest rate, 307–313, 317–319 efficiency of, 665 in long run, 661–663 versus perfect competition, macroeconomic theories, 663–665 355–359 monetarism, 348–350 monetary neutrality, 317–319 money supply, 316–319 output, prices, 315 in practice, 310–313 recessions, 355–356 revival of, 347–348 unconventional, 359 unemployment reduction, 356 “Monetary Policy Matters” (Romer, Romer), 313 Monetary policy rule, 349 Money. See also Monetary policy banks, 243–251 borrowing, lending, interest, 237–238 in short run, 659–661 Monopoly, 570, 614–615. See also Natural monopoly definition of, 571 demand curve, marginal revenue and, 608–612 economies of scale, 571 government-created barriers and, 572 versus perfect competition, 613–614 power, prevention of, 618–619 price elasticity of demand and, 614 profit and, 614–615 profit-maximizing output, price and, 612–613 resource or input, control of, 571 technological superiority and, MFCL
(marginal factor cost of labor), 700–702 cash, 231, 235, 247–248 classical macroeconomics, Michigan, unemployment rate, 343 572 124 Microeconomics, 5 Microsoft, 227 Middle East, oil, 378 Midpoint method, 462–464 Minimum average total cost, 555–556 Minimum, of curve, 41 Minimum wage, 82–85 labor market, 128 structural unemployment, 129 Minimum-cost output, 555–556, 665 Mirror test, 119 Mitchell, Wesley, 344 Model, 14 Moderate inflation, 327–329 Monetarism, 348–350, 355–357 Monetary aggregate, 234–235 Monetary base, 249–250, 266 A Monetary History of the United States, 1867–1960 (Friedman, Schwartz), 347–348 Monetary neutrality, 317–319 Monetary policy, 177 aggregate demand, 309–310 asset prices, 358–359 central bank targets, 358 contractionary, 310, 313 demand/supply shocks, 200–201 discretionary, 348, 357–359 exchange rate, 437–438 expansionary, 310, 355–356 Federal Reserve System, 262–266 versus fiscal policy, 355–357 counterfeit, 221, 234, 265 currency, 231, 235, 243 defined, 231–232 demand for, 268–273 history of dollar, 234 holding, opportunity cost, 268–270 inflation, 321–327 interest rates, 273–275 measuring supply, 234–235 multiplier, 248–251 output, prices, 315–319 present value, 237–241 printing, 324 roles of, 232–233 seignorage, 324–326 time value, 237–241 types of, 233–234 Money demand curve (MD), 270–273, 444 Money market, 268–275, 444 Money multiplier, 248–251 Money supply, 231–232, 247–251 cash, checkable deposits, welfare effects of, 617–618 Monopsonist, 701–702 Monopsony, 701–702 Montana, unemployment rate, 124 Moral hazard, 784–785 Morgan, J. P., 254–255 Movement along the demand curve, 51–52 Movement along the supply curve, 60–62 MPC (marginal propensity to consume), 159–160, 162–164 MPS (marginal propensity to save), 159–160 “Mr. Keynes and the Classics: A Suggested Interpretation” (Hicks), 347 MRPL (marginal revenue product of labor), 700 MRS (marginal rate
of sub- stitution), 792–795, 797–799 247–248 MS (money supply curve), Federal Reserve, 265–266, 273–274, 307–309 fixed, fiscal policy, 349 increase effects, 316–317 interest rate, 307–309, 317–319 money multiplier, 248–251 nominal, 322 price level, 321–324 Money supply curve (MS), 273–274, 444 Monopolist, 571 Monopolistic competition, 574–575, 659 273–274 Mugabe, Robert, 326 Mullainathan, Sendhil, 715 Multiplier, 158–161 fiscal policy, 209–213 government policy influence, 209–213 government purchases of goods and services, 209–210 government transfers, 210–211 Great Depression, 161 money, 248–251 MPC, MPS, 159–160 stimulus package, 213 taxes, 210–212 Muth, John, 352 Mutual fund, 228 N NAIRU (nonaccelerating inflation rate of unemployment), 336–337 Nash equilibrium, 646 Nash, John Forbes, 646 National accounts, 102–110 circular-flow diagram, 102–106 creation of, 113 Great Depression, 113 gross domestic product, 106–110 National Bureau of Economic Research (NBER), 10–11, 344 National income AD-AS model, 190–197, 199–207 aggregate demand, 172–177 aggregate supply, 179–188 consumer spending, 161–166 economic policy, 199–207, 209–213 expenditure, 158–170 investment spending, 166–170 multiplier, 158–161, 209–213 National Income, 1929–35 (Kuznets), 113 National income and prod- uct accounts, 102–110. See also National accounts National savings, 223 Natural gas, 63 Natural monopoly, 571 antitrust policy and, 756–758 control of, 621 public ownership, 619 regulation of, 619–620 Natural rate hypothesis, 350–351 Natural rate of unemployment, 126, 130–132, 328, 337–338 Natural resources, 378, 389–390 NBER (National Bureau of Economic Research), 10–11, 344 Near-moneys, 235 Negative demand shock, 172, 194–195 Negative economic profit, 533 Negative externalities, 392, 727 I N D E X I-9 Negative income tax, 769 Negative relationship, 37 Net exports, 108–109 Net present value, 240–241 Network externality definition, 740 monopol
19–521 Optimal consumption bundle, 515–517 Optimal consumption rule, 520 Optimal output rule, 536–537, 584–585 Ordinary goods, 795 Organ transplant, consumer surplus and, 488 Organization of Petroleum Exporting Countries (OPEC), 197, 639–640 Origin, 35 Other things equal (ceteris paribus) assumption, 14 Outflows, 223 Output, 12, 315–319. See also Actual output; Aggregate output; Potential output Output gap, 196 monetary policy, 311 unemployment rate, 328–329 Output per worker, 370 Overuse, 749–750 P Panic of 1907, 253–254 Patent, 572 Payoff, 644 Payoff matrix, 644 Pearl Harbor, 346 Pension fund, 228 Perfect competition, 567 changing fixed cost, 595 conditions for, 569–570 definition of, 568–569 free entry and exit, 570 graphs, interpretation of, 590–596 industry supply curve and, 599–605 labor market and, 700–703 versus monopolistic competi- tion, 663–665 versus monopoly, 613 product market and, 700 production and profits, 584–588, 595–596 profitability, market price and, 590–592 short-run production deci- sion, 592–593 shut-down price, 593–595 standardized product, 569–570 Perfect price discrimination, 627–629 Perfectly competitive industry, 569 Perfectly competitive mar- ket, 180–181, 568–569 Perfectly elastic, 467–468 Perfectly elastic supply, 479 Perfectly inelastic, 466–467 Perfectly inelastic supply, 478 Permanent income hypothesis, 166 Persistent surplus, 128 Peso, exchange rate, 423–426 Phelps, Edmund, 333, 350 Phillips, Alban W. H., 331 Phillips curve long-run, 335–336 short-run, 331–335 Physical asset, 224 Physical capital, 222, 680 aggregate demand curve, 176 aggregate production func- tion, 374–378 diminishing returns to, 374–377 government, 387–388 growth rates, 385–386 productivity, 371 Pie chart, 43 Pigouvian subsidy, 738 Pigouvian taxes, 734 Pin-making, specialization and, 23 Planned investment spending, 166–167 Political business cycle, 351 Poll tax, 508 Pollution, economic growth and, 390–393 Pollution, economics
of cost and benefits of, 724–725 external cost, 726–727 inefficiency of, 727–728 private solutions to, 728–729 Pollution, policies and, 731 cap and trade system, 736 emissions taxes, 732–734 environmental standards, 731–732 tradable emissions permists, 734–736 Poole, Bill, 295 Portugal, inflation, 101, 112 Positive demand shock, 194–195 Positive economic profit, 533 Positive economics, 6–8 Positive externalities, 727 Positive relationship, 37 Positive supply shock. See Supply shock Post-it note, productivity and, 371 Post-tax, 500 Potential output, 185–187 versus actual output, 186 output gap, 196 recessionary gap, 196 self-correcting, 195–196, 199 supply-side economics, 357 United States, 397 Pound (British currency), 435, 439 Poverty, 761 causes of, 763 consequences of, 763–764 demographics of, 762 trends in, 761–762 U.S. antipoverty programs, 768–771 Poverty rate, 761–762 Poverty threshold, 761 PPC (production possibili- ties curve), 16–21, 24–25 PPI (producer price index), 143, 145–146 Preferences, demand curve, 54 Prescott, Edward, 353 Present value, 237–241 Pre-tax, 500 Price ceilings, 77–82 apartment market, 78–82 black markets, 81 I-10 I N D E X Price ceilings (continued) classical macroeconomics, Productivity, 27, 370–371 effects of, 79 inefficient allocation to consumers, 80 inefficiently low quality, 81 reason for, 81–82 wasted resources, 80–81 Price competition, 641 Price controls, 77–85 Price determination AD-AS model, 190–197, 199–207 aggregate demand, 172–177 aggregate supply, 179–188 consumer spending, 161–166 economic policy, 199–207, 209–213 income, expenditure, 158–170 investment spending, 166–170 multiplier, 158–161, 209–213 Price discrimination definition, 624 elasticity and, 626 logic of, 624–626 perfect price discrimination, 627–629 Price effect 343 money supply, 321–324 Price regulation, 619–620 Price shock, 190 Price stability, 13, 200, 310 Price support programs, 84 Price war definition, 654 tacit collusion and, 653–
655 Price-fixing, 637 Price-taker, 568 Price-taking consumer, 568 Price-taking firm, 568 Price-taking firm’s optimal output rule, 585–586 Pricing power, 181 Principle of diminishing aggregate production func- tion, 374–378 diminishing returns to physical capital, 374–377 information technology, 379 natural resources, 378 physical capital, 371 short-run aggregate supply curve, 183–184 technological progress, 371, 377–378 total factor, 377–378 Profit accounting profit versus economic profit, 531–533, 539, 586 explicit versus implicit costs, marginal utility, 513 530–531 Principle of marginal analysis, 537–538 Prisoners’ dilemma, 644–647 arms race and, 649 repeated interaction, tacit collusion and, 647–649 Private goods characteristics of, 743–744 market supply of, 744–745 Private information, 782–784 Private savings, 105, 281, collusion and competition, 415–416 640 monopolist demand curve, marginal revenue and, 609–612 Price elasticity of demand, 457, 460–463 along demand curve, 471–472 examples of, 466–471 factors determining, 472–473 Producer price index (PPI), 143, 145–146 Producer surplus, 63–64, 482, 490 changes in trade quantity, 498–499 changing prices and, 492 cost and, 489–492 equity and efficiency, 499 gains from trade and, 495–496 monopoly behavior and, 614 market efficiency and, Price elasticity of supply, 457, 477–479 Price floors, 77, 82–85 agricultural, 82–84 effects of, 83 illegal activity, 85 inefficient allocation of sales among sellers, 84 inefficiently high quality, 85 inefficiently low quantity, 84 minimum wage, 82–85 reason for, 85 school lunches, 84 surplus, 83–84 wasted resources, 84–85 Price indexes, 142–147 Price leadership definition, 656 product differentiation and, 655–656 Price level. See also Aggregate price level 496–499 reallocation of consumption, 496–497 reallocation of sales, 497–498 taxation costs and, 506–507 Product differentiation advertising, role of, 670–671 brand names, 671–672 definition, 637, 655 by location, 669 price leadership and, 655–656 by quality, 669–670 by style or type
, 668–669 Product markets, 103, 700 Production capacity, 168 Production function, 542, 542–546 Production possibilities curve (PPC), 16–21, 24–25, 396–400 classic model, 322–323 Production workers, pay, 12 R Rate of return, 278 Rational expectations, 352 R&D (research and development), 386–387 Reagan, Ronald, 357 Real business cycle theory, 352–353 Real exchange rate, 423–425 Real gross domestic product (GDP), 112–116 aggregate demand, 172–173, 175 calculating, 113–115 chain-linking, 115 defining, 112–115 fiscal policy, 210–211 versus GDP, 113 Great Depression, 161 investment spending, 168 money demand curve, 272 multiplier, 159–160, 210–211 versus nominal GDP, 114 potential output, 185–186 unemployment, 122–123 Real gross domestic product (GDP) per capita, 115 economic growth, 13, 366–368 long-run economic growth comparison, 379–383 productivity, 370–371 Real income, 135, 459 Real interest rate, 138, 282 Real price of oil, 389–390 Real wage, 135 Recessionary gap, 195–196 expansionary fiscal policy, 205 Federal Reserve, 313 revaluation, 436 unemployment rate, 195, 328 Recessions, 10–11, 197 fiscal/monetary policy, 355–356 macroeconomic theories, 355–356 unemployment, 122 Reconstruction Finance Corporation (RFC), 256–257 Recovery. See Expansions Re-entrants, 127 Regional Federal Reserve Banks, 255–256 Regressive tax, 499 Regulation Q, 257, 273 Relative price, 797 Relative price rule, 798 Rent control, 78–82 Rental rate, 691 Reputation, 784 Required reserve ratio, 244 maximization of, 536–539 monopoly and, 612–615 negative, 533 normal, 533–534 perfect competition and, 584–588, 590–592, 595–596 positive, 533 production and, 539 Progressive tax, 499 Property rights, 3, 388–389 Property tax, 202–203 Proportional tax, 499 Public debt, 300–302 Public goods, 745–746 provision of, 746–748 voting as, 749 Public ownership, 619 Purchasing power parity, 425–426 Q Quantity competition, 641 Quantity control, 88–93 costs of, 92–93 deadweight loss, 90, 92 demand
55 curve, 174–177, 444 demand shock, 191–194 existing stock of physical capital, 176 expectation changes, 175 fiscal policy, 176–177 government policy, 176 government spending, 204 monetary policy, 177 rightward versus leftward shifts, 175 short-run effects, 191–192 wealth changes, 175–176 Shifts of the demand curve, 52–56, 444 effects, 71–72 equilibrium, 72 expectation changes, 54–55 income changes, 53–54 versus movement along the demand curve, 51–52 normal/inferior goods, 53–54 shifts, 73–74 substitutes, complements, 53 taste changes, 54 Shifts of the money demand curve, 271–273, 444 Shifts of the short-run aggre- gate supply curve, 181–184, 444 commodity prices, 182–183 nominal wages, 183 productivity, 183–184 rightward versus leftward shifts, 182 supply shock, 192–194 Shifts of the supply curve, 60–65, 444 effects, 72–73 equilibrium, 73 expectation changes, 63 input prices, 62–63 versus movement along the supply curve, 62 number of producers, 63–64 related goods/services prices, 63 simultaneous demand curve shifts, 73–74 substitutes/complements in production, 63 technology changes, 63 Shocks, 438 demand, 172, 191–197, 200 price, 190 supply, 192–194, 197, 200–201, 332–333 Shoe-leather costs, 136–137 Short run, 542 Shortage, 68–69 I N D E X I-11 South Korea economic growth, 379–381 natural resources, 378 Spain, economic growth, 382 Specialization, 23–24, 563 Spreading effect, 554 SRAS. See Short-run aggre- gate supply curve SRPC (short-run Phillips curve), 331–335 Stabilization policy, 199–201, 357 Stagflation (stagnation plus inflation), 193, 334 Standardized product, 569–570 Starbucks, 47–48, 53–55 Stern, Nicholas, 392 Stewart, Jimmy, 245 Sticky wages, 180 Stimulus package, 2008, 211, 213 Stock, 104, 224, 227 Stock bubble, 359 Stock market crash, 175–176 Stock of physical capital, 176 Store of value, 232 Strategic behavior, 647 Structural unemployment, 128–130, 132 Subletting, 80–81 Subprime lending, 258–259 Substitutes, 53
, 57 in factor markets, 706–707 in production, 63 Substitution effect, 458–459 Summer job, decline of, 699 Sunk cost, 563–564 Supplemental Nutrition Assistance Program, 769 Supply and demand model, Short-run aggregate supply curve (SRAS) classic model of the price level, 322–323 Keynesian versus classical macroeconomics, 345 versus long-run, 186–187 long-run macroeconomic equilibrium, 194 money supply increase, 316–317 movement along, 181 shifts of, 181–184, 444 Short-run costs concepts and measures, 564 versus long-run, 559–564 Short-run equilibrium aggre- gate output, 190–193 Short-run equilibrium aggregate price level, 190–193 Short-run fluctuations, eco- nomic growth, 400–401 Short-run individual supply equilibrium, 190–191 Short-run market equilibrium, 600–601 Short-run Phillips curve (SRPC), 331–335 expected inflation, 333–334 supply shocks, 332–333 Short-term interest rates, 268–270 Shut-down price, 593–595 Signaling, 784 Simple circular-flow diagram, 102–103 47–56 Single-price monopolist, 624 Sloan, Alfred, 670 Slope, 37 of horizontal and vertical curves, 38 of linear curve, 37–38 maximum and minimum points, 40–41 of nonlinear curves, 39–40 Smith, Adam, 23, 233 Smog, 391 Social insurance, 202–204 Social insurance taxes, 202–203 Social Security, 147, 203–204, 303–304, 769 Social Security Administration, 304 Social Security trust fund, 304 Socially optimal quantity of pollution, 725 Solar power, 392 Solow, Robert, 379 Sotheby’s, price-fixing, 655 South Africa, monetary neutral- ity, 318 demand curve, 49–56 equilibrium, 49–56, 66–69 equilibrium shifts, 71–74 exchange rate, 429 price controls, 77–85 quantity control, 88–93 supply curve, 59–65 Supply curve, 59–65 individual, 63–64 law of supply, 60 market, 64 movement along, 60–61 rightward versus leftward shifts, 61 shift effects, 72–73 shifts, 60–65, 444 supply schedule, 59–60 Supply price, 90 Supply schedule, 59–60 Supply shock, 192–194, 197 versus demand shock, 193–194,
s, 254, 652 Turkey, lira, 322 12 regional Federal Reserve Banks, 255–256 2008 stimulus package, 211, 213 Two-part tariffs, 628 Two-variable graph, 34–36 Two-way capital flows, 416 U U6, 120 UAW (United Auto Workers), 129 Underemployed, 120 Unemployed, 119 Unemployment, 12 benefits, 130, 132 business cycle, 11–12 cyclical, 130, 328–329 duration distribution, 127 economic growth, 122–123 Federal Reserve, 313 frictional, 127–128, 130 job creation/destruction, superiority, monopolies and, 126–127 572 supply curve, 63 Technology spillover, 738 TED spread, 259–260 Tehachapi Wind Farm, 390 Thatcher, Margaret, 508 Thelma and Louise, 645 long-run Phillips curve, 335–336 macroeconomic theories, 356 natural rate, 126, 130–132, 328, 337–338 nonaccelerating inflation rate of, 336–337 real GDP, 122–123 recessions, 122 reduction, fiscal/monetary policy, 356 housing bubble, 258–259, 358–359, 416 income inequality, 764–768 inflation, 12, 135–139, 321, short-run Phillips curve, 332–338 331–335 international capital flows, structural, 128–130, 132 Unemployment insurance, 769 Unemployment rate, 12 versus actual unemployment, 119–121 alternative measures of, 121 budget deficit, 298 defining, measuring, 119 demographics, 120–121 inflation, 134, 328–329 inflationary gap, 328 natural, 126, 130–132, 328, 337–338 output gap, 328–329 recessionary gap, 195, 328 significance of, 119–121 United States, 11–12, 415–417 loanable funds market, 414 monetary neutrality, 318 money system, 233–235 national accounts, 102–110 natural resources, 378 oil consumption, 391 poverty, 761–762 price controls, 1970s, 656 price floors, surplus, 82–84 producer price index, 143, 145–146 recessions, 10–11, 197 taxes, 202–204 unemployment, 11–12, 118–124, 126–132, 298, 332–338 118–124, 126–132, 298, 332–338 unemployment benefits, 130 United States Census Bureau, Unions, 713 Unit of account, 233 United Auto Workers (UAW), 129 United Kingdom. See Britain
United Nations, 383 United Nations Climate Change Conference, 393 United Network for Organ Sharing (UNOS), 488 United States (U.S.) actual/potential output, 397 antipoverty programs, 768–771 balance of payments, 409–413 banking system, 253–260 budget deficit, 296–304 business cycles, 11–12 carbon dioxide emissions, 392 clothing production, 27 consumer price index, 143–147, 337 debt, 296–304 deflation, 338–341 dollar, 234, 407, 419–426 economic growth, 13, 365–371 exchange rate, 431–432 factor distribution of income in, 681–682 farms, 477 Federal Reserve System, 253–260, 262–266 government spending, 202–204 gross domestic product, 13, 106–110, 367, 382 housing boom, 157, 169, 258–259 119 United States Department of Commerce, 102, 113 United States Justice Depart - ment, price-fixing, 641 United States Treasury, 265, 324 United States Treasury bills, 264–265, 324 Unit-elastic, 467–471 Unit-free measure, 476 Unit-of-account costs, 137–138 UNOS (United Network for Organ Sharing), 488 Unplanned inventory investment, 169–170 Unplanned investment spending, 168–170 Uruguay, economic growth, 381 U.S. See United States U-shaped average total cost curves, 553, 555–556 Utility, 511 budget constraints, 514–515 budget lines, 514–515 consumption and, 511–513 marginal dollar, 518–521 optimal consumption bun- dle, 515–517 principle of diminishing marginal utility, 513–514 Utility function, 512. See also Indifference curves Utils, 512, 790 V Value added, 107 Value in diversity, 669 Value of the marginal product, 684–686 I N D E X I-13 Value of the marginal prod- uct curve, 684–686 Value-added tax, 7 Variable, 34 Variable cost, 548, 564 Variable input, 542 Velocity of money, 349–350 Venezuela, GDP, 116 Vertical axis, 35 Vertical curve, slope of, 38 Vertical intercept, 37 Veterinarians, competition and, 65 Vicious cycle of deleveraging, 258 Vietnam, coffee, 47, 61, 71–73 Vitamins, Inc., 642 Volcker, Paul, 134 Volume discounts, 627 W Wage
F. Marginal analysis Module 1 The Study of Economics II. The Nature and Function of Product Markets (55–70%) Section 2: Supply and Demand A. Supply and demand 1. Market equilibrium 2. Determinants of supply and demand 3. Price and quantity controls 4. Elasticity Module 5 Supply and Demand: Introduction and Demand Module 6 Supply and Demand: Supply and Equilibrium Module 7 Supply and Demand: Changes in Supply and Demand Module 8 Supply and Demand: Price Controls Module 9 Supply and Demand: Quantity Controls Section 9: Behind the Demand Curve: Theory of Consumer Choice Module 46 Income and Substitution Effects and Elasticity Module 47 Interpreting Price Elasticity of demand Module 48 Other Elasticities 5. Consumer surplus, producer surplus, and market Module 49 Consumer and Producer Surplus efficiency 6. Tax incidence and deadweight loss Module 50 Efficiency and deadweight Loss B. Theory of consumer choice Module 51 Utility Maximization C. Production and costs 1. Production functions 2. Marginal product and diminishing returns 3. Short-run costs Section 10: Behind the Supply Curve: Profit, Production, and Costs Module 54 The Production Function Module 54 The Production Function Module 55 Firm Costs 4. Long-run costs and economies of scale Module 56 Long Run Costs and Economies of Scale 5. Cost minimizing input combination Module 72 Cost Minimizing Input Combinations D. Firm behavior and market structure Module 57 Introduction to Market Structures 1. Profit 2. Perfect competition 3. Monopoly Module 52 Defining Profit Module 53 Profit Maximization Section 11: Market Structures: Perfect Competition and Monopoly Module 58 Introduction to Perfect Competition Module 59 Graphing Perfect Competition Module 60 Long-Run Outcomes in Perfect Competition Module 61 Introduction to Monopoly Module 62 Monopoly and Public policy Module 63 Price Discrimination College Board AP Topic Outline Microeconomics Krugman’s Economics for AP* 4. Oligopoly Section 12: Market Structures: Imperfect Competition Module 64 Introduction to Oligopoly Module 65 Game Theory Module 66 Oligopoly in Practice 5. Monopolistic competition Module 67 Introduction to Monopolistic Competition Module 68 Product Differentiation and Advertising III. Factor Markets (10–18%) A. Derived factor demand Section 13: Factor Markets Module 69 Introduction and Factor Demand B. Marginal revenue product Module 69 Introduction and Factor Demand C. Labor market and firms’ hiring of labor Module 71 The Market for Labor D. Market distribution of income Module 73 Theories of Income Distribution Module 70 The Markets for Land and Capital IV. Market Failure and
the Role of Government (12–18%) A. Externalities Section 14: Market Failure and the Role of Government Introduction to Externalities Module 74 B. Public goods Module 76 Public goods C. Public policy to promote competition Module 77 Public Policy to Promote Competition: Anti-trust and Regulation D. Income distribution Module 78 Income Distribution and Income Inequality Module 75 Externalities and Public Policy Appendix: Enrichment Modules Module 79 The Economics of Information Module 80 Indifference Curves and Consumer Choice College Board AP Topic Outline Macroeconomics Krugman’s Economics for AP* B. The central bank and control of the money supply V. Inflation, Unemployment, and Stabilization Policies (20–30%) A. Fiscal and monetary policies Module 25 Banking and Money Creation Module 28 The Money Market Module 29 The Market for Loanable Funds Module 26 The Federal Reserve System: History and Structure Module 27 The Federal Reserve: Monetary Policy Section 6: Inflation, Unemployment, and Stabilization Policies Module 30 Long-run Implications of Fiscal Policy: Deficits and the Public Debt Module 31 Monetary Policy and the Interest Rate Module 32 Money, Output, and Prices in the Long Run B. Inflation and unemployment Module 33 Types of Inflation, Disinflation, and Deflation Module 34 Inflation and Unemployment: The Phillips Curve Module 35 History and Alternative Views of Macroeconomics Module 36 The Modern Macroeconomic Consensus VI. Economic Growth and Productivity (5–10%) Section 7: Economic Growth and Productivity Module 37 Long-run Economic Growth Module 38 Productivity and Growth Module 39 Growth Policy: Why Economic Growth Rates Differ Module 40 Economic Growth in Macroeconomic Models VII. Open Economy: International Trade and Finance (10–15%) Section 8: Open Economy: International Trade and Finance A. Balance of payments accounts, and C. Net exports Module 41 Capital Flows and the Balance of Payments and capital flows B. The foreign exchange market Module 42 The Foreign Exchange Market D. Links to financial and goods markets Module 44 Exchange Rates and Macroeconomic Policy Module 43 Exchange Rate Policy Module 45 Putting It All Together College Board AP Topic Outline Macroeconomics Krugman’s Economics for AP* I. Basic Economic Concepts (8–12%) A. Scarcity, choice, and opportunity costs Section 1: Basic Economic Concepts The Study of Economics Module 1 B. Production possibilities curve Module 3 The Production Possibilities Curve Model C. Comparative advantage, absolute advantage, Module 4 Comparative Advantage and Trade specialization, and exchange E. Macro
economic issues: business cycle, unemployment, inflation, growth Module 2 Introduction to Macroeconomics D. Demand, supply, and market equilibrium Section 2: Supply and Demand Module 5 Supply and Demand: Introduction and Demand Module 6 Supply and Demand: Supply and Equilibrium Module 7 Supply and Demand: Changes in Equilibrium II. Measurement of Economic Performance (12–16%) Section 3: Measurement of Economic Performance A. National income accounts Module 10 The Circular Flow and Gross Domestic Product Module 11 Interpreting Real Gross Domestic Product C. Unemployment Module 12 The Meaning and Calculation of Unemployment Module 13 The Causes and Categories of Unemployment B. Inflation measurement and adjustment Module 14 Inflation: An Overview Module 15 The Measurement and Calculation of Inflation III. National Income and Price Determination (10–15%) A. Aggregate demand Section 4: National Income and Price Determination Income and Expenditure Module 16 Module 17 Aggregate Demand: Introduction and Determinants B. Aggregate supply Module 18 Aggregate Supply: Introduction and Determinants C. Macroeconomic equilibrium Module 19 Equilibrium in the Aggregate Demand– Aggregate Supply Model Module 20 Economic Policy and the Aggregate Demand– Aggregate Supply Model Module 21 Fiscal Policy and the Multiplier IV. Financial Sector (15–20%) Section 5: The Financial Sector A. Money, banking, and financial markets Module 22 Saving, Investment, and the Financial System Module 23 The Definition and Measurement of Money Module 24 The Time Value of Money ~StormRG~s scarce if the choice of one alternative requires that another be given up. The existence of alternative uses forces us to make choices. The opportunity cost of any choice is the value of the best alternative forgone in making it • Economics is a social science that examines how people choose among the alternatives available to them. • Scarcity implies that we must give up one alternative in selecting another. A good that is not scarce is a free good. • The three fundamental economic questions are: What should be produced? How should goods and services be produced? For whom should goods and services be produced? • Every choice has an opportunity cost and opportunity costs affect the choices people make. The opportunity cost of any choice is the value of the best alternative that had to be forgone in making that choice. 1.1 Defining Economics 13 Chapter 1 Economics: The Study of Choice T R Y I T! Identify the elements of scarcity, choice, and opportunity cost in each of the following: 1. The Environmental Protection Agency is
considering an order that a 500-acre area on the outskirts of a large city be preserved in its natural state, because the area is home to a rodent that is considered an endangered species. Developers had planned to build a housing development on the land. 2. The manager of an automobile assembly plant is considering whether to produce cars or sport utility vehicles (SUVs) next month. Assume that the quantities of labor and other materials required would be the same for either type of production. 3. A young man who went to work as a nurses’ aide after graduating from high school leaves his job to go to college, where he will obtain training as a registered nurse. 1.1 Defining Economics 14 Chapter 1 Economics: The Study of Choice Case in Point: Canadians Make a Choice © Thinkstock Canadian Prime Minister Stephen Harper, head of the Conservative Party, had walked a political tightrope for five years as the leader of a minority government in Canada’s parliamentary system. His opponents, upset by policies such as a reduction in corporate tax rates, sought a no-confidence vote in Parliament in 2011. It passed Parliament overwhelmingly, toppling Harper’s government and forcing national elections for a new Parliament. The political victory was short-lived—the Conservative Party won the May 2011 election easily and emerged as the ruling party in Canada. This allowed Mr. Harper to continue to pursue a policy of deficit and tax reduction. Canadian voters faced the kinds of choices we have been discussing. Opposition parties—the New Democratic Party (NDP) and the more moderate Liberal Party—sought higher corporate tax rates and less deficit reduction than those advocated by the Conservatives. Under Mr. Harper, the deficit had fallen by one-third in 2010. He promises a surplus budget by 2015, a plan the International Monetary Fund has termed “strong and credible.” Canada’s unemployment rate in May, 2011 was 7.4 percent compared to a U.S. rate that month of 9.1 percent. GDP growth in Canada was 3.1 percent in 2010; 1.1 Defining Economics 15 Chapter 1 Economics: The Study of Choice the Bank of Canada projects 4.2 for its growth rate the first quarter of 2011, compared to a U.S. rate for that quarter of 1.8 percent. Mr. Stephens employed a stimulus package to battle the recession that began in Canada in 2008. He scaled back that effort in 2010 and 2011, producing substantial reductions in the deficit. Writing on the eve of the election,
Wall Street Journal columnist Mary Anastasia O’Grady termed the vote a “referendum on limited government.” Whether or not that characterization was accurate, Canadians clearly made a choice that will result in lower taxes and less spending than the packages offered by the NDP and Liberal Party. While the issue did not seem to figure prominently in the 2011 campaign, the NDP platform promised to reduce Canada’s greenhouse gas emissions, which have increased with the development of huge oil deposits in Alberta, deposits that have put Canada in third place (behind Venezuela and Saudi Arabia) in the world in terms of oil reserves. Mr. Harper and the Conservatives have promised to proceed with this development as a key factor in Canada’s growth, while the NDP would restrict it sharply. It is a classic case of the problem when choices are made between environmental quality and economic growth. Sources: Kathleen Harris, “A Vote for the Economy,” Canadian Business, 84(6), May 9, 2011; Nirmala Menon and Paul Vieira, “Canada’s Conservatives Win Majority,” The Wall Street Journal online, May 3, 2011; Paul Vieira, “Canada’s Budget Deficit Shrinks on Strong Growth,” The Wall Street Journal online, April 22, 2011; Mary Anastasia O’Grady, “Canada’s Capitalism Referendum, The Wall Street Journal online, May 2, 2011. The platform of the NDP is available at http://xfer.ndp.ca/2011/2011-Platform/NDP-2011-Platform-En.pdf. 1.1 Defining Economics 16 Chapter 1 Economics: The Study of Choice. The 500-acre area is scarce because it has alternative uses: preservation in its natural state or a site for homes. A choice must be made between these uses. The opportunity cost of preserving the land in its natural state is the forgone value of the land as a housing development. The opportunity cost of using the land as a housing development is the forgone value of preserving the land. 2. The scarce resources are the plant and the labor at the plant. The manager must choose between producing cars and producing SUVs. The opportunity cost of producing cars is the profit that could be earned from producing SUVs; the opportunity cost of producing SUVs is the profit that could be earned from producing cars. 3. The man can devote his time to his current career or to an education;
his time is a scarce resource. He must choose between these alternatives. The opportunity cost of continuing as a nurses’ aide is the forgone benefit he expects from training as a registered nurse; the opportunity cost of going to college is the forgone income he could have earned working full-time as a nurses’ aide. 1.1 Defining Economics 17 Chapter 1 Economics: The Study of Choice 1.2 The Field of Economics. Explain the distinguishing characteristics of the economic way of thinking. 2. Distinguish between microeconomics and macroeconomics. We have examined the basic concepts of scarcity, choice, and opportunity cost in economics. In this section, we will look at economics as a field of study. We begin with the characteristics that distinguish economics from other social sciences. The Economic Way of Thinking Economists study choices that scarcity requires us to make. This fact is not what distinguishes economics from other social sciences; all social scientists are interested in choices. An anthropologist might study the choices of ancient peoples; a political scientist might study the choices of legislatures; a psychologist might study how people choose a mate; a sociologist might study the factors that have led to a rise in single-parent households. Economists study such questions as well. What is it about the study of choices by economists that makes economics different from these other social sciences? Three features distinguish the economic approach to choice from the approaches taken in other social sciences: 1. Economists give special emphasis to the role of opportunity costs in their analysis of choices. 2. Economists assume that individuals make choices that seek to 3. maximize the value of some objective, and that they define their objectives in terms of their own self-interest. Individuals maximize by deciding whether to do a little more or a little less of something. Economists argue that individuals pay attention to the consequences of small changes in the levels of the activities they pursue. The emphasis economists place on opportunity cost, the idea that people make choices that maximize the value of objectives that serve their self-interest, and a 18 Chapter 1 Economics: The Study of Choice focus on the effects of small changes are ideas of great power. They constitute the core of economic thinking. The next three sections examine these ideas in greater detail. Opportunity Costs Are Important If doing one thing requires giving up another, then the expected benefits of the alternatives we face will affect the ones we choose. Economists argue that an understanding of opportunity cost is crucial to the examination of choices. As the set of available alternatives changes, we expect that
the choices individuals make will change. A rainy day could change the opportunity cost of reading a book; we might expect more reading to get done in bad than in good weather. A high income can make it very costly to take a day off; we might expect highly paid individuals to work more hours than those who are not paid as well. If individuals are maximizing their level of satisfaction and firms are maximizing profits, then a change in the set of alternatives they face may affect their choices in a predictable way. The emphasis on opportunity costs is an emphasis on the examination of alternatives. One benefit of the economic way of thinking is that it pushes us to think about the value of alternatives in each problem involving choice. Individuals Maximize in Pursuing Self-Interest What motivates people as they make choices? Perhaps more than anything else, it is the economist’s answer to this question that distinguishes economics from other fields. Economists assume that individuals make choices that they expect will create the maximum value of some objective, given the constraints they face. Furthermore, economists assume that people’s objectives will be those that serve their own selfinterest. Economists assume, for example, that the owners of business firms seek to maximize profit. Given the assumed goal of profit maximization, economists can predict how firms in an industry will respond to changes in the markets in which they operate. As labor costs in the United States rise, for example, economists are not surprised to see firms moving some of their manufacturing operations overseas. 1.2 The Field of Economics 19 Chapter 1 Economics: The Study of Choice Similarly, economists assume that maximizing behavior is at work when they examine the behavior of consumers. In studying consumers, economists assume that individual consumers make choices aimed at maximizing their level of satisfaction. In the next chapter, we will look at the results of the shift from skiing to snowboarding; that is a shift that reflects the pursuit of self-interest by consumers and by manufacturers. In assuming that people pursue their self-interest, economists are not assuming people are selfish. People clearly gain satisfaction by helping others, as suggested by the large charitable contributions people make. Pursuing one’s own self-interest means pursuing the things that give one satisfaction. It need not imply greed or selfishness. Choices Are Made at the Margin Economists argue that most choices are made “at the margin.” The margin6 is the current level of an activity. Think of it as the edge from which a choice is to be made. A choice at
the margin7 is a decision to do a little more or a little less of something. Assessing choices at the margin can lead to extremely useful insights. Consider, for example, the problem of curtailing water consumption when the amount of water available falls short of the amount people now use. Economists argue that one way to induce people to conserve water is to raise its price. A common response to this recommendation is that a higher price would have no effect on water consumption, because water is a necessity. Many people assert that prices do not affect water consumption because people “need” water. But choices in water consumption, like virtually all choices, are made at the margin. Individuals do not make choices about whether they should or should not consume water. Rather, they decide whether to consume a little more or a little less water. Household water consumption in the United States totals about 105 gallons per person per day. Think of that starting point as the edge from which a choice at the margin in water consumption is made. Could a higher price cause you to use less water brushing your teeth, take shorter showers, or water your lawn less? Could a higher price cause people to reduce their use, say, to 104 gallons per person per day? To 103? When we examine the choice to consume water at the margin, the notion that a higher price would reduce consumption seems much more plausible. Prices affect our consumption of water because choices in water consumption, like other choices, are made at the margin. 6. The current level of an activity. 7. A decision to do a little more or a little less of something. 1.2 The Field of Economics 20 Chapter 1 Economics: The Study of Choice The elements of opportunity cost, maximization, and choices at the margin can be found in each of two broad areas of economic analysis: microeconomics and macroeconomics. Your economics course, for example, may be designated as a “micro” or as a “macro” course. We will look at these two areas of economic thought in the next section. Microeconomics and Macroeconomics The field of economics is typically divided into two broad realms: microeconomics and macroeconomics. It is important to see the distinctions between these broad areas of study. Microeconomics8 is the branch of economics that focuses on the choices made by individual decision-making units in the economy—typically consumers and firms—and the impacts those choices have on individual markets. Macroeconomics9 is the branch of economics
that focuses on the impact of choices on the total, or aggregate, level of economic activity. Why do tickets to the best concerts cost so much? How does the threat of global warming affect real estate prices in coastal areas? Why do women end up doing most of the housework? Why do senior citizens get discounts on public transit systems? These questions are generally regarded as microeconomic because they focus on individual units or markets in the economy. Is the total level of economic activity rising or falling? Is the rate of inflation increasing or decreasing? What is happening to the unemployment rate? These are the questions that deal with aggregates, or totals, in the economy; they are problems of macroeconomics. The question about the level of economic activity, for example, refers to the total value of all goods and services produced in the economy. Inflation is a measure of the rate of change in the average price level for the entire economy; it is a macroeconomic problem. The total levels of employment and unemployment in the economy represent the aggregate of all labor markets; unemployment is also a topic of macroeconomics. Both microeconomics and macroeconomics give attention to individual markets. But in microeconomics that attention is an end in itself; in macroeconomics it is aimed at explaining the movement of major economic aggregates—the level of total output, the level of employment, and the price level. We have now examined the characteristics that define the economic way of thinking and the two branches of this way of thinking: microeconomics and 8. The branch of economics that focuses on the choices made by consumers and firms and the impacts those choices have on individual markets. 9. The branch of economics that focuses on the impact of choices on the total, or aggregate, level of economic activity. 1.2 The Field of Economics 21 Chapter 1 Economics: The Study of Choice macroeconomics. In the next section, we will have a look at what one can do with training in economics. Putting Economics to Work Economics is one way of looking at the world. Because the economic way of thinking has proven quite useful, training in economics can be put to work in a wide range of fields. One, of course, is in work as an economist. Undergraduate work in economics can be applied to other careers as well. Careers in Economics Economists generally work in three types of organizations: government agencies, business firms, and colleges and universities. Economists working for business firms and government agencies sometimes forecast economic activity to assist their employers in planning
. They also apply economic analysis to the activities of the firms or agencies for which they work or consult. Economists employed at colleges and universities teach and conduct research. Look at the website of your college or university’s economics department. Chances are the department will discuss the wide variety of occupations that their economics majors enter. Unlike engineering and accounting majors, economics and other social science majors tend to be distributed over a broad range of occupations. Applying Economics to Other Fields Suppose that you are considering something other than a career in economics. Would choosing to study economics help you? The evidence suggests it may. Suppose, for example, that you are considering law school. The study of law requires keen analytical skills; studying economics sharpens such skills. Economists have traditionally argued that undergraduate work in economics serves as excellent preparation for law school. Economist Michael Nieswiadomy of the University of North Texas collected data on Law School Admittance Test (LSAT) scores for the 12 undergraduate majors listed most often by students hoping to enter law school in the class of 2008–9. Table 1.1 "LSAT Scores for Students Taking the Exam in 2008" gives the scores, as well as the ranking for 1.2 The Field of Economics 22 Chapter 1 Economics: The Study of Choice each of these majors in 2008. Economics majors tied philosophy majors for the highest average score. Table 1.1 LSAT Scores for Students Taking the Exam in 2008 Rank Major Average LSAT Score # of Students 1 1 3 4 5 6 7 8 9 10 11 12 Economics Philosophy Engineering History English Finance Political science Psychology Sociology Communications Business administration Criminal justice 157.4 157.4 156.2 155.9 154.7 153.4 153.0 152.5 150.7 150.5 149.1 145.5 3,047 2,184 2,197 4,166 5,120 2,267 14,964 4,355 1,902 2,230 1,971 3,306 Here are the average LSAT scores and rankings for the 12 undergraduate majors with more than 1,900 students taking the test to enter law school in the 2008–2009 academic year. Source: Michael Nieswiadomy, “LSAT Scores of Economics Majors: The 2008–09 Class Update” Journal of Economic Education, 41:3 (Summer 2010): 331–333. Did the strong performance by economics and philosophy majors mean that training in those fields sharpens analytical skills tested in the LSAT, or that students
with good analytical skills are more likely to major in them? Both were probably at work. Economics and philosophy clearly attract students with good analytical skills—and studying economics or philosophy helps to develop those skills. Of course, you may not be interested in going to law school. One consideration relevant to selecting a major is potential earnings in that field. The National 1.2 The Field of Economics 23 Chapter 1 Economics: The Study of Choice Association of Colleges and Employers conducts a quarterly survey of salary offers received by college graduates with various majors. The results for the summer 2011 survey for selected majors are given in Table 1.2 "Average Yearly Salary Offers, Summer 2011". If you are going for the big bucks, the best strategy is to major in petroleum engineering. But as the table suggests, economics majors as a group did quite well in 2011. Table 1.2 Average Yearly Salary Offers, Summer 2011 Major Average Offer Petroleum engineering $80,849 Chemical engineering Computer engineering Computer science Electrical engineering Engineering 65,617 64,499 63,402 61,021 60,465 Mechanical engineering 60,345 Information science Economics Finance Accounting 57,499 53,906 52,351 49,671 Business administration 44,825 History English Psychology 40,051 39,611 34,000 Source: National Association of Colleges and Employers, Average Salary Offer to College Class of 2011 Rises 4.8 Percent, press release at http://www.naceweb.org/Press/ Releases/Average_Salary_Offer_to_College_Class_of_2011_Rises_4_8_Percent.aspx. For psychology, median salary offer is reported. One’s choice of a major is not likely to be based solely on considerations of potential earnings or the prospect of landing a spot in law school. You will also consider your interests and abilities in making a decision about whether to pursue further study in economics. And, of course, you will consider the expected benefits of alternative 1.2 The Field of Economics 24 Chapter 1 Economics: The Study of Choice courses of study. What is your opportunity cost of pursuing a study of economics? Does studying more economics serve your interests and will doing so maximize your satisfaction level? These considerations may be on your mind as you begin to study economics at the college level and obviously students will make many different choices. But, should you decide to pursue a major in economics, you should know that a background in this field is likely to serve you well • Econom
ists focus on the opportunity costs of choices, they assume that individuals make choices in a way that maximizes the value of an objective defined in terms of their own self-interest, and they assume that individuals make those choices at the margin. • Economics is divided into two broad areas: microeconomics and macroeconomics. • A wide range of career opportunities is open to economics majors. Empirical evidence suggests that students who enter the job market with a major in economics tend to earn more than do students in many other majors. Further, economics majors do particularly well on the LSAT. T R Y I T! The Department of Agriculture estimated that the expenditures a middleincome, husband–wife family of three would incur to raise one additional child from birth in 2005 to age 17 would be $250,530. In what way does this estimate illustrate the economic way of thinking? Would the Department’s estimate be an example of microeconomic or of macroeconomic analysis? Why? 1.2 The Field of Economics 25 Chapter 1 Economics: The Study of Choice Case in Point: Opportunity Cost with The Simpsons © Thinkstock In the animated television comedy The Simpsons, Homer’s father, Grampa Simpson, faced a classic problem in the allocation of a scarce resource—his time. He wanted to spend the day with his girlfriend, Bea—it was, after all, her birthday. His alternative was to spend the day with Homer and the family, which he did not really want to do, partly because they never visited him anyway. Homer and his family prevailed, however, and insisted on taking Grampa to “Discount Lion Safari,” a local amusement park. The cost of Grampa’s day with his family is the enjoyment he anticipated from spending time with Bea. It all ends up badly for Grampa anyway—Homer’s car breaks down on the way to the park. As for the forgone alternative, Bea dies that day, possibly because of a broken heart from not being able to spend the day with Grampa. Sources: R. Andrew Luccasen and M. Kathleen Thomas, “Simpsonomics: Teaching Economics Using Episodes of The Simpsons,” The Journal of Economic Education, 41(2), Spring 2010, 136–149. The Simpsons, Episode no. 30, first broadcast 28 March 1991 by Fox, directed by David Silverman and written by Jay Kogen and Wallace Wolodarsky. 1.2 The Field of Economics
26 Chapter 1 Economics: The Study of Choice The information given suggests one element of the economic way of thinking: assessing the choice at the margin. The estimate reflects the cost of one more child for a family that already has one. It is not clear from the information given how close the estimate of cost comes to the economic concept of opportunity cost. The Department of Agriculture’s estimate included such costs as housing, food, transportation, clothing, health care, child care, and education. An economist would add the value of the best alternative use of the additional time that will be required for the child. If the couple is looking far ahead, it may want to consider the opportunity cost of sending a child to college. And, if it is looking very far ahead, it may want to consider the fact that nearly half of all parents over the age of 50 support at least one child over the age of 21. This is a problem in microeconomic analysis, because it focuses on the choices of individual households. 1.2 The Field of Economics 27 Chapter 1 Economics: The Study of Choice 1.3 The Economists’ Tool Kit. Explain how economists test hypotheses, develop economic theories, and use models in their analyses. 2. Explain how the all-other-things unchanged (ceteris paribus) problem and the fallacy of false cause affect the testing of economic hypotheses and how economists try to overcome these problems. 3. Distinguish between normative and positive statements. Economics differs from other social sciences because of its emphasis on opportunity cost, the assumption of maximization in terms of one’s own self-interest, and the analysis of choices at the margin. But certainly much of the basic methodology of economics and many of its difficulties are common to every social science—indeed, to every science. This section explores the application of the scientific method to economics. Researchers often examine relationships between variables. A variable10 is something whose value can change. By contrast, a constant11 is something whose value does not change. The speed at which a car is traveling is an example of a variable. The number of minutes in an hour is an example of a constant. Research is generally conducted within a framework called the scientific method12, a systematic set of procedures through which knowledge is created. In the scientific method, hypotheses are suggested and then tested. A hypothesis13 is an assertion of a relationship between two or more variables that could be proven to be false. A statement is not a hypothesis if no conceivable test could show it to be false
. The statement “Plants like sunshine” is not a hypothesis; there is no way to test whether plants like sunshine or not, so it is impossible to prove the statement false. The statement “Increased solar radiation increases the rate of plant growth” is a hypothesis; experiments could be done to show the relationship between solar radiation and plant growth. If solar radiation were shown to be unrelated to plant growth or to retard plant growth, then the hypothesis would be demonstrated to be false. If a test reveals that a particular hypothesis is false, then the hypothesis is rejected or modified. In the case of the hypothesis about solar radiation and plant growth, we would probably find that more sunlight increases plant growth over some range 28 10. Something whose value can change. 11. Something whose value does not change. 12. A systematic set of procedures through which knowledge is created. 13. An assertion of a relationship between two or more variables that could be proven to be false. Chapter 1 Economics: The Study of Choice but that too much can actually retard plant growth. Such results would lead us to modify our hypothesis about the relationship between solar radiation and plant growth. If the tests of a hypothesis yield results consistent with it, then further tests are conducted. A hypothesis that has not been rejected after widespread testing and that wins general acceptance is commonly called a theory14. A theory that has been subjected to even more testing and that has won virtually universal acceptance becomes a law15. We will examine two economic laws in the next two chapters. Even a hypothesis that has achieved the status of a law cannot be proven true. There is always a possibility that someone may find a case that invalidates the hypothesis. That possibility means that nothing in economics, or in any other social science, or in any science, can ever be proven true. We can have great confidence in a particular proposition, but it is always a mistake to assert that it is “proven.” Models in Economics All scientific thought involves simplifications of reality. The real world is far too complex for the human mind—or the most powerful computer—to consider. Scientists use models instead. A model16 is a set of simplifying assumptions about some aspect of the real world. Models are always based on assumed conditions that are simpler than those of the real world, assumptions that are necessarily false. A model of the real world cannot be the real world. We will encounter an economic model in Chapter 2 "Confronting Scarcity: Choices in Production". For that model, we will
assume that an economy can produce only two goods. Then we will explore the model of demand and supply. One of the assumptions we will make there is that all the goods produced by firms in a particular market are identical. Of course, real economies and real markets are not that simple. Reality is never as simple as a model; one point of a model is to simplify the world to improve our understanding of it. Economists often use graphs to represent economic models. The appendix to this chapter provides a quick, refresher course, if you think you need one, on understanding, building, and using graphs. Models in economics also help us to generate hypotheses about the real world. In the next section, we will examine some of the problems we encounter in testing those hypotheses. 14. A hypothesis that has not been rejected after widespread testing and that wins general acceptance. 15. A theory that has been subjected to even more testing and that has won virtually universal acceptance. 16. A set of simplifying assumptions about some aspect of the real world. 1.3 The Economists’ Tool Kit 29 Chapter 1 Economics: The Study of Choice Testing Hypotheses in Economics Here is a hypothesis suggested by the model of demand and supply: an increase in the price of gasoline will reduce the quantity of gasoline consumers demand. How might we test such a hypothesis? Economists try to test hypotheses such as this one by observing actual behavior and using empirical (that is, real-world) data. The average retail price of gasoline in the United States rose from an average of $2.12 per gallon on May 22, 2005 to $2.88 per gallon on May 22, 2006. The number of gallons of gasoline consumed by U.S. motorists rose 0.3% during that period. The small increase in the quantity of gasoline consumed by motorists as its price rose is inconsistent with the hypothesis that an increased price will lead to a reduction in the quantity demanded. Does that mean that we should dismiss the original hypothesis? On the contrary, we must be cautious in assessing this evidence. Several problems exist in interpreting any set of economic data. One problem is that several things may be changing at once; another is that the initial event may be unrelated to the event that follows. The next two sections examine these problems in detail. The All-Other-Things-Unchanged Problem The hypothesis that an increase in the price of gasoline produces a reduction in the quantity demanded by consumers carries with it the assumption that there are no other changes that might also affect consumer
demand. A better statement of the hypothesis would be: An increase in the price of gasoline will reduce the quantity consumers demand, ceteris paribus. Ceteris paribus17 is a Latin phrase that means “all other things unchanged.” But things changed between May 2005 and May 2006. Economic activity and incomes rose both in the United States and in many other countries, particularly China, and people with higher incomes are likely to buy more gasoline. Employment rose as well, and people with jobs use more gasoline as they drive to work. Population in the United States grew during the period. In short, many things happened during the period, all of which tended to increase the quantity of gasoline people purchased. 17. A Latin phrase that means, “all other things unchanged.“ Our observation of the gasoline market between May 2005 and May 2006 did not offer a conclusive test of the hypothesis that an increase in the price of gasoline would lead to a reduction in the quantity demanded by consumers. Other things changed and affected gasoline consumption. Such problems are likely to affect any 1.3 The Economists’ Tool Kit 30 Chapter 1 Economics: The Study of Choice analysis of economic events. We cannot ask the world to stand still while we conduct experiments in economic phenomena. Economists employ a variety of statistical methods to allow them to isolate the impact of single events such as price changes, but they can never be certain that they have accurately isolated the impact of a single event in a world in which virtually everything is changing all the time. In laboratory sciences such as chemistry and biology, it is relatively easy to conduct experiments in which only selected things change and all other factors are held constant. The economists’ laboratory is the real world; thus, economists do not generally have the luxury of conducting controlled experiments. The Fallacy of False Cause Hypotheses in economics typically specify a relationship in which a change in one variable causes another to change. We call the variable that responds to the change the dependent variable18; the variable that induces a change is called the independent variable19. Sometimes the fact that two variables move together can suggest the false conclusion that one of the variables has acted as an independent variable that has caused the change we observe in the dependent variable. Consider the following hypothesis: People wearing shorts cause warm weather. Certainly, we observe that more people wear shorts when the weather is warm. Presumably, though, it is the warm weather that causes people to wear shorts rather than the wearing of shorts that causes warm weather; it would be incorrect
to infer from this that people cause warm weather by wearing shorts. Reaching the incorrect conclusion that one event causes another because the two events tend to occur together is called the fallacy of false cause20. The accompanying essay on baldness and heart disease suggests an example of this fallacy. 18. A variable that responds to change. 19. A variable that induces a change. 20. The incorrect assumption that one event causes another because the two events tend to occur together. Because of the danger of the fallacy of false cause, economists use special statistical tests that are designed to determine whether changes in one thing actually do cause changes observed in another. Given the inability to perform controlled experiments, however, these tests do not always offer convincing evidence that persuades all economists that one thing does, in fact, cause changes in another. In the case of gasoline prices and consumption between May 2005 and May 2006, there is good theoretical reason to believe the price increase should lead to a reduction in the quantity consumers demand. And economists have tested the 1.3 The Economists’ Tool Kit 31 Chapter 1 Economics: The Study of Choice hypothesis about price and the quantity demanded quite extensively. They have developed elaborate statistical tests aimed at ruling out problems of the fallacy of false cause. While we cannot prove that an increase in price will, ceteris paribus, lead to a reduction in the quantity consumers demand, we can have considerable confidence in the proposition. Normative and Positive Statements Two kinds of assertions in economics can be subjected to testing. We have already examined one, the hypothesis. Another testable assertion is a statement of fact, such as “It is raining outside” or “Microsoft is the largest producer of operating systems for personal computers in the world.” Like hypotheses, such assertions can be demonstrated to be false. Unlike hypotheses, they can also be shown to be correct. A statement of fact or a hypothesis is a positive statement21. Although people often disagree about positive statements, such disagreements can ultimately be resolved through investigation. There is another category of assertions, however, for which investigation can never resolve differences. A normative statement22 is one that makes a value judgment. Such a judgment is the opinion of the speaker; no one can “prove” that the statement is or is not correct. Here are some examples of normative statements in economics: “We ought to do more to help the poor.” “People in the United States should save more.” “Corporate profits are too high.�
� The statements are based on the values of the person who makes them. They cannot be proven false. Because people have different values, normative statements often provoke disagreement. An economist whose values lead him or her to conclude that we should provide more help for the poor will disagree with one whose values lead to a conclusion that we should not. Because no test exists for these values, these two economists will continue to disagree, unless one persuades the other to adopt a different set of values. Many of the disagreements among economists are based on such differences in values and therefore are unlikely to be resolved. 21. A statement of fact or a hypothesis. 22. A statement that makes a value judgment. 1.3 The Economists’ Tool Kit 32 Chapter 1 Economics: The Study of Choice • Economists try to employ the scientific method in their research. • Scientists cannot prove a hypothesis to be true; they can only fail to prove it false. • Economists, like other social scientists and scientists, use models to assist them in their analyses. • Two problems inherent in tests of hypotheses in economics are the all- other-things-unchanged problem and the fallacy of false cause. • Positive statements are factual and can be tested. Normative statements are value judgments that cannot be tested. Many of the disagreements among economists stem from differences in values. T R Y I T! Look again at the data in Table 1.1 "LSAT Scores for Students Taking the Exam in 2008". Now consider the hypothesis: “Majoring in economics will result in a higher LSAT score.” Are the data given consistent with this hypothesis? Do the data prove that this hypothesis is correct? What fallacy might be involved in accepting the hypothesis? 1.3 The Economists’ Tool Kit 33 Chapter 1 Economics: The Study of Choice Case in Point: Does Baldness Cause Heart Disease? © 2010 Jupiterimages Corporation A website called embarrassingproblems.com received the following email: “Dear Dr. Margaret, “I seem to be going bald. According to your website, this means I’m more likely to have a heart attack. If I take a drug to prevent hair loss, will it reduce my risk of a heart attack?” What did Dr. Margaret answer? Most importantly, she did not recommend that the questioner take drugs to treat his baldness, because doctors do not think that the baldness causes the heart disease. A more likely explanation for the association between baldness and heart disease is that both conditions
are affected by an underlying factor. While noting that more research needs to be done, one hypothesis that Dr. Margaret offers is that higher testosterone levels might be triggering both the hair loss and the heart disease. The good news for people with early balding (which is really where the association with increased risk of heart disease has been observed) is that they have a signal that might lead them to be checked early on for heart disease. 1.3 The Economists’ Tool Kit 34 Chapter 1 Economics: The Study of Choice Source: http://www.embarrassingproblems.com/problems/ problempage230701.htm. No longer posted The data are consistent with the hypothesis, but it is never possible to prove that a hypothesis is correct. Accepting the hypothesis could involve the fallacy of false cause; students who major in economics may already have the analytical skills needed to do well on the exam. 1.3 The Economists’ Tool Kit 35 Chapter 1 Economics: The Study of Choice 1.4 Review and Practice Summary Choices are forced on us by scarcity; economists study the choices that people make. Scarce goods are those for which the choice of one alternative requires giving up another. The opportunity cost of any choice is the value of the best alternative forgone in making that choice. Some key choices assessed by economists include what to produce, how to produce it, and for whom it should be produced. Economics is distinguished from other academic disciplines that also study choices by an emphasis on the central importance of opportunity costs in evaluating choices, the assumption of maximizing behavior that serves the interests of individual decision makers, and a focus on evaluating choices at the margin. Economic analyses may be aimed at explaining individual choice or choices in an individual market; such investigations are largely the focus of microeconomics. The analysis of the impact of those individual choices on such aggregates as total output, the level of employment, and the price level is the concern of macroeconomics. Working within the framework of the scientific method, economists formulate hypotheses and then test them. These tests can only refute a hypothesis; hypotheses in science cannot be proved. A hypothesis that has been widely tested often comes to be regarded as a theory; one that has won virtually universal acceptance is a law. Because of the complexity of the real world, economists rely on models that rest on a series of simplifying assumptions. The models are used to generate hypotheses about the economy that can be tested using realworld data. Statements of fact and hypotheses are positive statements. Norm
ative statements, unlike positive statements, cannot be tested and provide a source for potential disagreement. 36 Chapter 1 Economics: The Study of Choice P R O B L E M S 1. Why does the fact that something is scarce require that we make choices? 2. Does the fact that something is abundant mean it is not scarce in the 3. economic sense? Why or why not? In some countries, such as Cuba and North Korea, the government makes most of the decisions about what will be produced, how it will be produced, and for whom. Does the fact that these choices are made by the government eliminate scarcity in these countries? Why or why not? 4. Explain what is meant by the opportunity cost of a choice. 5. What is the approximate dollar cost of the tuition and other fees 6. associated with the economics course you are taking? Does this dollar cost fully reflect the opportunity cost to you of taking the course? In the Case in Point “Canadians Make a Choice,” what would be some of the things that would be included in an estimate of the opportunity cost of preserving part of northern Alberta Canada by prohibiting heavy crude oil extraction? Do you think that the increased extraction represents the best use of the land? Why or why not? 7. Indicate whether each of the following is a topic of microeconomics or macroeconomics: a. The impact of higher oil prices on the production of steel b. The increased demand in the last 15 years for exotic dietary supplements c. The surge in aggregate economic activity that hit much of Asia late in the early 2000s d. The sharp increases in U.S. employment and total output that occurred between 2003 and 2007 e. The impact of preservation of wilderness areas on the logging industry and on the price of lumber 8. Determine whether each of the following raises a “what,” “how,” or “for whom” issue. Are the statements normative or positive? a. A requirement that aluminum used in cars be made from recycled materials will raise the price of automobiles. b. The federal government does not spend enough for children. c. An increase in police resources provided to the inner city will lower the crime rate. d. Automation destroys jobs. 1.4 Review and Practice 37 Chapter 1 Economics: The Study of Choice e. Efforts to improve the environment tend to reduce f. production and employment. Japanese firms should be more willing to hire additional workers when production rises and to lay off workers when production
falls. g. Access to health care should not be limited by income. 9. Your time is a scarce resource. What if the quantity of time were increased, say to 48 hours per day, and everyone still lived as many days as before. Would time still be scarce? 10. Most college students are under age 25. Give two explanations for this—one based on the benefits people of different ages are likely to receive from higher education and one based on the opportunity costs of a college education to students of different ages. 11. Some municipal water companies charge customers a flat fee each month, regardless of the amount of water they consume. Others meter water use and charge according to the quantity of water customers use. Compare the way the two systems affect the cost of water use at the margin. 12. How might you test each of the following hypotheses? Suggest some problems that might arise in each test due to the ceteris paribus (all-other-things-unchanged) problem and the fallacy of false cause. a. Reducing the quantity of heroin available will increase total spending on heroin and increase the crime rate. b. Higher incomes make people happier. c. Higher incomes make people live longer. 13. Many models in physics and in chemistry assume the existence of a perfect vacuum (that is, a space entirely empty of matter). Yet we know that a perfect vacuum cannot exist. Are such models valid? Why are models based on assumptions that are essentially incorrect? 14. Suppose you were asked to test the proposition that publishing students’ teacher evaluations causes grade inflation. What evidence might you want to consider? How would the inability to carry out controlled experiments make your analysis more difficult? 15. Referring to the Case in Point “Baldness and Heart Disease,” explain the possible fallacy of false cause in concluding that baldness makes a person more likely to have heart disease. In 2005 the Food and Drug Administration ordered that Vioxx and other popular drugs for treating the pain of arthritis be withdrawn from the market. The order resulted from a finding that people taking the drugs 16. 1.4 Review and Practice 38 Chapter 1 Economics: The Study of Choice had an increased risk of cardiovascular problems. Some researchers criticized the government’s action, arguing that concluding that the drugs caused the cardiovascular problems represented an example of the fallacy of false cause. Can you think of any reason why this might be the case? 1.4 Review and Practice 39 Chapter 2 Confronting Scarcity: Choices in Production Start Up
: An Attempt to Produce Safer Air Travel In the wake of the terrorist attacks on the United States on September 11, 2001, American taxpayers continue to give up a great deal of money, and airline passengers continue to give much of their time—and a great deal of their privacy—in an effort to ensure that other terrorists will not turn their flights into tragedies. The U.S. effort is run by the Transportation Security Administration (TSA), a federal agency created in response to the 2001 attacks. TSA requirements became a bit more onerous after Richard Reid, an Englishman and member of al-Qaeda, tried in December of that same year to blow up an American Airlines flight with a bomb he had concealed in his shoe. Reid was unsuccessful, but passengers must now remove their shoes so TSA agents can check them for bombs. TSA restrictions became dramatically more stringent after Umar Farouk Abdulmutallab, a jihadist from Nigeria, tried—again without success—to blow up a plane flying from Amsterdam to Detroit on Christmas Day, 2009, using a bomb concealed in his underwear. The subsequent tightening of TSA regulations, and the introduction of body-scan machines and “patdown inspections,” were quick to follow. Each new procedure took additional money and time and further reduced passenger privacy. It was a production choice that has created many irate passengers but has also been successful, to date, in preventing subsequent terrorist attacks. While the TSA procedures represent an unusual production choice, it is still a production choice—one that is being made all over the world as countries grapple with the danger of terrorist attacks. In this chapter we introduce our first model, the production possibilities model1, to examine the nature of choices to produce more of some goods and less of others. As its name suggests, the production possibilities model shows the goods and services that an economy is capable of producing—its possibilities—given the factors of production and the technology it has available. The model specifies what it means to use resources fully and efficiently and suggests some important implications for international trade. We 40 1. The rules that define how an economy’s resources are to be owned and how decisions about their use are to be made. Chapter 2 Confronting Scarcity: Choices in Production can also use the model to illustrate economic growth, a process that expands the set of production possibilities available to an economy. We then turn to an examination of the type of economic system in which choices are made. An economic system2 is the set of rules that define how
an economy’s resources are to be owned and how decisions about their use are to be made. We will see that economic systems differ—primarily in the degree of government involvement—in terms of how they answer the fundamental economic questions. Many of the world’s economic systems, including the systems that prevail in North America, Europe, much of Asia, and parts of Central and South America, rely on individuals operating in a market economy to make those choices. Other economic systems rely principally on government to make these choices. Different economic systems result in different choices and thus different outcomes; that market economies generally outperform the others when it comes to providing more of the things that people want helps to explain the dramatic shift from governmentdominated toward market-dominated economic systems that occurred throughout the world in the last two decades of the 20th century. The chapter concludes with an examination of the role of government in an economy that relies chiefly on markets to allocate goods and services. 2. The set of rules that define how an economy’s resources are to be owned and how decisions about their use are to be made. 41 Chapter 2 Confronting Scarcity: Choices in Production 2.1 Factors of Production. Define the three factors of production—labor, capital, and natural resources. 2. Explain the role of technology and entrepreneurs in the utilization of the economy’s factors of production. Choices concerning what goods and services to produce are choices about an economy’s use of its factors of production3, the resources available to it for the production of goods and services. The value, or satisfaction, that people derive from the goods and services they consume and the activities they pursue is called utility4. Ultimately, then, an economy’s factors of production create utility; they serve the interests of people. The factors of production in an economy are its labor, capital, and natural resources. Labor5 is the human effort that can be applied to the production of goods and services. People who are employed—or are available to be—are considered part of the labor available to the economy. Capital6 is a factor of production that has been produced for use in the production of other goods and services. Office buildings, machinery, and tools are examples of capital. Natural resources7 are the resources of nature that can be used for the production of goods and services. In the next three sections, we will take a closer look at the factors of production we use to produce the goods and services we consume.
The three basic building blocks of labor, capital, and natural resources may be used in different ways to produce different goods and services, but they still lie at the core of production. We will then look at the roles played by technology and entrepreneurs in putting these factors of production to work. As economists began to grapple with the problems of scarcity, choice, and opportunity cost more than two centuries ago, they focused on these concepts, just as they are likely to do two centuries hence. Labor Labor is the human effort that can be applied to production. People who work to repair tires, pilot airplanes, teach children, or enforce laws are all part of the economy’s labor. People who would like to work but have not found 42 3. The resources available to the economy for the production of goods and services. 4. The value, or satisfaction, that people derive from the goods and services they consume and the activities they pursue. 5. The human effort that can be applied to the production of goods and services. 6. A factor of production that has been produced for use in the production of other goods and services. 7. The resources of nature that can be used for the production of goods and services. Chapter 2 Confronting Scarcity: Choices in Production employment—who are unemployed—are also considered part of the labor available to the economy. In some contexts, it is useful to distinguish two forms of labor. The first is the human equivalent of a natural resource. It is the natural ability an untrained, uneducated person brings to a particular production process. But most workers bring far more. Skills a worker has as a result of education, training, or experience that can be used in production are called human capital8. Students are acquiring human capital. Workers who are gaining skills through experience or through training are acquiring human capital. The amount of labor available to an economy can be increased in two ways. One is to increase the total quantity of labor, either by increasing the number of people available to work or by increasing the average number of hours of work per time period. The other is to increase the amount of human capital possessed by workers. Capital Long ago, when the first human beings walked the earth, they produced food by picking leaves or fruit off a plant or by catching an animal and eating it. We know that very early on, however, they began shaping stones into tools, apparently for use in butchering animals. Those tools were the first capital because they were produced for use in producing other goods—food and clothing
. Modern versions of the first stone tools include saws, meat cleavers, hooks, and grinders; all are used in butchering animals. Tools such as hammers, screwdrivers, and wrenches are also capital. Transportation equipment, such as cars and trucks, is capital. Facilities such as roads, bridges, ports, and airports are capital. Buildings, too, are capital; they help us to produce goods and services. Capital does not consist solely of physical objects. The score for a new symphony is capital because it will be used to produce concerts. Computer software used by business firms or government agencies to produce goods and services is capital. Capital may thus include physical goods and intellectual discoveries. Any resource is capital if it satisfies two criteria: 1. The resource must have been produced. 2. The resource can be used to produce other goods and services. 8. The skills a worker has as a result of education, training, or experience that can be used in production. One thing that is not considered capital is money. A firm cannot use money directly to produce other goods, so money does not satisfy the second criterion for capital. 2.1 Factors of Production 43 Chapter 2 Confronting Scarcity: Choices in Production Firms can, however, use money to acquire capital. Money is a form of financial capital. Financial capital9 includes money and other “paper” assets (such as stocks and bonds) that represent claims on future payments. These financial assets are not capital, but they can be used directly or indirectly to purchase factors of production or goods and services. Natural Resources There are two essential characteristics of natural resources. The first is that they are found in nature—that no human effort has been used to make or alter them. The second is that they can be used for the production of goods and services. That requires knowledge; we must know how to use the things we find in nature before they become resources. Consider oil. Oil in the ground is a natural resource because it is found (not manufactured) and can be used to produce goods and services. However, 250 years ago oil was a nuisance, not a natural resource. Pennsylvania farmers in the eighteenth century who found oil oozing up through their soil were dismayed, not delighted. No one knew what could be done with the oil. It was not until the midnineteenth century that a method was found for refining oil into kerosene that could be used to generate energy, transforming oil into a natural resource. Oil is now used to
make all sorts of things, including clothing, drugs, gasoline, and plastic. It became a natural resource because people discovered and implemented a way to use it. Defining something as a natural resource only if it can be used to produce goods and services does not mean that a tree has value only for its wood or that a mountain has value only for its minerals. If people gain utility from the existence of a beautiful wilderness area, then that wilderness provides a service. The wilderness is thus a natural resource. The natural resources available to us can be expanded in three ways. One is the discovery of new natural resources, such as the discovery of a deposit of ore containing titanium. The second is the discovery of new uses for resources, as happened when new techniques allowed oil to be put to productive use or sand to be used in manufacturing computer chips. The third is the discovery of new ways to extract natural resources in order to use them. New methods of discovering and mapping oil deposits have increased the world’s supply of this important natural resource. 9. Includes money and other “paper” assets (such as stocks and bonds) that represent claims on future payments. 2.1 Factors of Production 44 Chapter 2 Confronting Scarcity: Choices in Production Technology and the Entrepreneur Goods and services are produced using the factors of production available to the economy. Two things play a crucial role in putting these factors of production to work. The first is technology10, the knowledge that can be applied to the production of goods and services. The second is an individual who plays a key role in a market economy: the entrepreneur. An entrepreneur11 is a person who, operating within the context of a market economy, seeks to earn profits by finding new ways to organize factors of production. In non-market economies the role of the entrepreneur is played by bureaucrats and other decision makers who respond to incentives other than profit to guide their choices about resource allocation decisions. The interplay of entrepreneurs and technology affects all our lives. Entrepreneurs put new technologies to work every day, changing the way factors of production are used. Farmers and factory workers, engineers and electricians, technicians and teachers all work differently than they did just a few years ago, using new technologies introduced by entrepreneurs. The music you enjoy, the books you read, the athletic equipment with which you play are produced differently than they were five years ago. The book you are reading was written and manufactured using technologies that did not exist ten years ago. We can dispute whether all the changes have made o
ur lives better. What we cannot dispute is that they have made our lives different • Factors of production are the resources the economy has available to produce goods and services. • Labor is the human effort that can be applied to the production of goods and services. Labor’s contribution to an economy’s output of goods and services can be increased either by increasing the quantity of labor or by increasing human capital. • Capital is a factor of production that has been produced for use in the production of other goods and services. • Natural resources are those things found in nature that can be used for the production of goods and services. • Two keys to the utilization of an economy’s factors of production are technology and, in the case of a market economic system, the efforts of entrepreneurs. 10. The knowledge that can be applied to the production of goods and services. 11. A person who, operating within the context of a market economy, seeks to earn profits by finding new ways to organize factors of production. 2.1 Factors of Production 45 Chapter 2 Confronting Scarcity: Choices in Production T R Y I T! Explain whether each of the following is labor, capital, or a natural resource. 1. An unemployed factory worker 2. A college professor 3. The library building on your campus 4. Yellowstone National Park 5. An untapped deposit of natural gas 6. The White House 7. The local power plant 2.1 Factors of Production 46 Chapter 2 Confronting Scarcity: Choices in Production Case in Point: Technology Cuts Costs, Boosts Productivity, Profits, and Utility © 2010 Jupiterimages Corporation Technology can seem an abstract force in the economy—important, but invisible. It is not invisible to the 130 people who work on a Shell Oil Company oil rig called Mars, located in the deep waters of the Gulf of Mexico, about 160 miles southwest of Pensacola, Florida. The name Mars reflects its otherworld appearance—it extends 300 feet above the water’s surface and has steel tendons that reach 3,000 feet down to extract the Gulf’s oil deposits. This facility would not exist if it were not for the development of better oil discovery methods that include three-dimensional seismic mapping techniques, satellites that locate oil from space, and drills that can make turns as drilling foremen steer them by monitoring them on computer screens from the comfort of Mars. “We don’t hit as many dry holes,” commented Shell manager Miles Barrett. As a
result of these new technologies, over the past two decades, the cost of discovering a barrel of oil dropped from $20 to under $5. And the technologies continue to improve. Three-dimensional surveys are being replaced with four-dimensional ones that allow geologists to see how the oil fields change over time. 2.1 Factors of Production 47 Chapter 2 Confronting Scarcity: Choices in Production The Mars project was destroyed by Hurricane Katrina in 2005. Royal Dutch Shell completed repairs in 2006, at a cost of $200 million. But the facility is again pumping 130,000 barrels of oil per day and 150 million cubic feet of natural gas, the energy equivalent of an additional 26,000 barrels of oil. Shell announced a new Mars-like project, Mars B Olympus, in 2010. The second Mars hub will be located 100 miles south of New Orleans and is expected to begin production in 2015. Technology is doing more than helping energy companies track oil deposits. It is changing the way soft drinks and other grocery items are delivered to retail stores. For example, when a PepsiCo delivery driver arrives at a 7-Eleven, the driver keys into a handheld computer the store’s inventory of soft drinks, chips, and other PepsiCo products. The information is transmitted to a main computer at the warehouse that begins processing the next order for that store. The result is that the driver can visit more stores in a day and PepsiCo can cover a given territory with fewer drivers and trucks. New technology is even helping to produce more milk from cows. Ed Larsen, who owns a 1,200-cow dairy farm in Wisconsin, never gets up before dawn to milk the cows, the way he did as a boy. Rather, the cows are hooked up to electronic milkers. Computers measure each cow’s output, and cows producing little milk are sent to a “hospital wing” for treatment. With the help of such technology, as well as better feed, today’s dairy cows produce 50% more milk than did cows roughly 20 years ago. Even though the number of dairy cows in the United States in the last 20 years has fallen 17%, milk output has increased 25%. Who benefits from technological progress? Consumers gain from lower prices and better service. Workers gain: Their greater ability to produce goods and services translates into higher wages. And firms gain: Lower production costs mean higher profits. Of course, some people lose as technology advances. Some jobs are eliminated, and some firms find their services are no
longer needed. One can argue about whether particular technological changes have improved our lives, but they have clearly made—and will continue to make—them far different. Sources: David Ballingrud, “Drilling in the Gulf: Life on Mars,” St. Petersburg Times (Florida), August 5, 2001, p. 1A; Barbara Hagenbaugh, “Dairy Farms Evolve to Survive,” USA Today, August 7, 2003, p. 1B; Del Jones and Barbara Hansen, 2.1 Factors of Production 48 Chapter 2 Confronting Scarcity: Choices in Production “Special Report: A Who’s Who of Productivity,” USA Today, August 30, 2001, p. 1B; Christopher Helman, Shell Shocked, Forbes Online, July 27, 2006; “Shell Plans Second Deep Water Production Hub,” September 9, 2010 at http://www.greentechmedia.com/industry/read/shell-plans-second-deepwater-production-hub-in-the-gulfs-pro-15227/.. An unemployed factory worker could be put to work; he or she counts as labor. 2. A college professor is labor. 3. The library building on your campus is part of capital. 4. Yellowstone National Park. Those areas of the park left in their natural state are a natural resource. Facilities such as visitors’ centers, roads, and campgrounds are capital. 5. An untapped deposit of natural gas is a natural resource. Once extracted and put in a storage tank, natural gas is capital. 6. The White House is capital. 7. The local power plant is capital. 2.1 Factors of Production 49 Chapter 2 Confronting Scarcity: Choices in Production 2.2 The Production Possibilities Curve. Explain the concept of the production possibilities curve and understand the implications of its downward slope and bowed-out shape. 2. Use the production possibilities model to distinguish between full employment and situations of idle factors of production and between efficient and inefficient production. 3. Understand specialization and its relationship to the production possibilities model and comparative advantage. An economy’s factors of production are scarce; they cannot produce an unlimited quantity of goods and services. A production possibilities curve12 is a graphical representation of the alternative combinations of goods and services an economy can produce. It illustrates the production possibilities model. In drawing the production possibilities curve, we shall assume that the economy can produce
only two goods and that the quantities of factors of production and the technology available to the economy are fixed. Constructing a Production Possibilities Curve To construct a production possibilities curve, we will begin with the case of a hypothetical firm, Alpine Sports, Inc., a specialized sports equipment manufacturer. Christie Ryder began the business 15 years ago with a single ski production facility near Killington ski resort in central Vermont. Ski sales grew, and she also saw demand for snowboards rising—particularly after snowboard competition events were included in the 2002 Winter Olympics in Salt Lake City. She added a second plant in a nearby town. The second plant, while smaller than the first, was designed to produce snowboards as well as skis. She also modified the first plant so that it could produce both snowboards and skis. Two years later she added a third plant in another town. While even smaller than the second plant, the third was primarily designed for snowboard production but could also produce skis. 12. A graphical representation of the alternative combinations of goods and services an economy can produce. We can think of each of Ms. Ryder’s three plants as a miniature economy and analyze them using the production possibilities model. We assume that the factors of production and technology available to each of the plants operated by Alpine Sports are unchanged. 50 Chapter 2 Confronting Scarcity: Choices in Production Suppose the first plant, Plant 1, can produce 200 pairs of skis per month when it produces only skis. When devoted solely to snowboards, it produces 100 snowboards per month. It can produce skis and snowboards simultaneously as well. The table in Figure 2.1 "A Production Possibilities Curve" gives three combinations of skis and snowboards that Plant 1 can produce each month. Combination A involves devoting the plant entirely to ski production; combination C means shifting all of the plant’s resources to snowboard production; combination B involves the production of both goods. These values are plotted in a production possibilities curve for Plant 1. The curve is a downward-sloping straight line, indicating we have assumed that there is a linear, negative relationship between the production of the two goods. Neither skis nor snowboards is an independent or a dependent variable in the production possibilities model; we can assign either one to the vertical or to the horizontal axis. Here, we have placed the number of pairs of skis produced per month on the vertical axis and the number of snowboards produced per month on the horizontal axis. The negative
slope of the production possibilities curve reflects the scarcity of the plant’s capital and labor. Producing more snowboards requires shifting resources out of ski production and thus producing fewer skis. Producing more skis requires shifting resources out of snowboard production and thus producing fewer snowboards. The slope of Plant 1’s production possibilities curve measures the rate at which Alpine Sports must give up ski production to produce additional snowboards. Because the production possibilities curve for Plant 1 is linear, we can compute the slope between any two points on the curve and get the same result. Between points A and B, for example, the slope equals −2 pairs of skis/snowboard (equals −100 pairs of skis/50 snowboards). (Many students are helped when told to read this result as “−2 pairs of skis per snowboard.”) We get the same value between points B and C, and between points A and C. 2.2 The Production Possibilities Curve 51 Chapter 2 Confronting Scarcity: Choices in Production Figure 2.1 A Production Possibilities Curve The table shows the combinations of pairs of skis and snowboards that Plant 1 is capable of producing each month. These are also illustrated with a production possibilities curve. Notice that this curve is linear. To see this relationship more clearly, examine Figure 2.2 "The Slope of a Production Possibilities Curve". Suppose Plant 1 is producing 100 pairs of skis and 50 snowboards per month at point B. Now consider what would happen if Ms. Ryder decided to produce 1 more snowboard per month. The segment of the curve around point B is magnified in Figure 2.2 "The Slope of a Production Possibilities Curve". The slope between points B and B′ is −2 pairs of skis/snowboard. Producing 1 additional snowboard at point B′ requires giving up 2 pairs of skis. We can think of this as the opportunity cost of producing an additional snowboard at Plant 1. This opportunity cost equals the absolute value of the slope of the production possibilities curve. 2.2 The Production Possibilities Curve 52 Chapter 2 Confronting Scarcity: Choices in Production Figure 2.2 The Slope of a Production Possibilities Curve The slope of the linear production possibilities curve in Figure 2.1 "A Production Possibilities Curve" is constant; it is −2 pairs of skis/snowboard. In the section of the curve shown here,
the slope can be calculated between points B and B′. Expanding snowboard production to 51 snowboards per month from 50 snowboards per month requires a reduction in ski production to 98 pairs of skis per month from 100 pairs. The slope equals −2 pairs of skis/snowboard (that is, it must give up two pairs of skis to free up the resources necessary to produce one additional snowboard). To shift from B′ to B″, Alpine Sports must give up two more pairs of skis per snowboard. The absolute value of the slope of a production possibilities curve measures the opportunity cost of an additional unit of the good on the horizontal axis measured in terms of the quantity of the good on the vertical axis that must be forgone. The absolute value of the slope of any production possibilities curve equals the opportunity cost of an additional unit of the good on the horizontal axis. It is the amount of the good on the vertical axis that must be given up in order to free up the resources required to produce one more unit of the good on the horizontal axis. We will make use of this important fact as we continue our investigation of the production possibilities curve. Figure 2.3 "Production Possibilities at Three Plants" shows production possibilities curves for each of the firm’s three plants. Each of the plants, if devoted entirely to snowboards, could produce 100 snowboards. Plants 2 and 3, if devoted exclusively to ski production, can produce 100 and 50 pairs of skis per month, respectively. The exhibit gives the slopes of the production possibilities curves for each plant. The opportunity cost of an additional snowboard at each plant equals the absolute values of these slopes (that is, the number of pairs of skis that must be given up per snowboard). 2.2 The Production Possibilities Curve 53 Chapter 2 Confronting Scarcity: Choices in Production Figure 2.3 Production Possibilities at Three Plants The slopes of the production possibilities curves for each plant differ. The steeper the curve, the greater the opportunity cost of an additional snowboard. Here, the opportunity cost is lowest at Plant 3 and greatest at Plant 1. The exhibit gives the slopes of the production possibilities curves for each of the firm’s three plants. The opportunity cost of an additional snowboard at each plant equals the absolute values of these slopes. More generally, the absolute value of the slope of any production possibilities curve at any point gives the opportunity cost of an additional unit of the good on the horizontal axis, measured
in terms of the number of units of the good on the vertical axis that must be forgone. The greater the absolute value of the slope of the production possibilities curve, the greater the opportunity cost will be. The plant for which the opportunity cost of an additional snowboard is greatest is the plant with the steepest production possibilities curve; the plant for which the opportunity cost is lowest is the plant with the flattest production possibilities curve. The plant with the lowest opportunity cost of producing snowboards is Plant 3; its slope of −0.5 means that Ms. Ryder’s firm must give up half a pair of skis in that plant to produce an additional snowboard. In Plant 2, she must give up one pair of skis to gain one more snowboard. We have already seen that an additional snowboard requires giving up two pairs of skis in Plant 1. Comparative Advantage and the Production Possibilities Curve To construct a combined production possibilities curve for all three plants, we can begin by asking how many pairs of skis Alpine Sports could produce if it were producing only skis. To find this quantity, we add up the values at the vertical intercepts of each of the production possibilities curves in Figure 2.3 "Production 2.2 The Production Possibilities Curve 54 Chapter 2 Confronting Scarcity: Choices in Production Possibilities at Three Plants". These intercepts tell us the maximum number of pairs of skis each plant can produce. Plant 1 can produce 200 pairs of skis per month, Plant 2 can produce 100 pairs of skis at per month, and Plant 3 can produce 50 pairs. Alpine Sports can thus produce 350 pairs of skis per month if it devotes its resources exclusively to ski production. In that case, it produces no snowboards. Now suppose the firm decides to produce 100 snowboards. That will require shifting one of its plants out of ski production. Which one will it choose to shift? The sensible thing for it to do is to choose the plant in which snowboards have the lowest opportunity cost—Plant 3. It has an advantage not because it can produce more snowboards than the other plants (all the plants in this example are capable of producing up to 100 snowboards per month) but because it is the least productive plant for making skis. Producing a snowboard in Plant 3 requires giving up just half a pair of skis. Economists say that an economy has a comparative advantage13 in producing a good or service if the opportunity cost of producing that
good or service is lower for that economy than for any other. Plant 3 has a comparative advantage in snowboard production because it is the plant for which the opportunity cost of additional snowboards is lowest. To put this in terms of the production possibilities curve, Plant 3 has a comparative advantage in snowboard production (the good on the horizontal axis) because its production possibilities curve is the flattest of the three curves. 13. In producing a good or service, the situation that occurs if the opportunity cost of producing that good or service is lower for that economy than for any other. 2.2 The Production Possibilities Curve 55 Chapter 2 Confronting Scarcity: Choices in Production Figure 2.4 The Combined Production Possibilities Curve for Alpine Sports The curve shown combines the production possibilities curves for each plant. At point A, Alpine Sports produces 350 pairs of skis per month and no snowboards. If the firm wishes to increase snowboard production, it will first use Plant 3, which has a comparative advantage in snowboards. Plant 3’s comparative advantage in snowboard production makes a crucial point about the nature of comparative advantage. It need not imply that a particular plant is especially good at an activity. In our example, all three plants are equally good at snowboard production. Plant 3, though, is the least efficient of the three in ski production. Alpine thus gives up fewer skis when it produces snowboards in Plant 3. Comparative advantage thus can stem from a lack of efficiency in the production of an alternative good rather than a special proficiency in the production of the first good. The combined production possibilities curve for the firm’s three plants is shown in Figure 2.4 "The Combined Production Possibilities Curve for Alpine Sports". We begin at point A, with all three plants producing only skis. Production totals 350 pairs of skis per month and zero snowboards. If the firm were to produce 100 snowboards at Plant 3, ski production would fall by 50 pairs per month (recall that the opportunity cost per snowboard at Plant 3 is half a pair of skis). That would 2.2 The Production Possibilities Curve 56 Chapter 2 Confronting Scarcity: Choices in Production bring ski production to 300 pairs, at point B. If Alpine Sports were to produce still more snowboards in a single month, it would shift production to Plant 2, the facility with the next-lowest opportunity cost. Producing 100 snowboards at Plant 2 would leave Alpine Sports producing 200 snowboards and 200
kis. With all three plants producing only snowboards, the firm is at point D on the combined production possibilities curve, producing 300 snowboards per month and no skis. Notice that this production possibilities curve, which is made up of linear segments from each assembly plant, has a bowed-out shape; the absolute value of its slope increases as Alpine Sports produces more and more snowboards. This is a result of transferring resources from the production of one good to another according to comparative advantage. We shall examine the significance of the bowed-out shape of the curve in the next section. The Law of Increasing Opportunity Cost We see in Figure 2.4 "The Combined Production Possibilities Curve for Alpine Sports" that, beginning at point A and producing only skis, Alpine Sports experiences higher and higher opportunity costs as it produces more snowboards. The fact that the opportunity cost of additional snowboards increases as the firm produces more of them is a reflection of an important economic law. The law of increasing opportunity cost14 holds that as an economy moves along its production possibilities curve in the direction of producing more of a particular good, the opportunity cost of additional units of that good will increase. We have seen the law of increasing opportunity cost at work traveling from point A toward point D on the production possibilities curve in Figure 2.4 "The Combined Production Possibilities Curve for Alpine Sports". The opportunity cost of each of the first 100 snowboards equals half a pair of skis; each of the next 100 snowboards has an opportunity cost of 1 pair of skis, and each of the last 100 snowboards has an opportunity cost of 2 pairs of skis. The law also applies as the firm shifts from snowboards to skis. Suppose it begins at point D, producing 300 snowboards per month and no skis. It can shift to ski production at a relatively low cost at first. The opportunity cost of the first 200 pairs of skis is just 100 snowboards at Plant 1, a movement from point D to point C, or 0.5 snowboards per pair of skis. We would say that Plant 1 has a comparative advantage in ski production. The next 100 pairs of skis would be produced at Plant 2, where snowboard production would fall by 100 snowboards per month. The opportunity cost of skis at Plant 2 is 1 snowboard per pair of skis. Plant 3 would be the last plant converted to ski production. There, 50 14. As an economy moves along its production possibilities curve in the direction of producing
more of a particular good, the opportunity cost of additional units of that good will increase. 2.2 The Production Possibilities Curve 57 Chapter 2 Confronting Scarcity: Choices in Production pairs of skis could be produced per month at a cost of 100 snowboards, or an opportunity cost of 2 snowboards per pair of skis. The bowed-out shape of the production possibilities curve illustrates the law of increasing opportunity cost. Its downward slope reflects scarcity. Figure 2.5 "Production Possibilities for the Economy" illustrates a much smoother production possibilities curve. This production possibilities curve in Panel (a) includes 10 linear segments and is almost a smooth curve. As we include more and more production units, the curve will become smoother and smoother. In an actual economy, with a tremendous number of firms and workers, it is easy to see that the production possibilities curve will be smooth. We will generally draw production possibilities curves for the economy as smooth, bowed-out curves, like the one in Panel (b). This production possibilities curve shows an economy that produces only skis and snowboards. Notice the curve still has a bowed-out shape; it still has a negative slope. Notice also that this curve has no numbers. Economists often use models such as the production possibilities model with graphs that show the general shapes of curves but that do not include specific numbers. Figure 2.5 Production Possibilities for the Economy As we combine the production possibilities curves for more and more units, the curve becomes smoother. It retains its negative slope and bowed-out shape. In Panel (a) we have a combined production possibilities curve for Alpine Sports, assuming that it now has 10 plants producing skis and snowboards. Even though each of the plants has a linear curve, combining them according to comparative advantage, as we did with 3 plants in Figure 2.4 "The Combined Production Possibilities Curve for Alpine Sports", produces what appears to be a smooth, nonlinear curve, even though it is made up of linear segments. In drawing production possibilities curves for the economy, we shall generally assume they are smooth and “bowed out,” as in Panel (b). This curve depicts an entire economy that produces only skis and snowboards. 2.2 The Production Possibilities Curve 58 Chapter 2 Confronting Scarcity: Choices in Production Movements Along the Production Possibilities Curve We can use the production possibilities model to examine choices in the production of goods and services. In applying the model, we assume that the economy can
produce two goods, and we assume that technology and the factors of production available to the economy remain unchanged. In this section, we shall assume that the economy operates on its production possibilities curve so that an increase in the production of one good in the model implies a reduction in the production of the other. We shall consider two goods and services: national defense and security and a category we shall call “all other goods and services.” This second category includes the entire range of goods and services the economy can produce, aside from national defense and security. Clearly, the transfer of resources to the effort to enhance national security reduces the quantity of other goods and services that can be produced. In the wake of the 9/11 attacks in 2001, nations throughout the world increased their spending for national security. This spending took a variety of forms. One, of course, was increased defense spending. Local and state governments also increased spending in an effort to prevent terrorist attacks. Airports around the world hired additional agents to inspect luggage and passengers. The increase in resources devoted to security meant fewer “other goods and services” could be produced. In terms of the production possibilities curve in Figure 2.6 "Spending More for Security", the choice to produce more security and less of other goods and services means a movement from A to B. Of course, an economy cannot really produce security; it can only attempt to provide it. The attempt to provide it requires resources; it is in that sense that we shall speak of the economy as “producing” security. Figure 2.6 Spending More for Security At point A, the economy was producing SA units of security on the vertical axis—defense services and various forms of police protection—and OA units of other goods and services on the horizontal axis. The decision to devote more resources to security and less to other goods and services represents the choice we discussed in the chapter introduction. In this case we have categories of goods rather than specific goods. Thus, the economy chose to increase spending on security in the effort to defeat terrorism. Since we have assumed that the economy has a fixed quantity of available resources, the increased use of resources for 2.2 The Production Possibilities Curve 59 Chapter 2 Confronting Scarcity: Choices in Production security and national defense necessarily reduces the number of resources available for the production of other goods and services. The law of increasing opportunity cost tells us that, as the economy moves along the production possibilities curve in the direction of more of one good, its opportunity cost will
increase. We may conclude that, as the economy moved along this curve in the direction of greater production of security, the opportunity cost of the additional security began to increase. That is because the resources transferred from the production of other goods and services to the production of security had a greater and greater comparative advantage in producing things other than security. Here, an economy that can produce two categories of goods, security and “all other goods and services,” begins at point A on its production possibilities curve. The economy produces SA units of security and OA units of all other goods and services per period. A movement from A to B requires shifting resources out of the production of all other goods and services and into spending on security. The increase in spending on security, to SA units of security per period, has an opportunity cost of reduced production of all other goods and services. Production of all other goods and services falls by OA OB units per period. The production possibilities model does not tell us where on the curve a particular economy will operate. Instead, it lays out the possibilities facing the economy. Many countries, for example, chose to move along their respective production possibilities curves to produce more security and national defense and less of all other goods in the wake of 9/11. We will see in the chapter on demand and supply how choices about what to produce are made in the marketplace. Producing on Versus Producing Inside the Production Possibilities Curve An economy that is operating inside its production possibilities curve could, by moving onto it, produce more of all the goods and services that people value, such as food, housing, education, medical care, and music. Increasing the availability of these goods would improve the standard of living. Economists conclude that it is better to be on the production possibilities curve than inside it. Two things could leave an economy operating at a point inside its production possibilities curve. First, the economy might fail to use fully the resources available to it. Second, it might not allocate resources on the basis of comparative advantage. In either case, production within the production possibilities curve implies the economy could improve its performance. 2.2 The Production Possibilities Curve 60 Chapter 2 Confronting Scarcity: Choices in Production Idle Factors of Production Suppose an economy fails to put all its factors of production to work. Some workers are without jobs, some buildings are without occupants, some fields are without crops. Because an economy’s production possibilities curve assumes the full use of the factors of production available to it, the failure to use some
factors results in a level of production that lies inside the production possibilities curve. If all the factors of production that are available for use under current market conditions are being utilized, the economy has achieved full employment15. An economy cannot operate on its production possibilities curve unless it has full employment. Figure 2.7 Idle Factors and Production The production possibilities curve shown suggests an economy that can produce two goods, food and clothing. As a result of a failure to achieve full employment, the economy operates at a point such as B, producing FB units of food and CB units of clothing per period. Putting its factors of production to work allows a move to the production possibilities curve, to a point such as A. The production of both goods rises. 15. Situation in which all the factors of production that are available for use under current market conditions are being utilized. 2.2 The Production Possibilities Curve 61 Chapter 2 Confronting Scarcity: Choices in Production Figure 2.7 "Idle Factors and Production" shows an economy that can produce food and clothing. If it chooses to produce at point A, for example, it can produce FA units of food and CA units of clothing. Now suppose that a large fraction of the economy’s workers lose their jobs, so the economy no longer makes full use of one factor of production: labor. In this example, production moves to point B, where the economy produces less food (FB) and less clothing (CB) than at point A. We often think of the loss of jobs in terms of the workers; they have lost a chance to work and to earn income. But the production possibilities model points to another loss: goods and services the economy could have produced that are not being produced. Inefficient Production Now suppose Alpine Sports is fully employing its factors of production. Could it still operate inside its production possibilities curve? Could an economy that is using all its factors of production still produce less than it could? The answer is “Yes,” and the key lies in comparative advantage. An economy achieves a point on its production possibilities curve only if it allocates its factors of production on the basis of comparative advantage. If it fails to do that, it will operate inside the curve. Suppose that, as before, Alpine Sports has been producing only skis. With all three of its plants producing skis, it can produce 350 pairs of skis per month (and no snowboards). The firm then starts producing snowboards. This time, however, imagine that Alpine Sports switches plants from
skis to snowboards in numerical order: Plant 1 first, Plant 2 second, and then Plant 3. Figure 2.8 "Efficient Versus Inefficient Production" illustrates the result. Instead of the bowed-out production possibilities curve ABCD, we get a bowed-in curve, AB′C′D. Suppose that Alpine Sports is producing 100 snowboards and 150 pairs of skis at point B′. Had the firm based its production choices on comparative advantage, it would have switched Plant 3 to snowboards and then Plant 2, so it could have operated at a point such as C. It would be producing more snowboards and more pairs of skis—and using the same quantities of factors of production it was using at B′. Had the firm based its production choices on comparative advantage, it would have switched Plant 3 to snowboards and then Plant 2, so it would have operated at point C. It would be producing more snowboards and more pairs of skis—and using the same quantities of factors of production it was using at B′. When an economy is operating on its production possibilities curve, we say that it is engaging in efficient production16. If it is using the same quantities of factors of production but is operating inside its production possibilities curve, it is engaging in inefficient production17. Inefficient production implies that the economy could be producing more goods without using any additional labor, capital, or natural resources. 16. When an economy is operating on its production possibilities curve. 17. Situation in which the economy is using the same quantities of factors of production but is operating inside its production possibilities curve. 2.2 The Production Possibilities Curve 62 Chapter 2 Confronting Scarcity: Choices in Production Points on the production possibilities curve thus satisfy two conditions: the economy is making full use of its factors of production, and it is making efficient use of its factors of production. If there are idle or inefficiently allocated factors of production, the economy will operate inside the production possibilities curve. Thus, the production possibilities curve not only shows what can be produced; it provides insight into how goods and services should be produced. It suggests that to obtain efficiency in production, factors of production should be allocated on the basis of comparative advantage. Further, the economy must make full use of its factors of production if it is to produce the goods and services it is capable of producing. Specialization The production possibilities model suggests that specialization will occur. Specialization18 implies that an economy is producing the goods and services in which it has a
comparative advantage. If Alpine Sports selects point C in Figure 2.8 "Efficient Versus Inefficient Production", for example, it will assign Plant 1 exclusively to ski production and Plants 2 and 3 exclusively to snowboard production. Such specialization is typical in an economic system. Workers, for example, specialize in particular fields in which they have a comparative advantage. People work and use the income they earn to buy—perhaps import—goods and services from people who have a comparative advantage in doing other things. The result is a far greater quantity of goods and services than would be available without this specialization. Figure 2.8 Efficient Versus Inefficient Production When factors of production are allocated on a basis other than comparative advantage, the result is inefficient production. Suppose Alpine Sports operates the three plants we examined in Figure 2.3 "Production Possibilities at Three Plants". Suppose further that all three plants are devoted exclusively to ski production; the firm operates at A. Now suppose that, to increase snowboard production, it transfers plants in numerical order: Plant 1 first, then Plant 2, and finally Plant 3. The result is the bowed-in curve AB′C′D. Production on the production possibilities curve ABCD requires that factors of production be transferred according to comparative advantage. Think about what life would be like without specialization. Imagine that you are suddenly completely cut off from the rest of the economy. You must produce everything you consume; you obtain nothing from anyone else. Would you be able to consume what you consume now? Clearly not. It is hard to imagine that most of us could even survive in such a setting. The gains we achieve through specialization are enormous. 18. Situation in which an economy is producing the goods and services in which it has a comparative advantage. 2.2 The Production Possibilities Curve 63 Chapter 2 Confronting Scarcity: Choices in Production Nations specialize as well. Much of the land in the United States has a comparative advantage in agricultural production and is devoted to that activity. Hong Kong, with its huge population and tiny endowment of land, allocates virtually none of its land to agricultural use; that option would be too costly. Its land is devoted largely to nonagricultural use production possibilities curve shows the combinations of two goods an economy is capable of producing. • The downward slope of the production possibilities curve is an implication of scarcity. • The bowed-out shape of the production possibilities curve results from allocating resources based on comparative advantage. Such an allocation implies that the law of increasing opportunity cost will hold
. • An economy that fails to make full and efficient use of its factors of production will operate inside its production possibilities curve. • Specialization means that an economy is producing the goods and services in which it has a comparative advantage. 2.2 The Production Possibilities Curve 64 Chapter 2 Confronting Scarcity: Choices in Production T R Y I T! Suppose a manufacturing firm is equipped to produce radios or calculators. It has two plants, Plant R and Plant S, at which it can produce these goods. Given the labor and the capital available at both plants, it can produce the combinations of the two goods at the two plants shown. Output per day, Plant R Combination Calculators Radios A B C 100 50 0 0 25 50 Output per day, Plant S Combination Calculators Radios D E F 50 25 0 0 50 100 Put calculators on the vertical axis and radios on the horizontal axis. Draw the production possibilities curve for Plant R. On a separate graph, draw the production possibilities curve for Plant S. Which plant has a comparative advantage in calculators? In radios? Now draw the combined curves for the two plants. Suppose the firm decides to produce 100 radios. Where will it produce them? How many calculators will it be able to produce? Where will it produce the calculators? 2.2 The Production Possibilities Curve 65 Chapter 2 Confronting Scarcity: Choices in Production Case in Point: The Cost of the Great Depression © 2010 Jupiterimages Corporation The U.S. economy looked very healthy in the beginning of 1929. It had enjoyed seven years of dramatic growth and unprecedented prosperity. Its resources were fully employed; it was operating quite close to its production possibilities curve. In the summer of 1929, however, things started going wrong. Production and employment fell. They continued to fall for several years. By 1933, more than 25% of the nation’s workers had lost their jobs. Production had plummeted by almost 30%. The economy had moved well within its production possibilities curve. Output began to grow after 1933, but the economy continued to have vast numbers of idle workers, idle factories, and idle farms. These resources were not put back to work fully until 1942, after the U.S. entry into World War II demanded mobilization of the economy’s factors of production. 2.2 The Production Possibilities Curve 66 Chapter 2 Confronting Scarcity: Choices in Production Between 1929 and 1942, the economy produced 25% fewer goods and services than it would have if
its resources had been fully employed. That was a loss, measured in today’s dollars, of well over $3 trillion. In material terms, the forgone output represented a greater cost than the United States would ultimately spend in World War II. The Great Depression was a costly experience indeed The production possibilities curves for the two plants are shown, along with the combined curve for both plants. Plant R has a comparative advantage in producing calculators. Plant S has a comparative advantage in producing radios, so, if the firm goes from producing 150 calculators and no radios to producing 100 radios, it will produce them at Plant S. In the production possibilities curve for both plants, the firm would be at M, producing 100 calculators at Plant R. 2.2 The Production Possibilities Curve 67 Chapter 2 Confronting Scarcity: Choices in Production 2.3 Applications of the Production Possibilities Model. Understand the argument for unrestricted international trade in terms of economic specialization and comparative advantage. 2. Define economic growth in terms of the production possibilities model and discuss factors that make such growth possible. 3. Explain the classification of economic systems, the role of government in different economic systems, and the strengths and weaknesses of different systems. The production possibilities curve gives us a model of an economy. The model provides powerful insights about the real world, insights that help us to answer some important questions: How does trade between two countries affect the quantities of goods available to people? What determines the rate at which production will increase over time? What is the role of economic freedom in the economy? In this section we explore applications of the model to questions of international trade, economic growth, and the choice of an economic system. Comparative Advantage and International Trade One of the most important implications of the concepts of comparative advantage and the production possibilities curve relates to international trade. We can think of different nations as being equivalent to Christie Ryder’s plants. Each will have a comparative advantage in certain activities, and efficient world production requires that each nation specialize in those activities in which it has a comparative advantage. A failure to allocate resources in this way means that world production falls inside the production possibilities curve; more of each good could be produced by relying on comparative advantage. If nations specialize, then they must rely on each other. They will sell the goods in which they specialize and purchase other goods from other nations. Suppose, for example, that the world consists of two continents that can each produce two goods: South America and Europe can produce food and computers. Suppose they
can produce the two goods according to the tables in Panels (a) and (b) of Figure 2.9 "Production Possibilities Curves and Trade". We have simplified this example by assuming that each continent has a linear production possibilities curve; the curves are plotted below the tables in Panels (a) and (b). Each continent has a separate 68 Chapter 2 Confronting Scarcity: Choices in Production production possibilities curve; the two have been combined to illustrate a world production possibilities curve in Panel (c) of the exhibit. Figure 2.9 Production Possibilities Curves and Trade Suppose the world consists of two continents: South America and Europe. They can each produce two goods: food and computers. In this example, we assume that each continent has a linear production possibilities curve, as shown in Panels (a) and (b). South America has a comparative advantage in food production and Europe has a comparative advantage in computer production. With free trade, the world can operate on the bowed-out curve GHI, shown in Panel (c). If the continents refuse to trade, the world will operate inside its production possibilities curve. If, for example, each continent were to produce at the midpoint of its production possibilities curve, the world would produce 300 computers and 300 units of food per period at point Q. If each continent were to specialize in the good in which it has a comparative advantage, world production could move to a point such as H, with more of both goods produced. The world production possibilities curve assumes that resources are allocated between computer and food production based on comparative advantage. Notice that, even with only two economies and the assumption of linear production possibilities curves for each, the combined curve still has a bowed-out shape. At point H, for example, South America specializes in food, while Europe produces only computers. World production equals 400 units of each good. In this situation, we would expect South America to export food to Europe while Europe exports computers to South America. But suppose the regions refuse to trade; each insists on producing its own food and computers. Suppose further that each chooses to produce at the midpoint of its own production possibilities curve. South America produces 100 units of computers and 200 units of food per period, while Europe produces 200 units of computers and 100 units of food per period. World production thus totals 300 units of each good per period; the world operates at point Q in Figure 2.9 "Production Possibilities Curves and Trade". If the two continents were willing to move from
isolation to trade, the 2.3 Applications of the Production Possibilities Model 69 Chapter 2 Confronting Scarcity: Choices in Production world could achieve an increase in the production of both goods. Producing at point H requires no more resources, no more effort than production at Q. It does, however, require that the world’s resources be allocated on the basis of comparative advantage. The implications of our model for trade are powerful indeed. First, we see that trade allows the production of more of all goods and services. Restrictions on trade thus reduce production of goods and services. Second, we see a lesson often missed in discussions of trade: a nation’s trade policy has nothing to do with its level of employment of its factors of production. In our example, when South America and Europe do not engage in trade and produce at the midpoints of each of their respective production possibilities curves, they each have full employment. With trade, the two nations still operate on their respective production possibilities curves: they each have full employment. Trade certainly redistributes employment in the two continents. In South America, employment shifts from computer production to food production. In Europe, it shifts from food production to computer production. Once the shift is made, though, there is no effect on employment in either continent. Of course, this idealized example would have all of South America’s computer experts becoming farmers while all of Europe’s farmers become computer geeks! That is a bit much to swallow, but it is merely the result of assuming linear production possibilities curves and complete specialization. In the real world, production possibilities curves are concave, and the reallocation of resources required by trade is not nearly as dramatic. Still, free trade can require shifts in resources from one activity to another. These shifts produce enormous benefits, but they do not come without costs. Nearly all economists agree that largely unrestricted trade between countries is desirable; restrictions on trade generally force the world to operate inside its production possibilities curve. In some cases restrictions on trade could be desirable, but in the main, free trade promotes greater production of goods and services for the world’s people. The role of international trade is explored in greater detail in subsequent chapters of this book. Economic Growth 19. The process through which an economy achieves an outward shift in its production possibilities curve. An increase in the physical quantity or in the quality of factors of production available to an economy or a technological gain will allow the economy to produce more goods and services; it will shift
the economy’s production possibilities curve outward. The process through which an economy achieves an outward shift in its production possibilities curve is called economic growth19. An outward shift in a production possibilities curve is illustrated in Figure 2.10 "Economic Growth and 2.3 Applications of the Production Possibilities Model 70 Chapter 2 Confronting Scarcity: Choices in Production the Production Possibilities Curve". In Panel (a), a point such as N is not attainable; it lies outside the production possibilities curve. Growth shifts the curve outward, as in Panel (b), making previously unattainable levels of production possible. Figure 2.10 Economic Growth and the Production Possibilities Curve An economy capable of producing two goods, A and B, is initially operating at point M on production possibilities curve OMR in Panel (a). Given this production possibilities curve, the economy could not produce a combination such as shown by point N, which lies outside the curve. An increase in the factors of production available to the economy would shift the curve outward to SNT, allowing the choice of a point such as N, at which more of both goods will be produced. The Sources of Economic Growth Economic growth implies an outward shift in an economy’s production possibilities curve. Recall that when we draw such a curve, we assume that the quantity and quality of the economy’s factors of production and its technology are unchanged. Changing these will shift the curve. Anything that increases the quantity or quality of the factors of production available to the economy or that improves the technology available to the economy contributes to economic growth. Consider, for example, the dramatic gains in human capital that have occurred in the United States since the beginning of the past century. In 1900, about 3.5% of U.S. workers had completed a high school education. By 2009, that percentage rose almost to 92. Fewer than 1% of the workers in 1900 had graduated from college; as late as 1940 only 3.5% had graduated from college. By 2009, over 32% had graduated from college. In addition to being better educated, today’s workers have received more and better training on the job. They bring far more economically useful knowledge and skills to their work than did workers a century ago. 2.3 Applications of the Production Possibilities Model 71 Chapter 2 Confronting Scarcity: Choices in Production Moreover, the technological changes that have occurred within the past 100 years have greatly reduced the time and effort required to produce most goods and services. Autom
ated production has become commonplace. Innovations in transportation (automobiles, trucks, and airplanes) have made the movement of goods and people cheaper and faster. A dizzying array of new materials is available for manufacturing. And the development of modern information technology—including computers, software, and communications equipment—that seemed to proceed at breathtaking pace especially during the final years of the last century and continuing to the present has transformed the way we live and work. Look again at the technological changes of the last few years described in the Case in Point on advances in technology. Those examples of technological progress through applications of computer technology—from new ways of mapping oil deposits to new methods of milking cows—helped propel the United States and other economies to dramatic gains in the ability to produce goods and services. They have helped shift the countries’ production possibilities curve outward. They have helped fuel economic growth. Table 2.1 "Sources of U.S. Economic Growth, 1960–2007" summarizes the factors that have contributed to U.S. economic growth since 1960. When looking at the period of 1960–2007 as a whole we see that about 65% of economic growth stems from increases in quantities of capital and labor and about 35% from increases in qualities of the factors of production and improvements in technology or innovation. Looking at the three shorter subperiods (1960–1995, 1995-2000, and 2000-2007), we see that the share attributed to quantity increases declined (from 68% to 56% and then 50%), while the share attributed to improvement in the qualities of the factors of production and to technological improvement grew (from 32% to 44% and then to 50%). Table 2.1 Sources of U.S. Economic Growth, 1960–2007 Period Percentage Contribution to Growth Period Growth Rate Years 1960–2007 Increase in quantity of labor Increase in quantity of capital Increase in quality of labor Increase in quality of capital 0.74% 1.48% 0.23% 0.58% 3.45% 2.3 Applications of the Production Possibilities Model 72 Chapter 2 Confronting Scarcity: Choices in Production Period Percentage Contribution to Growth Period Growth Rate Improved technology Years 1960–1995 Increase in quantity of labor Increase in quantity of capital Increase in quality of labor Increase in quality of capital Improved technology Years 1995–2000 Increase in quantity of labor Increase in quantity of capital Increase in quality of labor Increase in quality of capital Improved technology Years 2000–2007 Increase in quantity of labor Increase in quantity of capital Increase in quality of
labor Increase in quality of capital Improved technology 0.41% 0.80% 1.55% 0.24% 0.56% 0.28% 1.09% 1.43% 0.20% 0.89% 0.90% 0.17% 1.21% 0.22% 0.46% 0.72% 3.42% 4.52% 2.78% Total output for the period shown increased nearly fivefold. The chart shows the percentage of growth accounted for by increases in the quantity of labor and of capital and by increases in the quality of labor and of capital and improvements in technology. Source: Dale W. Jorgenson, Mun Ho, and Jon Samuels, “Information Technology and U.S. Productivity Growth: Evidence from a Prototype Industry Production Account,” prepared for Matilde Mas and Robert Stehrer, Industrial Productivity in Europe: Growth and Crisis, November 19, 2010. 2.3 Applications of the Production Possibilities Model 73 Chapter 2 Confronting Scarcity: Choices in Production Another way of looking at these data is to note that while the contribution of improved technology has increased over time (from 8% for the 1960–1995 period, to 20% for the 1995–2000 period, and 26% for the 2000–2007 period), most growth comes from more and better-quality factors of production. The study by economists Dale Jorgenson, Mun Ho, and Jon Samuels, on which the data shown in Table 2.1 "Sources of U.S. Economic Growth, 1960–2007" are derived, concludes that “the great preponderance of economic growth in the U.S. involves the replication of existing technologies through investment in equipment and software and expansion of the labour force. Replication generates economic growth with no increase in productivity. Productivity growth is the key economic indicator of innovation…Although innovation contributes only a modest portion of growth, this is vital to long-term gains in the American standard of living.”Dale W. Jorgenson, Mun Ho, and Jon Samuels, “Information Technology and U.S. Productivity Growth: Evidence from a Prototype Industry Production Account,” in Industrial Productivity in Europe: Growth and Crisis, ed. Matilde Mas and Robert Stehrer (Gloucestershire, UK: Edward Elgar, forthcoming). Waiting for Growth One key to growth is, in effect, the willingness to wait, to postpone
current consumption in order to enhance future productive capability. When Stone Age people fashioned the first tools, they were spending time building capital rather than engaging in consumption. They delayed current consumption to enhance their future consumption; the tools they made would make them more productive in the future. Resources society could have used to produce consumer goods are being used to produce new capital goods and new knowledge for production instead—all to enhance future production. An even more important source of growth in many nations has been increased human capital. Increases in human capital often require the postponement of consumption. If you are a college student, you are engaged in precisely this effort. You are devoting time to study that could have been spent working, earning income, and thus engaging in a higher level of consumption. If you are like most students, you are making this choice to postpone consumption because you expect it will allow you to earn more income, and thus enjoy greater consumption, in the future. Think of an economy as being able to produce two goods, capital and consumer goods (those destined for immediate use by consumers). By focusing on the production of consumer goods, the people in the economy will be able to enjoy a higher standard of living today. If they reduce their consumption—and their standard of living—today to enhance their ability to produce goods and services in the future, they will be able to shift their production possibilities curve outward. 2.3 Applications of the Production Possibilities Model 74 Chapter 2 Confronting Scarcity: Choices in Production That may allow them to produce even more consumer goods. A decision for greater growth typically involves the sacrifice of present consumption. Arenas for Choice: A Comparison of Economic Systems Under what circumstances will a nation achieve efficiency in the use of its factors of production? The discussion above suggested that Christie Ryder would have an incentive to allocate her plants efficiently because by doing so she could achieve greater output of skis and snowboards than would be possible from inefficient production. But why would she want to produce more of these two goods—or of any goods? Why would decision makers throughout the economy want to achieve such efficiency? Economists assume that privately owned firms seek to maximize their profits. The drive to maximize profits will lead firms such as Alpine Sports to allocate resources efficiently to gain as much production as possible from their factors of production. But whether firms will seek to maximize profits depends on the nature of the economic system within which they operate. Classifying Economic Systems Each of the world’s economies can be viewed as operating somewhere on a spectrum between market capitalism
and command socialism. In a market capitalist economy20, resources are generally owned by private individuals who have the power to make decisions about their use. A market capitalist system is often referred to as a free enterprise economic system. In a command socialist economy21, the government is the primary owner of capital and natural resources and has broad power to allocate the use of factors of production. Between these two categories lie mixed economies22 that combine elements of market capitalist and of command socialist economic systems. No economy represents a pure case of either market capitalism or command socialism. To determine where an economy lies between these two types of systems, we evaluate the extent of government ownership of capital and natural resources and the degree to which government is involved in decisions about the use of factors of production. Figure 2.11 "Economic Systems" suggests the spectrum of economic systems. Market capitalist economies lie toward the left end of this spectrum; command socialist economies appear toward the right. Mixed economies lie in between. The market capitalist end of the spectrum includes countries such as the United States, the United Kingdom, and Chile. Hong Kong, though now part of China, has a long 20. Economy in which resources are generally owned by private individuals who have the power to make decisions about their use. 21. Economy in which government is the primary owner of capital and natural resources and has broad power to allocate the use of factors of production. 22. Economy that combine elements of market capitalist and of command socialist economic systems. 2.3 Applications of the Production Possibilities Model 75 Chapter 2 Confronting Scarcity: Choices in Production history as a market capitalist economy and is generally regarded as operating at the market capitalist end of the spectrum. Countries at the command socialist end of the spectrum include North Korea and Cuba. Figure 2.11 Economic Systems Some European economies, such as France, Germany, and Sweden, have a sufficiently high degree of regulation that we consider them as operating more toward the center of the spectrum. Russia and China, which long operated at the command socialist end of the spectrum, can now be considered mixed economies. Most economies in Latin America once operated toward the right end of the spectrum. While their governments did not exercise the extensive ownership of capital and natural resources that are one characteristic of command socialist systems, their governments did impose extensive regulations. Many of these nations are in the process of carrying out economic reforms that will move them further in the direction of market capitalism. The global shift toward market capitalist economic systems that occurred in the 1980s and 1990s was in large part the result of
three important features of such economies. First, the emphasis on individual ownership and decision-making power has generally yielded greater individual freedom than has been available under command socialist or some more heavily regulated mixed economic systems that lie toward the command socialist end of the spectrum. People seeking political, religious, and economic freedom have thus gravitated toward market capitalism. Second, market economies are more likely than other systems to allocate resources on the basis of comparative advantage. They thus tend to generate higher levels of production and income than do other economic systems. Third, market capitalisttype systems appear to be the most conducive to entrepreneurial activity. Suppose Christie Ryder had the same three plants we considered earlier in this chapter but was operating in a mixed economic system with extensive government regulation. In such a system, she might be prohibited from transferring resources from one use to another to achieve the gains possible from comparative advantage. If she were operating under a command socialist system, she would not be the owner of the plants and thus would be unlikely to profit from their efficient use. If that were the case, there is no reason to believe she would make any effort to assure the efficient use of the three plants. Generally speaking, it is economies toward the 2.3 Applications of the Production Possibilities Model 76 Chapter 2 Confronting Scarcity: Choices in Production market capitalist end of the spectrum that offer the greatest inducement to allocate resources on the basis of comparative advantage. They tend to be more productive and to deliver higher material standards of living than do economies that operate at or near the command socialist end of the spectrum. Figure 2.12 Economic Freedom and Income The graph shows the relationship between economic freedom and per capita income by region. Countries with higher degrees of economic freedom tended to have higher per capita incomes. Source: Terry Miller and Kim R. Holmes, 2011 Index of Economic Freedom (Washington, D.C.: The Heritage Foundation and Dow Jones & Company, Inc., 2011), at www.heritage.org/index. Market capitalist economies rely on economic freedom. Indeed, one way we can assess the degree to which a country can be considered market capitalist is by the degree of economic freedom it permits. Several organizations have attempted to compare economic freedom in various countries. One of the most extensive comparisons is a joint annual effort by the Heritage Foundation and the Wall Street Journal. The 2011 rating was based on policies in effect in 183 nations early that year. The report ranks these nations on the basis of such things as the degree of regulation of firms, tax levels, and restrictions on international trade.

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