Microeconomics [3 ed.] 1260566641, 9781260566642
113 75 16MB
English Pages [72] Year 2019
Table of Contents and Preface
Half title page
The McGraw-Hill Economics Series
Titlepage
Improve Your World
Copyright
Dedication
About the Authors
Brief Contents
Improve Your World
Inspire Student Learning
Digital Solutions
Connect Economics
Connect
For Instructors
FOR STUDENTS
Detailed Content Changes
In all chapters
Chapter 1: Economics and Life
Chapter 2: Specialization and Exchange
Appendix A: Math Essentials: Understanding Graphs and Slopes
Chapter 3: Markets
Chapter 4: Elasticity
Chapter 5: Efficiency
Chapter 6: Government Intervention
Chapter 7: Consumer Behavior
Appendix E: Using Indifference Curves
Chapter 8: Behavioral Economics
Chapter 9: Game Theory and Strategic Thinking
Chapter 10: Information
Chapter 11: Time and Uncertainty
Appendix F: Math Essentials: Compounding
Chapter 12: The Costs of Production
Chapter 13: Perfect Competition
Chapter 14: Monopoly
Chapter 15: Monopolistic Competition and Oligopoly
Chapter 16: The Factors of Production
Chapter 17: International Trade
Chapter 18: Externalities
Chapter 19: Public Goods and Common Resources
Chapter 20: Taxation and the Public Budget
Chapter 21: Poverty, Inequality, and Discrimination
Chapter 22: Political Choices
Chapter 23: Public Policy and Choice Architecture
Guide to Data Sources
Acknowledgments
Detailed Contents
Feature Boxes
Chapter 1: Economics and Life
Part One
The Power of Economics
Introduction
Making an Impact with Small Loans
The Basic Insights of Economics
Scarcity
Opportunity cost and marginal decision making
Incentives
Efficiency
An Economist’s Problem-Solving Toolbox
Correlation and causation
Models
Positive and normative analysis
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Chapter 2: Specialization and Exchange
Introduction
The Origins of a T-Shirt
Production Possibilities
Drawing the production possibilities frontier
Choosing among production possibilities
Shifting the production possibilities frontier
Absolute and Comparative Advantage
Absolute advantage
Comparative advantage
Why Trade?
Specialization
Gains from trade
Comparative advantage over time
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Endnotes
Appendix A: Math Essentials: Understanding Graphs and Slope
Introduction
Creating a Graph
Graphs of one variable
Graphs of two variables
Slope
Calculating slope
The direction of a slope
The steepness of a slope
Key Terms
Problems and Applications
Chapter 3: Markets
Part Two
Supply and Demand
Introduction
Mobiles Go Global
Markets
What is a market?
What is a competitive market?
Demand
The demand curve
Determinants of demand
Shifts in the demand curve
Supply
The supply curve
Determinants of supply
Shifts in the supply curve
Market Equilibrium
Reaching equilibrium
Changes in equilibrium
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Endnotes
Appendix B: Math Essentials: Working with Linear Equations
Introduction
Interpreting the Equation of a Line
Turning a graph into an equation
Turning an equation into a graph
Equations with x and y reversed
Shifts and Pivots
Solving for Equilibrium
Problems and Applications
Chapter 4: Elasticity
Introduction
Coffee Becomes Chic
What Is Elasticity?
Price Elasticity of Demand
Calculating price elasticity of demand
Determinants of price elasticity of demand
Using price elasticity of demand
Price Elasticity of Supply
Calculating price elasticity of supply
Determinants of price elasticity of supply
Other Elasticities
Cross-price elasticity of demand
Income elasticity of demand
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Appendix C: Math Essentials: Calculating Percentage Change, Slope, and Elasticity
Introduction
Percentage Change
Slope and Elasticity
X over Y, or Y over X?
Elasticity changes along lines with constant slope
Problems and Applications
Chapter 5: Efficiency
Introduction
A Broken Laser Pointer Starts an Internet Revolution
Willingness to Pay and Sell
Willingness to pay and the demand curve
Willingness to sell and the supply curve
Measuring Surplus
Consumer surplus
Producer surplus
Total surplus
Using Surplus to Compare Alternatives
Market equilibrium and efficiency
Changing the distribution of total surplus
Deadweight loss
Missing markets
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Appendix D: Math Essentials: The Area under a Linear Curve
Introduction
The Area under a Linear Curve
Problems and Applications
Chapter 6: Government Intervention
Introduction
Feeding the World, One Price Control at a Time
Why Intervene?
Three reasons to intervene
Four real-world interventions
Price Controls
Price ceilings
Price floors
Taxes and Subsidies
Taxes
Subsidies
Evaluating Government Interventions
How big is the effect of a tax or subsidy?
Short-run versus long-run impact
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Endnotes
Chapter 7: Consumer Behavior
Part Three
Individual Decisions
Introduction
The Season for Giving
The Basic Idea of Utility
Utility and decision making
Revealed preference
Utility functions
Marginal Utility
Maximizing utility within constraints
Responding to Changes in Income and Prices
Changes in income
Changes in prices
Utility and Society
Utility and status
Utility and altruism
Utility and reciprocity
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Endnotes
Appendix E: Using Indifference Curves
Introduction
Representing Preferences Graphically
Consumption bundles and indifference curves
Properties of indifference curves
Perfect substitutes and perfect complements
Understanding Consumer Choice
Equalizing the marginal utility of the last purchase
Finding the highest indifference curve
How Consumers Respond to Change
Responding to a change in income
Responding to a change in prices
Deriving the demand curve using indifference curves
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Chapter 8: Behavioral Economics: A Closer Look at Decision Making
Introduction
When Is $20 Not Quite$20?
Dealing with Temptation and Procrastination
Time inconsistency, competing selves, and commitment
Thinking Irrationally about Costs
The sunk-cost fallacy
Undervaluing opportunity costs
Forgetting about Fungibility
Creating mental categories for money
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Endnote
Chapter 9: Game Theory and Strategic Thinking
Introduction
Litterbugs Beware
Games and Strategic Behavior
Rules, strategies, and payoffs
One-Time Games and the Prisoners’ Dilemma
Prisoners’ dilemma
Finding the dominant strategy
Reaching equilibrium
Avoiding competition through commitment
Promoting competition in the public interest
Repeated Play in the Prisoners’ Dilemma
The tit-for-tat strategy
Sequential Games
Think forward, work backward
Deterring market entry: A sequential game
First-mover advantage in sequential games
Repeated sequential games
Commitment in sequential games
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Chapter 10: Information
Introduction
A Solution for Student Loans?
Information: Knowledge Is Power
Information asymmetry
Adverse selection and the lemons problem
Principal–agent problems and moral hazard
Moral hazard and adverse selection—avoiding confusion
Solving Information Problems
Screening
Signaling
Reputation
Statistical discrimination
Regulation and education
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Chapter 11: Time and Uncertainty
Introduction
Is College Worth It?
Value over Time
Timing matters
Interest rates
Compounding
Present value
Risk and Uncertainty
What is risk?
Expected value
Propensity for risk
Insurance and Managing Risk
The market for insurance
Pooling and diversifying risk
Problems with insurance
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Endnotes
Appendix F: Math Essentials: Compounding
Introduction
Compounding and Future Value
The rule of 70
Problems and Applications
Chapter 12: The Costs of Production
Part Four
Firm Decisions
Endnotes
Introduction
What Are You Paying forin That Prescription?
The Building Blocks of Business: Revenues, Costs, and Profits
Profit is revenue minus costs
Fixed and variable costs
Explicit and implicit costs
Economic and accounting profit
Production Functions
Marginal product
Cost Curves
Total, average, and marginal costs
Production in the Short Run and the Long Run
Costs in the long run
Economies and diseconomies of scale
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Endnotes
Chapter 13: Perfect Competition
Introduction
Trainside Variety
A Competitive Market
Characteristics of a competitive market
Revenues in a perfectly competitive market
Profits and Production Decisions
Deciding how much to produce
Deciding when to operate
Behind the Supply Curve
Short-run supply
Long-run supply
Why the long-run market supply curve shouldn’t slope upward, but does
Responding to shifts in demand
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Chapter 14: Monopoly
Introduction
Diamonds Weren’t AlwaysForever
Why Do Monopolies Exist?
Barriers to entry
How Monopolies Work
Monopolists and the demand curve
Monopoly revenue
Problems with Monopoly and Public Policy Solutions
The welfare costs of monopoly
Public policy responses
Market Power and Price Discrimination
What is price discrimination?
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Endnotes
Chapter 15: Monopolistic Competition and Oligopoly
Introduction
Which One of These Is Just Likethe Others?
What Sort of Market?
Oligopoly and monopolistic competition
Monopolistic Competition
Monopolistic competition in the short run
Monopolistic competition in the long run
The welfare costs of monopolistic competition
Product differentiation, advertising, and branding
Oligopoly
Oligopolies in competition
Compete or collude? Using game theory to analyze oligopolies
Oligopoly and public policy
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Endnotes
Chapter 16: The Factors of Production
Introduction
The Fields of California
The Factors of Production: Land, Labor, and Capital
Derived demand
Marginal productivity
Picking the right combination of inputs
Labor Markets and Wages
Demand for labor
Supply of labor
Reaching equilibrium
Shifts in labor supply and labor demand
What’s missing? Human capital
Land and Capital
Capitalists: Who are they?
Markets for land and capital
The factor distribution of income
Real-World Labor Markets
Minimum wages and efficiency wages
Company towns, unions, and labor laws
Changing demographics
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Endnotes
Chapter 17: International Trade
Introduction
A New Meaning to “Made in the USA”
Why Trade? A Review
Comparative advantage
Gains from trade
The roots of comparative advantage
Incomplete specialization
From Autarky to Free Trade
Becoming a net-importer
Becoming a net-exporter
Big economy, small economy
Restrictions on Trade
Why restrict trade?
Tariffs
Quotas
Trade Agreements
International labor and capital
The WTO and trade mediation
Labor and environmental standards
Embargoes: Trade as foreign policy
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Endnotes
Chapter 18: Externalities
Part Five
Public Economics
Introduction
The Costs of Car Culture
What Are Externalities?
External costs and benefits
Negative externalities and the problem of “too much”
Positive externalities and the problem of “too little”
Private Solutions to Externalities
Public Solutions to Externalities
Taxes and subsidies
Other policy options: Quotas and tradable allowances
Targeting externalities with public policy
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Endnotes
Chapter 19: Public Goods and Common Resources
Introduction
A New Tragedy of theCommons
Characteristics of Goods
Excludable goods
Rival-in-consumption goods
Four categories of goods
Public Goods
The free-rider problem
Solutions to the free-rider problem
Common Resources
The tragedy of the commons
Solutions to the tragedy of the commons
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Endnotes
Chapter 20: Taxation and the Public Budget
Introduction
Happy to Pay Taxes?
Why Tax?
Principles of Taxation
Efficiency: How much (extra) will the tax cost?
Revenue: How much money will the tax raise?
Incidence: Who ultimately pays the tax?
A Taxonomy of Taxes
Personal income tax
Capital gains tax
Payroll tax
Corporate income tax
Other taxes
The Public Budget
Balancing the budget
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Endnotes
Chapter 21: Poverty, Inequality, and Discrimination
Introduction
Striking It Richer
Poverty
Measuring poverty
Why are people poor?
Inequality
Measuring inequality
Income inequality versus income mobility
Policies to Reduce Poverty and Inequality
Public policy goals
The welfare state
Trade-offs between equity and efficiency
Discrimination
Measuring discrimination in the labor market
Do free markets reduce discrimination?
Long-term effects of discrimination
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Endnotes
Chapter 22: Political Choices
Introduction
Global Warming Hot Potato
The Economics of Elections
Stick to the middle: Median-voter theorem
The elusive perfect voting system
Political participation and the myth of the “rational voter”
The Economics of Policy-Making
Diffuse costs, concentrated benefits
Corruption and rent-seeking
The system matters: How political structure affects outcomes
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Endnotes
Chapter 23: Public Policy and Choice Architecture
Introduction
Saving More for Tomorrow
Choice Architecture and Nudges
Why nudge?
Mistakes people make
Tools of Choice Architecture
Commitment devices
Information campaigns and disclosure rules
Default rules
Framing choices
Conclusion
Key Terms
Summary
Review Questions
Problems and Applications
Endnotes
Guide to Data Sources
Introduction
National (United States) Data
Bureau of Economic Analysis (BEA)
Federal Reserve Economic Data (FRED), Federal Reserve Bank of St. Louis
U.S. Bureau of Labor Statistics (BLS)
Congressional Budget Office (CBO)
U.S. Census Bureau
International Data
The World Bank
CIA World Factbook
The United Nations Statistics Division
Other Directories of Data
Google’s Public Data
The U.S. Government
Williams College Economics Department
Glossary
Glossary
Index
Index
A
B
C
D
E
F
G
H
I
J
K
L
M
N
O
P
Q
R
S
T
U
V
W
X
Y
Z
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MICROECONOMICS
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MICROECONOMICS Improve Your World THIRD EDITION
Dean Karlan Northwestern University and Innovations for Poverty Action
Jonathan Morduch New York University
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Get complete eBook Order by email at [email protected] brief contents
Page ix
Thinking Like an Economist Part 1 1 2
The Power of Economics 1 Economics and Life 3 Specialization and Exchange 25
Part 2 3 4 5 6
Supply and Demand 47 Markets 49 Elasticity 79 Efficiency 103 Government Intervention 129
Microeconomics: Thinking Like a Microeconomist Part 3 7 8 9 10 11
Individual Decisions 163 Consumer Behavior 165 Behavioral Economics: A Closer Look at Decision Making 189 Game Theory and Strategic Thinking 203 Information 229 Time and Uncertainty 245
Part 4 12 13 14 15 16 17
Firm Decisions 265 The Costs of Production 267 Perfect Competition 293 Monopoly 323 Monopolistic Competition and Oligopoly 353 The Factors of Production 383 International Trade 419
Part 5 18 19 20 21 22 23
Public Economics 449 Externalities 451 Public Goods and Common Resources 477 Taxation and the Public Budget 497 Poverty, Inequality, and Discrimination 525 Political Choices 563 Public Policy and Choice Architecture 585 Page x
DIGITAL EDITION
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Get complete eBook Order by email at [email protected] detailed content changes
Page xxiii
We’ve made numerous changes to the third edition of this text, prompted by users, reviewers, and developing ideas in economics. This section provides a detailed list of changes.
In all chapters In all chapters, the authors have made the following changes: Updated real-world data in text, figures, and tables. Added a new category of boxed insert, “Econ and YOU,” that offers examples of economics at play in personal decisions large and small. Topics include personal finance, raising a family, and unpaid internships, among others. Added new boxes (see details in the chapter lists below). Freshened existing boxes either by updating or by substituting new box topics for old ones, as detailed below. In addition, we’ve retitled the “Real Life” boxes as “Economics in Action.” Reformatted long discussions into smaller bites of content, to further sharpen the text’s already-strong readability and student interest. Added more female names and examples throughout. Added more non-Western names in end-of-chapter materials. Added photos in some boxes, for greater student interest. The following list does not repeat these text-wide changes but, rather, details specific changes made to each chapter.
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Get complete eBookand Order Chapter 1: Economics Lifeby email at [email protected] Changed the fourth economist’s question from “Why isn’t someone already doing it?” to “Are resources being allocated in the best way possible?” to clarify the idea of efficiency. Revised the associated text section on efficiency, with discussion of the practical implications of efficiency. Clarified the opportunity cost example—changed from going on a road trip to having dinner with friends. Added example of unpaid internship. Added “Marginal decision making” subheading. New Figure 1-1 (showing total revenue generated by bowling alleys correlated with per capita consumption of sour cream) illustrates the need to differentiate between correlation and causation. Replaced the box about Malthus’s model with a new Economics in Action box, titled When education pays off, about Goldin & Katz’s model explaining gains from education.
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Get complete eBook Order email at [email protected] Chapter 2: Specialization and by Exchange Slightly revised and shortened the From Another Angle box about Babe Ruth as an example of absolute and comparative advantage. Replaced Bill Gates as a text example of specialization with Stacy Brown-Philpot, CEO of TaskRabbit. Replaced the Economics in Action Is self-sufficiency a virtue? box with a new box Winners and losers; the new box describes the closing of an Ohio factory as a way to show how international trade results in some winners and some losers (suggesting that getting the benefits of trade can depend on compensating those who lose out from trade).
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Moved from online-only into the print product the Economics in Action box Comparative advantage: The good, the bad, and the ugly that discusses whether a country’s loss of comparative advantage at producing a particular good is something to worry about.
Appendix A: Math Essentials: Understanding Graphs and Slopes Revised
Replaced
Figures A-1 and
A-3 with new data.
Figure A-2 with data showing market share for domestic and imported vehicle types.
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Get complete eBook Order by email at [email protected] Chapter 3: Markets Replaced the Real Life The Prius shortage of 2003 box with a new Economics in Action box, The great Elmo shortage. Revised the Economics in Action Give a man a fish box to clarify the findings of economist Robert Jensen’s research on how cell phones changed the market for fish in Kerala, India.
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Get complete eBook Order by email at [email protected] Chapter 4: Elasticity Revised the Economics in Action Does charging for bednets decrease malaria? box to clarify and better highlight the work of Jessica Cohen and Pascaline Dupas on the price elasticity of demand for bednets in Kenya. Updated the What Do You Think? Should entrance fees at national parks be raised? box to include the 2017 proposal to increase fees in national parks. Removed the Where Can It Take You? Pricing analyst box and replaced it with a new Econ and YOU Finding a travel bargain box that discusses how understanding price elasticity can help when you buy airline tickets.
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Get complete eBook Order by email at [email protected] Chapter 5: Efficiency In the “Willingness to sell and the supply curve” subsection, revised the example (and related figures) by changing Seller #1 from a comic book collector to a college student wanting money to see a favorite band. Changed the Real Life Haggling and bluffing box to an Econ and YOU It pays to negotiate box that discusses salary negotiations as a common version of price negotiation. The new box references recent research by Marianne Bertrand; Hannah Riley Bowles, Linda Babcock, and Lei Lai; Andres Leibbrandt and John List; and Ellen Pao on gender differences in negotiation.
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Get complete eBook Order by email at [email protected] Chapter 6: Government Intervention Revised the What Do You Think? Put a cap on payday lending? box (including questions) to make it more personal (a broken-down car). Revised the data in the “Buyers pay more” example in
Figure 6-10.
Removed the Where Can It Take You? Public economics box and replaced it with a new Econ and YOU Out of sight, out of mind box that looks at research by Raj Chetty, Adam Looney, and Kory Kroft to test whether grocery-store shoppers “forget” about sales tax when they look at price tags. Replaced the What Do You Think? Farm subsidies box with a new Fight for $15 box that looks at the debate and economic research about a $15 federal minimum wage. Page xxv
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Get complete eBookBehavior Order by email at [email protected] Chapter 7: Consumer Revised the Real Life The science of happiness box. Repurposed as an Econ and YOU box titled Spending your way to happiness?, it now looks at the idea of utility to understand what makes people happy and includes research by Tamas Hajdu and Gabor Hajdu from a survey tracking the overall life satisfaction and spending habits of 10,000 people in Hungary. Fixed text references to points in panels A and B of
Figure 7-1, and added a point B to panel B of
Figure 7-1.
Repurposed the What Do You Think? Choosing a league box to Econ and YOU. Shortened the Economics in Action Why we give box.
Appendix E: Using Indifference Curves Changed the gender in the example used throughout the appendix from male (Malik) to female (Laila), to further differentiate the related examples used in the body of Chapter 7 and in this appendix.
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Get complete eBookEconomics Order by email at [email protected] Chapter 8: Behavioral Added a new Econ and YOU Is a dollar a dollar? box about the method-of-payment effect.
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Get complete Order by email Thinking at [email protected] Chapter 9: GameeBook Theory and Strategic In the “Prisoners’ dilemma” subsection, changed the text references from the Bush and Kerry 2004 campaign to more-generic Party A and Party B. Revised the colors used in the decision matrixes in the chapter to make them more lively. Repurposed the From Another Angle Tit-for-tat and human emotions box to an Econ and YOU Can game theory explain why you feel guilt? box; the box looks at how emotions may have promoted cooperation in hunter-gatherer societies. Revised the Real Life Dr. Strangelove. . . box to an Economics in Action box titled Totally MAD that focuses on the story of Soviet Commander Stanislav Petrov who used his understanding of game theory, and his intuition, to decide not to launch a missile attack against the United States in 1983.
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Get complete eBook Order by email at [email protected] Chapter 10: Information Replaced the Where Can It Take You? Risk management box with a new Econ and YOU Is college worth it? box that discusses the financial return on a college degree and introduces Bryan Caplan’s idea of a degree as a signaling device. Deleted the Real Life Dress for success box. Revised the What Do You Think? From spray paint to auto insurance box, retitled Should teenagers be able to buy assault rifles? to focus on a more current and controversial issue of statistical discrimination. Moved from online-only into the print product the What Do You Think? box How much information is too much? for a health-related look at adverse selection.
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Get complete Order by email at [email protected] Chapter 11: TimeeBook and Uncertainty Added a new Econ and YOU The rule of 70 box about how to estimate compounding of both savings and debt over time. Repurposed the From Another Angle Hindsight is 20/20 box to an Econ and YOU Are extended warranties worth it? box that looks at the costs and benefits of such insurance. Page xxvi
Appendix F: Math Essentials: Compounding Shortened the discussion of the rule of 70 in this appendix and elaborated on it in the body of
Chapter 11 instead.
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Get complete Order by email at [email protected] Chapter 12: The eBook Costs of Production Revised the chapter-opening feature story to discuss EpiPen pricing (instead of Lipitor). Repurposed the From Another Angle The “production” of kids box to an Econ and YOU The quarter-million dollar kid box, updated with USDA estimates. Revised the From Another Angle Beyond the bottom line box for greater clarity about the goals of social enterprises. Revised
Figure 12-2 by changing the axes to flatten out the total production curve.
Revised
Figure 12-3 by changing the axes to flatten out the average and marginal product curves.
Added new subheadings “Graphing total cost” and “Graphing average cost” to present the discussion of total and average costs in smaller bites. Revised
Figure 12-4 by changing the axes and showing data points, for better student understanding.
Revised Figure 12-5 by changing the axes and showing data points, with call-out labels to differentiate between the lowest points on the AVC and ATC curves, for better student understanding. Revised
Figure 12-6 by changing the axes and showing data points to correct the shape of the marginal cost curve.
Figure 12-7 by changing the axes and showing data points to correct the shape of the marginal cost curve and its intersection with the Revised average total cost curve. Revised Figure 12-9 to make the long-run ATC curve more U-shaped and highlight that the long-run ATC curve represents the lowest point of all short-run ATC curves. Updated the Economics in Action Walmart and economies of scale box with a comparison of economies of scale for Walmart and Amazon. Updated and shortened the What Do You Think? The profit motive and “orphan” drugs box, retitled Should drug companies care about neglected diseases? to focus on the ethical issues surrounding drug development.
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Get complete eBook Order by email at [email protected] Chapter 13: Perfect Competition Revised the Real Life Bazaar competition box and retitled it Economics in Action Why does the “Motor Mile” exist? to discuss why we often see many businesses of the same type clustered near each other. Revised
Figure 13-1 to show a more traditional marginal cost curve.
Added a new From Another Angle Who wants competition? box, discussing that the amount of competition in a market can make or break a contestant’s hopes on the ABC television show Shark Tank.
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Get complete eBook Order by email at [email protected] Chapter 14: Monopoly Made slight revisions to the discussion of natural monopolies, to clarify. Revised the From Another Angle Poor monopolists box for greater clarity and retitled it Phone ladies. Updated the text examples of recent big mergers (e.g., Amazon and Whole Foods). Added a new From Another Angle The origins of Monopoly box, discussing the original economic message and intent of the now-familiar board game. Page xxvii
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Get complete eBook Order by emailand at [email protected] Chapter 15: Monopolistic Competition Oligopoly Updated
Figure 15-1 with revised data showing market share in the music business.
Added a new Econ and YOU Fight the (market) power! box about market power and its economic effects. In the “Oligopolies in competition” subsection, added subheadings for “Two firms (duopoly)” and “Three or more firms,” to break down text into smaller discrete bites.
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Get complete by email at [email protected] Chapter 16: The eBook FactorsOrder of Production Replaced the featured player (Clayton Kershaw) in the chapter-opening story with Mike Trout. Expanded the discussion of the income and price effects of a wage increase with additional explanation of the fact that individual labor supply curves are not always linear and so the effect of a change in wages on hours worked may depend on where an individual is on the labor supply curve. Corrected the text statement in the discussion of
Updated
Figure 16-7, which said (incorrectly) that demand shifted to the right, rather than to the left.
Figure 16-8, to show immigration through 2017.
Revised the What Do You Think Should the United States be a country of immigrants? box to expand the discussion and to include mention of H-1B visas. Updated
Figure 16-11, showing the factor distribution of income.
In the subsection on “minimum wages and efficiency wages,” expanded the text discussion of the effects of minimum-wage laws. Revised the online-only box on monopsony in baseball with a new Economics in Action Have noncompete clauses gone too far? box that explores how the idea of monopsony applies in today’s labor market. Updated with a new paragraph on the 2018 Supreme Court ruling that public-sector unions can’t force all employees to join the union and pay union dues.
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Get complete eBook Order Chapter 17: International Tradeby email at [email protected] Replaced the chapter-opening feature story with one titled A New Meaning to “Made in the USA” that focuses on U.S.–China trade. Repurposed the old chapter-opening feature story about the garment business in Lesotho to a new in-chapter Economics in Action Made in Lesotho. But why? box to show that trade agreements can sometimes be more important than natural resources and climate in producing comparative advantage. In both the “Becoming a net importer” and “Becoming a net exporter” sections, expanded the text a bit to acknowledge that though the outcome of competition in world trade might be efficient, trade forces uncomfortable economic adjustments and has real political consequences. Clarified the callout labels in Revised the price data in
Figure 17-6.
Figure 17-7.
Deleted the subsection “Selective exemptions from quotas and tariffs.” In the“WTO and trade mediation” section, added a paragraph about the most-favored-nation provision. Also added a short discussion about 2018 trade negotiations between the United States and China. Revised the From Another Angle Are environmental regulations bad for the environment? box to address the idea of pollution displacement enabled by international trade and trade agreements. Retitled the subheading “Fair(ly) free trade” to “Pocketbook activism.” Deleted the What Do You Think? Lift the embargo on Cuba? box. Page xxviii
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Get complete eBook Order by email at [email protected] Chapter 18: Externalities Added clarifying text statements about the terminology marginal social cost curve and the marginal social benefit curve. Replaced the Real Life The fight over cap-and-trade legislation box with a new Economics in Action Why not tax ourselves? box about the difficulties of imposing taxes on external costs like contributions to greenhouse-gas emissions.
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Get complete eBook Order email at [email protected] Chapter 19: Public Goods and by Common Resources Slightly revised examples in
Figure 19-1 showing four categories of goods.
Added as key terms private goods and artificially scarce goods. Added a new Economics in Action Artificially scarce music box about how streaming services like Spotify and Pandora make music excludable, creating an artificially scarce good that enables the services to charge a price above marginal cost. Replaced the text paragraph about Elinor Ostrom’s research with a new Economics in Action It’s not necessarily a tragedy box that looks in more depth at Ostrom’s research into how social norms can sometimes be powerful enough for commonly held property to be managed extremely well. Moved from online-only into the print product the Economics in Action Why the Colorado River no longer reaches the ocean box that illustrates some mistakes in the management of a very important common resource, water. Deleted the Real Life North American fisheries learn from failure box.
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Get complete eBook Order by email at [email protected] Chapter 20: Taxation and the Public Budget Updated the tax data in the chapter’s text, figures, and tables. Shortened the From Another Angle Love the sinner, love the sin tax box, now retitled Can some taxes make people happier? and refocused on the purpose and effects of “sin taxes,” particularly in helping people curb consumption of cigarettes or alcohol. Added subheadings under the “Personal income tax” subheading for smaller bites of content and to differentiate between calculating personal income tax and the topic of capital gains tax. In the section on “Other taxes,” added a paragraph about Internet sales tax collection, with reference to the 2018 Supreme Court ruling. Retitled the What Do You Think? Death, taxes, and “death taxes” box as Death and taxes. Revised the term nondiscretionary spending to mandatory spending and made it a key term. Added a short paragraph about voluntary gifts to the U.S. Treasury.
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Get complete eBook Order by email at [email protected] Chapter 21: Poverty, Inequality, and Discrimination Updated poverty data in the chapter’s text, figures, and tables. Replaced the Real Life What if your $2 a day doesn’t come every day? box with a related Economics in Action box, Up and down in America that focuses on Jonathan Morduch’s U.S. financial diaries research. Slightly broadened
LO 21-2 to address factors that contribute to poverty.
Revised and shortened the Economics in Action Getting out of the neighborhood box. Revised the discussion of the Gini coefficient to use 100 (rather than 1) to indicate perfectly unequal income distribution, to reflect data found in typical Gini-coefficient resources. The revised
Figure 21-5 now shows Gini coefficients for 30 countries.
Added a new From Another Angle Just give money box about universal basic income (UBI). The new box replaces the online-only From Another Angle Paying people to help themselves box. In the discussion of statistical discrimination, added a text statistic about changes in the number of male doctors between 1960 and 2010.
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Updated the Economics in Action Are Emily and Greg more employable than Lakisha and Jamal? box with follow-up research.
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Get complete eBook Order by email at [email protected] Chapter 22: Political Choices Updated the chapter-opening story to include the October 2018 report on global warming conducted by the Intergovernmental Panel on Climate Change and to mention the 2018 Nobel Memorial Prize in Economics awarded to Yale’s William Nordhaus, which recognized the contribution that economists can have in addressing the complexities of climate change. Slightly expanded the discussion of the median-voter theorem. Added a new Economics in Action The rise of Donald Trump box that addresses recent real-world evidence that contradicts the median-voter theorem. Slightly expanded the discussion of alternative voting systems. Added a new Economics in Action Ranked-choice takes the Golden ticket to Washington box about the application of a ranked-choice voting system in the election of Congressman Jared Golden (Maine). Deleted the Real Life Monitoring corruption in Indonesia box.
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Get complete eBook Order emailArchitecture at [email protected] Chapter 23: Public Policy and by Choice In the chapter-opening story, added mention of Richard Thaler’s Nobel Prize in economics. Revised the Real Life Committing to fertilizer box to liken the decision Kenyan farmers make about whether to purchase fertilizer to decisions people make about saving for retirement and retitled it as Economics in Action It’s all about timing. Moved from online-only into the print product the Real Life Is payday lending predatory box and recategorized the box as Econ and YOU.
Guide to Data Sources Made updates to sources and revised accompanying questions, for currency. page xxx
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Get complete eBook Order by email at [email protected] acknowledgments
Page xxxi
Many people helped us create this text. It’s said that “it takes a village,” but it often felt like we had the benefit of an entire town. We thank Meredith Startz, Ted Barnett, and Andrew Wright for the foundational work they contributed to the first edition, which still shines through in this edition. Thanks, too, to Victor Matheson (College of the Holy Cross), Diana Beck (New York University), Amanda Freeman (Kansas State University), and John Kane (SUNY--Oswego) for their contributions to and thoughts about early drafts of chapters. An energetic group of collaborators helped us shape second-edition content in ways that are relevant and engaging for a student audience: David “Dukes” Love (Williams College) steered us through the writing of the macro chapters, helping us revamp our treatment of the aggregate expenditure model and how it leads into the aggregate demand and aggregate supply model. Erin Moody (University of Maryland) applied her extensive classroom experience as an essential contributor throughout the micro chapters, ensuring that we addressed the many suggestions we received from users and reviewers of our text. Camille Soltau Chapter 18, “Externalities,” and made immeasurable improvements. Our IPA team of researchers, Radhika Nelson (Oregon State University) analyzed Lokur and Noor Sethi, brought a recent-student perspective to the text and helped us update many of our examples and figures with the most current data. Many other talented individuals have contributed to previous editions. We thank Bob Schwab, Kevin Stanley, Ross vanWassenhove, and James Peyton for Chapter 18 and helping guide us toward a final version. We thank John Neri and Murat Doral for providing detailed closely reviewing a draft of our revised feedback on all the macro chapters of the text. We appreciate Jodi Begg’s help in providing a base to work from for Chapter 28, “Aggregate Expenditure.” We thank Chiuping Chen, Ashley Hodgson, Michael Machiorlatti, and Germain Pichop for reviewing said chapter in its draft stages to ensure we were on the right track. We thank Peggy Dalton (Frostburg State University) and Erin Moody (University of Maryland) for their many and varied contributions to end-of-chapter and test bank content, both in the text and in Connect. We are very appreciative of the extensive work done by Katrina Babb (Indiana State University) and Susan Bell (Seminole State College) in accuracy-checking this content. In addition, we thank Greg Gilpin (Montana State University) for authoring the PowerPoint Presentation and Russell Kellogg (University of Colorado Denver) for authoring the LearnSmart content. Ted Barnett played an essential role in this edition, helping us introduce new material and new ways of describing economic ideas. We are grateful for his creativity and knowledge of pedagogy and economics. He also made improvements to the test bank content. We thank Dick Startz for sharing his insights about new approaches in macroeconomics and for his feedback. Fatima Khan led the efforts to update the data and figures throughout the text. We also want to share our appreciation to the following people at McGraw-Hill for the hard work they put into creating the product you see before you: Anke Weekes, Portfolio Director, helped us communicate the overarching vision and promoted our revision. Bobby Pearson, Marketing Manager, guided us in visiting schools and working with the sales team. Ann Torbert, Content Developer, has been an exemplary editor, improving the exposition on each page and keeping attention on both the big picture and key details. We feel lucky to have had her partnership on all three editions. Christina Kouvelis, Senior Product Developer, managed innumerable and indispensable details—reviews, manuscript, and the many aspects of the digital products and overall package. Kathryn Wright, Senior Core Content Project Manager, helped turn our manuscript into the finished, polished product you see before you. Keri Johnson, Senior Assessment Content Project Manager, skillfully guided the digital plan. Thanks, too, to Douglas Ruby, Senior Director of Digital Content, for his careful shepherding of the digital materials that accompany the text. Page xxxii
Thank You! Creating the third edition of a book is a daunting task. We wanted to do everything we could to improve upon the previous editions, and we couldn’t have done this without professors who told us honestly what they thought we could do better. To everyone who helped shape this edition, we thank you for sharing your insights and recommendations.
Symposia Luca Bossi University of Pennsylvania Regina Cassady Valencia College June Charles North Lake College Monica Cherry St. John Fisher College and State University of New York at Buffalo George Chikhladze University of Missouri–Columbia Patrick Crowley Texas A&M University–Corpus Christi Attila Cseh Valdosta State University Susan Doty University of Texas at Tyler Irene Foster George Washington University Don Holley Boise State University Ricot Jean Valencia College
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Focus Groups Siddiq Abdullah University of Massachusetts–Boston Seemi Ahmad Dutchess Community College Nurul Aman University of Massachusetts–Boston Aimee Chin University of Houston Can Erbil Boston College Varun Gupta Wharton County Junior College Moon Han North Shore Community College Hilaire Jean-Gilles Bunker Hill Community College Jennifer Lehman Wharton County Junior College
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Highline College Get complete eBook Order by email at [email protected] Steve Trost Virginia Polytechnic Institute and State University Ross S. vanWassenhove University of Houston Allison Witman University of North Carolina-Wilimington In addition, we continue to be grateful to the first-edition contributors, who over the course of several years of development attended focus groups or symposia or provided content reviews. Thanks to the following, whose insights, recommendations, and feedback helped immeasurably as the project took shape. Mark Abajian San Diego Mesa College Tom Adamson Midland University Richard Agesa Marshall University Rashid Al-Hmoud Texas Tech University Frank Albritton Seminole State College-Sanford Terence Alexander Iowa State University Clifford Althoff Joliet Junior College Diane Anstine North Central College Michael Applegate Oklahoma State University–Stillwater Campus Ali Ataiifar Delaware County Community College Roberto Ayala California State Polytechnic University–Pomona Jim Barbour Elon University Gary Benson Southwest Community College Laura Jean Bhadra Northern Virginia Community College–Manassas Prasun Bhattacharjee East Tennessee State University–Johnson City Radha Bhattacharya California State University–Fullerton Michael Bonnal University of Tennessee–Chattanooga Camelia Bouzerdan Middlesex Community College Dale Bremmer Rose-Hulman Institute of Technology Anne Bresnock University of California–Los Angeles Bruce Brown California State Polytechnic University–Pomona Ken Brown University of Northern Iowa Laura Bucila Texas Christian University Andrew Cassey Washington State University Kalyan Chakraborty Emporia State University Catherine Chambers University of Central Missouri Britton Chapman State College of Florida–Manatee Sanjukta Chaudhuri University of Wisconsin–Eau Claire
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Chiuping Chen Get complete eBook Order by email at [email protected] American River College Ron Cheung Oberlin College Young Back Choi Saint John’s University Dmitriy Chulkov Indiana University–Kokomo Cindy Clement University of Maryland–College Park Howard Cochran Belmont University Jim Cox Georgia Perimeter College Matt Critcher University of Arkansas Community College–Batesville Chifeng Dai Southern Illinois University–Carbondale Thomas Davidson Principia College Rafael Donoso Lone State College–North Harris Floyd Duncan Virginia Military Institute David Eaton Murray State University Eric Eide Brigham Young University–Provo Marwan El Nasser State University of New York–Fredonia Harry Ellis University of North Texas Maxwell Eseonu Virginia State University Brent Evans Mississippi State University Russell Evans Oklahoma State University Fidelis Ezeala-Harrison Jackson State University Chris Fant Spartanburg Community College Michael Fenick Broward College Abdollah Ferdowsi Ferris State University Tawni Ferrarini Northern Michigan University Herbert Flaig Milwaukee Area Technical College Irene Foster George Washington University Joseph Franklin Newberry College Shelby Frost Georgia State University Fran Lara Garib San Jacinto College Deborah Gaspard Southeast Community College Karen Gebhardt Colorado State University Juan Alejandro Gelves Midwestern State University Kirk Gifford Brigham Young University–Idaho
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Albert Sumell Get complete eBook Order by email at [email protected] Youngstown State University Philip Isak Szmedra Georgia Southwestern State University Christine Tarasevich Del Mar College Noreen Templin Butler Community College Darryl Thorne Valencia College East Kiril Tochkov Texas Christian University Demetri Tsanacas Ferrum College George Tvelia Suffolk County Community College Nora Underwood University of Central Florida Jose Vazquez University of Illinois–Champaign Marieta Velikova Belmont University Jeffery Vicek Parkland College Jennifer Vincent Champlain College Terry von Ende Texas Tech University Craig Walker Oklahoma Baptist University Jennifer Ward-Batts Wayne State University Tarteashia Williams Valencia College–West Campus Melissa Wiseman Houston Baptist University Jim Wollscheid University of Arkansas–Fort Smith Jeff Woods University of Indianapolis Ranita Wyatt Pasco-Hernando Community College–West Campus Suthathip Yaisawarng Union College Jim Yates Darton College Daehyun Yoo Elon University Ceren Ertan Yoruk Sage College of Albany Chuck Zalonka Oklahoma State University–Oklahoma City Finally, thanks to the following instructors, and their students, who class-tested chapters of the first edition before publication. Their engagement with the content and their feedback from the “test drive” made this a better product. Richard Agesa Marshall University Anne Bresnock University of California–Los Angeles Chiuping Chen American River College John Kane State University of New York–Oswego Jim Lee Texas A&M University–Corpus Christi Martin Milkman Murray State University
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Kolleen Rask Get complete eBook Order by email at [email protected] College of the Holy Cross Jesse Schwartz Kennesaw State University Jennifer Vincent Champlain College
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Part 1 The Power of Economics 1 Chapter 1
Economics and Life 3 Making an Impact with Small Loans 3 The Basic Insights of Economics 4 Scarcity 5 Opportunity cost and marginal decision making 6 Incentives 9 Efficiency 10 An Economist’s Problem-Solving Toolbox 12 Correlation and causation 13 Models 15 Positive and normative analysis 17 Conclusion 19 Chapter 2
Specialization and Exchange 25 The Origins of a T-Shirt 25
Production Possibilities 27 Drawing the production possibilities frontier 27 Choosing among production possibilities 30 Shifting the production possibilities frontier 31 Absolute and Comparative Advantage 33 Absolute advantage 33 Comparative advantage 33 Why Trade? 35 Specialization 35 Gains from trade 37 Comparative advantage over time 40 Conclusion 42 APPENDIX A Math Essentials: Understanding Graphs and Slope 46A
Creating a Graph 46A Graphs of one variable 46A Graphs of two variables 46C Slope 46F Calculating slope 46G The direction of a slope 46H The steepness of a slope 46I
Part 2 Supply and Demand 47 Chapter 3
Markets 49 Mobiles Go Global 49
Markets 50
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is a market? 50 eBook Order by email at [email protected] Get What complete
What is a competitive market? 50 Demand 52 The demand curve 53 Determinants of demand 53 Shifts in the demand curve 57 Supply 59 The supply curve 60 Determinants of supply 60 Shifts in the supply curve 62 Market Equilibrium 63 Reaching equilibrium 64 Changes in equilibrium 65 Conclusion 72 APPENDIX B Math Essentials: Working with Linear Equations 78A
Interpreting the Equation of a Line 78A Turning a graph into an equation 78B Turning an equation into a graph 78B Equations with x and y reversed 78D Shifts and Pivots 78E Solving for Equilibrium 78H Chapter 4
Elasticity 79 Coffee Becomes Chic 79 What Is Elasticity? 80 Price Elasticity of Demand 81 Calculating price elasticity of demand 81 Determinants of price elasticity of demand 84 Using price elasticity of demand 85 Price Elasticity of Supply 92 Calculating price elasticity of supply 92 Determinants of price elasticity of supply 93 Other Elasticities 94
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Cross-price elasticity of demand 94 Income elasticity of demand 95 Conclusion 98 APPENDIX C Math Essentials: Calculating Percentage Change, Slope, and Elasticity 102A
Percentage Change 102A Slope and Elasticity 102B X over Y, or Y over X? 102D Elasticity changes along lines with constant slope 102D Chapter 5
Efficiency 103 A Broken Laser Pointer Starts an Internet Revolution 103
Willingness to Pay and Sell 104 Willingness to pay and the demand curve 105 Willingness to sell and the supply curve 107
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Surplus 109 eBook Order by email at [email protected] GetMeasuring complete Consumer surplus 110 Producer surplus 112 Total surplus 113 Using Surplus to Compare Alternatives 115 Market equilibrium and efficiency 115 Changing the distribution of total surplus 117 Deadweight loss 118 Missing markets 119 Conclusion 121 APPENDIX D Math Essentials: The Area under a Linear Curve 128A
The Area under a Linear Curve 128A Chapter 6
Government Intervention 129 Feeding the World, One Price Control at a Time 129 Why Intervene? 130 Three reasons to intervene 130 Four real-world interventions 131 Price Controls 132 Price ceilings 132 Price floors 136 Taxes and Subsidies 139 Taxes 140 Subsidies 146 Evaluating Government Interventions 150 How big is the effect of a tax or subsidy? 151 Short-run versus long-run impact 153 Conclusion 156
Part 3 Individual Decisions 163 Chapter 7
Consumer Behavior 165 The Season for Giving 165
The Basic Idea of Utility 166 Utility and decision making 167 Revealed preference 168 Utility functions 169 Marginal Utility 170 Maximizing utility within constraints 172 Responding to Changes in Income and Prices 175 Changes in income 175 Changes in prices 177 Utility and Society 180 Utility and status 180 Utility and altruism 182 Utility and reciprocity 183 Conclusion 184 APPENDIX E Using Indifference Curves 188A
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GetRepresenting complete Order by email at [email protected] Preferences eBook Graphically 188A Consumption bundles and indifference curves 188A Properties of indifference curves 188C Perfect substitutes and perfect complements 188D Understanding Consumer Choice 188E Equalizing the marginal utility of the last purchase 188E Finding the highest indifference curve 188G How Consumers Respond to Change 188H Responding to a change in income 188I Responding to a change in prices 188I Deriving the demand curve using indifference curves 188K Conclusion 188L Chapter 8
Behavioral Economics: A Closer Look at Decision Making 189 When Is $20 Not Quite $20? 189
Dealing with Temptation and Procrastination 191 Time inconsistency, competing selves, and commitment 191 Thinking Irrationally about Costs 194 The sunk-cost fallacy 194 Undervaluing opportunity costs 195 Forgetting about Fungibility 196 Creating mental categories for money 196 Conclusion 199 Chapter 9
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Game Theory and Strategic Thinking 203 Litterbugs Beware 203
Games and Strategic Behavior 204 Rules, strategies, and payoffs 205 One-Time Games and the Prisoners’ Dilemma 205 Prisoners’ dilemma 205 Finding the dominant strategy 207 Reaching equilibrium 208 Avoiding competition through commitment 209 Promoting competition in the public interest 210 Repeated Play in the Prisoners’ Dilemma 212 The tit-for-tat strategy 212 Sequential Games 214 Think forward, work backward 215 Deterring market entry: A sequential game 215 First-mover advantage in sequential games 218 Repeated sequential games 218 Commitment in sequential games 219 Conclusion 221 Chapter 10
Information 229 A Solution for Student Loans? 229
Information: Knowledge Is Power 230
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asymmetryeBook 231 Get Information complete Order by email at [email protected]
Adverse selection and the lemons problem 231 Principal–agent problems and moral hazard 233 Moral hazard and adverse selection—avoiding confusion 234 Solving Information Problems 235 Screening 235 Signaling 236 Reputation 237 Statistical discrimination 237 Regulation and education 239 Conclusion 241 Chapter 11
Time and Uncertainty 245 Is College Worth It? 245 Value over Time 246 Timing matters 246 Interest rates 247 Compounding 248 Present value 249 Risk and Uncertainty 251 What is risk? 251 Expected value 252 Propensity for risk 253 Insurance and Managing Risk 254 The market for insurance 254 Pooling and diversifying risk 254 Problems with insurance 258 Conclusion 260 APPENDIX F Math Essentials: Compounding 264A
Compounding and Future Value 264A The rule of 70 264C
Part 4 Firm Decisions 265 Chapter 12
The Costs of Production 267 What Are You Paying for in That Prescription? 267
The Building Blocks of Business: Revenues, Costs, and Profits 268 Profit is revenue minus costs 269 Fixed and variable costs 269 Explicit and implicit costs 271 Economic and accounting profit 272 Production Functions 274 Marginal product 274 Cost Curves 277 Total, average, and marginal costs 277 Production in the Short Run and the Long Run 283 Costs in the long run 283 Economies and diseconomies of scale 283
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287 GetConclusion complete eBook Order by email at [email protected] Chapter 13
Perfect Competition 293 Trainside Variety 293
A Competitive Market 294 Characteristics of a competitive market 294 Revenues in a perfectly competitive market 298 Profits and Production Decisions 300 Deciding how much to produce 300 Deciding when to operate 303 Behind the Supply Curve 307 Short-run supply 307 Long-run supply 308 Why the long-run market supply curve shouldn’t slope upward, but does 313 Responding to shifts in demand 315 Conclusion 316 Chapter 14
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Monopoly 323 Diamonds Weren’t Always Forever 323
Why Do Monopolies Exist? 324 Barriers to entry 325 How Monopolies Work 327 Monopolists and the demand curve 327 Monopoly revenue 329 Problems with Monopoly and Public Policy Solutions 333 The welfare costs of monopoly 334 Public policy responses 336 Market Power and Price Discrimination 341 What is price discrimination? 341 Conclusion 346 Chapter 15
Monopolistic Competition and Oligopoly 353 Which One of These Is Just Like the Others? 353
What Sort of Market? 354 Oligopoly and monopolistic competition 355 Monopolistic Competition 356 Monopolistic competition in the short run 357 Monopolistic competition in the long run 358 The welfare costs of monopolistic competition 361 Product differentiation, advertising, and branding 362 Oligopoly 367 Oligopolies in competition 368 Compete or collude? Using game theory to analyze oligopolies 371 Oligopoly and public policy 374 Conclusion 376 Chapter 16
The Factors of Production 383 The Fields of California 383
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GetThecomplete eBook Order by email at [email protected] Factors of Production: Land, Labor, and Capital 384 Derived demand 385 Marginal productivity 385 Picking the right combination of inputs 385 Labor Markets and Wages 386 Demand for labor 387 Supply of labor 389 Reaching equilibrium 393 Shifts in labor supply and labor demand 394 What’s missing? Human capital 399 Land and Capital 401 Capitalists: Who are they? 401 Markets for land and capital 401 The factor distribution of income 403 Real-World Labor Markets 405 Minimum wages and efficiency wages 405 Company towns, unions, and labor laws 407 Changing demographics 409 Conclusion 411 Chapter 17
International Trade 419 A New Meaning to “Made in the USA” 419
Why Trade? A Review 420 Comparative advantage 420 Gains from trade 421 The roots of comparative advantage 422 Incomplete specialization 424 From Autarky to Free Trade 425 Becoming a net-importer 426 Becoming a net-exporter 428 Big economy, small economy 430 Restrictions on Trade 433 Why restrict trade? 433 Tariffs 433 Quotas 435 Trade Agreements 437 International labor and capital 437 The WTO and trade mediation 438 Labor and environmental standards 439 Embargoes: Trade as foreign policy 441 Conclusion 442
Part 5 Public Economics 449 Chapter 18
Externalities 451 The Costs of Car Culture 451 What Are Externalities? 452 External costs and benefits 453
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externalities and the problem ofOrder “too much” 455 Get Negative complete eBook by email at [email protected] Positive externalities and the problem of “too little” 457
Private Solutions to Externalities 459 Public Solutions to Externalities 463 Taxes and subsidies 464 Other policy options: Quotas and tradable allowances 467
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Targeting externalities with public policy 469 Conclusion 469 Chapter 19
Public Goods and Common Resources 477 A New Tragedy of the Commons 477
Characteristics of Goods 478 Excludable goods 479 Rival-in-consumption goods 479 Four categories of goods 480 Public Goods 481 The free-rider problem 481 Solutions to the free-rider problem 484 Common Resources 486 The tragedy of the commons 486 Solutions to the tragedy of the commons 487 Conclusion 492 Chapter 20
Taxation and the Public Budget 497 Happy to Pay Taxes? 497
Why Tax? 498 Principles of Taxation 500 Efficiency: How much (extra) will the tax cost? 500 Revenue: How much money will the tax raise? 503 Incidence: Who ultimately pays the tax? 505 A Taxonomy of Taxes 508 Personal income tax 508 Capital gains tax 511 Payroll tax 511 Corporate income tax 512 Other taxes 512 The Public Budget 514 Balancing the budget 516 Conclusion 519 Chapter 21
Poverty, Inequality, and Discrimination 525 Striking It Richer 525 Poverty 526 Measuring poverty 527 Why are people poor? 533 Inequality 536 Measuring inequality 536 Income inequality versus income mobility 542
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to Reduce PovertyeBook and InequalityOrder 543 GetPolicies complete by email at [email protected] Public policy goals 543 The welfare state 545 Trade-offs between equity and efficiency 548 Discrimination 549 Measuring discrimination in the labor market 550 Do free markets reduce discrimination? 552 Long-term effects of discrimination 552 Conclusion 554 Chapter 22
Political Choices 563 Global Warming Hot Potato 563
The Economics of Elections 564 Stick to the middle: Median-voter theorem 565 The elusive perfect voting system 567 Political participation and the myth of the “rational voter” 572 The Economics of Policy-Making 574 Diffuse costs, concentrated benefits 574 Corruption and rent-seeking 576 The system matters: How political structure affects outcomes 577 Conclusion 579 Chapter 23
Public Policy and Choice Architecture 585 Saving more for Tomorrow 585
Choice Architecture and Nudges 587 Why nudge? 587 Mistakes people make 590 Tools of Choice Architecture 592 Commitment devices 592 Information campaigns and disclosure rules 593 Default rules 595 Framing choices 597 Conclusion 598 Guide to Data Sources GU-1 Glossary GL-1 Indexes IN-1 page xli
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ECONOMICS IN ACTION When education pays off 17 Specialization sauce 37 Winners and losers 39 Comparative advantage: The good, the bad, and the ugly 41 Can instant noodle sales predict a recession? 56 The great Elmo shortage 66 Give a man a fish 71 Does charging for bednets decrease malaria? 87 The unintended consequences of biofuel subsidies 150 Why we give 183 Give more tomorrow 192 Take out a contract on yourself 193 What do price-matching guarantees guarantee? 213 Totally MAD 220 The weather can’t cheat 234 Walmart and economies of scale 285 Why does the “Motor Mile” exist? 297 How Ford changed the world 313 Rockers vs. Ticketmaster 337 What really sells loans? 364 Have noncompete clauses gone too far? 407 Made in Lesotho. But why? 423 Why not tax ourselves? 468 Artificially scarce music 480 It’s not necessarily a tragedy 487 Why the Colorado River no longer reaches the ocean 491 The insecure future of Social Security 518 Up and down in America 532 Getting out of the neighborhood 534 Are Emily and Greg more employable than Lakisha and Jamal? 551 The rise of Donald Trump 566 Ranked-choice takes the Golden ticket to Washington 571 Face value—May the best-looking politician win 573 Enfranchising the poor helps the poor 578 It’s all about timing 588 Who doesn’t want to be an organ donor? 595
FROM ANOTHER ANGLE Does ice cream cause polio? 14 Babe Ruth, star pitcher 34 How much would you pay to keep the Internet from disappearing? 110 Beyond the bottom line 273 Who wants competition? 309 Phone ladies 336 The origins of Monopoly 340 Rickshaw rides: Price discrimination and asymmetric information 346 Coke, Pepsi, and the not-so-secret formula 366 Are environmental regulations bad for the environment? 440
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Does no-fault divorce law increase the divorce rate? 463 Why does Wikipedia work? 483 Can some taxes make people happier? 499 “Just give money” 546 Turn down the AC for a smiley face 597
ECON AND YOU
a travel bargain 97 GetFinding complete eBook Order by email at [email protected]
to negotiate 108 eBook Order by email at [email protected] GetItOutpays complete of sight, out of mind 152 Spending your way to happiness? 168 Choosing a league 181 Why we give 183 Is a dollar a dollar? 198 Can game theory explain why you feel guilt? 214 Is college worth it? 236 The rule of 70 249 Are extended warranties worth it? 257 The quarter-million dollar kid 271 Fight the (market) power! 362 Is payday lending predatory? 594
WHAT DO YOU THINK? The opportunity cost of a life 7 The cost of college cash 18 Should entrance fees at national parks be raised? 91 Kidneys for sale 120 Put a cap on payday lending? 135 Fight for $15 154 Credit-card categories: More realistic or more confusing? 197 Surviving with strategic thinking 217 Should teenagers be able to buy assault rifles? 238 How much information is too much? 240 Who should bear the risk that a college degree doesn’t pay off? 255 Should health insurance include preventive care? 259 Should drug companies care about neglected diseases? 286 Should the United States be a country of immigrants? 397 Work, wages, and social value 404 Population policy and the wealth of nations 410 Reclining transactions 461 Should conservationists be principled or pragmatic? 489 Death and taxes 513 The super-wealthy 540 Affirmative action in college admissions 553
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Get complete eBook Order by email at [email protected] Part One The Power of Economics The two chapters in Part 1 will introduce you to . . . the tools and intuition essential to the study of economics. Chapter 1, “Economics and Life,” presents four questions that introduce the fundamental concepts of economic problem solving. We also describe how economists think about data and analyze policies: You’ll see that we typically separate how one wants the world to look (“normative” analysis) from how the world actually works (“positive” analysis). Chapter 2, “Specialization and Exchange,” presents the ideas of absolute and comparative advantage, to explain how people (and countries) can most effectively use their resources and talents. Should you hire a plumber or fix the pipes yourself? Should you become a pop star or an economist? We develop these ideas to show how trade can make everyone better off, on both a personal and a national level. This is just a start. Throughout the book, we’ll use these tools to gain a deeper understanding of how people interact and manage their resources, which in turn gives insight into tough problems of all sorts. Economic ideas weave a common thread through many subjects, from the purely economic to political, environmental, and cultural issues, as well as personal decisions encountered in everyday life. Economics is much more than just the study of money, and we hope you’ll find that what you learn here will shed light far beyond your economics classes. Page 2
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Chapter 1
Economics and Life LEARNING OBJECTIVES LO 1.1 LO 1.2 LO 1.3 LO 1.4 LO 1.5 LO 1.6 LO 1.7
Explain the economic concept of scarcity. Explain the economic concepts of opportunity cost and marginal decision making. Explain the economic concept of incentives. Explain the economic concept of efficiency. Distinguish between correlation and causation. List the characteristics of a good economic model. Distinguish between positive and normative analysis.
Making an Impact with Small Loans On the morning of October 13, 2006, Bangladeshi economist Muhammad Yunus received an unexpected telephone call from Oslo, Norway. Later that day, the Nobel committee announced that Yunus and the Grameen Bank, which he founded in 1976, would share the 2006 Nobel Peace Prize. Past recipients of the Nobel Peace Prize include Mother Teresa, who spent over 50 years ministering to beggars and lepers; Martin Luther King Jr., who used peaceful protest to oppose racial segregation; and the Dalai Lama, an exiled Tibetan Buddhist leader who symbolizes the struggle for religious and cultural tolerance. What were an economist and his bank doing in such company? Grameen is not a typical bank. Yes, it makes loans and offers savings accounts, charging customers for its services, just like other banks. But it serves some of the poorest people in the poorest villages in one of the poorest countries in the world. It makes loans so small that it’s hard for people in wealthy countries to imagine what good they can do: The first group of loans Yunus made totaled only $27. Before Grameen came along, other banks had been unwilling to work in these poor communities. They believed it wasn’t worth bothering to lend such small amounts; many believed the poor could not be counted on to repay their loans.
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Yunus disagreed. He was convinced that even small loans would allow poor villagers to expand their small businesses—maybe buying a sewing machine or a cow to produce milk for the local market—and earn more money. Or perhaps a villager wouldn’t expand a small business but would instead use the money to pay for a health emergency or to buy food when faced with hunger. Regardless of the way the loans were used, villagers’ lives would be more comfortable and secure, and their children would have a better future. Yunus claimed that they would be able to repay the loans and that his new bank would earn a profit. Page 4 Muhammad Yunus was trained as an economist. He earned a PhD at Vanderbilt University in Nashville and then taught in Tennessee before becoming a professor in Bangladesh. When a devastating famine struck Bangladesh, Yunus became disillusioned with teaching. What did abstract equations and stylized graphs have to do with the suffering he saw around him? Ultimately, Yunus realized that economic thinking holds the key to solving hard problems that truly matter. The genius of Grameen Bank is that it is neither a traditional charity nor a traditional bank. Instead, it is a business that harnesses basic economic insights to make the world a better place.
In this book, we’ll introduce you to the tools economists are using to tackle some of the world’s biggest challenges, from health care reform, to climate change, to lifting people out of poverty. Of course, these tools are not just for taking on causes worthy of Nobel Prizes. Economics can also help you become a savvier consumer, successfully launch a new cell phone app, or simply make smarter decisions about how to spend your time and money. Throughout this book, we promise we’ll ask you not just to memorize theories, but also to apply the ideas you read about to the everyday decisions you face in your own life. Text discussions will spotlight such decisions as will boxed inserts such as those titled “Econ and YOU.”
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Get complete eBook Order by email at [email protected] The Basic Insights of Economics When people think of economics, they often think of the stock market, the unemployment rate, or media reports saying things like “the Federal Reserve has raised its target for the federal funds rate.” Although economics does include these topics, its reach is much broader. Economics is the study of how people manage resources. Decisions about how to allocate resources can be made by individuals, but also by groups of people in families, firms, governments, and other organizations. In economics, resources are not just physical things like cash and gold mines. They are also intangible things, such as time, ideas, technology, job experience, and even personal relationships. Traditionally, economics has been divided into two broad fields: microeconomics and macroeconomics. Microeconomics is the study of how individuals and firms manage resources. Macroeconomics is the study of the economy as a whole, and how policy-makers manage the growth and behavior of the overall economy. Microeconomics and macroeconomics are highly related and interdependent; we need both to fully understand how economies work. Economics starts with the idea that people compare the choices available to them and purposefully behave in the way that will best achieve their goals. As human beings, we have ambitions and we make plans to realize them. We strategize. We marshal our resources. When people make choices to achieve their goals in the most effective way possible given the resources they have, economists say they are exhibiting rational behavior. The assumption that people behave rationally isn’t perfect. As we’ll see later in the text, people can sometimes be short-sighted or swayed merely by the way choices are presented. Nevertheless, the assumption of rational behavior helps to explain a lot about the world. Page 5 People use economics every day, from Wall Street to Walmart, from state capitol buildings to Bangladeshi villages. They apply economic ideas to everything from shoe shopping to baseball, from running a hospital to running for political office. What ties these topics together is a common approach to problem solving. Economists tend to approach problems by asking four questions: 1.
What are the wants and constraints of those involved?
2.
What are the trade-offs?
3.
How will others respond?
4.
Are resources being allocated in the best way possible?
Underneath these questions are some important economics concepts, which we will begin to explore in this chapter. The questions and the underlying concepts are based on just a few common-sense assumptions about how people behave, yet they offer a surprising amount of insight into tough problems of all sorts. They are so important to economic problem solving that they will come up again and again in this text. In this chapter we’ll take a bird’s-eye view of economics, focusing on the fundamental concepts and skimming over the details. Later in the text, we’ll return to each question in more depth.
Scarcity Question 1: What are the wants and constraints of those involved? LO 1.1 Explain the economic concept of scarcity. For the most part, people make decisions that are aimed at getting the things they want. Of course, you can’t always get what you want. People want a lot of things, but they are constrained by limited resources. Economists define scarcity as the condition of wanting more than we can get with available resources. Scarcity is a fact of life. You have only so much time and only so much money. You can arrange your resources in a lot of different ways—studying or watching TV, buying a car, or traveling to Las Vegas—but at any given time, you have a fixed range of possibilities. Scarcity also describes the world on a collective level: As a society, we can produce only so many things, and we have to decide how those things are divided among many people. On the other hand, some things are not restricted by resources. Consider, for example, knowledge. The total quantity of available knowledge does not diminish as more and more people acquire it. Similarly, sunlight and air can also be considered nonscarce goods. In economic terms, however, it is safe to say that most goods are considered to be scarce. The first question to ask in untangling a complex economic problem is, “What are the wants and constraints of those involved?” Given both rational behavior and scarcity, we can expect people to try to get what they want but to be constrained by the limited resources available to them. Suppose you want to spend as much time as possible this summer taking road trips around the country. You are constrained by the available time (three months of summer vacation) and by the amount of money you have available to pay for gas, food, and places to stay. Behaving rationally, you might choose to work double shifts for two months to earn enough to spend one month on the road. Since you are now constrained by having only one month to travel, you’ll have to prioritize your time, activities, and expenses. Now put yourself in Muhammad Yunus’s shoes, back in 1976. He sees extremely poor but entrepreneurial Bangladeshi villagers and thinks they could improve their lives with access to loans. Why aren’t banks providing financial services for these people? We can apply the first of the economists’ questions to start to untangle this puzzle: What are the wants and constraints of those involved? In this case, those involved are traditional Bangladeshi banks and poor Bangladeshi villagers. Let’s look at both: The banks want to make profits by lending money to people who will pay them back with interest. The banks are constrained by having limited funds available to lend and needing to pay employees and branch expenses. We can therefore expect banks to prioritize making large loans to customers they believe are likely to pay them back. Before 1976, that meant wealthier, urban Bangladeshis, not the very poor in remote rural villages. The villagers want the chance to increase their incomes. They have energy and business ideas but are constrained in their ability to borrow money because banks believe they are too poor to repay loans. Analyzing the wants and constraints of those involved gives us some valuable information about why poor Bangladeshis didn’t have access to loans. Banks wanted to earn profits and managed their constrained funds to prioritize those they thought would be profitable customers. Bangladeshi villagers wanted to increase their incomes but couldn’t follow up on business opportunities due to constrained start-up money.
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That’s good information, but we haven’t yet come up with the solution that Dr. Yunus was looking for. To take the next step in solving the puzzle, we turn to another question economists often ask.
Opportunity cost and marginal decision making Question 2: What are the trade-offs? LO 1.2 Explain the economic concepts of opportunity cost and marginal decision making. Every decision in life involves weighing the trade-off between costs and benefits. We look at our options and decide whether it is worth giving up one in order to get the other. We choose to do things only when we think the benefits will be greater than the costs. The potential benefit of taking an action is often easy to see: Having dinner with friends would be fun. Taking a loan from a bank would help pay emergency expenses that occur. The costs of a decision, on the other hand, are not always clear. You might think it is clear—that the cost of a meal with friends is simply the amount of money you spend on dinner. But something is missing from that way of thinking. The true cost of something is not just the amount you have to pay for it. Rather, the cost also includes the opportunity you must now give up for something that you might have enjoyed otherwise. Suppose, if you hadn’t gone out for dinner, your second choice would have been to spend that night watching a newly released movie. The true cost of going out for dinner includes passing up the enjoyment you would have had at the movie. Behaving rationally, you should go out to dinner only if it will be more valuable to you than the best alternative use for your time and money. This is a matter of personal preference. Because people have different alternatives and place different values on things like a dinner or a movie, they will make different decisions.
Opportunity costs Economists call this true cost of your choice the opportunity cost. It is equal to the value to you of what you have to give up in order to get something. Put another way, opportunity cost is the value you could have gained by choosing your next-best alternative—the “opportunity” you have to pass up in order to take your first choice. Let’s return to the dinner. Say you’re going with a friend and her plan B would have been staying home to catch up on homework. The opportunity cost of her dinner is different from yours. For her, the opportunity cost is the satisfaction she would have had from finally catching up on her work. If she’s behaving rationally, she will join you for dinner only if she believes it will be more valuable than staying home with her assignments. Opportunity cost helps us think more clearly about trade-offs. If someone asked you how much your dinner cost and you responded by adding up the cost of your appetizer, main course, and a drink, you would be failing to capture some of the most important and interesting aspects of the trade-offs you made. Opportunity cost helps us to see why, for example, a self-employed consultant and a factory worker earning the same amount of money may face truly different trade-offs when they dream about taking the same vacation for the same price. The self-employed consultant likely forgoes earning income in order to take the time off for a vacation. The factory worker likely gets paid vacation days. The opportunity cost for the consultant includes the value of what he or she would buy with the money earned by working instead of taking the vacation. The opportunity cost for the factory worker includes the benefit she would get from taking a different vacation. Thus the opportunity cost of a vacation for the consultant is much higher than it is for the factory worker. That difference makes it more expensive for the consultant to take a vacation than the factory worker. Page 7 Economists often express opportunity cost as a dollar value. Suppose you’re offered a part-time job that pays $100 a week for four months (or $1,600 in total). Alternatively, you have the chance to take an internship for four months that offers useful career-related experience but no pay. Your time is tight, so you have to choose between the offers. What are the opportunity costs of the choices? The opportunity cost of the unpaid internship is the $1,600 that you would have earned if you had instead chosen the paid job. The opportunity cost of the paid job is a bit trickier. It’s what you would give up by not taking the internship. Part of the value of the internship is that you expect the experience to contribute to your career. It may be hard to put an exact number on the expected value to your career, but you may be able to predict whether the expected contribution of the internship is bigger or smaller than $1,600. The internship would be appealing if the expected gain to your career substantially exceeds $1,600. Otherwise, the paid job could make more financial sense. Of course, we’re simplifying a lot here. You might need the money now, rather than at a later date—which would push you toward the paid job. Also, you may be looking for gains that are not purely financial—like having interesting experiences and meeting new people. Either way, thinking about opportunity costs is a critical part of making good decisions of all kinds. Once you start to think about opportunity costs, you see them everywhere. For an application of opportunity cost to a serious moral question, read the What Do You Think? box “ The opportunity cost of a life.”
What Do You Think? The opportunity cost of a life What Do You Think? boxes present questions that require you to combine facts and economic analysis with values and moral reasoning. There can be many “correct” answers, depending on your values and goals. The philosopher Peter Singer writes that opportunity costs can be a matter of life or death. Imagine you are a salesperson, and on your way to a meeting on a hot summer day, you drive by a lake. Suddenly, you notice that a child who has been swimming in the lake is drowning. No one else is in sight. You have a choice. If you stop the car and dive into the lake to save the child, you will be late for your meeting, miss out on making a sale, and lose $1,500. The opportunity cost of saving the child’s life is $1,500. Alternatively, if you continue on to your meeting, you earn the $1,500, but you lose the opportunity to dive into the lake and save the child’s life. The opportunity cost of going to the meeting is one child’s life.
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What would you do? Most people don’t hesitate. They immediately say they would stop the car, dive into the lake, and save the drowning child. After all, a child’s life is worth more than $1,500. Now suppose you’re thinking about spending $1,500 on a new MacBook. That $1,500 could instead have been used for some charitable purpose, such as immunizing a group of children in another country against yellow fever. Suppose that for every $1,500 donated, an average of one child’s life ends up being saved. What is the opportunity cost of buying a MacBook? According to Peter Singer, it is the same as the opportunity cost of going straight to the meeting: a child’s life. These two situations are not exactly the same, of course, but why does the first choice (jump in the lake) seem so obvious to most people, while the second seems much less obvious?
WHAT DO YOU THINK? 1.
In what ways do the two situations presented by Singer—the sales meeting and the drowning child versus the MacBook and the unvaccinated child —differ?
2.
Singer argues that even something like buying a MacBook is a surprisingly serious moral decision. Do you agree? What sort of opportunity costs do you typically consider when making such a decision?
3.
What might be missing from Singer’s analysis of the trade-offs people face when making a decision about how to spend money?
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Marginal decision making Another important principle for understanding trade-offs is the idea that rational people make decisions at the margin. Marginal decision making describes the idea that rational people compare the additional benefits of a choice against the additional costs, without considering related benefits and costs of past choices. For example, suppose an amusement park has a $20 admission price and charges $2 per ride. If you are standing outside the park, the cost of the first ride is $22: You will have to pay the admission price and buy a ticket for the ride. Once you are inside the park, the marginal cost of each additional ride is $2. When deciding whether to go on the roller coaster a second or third time, you should compare only the benefit or enjoyment you will get from one more ride to the opportunity cost of that additional ride. This may sound obvious, but in practice, many people don’t make decisions on the margin. Suppose you get into the amusement park and start to feel sick shortly thereafter. If doing something else with your $2 and your time would bring you more enjoyment than another roller coaster ride while feeling sick, the rational thing to do would be to leave. The relevant trade-off is between the additional benefits that going on another ride would bring versus the additional costs. You cannot get back the $20 admission fee or any of the other money you’ve already spent on rides. Economists call a cost that has already been incurred and cannot be recovered a sunk cost. Sunk costs should not have any bearing on your marginal decision about what to do next. But many people feel the need to go on a few more rides to psychologically justify the $20 admission. Trade-offs play a crucial role in businesses’ decisions about what goods and services to produce. Let’s return to the example that started this chapter and apply the idea to a bank in Bangladesh: What are the trade-offs involved in making a small loan? For traditional banks, the opportunity cost of making small loans to the poor was the money that the bank could have earned by making loans to wealthier clients instead. For poor borrowers, the opportunity cost of borrowing was whatever else they would have done with the time they spent traveling to the bank and with the money they would pay in fees and interest on the loan. The benefit, of course, was whatever the loan would enable them to do that they could not have done otherwise, such as starting a small business or buying food or livestock. Based on this analysis of trade-offs, we can see why traditional banks made few loans to poor Bangladeshis. Banks perceived the poor to be risky clients. The opportunity cost of making small loans to the poor seemed to outweigh the benefits—unless the banks charged very high fees. From the perspective of poor rural villagers, high fees meant that the opportunity cost of borrowing was higher than the benefits; they chose not to borrow under the terms offered by banks. Page 9
Notice that the answer to this question built off the answer to the first: We had to know the wants and constraints of each party before we could assess the trade-offs they faced. Now that we understand the motivations and the trade-offs that led to the situation Dr. Yunus observed, we can turn to a third question he might have asked himself when considering what would happen when he founded the Grameen Bank.
Incentives Question 3: How will others respond? LO 1.3 Explain the economic concept of incentives. You’re in the mood for pizza, so you decide to go to a favorite neighborhood restaurant that has a short menu: pizza and spaghetti. When you get there, you discover that the prices have changed. Both used to cost $15, which made your decision relatively easy: which food were you in the mood for that night? Tonight you discover that pizza now costs $50, instead of $15. What will you do? You could leave, but you’re already here, are hungry, and feel committed to stay. Unless you can easily afford $50 for a pizza or you just really hate spaghetti, you’ll order spaghetti. We’re sure that you can think of ways to spend $35 that are worth more to you than your preference for pizza over spaghetti. But what if the prices had changed less drastically—say, $18 for pizza? That might be a tougher call. As the trade-offs change, so will the choices people make. When the restaurant owner considers how much to charge for each dish, she must consider how others will respond to changing prices. If she knows the pizza is popular, she might be tempted to try charging more to boost her profits. But as she increases the price, fewer diners will decide to order it.
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If a trade-off faced by a lot of people changes, even by a small amount, the combined change in behavior by everyone involved can add up to a big shift. Asking “How will others respond?” to a trade-off that affects a lot of people gives us a complete picture of how a particular decision affects the world. The collective reaction to a changing trade-off is a central idea in economics; it will come up in almost every chapter of this book. You’ll see it in questions such as What happens when prices change? What happens when the government implements a new policy? What happens when a company introduces a new product? Answering any of these questions requires us to consider a large-scale reaction, rather than the behavior of just one person, company, or policy-maker. In answering this question about trade-offs, economists commonly make two assumptions. The first is that people respond to incentives. An incentive is something that causes people to behave in a certain way by changing the trade-offs they face. Incentives can be positive or negative: A positive incentive (sometimes just called an incentive) makes people more likely to do something. For example, lowering the price of spaghetti creates a positive incentive for people to order it because it lowers the opportunity cost: When you pay less for spaghetti, you give up fewer other things you could have spent the money on. A negative incentive (sometimes called a disincentive) makes them less likely to do it. Charging people more for pizza is a negative incentive to buy pizza because they now have to give up more alternative purchases. The second assumption economists make about trade-offs is that nothing happens in a vacuum. That is, you can’t change just one thing in the world without eliciting a response from others. If you change your behavior—even if only in a small way—that action will change the incentives of the people around you, causing them to change their behavior in response. If you invent a new product, competitors will copy it. If you raise prices, consumers will buy less. If you tax a good or service, people will produce less of it. Page 10 Asking how others will respond can help prevent bad decisions by predicting the undesirable side effects of a change in prices or policies. The question can also be used to design changes that elicit positive responses. When Muhammad Yunus was setting up Grameen Bank, he had to think carefully about the incentives that both rural villagers and traditional banks faced; he considered how those incentives could be changed without incurring negative side effects. One reason banks saw rural villagers as risky customers is that they were too poor to have collateral to offer the bank. Collateral is a possession, like a house or a car, pledged by a borrower to a lender. If the borrower cannot repay the loan, the lender keeps the collateral. The threat of losing the collateral increases the cost of choosing to not repay the loan; collateral gives the borrower a positive incentive to repay. When traditional banks thought about lending to poor Bangladeshis, they believed that without the threat of losing collateral, the villagers would be unlikely to repay their loans. Yunus needed to think up a different way of creating a positive incentive for poor customers to repay their loans. His best-known solution was to require borrowers to apply for loans in five-person groups. Every person in the group would have a stake in the success of the other members. If one person didn’t repay a loan, no one else in the group could borrow from the bank again. Yunus’s idea, called group responsibility, was simple but hugely significant. Yunus concluded that borrowers would have a strong incentive to repay their loans: They wouldn’t want to ruin relationships with other members of the group—their fellow villagers, with whom they live every day and rely on for mutual support in hard times. This incentive, in turn, changed the trade-off faced by banks; they responded by being more willing to lend to the poor. By asking himself how villagers would respond to the new kind of loan and how banks in turn would respond to the villagers’ response, Yunus was able to predict that his idea could be the key to spreading banking services to the poor. Dr. Yunus’s predictions proved to be correct. Seeing that poor villagers nearly always repaid their loans under Grameen’s system gave other banks confidence that small borrowers could be reliable customers. Banks offering microloans, savings accounts, and other services to the very poor have spread around the world. As a result of Yunus’s creativity and thoughtfulness about incentives, the poor have better access to financial services, and banks earn money from providing them. Today, other ideas have proved even more effective in providing the right incentives for small borrowers, continuing in the tradition of experimentation and innovation pioneered by Yunus and Grameen Bank. Throughout this book, you will see many examples of how the power of incentives can be harnessed to accomplish everything from increasing a company’s profits to protecting the environment. But before we get carried away with brilliant economic innovations, we have to ask ourselves one more question, the final test for any ideas that come out of our problem-solving process.
Efficiency Question 4: Are resources being allocated in the best way possible? LO 1.4 Explain the economic concept of efficiency. Once you’ve considered needs, incentives, and trade-offs, it’s natural to ask whether resources are being used in the best way possible. Of course, there are many ways to define “in the best way possible.” One way is to ask whether outcomes are fair or ethical. Of course, people debate what’s fair or ethical, and we’ll stop regularly to consider the fairness of economic outcomes too (especially in “What do you think?” boxes). Here, we focus on a separate concept: efficiency. It’s one of the building blocks of economic thinking, and it has a specific meaning that differs from the everyday usage of the word. For economists, efficiency is not just about maximizing productivity, it is also about ensuring that people get what they most want and need given the available resources. Page 11 Efficiency doesn’t mean that outcomes are necessarily fair or ethical, but it reflects an important idea about economic outcomes. As described later in the text, when the economy is efficient, there is no way to reorganize things to make anyone better off without someone else becoming worse off. A resource is anything that can be used to make something of value, from natural resources (such as water and trees) to human resources (such as talents and knowledge). When the economy is efficient, resources are being used to create the greatest total economic value to society. (We’ll take a broad view for now: Something is valuable if someone wants it.)
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Let’s turn to a practical implication. There are millions of businesses in the world, each trying to make a profit. When consumers want a good or service, businesses have incentives to earn money by providing it. When you think you see a big, unexploited opportunity—a new product, policy, technology, or business model that could change the world or earn you millions of dollars—stop for a moment. Ask yourself: If it’s such a great idea, why isn’t someone doing it? One possible answer is simply that nobody has thought of it before. That’s possible. Perhaps you have seen an efficient way to allocate resources in a way that produces economic value for society. But if you have seen the opportunity, doesn’t it seem likely that at least one of the billions of other smart, rational people in the world will have seen it too? This leads to our final claim: Under normal circumstances, individuals and firms will act to provide the things people want. If a genuine profit-making opportunity exists, someone will take advantage of it, and usually sooner rather than later. Don’t get us wrong: We’re not saying there is never an opportunity to do something new in the world. Great new ideas happen all the time—they drive progress. But there’s a strong possibility that other people have already thought about the idea, and if they chose not to take advantage of it, that’s a hint that you might be missing something. In that case, the first thing to do is backtrack to the first three economists’ questions: Have you misjudged people’s wants and constraints? Have you miscalculated the trade-offs they face? Have you misunderstood how people will respond to incentives? If you think back through those questions and still think you’re on to something, here are some more possibilities to consider. We said that under normal circumstances, the economy is operating efficiently and individuals or firms provide the things people want. What are some ways in which circumstances might not be normal? Innovation: Innovation is the explanation you’re hoping is correct. Maybe your idea has not been used yet because it is too new. If you have come up with a truly new idea, whether it is new technology or a new business model, people cannot have taken advantage of it yet because it didn’t exist before. Market failure: Market failures are an important cause of inefficiency. Sometimes people and firms fail to take advantage of opportunities because something prevents them from capturing the benefits of the opportunity or imposes additional costs on them. For instance, maybe your great new idea won’t work because it would be impossible to prevent others from quickly copying it. Or perhaps your great new idea won’t work because a few big companies already have the market for it sewn up. Economists call such situations market failures. We will discuss market failures in much greater depth later in the text. Intervention: If a powerful force—often the government—intervenes in the economy, transactions cannot take place the way they normally would. We’ll see later in the text that many government economic policies intentionally or unintentionally interfere with people’s ability to take advantage of profitmaking opportunities. Unprofitable idea: Maybe your idea won’t produce a profit. Individuals and governments have goals other than profit, of course—for example, creating great art or promoting social justice. But if your idea doesn’t also generate a profit, then it is less surprising that no one has taken advantage of it. When Muhammad Yunus asked himself the question, “Why isn’t someone already lending to the poor?” he first identified a market failure Page 12 involving lack of collateral. Understanding the market-failure problem enabled him to come up with the idea of group responsibility to fix it. But then he had to ask himself, “Why aren’t other banks already using the group responsibility idea?” Maybe there was another market failure Yunus hadn’t spotted. Maybe some government policy prevented it. Maybe traditional banks had considered it and decided it still wouldn’t generate a profit. Yunus wasn’t primarily interested in making a profit, of course—he was interested in helping the poor. But if microloans weren’t going to earn a profit for the banks even with group responsibility, then that would explain why no one was already doing it. Fortunately, none of those answers were correct. This was a case in which the answer to why isn’t someone already doing it? was that the idea was genuinely new. Grameen Bank was able to help very poor people in Bangladesh by lending them money, while making enough profit to expand and serve more customers. Today, over 20 million people in Bangladesh can get small loans from Grameen Bank and other organizations. Around the world, over 200 million low-income customers enjoy the same opportunity. Sometimes, something that seems like a great new idea really is exactly that.
TEST YOURSELF In every chapter of this book you will find a few Test Yourself quizzes. These questions test your understanding of the concepts presented in the preceding section. If you have trouble answering any of the questions, go back and review the section. Don’t move forward until you understand these ideas. How do constraints affect decision making? [
What do opportunity costs represent? [
LO 1.1]
LO 1.2]
What is the name for something that changes the trade-offs that people face when making a decision? [ Give four reasons that might explain why a product isn’t already in the market. [
LO 1.3]
LO 1.4]
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Get complete eBook Order by email at [email protected] An Economist’s Problem-Solving Toolbox The four questions we’ve just discussed are some of the fundamental insights of economics. Using them to understand how the world might work is only half the battle. Understanding when and how to apply them is the other half. In this second part of this chapter, we will describe some tools economists use to apply these insights to real situations. Accurately spotting the fundamental economic concepts at work in the world is sometimes less obvious than you might think. Throughout history, people have observed the world around them and drawn conclusions that have proved hilariously—or sometimes tragically—wrong. We now know that the sun doesn’t revolve around the earth. Droughts are not caused by witches giving people the evil eye. Yet, intelligent people once believed these things. It’s human nature to draw meaning from the patterns we observe around us, but our conclusions are not always correct. Economic analysis requires us to combine theory with observations and to subject both to tough scrutiny before drawing conclusions. In this section we will see how to put together theories and facts to determine what causes what. We will also distinguish between the way things are and the way we think they should be. You can apply these tools to all sorts of situations, from personal life choices to business decisions and policy analysis. Page 13
Correlation and causation LO 1.5 Distinguish between correlation and causation. A die-hard sports fan may wear a particular jersey while watching his or her team win the NBA finals or Super Bowl, and then forever insist that jersey is lucky. This is an exaggerated example of a common human tendency: When we see that two events occur together, we tend to assume that one causes the other. Economists, however, try to be particularly careful about what causes what. To differentiate between two variables that move together and two variables that have a cause-and-effect relationship, we use two different terms. For the instance in which two variables have a consistent relationship, we say there is a correlation between them. Correlation can be positive or negative:
If both variables tend to move in the same direction, we say they are positively correlated. For example, wearing raincoats is positively correlated with rain. When two variables move in opposite directions, we say they are negatively correlated. High temperatures are negatively correlated with people wearing down jackets. If there is no consistent relationship between two variables, we say they are uncorrelated. Correlation differs from causation. Causation means that one variable causes the other. As the preceding examples show, causation and correlation often go together. Weather and clothing are often correlated because weather causes people to make certain choices about the clothing they wear. Figure 1-1 humorously shows. Correlation and causation can be Correlation and causation do not always go together in a straightforward way, as confused in three major ways: coincidence, omitted variables, and reverse causation. FIGURE 1-1 Total revenue generated by bowling alleys correlates with per capita consumption of sour cream The graph shows the relationship between X and Y. Obviously, there’s no connection between X and Y, but if you took these data at face value, you might think otherwise.
Source: www.tylervigen.com/view_correlation?id=28797
Coincidence Does the result of the Super Bowl predict the performance of the stock market? A few years ago, some people thought it might. The Super Bowl pits the top team from the American Football Conference against the top team from the National Football Conference. For a long time, when a team from the AFC won, the stock market had a bad year; when a team from the NFC won, the stock market had a great year. In fact, this pattern held true nearly 80 percent of the time between 1967 and 2017. Would it have been a good idea to base your investment strategy on the results of the Super Bowl? We think not. There is no plausible cause-and-effect relationship here. Stock market outcomes happened to be correlated with Super Bowl outcomes for a number of years, but there is no logical way they could be
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caused by them. If you search long enough for odd coincidences, you will eventually find some.
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Omitted variables Consider the following statement: There is a positive correlation between the presence of firefighters and people with serious burn injuries. Does this statement mean that firefighters cause burn injuries? Of course not. We know that firefighters are not burning people; they’re trying to save them. Instead, there must be some common underlying variable behind both observed outcomes—fires, in this case. Sometimes, two events that are correlated occur together because both are caused by the same underlying factor. Each has a causal relationship with a third factor, but not with each other. The underlying factor is called an omitted variable—despite the fact that it is an important part of the cause-and-effect story, it has been left out of the analysis. The From Another Angle box “ Does ice cream cause polio?” tells the story of an omitted variable that convinced some doctors to mistakenly campaign against a staple of summer fun: ice cream.
From Another Angle Does ice cream cause polio? From Another Angle boxes show you a completely different way of looking at an economic concept. We find that a little bit of weirdness goes a long way in helping us to remember things. Polio is a disease that once crippled or killed thousands of children in the United States every year. Before the cause of polio was known, doctors noticed that polio infections seemed to be more common in children who had been eating lots of ice cream. Observing this correlation led some people to assume that there was a causal relationship between the two. Some doctors recommended that kids stop eating ice cream, and many fearful parents understandably took their advice. We now know that ice cream is safe. Polio is caused by a virus that spreads from one person to another. The virus is transmitted through contaminated food and water—for example, dirty swimming pools or water fountains. It has nothing to do with ice cream. The ice cream confusion was caused by an omitted variable: warm weather. In warm weather, children are more likely to use swimming pools and water fountains. And in warm weather, children are also more likely to eat ice cream. Polio was therefore correlated with eating ice cream, but it certainly wasn’t caused by it. Happily, in 1952 a scientist named Jonas Salk developed a vaccine that made polio a rare disease. One unintended benefit was that doctors, and parents, stopped telling kids to stay away from ice cream. Source: Steve Lohr, “For Today’s Graduate, Just One Word: Statistics,” New York Times, August 5, 2009.
Reverse causation A third common source of confusion between correlation and causation is reverse causation: Did A cause B, or did B cause A? When two events always happen together, it can be hard to say which caused the other. Let’s return to the correlation between rain and raincoats. If we knew nothing about rain, we might observe that it often appears together with raincoats; we might conclude that wearing a raincoat (A) causes rain (B). In this case, we all know that the causation goes the other way, but observation alone does not tell us that. Looking at the timing of two correlated events can sometimes provide clues. Often, if A happens before B, it hints that A causes B rather than vice versa. But grabbing a raincoat as you leave home in the morning frequently happens before it rains in the afternoon. The timing notwithstanding, taking your raincoat with you in the morning clearly does not cause rain later in the day. In this case, your anticipation of B causes A to happen. Page 15 An important lesson for economists and noneconomists alike is never to take observations at face value. Always make sure you can explain why two events are related. To do so, you need another tool in the economist’s toolbox: a model.
Models LO 1.6 List the characteristics of a good economic model. A model is a simplified representation of a complicated situation. In economics, models show how people, firms, and governments make decisions about managing resources and how their decisions interact. An economic model can represent a situation as basic as how people decide what car to buy or as complex as what causes a global recession. Because models simplify complex problems, they allow us to focus our attention on the most important parts. Models rarely include every detail of a given situation, but that is a good thing. If we had to describe the entire world with perfect accuracy before solving a problem, we’d be so overwhelmed with details that we’d never get the answer. By carefully simplifying the situation to its essentials, we can get useful answers that are approximately right. One of the most basic models of the economy is the circular flow model. The economy involves billions of transactions every day, and the circular flow Figure 1-2 shows the model helps show how all of those transactions work together. The model slashes through complexity to show important patterns. circular flow of economic transactions in a graphic format called the circular flow diagram. FIGURE 1-2 Circular flow diagram
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The first simplification of the circular flow model is to narrow our focus to the two most important types of actors in the economy, households and firms: Households are vital in two ways. First, they supply land and labor to firms and invest capital in firms. (Land, labor, and capital are called the factors of production.) Second, they buy the goods and services that firms produce. Firms too are vital but do the opposite of households: They buy or rent the land, labor, and capital supplied by households, and they produce and sell goods and services. The circular flow model shows that firms and households are tightly connected through both production and consumption.
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In another helpful simplification, the circular flow model narrows the focus to two markets that connect households and firms: The market for goods and services is exactly what it sounds: It reflects all of the activity involved in the buying and selling of goods and services. In this market, households spend their wages from labor and their income from land and capital, and firms earn revenue from selling their goods and services. The second market is the market for the factors of production. Here, households supply land, labor, and capital, and firms hire and purchase or rent these inputs. The model puts all of this together. The transactions we have described are part of two loops: One is a loop of inputs and outputs as they travel throughout the economy. The inputs are the land, labor, and capital firms use to produce goods. The outputs are the goods and services that firms produce using the factors of production. Another loop represents the flow of dollars. Households buy goods and services using the money they get from firms for using their factors of production. Firms get revenues from selling these goods and services—and, in turn, firms can then use the money to buy or rent factors of production. You might be a little dizzy at this point, with everything spinning in loops. To help straighten things out, let’s follow $5 from your wallet as it flows through the economy. You could spend this $5 in any number of ways. As you’re walking down the street, you see a box of donuts sitting in the window of your local bakery. You head in and give the baker your $5, a transaction in the market for goods. The money represents revenue for the baker and spending by you. The donuts are an output of the bakery. The story of your $5 is not over, though. In order to make more donuts, the baker puts that $5 toward buying inputs in the market for the factors of production. This might include paying rent for the bakery or paying wages for an assistant. The baker’s spending represents income for the households that provide the labor in the bakery or rent out the space. Once the baker pays wages or rent with that $5, it has made it through a cycle in the circular flow. As the circular flow model shows, an economic model approximates what happens in the real economy. Later in the text, we’ll discuss other models that focus on specific questions—like how much gasoline prices will go up when the government raises taxes or how fast the economy is likely to grow in the next decade. The best models lead us to clearer answers about complicated questions. What makes a good economic model? We have already said that good models can leave out details that are not crucial, and they focus on the important aspects of a situation. To be useful, a model should also do three things: 1.
A good model predicts cause and effect. The circular flow model gives a useful description of the basics of the economy. Often, though, we want to go further. Many times we want a model not only to describe economic connections but also to predict how things will happen in the future. To do that, we have to get cause and effect right. If your model says that A causes B, you should be able to explain why. In the “ Markets” chapter we’ll learn about a central model in economics that shows that for most goods and services, the quantity people want to buy goes down as the price goes up. Why? As the cost of an item rises, but the benefit of owning it remains the same, more people will decide that the trade-off is not worth it.
2.
A good model states its assumptions clearly. Although models are usually too simple to fit the real world perfectly, it’s important that they be clear about their simplifying assumptions. Doing so helps us to know when the model will predict real events accurately and when it will not. For example, we said earlier that economists often assume that people behave rationally. We know that isn’t always true, but we accept it as an assumption because it is approximately accurate in many situations. As long as we are clear that we are making this assumption, we will know that the model may not be accurate when people fail to behave rationally. Page 17
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3.
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A good model describes the real world accurately. If a model does not describe what actually happens in the real world, something about the model is wrong. We’ve admitted that models are not perfectly accurate because they are intentionally simpler than the real world. But if a model predicts things that are not usually or approximately true, it is not useful. How do we tell if a model is realistic? Economists test their models by observing what happens in the real world and collecting data, which they use to verify or reject the model. In the Economics in Action box “ When education pays off,” take a look at a model that explains the returns that people experience when investing in a college education.
Economics in Action When education pays off Economics in Action boxes show how the concept you’re reading about relates to the real world. Often these boxes present interesting ideas or describe situations in which people used an economic idea to solve business or policy questions. Why go to college? Well, of course, you learn a lot of important things and can make amazing friends. Also—not to be too crass about it—a college diploma will generally lead to bigger paychecks. On average, completing college roughly doubles lifetime earnings compared to earnings without a degree. In fact, the earnings advantage from having more education has grown bigger over time. What drives those gains to education? To answer that question, Claudia Goldin and Lawrence Katz, economists at Harvard University, pieced together a century of data on wages in the United States. Two models helped them explain the patterns over time. The first model predicts that education boosts earnings because it allows workers to take advantage of technical innovations that increase productivity. The greater the pace of technical innovation, the bigger will be the wage gains from education. Goldin and Katz’s data showed a centurylong steady increase in technology (starting well before the latest mobile phones, office technologies, and self-driving cars), which helped sustain wage growth for educated workers. But Goldin and Katz argue that the story doesn’t end there. Their second model focuses on the number of people getting educated. The second model predicts that when opportunities created by new technology increase much faster than education rates, there’s more competition for educated workers. To attract workers, firms offer higher wages, and wages grow even faster than predicted by the education rate alone. So, why are the gains to education continuing at a high rate, and even growing over time? It turns out that college completion rates have been slowing in the United States in recent decades. Students are starting school, but many are leaving before getting degrees. Overall, nearly a third of students who started college in 2011 had not finished or were no longer enrolled six years later. One consequence is a bigger relative gain for those who ultimately do get diplomas—and a wider gap in earnings between those who finish college and those who don’t. Sources: Brad Hershbein and Melissa Kearney, “Major Decisions: What Graduates Earn Over Their Lifetimes,” Hamilton Project, September 2014; Claudia Goldin and Lawrence F. Katz, “The Future of Inequality: The Other Reason Education Matters So Much,” Milken Institute Review, Third Quarter, 2009.
Positive and normative analysis LO 1.7 Distinguish between positive and normative analysis. Economics is a field of study in which people frequently confuse facts with judgments that are based on beliefs. Think about the following example:
Statement #1: Income taxes reduce the number of hours that people want to work. Statement #2: Income taxes should be reduced or abolished. Many people have trouble separating these two statements. Some feel that the second statement flows logically from the first. Others disagree Page 18 with the second statement, so they assume the first can’t possibly be true. If you read carefully, however, you’ll see that the first sentence is a statement about cause and effect. Thus, it can be proved true or false by data and evidence. A statement that makes a factual claim about how the world actually works is called a positive statement. The second sentence, on the other hand, cannot be proved true or false. Instead, it indicates what should be done—but only if we share certain goals, understandings, and moral beliefs. A statement that makes a claim about how the world should be is called a normative statement. To see how important the distinction between positive and normative statements can be, consider two claims that a physicist might make:
Positive statement: A nuclear weapon with the explosive power of 10 kilotons of TNT will have a fallout radius of up to six miles. Normative statement: The United States was right to use nuclear weapons in World War II.
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A famous quote makes this point nicely: “Everyone has a right to their own opinion, but not to their own facts.” If you search the internet for this quote, you’ll see that it has been attributed to many people.
Source: Karen Glasbergen, used with permission.
Although people could disagree about both of these statements, the first is a question of scientific fact; the second depends heavily on a person’s ethical and political beliefs. The first statement may inform your opinion of the second, but you can still agree with one and not the other. Earlier in this chapter, we introduced a feature called “What Do You Think?” that asks for your opinion about an important policy or life decision. From this point forward, you can use your understanding of the differences between normative and positive analysis to untangle the questions asked in these boxes and combine the two kinds of analysis to arrive at a conclusion. Begin trying your hand at this with the What Do You Think? box “ The cost of college cash.”
What Do You Think? The cost of college cash In 2014−2015, the average yearly cost of a college education ranged from $16,188 at public universities to $37,424 at private universities. Students have a number of options for paying the bill. They can take out federal loans, private loans, or a combination of the two to defer payments until later, or they can use savings or earnings to foot the bill. Students who qualify for federal loans enjoy benefits such as limits on the interest rate they can be charged or the total payments they can be expected to make. They also have the possibility of loan forgiveness if they enter certain fields after graduation. Lending to students is a controversial topic. Some people argue for more controls on private lending institutions, such as interest-rate caps and greater protection for students who default. They reason that lending programs should support students who would not otherwise be able to afford college. Furthermore, they argue, graduating with a lot of debt discourages students from going into lower-paid public service jobs. Other people maintain that the existing lending system is fine. Getting a college degree, they argue, increases a person’s future earning power so much that graduates should be able to handle the debt, even at high interest rates. They worry that overregulation will discourage private lenders from offering student loans, defeating the purpose of giving students better access to financial assistance.
WHAT DO YOU THINK? Use the four basic questions economists ask to break down the problem. Remember that your answer can draw on both positive analysis (what will happen if a certain policy is followed) and normative analysis (what should be done, given your values and goals). You should be able to say which parts of your answers fall into each category. 1.
What motivations and constraints apply to students who are considering different schools and loan options? What motivations and constraints apply to private lenders?
2.
What opportunity costs do students face when deciding how to pay for college? Should they avoid loans by skipping college altogether or by working their way through college?
3.
How would prospective students respond to government limits on the interest rate on student loans? How would private banks that offer student loans respond?
4.
Why do you think the federal government has not yet implemented interest-rate caps on private student loans? Do you anticipate any unintended side-effects of that policy?
5.
Consider your arguments in response to questions 1 through 4. Which parts were based on normative statements and which on positive statements?
Sources: “Trends in college pricing,” National Center for Education Statistics, http://nces.ed.gov/fastfacts/display.asp?id=76; “How much student debt is too much?” http://roomfo rdebate.blogs.nytimes.com/2009/06/14/how-much-student-debt-is-too-much/?scp=1&sq=student%20loans&st=cse.
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Throughout this text, remember that you don’t have to buy into a particular moral or political outlook in order for economics to be useful to you. Our goal is to provide you with a toolbox of economic concepts that you can use to engage in positive analysis. We will also highlight important decisions you may face that will require you to engage in normative thinking, informed by economic analysis. You will find that economics can help you to make better decisions and identify the most effective policies, regardless of your goals and beliefs. Page 19
TEST YOURSELF What does it mean when two variables are positively correlated? [
What are the characteristics of a good economic model? [
LO 1.5]
LO 1.6]
What is the difference between a positive statement and a normative statement? [
LO 1.7]
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Get complete eBook Order by email at [email protected] Conclusion Economists approach problems differently from many other people. A basic principle of human behavior underlies economics—the idea that people typically make choices to achieve their goals in the most effective way possible, subject to the constraints they face. In this chapter we have introduced the basic concepts economists use, as well as four questions they ask to break down problems. Throughout this book, you will see these concepts and questions over and over again: 1.
Scarcity: What are the wants and constraints of those involved?
2.
Opportunity cost: What are the trade-offs?
3.
Incentives: How will others respond?
4.
Efficiency: Are resources being allocated in the best way possible?
In later chapters, as we progress to more complicated problems, try using these four questions to break down problems into manageable pieces. Then you can tackle those smaller pieces using the four fundamental concepts presented in this chapter.
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Page 21
1.
Suppose you are shopping for new clothes to wear to job interviews, but you’re on a tight budget. In this situation, what are your wants and constraints? What does it mean to behave rationally in the face of scarcity? [ LO 1.1]
2.
You are a student with a demanding schedule of classes. You also work part time and your supervisor allows you to determine your schedule. In this situation, what is your scarce resource? How do you decide how many hours to work? [ LO 1.1]
3. 4.
Think about the definition of scarcity that you learned in this chapter. Name three ways that you confront scarcity in your own life. [
LO 1.1]
When shopping for your interview clothes, what are some trade-offs you face? What is the opportunity cost of buying new clothes? What are the benefits? How do you balance the two? [ LO 1.2]
5.
You have an 8:30 class this morning, but you are feeling extremely tired. How do you decide whether to get some extra sleep or go to class? [
LO 1.2]
6.
It’s Friday night. You already have a ticket to a concert, which cost you $30. A friend invites you to go out for a game of paintball instead. Admission would cost you $25, and you think you’d get $25 worth of enjoyment out of it. Your concert ticket is nonrefundable. What is your opportunity cost (in dollars) of playing paintball? [ LO 1.2]
7.
Suppose you have two job offers and are considering the trade-offs between them. Job A pays $45,000 per year; it includes health insurance and two weeks of paid vacation. Job B pays $30,000 per year; it includes four weeks of paid vacation but no health insurance. [ LO 1.2] a. List the benefits of Job A and the benefits of Job B. b.
8.
9.
List the opportunity cost of Job A and the opportunity cost of Job B.
Your former neighbors gave you their lawnmower when they moved. You are thinking of using this gift to mow lawns in your neighborhood this summer for extra cash. As you think about what to charge your neighbors and whether this idea is worth your effort, what opportunity costs do you need to consider? [ LO 1.2] Think of a few examples of incentives in your daily life. How do you respond to those incentives? [
LO 1.3]
10.
You supervise a team of salespeople. Your employees already receive a company discount. Suggest a positive incentive and a negative incentive you could use to improve their productivity. [ LO 1.3]
11.
Your boss decides to pair workers in teams and offer bonuses to the most productive team. Why might your boss offer team bonuses instead of individual bonuses? [ LO 1.3]
12.
Think of a public policy—a local or national law, tax, or public service—that offers an incentive for a particular behavior. Explain what the incentive is, who is offering it, and what they are trying to encourage or discourage. Does the incentive work? [ LO 1.3]
13. 14.
Why do individuals or firms usually provide the goods and services people want? [
LO 1.4]
You may have seen TV advertisements for products or programs that claim to teach a sure-fire way to make millions on the stock market. Apply the Why isn’t someone already doing it? test to this situation. Do you believe the ads? Why or why not? [ LO 1.4]
15.
Describe an innovation in technology, business, or culture that had a major economic impact in your lifetime. [
16.
Why do people confuse correlation with causation? [
17.
Name two things that are positively correlated and two things that are negatively correlated. [
18.
Why is it important for a good economic model to predict cause and effect? [
LO 1.6]
19.
Why is it important for a good economic model to make clear assumptions? [
LO 1.6]
20.
What is the difference between disagreeing about a positive statement and disagreeing about a normative statement? [
21.
Would a good economic model be more likely to address a positive statement or a normative statement? Why? [
22.
Write a positive statement and a normative statement about your favorite hobby. [
LO 1.4]
LO 1.5] LO 1.5]
LO 1.7]
LO 1.7]
LO 1.7]
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Get complete eBook Order by email at [email protected] Problems and Applications 1.
Think about how and why goods and resources are scarce. Goods and resources can be scarce for reasons that are inherent to their nature at all times, that are temporary or seasonal, or that are artificially created. Separate the goods listed below into two groups; indicate which (if any) are artificially scarce (AS) and which (if any) are inherently scarce (IS). [ LO 1.1] a. Air of any quality ______
b.
2.
Land ______
c.
Patented goods ______
d.
Original Picasso paintings ______
You are looking for a new apartment in Manhattan. Your income is $4,000 per month, and you know that you should not spend more than Table 1P-1. You are indifferent 25 percent of your income on rent. You have come across the listings for one-bedroom apartments shown in about location, and transportation costs are the same to each neighborhood. [ LO 1.1]
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TABLE 1P-1 Location
Monthly Rent
Chelsea
$1,200
Battery Park
a. b. 3.
2,200
Delancey
950
Midtown
1,500
Which apartments fall within your budget? Suppose that you adhere to the 25 percent guideline but also receive a $1,000 cost-of-living supplement because you are living and working in Manhattan. Which apartments fall within your budget now?
Table 1P-2. He gets the most benefit from Suppose the price of a sweater is $26. Jaylen’s benefit from purchasing each additional sweater is given in the first sweater and less benefit from each additional sweater. If Jaylen is behaving rationally, how many sweaters will he purchase? [ LO 1.2]
TABLE 1P-2 Marginal benefit ($)
4.
1st sweater
60
2nd sweater
45
3rd sweater
40
4th sweater
33
5th sweater
22
6th sweater
18
Sweaters sell for $15 at the crafts fair. Allie knits sweaters; her marginal costs are given in sweater. If Allie is behaving rationally, how many sweaters will she sell? [ LO 1.2]
Table 1P-3. Allie’s costs increase with each additional
TABLE 1P-3 Marginal cost ($) 1st sweater
5
2nd sweater
8
3rd sweater
12
4th sweater
18
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Get complete eBook Order by email [email protected] Marginal ($)
5.
25
6th sweater
32
Last year, you estimated you would earn $5 million in sales revenues from developing a new product. So far, you have spent $3 million developing the product, but it is not yet complete. Meanwhile, this year you have new sales projections that show expected revenues from the new product will actually be only $4 million. How much should you be willing to spend to complete the product development? [ LO 1.2] a.
$0.
b.
Up to $1 million.
c.
Up to $4 million.
d.
Whatever it takes.
6.
7.
5th sweater
Consider the following examples. For each one, say whether the incentive is positive or negative. [ a.
Bosses who offer time-and-a-half for working on national holidays.
b.
Mandatory minimum sentencing for drug offenses.
c.
Fines for littering.
d.
Parents who offer their children extra allowance money for good grades.
Consider the events that change prices as described in increases or decreases. [ LO 1.3]
LO 1.3]
Table 1P-4. For each one, say whether the opportunity cost of consuming the affected good
TABLE 1P-4 Affected good Movie tickets
a.
A local movie theater offers a student discount.
b.
A tax on soft drinks passes in your state.
c.
Subsidies on corn are cut in half.
d.
Your student health center begins offering flu shots for free.
Soft drinks Corn subsidies Flu shots
8.
Your best friend has an idea for a drive-through bar. Indicate the best explanation for why others have not taken advantage of her idea: true innovation, market failure, government intervention, or unprofitability. [ LO 1.4]
9.
Your best friend has an idea for a long-distance car service to drive people across the country. Indicate the best explanation for why others have not taken advantage of her idea: true innovation, market failure, intervention, or unprofitability. [ LO 1.4]
10.
Determine whether each of the following questionable statements is best explained by coincidence, an omitted variable, or reverse causation. [ LO 1.5] a.
In cities that have more police, crime rates are higher.
b.
Many retired people live in states where everyone uses air conditioning during the summer.
c.
More people come down with the flu during the Winter Olympics than during the Summer Olympics.
d.
For the last five years, Punxsutawney Phil has seen his shadow on Groundhog Day, and spring has come late.
11. a. b.
12.
For each of the pairs below, determine whether they are positively correlated, negatively correlated, or uncorrelated. [ Time spent studying and test scores.
LO 1.5]
Vaccination and illness.
c.
Soft drink preference and music preference.
d.
Income and education.
Each statement below is part of an economic model. Indicate whether the statement is a prediction of cause and effect or an assumption. [ a. People behave rationally. b.
If the price of a good falls, people will consume more of that good.
c.
Mass starvation will occur as population outgrows the food supply.
d.
Firms want to maximize profits.
13. a.
Page 23
From the list below, select the characteristics that describe a good economic model. [ Includes every detail of a given situation.
LO 1.6]
LO 1.6]
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b. Predicts that A causes B. Get complete eBook Order by email at [email protected] c. Makes approximately accurate assumptions.
14.
d.
Fits the real world perfectly.
e.
Predicts things that are usually true.
Determine whether each of the following statements is positive or normative. (Remember that a positive statement isn’t necessarily correct; it just makes a factual claim rather than a moral judgment.) [ LO 1.7] a. People who pay their bills on time are less likely than others to get into debt.
b.
15.
Hard work is a virtue.
c.
Everyone should pay his or her bills on time.
d.
China has a bigger population than any other country in the world.
e.
China’s One-Child Policy (which limits families to one child each) helped to spur the country’s rapid economic growth.
f.
Lower taxes are good for the country.
You just received your midterm exam results and your professor wrote the following note: “You received a 70 on this exam, the average score. If you want to improve your grade, you should study more.” Evaluate your professor’s note. [ LO 1.7] a. Is the first sentence positive or normative? b.
Is the second sentence positive or normative?
Page 24
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