economics stiglitz
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J. StiglitzTRANSCRIPT
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ECONOMICSF O U R T H E D I T I O N
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Joseph E. StiglitzC O L U M B I A U N I V E R S I T Y
Carl E.WalshU N I V E R S I T Y O F C A L I F O R N I A , S A N TA C R U Z
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ECONOMICSF O U R T H E D I T I O NB
W. W. NORTON & COMPANYNEW YORK LONDON
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BCopyright 2006, 2002, 1997, 1993 by W. W. Norton & Company, Inc.
All rights reserved
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Library of Congress Cataloging-in Publication Data
Stiglitz, Joseph E.
Economics / Joseph E. Stiglitz, Carl E. Walsh.4th ed.
p. cm.
Includes index.
ISBN 0-393-92622-2
1. Economics. I. Walsh, Carl E. II. Title
HB171.5.S884 2005
330dc22
2005055518
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ABOUT THE AUTHORS
Joseph E. Stiglitz is professor of economics, business, and international andpublic affairs at Columbia University. Before joining the Columbia faculty, he heldappointments at Yale, Oxford, Princeton, and Stanford. Internationally recognizedas one of the leading economists of his generation, Professor Stiglitz has made impor-tant contributions to virtually all of the major subfields of economics, in particularthe economics of information, one of the key topics highlighted in this text. He wasa co-recipient of the Nobel Prize in Economic Science in 2001, and earlier in hiscareer received the American Economic Associations John Bates Clark Medal,which is given every two years to the most outstanding economist under the age offorty. Professor Stiglitz is the author and editor of hundreds of scholarly articlesand books, including the best-selling undergraduate textbook Economics of the PublicSector (Norton) and, with Anthony Atkinson, the classic graduate textbook Lecturesin Public Economics. He is the author of two influential popular books as well:Globalization and Its Discontents and The Roaring Nineties. In addition, he was thefounding editor of the Journal of Economic Perspectives. Professor Stiglitz has alsoplayed a prominent role at the highest levels of economic policy making. He was amember and chairman of President Clintons Council of Economic Advisers andlater served as Senior Vice President and Chief Economist of the World Bank.
Carl E.Walsh is professor of economics at the University of California, SantaCruz, where he teaches principles of economics. He previously held faculty appoint-ments at Princeton and the University of Auckland, New Zealand, and has been a vis-iting professor at Stanford. He is widely known for his research in monetary economicsand is the author of a leading graduate text, Monetary Theory and Policy (MIT Press).Before joining the Santa Cruz faculty, Professor Walsh was senior economist at theFederal Reserve Bank of San Francisco, where he continues to serve as a visitingscholar. He has also been a visiting scholar at the Federal Reserve Banks of KansasCity, Philadelphia, and at the Board of Governors. He has taught courses in mone-tary economics to the research department and staff economists at the central banksof Hong Kong, Norway, Portugal, Spain, and the United Kingdom, and at theInternational Monetary Fund. He is a past member of the board of editors of theAmerican Economic Review and is currently an associate editor of the Journal ofMoney, Credit, and Banking and the Journal of Economics and Business. He is also onthe editorial board of the Journal of Macroeconomics.
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CONTENTS IN BRIEF
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PART 1 INTRODUCTION 1Chapter 1 Modern Economics 3Chapter 2 Thinking Like an Economist 25
PART 2 PERFECT MARKETS 51Chapter 3 Demand, Supply, and Price 53Chapter 4 Using Demand and Supply 77Chapter 5 The Consumption Decision 101Chapter 6 The Firms Costs 131Chapter 7 The Competitive Firm 155Chapter 8 Labor Markets 175Chapter 9 Capital Markets 191Chapter 10 The Efficiency of Competitive Markets 215
PART 3 IMPERFECT MARKETS 237Chapter 11 Introduction to Imperfect Markets 239Chapter 12 Monopoly, Monopolistic Competition, and Oligopoly 261Chapter 13 Government Policies Toward Competition 289Chapter 14 Strategic Behavior 311Chapter 15 Imperfect Information in the Product Market 333Chapter 16 Imperfections in the Labor Market 355
PART 4 ISSUES IN PUBLIC POLICY 373Chapter 17 The Public Sector 375Chapter 18 Environmental Economics 405Chapter 19 International Trade and Trade Policy 423Chapter 20 Technological Change 453
PART 5 INTRODUCTION TO MACROECONOMICS 471Chapter 21 Macroeconomics and the Economic Perspective 473Chapter 22 Measuring Output and Unemployment 485Chapter 23 The Cost of Living and Inflation 509
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PART 6 FULL-EMPLOYMENT MACROECONOMICS 523Chapter 24 The Full-Employment Model 525Chapter 25 Government Finance at Full Employment 547Chapter 26 The Open Economy at Full Employment 567Chapter 27 Growth and Productivity 585Chapter 28 Money, the Price Level, and the Federal Reserve 605
PART 7 MACROECONOMIC FLUCTUATIONS 635Chapter 29 Introduction to Macroeconomic Fluctuations 637Chapter 30 Aggregate Expenditures and Income 661Chapter 31 Aggregate Demand and Inflation 689Chapter 32 The Federal Reserve and Interest Rates 715Chapter 33 The Role of Macroeconomic Policy 727
PART 8 THE GLOBAL ECONOMY 755Chapter 34 The International Financial System 757Chapter 35 Policy in the Open Economy 779Chapter 36 Development and Transition 793
PART 9 FURTHER TOPICS IN MACROECONOMICS 817Chapter 37 Inflation and Unemployment 819Chapter 38 Controversies in Macroeconomic Policy 837Chapter 39 A Students Guide to Investing 865
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CONTENTS ix
CONTENTS
PREFACE XXXV
PART 1 INTRODUCTION 1
CHAPTER 1 MODERN ECONOMICS 3INTERNET CONNECTION: Tracking the Digital
Economy 6
What Is Economics? 6
Trade-offs 7
Incentives 8
THINKING LIKE AN ECONOMIST: Incentives and
the Price of AOL 9
Exchange 10
INTERNET CONNECTION: Auction Sites 11
Information 13
Distribution 14
The Three Major Markets 15
Keeping Track of Tricky Terms 16
Microeconomics and Macroeconomics: The Two
Branches of Economics 17
The Science of Economics 18
Discovering and Interpreting Relationships 18
Causation and Correlation 19
Why Economists Disagree 19
REVIEW AND PRACTICE 21
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CHAPTER 2 THINKING LIKE AN ECONOMIST 25The Basic Competitive Model 25
Rational Consumers and Profit-Maximizing Firms 26
Competitive Markets 27
e-INSIGHT: Markets, Exchange, and e-Commerce 27
Efficiency and Distribution in the Basic Competitive
Model 28
The Basic Competitive Model as a Benchmark 28
Incentives and Information: Prices, Property Rights, and
Profits 29
Incentives Versus Equality 31
When Property Rights Fail 31
Alternatives to the Price System 32
Opportunity Sets and Trade-Offs 34
Budget and Time Constraints 34
The Production Possibilities Curve 35
Costs 37
Opportunity Costs 38
THINKING LIKE AN ECONOMIST: Trade-Offs 39
INTERNET CONNECTION: Internet Resources for
Economists 40
CASE IN POINT: The Opportunity Cost of Attending
College 40
Sunk Costs 42
Marginal Costs 43
INTERNET CONNECTION: The Economists Voice
43
REVIEW AND PRACTICE 45
APPENDIX: Reading Graphs 47
Slope 48
Interpreting Curves 49
PART 2 PERFECT MARKETS 51
CHAPTER 3 DEMAND, SUPPLY, AND PRICE 53The Role of Prices 53
Demand 54
The Individual Demand Curve 54
The Market Demand Curve 55
Shifts in Demand Curves 57
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Sources of Shifts in Demand Curves 57
CASE IN POINT: Gasoline Prices and the Demand for
SUVs 59
Shifts in a Demand Curve Versus Movements along a
Demand Curve 60
FUNDAMENTALS OF DEMAND, SUPPLY, AND
PRICE 1: Demand Declines as Price Rises 61
Supply 61
e-INSIGHT: The Demand for Computers and
Information Technology 62
Market Supply 64
Shifts in Supply Curves 65
Sources of Shifts in Supply Curves 65
Shifts in a Supply Curve Versus Movements along a
Supply Curve 67
FUNDAMENTALS OF DEMAND, SUPPLY, AND
PRICE 2: Supply Increases as Price Rises 67
Law of Supply and Demand 67
Using Demand and Supply Curves 69
Consensus on the Determination of Prices 70
FUNDAMENTALS OF DEMAND, SUPPLY, AND
PRICE 3: The Market Clears at the Equilibrium
Price 71
Price, Value, and Cost 70
INTERNET CONNECTION: The Demand and Supply
in the Oil Market 71
REVIEW AND PRACTICE 72
CHAPTER 4 USING DEMAND AND SUPPLY 77The Price Elasticity of Demand 77
Price Elasticity and Revenues 79
The Determinants of the Elasticity of Demand 80
The Price Elasticity of Supply 82
INTERNATIONAL PERSPECTIVE: Comparing
Reactions to the Oil Price Shock of 2000 83
Using Demand and Supply Elasticities 85
Shortages and Surpluses 88
Interfering with the Law of Supply and Demand 90
THINKING LIKE AN ECONOMIST: Incentives and
the Window Tax 90
Price Ceilings 91
CASE IN POINT: Rent Control in New York City 93
CONTENTS xi
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Price Floors 93
INTERNET CONNECTION: Flawed Deregulation 94
Alternative Solutions 94
REVIEW AND PRACTICE 96
APPENDIX: Elasticity and Slope 98
CHAPTER 5 THE CONSUMPTION DECISION 101The Basic Problem of Consumer Choice 101
The Budget Constraint 102
Choosing a Point on the Budget Constraint: Individual
Preferences 104
What Happens to Consumption When Income Changes?
105
CASE IN POINT: The Fate of the BTU Tax 107
INTERNET CONNECTION: What We Consume 109
A Closer Look at the Demand Curve 109
Deriving Demand Curves 110
The Importance of Distinguishing Between Income and
Substitution Effects 111
THINKING LIKE AN ECONOMIST: Incentives,
Income Effects, and Substitution Effects 112
Utility and the Description of Preferences 113
Consumer Surplus 117
Looking Beyond the Basic Model 118
How Well Do the Underlying Assumptions Match Reality?
118
Behavioral Economics 119
REVIEW AND PRACTICE 122
APPENDIX: Indifference Curves and the Consumption
Decision 124
Using Indifference Curves to Illustrate Consumer Choices
124
Indifference Curves and Marginal Rates of Substitution
126
Using Indifference Curves to Illustrate Choices 127
Using Indifference Curves to Derive Demand Curves 128
Substitution and Income Effects 128
CHAPTER 6 THE FIRMS COSTS 131Profits, Costs, and Factors of Production 132
Production with One Variable Input 132
Types of Costs and Cost Curves 135
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Short-Run and Long-Run Cost Curves 141
Short-Run Cost Curves 142
Long-Run Cost Curves 142
INTERNET CONNECTION: Economic Definitions
146
Production with Many Factors 146
Cost Minimization 147
The Principle of Substitution 147
CASE IN POINT: The Principle of Substitution and
Global Warming 148
Economies of Scope 150
REVIEW AND PRACTICE 151
CHAPTER 7 THE COMPETITIVE FIRM 155Revenue 155
Costs 156
INTERNET CONNECTION: Firms Profit-and-Loss
Statements 157
Basic Conditions of Competitive Supply 158
Entry, Exit, and Market Supply 160
Sunk Costs and Exit 161
The Firms Supply Curve 162
The Market Supply Curve 163
Long-Run Versus Short-Run Supply 164
e-INSIGHT: The 2001 Recession: Cutbacks Versus
Shutdowns 165
Accounting Profits and Economic Profits 166
Opportunity Costs 166
Economic Rent 168
CASE IN POINT: Entering the Painting Business and
Opportunity Costs 169
The Theory of the Competitive Firm 171
REVIEW AND PRACTICE 172
CHAPTER 8 LABOR MARKETS 175The Labor Supply Decision 175
INTERNET CONNECTION: Labor Force Data 176
The Choice Between Leisure and Consumption 176
Labor Force Participation 179
THINKING LIKE AN ECONOMIST: Trade-Offs 179
Firms and the Demand for Labor 181
Factor Demand 182
CONTENTS xiii
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From the Firms Factor Demand to the Markets Factor
Demand 184
Labor Supply, Demand, and the Equilibrium Wage 184
REVIEW AND PRACTICE 186
APPENDIX: Indifference Curves and the Labor Supply
Decision 188
Deciding Whether to Work 188
CHAPTER 9 CAPITAL MARKETS 191Supply in the Capital Market 191
The Household Decision to Save 192
THINKING LIKE AN ECONOMIST: Wealth
Distribution and Interest Rates 197
INTERNET CONNECTION: Household Saving 198
CASE IN POINT: Why is the U.S. Saving Rate So Low?
198
Demand in the Capital Market 200
A Behavioral Perspective on Saving 202
Education and Human Capital 203
e-INSIGHT: Financing the New Economy 205
Education and Economic Trade-Offs 206
The Basic Competitive Model 206
REVIEW AND PRACTICE 207
APPENDIX A: Indifference Curves and the Saving
Decision 209
Deciding How Much to Save 209
Changing the Interest Rate 210
APPENDIX B: Calculating Present Discounted Value 211
CHAPTER 10 THE EFFICIENCY OF COMPETITIVEMARKETS 215Competitive Markets and Economic Efficiency 216
Consumer and Producer Surplus 217
FUNDAMENTALS OF COMPETITIVE MARKETS 1:
Households and Firms are Price Takers 218
FUNDAMENTALS OF COMPETITIVE MARKETS 2:
The Equilibrium Price Maximizes Consumer Plus
Producer Surplus 219
INTERNET CONNECTION: Digital Economist 219
Taxes and Efficiency 220
Efficiency 221
Pareto Efficiency 222
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Conditions for the Pareto Efficiency of the Market
Economy 222
THINKING LIKE AN ECONOMIST: Exchange and
Distribution 224
Competitive Markets and Pareto Efficiency 225
FUNDAMENTALS OF COMPETITIVE MARKETS 3:
The Competitive Market Economy is Pareto
Efficient 225
Competitive Markets and Income Distribution 225
General Equilibrium Analysis 227
The Basic Competitive Equilibrium Model 227
THINKING LIKE AN ECONOMIST: Indirect Trade-
Offs and Air Safety for Children 228
CASE IN POINT: The Labor Market and the Widening
Wage Gap 230
CASE IN POINT: The Minimum Wage and General
Equilibrium 231
General Equilibrium Over Time 232
When Partial Equilibrium Analysis Will Do 234
Looking Beyond the Basic Model 234
REVIEW AND PRACTICE 235
PART 3 IMPERFECT MARKETS 237
CHAPTER 11 INTRODUCTION TO IMPERFECTMARKETS 239Extending the Basic Competitive Model 240
FUNDAMENTALS OF IMPERFECT MARKETS 1:
Imperfect Markets Lead to Market Failures 242
Imperfect Competition and Market Structure 242
Price and Quantity with Imperfect Competition 244
Government Policies 245
INTERNET CONNECTION: The Federal Trade
Commission 245
INTERNATIONAL PERSPECTIVE: Trade and
Competition 246
FUNDAMENTALS OF IMPERFECT MARKETS 2:
Imperfect Competition 246
Imperfect Information 247
The Information Problem 247
How Big a Problem? 247
CONTENTS xv
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How Prices Convey Information 248
Markets for Information 249
e-INSIGHT: Information, Competition, and the Internet
249
Government Policies 250
FUNDAMENTALS OF IMPERFECT MARKETS 3:
Imperfect Information 251
Externalities 252
Government Policies Toward Externalities 252
THINKING LIKE AN ECONOMIST: Incentives and
the Environment 253
FUNDAMENTALS OF IMPERFECT MARKETS 4:
Externalities 254
Public Goods 254
FUNDAMENTALS OF IMPERFECT MARKETS 5:
Public Goods 255
Looking Ahead 256
REVIEW AND PRACTICE 257
CHAPTER 12 MONOPOLY, MONOPOLISTICCOMPETITION, AND OLIGOPOLY261Monopoly Output 261
An Example: The ABC-ment Company 264
Monopoly Profits 265
Price Discrimination 266
Economies of Scale and Natural Monopolies 267
INTERNATIONAL PERSPECTIVE: South Africa,
AIDS, and Price Discrimination 268
Assessing the Degree of Competition 270
Number of Firms in the Industry 270
Product Differentiation 271
e-INSIGHT: Network Externalities, the New Economy,
and Monopoly Power 272
Equilibrium with Monopolistic Competition 273
Oligopolies 274
Collusion 275
Restrictive Practices 279
Entry Deterrence 281
INTERNET CONNECTION: Keeping Track of
Oligopolies 281
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THINKING LIKE AN ECONOMIST: Trade-Offs,
American Airlines, and Predation 283
The Importance of Imperfections in Competition 284
REVIEW AND PRACTICE 285
CHAPTER 13 GOVERNMENT POLICIES TOWARDCOMPETITION 289The Drawbacks of Monopolies and Limited Competition
289
Restricted Output 289
Managerial Slack 291
Reduced Research and Development 291
Rent Seeking 292
Further Drawbacks of Limited Competition 292
e-INSIGHT: Using the Internet to Enhance Price
Discrimination 293
Policies Toward Natural Monopolies 293
Public Ownership 294
Regulation 295
Encouraging Competition 296
INTERNATIONAL PERSPECTIVE: The Darker Side of
Privatization 296
CASE IN POINT: California Electricity Deregulation
298
Antitrust Policies 299
Limiting Market Domination 300
Defining Markets 301
INTERNET CONNECTION: U.S. Department of
Justice and Antitrust Laws 301
THINKING LIKE AN ECONOMIST: Incentives and
the Remedy to the Microsoft Monopoly Problem
302
Curbing Restrictive Practices 304
Enforcing the Antitrust Laws 305
CASE IN POINT: Coke and Pepsi Play Merger 306
REVIEW AND PRACTICE 308
CHAPTER 14 STRATEGIC BEHAVIOR 311Review of the Prisoners Dilemma 312
Dominant Strategies 313
CONTENTS xvii
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Nash Equilibrium 313
Strategic Behavior in More General Games 316
Games With Only One Dominant Strategy 316
INTERNATIONAL PERSPECTIVE: Beggar-Thy-
Neighbor Tariff Policies 317
Games Without Dominant Strategies 318
INTERNET CONNECTION: The Zero-Sum Game
Solver 319
Repeated Games 320
Reputations 321
Tit for Tat 321
INTERNET CONNECTION: The Prisoners Dilemma
321
Institutions 322
CASE IN POINT: Banking Panics 322
Sequential Moves 324
THINKING LIKE AN ECONOMIST: Information and
Thinking Strategically 326
Time Inconsistency 326
Commitment 327
REVIEW AND PRACTICE 329
CHAPTER 15 IMPERFECT INFORMATION IN THEPRODUCT MARKET 333The Market for Lemons and Adverse Selection 333
Signaling 335
Judging Quality by Price 336
The Incentive Problem 337
Market Solutions 337
Contract Solutions 338
Reputation Solutions 339
The Market for Health Insurance 340
CASE IN POINT: Buying Health Insurance 341
The Search Problem 342
THINKING LIKE AN ECONOMIST: Incentive and
Information Problems in the Housing Market
343
e-INSIGHT: Information Technology and Middlemen
344
INTERNET CONNECTION: Job Search 345
Search and Imperfect Competition 345
Search and the Labor Market 346
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Search and Information Intermediaries 346
Advertising 347
Advertising and Competition 348
Advertising and Profits 348
The Importance of Imperfect Information 350
REVIEW AND PRACTICE 351
CHAPTER 16 IMPERFECTIONS IN THE LABOR MARKET 355Labor Unions 355
A Brief History 356
INTERNET CONNECTION: Unions on the Internet
358
Economic Effects 359
Limits on Union Power 360
Wage Differentials 362
Discrimination 363
Motivating Workers 364
Piece Rates and Incentives 365
Efficiency Wages 366
CASE IN POINT: Minimum Wages 367
Other Incentives 368
Compensating Workers 368
e-INSIGHT: Labor Markets and the Internet 369
REVIEW AND PRACTICE 371
PART 4 ISSUES IN PUBLIC POLICY373
CHAPTER 17 THE PUBLIC SECTOR 375Why Does the Government Intervene in the Economy?
377
INTERNATIONAL PERSPECTIVE:The Size of
Government in Different Countries 377
Equity-Efficiency Trade-Offs 380
e-INSIGHT: The New Economy and Inequality 381
The U.S. Tax System in Practice 381
CONTENTS xix
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Characteristics of a Good Tax System 382
The Scope of the U.S. Tax System 383
Grading the U.S. Tax System 383
Transfers 386
Welfare 387
Housing 388
Social Insurance 389
Designing Government Programs 390
Government Failures 391
Incentives and Constraints 392
Budgeting and Spending Procedures 393
Imperfections of Information 393
Collective Decision Making 394
Current and Recent Controversies in the Economics of
the Public Sector 395
Dealing With the Deficit 395
Social Security 396
Health Care 398
INTERNET CONNECTION: Policy Analysis 400
REVIEW AND PRACTICE 401
CHAPTER 18 ENVIRONMENTAL ECONOMICS 405Negative Externalities and Oversupply 405
Policy Responses to Problems in the Environment 407
Property Rights Responses 407
INTERNATIONAL PERSPECTIVE: Global Warming
408
THINKING LIKE AN ECONOMIST: Environmental
and Economic Trade-Offs 410
Regulation 410
Taxes and Subsidies 412
The Marketable Permit Response 413
CASE IN POINT: Reducing Acid Rain 414
Weighing the Alternative Approaches 415
Natural Resources 416
INTERNET CONNECTION: The National Center for
Environmental Economics 416
e-INSIGHT: Information and the Environment 418
Merit Goods and the Environment 418
REVIEW AND PRACTICE 419
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CHAPTER 19 INTERNATIONAL TRADE AND TRADEPOLICY 423Trade Between Countries 423
Interdependence in the Product Market 424
Interdependence in the Labor Market 424
Interdependence in the Capital Market 425
Multilateral Trade 425
Comparative Advantage 426
INTERNET CONNECTION: David Ricardo 427
Production Possibilities Curves and Comparative
Advantage 427
Comparative Advantage and Specialization 428
e-INSIGHT: The United States Comparative Advantage
in the Internet Age 429
What Determines Comparative Advantage? 430
The Perceived Costs of International Interdependence
432
THINKING LIKE AN ECONOMIST: Exchange and
the Globalization Controversy 432
Trade Policies 434
Commercial Policy 434
Tariffs 435
Quotas 436
Voluntary Export Restraints 436
Other Nontariff Barriers 437
Fair Trade Laws 437
INTERNATIONAL PERSPECTIVE: Surrogate
Countries and Canadian Golf Carts 438
Political and Economic Rationale for Protection 439
Displaced Firms and Workers 440
Beggar-Thy-Neighbor Policies 441
Wages in Affected Sectors 442
Increased Competition 442
THINKING LIKE AN ECONOMIST: Distribution and
Trade Liberalization 443
The Infant Industry Argument 443
e-INSIGHT: Trade Liberalization in Information
Technology and Financial Services 444
Strategic Trade Theory 445
International Cooperation 445
GATT and the WTO 445
CONTENTS xxi
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The Growing Protest Against the WTO 446
CASE IN POINT: The Banana War 447
Regional Trading Blocs 448
INTERNET CONNECTION: The World Trade
Organization 449
REVIEW AND PRACTICE 450
CHAPTER 20 TECHNOLOGICAL CHANGE 453Links Between Technological Change and Imperfect
Competition 454
e-INSIGHT: The New Economy and Innovation 455
Patents and the Production of Ideas 455
THINKING LIKE AN ECONOMIST: Intellectual
Property Rights and Distribution 456
The Trade-Off Between Short-term Efficiency and
Innovation 457
CASE IN POINT: Eli Whitney and the Cotton Gin 460
R & D as a Fixed Cost 460
Learning by Doing 461
Access to Capital Markets 462
Schumpeterian Competition 463
Basic Research as a Public Good 464
Government Promotion of Technological Progress 465
Subsidies 465
Protection 466
Relaxing Antitrust Policies 466
INTERNET CONNECTION: Competitiveness 468
Technological Change and Economic Growth 468
REVIEW AND PRACTICE 469
PART 5 INTRODUCTION TOMACROECONOMICS 471
CHAPTER 21 MACROECONOMICS AND THEECONOMIC PERSPECTIVE 473The Commitment to Full Employment and Growth 474
Getting the Country Moving Again 477
Stagflation 477
The Conquest of Inflation 478
xxii CONTENTS
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Government Deficits and Trade Deficits 479
Getting the Economy Moving (Again) 479
New Challenges 480
The Three Key Goals of Macroeconomic Performance 481
A Look Ahead 482
REVIEW AND PRACTICE 483
CHAPTER 22 MEASURING OUTPUT ANDUNEMPLOYMENT 485Measuring Output and Growth 485
Gross Domestic Product 486
Measuring GDP: The Value of Output 489
INTERNET CONNECTION: The Bureau of Economic
Analysis 489
CASE IN POINT: Is Software a Final Good or an
Intermediate Good? 491
Potential GDP 494
INTERNATIONAL PERSPECTIVE: What Gets
Measured in the GDP? 495
Problems in Measuring Output 496
Measuring the Standard of Living 497
A Green GDP 497
Unemployment 498
Unemployment Statistics 499
Forms of Unemployment 500
Output Gaps and the Natural Rate of Unemployment 503
Flows and Stocks 505
REVIEW AND PRACTICE 506
CHAPTER 23 THE COST OF LIVING AND INFLATION 509The Costs of Inflation 509
Who Suffers from Inflation 510
The Economy 511
The Costs of Deflation 512
CASE IN POINT: Hyperinflation in Germany in the
1920s 512
Measuring Inflation 514
INTERNET CONNECTION: Improving Our Measure
of the CPI 516
CASE IN POINT: The Price Index Makes a Difference
516
CONTENTS xxiii
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Alternative Measures of Inflation 517
INTERNET CONNECTION: The Inflation Calculator
517
e-INSIGHT: Measuring the Price and Quantity of
Software 518
The American Experience with Inflation 519
REVIEW AND PRACTICE 521
PART 6 FULL-EMPLOYMENTMACROECONOMICS 523
CHAPTER 24 THE FULL-EMPLOYMENT MODEL 525Macroeconomic Equilibrium 526
The Labor Market 527
Shifts in the Demand and Supply of Labor 529
CASE IN POINT: Mass Migration in the Nineteenth
Century 531
e-INSIGHT: Labor Markets and the Internet 532
The Product Market 532
Potential GDP 533
Demand and Equilibrium Output 534
The Capital Market 536
Household Saving 536
Investment 537
Equilibrium in the Capital Market 538
The General Equilibrium Model 540
Using the General Equilibrium Model 541
REVIEW AND PRACTICE 543
CHAPTER 25 GOVERNMENT FINANCE AT FULLEMPLOYMENT 547The Composition of Spending and Taxes 548
Extending the Basic Full-Employment Model 548
Adding the Government 549
The Government and the Capital Market 549
Leakages and Injections 554
INTERNATIONAL PERSPECTIVE: Deficits in Other
Countries 555
THINKING LIKE AN ECONOMIST: Distribution,
Deficits and Intergenerational Transfers 556
xxiv CONTENTS
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Evaluating Government Deficits and Surpluses 557
Government Deficits and Surpluses: Our Recent
Experiences 558
Factors Affecting the Federal Budget 561
Risk Factors for the Federal Budget 562
REVIEW AND PRACTICE 563
CHAPTER 26 THE OPEN ECONOMY AT FULLEMPLOYMENT 567The Open Economy 568
The Capital Market in the Open Economy 568
The Basic Trade Identity 572
INTERNET CONNECTION: U.S. Trade Data 573
CASE IN POINT: The Trade Deficit 574
e-INSIGHT: High-Tech Exports and Imports 576
Exchange Rates 577
THINKING LIKE AN ECONOMIST: Net Exports and
the Exchange Rate 579
Is the Trade Deficit a Problem? 580
REVIEW AND PRACTICE 583
CHAPTER 27 GROWTH AND PRODUCTIVITY 585Rising Standards of Living 586
Explaining Productivity 589
INTERNET CONNECTION: How Fast Is Modern
Economic Growth? 590
The Capital Stock and the Role of Saving and Investment
590
The Quality of the Labor Force 592
The Reallocation of Resources from Low- to High-
Productivity Sectors 592
Technological Change and the Role of Ideas 593
Total Factor Productivity: Measuring the Sources of
Growth 596
CASE IN POINT: Calculating Total Factor Productivity
in the 1990s 597
e-INSIGHT: Computers and Increased Productivity
Growth 598
FUNDAMENTALS OF GROWTH: Growth in the
Economys Labor Force, Growth in the Economys
Capital Stock, Technological Change 599
CONTENTS xxv
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Are There Limits to Economic Growth? 600
THINKING LIKE AN ECONOMIST: Trade-Offs and
the Costs of Economic Growth 601
REVIEW AND PRACTICE 602
CHAPTER 28 MONEY, THE PRICE LEVEL, AND THEFEDERAL RESERVE 605Prices and Inflation 606
Money Demand 607
Money Supply 609
The Price Level 609
INTERNET CONNECTION: How Much Cash Do We
Hold? 610
The Financial System in Modern Economies 612
CASE IN POINT: When Atlanta Printed Money 614
Creating Money in Modern Economies 615
Money Is What Money Does 615
Measuring the Money Supply 617
Money and Credit 618
CASE IN POINT: Boggs Bills and the Meaning of
Money 619
The Money Supply and the Banks Balance Sheet 620
THINKING LIKE AN ECONOMIST: Exchange,
Money, and the Internet 620
How Banks Create Money 622
e-INSIGHT: Electronic Cash 623
The Federal Reserve 626
How the Fed Affects the Money Supply 628
INTERNET CONNECTION: The Federal Reserve
Banks and International Central Banks 629
The Stability of the U.S. Banking System 630
Reducing the Threat of Bank Runs 631
REVIEW AND PRACTICE 633
xxvi CONTENTS
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PART 7 MACROECONOMICFLUCTUATIONS 635
CHAPTER 29 INTRODUCTION TOMACROECONOMIC FLUCTUATIONS637Economic Fluctuations 638
INTERNET CONNECTION: Dating Business Cycle
Peaks and Troughs 642
CASE IN POINT: Estimating the Output Costs of a
Recession 642
THINKING LIKE AN ECONOMIST: Employment
Fluctuations and Trade-Offs 643
Why Economies Experience Fluctuations 643
Nominal Versus Real Wages 645
The Slow Adjustment of Nominal Wages 645
The Slow Adjustment of Prices 645
THINKING LIKE AN ECONOMIST: Information and
Measuring the Business Cycle 647
Understanding Macroeconomic Fluctuations: Key
Concepts 648
Sticky Wages 649
FUNDAMENTALS OF FLUCTUATIONS 1: Sticky
Wages 649
Sticky Prices 649
e-INSIGHT: Cyclical and Structural Productivity 650
FUNDAMENTALS OF FLUCTUATIONS 2: Sticky
Prices 651
Inflation and Adjustment 652
FUNDAMENTALS OF FLUCTUATIONS 3: Short-Run
Inflation-Unemployment Trade-Off 653
Inflation, Monetary Policy, and Spending 653
FUNDAMENTALS OF FLUCTUATIONS 4: Inflation,
Monetary Policy, and Spending 655
CASE IN POINT: Inflation Targeting 655
Linking the Four Key Concepts 656
REVIEW AND PRACTICE 657
CONTENTS xxvii
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CHAPTER 30 AGGREGATE EXPENDITURES ANDINCOME 661Income-Expenditure Analysis 661
The National Income-Output Identity 663
Equilibrium Output 663
Shifts in the Aggregate Expenditures Schedule 664
Mathematical Formulation 665
A Look Forward 666
Consumption 667
Disposable Income 667
Expectations of Future Income 671
Wealth 671
Investment 672
Investment and the Real Interest Rate 673
Inventory Investment 674
Macroeconomic Implications of Investment 675
Government Purchases 676
Net Exports 676
Exports 678
Imports 678
Macroeconomic Implications 679
Putting International Trade into the Equation 680
Calculating Equilibrium Output 681
Aggregate Expenditures and the Real Interest Rate
683
THINKING LIKE AN ECONOMIST: Incentives and
the Real After-Tax Rate of Interest 684
REVIEW AND PRACTICE 685
CHAPTER 31 AGGREGATE DEMAND ANDINFLATION 689The Real Interest Rate and the Capital Market 690
The Aggregate DemandInflation Curve 691
The Feds Policy Rule 692
What Can Shift the ADI Curve? 694
INTERNATIONAL PERSPECTIVE: How Do Other
Central Banks React to Inflation? 696
Other Factors That Can Shift the ADI Curve 696
Using the ADI Curve 697
Output Effects of a Shift in the ADI Curve 698
CASE IN POINT: The Volcker Disinflation 700
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An Expansionary Shift in the ADI Curve 701
CASE IN POINT: The Kennedy Tax Cut 701
THINKING LIKE AN ECONOMIST: Tough Trade-
Offs 703
Macroeconomic Policy and Shifts in the ADI Curve 703
Shifts in the Inflation Adjustment Curve 704
Changes in Energy Prices 704
CASE IN POINT: Oil Price Shocks of the 1970s 705
A Shift in Potential GDP 705
CASE IN POINT: The 1990s 707
e-INSIGHT: Productivity Growth and the Punch Bowl
708
INTERNET CONNECTION: The FOMC 710
REVIEW AND PRACTICE 711
CHAPTER 32 THE FEDERAL RESERVE AND INTERESTRATES 715The Federal Funds Market 715
A Day at the Trading Desk 716
The Demand for Reserves 718
The Supply of Reserves 719
Open Market Operations 719
Equilibrium in the Federal Funds Market 720
Monetary Policy Operating Procedures 721
Inflation, Money Supply, and the Nominal Rate of Interest
722
REVIEW AND PRACTICE 724
CHAPTER 33 THE ROLE OF MACROECONOMICPOLICY 727Inflation-Unemployment Trade-Offs 728
The Old Inflation-Unemployment Trade-Off 728
The New Trade-Off: Output StabilityInflation Stability
429
Fiscal Policy 729
Automatic Stabilizers 729
Discretionary Policy Actions 731
INTERNET CONNECTION: The Economic Report of
the President 732
The Full-Employment Deficit 733
CONTENTS xxix
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INTERNATIONAL PERSPECTIVE: Fiscal Transfers
734
Monetary Policy 736
Behind the ADI CurveThe Role of Monetary Policy
736
INTERNET CONNECTION: The Beige Book 738
CASE IN POINT: Announcing the Feds Decisions 738
Real Interest Rates and Nominal Interest Rates 739
The Central Bank Policy Rule 740
THINKING LIKE AN ECONOMIST: Real Values
Matter for Incentives 742
CASE IN POINT: The Interest Rate Cut of January 3,
2001 743
CASE IN POINT: September 11, 2001 743
e-INSIGHT: The Dot-Com Bubble and Macroeconomic
Stability 744
The Position of the Policy Rule 745
The Slope of the Policy Rule 748
Interactions Between Monetary and Fiscal Policies 749
REVIEW AND PRACTICE 752
PART 8 THE GLOBAL ECONOMY755
CHAPTER 34 THE INTERNATIONAL FINANCIALSYSTEM 757Determining the Exchange Rate 758
Supply and Demand in the Foreign Exchange Market
759
THINKING LIKE AN ECONOMIST: Incentives and
the Real Exchange Rate 764
Exchange Rate Management 766
INTERNATIONAL PERSPECTIVE: Global Financial
Crises 770
Flexible Exchange Rate Systems 771
CASE IN POINT: Currency Boards and Dollarization
772
REVIEW AND PRACTICE 775
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CHAPTER 35 POLICY IN THE OPEN ECONOMY779The ADI Curve and the Open Economy 780
Inflation, the Interest Rate, and the Exchange Rate 780
The Exchange Rate and Aggregate Expenditures 781
The Exchange Rate and Inflation 783
Imported Inputs 783
THINKING LIKE AN ECONOMIST: Interest Parity
and Incentives 784
Consumer Price Inflation and the Exchange Rate 784
INTERNET CONNECTION: Foreign Exchange Rates
785
Comparing Monetary and Fiscal Policies in the Open
Economy 785
Monetary Policy with Flexible Exchange Rates 785
e-INSIGHT: New Technology and the Integration of
World Financial Markets 786
Fiscal Policy with Flexible Exchange Rates 787
INTERNATIONAL PERSPECTIVE: Is a Strong Dollar
Good for the United States? 788
Policy Coordination 789
REVIEW AND PRACTICE 790
CHAPTER 36 DEVELOPMENT AND TRANSITION793Development 794
INTERNET CONNECTION: The World Banks
Development Goals 796
Life in a Less-Developed Country 797
The Success of East Asia 799
Alternative Development Strategies 802
Globalization and Development 803
CASE IN POINT: A Historical Perspective on
Globalization 804
e-INSIGHT: Indian Engineers in Silicon Valley and
Silicon Valleys Capital in India 806
The Prognosis for Development 807
Economies in Transition 808
The Communist Economic System 808
The Move Toward a Market Economy 810
REVIEW AND PRACTICE 814
CONTENTS xxxi
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PART 9 FURTHER TOPICS INMACROECONOMICS 817
CHAPTER 37 INFLATION AND UNEMPLOYMENT819Short-Run Inflation Adjustment 820
The Role of Expectations: Shifts in the Short-Run Inflation
Adjustment Curve 824
THINKING LIKE AN ECONOMIST: Distributional
Effects of Inflation and Unemployment 826
CASE IN POINT: Nobel Views on Inflation and
Unemployment 827
INTERNET CONNECTION: Winners of the Nobel
Prize in Economics 829
Shifts in the Natural Rate 829
CASE IN POINT: The Baby Boomers and the Natural
Rate 829
Shifts in Potential GDP 830
Inflation Shocks 830
FUNDAMENTALS OF INFLATION: Cyclical
Unemployment, Expectations, Inflation Shocks 831
Combining the Aggregate DemandInflation and Inflation
Adjustment Curves 832
REVIEW AND PRACTICE 834
CHAPTER 38 CONTROVERSIES INMACROECONOMIC POLICY 837Do Deficits Matter? 838
Deficits and the Traditional View 839
Economic Consequences of Deficits and Surpluses 840
How Future Generations Are Affected by Government
Debt 840
Alternative Views 841
The Goals of Macroeconomic Policy 842
The Noninterventionist Perspective 844
THINKING LIKE AN ECONOMIST: Trade-Offs and
Choices 845
The Interventionist Perspective 847
Should the Federal Reserve Target Inflation? 848
Inflation Targeting and Policy Trade-Offs 849
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CASE IN POINT: Fed Policy StatementsBalancing
Policy Goals 851
INTERNET CONNECTION: Banks and Inflation
Targeting 852
Consequences of Inflation Targeting 853
INTERNATIONAL PERSPECTIVE: Central Bank
Mandates 855
Demand Versus Supply Disturbances and Policy Trade-
Offs 857
e-INSIGHT: e-Time and Macroeconomic Policy 858
REVIEW AND PRACTICE 860
APPENDIX: Price Level Targeting 862
CHAPTER 39 A STUDENTS GUIDE TO INVESTING865Investment Alternatives 866
Bank Deposits 866
Housing 866
INTERNET CONNECTION: Calculating Interest Rates
867
Bonds 867
Shares of Stock 868
Mutual Funds 869
Desirable Attributes of Investments 870
Expected Returns 870
INTERNET CONNECTION: Index Funds 870
e-INSIGHT: Investing in the New Economy 872
CASE IN POINT: PG&E Employees Learn Why
Diversification Is Important 872
Risk 874
Tax Considerations 876
Liquidity 877
Expectations and the Market for Assets 878
THINKING LIKE AN ECONOMIST: The Distribution
of Wealth and Ownership of Assets 879
Forming Expectations 880
Efficient Market Theory 881
Efficiency and the Stock Market 882
Efficient Markets or Random Noise? 884
Strategies for Intelligent Investing 885
REVIEW AND PRACTICE 887
CONTENTS xxxiii
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GLOSSARY A-1
CREDITS A-13
INDEX A-15
-
PREFACE
T he study of economics has always been fascinating, yet it is difficult toremember a more exciting or important time in the discipline. Think of todays major economic issuesthe huge American trade and budgetdeficits, global warming, the debate between proponents of conservation and energyexploration, ensuring adequate health care, ending global poverty, reforming SocialSecurity, outsourcing, rethinking the nature of competition and regulation in theInternet age, and copyright protection in a digital, downloadable world. The listgoes on and on. To understand these issues, the core insights of economics areinvaluable.
Exciting new theoretical advances are allowing economists to better understandhow individuals, families, and businesses make decisions about what to buy, whatto sell, how much to save, and how to invest their savings. These advances affectthe way governments design policies to protect the environment, promote educationalopportunities, and deal with the changes in our economy brought about by innova-tions in information technologies and the increasingly global economic marketplacein which we all participate.
There has never been a time in which the need to be informed about economicissues has been more acute. Nor is it any less critical for students to acquire thetools that will enable them to think critically about the economic decisions they facein their personal lives and the issues they must decide on as engaged citizens. Evensomething as basic to the study of economics as the concept of trade-offs helps pro-vide students with a tool that can inform the way they think about issues at the per-sonal, local, state, national, and even global level. Whereas the Principles of Economicscourse has always been popular among business students, now most students real-ize that everyone needs to be conversant with the fundamentals of economics. Wehave written our book, and revised it for the Fourth Edition, keeping this very impor-tant concept of the politically engaged student in mind.
Preparing the Fourth Edition of this textbook has provided us with the oppor-tunity to make several fundamental improvements over the previous edition. Westill emphasize the five core concepts of modern economics, which are the importanceof trade-offs, incentives, exchange, information, and distribution. Yet, economicresearch is continuously yielding new, interesting, and important insights, and webelieve that these exciting new developments should be conveyed to students inintroductory courses. While the textbook has always offered the most integratedcoverage of information economics, in this new edition we introduce students tosome of the results from new research in behavioral economics. We have also madeseveral changes to the organization of the book that will give instructors increasedflexibility in structuring their courses.
PREFACE xxxv
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Mission Statement for the FourthEditionOur text has always strived for two goals: One, to be transparently accessible and inter-esting, dare we say a good read, for the student reader; and two, to not shy awayfrom teaching students the latest exciting insights of the discipline, to teach them thesubstance of economics as a field of study. Many books seem to take the stance thatstudents cannot handle the new topicswe believe that it is just a matter of explain-ing the ideas simply and clearly.
To achieve these goals, the four main objectives of previous editions continuedto guide us. These objectives are to provide students with a clear presentation ofthe basic competitive model, to present macroeconomics in its modern form con-sistent with the way active researchers and economists in policy-making institu-tions analyze the economy, to structure the textbook in ways that are conducive togood teaching and to student learning, and to ensure that the textbook reflects thecontemporary scene, stressing the core insights economics provides for understand-ing the ever-changing economy.
Changes to the Fourth EditionMicroeconomicsThe hallmark of this textbook, its emphasis on information, imperfect markets, innova-tion, and technology, remain in the new edition. New material on behavioral economicshas been incorporated into the chapters on consumer choice and capital markets.
KEY CHANGES FOR THE FOURTH EDITION:For the Fourth Edition, we worked hard to streamline the text. Chapters in earliereditions that many students found too long or too dense have been significantlyrestructured. In some cases, material has been divided into separate chapters,making chapters shorter on average and more focused.
Important changes made to the microeconomic sections include:
Shortening the introductory section, Part 1, to provide a greater focus onthe core concepts of economics.
Splitting the material on the labor and capital markets under perfectcompetition into two separate chapters. This helps make the presentationmore student-friendly as well as giving instructors increased flexibility indeciding what material to include in their courses.
Reorganizing Part 3 to provide a more cohesive discussion of imperfectmarkets and public policy issues. Because strategic behavior is at the heart
xxxvi PREFACE
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of the economists approach to imperfect competition, the chapter onstrategic behavior has been moved into Part 3 (Chapter 14).
Part 4, now titled Issues in Public Policy, is more closely organized aroundthe theme of public policy, rather than simply including a set of topics.Part 4 includes chapters on the public sector (Chapter 17), environmentalpolicy (Chapter 18), and international trade and trade policy (Chapter 19).
Changes to the Fourth EditionMacroeconomicsThe new edition maintains the modern approach to macroeconomics, one that rec-ognizes that the Federal Reserve and other central banks implement monetary policythrough interest rates rather than through the explicit control of the money supply.By providing a more realistic treatment of monetary policy, the modern approachalso allows students to understand and discuss the types of policy actions they readabout in newspapers. While the general approach developed in the Third Edition ismaintained, our treatment of macroeconomics in the new edition aims to streamlinethe presentation, moving more advanced material into the Topics chapters.
KEY CHANGES FOR THE FOURTH EDITION:Important changes made to the macroeconomic sections include:
The opening chapter of the macroeconomics material has been updated toreflect new developments since the Third Edition.
The discussion of price indices and the measurement of inflation are nowtreated in a separate chapter (Chapter 23).
Part 6, on Full-Employment Macroeconomics, has been reorganized.Separate chapters are now devoted to government finance (Chapter 25)and the open economy (Chapter 26). This allows these two important topicsto be treated individually, allowing instructors greater choice in decidinghow to organize their course, as well as reducing the number of newconcepts introduced in each chapter.
The important material on government deficits and surpluses has beencombined in Chapter 25 rather than split between Part 6 and Part 8 as inthe previous edition.
The material on money, prices, and the Federal Reserve has been moved tothe end of Part 6 (Chapter 28). This improves the flow of the full-employmentsection, with Chapter 24 providing the basic framework for the determinationof real output, real wages, and the real interest rate, Chapter 25 adding the
PREFACE xxxvii
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government, Chapter 26 extending the results to the case of the openeconomy, and Chapter 27 providing a discussion of economic growth. Thematerial on money and prices then follows in Chapter 28.
Part 7 on Macroeconomic Fluctuations has been extensively rewritten toimprove the exposition. Many users of the Third Edition felt that too muchmaterial was introduced in the chapters on the aggregate demandinflationrelationship and the short-run inflation adjustment relationship. To addressthis concern, we have moved the extended discussion of inflation andunemployment into Part 9 (Further Topics in Macroeconomics). Part 7begins with an overview (Chapter 29), covers the basics of aggregateexpenditures (Chapter 30), and then develops the aggregatedemandinflation relationship in Chapter 31.
The material on the international economy has been consolidated into anew Part 8, with chapters dealing with the international financial system(Chapter 34), policy in the open economy (Chapter 35), and economicdevelopment and transition (Chapter 36).
In making these changes, we have continued to be motivated by the desire to writea modern, student-friendly textbook that reflects the way economists approach theirsubject today.
The Organization of the TextThe text is organized to work for both students and instructors. For students, we uti-lize the five core concepts of trade-offs, incentives, exchange, information, and distri-bution throughout the text, in both the chapters on microeconomics and those onmacroeconomics. These concepts anchor the wide range of topics we cover, linkingall the topics to a core set of basic principles to which students can always refer. We alsoprovide a firm grounding in basic concepts first, but we do not stop there. We alsoensure that students are able to understand the tremendous insights offered by thebasic economic model of competitive markets and its limitations. This prepares thestudent for understanding the lessons offered by modern economics for study of imper-fect competition, information, growth, and economic fluctuations. We show how theseinsights help one understand economic phenomena that classical economics cannot.By exposing students to modern economicsfrom the economics of information andinnovation to behavioral economicsthe text helps them obtain a sense of the rich-ness of the discipline and its value for understanding the world around them.
The text is designed to offer solid coverage of traditional topics, combined with aflexible structure that allows it to be tailored to fit with the individual needs of theinstructor. In covering both microeconomics and macroeconomics, the basic mate-rial of competitive markets and the full-employment economy are presented first.Then, the sections dealing with imperfect markets and fluctuations each begin withan overview chapter that allows students to gain insight into the basic institutionsand key issues that are addressed in more detail in subsequent chapters. This struc-
xxxviii PREFACE
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ture also allows an instructor who does not wish to devote too much time to a topicsuch as imperfect information to still give students a sense of the its importance andthe lessons economists have learned about this important topic. Finally, both themicroeconomics and macroeconomics sections end with topics chapters that offeradditional flexibility for the instructor in fine-tuning the readings from the text tothe context of his or her course structure, while a new and expanded treatment ofthe international economy is contained in the macroeconomics section.
Learning ToolsWe have developed a clutch of Learning Tools that will help our student readersrelate to the principles being described and also better retain the information.
RIVETING BOXES THAT HIGHLIGHT THENEW ECONOMY BEING CREATED BY THEINTERNET AND INFORMATIONREVOLUTION
From Google, to eBay, Expedia, StubHub, Napster, and online poker, the manifes-tations of the New Economy are changing the way we live, work, shop, travel, andspend our leisure time. Though the fundamentals of economics will not change, howthose fundamentals are utilized is changing, at an ever-quickening pace. Stiglitz/WalshFourth Edition recognizes this fact.
e-INSIGHT BOXES apply economic principles to new developments in informationtechnology and the Internet.
INTERNET CONNECTION BOXES provide useful links to Web resources andhome pages.
ADDITIONAL TOOLS TO HEIGHTENSTUDENT UNDERSTANDING
THINKING LIKE AN ECONOMIST boxes reinforce the core ideas emphasizedthroughout the book: Trade-offs, Incentives, Exchange, Information, and Distribution.
CASE IN POINT vignettes highlight real-world applications in each chapter.
INTERNATIONAL PERSPECTIVE boxes present applications to internationalissues.
2
1
PREFACE xxxix
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FUNDAMENTALS OF . . . sections distill the essence of particularly importantand tricky topics.
WRAP-UPS provide a short summary of the key points presented in a section.
ECONOMICS, FOURTH EDITION e-BOOK
Same Great Content, Half the Price The e-book version of Economics,Fourth Edition, offers the full content of the print version, at half the price.
In addition, a variety of features make the Norton e-book a powerful tool forstudy and review.
Zoomable images allow students to get a closer look at the figures andphotographs.
Clear text, designed specifically for screen use, makes reading easy.
A search function facilitates study and review.
A print function permits individual pages to be printed as needed.
Sticky notes allow students to add their own notes to the text.
Online and cross-platform software works on both Macs and PCs and allows stu-dents to access their e-book from home, school, or anywhere with an Internet con-nection. Visit NortonEbooks.com for more information.
Ancillary Package A variety of valuable supplements are available to students and teachers who use thetextbook.
SmartWork Homework Management System Developed in coordina-tion with Science Technologies, SmartWork is an innovative online homework man-agement system. SmartWork requires active learning from students and providessmart, interactive feedback. Instructors can choose from three types of ready-madeassignments:
Interactive Graphing Exercises allow students to manipulate points, lines, andcurves, see the implications instantly, and then answer questions about them.
Audio Graphs guide students step-by-step through a slide show presentingcore concepts. On screen, students see economic equations worked out andgraphs manipulated while hearing an audio presentation of the lesson.
Conceptual Quizzes pair questions with thought-provoking feedback.Students are asked to reconsider their answers after they respond to eachquestion.
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With SmartWorks intuitive interface, instructors can also customize Nortons ready-made assignments or write their own exercises with remarkable ease. Access toSmartWork is free to all students who purchase a new textbook or e-book.
Student Web Site This free companion Web site offers students powerfulreview materials. Practice quizzes feature diagnostic feedback indicating which sec-tions in the chapter the student should review. The student Web site also provideschapter reviews, a glossary, and a daily economics newsfeed.
NORTON MEDIA LIBRARYThis instructors CD-ROM includes PowerPoint lecture slides (corresponding to thelecture modules in the Instructors Manual) as well as all the graphs and tables fromthe book. New lecture-launcher audio/visual slide shows provide brief segmentson each chapters material as it relates to imperfect markets or the new economy.
NORTON RESOURCE LIBARYThe Norton Resource Library provides comprehensive instructor resources in onecentralized online location. In the library, instructors can download ready-to-use,one-stop solutions for online courses, such as WebCT e-packs and BlackBoard coursecartridges, or can tailor these pre-made course packs to suit their own needs. Thelibrarys exceptional resources include PowerPoint lecture slides, graphs and tablesfrom the book, and a computerized test-item file.
TRANSPARENCIESA set of color transparencies is available to qualified adopters.
STUDY GUIDEBY LAWRENCE W. MARTIN, MICHIGAN STATE UNIVERSITYPRINCIPLES OF MICROECONOMICS 0-393-92826-8 PAPERPRINCIPLES OF MACROECONOMICS 0-393-92827-6 PAPER
This innovative study guide reinforces the key concepts of each chapter throughreviews, practice exams, and problem sets designed to help students apply whattheyve learned. Doing Economics sections are structured around a series of ToolKits in which students learn a problem-solving technique through its step-by-stepapplication. Each Tool Kit is followed by worked examples and practice problemsthat apply the relevant technique.
PREFACE xli
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INSTRUCTORS MANUALBY GERALD McINTYRE, OCCIDENTAL COLLEGEPRINCIPLES OF MICROECONOMICS 0-393-92805-5 PAPERPRINCIPLES OF MACROECONOMICS 0-393-92821-7 PAPER
For each chapter of the textbook the Instructors Manual contains lecture advice,lecture modules, lecture applications, problem sets, and solutions. The extensivelecture modules can be used with a set of PowerPoint slides that Gerald McIntyrehas prepared. These lecture notes are far more extensive than what other publish-ers offer, and will be extremely valuable to the first time instructor.
TEST-ITEM FILE BY DAVID GILLETTE, TRUMAN STATE UNIVERSITYPRINCIPLES OF MICROECONOMICS 0-393-92840-3 PAPERPRINCIPLES OF MACROECONOMICS 0-393-10727-2 PAPER
The Fourth Edition Test-Item File includes over 4,000 questions, a 15 percent increaseover the previous edition. In addition, each chapter includes a subset of questionscovering the boxed inserts (such as e-Insights), which professors can use in theirexams, thereby encouraging students to read these discussions.
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AcknowledgmentsThe books first three editions were improved immeasurable by the input of numer-ous reviewers. In particular, we thank Robert T. Averitt, Smith College; MohsenBahmani-Oskoose, University of Wisconsin, Milwaukee; Richard Barret, Universityof Montana; H. Scott Bierman, Carleton College; John Payne Bigelow, University ofMissouri; Howard Bodenhorn, Lafayette College; Bruce R. Bolnick, NortheasternUniversity; Adhip Chaudhuri, Georgetown University; Michael D. Curley, KennesawState College; John Devereus, University of Miami; Stephen Erfle, Dickinson College;Rudy Fichtenbaum, Wright State University; Kevin Forbes, Catholic University; K.K. Fung, Memphis State; Christopher Georges, Hamilton College; Ronald D. Gilbert,Texas Tech University; Robert E. Graf, Jr., United States Military Academy; GlennW. Harrison, University of South Carolina; Marc Hayford, Loyola University; YutakaHoriba, Tulane University; Charles How, University of Colorado; Sheng Cheng Hu,Purdue University; Glenn Hubbard, Columbia University; Nancy Jianakopolos,Colorado State University; Allen C, Kelley, Duke University; Lori Kletzer, Universityof California, Santa Cruz; Michael M. Knetter, Dartmouth College; Kevin Lang,Boston University; William Lastrapes, University of Georgia; John Leahy, BostonUniversity; Eric Leeper, Indiana University; Colin Linsley, St. John Fisher College;Stefan Lutz, Purdue University; Mark J. Machina, University of California, SanDiego; Burton G. Malkiel, Princeton University; Lawrence Martin, Michigan StateUniversity; Thomas Mayer, University of California, Davis; Craig J. McCann, Universityof South Carolina; Henry N. McCarl, University of Alabama, Birmingham; JohnMcDermott, University of South Carolina; Marshall H. Medoff, University of California,Irving; Peter Mieszkowski, Rice University; Myra Moore, University of Georgia; W.Douglas Morgan, University of California, Santa Barbara; John S. Murphy, CanisiusCollege; Michael Nelson, University of Akron; William Nielson, Texas A & MUniversity; Neil B. Niman, University of New Hampshire; David H. Papell, Universityof Houston; Douglas Pearce, North Carolina State University; Jerrold Peterson,University of Minnesota, Duluth; James E. Price, Syracuse University; Daniel M.Raff, Harvard Business School; Christina D. Romer, University of California, Berkeley;Richard Rosenberg, Pennsylvania State University; Rosemary Rossiter, OhioUniversity; David F. Ruccio, University of Notre Dame; Christopher J. Ruhm, BostonUniversity; Suzanna A. Scotchmer, University of California, Berkeley; Richard Selden,University of Virginia; Andrei Shleifer, Harvard University; Nirvikar Singh, Universityof California, Santa Cruz; John L. Solow, University of Iowa; George Spiva, Universityof Tennessee, Mark Sproul, University of California, Los Angeles; Frank P. Stafford,University of Michigan; Raghu Sundaram, University of Rochester; Hal R. Varian,University of California, Berkeley; Franklin V. Walker, State University of New Yorkat Albany; James M. Walker, Indiana University; Andrew Weiss, Boston University;Mark Wohar, University of Nebraska, Omaha; and Gilbert R. Yochum, Old DominionUniversity.
Many additional reviewers provided suggestions that help guide us in prepar-ing the Fourth Edition. Our thanks to John Nader, Grand Valley State University;Timothy A. Duy, University of Oregon; Richard Fox, Madonna University; DaleCloninger, University of Houston, Clear Lake; Gavin Wright, Stanford University;
PREFACE xliii
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Richard Stahnke, Hamilton College; Maristella Botticini, Boston University; ChrisNiggle, University of Redlands; Santanu Roy, Southern Methodist University; RogerWhite, Franklin and Marshall College; Geoffrey Carliner, Boston University; RobertL. Pennington, University of Central Florida; Roger A. McCain, Drexel University;Nancy A. Jianakoplos, Colorado State University; Sudeshna C. Bandyopadhyay,West Virginia University; Jennifer Thacher, University of New Mexico; AlanGummerson, Florida International University; Nejat Anbarci, Florida InternationalUniversity; Samuel Allen, University of California, Davis; Robert G. Bise, OrangeCoast College; Sarah L. Stafford, College of William and Mary; Catherine Krause,University of New Mexico; Ariel Belasen, Binghamton University; Alina Luca, DrexelUniversity; S. Abu Turab Rizvi, University of Vermont; Nivedita Mukherji, OaklandUniversity; Faik A. Koray, Louisiana State University; Mehdi Haririan, BloomsburgUniversity; F. G. Hank Hilton, Loyola College; Michael Margolis, Oberlin College;Joseph K. Cavanaugh, Wright State University; Lisa Gundersen, Iowa State University;Eva Toth Szalvai, Bowling Green State University; Maya Federman, Pitzer College;Annie Fang Yang, University of Minnesota, Twin Cities; Molly Espey, ClemsonUniversity; Nora Underwood, University of California, Davis; Mary Schranz, Universityof Wisconsin, Madison; Scott Cunningham, University of Georgia; Ehsan Ahmed,James Madison University; Lee van Scyoc, University of Wisconsin, Oshkosh; ParkerWheatley, Carleton College; Daniel Rubenson, Southern Oregon University; ElliottParker, University of Nevada, Reno; Peter Murrell, University of Maryland;Abdulhamid Sukar, Cameron University; Philip S. Heap, James Madison University;Erik D. Craft, University of Richmond; Sharmila King, University of the Pacific;Linus Yamane, Pitzer College; Cathleen Leue, University of Oregon; Daniel Monchuk,University of Southern Mississippi; Rik W. Hafer, Southern Illinois University,Edwardsville; and Ben Young, University of Missouri, Kansas City.
A particular note of appreciation is due Mary Schranz, University of Wisconsin,Madison, who provided detailed, thoughtful, and extremely helpful comments ondraft chapters of the macroeconomics material. Her insights significantly improvedthe end product.
The major changes in the Fourth Edition and the improvements they representare due in no small measure to the constant encouragement, advice, and enthusi-asm of our editor, Jack Repcheck. Jack provided the perfect blend of critical feed-back and positive reinforcement to encourage us at each stage of the process tostrive towards our goals of accessibility and modernity, and to incorporate the latestinsights from the forefront of economics in a manner that is accessible to studentsgetting their first introduction to economics.
We would also like to thank and acknowledge the entire team at Norton whomade working on the Fourth Edition such a pleasure: Lory Frenkel, Matt Arnold,Mik Awake, Sarah Solomon, Rubina Yeh, Kelly Mitchell, Roy Tedoff, John McAusland,Alice Falk, and Barbara Hults.
A special note of thanks continues to be owed Judy Walsh. Judys knowledge ofeconomics and her willingness to discuss ideas, make suggestions, offer examples andencouragement have all helped contribute greatly to the improvements made to theFourth Edition.
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Alternative Course OutlineIn the Fourth Edition, we have further improved the flexibility of the book, allow-ing it to be easily adapted to courses of varying length and objectives. Part 4, Issuesin Public Policy and Part 9, Further Topics in Macroeconomics, contain chap-ters that can be covered at the end of a course, time permitting, or integrated withthe core discussions of microeconomics and macroeconomics. Part 8, The GlobalEconomy, provides instructors with the option of constructing a more internation-ally focused introductory course, covering international trade, finance, and develop-ment. Alternatively, instructors can selectively choose from among these topics andinclude them in a more traditional organized course. The following outlines, whichrepresent only a small subset of those that might be devised, reflect the flexibility theFourth Edition offers.
OUTLINE FOR A ONE-SEMESTER COURSE INMICROECONOMICS AND MACROECONOMICSCHAPTER TITLE
1 Modern Economics 2 Thinking Like an Economist3 Demand, Supply, and Price4 Using Demand and Supply5 The Consumption Decision6 The Firms Costs7 The Competitive Firm8 Labor Markets 9 Capital Markets
10 The Efficiency of Competitive Markets11 Introduction to Imperfect Markets12 Monopoly, Monopolistic Competition, and Oligopoly13 Government Policies Toward Competition21 Macroeconomics and the Economic Perspective22 Measuring Economic Output and Unemployment23 The Cost of Living and Inflation24 The Full-Employment Model25 Government Finance at Full-Employment26 Money, the Price Level, and the Federal Reserve29 Introduction to Economic Fluctuations31 Aggregate Demand and Inflation32 The Federal Reserve and Interest Rates33 The Role of Macroeconomic Policy
PREFACE xlv
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OUTLINE FOR A SHORT COURSE INMICROECONOMICS AND MACROECONOMICSCHAPTER TITLE
1 Modern Economics2 Thinking Like an Economist3 Demand, Supply, and Price4 Using Demand and Supply5 The Consumption Decision6 The Firms Costs7 The Competitive Firm
10 The Efficiency of Competitive Markets11 Introduction to Imperfect Markets21 Macroeconomics and the Economic Perspective22 Measuring Economic Output and Unemployment23 The Cost of Living and Inflation24 The Full-Employment Model25 Government Finance at Full Employment28 Money, the Price Level, and the Federal Reserve29 Introduction to Macroeconomic Fluctuations31 Aggregate Demand and Inflation32 The Federal Reserve and Interest Rates
OUTLINE FOR A ONE-SEMESTER COURSE INMICROECONOMICSCHAPTER TITLE
1 Modern Economics2 Thinking Like an Economist3 Demand, Supply, and Price4 Using Demand and Supply5 The Consumption Decision6 The Firms Costs7 The Competitive Firm8 Labor Markets 9 Capital Markets
10 The Efficiency of Competitive Markets11 Introduction to Imperfect Markets12 Monopoly, Monopolistic Competition, and Oligopoly13 Government Policies Toward Competition14 Strategic Behavior15 Imperfect Information in the Product Market16 Imperfections in the Labor Market
xlvi PREFACE
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Plus any of the optional chapters comprising Part 4.17 The Public Sector18 Environmental Economics19 International Trade and Trade Policy20 Technological Change39 A Students Guide to Investing
OUTLINE FOR A SHORT COURSE INMICROECONOMICSCHAPTER TITLE
1 Modern Economics2 Thinking Like an Economist3 Demand, Supply, and Price4 Using Demand and Supply5 The Consumption Decision6 The Firms Costs7 The Competitive Firm8 Labor Markets 9 Capital Markets
10 The Efficiency of Competitive Markets11 Introduction to Imperfect Markets12 Monopoly, Monopolistic Competition, and Oligopoly13 Government Policies Toward Competition17 The Public Sector
OUTLINE FOR A ONE-SEMESTER COURSE INMACROECONOMICSCHAPTER TITLE
21 Macroeconomics and the Economic Perspective
Core macroeconomics presentation22 Measuring Economic Output and Unemployment23 The Cost of Living and Inflation24 The Full-Employment Model25 Government Finance at Full Employment26 The Open Economy at Full Employment27 Growth and Productivity28 Money, the Price Level, and the Federal Reserve29 Introduction to Economic Fluctuations30 Aggregate Expenditures and Income
PREFACE xlvii
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31 Aggregate Demand and Inflation32 The Federal Reserve and Interest Rates33 The Role of Macroeconomic Policy
Plus any of the optional chapters comprising Parts 8 and 934 The International Financial System35 Policy in the Open Economy36 Economic Development and Transition37 Inflation and Unemployment38 Controversies in Macroeconomics39 A Students Guide to Investing
OUTLINE FOR A SHORT COURSE INMACROECONOMICSCHAPTER TITLE
21 Macroeconomics and the Economic Perspective
Core macroeconomics presentation22 Measuring Economic Output and Unemployment23 The Cost of Living and Inflation24 The Full-Employment Model25 Government Finance at Full Employment27 Growth and Productivity28 Money, the Price Level, and the Federal Reserve29 Introduction to Macroeconomic Fluctuations31 Aggregate Demand and Inflation32 The Federal Reserve and Interest Rates33 The Role of Macroeconomic Policy
xlviii PREFACE
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1
Part 1
INTRODUCTION
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Learning GoalsIn this chapter, you will learn
What economics is, and whatthe key concepts that definecore ideas in economics are
What markets are, and whichare the principal markets thatmake up the economy
Why economics is called ascience, and why it is thateconomists often disagree
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Chapter 1
MODERNECONOMICS
The past decade has seen tremendous changes in the world economy. Manyof these changes are linked to new technological advances that have trans-formed what the global economy produces, the ways in which many goodsand services are produced, where they are produced, and how goods and servicesare transferred from the firms that produce them to the households, governments,and other firms that buy them. New technologies are transforming everything, fromhow airlines sell tickets to how automobiles are produced, from how we buy booksto how we communicate with one another.
Like the industrial revolution of the eighteenth and nineteenth centuries thattransformed first Britain and then other countries from agricultural to manufacturing-based economies, the information revolution of the late twentieth and early twenty-first centuries promises to transform almost all aspects of our daily lives. In 1999, inrecognition of the growing importance of new, high-tech firms, Microsoft and Intelthe producer of the Windows computer operating system and the major producerof the microprocessors at the heart of personal computers, respectivelywere addedto the Dow-Jones Industrial Average, the most widely followed index of prices on U.S. stock markets. Though the booming stock market of the late 1990s that was driven in part by enthusiasm for new technologies came to an end in 2000, innovation continues to be a critical force in the economy.
But the old economy is still alive and kicking. Four of the five largest UnitedStates corporations in Fortune magazines top 500 list for 2003 were traditionalindustrial firmsGeneral Motors, Exxon, Ford, and General Electric. IBM at number8 and Verizon Communications at number 10 were the only information or techfirms in the top 10. Hewlett-Packard was number 14 and Dell Computers was 36,but Microsoft managed to make it no higher than number 47.
So the old economy and the new economy coexist side by side. But it is not justthe emergence of new software and Internet companies that represents the effectsof new technologies. The way all firms do business is being changed, and their
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customers are being affected too. Assembly lines now rely on robots aided and controlled by computers. Car repair shops with grease-stained floors have beenreplaced by clean, quiet garages where computers diagnose a cars problems. Theway we buy things is also changing. Whether an individual purchases a car, book,or CD over the Web; books a hotel or plane reservation; or even applies to a collegethrough the Internet, the relationship between people and firms is evolving. Newtechnologies are changing the way courses are taught, tootextbooks like this onehave Web sites that provide students with help, with interactive exercises, and withlinks to news, policy debates, and the latest economic information. The address ofthe home page for this text is www.wwnorton.com/stiglitzwalsh4.
With such far-reaching changes, what insights and understanding does the studyof economics have to offer? After all, the field usually looks to Adam Smith, an eighteenth-century Scottish professor of moral philosophy, as its founder. Smithpublished his most famous book, The Wealth of Nations, in 1776, a time when todaysindustrial economies were still overwhelmingly agriculture-based. It might seemunlikely that a theory developed to understand the factors that determine the priceof wheat would have much to say about todays modern economy.
But, in fact, study of economics continues to provide a critical understanding oftodays global economy. As Carl Shapiro and Hal Varian of the University of California,Berkeley, put it, Technology changes. Economic laws do not.1 The way we producethings, what we produce, and how goods are exchanged have altered tremendouslysince Smith wrote. Yet the same fundamental laws of economics that explained agri-cultural prices in the eighteenth century can help us understand how economiesfunction in the twenty-first century The foundation laid by Adam Smith and builtupon by generations of economists has yielded insights that will continue to offerguidance to anyone wishing to make sense of the modern economy.
Over the past two hundred years, economists have refined and expanded ourunderstanding of economic behavior. By incorporating the role of information andtechnological change, they are now able to explain much more than was possiblejust twenty years ago, offering new insights into topics that range from why car deal-ers build fancy showrooms to how the factors important for encouraging the pro-duction of new ideas differ from those that encourage the production of new cars.
But what are these insights? What do economists study? And what can we learnfrom looking at things from the perspective of economics? How can economics helpus understand why we need to worry about the extinction of salmon but not of sheep,why auto manufacturers advertise but wheat farmers dont, why countries that relyon uncoordinated markets have done better than countries that rely on governmentplanners, and why letting a single firm dominate an industry is bad?
The headlines from some recent news stories involving the computer industryand the Internet illustrate some of the key issues that a study of economics can help illuminate.
Bill to Curb Online Piracy Is Challenged as Too Broad, New York Times,June 24, 2004. A bill recently introduced in the U.S. Senate aims to restrict
4 CHAPTER 1 MODERN ECONOMICS
1Carl Shapiro and Hal R. Varian, Information Rules: A Strategic Guide to the Network Economy (Boston: Harvard
Business School Press, 1999), p. 2.
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the illegal online sharing of music and other files. This proposed legislationrepresents just the latest development in the running battle between the com-panies that own the rights to the music and consumers who want to freelyshare music files. After all, it doesnt cost the music company any more tohave a file shared by a thousand people than it does to have it shared by two.So why, many ask, should they have to pay for music files? The advent of digi-tal music has made it possible for listeners to exchange copies indistinguish-able from the originals. But if the producers of the music cannot earn a profit,they have less incentive to seek out and record new artists. Property rightsin this case, the legal right of the music company to charge for the use of itspropertyplay an important role in market economics, and disputes overproperty rights arent new. But the new information technologies have madetrading this property much easier and raised new questions. As we will see,economics can tell us a great deal about the issues involved in these disputes.
Internet Drug Trade Proves Bitter Pill for Canada, Financial Times,April 21, 2004. The Internet has changed the nature of the market forgoods such as prescription drugs. Buyers in Florida can as easily havetheir prescriptions filled by a pharmacy based in California, or Canada, asby one in Florida. But why has this led to shortages of some popular pre-scription drugs in Canada? What will be the likely consequences for drugprices in Canada and the United States?
Intel Cancels 2 Chip Projects, San Jose Mercury News, May 8, 2004. After spending as much as $2 billion on a new line of computer chips calledthe Itanium, Intel pulled the plug on the project. As the company decidedwhether to go ahead with the project, was the money already invested a factor? Firms are always concerned about costs, but economics gives criticalinsights that help us understand which costs are important and whethersome costs, such as the $2 billion Intel had already sunk into the Itaniumproject, arent.
Ebay Bids and Buys Baazee, The Economic Times, June 23, 2004.According to a story on economictimes.indiatimes.com, the online auctioncompany eBay purchased Baazee.com, an Indian online shopping company,for $50 million. The purchase extends eBays network throughout Asia,adding to its current ventures in Hong Kong, Singapore, and China. Bylinking online buyers and sellers globally, eBay will enable a consumer inSioux City, Iowa, to trade with someone in Bangalore, India.
Oracles Bid for PeopleSoft to Be Tested in Court, New York Times, June7, 2004. In early 2004, the software giant Oracle announced that it was mak-ing a hostile bid to buy PeopleSoft, another software company. The U.S.Justice Department initially filed a lawsuit to block this takeover, arguingthat it would reduce competition in the market for business software. Oraclewas eventually allowed to take over PeopleSoft, but why does the govern-ment try to ensure that there is competition? What are the advantages ofcompetition? What tools does the government use to promote competition?
FASB Holds Meeting on Expensing Stock Options, San Jose MercuryNews, June 24, 2004. Many tech companies, particularly those located inCalifornias Silicon Valley, have used stock options to reward their employees.
MODERN ECONOMICS 5
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Internet Connection
TRACKING THE DIGITAL ECONOMY
Since 1998, the U.S. Department of Commerce has issued anannual report on the digital economy. You can find the latest
report at www.esa.doc.gov/reports.cfm.
This mechanism grants the employee the opportunity to purchase shares inthe company at a set price. If the company does well and its shares go up invalue, the employee can sell the stock for a profita prospect that creates anincentive to work hard and help the company succeed. The FederalAccounting Standards Board (FASB) proposed new accounting rules requir-ing firms that offer stock options to report these as an expense, thereby re-ducing the firms reported profits. The FASB argues that to do so wouldpresent investors with a more accurate picture of the firms profits, enablinginvestors to make better decisions about buying stock in the company.
News headlines frequently focus on economic issues, and these six point to someof the key topics that economists study: the role of incentives and information, glob-alization and exchange, competition and government regulation, costs and businessdecisions. The study of economics will give you new insights into the news stories yousee in the paper, it will give you insights into the world of business, and it will helpyou understand the world of economics you participate in every day.
What Is Economics? Headlines can illustrate many of the important issues with which economics deals,but now a definition of our subject is in order. Economics studies how individuals,firms, government, and other organizations within our society make choices, andhow these choices determine societys use of its resources. Why did consumerschoose to buy small, energy-efficient cars in the 1970s and large sports utility vehi-cles in the 1990s? What determines how many individuals work in health careindustries and how many work in the computer industry? Why did the income gapbetween rich and poor rise in the 1980s? To understand how choices are madeand how these choices affect the use of societys resources, we must examine fiveconcepts that play an important role: trade-offs, incentives, exchange, information,and distribution.
1. Choice involves trade-offsdeciding to spend more on one thing leaves lessto spend on something else; devoting more time to studying economics leavesless time to study physics.
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2. In making choices, individuals respond to incentives. If the price of Zen MP3players falls relative to the price of iPods, there is a greater incentive to buy aZen. If the salaries for engineers rise relative to the salaries of people with anMBA, there is an increased incentive to choose to study for an engineeringdegree rather than a business degree.
3. When we exchange with others, our range of choices becomes larger. 4. Making intelligent choices requires that we have, and utilize, information.5. Finally, the choices we makeabout how much education to get, what occupa-
tion to enter, and what goods and service to buydetermine the distributionof wealth and income in our society.
These five concepts define the core ideas that are critical to understanding eco-nomics. They also guide the way economists think about issues and problems.Learning to think like an economist means learning how to discover the trade-offsand incentives faced, the implications of exchange, the role of information, and theconsequences for distribution. These key concepts are emphasized throughout thetext in Thinking Like an Economist boxes.
TRADE-OFFS Each of us is constantly making choicesstudents decide to study at thelibrary rather than in the dorm, to have pizza rather than sushi, to go to collegerather than work full-time. Societies, too, make choicesto preserve open spaces rather than provide more housing, to produce computers and import tele-visions rather than produce televisions and import computers, to cut taxes ratherthan increase government expenditures. In some cases, individuals or governments explicitly make these choices. You decided to study economics rather than someother subject. The government decides each year whether to cut taxes or to increasespending. In other cases, however, the choices were the result of the uncoordinatedactions of millions of individuals. Neither the government nor any one individualdecided that the United States would import cars from Japan and export wheat to India. But in each case, choice involves trade-offsto get more of one thinginvolves having less of something else. We are forced to make trade-offs becauseof scarcity.
Scarcity figures prominently in economics; choices matter because resources arescarce. For most of us, our limited income forces us to make choices. We cannot affordeverything we might want. Spending more on rent leaves less available for clothes andentertainment. Getting a sunroof on a new car may mean forgoing leather seats to staywithin a fixed budget. Limited income is not the only reason we are forced to maketrade-offs. Time is also a scarce resource, and even the wealthiest individual mustdecide what expensive toy to play with each day. When we take time into account, werealize scarcity is a fact of life for everyone.
One of the most important points on which economists agree concerns the criticalrole of scarcity. We can summarize this point as follows: There is no free lunch. Having moreof one thing requires giving up something else. Scarcity means that trade-offs are a basic fact of life.
WHAT IS ECONOMICS? 7
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INCENTIVES It is one thing to say we all face trade-offs in the choices we make. It is quite anotherto understand how individuals and firms make choices and how those choices mightchange as economic circumstances change. If new technologies are developed, willfirms decide to increase or decrease the amount of labor they employ? If the priceof gasoline rises, will individuals decide to buy different types of automobiles?
When faced with a choice, people evaluate the pros and cons of the differentoptions. In deciding what to eat for dinner tonight, you and your roommates mightweigh the advantages and disadvantages of having a frozen pizza again over goingout for sushi. Similarly, a firm evaluates the pros and cons of its alternatives in termsof the effects different choices will have on its profits. For example, a retail chaindeciding on the location for a new store must weigh the relative advantages of dif-ferent locations. One location might have more foot traffic but also higher rent.Another location might be less desirable but have lower rent.
When decision makers systematically weigh the pros and cons of the alternativesthey face, we can predict how they will respond to changing economic conditions.Higher gas prices raise the cost of driving, but the cost of driving a fuel-efficient carrises less than the cost of driving a sports utility vehicle. Therefore, households weigh-ing a car purchase have a greater incentive to choose the fuel-efficient car. If a firm startsselling more of its goods through the Internet, it will rely less on foot traffic into itsretail store. This shift reduces its incentive to pay a high rent for a good location.
Economists analyze choices by focusing on incentives. In an economic context,incentives are benefits (including reduced costs) that motivate a decision maker infavor of a particular choice. Many things can affect incentives, but among the mostimportant are prices. If the price of gasoline rises, people have a greater incentive todrive less. If the price of MP3 players falls, people have a greater incentive to buy one.When the price of a good rises, firms are induced to produce more of that good, inorder to increase their profits. If a re