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,200 Table B1 The Consumption Function However, a number of factors other than income can also cause the entire consumption function to shift. These factors were summarized in the earlier discussion of consumption, and listed in Table B1. When the consumption function moves, it can shift in two ways: either the entire consumption function can move up or down in a parallel manner, or the slope of the consumption function can shift so that it becomes steeper or flatter. For example, if a tax cut leads consumers to spend more, but does not affect their marginal propensity to consume, it would cause an upward shift to a new consumption function that is parallel to the original one. However, a change in household preferences for saving that reduced the marginal propensity to save would cause the slope of the consumption function to become steeper: that is, if the savings rate is lower, then every increase in income leads to a larger rise in consumption. 544 Appendix B Investment as a Function of National Income Investment decisions are forward-looking, based on expected rates of return. Precisely because investment decisions depend primarily on perceptions about future economic conditions, they do not depend primarily on the level of GDP in the current year. Thus, on a Keynesian cross diagram, the investment function can be drawn as a horizontal line, at a fixed level of expenditure. Figure B3 shows an investment function where the level of investment is, for the sake of concreteness, set at the specific level of 500. Just as a consumption function shows the relationship between consumption levels and real GDP (or national income), the investment function shows the relationship between investment levels and real GDP. Figure B3 The Investment Function The investment function is drawn as a flat line because investment is based on interest rates and expectations about the future, and so it does not change with the level of current national income. In this example, investment expenditures are at a level of 500. However, changes in factors like technological opportunities, expectations about near-term economic growth, and interest rates would all cause the investment function to shift up or down. The appearance of the investment function as a horizontal line does not mean that the level of investment never moves. It means only that in the context of this two-dimensional diagram, the level of investment on the vertical aggregate expenditure axis does not vary according to the current level of real GDP on the horizontal axis. However, all the other factors that vary investment—new technological opportunities, expectations about near-term economic growth, interest rates, the price of key inputs, and tax incentives for investment—can cause the horizontal investment function to shift up or down. Government Spending and Taxes as a Function of National Income In the Keynesian cross diagram, government spending appears as a horizontal line, as in Figure B4, where government spending is set at a level of 1,300. As in the case of investment spending, this horizontal line does not mean that government spending is unchanging. It means only that government spending changes when Congress decides on a change in the budget, rather than shifting in a predictable way with the current size of the real GDP shown on the horizontal axis. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Appendix B 545 Figure B4 The Government Spending Function The level of government spending is determined by political factors, not by the level of real GDP in a given year. Thus, government spending is drawn as a horizontal line. In this example, government spending is at a level of 1,300. Congressional decisions to increase government spending will cause this horizontal line to shift up, while decisions to reduce spending would cause it to shift down. The situation of taxes is different because taxes often rise or fall with the volume of economic activity. For example, income taxes are based on the level of income earned and sales taxes are based on the amount of sales made, and both income and sales tend to be higher when the economy is growing and lower when the economy is in a recession. For the purposes of constructing the basic Keynesian cross diagram, it is helpful to view taxes as a proportionate share of GDP. In the United States, for example, taking federal, state, and local taxes together, government typically collects about 30–35 % of income as taxes. Table B2 revises the earlier table on the consumption function so that it takes taxes into account. The first column shows national income. The second column calculates taxes, which in this example are set at a rate of 30%, or 0.3. The third column shows after-tax income; that is, total income minus taxes. The fourth column then calculates consumption in the same manner as before: multiply after-tax income by 0.8, representing the marginal propensity to consume, and then add $600, for the amount that would be consumed even if income was zero. When taxes are included, the marginal propensity to consume is reduced by the amount of the tax rate, so each additional dollar of income results in a smaller increase in consumption than before taxes. For this reason, the consumption function, with taxes included, is flatter than the consumption function without taxes, as Figure B5 shows. Figure B5 The Consumption Function Before and After Taxes The upper line repeats the consumption function from Figure B2. The lower line shows the consumption function if taxes must first be paid on income, and then consumption is based on after-tax income. 546 Appendix B Income Taxes After-Tax Income Consumption Savings $0 $1,000 $2,000 $3,000 $4,000 $5,000 $6,000 $7,000 $8,000 $9,000 $0 $300 $600 $900 $1,200 $1,500 $1,800 $2,100 $2,400 $2,700 $0 $700 $1,400 $2,100 $2,800 $3,500 $4,200 $4,900 $5,600 $6,300 $600 $1,160 $1,720 $2,280 $2,840 $3,400 $3,960 $4,520 $5,080 $5,640 –$600 –$460 –$320 –$180 –$40 $100 $240 $380 $520 $660 Table B2 The Consumption Function Before and After Taxes Exports and Imports as a Function of National Income The export function, which shows how exports change with the level of a country’s own real GDP, is drawn as a horizontal line, as in the example in Figure B6 (a) where exports are drawn at a level of $840. Again, as in the case of investment spending and government spending, drawing the export function as horizontal does not imply that exports never change. It just means that they do not change because of what is on the horizontal axis—that is, a country’s own level of domestic production—and instead are shaped by the level of aggregate demand in other countries. More demand for exports from other countries would cause the export function to shift up; less demand for exports from other countries would cause it to shift down. Figure B6 The Export and Import Functions (a) The export function is drawn as a horizontal line because exports are determined by the buying power of other countries and thus do not change with the size of the domestic economy. In this example, exports are set at 840. However, exports can shift up or down, depending on buying patterns in other countries. (b) The import function is drawn in negative territory because expenditures on imported products are a subtraction from expenditures in the domestic economy. In this example, the marginal propensity to import is 0.1, so imports are calculated by multiplying the level of income by –0.1. Imports are drawn in the Keynesian cross diagram as a downward-sloping line, with the downward slope determined This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Appendix B 547 by the marginal propensity to import (MPI), out of national income. In Figure B6 (b), the marginal propensity to import is 0.1. Thus, if real GDP is $5,000, imports are $500; if national income is $6,000, imports are $600, and so on. The import function is drawn as downward sloping and negative, because it represents a subtraction from the aggregate expenditures in the domestic economy. A change in the marginal propensity to import, perhaps as a result of changes in preferences, would alter the slope of the import function. Using an Algebraic Approach to the Expenditure-Output Model In the expenditure-output or Keynesian cross model, the equilibrium occurs where the aggregate expenditure line (AE line) crosses the 45-degree line. Given algebraic equations for two lines, the point where they cross can be readily calculated. Imagine an economy with the following characteristics. Y = Real GDP or national income T = Taxes = 0.3Y C = Consumption = 140 + 0.9(Y – T) I = Investment = 400 G = Government spending = 800 X = Exports = 600 M = Imports = 0.15Y Step 1. Determine the aggregate expenditure function. In this case, it is: AE = C + I + G + X – M AE = 140 + 0.9(Y – T) + 400 + 800 + 600 – 0.15Y Step 2. The equation for the 45-degree line is the set of points where GDP or national income on the horizontal axis is equal to aggregate expenditure on the vertical axis. Thus, the equation for the 45-degree line is: AE = Y. Step 3. The next step is to solve these two equations for Y (or AE, since they will be equal to each other). Substitute Y for AE: Y = 140 + 0.9(Y – T) + 400 + 800 + 600 – 0.15Y Step 4. Insert the term 0.3Y for the tax rate T. This produces an equation with only one variable, Y. Step 5. Work through the algebra and solve for Y. Y = 140 + 0.9(Y – 0.3Y) + 400 + 800 + 600 – 0.15Y Y = 140 + 0.9Y – 0.27Y + 1800 – 0.15Y Y = 1940 + 0.48Y Y – 0.48Y = 1940 0.52Y = 1940 = 1940 0.52Y 0.52 0.52 Y = 3730 This algebraic framework is flexible and useful actions will affect real GDP. in predicting how economic events and policy Step 6. Say, for example, that because of changes in the relative prices of domestic and foreign goods, the marginal propensity to import falls to 0.1. Calculate the equilibrium output when the m
arginal propensity to import is changed to 0.1. 548 Appendix B Y = 140 + 0.9(Y – 0.3Y) + 400 + 800 + 600 – 0.1Y Y = 1940 – 0.53Y 0.47Y = 1940 Y = 4127 Step 7. Because of a surge of business confidence, investment rises to 500. Calculate the equilibrium output. Y = 140 + 0.9(Y – 0.3Y) + 500 + 800 + 600 – 0.15Y Y = 2040 + 0.48Y Y – 0.48Y = 2040 0.52Y = 2040 Y = 3923 For issues of policy, the key questions would be how to adjust government spending levels or tax rates so that the equilibrium level of output is the full employment level. In this case, let the economic parameters be: Y = National income T = Taxes = 0.3Y C = Consumption = 200 + 0.9(Y – T) I = Investment = 600 G = Government spending = 1,000 X = Exports = 600 Y = Imports = 0.1(Y – T) Step 8. Calculate the equilibrium for this economy (remember Y = AE). Y = 200 + 0.9(Y – 0.3Y) + 600 + 1000 + 600 – 0.1(Y – 0.3Y) Y – 0.63Y + 0.07Y = 2400 0.44Y = 2400 Y = 5454 Step 9. Assume that the full employment level of output is 6,000. What level of government spending would be necessary to reach that level? To answer this question, plug in 6,000 as equal to Y, but leave G as a variable, and solve for G. Thus: 6000 = 200 + 0.9(6000 – 0.3(6000)) + 600 + G + 600 – 0.1(6000 – 0.3(6000)) Step 10. Solve this problem arithmetically. The answer is: G = 1,240. In other words, increasing government spending by 240, from its original level of 1,000, to 1,240, would raise output to the full employment level of GDP. Indeed, the question of how much to increase government spending so that equilibrium output will rise from 5,454 to 6,000 can be answered without working through the algebra, just by using the multiplier formula. The multiplier equation in this case is: 1 1 – 0.56 = 2.27 Thus, to raise output by 546 would require an increase in government spending of 546/2.27=240, which is the same as the answer derived from the algebraic calculation. This algebraic framework is highly flexible. For example, taxes can be treated as a total set by political considerations (like government spending) and not dependent on national income. Imports might be based on before-tax income, not after-tax income. For certain purposes, it may be helpful to analyze the economy without exports and imports. A more complicated approach could divide up consumption, investment, government, exports and imports into smaller categories, or to build in some variability in the rates of taxes, savings, and imports. A wise economist will shape the model This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Appendix B 549 to fit the specific question under investigation. Building the Combined Aggregate Expenditure Function the components of aggregate demand—consumption, All investment, government spending, and the trade balance—are now in place to build the Keynesian cross diagram. Figure B7 builds up an aggregate expenditure function, based on the numerical illustrations of C, I, G, X, and M that have been used throughout this text. The first three columns in Table B3 are lifted from the earlier Table B2, which showed how to bring taxes into the consumption function. The first column is real GDP or national income, which is what appears on the horizontal axis of the income-expenditure diagram. The second column calculates after-tax income, based on the assumption, in this case, that 30% of real GDP is collected in taxes. The third column is based on an MPC of 0.8, so that as after-tax income rises by $700 from one row to the next, consumption rises by $560 (700 × 0.8) from one row to the next. Investment, government spending, and exports do not change with the level of current national income. In the previous discussion, investment was $500, government spending was $1,300, and exports were $840, for a total of $2,640. This total is shown in the fourth column. Imports are 0.1 of real GDP in this example, and the level of imports is calculated in the fifth column. The final column, aggregate expenditures, sums up C + I + G + X – M. This aggregate expenditure line is illustrated in Figure B7. Figure B7 A Keynesian Cross Diagram Each combination of national income and aggregate expenditure (after-tax consumption, government spending, investment, exports, and imports) is graphed. The equilibrium occurs where aggregate expenditure is equal to national income; this occurs where the aggregate expenditure schedule crosses the 45-degree line, at a real GDP of $6,000. Potential GDP in this example is $7,000, so the equilibrium is occurring at a level of output or real GDP below the potential GDP level. National Income After-Tax Income Consumption Government Spending + Investment + Exports Imports Aggregate Expenditure $3,000 $2,100 $2,280 $4,000 $2,800 $2,840 $5,000 $3,500 $3,400 $6,000 $4,200 $3,960 $2,640 $2,640 $2,640 $2,640 Table B3 National Income-Aggregate Expenditure Equilibrium $300 $400 $500 $600 $4,620 $5,080 $5,540 $6,000 550 Appendix B National Income After-Tax Income Consumption Government Spending + Investment + Exports Imports Aggregate Expenditure $7,000 $4,900 $4,520 $8,000 $5,600 $5,080 $9,000 $6,300 $5,640 $2,640 $2,640 $2,640 $700 $800 $900 $6,460 $6,920 $7,380 Table B3 National Income-Aggregate Expenditure Equilibrium The aggregate expenditure function is formed by stacking on top of each other the consumption function (after taxes), the investment function, the government spending function, the export function, and the import function. The point at which the aggregate expenditure function intersects the vertical axis will be determined by the levels of investment, government, and export expenditures—which do not vary with national income. The upward slope of the aggregate expenditure function will be determined by the marginal propensity to save, the tax rate, and the marginal propensity to import. A higher marginal propensity to save, a higher tax rate, and a higher marginal propensity to import will all make the slope of the aggregate expenditure function flatter—because out of any extra income, more is going to savings or taxes or imports and less to spending on domestic goods and services. The equilibrium occurs where national income is equal to aggregate expenditure, which is shown on the graph as the point where the aggregate expenditure schedule crosses the 45-degree line. In this example, the equilibrium occurs at 6,000. This equilibrium can also be read off the table under the figure; it is the level of national income where aggregate expenditure is equal to national income. Equilibrium in the Keynesian Cross Model With the aggregate expenditure line in place, the next step is to relate it to the two other elements of the Keynesian cross diagram. Thus, the first subsection interprets the intersection of the aggregate expenditure function and the 45-degree line, while the next subsection relates this point of intersection to the potential GDP line. Where Equilibrium Occurs The point where the aggregate expenditure line that is constructed from C + I + G + X – M crosses the 45-degree line will be the equilibrium for the economy. It is the only point on the aggregate expenditure line where the total amount being spent on aggregate demand equals the total level of production. In Figure B7, this point of equilibrium (E0) happens at 6,000, which can also be read off Table B3. The meaning of “equilibrium” remains the same; that is, equilibrium is a point of balance where no incentive exists to shift away from that outcome. To understand why the point of intersection between the aggregate expenditure function and the 45-degree line is a macroeconomic equilibrium, consider what would happen if an economy found itself to the right of the equilibrium point E, say point H in Figure B8, where output is higher than the equilibrium. At point H, the level of aggregate expenditure is below the 45-degree line, so that the level of aggregate expenditure in the economy is less than the level of output. As a result, at point H, output is piling up unsold—not a sustainable state of affairs. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Appendix B 551 Figure B8 Equilibrium in the Keynesian Cross Diagram If output was above the equilibrium level, at H, then the real output is greater than the aggregate expenditure in the economy. This pattern cannot hold, because it would mean that goods are produced but piling up unsold. If output was below the equilibrium level at L, then aggregate expenditure would be greater than output. This pattern cannot hold either, because it would mean that spending exceeds the number of goods being produced. Only point E can be at equilibrium, where output, or national income and aggregate expenditure, are equal. The equilibrium (E) must lie on the 45-degree line, which is the set of points where national income and aggregate expenditure are equal. Conversely, consider the situation where the level of output is at point L—where real output is lower than the equilibrium. In that case, the level of aggregate demand in the economy is above the 45-degree line, indicating that the level of aggregate expenditure in the economy is greater than the level of output. When the level of aggregate demand has emptied the store shelves, it cannot be sustained, either. Firms will respond by increasing their level of production. Thus, the equilibrium must be the point where the amount produced and the amount spent are in balance, at the intersection of the aggregate expenditure function and the 45-degree line. 552 Appendix B Finding Equilibrium Table B4 gives some information on an economy. The Keynesian model assumes that there is some level of consumption even without income. That amount is $236 – $216 = $20. $20 will be consumed when national income equals zero. Assume that taxes are 0.2 of real GDP. Let the marginal propensity to save of after-tax income be 0.1. The level of investment is $70, the level of government spending is $80, and
the level of exports is $50. Imports are 0.2 of after-tax income. Given these values, you need to complete Table B4 and then answer these questions: • What is the consumption function? • What is the equilibrium? • Why is a national income of $300 not at equilibrium? • How do expenditures and output compare at this point? National Income Taxes After-tax income Consumption I + G + X Imports Aggregate Expenditures $236 $300 $400 $500 $600 $700 Table B4 Step 1. Calculate the amount of taxes for each level of national income(reminder: GDP = national income) for each level of national income using the following as an example: National Income (Y) Taxes = 0.2 or 20% Tax amount (T) $300 × 0.2 $60 Step 2. Calculate after-tax income by subtracting the tax amount from national income for each level of national income using the following as an example: National income minus taxes After-tax income $300 –$60 $240 Step 3. Calculate consumption. The marginal propensity to save is given as 0.1. This means that the marginal propensity to consume is 0.9, since MPS + MPC = 1. Therefore, multiply 0.9 by the after-tax income amount using the following as an example: After-tax Income MPC Consumption $240 × 0.9 $216 Step 4. Consider why the table shows consumption of $236 in the first row. As mentioned earlier, the Keynesian model assumes that there is some level of consumption even without income. That amount is $236 – $216 = $20. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Appendix B 553 Step 5. There is now enough information to write the consumption function. The consumption function is found by figuring out the level of consumption that will happen when income is zero. Remember that: C = Consumption when national income is zero + MPC (after-tax income) Let C represent the consumption function, Y represent national income, and T represent taxes. C = $20 + 0.9(Y – T) = $20 + 0.9($300 – $60) = $236 Step 6. Use the consumption function to find consumption at each level of national income. Step 7. Add investment (I), government spending (G), and exports (X). Remember that these do not change as national income changes: Step 8. Find imports, which are 0.2 of after-tax income at each level of national example: income. For After-tax income Imports of 0.2 or 20% of Y – T Imports $240 × 0.2 $48 Step 9. Find aggregate expenditure by adding C + I + G + X – I for each level of national income. Your completed table should look like Table B5. National Income (Y) Tax = 0.2 × Y (T) After-tax income (Y – T) Consumption C = $20 + 0.9(Y – T) I + G + X Minus Imports (M) Aggregate Expenditures AE = 60 $80 $240 $320 $100 $400 $120 $480 $140 $560 $236 $308 $380 $452 $524 $300 $400 $500 $600 $700 Table B5 $200 $48 $200 $64 $200 $80 $200 $96 $200 $112 $388 $444 $500 $556 $612 Step 10. Answer the question: What is equilibrium? Equilibrium occurs where AE = Y. Table B5 shows that equilibrium occurs where national income equals aggregate expenditure at $500. Step 11. Find equilibrium mathematically, knowing that national expenditure. income is equal to aggregate Y = AE = 20 + 0.9(Y – T) + $70 + $80 + $50 – 0.2(Y – T) = $220 + 0.9(Y – T) – 0.2(Y – T) Since T is 0.2 of national income, substitute T with 0.2 Y so that: Y = $220 + 0.9(Y – 0.2Y) – 0.2(Y – 0.2Y) = $220 + 0.9Y – 0.18Y – 0.2Y + 0.04Y = $220 + 0.56Y 554 Solve for Y. Appendix B Y = $220 + 0.56Y Y – 0.56Y = $220 0.44Y = $220 = $220 0.44Y 0.44 0.44 Y = $500 Step 12. Answer this question: Why is a national income of $300 not an equilibrium? At national income of $300, aggregate expenditures are $388. Step 13. Answer this question: How do expenditures and output compare at this point? Aggregate expenditures cannot exceed output (GDP) in the long run, since there would not be enough goods to be bought. Recessionary and Inflationary Gaps In the Keynesian cross diagram, if the aggregate expenditure line intersects the 45-degree line at the level of potential GDP, then the economy is in sound shape. There is no recession, and unemployment is low. But there is no guarantee that the equilibrium will occur at the potential GDP level of output. The equilibrium might be higher or lower. For example, Figure B9 (a) illustrates a situation where the aggregate expenditure line intersects the 45-degree line at point E0, which is a real GDP of $6,000, and which is below the potential GDP of $7,000. In this situation, the level of aggregate expenditure is too low for GDP to reach its full employment level, and unemployment will occur. The distance between an output level like E0 that is below potential GDP and the level of potential GDP is called a recessionary gap. Because the equilibrium level of real GDP is so low, firms will not wish to hire the full employment number of workers, and unemployment will be high. Figure B9 Addressing Recessionary and Inflationary Gaps (a) If the equilibrium occurs at an output below potential GDP, then a recessionary gap exists. The policy solution to a recessionary gap is to shift the aggregate expenditure schedule up from AE0 to AE1, using policies like tax cuts or government spending increases. Then the new equilibrium E1 occurs at potential GDP. (b) If the equilibrium occurs at an output above potential GDP, then an inflationary gap exists. The policy solution to an inflationary gap is to shift the aggregate expenditure schedule down from AE0 to AE1, using policies like tax increases or spending cuts. Then, the new equilibrium E1 occurs at potential GDP. What might cause a recessionary gap? Anything that shifts the aggregate expenditure line down is a potential cause of recession, including a decline in consumption, a rise in savings, a fall in investment, a drop in government spending or a rise in taxes, or a fall in exports or a rise in imports. Moreover, an economy that is at equilibrium with a recessionary This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Appendix B 555 gap may just stay there and suffer high unemployment for a long time; remember, the meaning of equilibrium is that there is no particular adjustment of prices or quantities in the economy to chase the recession away. The appropriate response to a recessionary gap is for the government to reduce taxes or increase spending so that the aggregate expenditure function shifts up from AE0 to AE1. When this shift occurs, the new equilibrium E1 now occurs at potential GDP as shown in Figure B9 (a). Conversely, Figure B9 (b) shows a situation where the aggregate expenditure schedule (AE0) intersects the 45-degree line above potential GDP. The gap between the level of real GDP at the equilibrium E0 and potential GDP is called an inflationary gap. The inflationary gap also requires a bit of interpreting. After all, a naïve reading of the Keynesian cross diagram might suggest that if the aggregate expenditure function is just pushed up high enough, real GDP can be as large as desired—even doubling or tripling the potential GDP level of the economy. This implication is clearly wrong. An economy faces some supply-side limits on how much it can produce at a given time with its existing quantities of workers, physical and human capital, technology, and market institutions. The inflationary gap should be interpreted, not as a literal prediction of how large real GDP will be, but as a statement of how much extra aggregate expenditure is in the economy beyond what is needed to reach potential GDP. An inflationary gap suggests that because the economy cannot produce enough goods and services to absorb this level of aggregate expenditures, the spending will instead cause an inflationary increase in the price level. In this way, even though changes in the price level do not appear explicitly in the Keynesian cross equation, the notion of inflation is implicit in the concept of the inflationary gap. The appropriate Keynesian response to an inflationary gap is shown in Figure B9 (b). The original intersection of aggregate expenditure line AE0 and the 45-degree line occurs at $8,000, which is above the level of potential GDP at $7,000. If AE0 shifts down to AE1, so that the new equilibrium is at E1, then the economy will be at potential GDP without pressures for inflationary price increases. The government can achieve a downward shift in aggregate expenditure by increasing taxes on consumers or firms, or by reducing government expenditures. The Multiplier Effect The Keynesian policy prescription has one final twist. Assume that for a certain economy, the intersection of the aggregate expenditure function and the 45-degree line is at a GDP of 700, while the level of potential GDP for this economy is $800. By how much does government spending need to be increased so that the economy reaches the full employment GDP? The obvious answer might seem to be $800 – $700 = $100; so raise government spending by $100. But that answer is incorrect. A change of, for example, $100 in government expenditures will have an effect of more than $100 on the equilibrium level of real GDP. The reason is that a change in aggregate expenditures circles through the economy: households buy from firms, firms pay workers and suppliers, workers and suppliers buy goods from other firms, those firms pay their workers and suppliers, and so on. In this way, the original change in aggregate expenditures is actually spent more than once. This is called the multiplier effect: An initial increase in spending, cycles repeatedly through the economy and has a larger impact than the initial dollar amount spent. How Does the Multiplier Work? To understand how the multiplier effect works, return to the example in which the current equilibrium in the Keynesian cross diagram is a real GDP of $700, or $100 short of the $800 needed to be at full employment, potential GDP. If the government spends $100 to close this gap, someone in the economy receives that spending and can treat it as income. Assume that those who recei
ve this income pay 30% in taxes, save 10% of after-tax income, spend 10% of total income on imports, and then spend the rest on domestically produced goods and services. As shown in the calculations in Figure B10 and Table B6, out of the original $100 in government spending, $53 is left to spend on domestically produced goods and services. That $53 which was spent, becomes income to someone, somewhere in the economy. Those who receive that income also pay 30% in taxes, save 10% of after-tax income, and spend 10% of total income on imports, as shown in Figure B10, so that an additional $28.09 (that is, 0.53 × $53) is spent in the third round. The people who receive that income then pay taxes, save, and buy imports, and the amount spent in the fourth round is $14.89 (that is, 0.53 × $28.09). 556 Appendix B Figure B10 The Multiplier Effect An original increase of government spending of $100 causes a rise in aggregate expenditure of $100. But that $100 is income to others in the economy, and after they save, pay taxes, and buy imports, they spend $53 of that $100 in a second round. In turn, that $53 is income to others. Thus, the original government spending of $100 is multiplied by these cycles of spending, but the impact of each successive cycle gets smaller and smaller. Given the numbers in this example, the original government spending increase of $100 raises aggregate expenditure by $213; therefore, the multiplier in this example is $213/$100 = 2.13. Original increase in aggregate expenditure from government spending 100 Which is income to people throughout the economy: Pay 30% in taxes. Save 10% of after-tax income. Spend 10% of income on imports. Second-round increase of… 70 – 7 – 10 = 53 Which is $53 of income to people through the economy: Pay 30% in taxes. Save 10% of after-tax income. Spend 10% of income on imports. Third-round increase of… 37.1 – 3.71 – 5.3 = 28.09 Which is $28.09 of income to people through the economy: Pay 30% in taxes. Save 10% of after-tax income. Spend 10% of income on imports. Fourth-round increase of… 19.663 – 1.96633 – 2.809 = 14.89 Table B6 Calculating the Multiplier Effect Thus, over the first four rounds of aggregate expenditures, the impact of the original increase in government spending of $100 creates a rise in aggregate expenditures of $100 + $53 + $28.09 + $14.89 = $195.98. Figure B10 shows these total aggregate expenditures after these first four rounds, and then the figure shows the total aggregate expenditures after 30 rounds. The additional boost to aggregate expenditures is shrinking in each round of consumption. After about 10 rounds, the additional increments are very small indeed—nearly invisible to the naked eye. After 30 rounds, the additional increments in each round are so small that they have no practical consequence. After 30 rounds, the cumulative value of the initial boost in aggregate expenditure is approximately $213. Thus, the government spending increase of $100 eventually, after many cycles, produced an increase of $213 in aggregate expenditure and real GDP. In this example, the multiplier is $213/$100 = 2.13. Calculating the Multiplier Fortunately for everyone who is not carrying around a computer with a spreadsheet program to project the impact of an original increase in expenditures over 20, 50, or 100 rounds of spending, there is a formula for calculating the multiplier. The data from Figure B10 and Table B6 is: Spending Multiplier = 1/(1 – MPC * (1 – tax rate) + MPI) This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Appendix B 557 • Marginal Propensity to Save (MPS) = 30% • Tax rate = 10% • Marginal Propensity to Import (MPI) = 10% The MPC is equal to 1 – MPS, or 0.7. Therefore, the spending multiplier is: Spending Multiplier = 1 1 – (0.7 – (0.10)(0.7) – 0.10) = 1 0.47 = 2.13 A change in spending of $100 multiplied by the spending multiplier of 2.13 is equal to a change in GDP of $213. Not coincidentally, this result is exactly what was calculated in Figure B10 after many rounds of expenditures cycling through the economy. The size of the multiplier is determined by what proportion of the marginal dollar of income goes into taxes, saving, and imports. These three factors are known as “leakages,” because they determine how much demand “leaks out” in each round of the multiplier effect. If the leakages are relatively small, then each successive round of the multiplier effect will have larger amounts of demand, and the multiplier will be high. Conversely, if the leakages are relatively large, then any initial change in demand will diminish more quickly in the second, third, and later rounds, and the multiplier will be small. Changes in the size of the leakages—a change in the marginal propensity to save, the tax rate, or the marginal propensity to import—will change the size of the multiplier. Calculating Keynesian Policy Interventions Returning to the original question: How much should government spending be increased to produce a total increase in real GDP of $100? If the goal is to increase aggregate demand by $100, and the multiplier is 2.13, then the increase in government spending to achieve that goal would be $100/2.13 = $47. Government spending of approximately $47, when combined with a multiplier of 2.13 (which is, remember, based on the specific assumptions about tax, saving, and import rates), produces an overall increase in real GDP of $100, restoring the economy to potential GDP of $800, as Figure B11 shows. Figure B11 The Multiplier Effect in an Expenditure-Output Model The power of the multiplier effect is that an increase in expenditure has a larger increase on the equilibrium output. The increase in expenditure is the vertical increase from AE0 to AE1. However, the increase in equilibrium output, shown on the horizontal axis, is clearly larger. The multiplier effect is also visible on the Keynesian cross diagram. Figure B11 shows the example we have been discussing: a recessionary gap with an equilibrium of $700, potential GDP of $800, the slope of the aggregate expenditure function (AE0) determined by the assumptions that taxes are 30% of income, savings are 0.1 of after-tax income, and imports are 0.1 of before-tax income. At AE1, the aggregate expenditure function is moved up to reach potential GDP. 558 Appendix B Now, compare the vertical shift upward in the aggregate expenditure function, which is $47, with the horizontal shift outward in real GDP, which is $100 (as these numbers were calculated earlier). The rise in real GDP is more than double the rise in the aggregate expenditure function. (Similarly, if you look back at Figure B9, you will see that the vertical movements in the aggregate expenditure functions are smaller than the change in equilibrium output that is produced on the horizontal axis. Again, this is the multiplier effect at work.) In this way, the power of the multiplier is apparent in the income–expenditure graph, as well as in the arithmetic calculation. The multiplier does not just affect government spending, but applies to any change in the economy. Say that business confidence declines and investment falls off, or that the economy of a leading trading partner slows down so that export sales decline. These changes will reduce aggregate expenditures, and then will have an even larger effect on real GDP because of the multiplier effect. Read the following Clear It Up feature to learn how the multiplier effect can be applied to analyze the economic impact of professional sports. How can the multiplier be used to analyze the economic impact of professional sports? Attracting professional sports teams and building sports stadiums to create jobs and stimulate business growth is an economic development strategy adopted by many communities throughout the United States. In his recent article, “Public Financing of Private Sports Stadiums,” James Joyner of Outside the Beltway looked at public financing for NFL teams. Joyner’s findings confirm the earlier work of John Siegfried of Vanderbilt University and Andrew Zimbalist of Smith College. Siegfried and Zimbalist used the multiplier to analyze this issue. They considered the amount of taxes paid and dollars spent locally to see if there was a positive multiplier effect. Since most professional athletes and owners of sports teams are rich enough to owe a lot of taxes, let’s say that 40% of any marginal income they earn is paid in taxes. Because athletes are often high earners with short careers, let’s assume that they save one-third of their after-tax income. However, many professional athletes do not live year-round in the city in which they play, so let’s say that one-half of the money that they do spend is spent outside the local area. One can think of spending outside a local economy, in this example, as the equivalent of imported goods for the national economy. Now, consider the impact of money spent at local entertainment venues other than professional sports. While the owners of these other businesses may be comfortably middle-income, few of them are in the economic stratosphere of professional athletes. Because their incomes are lower, so are their taxes; say that they pay only 35% of their marginal income in taxes. They do not have the same ability, or need, to save as much as professional athletes, so let’s assume their MPC is just 0.8. Finally, because more of them live locally, they will spend a higher proportion of their income on local goods—say, 65%. If these general assumptions hold true, then money spent on professional sports will have less local economic impact than money spent on other forms of entertainment. For professional athletes, out of a dollar earned, 40 cents goes to taxes, leaving 60 cents. Of that 60 cents, one-third is saved, leaving 40 cents, and half is spent outside the area, leaving 20 cents. Only 20 cents of each dollar is cycled into the local economy in the first round. For locally-owned entertain
ment, out of a dollar earned, 35 cents goes to taxes, leaving 65 cents. Of the rest, 20% is saved, leaving 52 cents, and of that amount, 65% is spent in the local area, so that 33.8 cents of each dollar of income is recycled into the local economy. Siegfried and Zimbalist make the plausible argument that, within their household budgets, people have a fixed amount to spend on entertainment. If this assumption holds true, then money spent attending professional sports events is money that was not spent on other entertainment options in a given metropolitan area. Since the multiplier is lower for professional sports than for other local entertainment options, the arrival of professional sports to a city would reallocate entertainment This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Appendix B 559 spending in a way that causes the local economy to shrink, rather than to grow. Thus, their findings seem to confirm what Joyner reports and what newspapers across the country are reporting. A quick Internet search for “economic impact of sports” will yield numerous reports questioning this economic development strategy. Multiplier Tradeoffs: Stability versus the Power of Macroeconomic Policy Is an economy healthier with a high multiplier or a low one? With a high multiplier, any change in aggregate demand will tend to be substantially magnified, and so the economy will be more unstable. With a low multiplier, by contrast, changes in aggregate demand will not be multiplied much, so the economy will tend to be more stable. However, with a low multiplier, government policy changes in taxes or spending will tend to have less impact on the equilibrium level of real output. With a higher multiplier, government policies to raise or reduce aggregate expenditures will have a larger effect. Thus, a low multiplier means a more stable economy, but also weaker government macroeconomic policy, while a high multiplier means a more volatile economy, but also an economy in which government macroeconomic policy is more powerful. Key Concepts and Summary The expenditure-output model or Keynesian cross diagram shows how the level of aggregate expenditure (on the vertical axis) varies with the level of economic output (shown on the horizontal axis). Since the value of all macroeconomic output also represents income to someone somewhere else in the economy, the horizontal axis can also be interpreted as national income. The equilibrium in the diagram will occur where the aggregate expenditure line crosses the 45-degree line, which represents the set of points where aggregate expenditure in the economy is equal to output (or national income). Equilibrium in a Keynesian cross diagram can happen at potential GDP, or below or above that level. The consumption function shows the upward-sloping relationship between national income and consumption. The marginal propensity to consume (MPC) is the amount consumed out of an additional dollar of income. A higher marginal propensity to consume means a steeper consumption function; a lower marginal propensity to consume means a flatter consumption function. The marginal propensity to save (MPS) is the amount saved out of an additional dollar of income. It is necessarily true that MPC + MPS = 1. The investment function is drawn as a flat line, showing that investment in the current year does not change with regard to the current level of national income. However, the investment function will move up and down based on the expected rate of return in the future. Government spending is drawn as a horizontal line in the Keynesian cross diagram, because its level is determined by political considerations, not by the current level of income in the economy. Taxes in the basic Keynesian cross diagram are taken into account by adjusting the consumption function. The export function is drawn as a horizontal line in the Keynesian cross diagram, because exports do not change as a result of changes in domestic income, but they move as a result of changes in foreign income, as well as changes in exchange rates. The import function is drawn as a downward-sloping line, because imports rise with national income, but imports are a subtraction from aggregate demand. Thus, a higher level of imports means a lower level of expenditure on domestic goods. In a Keynesian cross diagram, the equilibrium may be at a level below potential GDP, which is called a recessionary gap, or at a level above potential GDP, which is called an inflationary gap. The multiplier effect describes how an initial change in aggregate demand generated several times as much as cumulative GDP. The size of the spending multiplier is determined by three leakages: spending on savings, taxes, and imports. The formula for the multiplier is: Multiplier = 1 1 – (MPC × (1 – tax rate) + MPI) An economy with a lower multiplier is more stable—it is less affected either by economic events or by government policy than an economy with a higher multiplier. Self-Check Questions Exercise B1 Sketch the aggregate expenditure-output diagram with the recessionary gap. 560 Solution The following figure shows the aggregate expenditure-output diagram with the recessionary gap. Appendix B Figure B12 Exercise B2 Sketch the aggregate expenditure-output diagram with an inflationary gap. Solution The following figure shows the aggregate expenditure-output diagram with an inflationary gap. Figure B13 Exercise B3 An economy has the following characteristics: Y = National income This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Appendix B 561 Taxes = T = 0.25Y C = Consumption = 400 + 0.85(Y – T) I = 300 G = 200 X = 500 M = 0.1(Y – T) Find the equilibrium for this economy. If potential GDP is 3,500, then what change in government spending is needed to achieve this level? Do this problem two ways. First, plug 3,500 into the equations and solve for G. Second, calculate the multiplier and figure it out that way. Solution First, set up the calculation. AE = 400 + 0.85(Y – T) + 300 + 200 + 500 – 0.1(Y – T) AE = Y Then insert Y for AE and 0.25Y for T. Y = 400 + 0.85(Y – 0.25Y) + 300 + 200 + 500 – 0.1(Y – 0.25Y) Y = 1400 + 0.6375Y – 0.075Y 0.4375Y = 1400 Y = 3200 If full employment is 3,500, then one approach is to plug in 3,500 for Y throughout the equation, but to leave G as a separate variable. Y = 400 + 0.85(Y – 0.25Y) + 300 + G + 500 + 0.1(Y – 0.25Y) 3500 = 400 + 0.85(3500 – 0.25(3500)) + 300 + G + 500 – 0.1(3500 – 0.25(3500)) G = 3500 – 400 – 2231.25 – 1300 – 500 + 262.5 G = 331.25 A G value of 331.25 is an increase of 131.25 from its original level of 200. Alternatively, the multiplier is that, out of every dollar spent, 0.25 goes to taxes, leaving 0.75, and out of after-tax income, 0.15 goes to savings and 0.1 to imports. Because (0.75)(0.15) = 0.1125 and (0.75)(0.1) = 0.075, this means that out of every dollar spent: 1 –0.25 –0.1125 –0.075 = 0.5625. Thus, using the formula, the multiplier is: 1 1 – 0.5625 = 2.2837 To increase equilibrium GDP by 300, it will take a boost of 300/2.2837, which again works out to 131.25. Exercise B4 Table B7 represents the data behind a Keynesian cross diagram. Assume that the tax rate is 0.4 of national income; the MPC out of the after-tax income is 0.8; investment is $2,000; government spending is $1,000; exports are $2,000 and imports are 0.05 of after-tax income. What is the equilibrium level of output for this economy? National Income After-tax Income Consumption I + G + X Minus Imports Aggregate Expenditures $8,000 $9,000 Table B7 $4,340 562 Appendix B National Income After-tax Income Consumption I + G + X Minus Imports Aggregate Expenditures $10,000 $11,000 $12,000 $13,000 Table B7 Solution The following table illustrates the completed table. The equilibrium is level is italicized. National Income After-tax Income Consumption I + G + X Minus Imports Aggregate Expenditures $8,000 $9,000 $10,000 $11,000 $12,000 $13,000 Table B8 $4,800 $5,400 $6,000 $6,600 $7,200 $7,800 $4,340 $4,820 $5,300 $5,780 $6,260 $5,000 $240 $5,000 $270 $5,000 $300 $5,000 $330 $5,000 $360 $46,740 $5,000 $4,390 $9,100 $9,550 $10,000 $10,450 $10,900 $11,350 The alternative way of determining equilibrium is to solve for Y, where Y = national income, using: Y = AE = 500 + 0.8(Y – T) + $2,000 + $1,000 + $2,000 – 0.05(Y – T) Solving for Y, we see that the equilibrium level of output is Y = $10,000. Exercise B5 Explain how the multiplier works. Use an MPC of 80% in an example. Solution The multiplier refers to how many times a dollar will turnover in the economy. It is based on the Marginal Propensity to Consume (MPC) which tells how much of every dollar received will be spent. If the MPC is 80% then this means that out of every one dollar received by a consumer, $0.80 will be spent. This $0.80 is received by another person. In turn, 80% of the $0.80 received, or $0.64, will be spent, and so on. The impact of the multiplier is diluted when the effect of taxes and expenditure on imports is considered. To derive the multiplier, take the 1/1 – F; where F is equal to percent of savings, taxes, and expenditures on imports. Review Questions Exercise B6 What is on the axes of an expenditure-output diagram? This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Appendix B Exercise B7 What does the 45-degree line show? Exercise B8 What determines the slope of a consumption function? Exercise B9 563 What is the marginal propensity to consume, and how is it related to the marginal propensity to import? Exercise B10 Why are the investment function, the government spending function, and the export function all drawn as flat lines? Exercise B11 Why does the import function slope down? What is the marginal propensity to import? Exercise B12 What are the components on which the aggregate expenditure function is based? Exercise B13 Is the equilibrium in a Keynesian cross diagram usually expected to be at or near pote
ntial GDP? Exercise B14 What is an inflationary gap? A recessionary gap? Exercise B15 What is the multiplier effect? Exercise B16 Why are savings, taxes, and imports referred to as “leakages” in calculating the multiplier effect? Exercise B17 Will an economy with a high multiplier be more stable or less stable than an economy with a low multiplier in response to changes in the economy or in government policy? Exercise B18 How do economists use the multiplier? Critical Thinking Questions Exercise B19 What does it mean when the aggregate expenditure line crosses the 45-degree line? In other words, how would you explain the intersection in words? Exercise B20 Which model, the AD/AS or the AE model better explains the relationship between rising price levels and GDP? Why? Exercise B21 564 Appendix B What are some reasons that the economy might be in a recession, and what is the appropriate government action to alleviate the recession? Exercise B22 What should the government do to relieve inflationary pressures if the aggregate expenditure is greater than potential GDP? Exercise B23 Two countries are in a recession. Country A has an MPC of 0.8 and Country B has an MPC of 0.6. In which country will government spending have the greatest impact? Exercise B24 Compare two policies: a tax cut on income or an increase in government spending on roads and bridges. What are both the short-term and long-term impacts of such policies on the economy? Exercise B25 What role does government play in stabilizing the economy and what are the tradeoffs that must be considered? Exercise B26 If there is a recessionary gap of $100 billion, should the government increase spending by $100 billion to close the gap? Why? Why not? Exercise B27 What other changes in the economy can be evaluated by using the multiplier? References Joyner, James. Outside the Beltway. “Public Financing of Private Sports Stadiums.” Last modified May 23, 2012. http://www.outsidethebeltway.com/public-financing-of-private-sports-stadiums/. Siegfried, John J., and Andrew Zimbalist. “The Economics of Sports Facilities and Their Communities.” Journal of Economic Perspectives. no. 3 (2000): 95-114. http://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.14.3.95. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Answer Key 565 ANSWER KEY Chapter 1 1. Scarcity means human wants for goods and services exceed the available supply. Supply is limited because resources are limited. Demand, however, is virtually unlimited. Whatever the supply, it seems human nature to want more. 2. 100 people / 10 people per ham = a maximum of 10 hams per month if all residents produce ham. Since consumption is limited by production, the maximum number of hams residents could consume per month is 10. 3. She is very productive at her consulting job, but not very productive growing vegetables. Time spent consulting would produce far more income than it what she could save growing her vegetables using the same amount of time. So on purely economic grounds, it makes more sense for her to maximize her income by applying her labor to what she does best (i.e. specialization of labor). 4. The engineer is better at computer science than at painting. Thus, his time is better spent working for pay at his job and paying a painter to paint his house. Of course, this assumes he does not paint his house for fun! 5. There are many physical systems that would work, for example, the study of planets (micro) in the solar system (macro), or solar systems (micro) in the galaxy (macro). 6. Draw a box outside the original circular flow to represent the foreign country. Draw an arrow from the foreign country to firms, to represents imports. Draw an arrow in the reverse direction representing payments for imports. Draw an arrow from firms to the foreign country to represent exports. Draw an arrow in the reverse direction to represent payments for imports. 7. There are many such problems. Consider the AIDS epidemic. Why are so few AIDS patients in Africa and Southeast Asia treated with the same drugs that are effective in the United States and Europe? It is because neither those patients nor the countries in which they live have the resources to purchase the same drugs. 8. Public enterprise means the factors of production (resources and businesses) are owned and operated by the government. 9. The United States is a large country economically speaking, so it has less need to trade internationally than the other countries mentioned. (This is the same reason that France and Italy have lower ratios than Belgium or Sweden.) One additional reason is that each of the other countries is a member of the European Union, where trade between members occurs without barriers to trade, like tariffs and quotas. Chapter 2 1. The opportunity cost of bus tickets is the number of burgers that must be given up to obtain one more bus ticket. Originally, when the price of bus tickets was 50 cents per trip, this opportunity cost was 0.50/2 = .25 burgers. The reason for this is that at the original prices, one burger ($2) costs the same as four bus tickets ($0.50), so the opportunity cost of a burger is four bus tickets, and the opportunity cost of a bus ticket is .25 (the inverse of the opportunity cost of a burger). With the new, higher price of bus tickets, the opportunity cost rises to $1/$2 or 0.50. You can see this graphically since the slope of the new budget constraint is steeper than the original one. If Alphonso spends all of his budget on burgers, the higher price of bus tickets has no impact so the vertical intercept of the budget constraint is the same. If he spends all of his budget on bus tickets, he can now afford only half as many, so the vertical intercept is half as much. In short, the budget constraint rotates clockwise around the vertical intercept, steepening as it goes and the opportunity cost of bus tickets increases. 566 Answer Key 2. Because of the improvement in technology, the vertical intercept of the PPF would be at a higher level of healthcare. In other words, the PPF would rotate clockwise around the horizontal intercept. This would make the PPF steeper, corresponding to an increase in the opportunity cost of education, since resources devoted to education would now mean forgoing a greater quantity of healthcare. 3. No. Allocative efficiency requires productive efficiency, because it pertains to choices along the production possibilities frontier. 4. Both the budget constraint and the PPF show the constraint that each operates under. Both show a tradeoff between having more of one good but less of the other. Both show the opportunity cost graphically as the slope of the constraint (budget or PPF). 5. When individuals compare cost per unit in the grocery store, or characteristics of one product versus another, they are behaving approximately like the model describes. 6. Since an op-ed makes a case for what should be, it is considered normative. 7. Assuming that the study is not taking an explicit position about whether soft drink consumption is good or bad, but just reporting the science, it would be considered positive. Chapter 3 1. Since $1.60 per gallon is above the equilibrium price, the quantity demanded would be lower at 550 gallons and the quantity supplied would be higher at 640 gallons. (These results are due to the laws of demand and supply, respectively.) The outcome of lower Qd and higher Qs would be a surplus in the gasoline market of 640 – 550 = 90 gallons. 2. To make it easier to analyze complex problems. Ceteris paribus allows you to look at the effect of one factor at a time on what it is you are trying to analyze. When you have analyzed all the factors individually, you add the results together to get the final answer. 3. 4. a. An improvement in technology that reduces the cost of production will cause an increase in supply. Alternatively, you can think of this as a reduction in price necessary for firms to supply any quantity. Either way, this can be shown as a rightward (or downward) shift in the supply curve. b. An improvement in product quality is treated as an increase in tastes or preferences, meaning consumers demand more paint at any price level, so demand increases or shifts to the right. If this seems counterintuitive, note that demand in the future for the longer-lasting paint will fall, since consumers are essentially shifting demand from the future to the present. c. An increase in need causes an increase in demand or a rightward shift in the demand curve. d. Factory damage means that firms are unable to supply as much in the present. Technically, this is an increase in the cost of production. Either way you look at it, the supply curve shifts to the left. a. More fuel-efficient cars means there is less need for gasoline. This causes a leftward shift in the demand for gasoline and thus oil. Since the demand curve is shifting down the supply curve, the equilibrium price and This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Answer Key 567 quantity both fall. b. Cold weather increases the need for heating oil. This causes a rightward shift in the demand for heating oil and thus oil. Since the demand curve is shifting up the supply curve, the equilibrium price and quantity both rise. c. A discovery of new oil will make oil more abundant. This can be shown as a rightward shift in the supply curve, which will cause a decrease in the equilibrium price along with an increase in the equilibrium quantity. (The supply curve shifts down the demand curve so price and quantity follow the law of demand. If price goes down, then the quantity goes up.) d. When an economy slows down, it produces less output and demands less input, including energy, which is used in the production of virtually everything. A decrease in demand for energy will be reflected as a decrease in the demand for oil, or a leftward shift in demand for oil. Since the demand curve
is shifting down the supply curve, both the equilibrium price and quantity of oil will fall. e. Disruption of oil pumping will reduce the supply of oil. This leftward shift in the supply curve will show a movement up the demand curve, resulting in an increase in the equilibrium price of oil and a decrease in the equilibrium quantity. Increased insulation will decrease the demand for heating. This leftward shift in the demand for oil causes a movement down the supply curve, resulting in a decrease in the equilibrium price and quantity of oil. f. g. Solar energy is a substitute for oil-based energy. So if solar energy becomes cheaper, the demand for oil will decrease as consumers switch from oil to solar. The decrease in demand for oil will be shown as a leftward shift in the demand curve. As the demand curve shifts down the supply curve, both equilibrium price and quantity for oil will fall. h. A new, popular kind of plastic will increase the demand for oil. The increase in demand will be shown as a rightward shift in demand, raising the equilibrium price and quantity of oil. 5. Step 1. Draw the graph with the initial supply and demand curves. Label the initial equilibrium price and quantity. Step 2. Did the economic event affect supply or demand? Jet fuel is a cost of producing air travel, so an increase in jet fuel price affects supply. Step 3. An increase in the price of jet fuel caused a decrease in the cost of air travel. We show this as a downward or rightward shift in supply. Step 4. A rightward shift in supply causes a movement down the demand curve, lowering the equilibrium price of air travel and increasing the equilibrium quantity. 6. Step 1. Draw the graph with the initial supply and demand curves. Label the initial equilibrium price and quantity. Step 2. Did the economic event affect supply or demand? A tariff is treated like a cost of production, so this affects supply. Step 3. A tariff reduction is equivalent to a decrease in the cost of production, which we can show as a rightward (or downward) shift in supply. Step 4. A rightward shift in supply causes a movement down the demand curve, lowering the equilibrium price and raising the equilibrium quantity. 7. A price ceiling (which is below the equilibrium price) will cause the quantity demanded to rise and the quantity supplied to fall. This is why a price ceiling creates a shortage. 8. A price ceiling is just a legal restriction. Equilibrium is an economic condition. People may or may not obey the price ceiling, so the actual price may be at or above the price ceiling, but the price ceiling does not change the equilibrium price. 9. A price ceiling is a legal maximum price, but a price floor is a legal minimum price and, consequently, it would leave room for the price to rise to its equilibrium level. In other words, a price floor below equilibrium will not be binding and will have no effect. 10. Assuming that people obey the price ceiling, the market price will be below equilibrium, which means that Qd will be more than Qs. Buyers can only buy what is offered for sale, so the number of transactions will fall to Qs. This is easy to see graphically. By analogous reasoning, with a price floor the market price will be above the equilibrium price, so Qd will be less than Qs. Since the limit on transactions here is demand, the number of transactions will fall to Qd. Note that because both price floors and price ceilings reduce the number of transactions, social surplus is less. 11. Because the losses to consumers are greater than the benefits to producers, so the net effect is negative. Since the 568 Answer Key lost consumer surplus is greater than the additional producer surplus, social surplus falls. Chapter 4 1. Changes in the wage rate (the price of labor) cause a movement along the demand curve. A change in anything else that affects demand for labor (e.g., changes in output, changes in the production process that use more or less labor, government regulation) causes a shift in the demand curve. 2. Changes in the wage rate (the price of labor) cause a movement along the supply curve. A change in anything else that affects supply of labor (e.g., changes in how desirable the job is perceived to be, government policy to promote training in the field) causes a shift in the supply curve. 3. Since a living wage is a suggested minimum wage, it acts like a price floor (assuming, of course, that it is followed). If the living wage is binding, it will cause an excess supply of labor at that wage rate. 4. Changes in the interest rate (i.e., the price of financial capital) cause a movement along the demand curve. A change in anything else (non-price variable) that affects demand for financial capital (e.g., changes in confidence about the future, changes in needs for borrowing) would shift the demand curve. 5. Changes in the interest rate (i.e., the price of financial capital) cause a movement along the supply curve. A change in anything else that affects the supply of financial capital (a non-price variable) such as income or future needs would shift the supply curve. 6. If market interest rates stay in their normal range, an interest rate limit of 35% would not be binding. If the equilibrium interest rate rose above 35%, the interest rate would be capped at that rate, and the quantity of loans would be lower than the equilibrium quantity, causing a shortage of loans. 7. b and c will lead to a fall in interest rates. At a lower demand, lenders will not be able to charge as much, and with more available lenders, competition for borrowers will drive rates down. 8. a and c will increase the quantity of loans. More people who want to borrow will result in more loans being given, as will more people who want to lend. 9. A price floor prevents a price from falling below a certain level, but has no effect on prices above that level. It will have its biggest effect in creating excess supply (as measured by the entire area inside the dotted lines on the graph, from D to S) if it is substantially above the equilibrium price. This is illustrated in the following figure. It will have a lesser effect if it is slightly above the equilibrium price. This is illustrated in the next figure. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Answer Key 569 It will have no effect if it is set either slightly or substantially below the equilibrium price, since an equilibrium price above a price floor will not be affected by that price floor. The following figure illustrates these situations. 10. A price ceiling prevents a price from rising above a certain level, but has no effect on prices below that level. It will have its biggest effect in creating excess demand if it is substantially below the equilibrium price. The following figure illustrates these situations. 570 Answer Key When the price ceiling is set substantially or slightly above the equilibrium price, it will have no effect on creating excess demand. The following figure illustrates these situations. 11. Neither. A shift in demand or supply means that at every price, either a greater or a lower quantity is demanded or supplied. A price floor does not shift a demand curve or a supply curve. However, if the price floor is set above the equilibrium, it will cause the quantity supplied on the supply curve to be greater than the quantity demanded on the demand curve, leading to excess supply. 12. Neither. A shift in demand or supply means that at every price, either a greater or a lower quantity is demanded or supplied. A price ceiling does not shift a demand curve or a supply curve. However, if the price ceiling is set below the equilibrium, it will cause the quantity demanded on the demand curve to be greater than the quantity supplied on the supply curve, leading to excess demand. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Answer Key Chapter 5 571 1. From point B to point C, price rises from $70 to $80, and Qd decreases from 2,800 to 2,600. So: % change in quantity = 2600 – 2800 (2600 + 2800) ÷ 2 × 100 × 100 = –200 2700 = –7.41 % change in price = 80 – 70 (80 + 70) ÷ 2 × 100 × 100 = 10 75 = 13.33 Elasticity of Demand = –7.41% 13.33% = 0.56 The demand curve is inelastic in this area; that is, its elasticity value is less than one. Answer from Point D to point E: % change in quantity = 2200 – 2400 (2200 + 2400) ÷ 2 × 100 × 100 = –200 2300 = –8.7 % change in price = 100 – 90 (100 + 90) ÷ 2 × 100 × 100 = 10 95 = 10.53 Elasticity of Demand = –8.7% 10.53% = 0.83 The demand curve is inelastic in this area; that is, its elasticity value is less than one. Answer from Point G to point H: % change in quantity = 1600 – 1800 1700 × 100 × 100 = –200 1700 = –11.76 % change in price = 130 – 120 125 × 100 × 100 = 10 125 = 8.00 Elasticity of Demand = –11.76% 8.00% = –1.47 The demand curve is elastic in this interval. 2. From point J to point K, price rises from $8 to $9, and quantity rises from 50 to 70. So: 572 Answer Key % change in quantity = 70 – 50 (70 + 50) ÷ 2 × 100 × 100 = 20 60 = 33.33 % change in price = $9 – $8 ($9 + $8) ÷ 2 × 100 × 100 = 1 8.5 = 11.76 Elasticity of Supply = 33.33% 11.76% = 2.83 The supply curve is elastic in this area; that is, its elasticity value is greater than one. From point L to point M, the price rises from $10 to $11, while the Qs rises from 80 to 88: % change in quantity = 88 – 80 (88 + 80) ÷ 2 × 100 × 100 = 8 84 = 9.52 %change in price = $11 – $10 ($11 + $10) ÷ 2 × 100 × 100 = 1 10.5 = 9.52 Elasticity of Demand = 9.52% 9.52% = 1.0 The supply curve has unitary elasticity in this area. From point N to point P, the price rises from $12 to $13, and Qs rises from 95 to 100: % change in quantity = 100 – 95 (100 + 95) ÷ 2 ×100 ×100 = 5 97.5 = 5.13 % change in price = $13 – $12 ($13 + $12) ÷ 2 × 100 × 100 = 1 12.5 = 8.0 Elasticity of Supply = 5.13% 8.0% = 0.64 The supply curve is inelastic in this region of the supply curve. 3. The demand
curve with constant unitary elasticity is concave because the absolute value of declines in price are not identical. The left side of the curve starts with high prices, and then price falls by smaller amounts as it goes down toward the right side. This results in a slope of demand that is steeper on the left but flatter on the right, creating a curved, concave shape. 4. The constant unitary elasticity is a straight line because the curve slopes upward and both price and quantity are increasing proportionally. 5. Carmakers can pass this cost along to consumers if the demand for these cars is inelastic. If the demand for these cars is elastic, then the manufacturer must pay for the equipment. 6. If the elasticity is 1.4 at current prices, you would advise the company to lower its price on the product, since a This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Answer Key 573 decrease in price will be offset by the increase in the amount of the drug sold. If the elasticity were 0.6, then you would advise the company to increase its price. Increases in price will offset the decrease in number of units sold, but increase your total revenue. If elasticity is 1, the total revenue is already maximized, and you would advise that the company maintain its current price level. 7. The percentage change in quantity supplied as a result of a given percentage change in the price of gasoline. 8. Percentage change in quantity demanded = [(change in quantity)/(original quantity)] × 100 = [22 – 30]/[(22 + 30)/2] × 100 = –8/26 × 100 = –30.77 Percentage change in income = [(change in income)/(original income)] × 100 = [38,000 – 25,000]/[(38,000 + 25,000)/2] × 100 = 13/31.5 × 100 = 41.27 In this example, bread is an inferior good because its consumption falls as income rises. 9. The formula for cross-price elasticity is % change in Qd for apples / % change in P of oranges. Multiplying both sides by % change in P of oranges yields: % change in Qd for apples = cross-price elasticity X% change in P of oranges = 0.4 × (–3%) = –1.2%, or a 1.2 % decrease in demand for apples. Chapter 6 1. GDP is C + I + G + (X – M). GDP = $2,000 billion + $50 billion + $1,000 billion + ($20 billion – $40 billion) = $3,030 2. If Grandma gets paid and reports this as income, it is part of GDP, otherwise not. a. Hospital stays are part of GDP. b. Changes in life expectancy are not market transactions and not part of GDP. c. Child care that is paid for is part of GDP. d. e. A used car is not produced this year, so it is not part of GDP. f. A new car is part of GDP. g. Variety does not count in GDP, where the cheese could all be cheddar. h. The iron is not counted because it is an intermediate good. 3. From 1980 to 1990, real GDP grew by (8,225.0 – 5,926.5) / (5,926.5) = 39%. Over the same period, prices increased by (72.7 – 48.3) / (48.3/100) = 51%. So about 57% of the growth 51 / (51 + 39) was inflation, and the remainder: 39 / (51 + 39) = 43% was growth in real GDP. 4. Two other major recessions are visible in the figure as slight dips: those of 1973–1975, and 1981–1982. Two other recessions appear in the figure as a flattening of the path of real GDP. These were in 1990–1991 and 2001. 5. 11 recessions in approximately 70 years averages about one recession every six years. 6. The table lists the “Months of Contraction” for each recession. Averaging these figures for the post-WWII recessions gives an average duration of 11 months, or slightly less than a year. 7. The table lists the “Months of Expansion.” Averaging these figures for the post-WWII expansions gives an average expansion of 60.5 months, or more than five years. 8. Yes. The answer to both questions depends on whether GDP is growing faster or slower than population. If population grows faster than GDP, GDP increases, while GDP per capita decreases. If GDP falls, but population falls faster, then GDP decreases, while GDP per capita increases. 574 Answer Key 9. Start with Central African Republic’s GDP measured in francs. Divide it by the exchange rate to convert to U.S. dollars, and then divide by population to obtain the per capita figure. That is, 1,107,689 million francs / 284.681 francs per dollar / 4.862 million people = $800.28 GDP per capita. 10. a. A dirtier environment would reduce the broad standard of living, but not be counted in GDP, so a rise in GDP would overstate the standard of living. b. A lower crime rate would raise the broad standard of living, but not be counted directly in GDP, and so a rise in GDP would understate the standard of living. c. A greater variety of goods would raise the broad standard of living, but not be counted directly in GDP, and so a rise in GDP would understate the rise in the standard of living. d. A decline in infant mortality would raise the broad standard of living, but not be counted directly in GDP, and so a rise in GDP would understate the rise in the standard of living. Chapter 7 1. The Industrial Revolution refers to the widespread use of power-driven machinery and the economic and social changes that resulted in the first half of the 1800s. Ingenious machines—the steam engine, the power loom, and the steam locomotive—performed tasks that would have taken vast numbers of workers to do. The Industrial Revolution began in Great Britain, and soon spread to the United States, Germany, and other countries. 2. Property rights are the rights of individuals and firms to own property and use it as they see fit. Contractual rights are based on property rights and they allow individuals to enter into agreements with others regarding the use of their property providing recourse through the legal system in the event of noncompliance. Economic growth occurs when the standard of living increases in an economy, which occurs when output is increasing and incomes are rising. For this to happen, societies must create a legal environment that gives individuals the ability to use their property to their fullest and highest use, including the right to trade or sell that property. Without a legal system that enforces contracts, people would not be likely to enter into contracts for current or future services because of the risk of non-payment. This would make it difficult to transact business and would slow economic growth. 3. Yes. Since productivity is output per unit of input, we can measure productivity using GDP (output) per worker (input). 4. In 20 years the United States will have an income of 10,000 × (1 + 0.01)20 = $12,201.90, and South Korea will have an income of 10,000 × (1 + 0.04)20 = $21,911.23. South Korea has grown by a multiple of 2.1 and the United States by a multiple of 1.2. 5. Capital deepening and technology are important. What seems to be more important is how they are combined. 6. Government can contribute to economic growth by investing in human capital through the education system, building a strong physical infrastructure for transportation and commerce, increasing investment by lowering capital gains taxes, creating special economic zones that allow for reduced tariffs, and investing in research and development. 7. Public education, low investment taxes, funding for infrastructure projects, special economic zones 8. A good way to think about this is how a runner who has fallen behind in a race feels psychologically and physically as he catches up. Playing catch-up can be more taxing than maintaining one’s position at the head of the pack. 9. a. No. Capital deepening refers to an increase in the amount of capital per person in an economy. A decrease in investment by firms will actually cause the opposite of capital deepening (since the population will grow over time). b. There is no direct connection between an increase in international trade and capital deepening. One could imagine particular scenarios where trade could lead to capital deepening (for example, if international capital This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Answer Key 575 inflows—which are the counterpart to increasing the trade deficit—lead to an increase in physical capital investment), but in general, no. c. Yes. Capital deepening refers to an increase in either physical capital or human capital per person. Continuing education or any time of lifelong learning adds to human capital and thus creates capital deepening. 10. The advantages of backwardness include faster growth rates because of the process of convergence, as well as the ability to adopt new technologies that were developed first in the “leader” countries. While being “backward” is not inherently a good thing, Gerschenkron stressed that there are certain advantages which aid countries trying to “catch up.” 11. Capital deepening, by definition, should lead to diminished returns because you're investing more and more but using the same methods of production, leading to the marginal productivity declining. This is shown on a production function as a movement along the curve. Improvements in technology should not lead to diminished returns because you are finding new and more efficient ways of using the same amount of capital. This can be illustrated as a shift upward of the production function curve. 12. Productivity growth from new advances in technology will not slow because the new methods of production will be adopted relatively quickly and easily, at very low marginal cost. Also, countries that are seeing technology growth usually have a vast and powerful set of institutions for training workers and building better machines, which allows the maximum amount of people to benefit from the new technology. These factors have the added effect of making additional technological advances even easier for these countries. Chapter 8 1. The population is divided into those “in the labor force” and those “not in the labor force.” Thus, the number of adults not in the labor force is 237.8 – 153.9 = 83.9 million. Since the labor force is divided into employ
ed persons and unemployed persons, the number of unemployed persons is 153.9 – 139.1 = 14.8 million. Thus, the adult population has the following proportions: • 139.1/237.8 = 58.5% employed persons • 14.8/237.8 = 6.2% unemployed persons • 83.9/237.8 = 35.3% persons out of the labor force 2. The unemployment rate is defined as the number of unemployed persons as a percentage of the labor force or 14.8/ 153.9 = 9.6%. This is higher than the February 2015 unemployment rate, computed earlier, of 5.5%. 3. Over the long term, the U.S. unemployment rate has remained basically the same level. 4. a. Nonwhites b. The young c. High school graduates 5. Because of the influx of women into the labor market, the supply of labor shifts to the right. Since wages are sticky downward, the increased supply of labor causes an increase in people looking for jobs (Qs), but no change in the number of jobs available (Qe). As a result, unemployment increases by the amount of the increase in the labor supply. This can be seen in the following figure. Over time, as labor demand grows, the unemployment will decline and eventually wages will begin to increase again. But this increase in labor demand goes beyond the scope of this problem. 576 Answer Key 6. The increase in labor supply was a social demographic trend—it was not caused by the economy falling into a recession. Therefore, the influx of women into the work force increased the natural rate of unemployment. 7. New entrants to the labor force, whether from college or otherwise, are counted as frictionally unemployed until they find a job. Chapter 9 1. To compute the amount spent on each fruit in each year, you multiply the quantity of each fruit by the price. • 10 apples × 50 cents each = $5.00 spent on apples in 2001. • 12 bananas × 20 cents each = $2.40 spent on bananas in 2001. • 2 bunches of grapes at 65 cents each = $1.30 spent on grapes in 2001. • 1 pint of raspberries at $2 each = $2.00 spent on raspberries in 2001. Adding up the amounts gives you the total cost of the fruit basket. The total cost of the fruit basket in 2001 was $5.00 + $2.40 + $1.30 + $2.00 = $10.70. The total costs for all the years are shown in the following table. 2001 2002 2003 2004 $10.70 $13.80 $15.35 $16.31 2. If 2003 is the base year, then the index number has a value of 100 in 2003. To transform the cost of a fruit basket each year, we divide each year’s value by $15.35, the value of the base year, and then multiply the result by 100. The price index is shown in the following table. 2001 2002 2003 2004 69.71 89.90 100.00 106.3 Note that the base year has a value of 100; years before the base year have values less than 100; and years after have values more than 100. 3. The inflation rate is calculated as the percentage change in the price index from year to year. For example, the inflation rate between 2001 and 2002 is (84.61 – 69.71) / 69.71 = 0.2137 = 21.37%. The inflation rates for all the years are shown in the last row of the following table, which includes the two previous answers. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Answer Key 577 Items Qty (2001) Price (2001) Amount Spent (2002) Price (2002) Amount Spent (2003) Price (2003) Amount Spent (2004) Price (2004) Amount Spent 10 12 2 1 Apples Bananas Grapes Raspberries Total Price Index Inflation Rate $0.50 $5.00 $0.75 $7.50 $0.85 $8.50 $0.88 $8.80 $0.20 $2.40 $0.25 $3.00 $0.25 $3.00 $0.29 $3.48 $0.65 $1.30 $0.70 $1.40 $0.90 $1.80 $0.95 $1.90 $2.00 $2.00 $1.90 $1.90 $2.05 $2.05 $2.13 $2.13 $10.70 69.71 $13.80 84.61 21.37% $15.35 100.00 18.19% $16.31 106.3 6.3% 4. Begin by calculating the total cost of buying the basket in each time period, as shown in the following table. Items Quantity (Time 1) Price (Time 1) Total Cost (Time 2) Price (Time 2) Total Cost 12 24 6 2 Gifts Pizza Blouses Trips Total Cost $50 $15 $60 $400 $600 $360 $360 $800 $2,120 $60 $16 $50 $420 $720 $384 $300 $840 $2,244 The rise in cost of living is calculated as the percentage increase: (2244 – 2120) / 2120 = 0.0585 = 5.85%. 5. Since the CPI measures the prices of the goods and services purchased by the typical urban consumer, it measures the prices of things that people buy with their paycheck. For that reason, the CPI would be the best price index to use for this purpose. 6. The PPI is subject to those biases for essentially the same reasons as the CPI is. The GDP deflator picks up prices of what is actually purchased that year, so there are no biases. That is the advantage of using the GDP deflator over the CPI. 7. The calculator requires you to input three numbers: • The first year, in this case the year of your birth • The amount of money you would want to translate in terms of its purchasing power • The last year—now or the most recent year the calculator will accept My birth year is 1955. The amount is $1. The year 2012 is currently the latest year the calculator will accept. The simple purchasing power calculator shows that $1 of purchases in 1955 would cost $8.57 in 2012. The website also explains how the true answer is more complicated than that shown by the simple purchasing power calculator. 8. The state government would benefit because it would repay the loan in less valuable dollars than it borrowed. Plus, tax revenues for the state government would increase because of the inflation. 9. Higher inflation reduces real interest rates on fixed rate mortgages. Because ARMs can be adjusted, higher inflation 578 Answer Key leads to higher interest rates on ARMs. 10. Because the mortgage has an adjustable rate, the rate should fall by 3%, the same as inflation, to keep the real interest rate the same. Chapter 10 1. The stock and bond values will not show up in the current account. However, the dividends from the stocks and the interest from the bonds show up as an import to income in the current account. 2. It becomes more negative as imports, which are a negative to the current account, are growing faster than exports, which are a positive. 3. a. Money flows out of the Mexican economy. b. Money flows into the Mexican economy. c. Money flows out of the Mexican economy. 4. GDP is a dollar value of all production of goods and services. Exports are produced domestically but shipped abroad. The percent ratio of exports to GDP gives us an idea of how important exports are to the national economy out of all goods and services produced. For example, exports represent only 14% of U.S. GDP, but 50% of Germany’s GDP 5. Divide $542 billion by $1,800 billion. 6. Divide –$400 billion by $16,800 billion. 7. The trade balance is the difference between exports and imports. The current account balance includes this number (whether it is a trade balance or a trade surplus), but also includes international flows of money from global investments. 8. a. An export sale to Germany involves a financial flow from Germany to the U.S. economy. b. The issue here is not U.S. investments in Brazil, but the return paid on those investments, which involves a financial flow from the Brazilian economy to the U.S. economy. c. Foreign aid from the United States to Egypt is a financial flow from the United States to Egypt. d. Importing oil from the Russian Federation means a flow of financial payments from the U.S. economy to the Russian Federation. Japanese investors buying U.S. real estate is a financial flow from Japan to the U.S. economy. e. 9. The top portion tracks the flow of exports and imports and the payments for those. The bottom portion is looking at international financial investments and the outflow and inflow of monies from those investments. These investments can include investments in stocks and bonds or real estate abroad, as well as international borrowing and lending. 10. If more monies are flowing out of the country (for example, to pay for imports) it will make the current account more negative or less positive, and if more monies are flowing into the country, it will make the current account less negative or more positive. 11. Write out the national savings and investment identity for the situation of the economy implied by this question: Supply of capital = Demand for capital S + (M – X) + (T – G) = I (government budget surplus) = Investment Savings + (trade deficit) nothing else changes, then the trade deficit will fall. In effect, the economy would be relying more on domestic capital and less on foreign capital. If the government starts borrowing instead of saving, then the trade deficit must rise. In effect, the government is no longer providing savings and so, if nothing else is to change, more investment funds must arrive from abroad. If the rate of domestic investment surges, then, ceteris paribus, the trade deficit must also rise, to If domestic savings increases and This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Answer Key 579 provide the extra capital. The ceteris paribus—or “other things being equal”—assumption is important here. In all of these situations, there is no reason to expect in the real world that the original change will affect only, or primarily, the trade deficit. The identity only says that something will adjust—it does not specify what. 12. The government is saving rather than borrowing. The supply of savings, whether private or public, is on the left side of the identity. 13. A trade deficit is determined by a country’s level of private and public savings and the amount of domestic investment. 14. The trade deficit must increase. To put it another way, this increase in investment must be financed by an inflow of financial capital from abroad. 15. Incomes fall during a recession, and consumers buy fewer good, including imports. 16. A booming economy will increase the demand for goods in general, so import sales will increase. If our trading partners’ economies are doing well, they will buy more of our products and so U.S. exports will increase. 17. a. b. c. d. Increased federal spendin
g on Medicare may not increase productivity, so a budget deficit is not justified. Increased spending on education will increase productivity and foster greater economic growth, so a budget deficit is justified. Increased spending on the space program may not increase productivity, so a budget deficit is not justified. Increased spending on airports and air traffic control will increase productivity and foster greater economic growth, so a budget deficit is justified. 18. Foreign investors worried about repayment so they began to pull money out of these countries. The money can be pulled out of stock and bond markets, real estate, and banks. 19. A rapidly growing trade surplus could result from a number of factors, so you would not want to be too quick to assume a specific cause. However, if the choice is between whether the economy is in recession or growing rapidly, the answer would have to be recession. In a recession, demand for all goods, including imports, has declined; however, demand for exports from other countries has not necessarily altered much, so the result is a larger trade surplus. 20. Germany has a higher level of trade than the United States. The United States has a large domestic economy so it has a large volume of internal trade. 21. a. A large economy tends to have lower levels of international trade, because it can do more of its trade internally, but this has little impact on its trade imbalance. b. An imbalance between domestic physical investment and domestic saving (including government and private saving) will always lead to a trade imbalance, but has little to do with the level of trade. c. Many large trading partners nearby geographically increases the level of trade, but has little impact one way or the other on a trade imbalance. d. The answer here is not obvious. An especially large budget deficit means a large demand for financial capital which, according to the national saving and investment identity, makes it somewhat more likely that there will be a need for an inflow of foreign capital, which means a trade deficit. e. A strong tradition of discouraging trade certainly reduces the level of trade. However, it does not necessarily say much about the balance of trade, since this is determined by both imports and exports, and by national levels of physical investment and savings. Chapter 11 1. In order to supply goods, suppliers must employ workers, whose incomes increase as a result of their labor. They use this additional income to demand goods of an equivalent value to those they supply. 580 Answer Key 2. When consumers demand more goods than are available on the market, prices are driven higher and the additional opportunities for profit induce more suppliers to enter the market, producing an equivalent amount to that which is demanded. 3. Higher input prices make output less profitable, decreasing the desired supply. This is shown graphically as a leftward shift in the AS curve. 4. Equilibrium occurs at the level of GDP where AD = AS. Insufficient aggregate demand could explain why the equilibrium occurs at a level of GDP less than potential. A decrease (or leftward shift) in aggregate supply could be another reason. 5. Immigration reform as described should increase the labor supply, shifting SRAS to the right, leading to a higher equilibrium GDP and a lower price level. 6. Given the assumptions made here, the cuts in R&D funding should reduce productivity growth. The model would show this as a leftward shift in the SRAS curve, leading to a lower equilibrium GDP and a higher price level. 7. An increase in the value of the stock market would make individuals feel wealthier and thus more confident about their economic situation. This would likely cause an increase in consumer confidence leading to an increase in consumer spending, shifting the AD curve to the right. The result would be an increase in the equilibrium level of GDP and an increase in the price level. 8. Since imports depend on GDP, if Mexico goes into recession, its GDP declines and so do its imports. This decline in our exports can be shown as a leftward shift in AD, leading to a decrease in our GDP and price level. 9. Tax cuts increase consumer and investment spending, depending on where the tax cuts are targeted. This would shift AD to the right, so if the tax cuts occurred when the economy was in recession (and GDP was less than potential), the tax cuts would increase GDP and “lead the economy out of recession.” 10. A negative report on home prices would make consumers feel like the value of their homes, which for most Americans is a major portion of their wealth, has declined. A negative report on consumer confidence would make consumers feel pessimistic about the future. Both of these would likely reduce consumer spending, shifting AD to the left, reducing GDP and the price level. A positive report on the home price index or consumer confidence would do the opposite. 11. A smaller labor force would be reflected in a leftward shift in AS, leading to a lower equilibrium level of GDP and higher price level. 12. Higher EU growth would increase demand for U.S. exports, reducing our trade deficit. The increased demand for exports would show up as a rightward shift in AD, causing GDP to rise (and the price level to rise as well). Higher GDP would require more jobs to fulfill, so U.S. employment would also rise. 13. Expansionary monetary policy shifts AD to the right. A continuing expansionary policy would cause larger and larger shifts (given the parameters of this problem). The result would be an increase in GDP and employment (a decrease in unemployment) and higher prices until potential output was reached. After that point, the expansionary policy would simply cause inflation. 14. Since the SRAS curve is vertical in the neoclassical zone, unless the economy is bordering the intermediate zone, a decrease in AS will cause a decrease in the price level, but no effect on real economic activity (for example, real GDP or employment). 15. Because the SRAS curve is horizontal in the Keynesian zone, a decrease in AD should depress real economic activity but have no effect on prices. Chapter 12 1. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Answer Key 581 a. An increase in home values will increase consumption spending (due to increased wealth). AD will shift to the right and may cause inflation if it goes beyond potential GDP. b. Rapid growth by a major trading partner will increase demand for exports. AD will shift to the right and may c. cause inflation if it goes beyond potential GDP. Increased profit opportunities will increase business investment. AD will shift to the right and may cause inflation if it goes beyond potential GDP. d. Higher interest rates reduce investment spending. AD will shift to the left and may cause recession if it falls below potential GDP. e. Demand for cheaper imports increases, reducing demand for domestic products. AD will shift to the left and may be recessionary. 2. a. A tax increase on consumer income will cause consumption to fall, pushing the AD curve left, and is a possible solution to inflation. b. A surge in military spending is an increase in government spending. This will cause the AD curve to shift to the right. If real GDP is less than potential GDP, then this spending would pull the economy out of a recession. If real GDP is to the right of potential GDP, then the AD curve will shift farther to the right and military spending will be inflationary. c. A tax cut focused on business investment will shift AD to the right. If the original macroeconomic equilibrium is below potential GDP, then this policy can help move an economy out of a recession. d. Government spending on healthcare will cause the AD curve to shift to the right. If real GDP is less than potential GDP, then this spending would pull the economy out of a recession. If real GDP is to th right of potential GDP, then the AD curve will shift farther to the right and healthcare spending will be inflationary. 3. An inflationary gap is the result of an increase in aggregate demand when the economy is at potential output. Since the AS curve is vertical at potential GDP, any increase in AD will lead to a higher price level (i.e. inflation) but no higher real GDP. This is easy to see if you draw AD1 to the right of AD0. 4. A decrease in government spending will shift AD to the left. 5. A decrease in energy prices, a positive supply shock, would cause the AS curve to shift out to the right, yielding more real GDP at a lower price level. This would shift the Phillips curve down toward the origin, meaning the economy would experience lower unemployment and a lower rate of inflation. 6. Keynesian economics does not require microeconomic price controls of any sort. It is true that many Keynesian economic prescriptions were for the government to influence the total amount of aggregate demand in the economy, often through government spending and tax cuts. 7. The three problems center on government’s ability to estimate potential GDP, decide whether to influence aggregate demand through tax changes or changes in government spending, and the lag time that occurs as Congress and the President attempt to pass legislation. Chapter 13 1. No, this statement is false. It would be more accurate to say that rational expectations seek to predict the future as accurately as possible, using all of past experience as a guide. Adaptive expectations are largely backward looking; that is, they adapt as experience accumulates, but without attempting to look forward. 2. An unemployment rate of zero percent is presumably well below the rate that is consistent with potential GDP and with the natural rate of unemployment. As a result, this policy would be attempting to push AD out to the right. In the short run, it is possible to have unemployment slightly below the natural rate for a time, at a price of higher inf
lation, as shown by the movement from E0 to E1 along the short-run AS curve. However, over time the extremely low unemployment rates will tend to cause wages to be bid up, and shift the short-run AS curve back to the left. The result would be a higher price level, but an economy still at potential GDP and the natural rate of unemployment, as determined by the long-run AS curve. If the government continues this policy, it will continually be pushing the price 582 Answer Key level higher and higher, but it will not be able to achieve its goal of zero percent unemployment, because that goal is inconsistent with market forces. 3. The statement is accurate. Rational expectations can be thought of as a version of neoclassical economics because it argues that potential GDP and the rate of unemployment are shaped by market forces as wages and prices adjust. However, it is an “extreme” version because it argues that this adjustment takes place very quickly. Other theories, like adaptive expectations, suggest that adjustment to the neoclassical outcome takes a few years. 4. The short-term Keynesian model is built on the importance of aggregate demand as a cause of business cycles and a degree of wage and price rigidity, and thus does a sound job of explaining many recessions and why cyclical unemployment rises and falls. The neoclassical model emphasizes aggregate supply by focusing on the underlying determinants of output and employment in markets, and thus tends to put more emphasis on economic growth and how labor markets work. Chapter 14 1. As long as you remain within the walls of the casino, chips fit the definition of money; that is, they serve as a medium of exchange, a unit of account, and a store of value. Chips do not work very well as money once you leave the casino, but many kinds of money do not work well in other areas. For example, it is hard to spend money from Turkey or Brazil at your local supermarket or at the movie theater. 2. Many physical items that a person buys at one time but may sell at another time can serve as an answer to this question. Examples include a house, land, art, rare coins or stamps, and so on. 3. The currency and checks in M1 are easiest to spend. It is harder to spend M2 directly, although if there is an automatic teller machine in the shopping mall, you can turn M2 from your savings account into an M1 of currency quite quickly. If your answer is about “credit cards,” then you are really talking about spending M1—although it is M1 from the account of the credit card company, which you will repay later when you credit card bill comes due. 4. a. Neither in M1 or M2 b. That is part of M1, and because M2 includes M1 it is also part of M2 c. Currency out in the public hands is part of M1 and M2 d. Checking deposits are in M1 and M2 e. Money market accounts are in M2 5. A bank’s assets include cash held in their vaults, but assets also include monies that the bank holds at the Federal Reserve Bank (called “reserves”), loans that are made to customers, and bonds. 6. a. A borrower who has been late on a number of loan payments looks perhaps less likely to repay the loan, or to repay it on time, and so you would want to pay less for that loan. If interest rates generally have risen, then this loan made at a time of relatively lower interest rates looks less attractive, and you would pay less for it. If the borrower is a firm with a record of high profits, then it is likely to be able to repay the loan, and you would be willing to pay more for the loan. If interest rates in the economy have fallen, then the loan is worth more. b. c. d. Chapter 15 1. Longer terms insulate the Board from political forces. Since the presidency can potentially change every four years, the Federal Reserve’s independence prevents drastic swings in monetary policy with every new administration and allows policy decisions to be made only on economic grounds. 2. Banks make their money from issuing loans and charging interest. The more money that is stored in the bank’s vault, the less is available for lending and the less money the bank stands to make. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Answer Key 583 3. The fear and uncertainty created by the suggestion that a bank might fail can lead depositors to withdraw their money. If many depositors do this at the same time, the bank may not be able to meet their demands and will, indeed, fail. 4. The bank has to hold $1,000 in reserves, so when it buys the $500 in bonds, it will have to reduce its loans by $500 to make up the difference. The money supply decreases by the same amount. 5. An increase in reserve requirements would reduce the supply of money, since more money would be held in banks rather than circulating in the economy. 6. Contractionary policy reduces the amount of loanable funds in the economy. As with all goods, greater scarcity leads a greater price, so the interest rate, or the price of borrowing money, rises. 7. An increase in the amount of available loanable funds means that there are more people who want to lend. They, therefore, bid the price of borrowing (the interest rate) down. 8. In times of economic uncertainty, banks may worry that borrowers will lose the ability to repay their loans. They may also fear that a panic is more likely and they will need the excess reserves to meet their obligations. 9. If consumer optimism changes, spending can speed up or slow down. This could also happen in a case where consumers need to buy a large number of items quickly, such as in a situation of national emergency. Chapter 16 1. a. The British use the pound sterling, while Germans use the euro, so a British exporter will receive euros from export sales, which will need to be exchanged for pounds. A stronger euro will mean more pounds per euro, so the exporter will be better off. In addition, the lower price for German imports will stimulate demand for British exports. For both these reasons, a stronger euro benefits the British exporter. b. The Dutch use euros while the Chileans use pesos, so the Dutch tourist needs to turn euros into Chilean pesos. An increase in the euro means that the tourist will get more pesos per euro. As a consequence, the Dutch tourist will have a less expensive vacation than he planned, so the tourist will be better off. c. The Greek use euros while the Canadians use dollars. An increase in the euro means it will buy more Canadian dollars. As a result, the Greek bank will see a decrease in the cost of the Canadian bonds, so it may purchase more bonds. Either way, the Greek bank benefits. d. Since both the French and Germans use the euro, an increase in the euro, in terms of other currencies, should have no impact on the French exporter. 2. Expected depreciation in a currency will lead people to divest themselves of the currency. We should expect to see an increase in the supply of pounds and a decrease in demand for pounds. The result should be a decrease in the value of the pound vis à vis the dollar. 3. Lower U.S. interest rates make U.S. assets less desirable compared to assets in the European Union. We should expect to see a decrease in demand for dollars and an increase in supply of dollars in foreign currency markets. As a result, we should expect to see the dollar depreciate compared to the euro. 4. A decrease in Argentine inflation relative to other countries should cause an increase in demand for pesos, a decrease in supply of pesos, and an appreciation of the peso in foreign currency markets. 5. The problem occurs when banks borrow foreign currency but lend in domestic currency. Since banks’ assets (loans they made) are in domestic currency, while their debts (money they borrowed) are in foreign currency, when the domestic currency declines, their debts grow larger. If the domestic currency falls substantially in value, as happened during the Asian financial crisis, then the banking system could fail. This problem is unlikely to occur for U.S. banks because, even when they borrow from abroad, they tend to borrow dollars. Remember, there are trillions of dollars in circulation in the global economy. Since both assets and debts are in dollars, a change in the value of the dollar does not cause banking system failure the way it can when banks borrow in foreign currency. 584 Answer Key 6. While capital flight is possible in either case, if a country borrows to invest in real capital it is more likely to be able to generate the income to pay back its debts than a country that borrows to finance consumption. As a result, an investment-stimulated economy is less likely to provoke capital flight and economic recession. 7. A contractionary monetary policy, by driving up domestic interest rates, would cause the currency to appreciate. The higher value of the currency in foreign exchange markets would reduce exports, since from the perspective of foreign buyers, they are now more expensive. The higher value of the currency would similarly stimulate imports, since they would now be cheaper from the perspective of domestic buyers. Lower exports and higher imports cause net exports (EX – IM) to fall, which causes aggregate demand to fall. The result would be a decrease in GDP working through the exchange rate mechanism reinforcing the effect contractionary monetary policy has on domestic investment expenditure. However, cheaper imports would stimulate aggregate supply, bringing GDP back to potential, though at a lower price level. 8. For a currency to fall, a central bank need only supply more of its currency in foreign exchange markets. It can print as much domestic currency as it likes. For a currency to rise, a central bank needs to buy its currency in foreign exchange markets, paying with foreign currency. Since no central bank has an infinite amount of foreign currency reserves, it cannot buy its currency indefinitely. 9. Variations in exchange rates, because they change import and expo
rt prices, disturb international trade flows. When trade is a large part of a nation’s economic activity, government will find it more advantageous to fix exchange rates to minimize disruptions of trade flows. Chapter 17 1. The government borrows funds by selling Treasury bonds, notes, and bills. 2. The funds can be used to pay down the national debt or else be refunded to the taxpayers. 3. Yes, a nation can run budget deficits and see its debt/GDP ratio fall. In fact, this is not uncommon. If the deficit is small in a given year, than the addition to debt in the numerator of the debt/GDP ratio will be relatively small, while the growth in GDP is larger, and so the debt/GDP ratio declines. This was the experience of the U.S. economy for the period from the end of World War II to about 1980. It is also theoretically possible, although not likely, for a nation to have a budget surplus and see its debt/GDP ratio rise. Imagine the case of a nation with a small surplus, but in a recession year when the economy shrinks. It is possible that the decline in the nation’s debt, in the numerator of the debt/GDP ratio, would be proportionally less than the fall in the size of GDP, so the debt/GDP ratio would rise. 4. Progressive. People who give larger gifts subject to the higher tax rate would typically have larger incomes as well. 5. Corporate income tax on his profits, individual income tax on his salary, and payroll tax taken out of the wages he pays himself. 6. individual income taxes 7. The tax is regressive because wealthy income earners are not taxed at all on income above $113,000. As a percent of total income, the social security tax hits lower income earners harder than wealthier individuals. 8. As debt increases, interest payments also rise, so that the deficit grows even if we keep other government spending constant. 9. a. As a share of GDP, this is false. In nominal dollars, it is true. b. False. c. False. d. False. Education spending is much higher at the state level. e. False. As a share of GDP, it is up about 50. f. As a share of GDP, this is false, and in real dollars, it is also false. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Answer Key 585 g. False. h. False; it’s about 1%. i. False. Although budget deficits were large in 2003 and 2004, and continued into the later 2000s, the federal government ran budget surpluses from 1998–2001. j. False. 10. To keep prices from rising too much or too rapidly. 11. To increase employment. 12. It falls below because less tax revenue than expected is collected. 13. Automatic stabilizers take effect very quickly, whereas discretionary policy can take a long time to implement. 14. In a recession, because of the decline in economic output, less income is earned, and so less in taxes is automatically collected. Many welfare and unemployment programs are designed so that those who fall into certain categories, like “unemployed” or “low income,” are eligible for benefits. During a recession, more people fall into these categories and become eligible for benefits automatically. The combination of reduced taxes and higher spending is just what is needed for an economy in recession producing below potential GDP. With an economic boom, average income levels rise in the economy, so more in taxes is automatically collected. Fewer people meet the criteria for receiving government assistance to the unemployed or the needy, so government spending on unemployment assistance and welfare falls automatically. This combination of higher taxes and lower spending is just what is needed if an economy is producing above its potential GDP. 15. Prices would be pushed up as a result of too much spending. 16. Employment would suffer as a result of too little spending. 17. Monetary policy probably has shorter time lags than fiscal policy. Imagine that the data becomes fairly clear that an economy is in or near a recession. Expansionary monetary policy can be carried out through open market operations, which can be done fairly quickly, since the Federal Reserve’s Open Market Committee meets six times a year. Also, monetary policy takes effect through interest rates, which can change fairly quickly. However, fiscal policy is carried out through acts of Congress that need to be signed into law by the president. Negotiating such laws often takes months, and even after the laws are negotiated, it takes more months for spending programs or tax cuts to have an effect on the macroeconomy. 18. The government would have to make up the revenue either by raising taxes in a different area or cutting spending. 19. Programs where the amount of spending is not fixed, but rather determined by macroeconomic conditions, such as food stamps, would lose a great deal of flexibility if spending increases had to be met by corresponding tax increases or spending cuts. Chapter 18 1. We use the national savings and investment identity to solve this question. In this case, the government has a budget surplus, so the government surplus appears as part of the supply of financial capital. Then: Quantity supplied of financial capi al = Quantity demanded of financial capi al S + (T – G) = I + (X – M) 600 + 200 = I + 100 I = 700 2. a. Since the government has a budget surplus, the government budget term appears with the supply of capital. economy. following identity shows and this the for The Quantity supplied of financial capi al = Quantity demanded of financial capi al S + (T – G) = I + (X – M) investment national savings 586 Answer Key b. Plugging the given values into the identity shown in part (a), we find that (X – M) = 0. c. Since the government has a budget deficit, the government budget term appears with the demand for capital. You do not know in advance whether the economy has a trade deficit or a trade surplus. But when you see that the quantity demanded of financial capital exceeds the quantity supplied, you know that there must be an additional quantity of financial capital supplied by foreign investors, which means a trade deficit of 2000. This example shows that in this case there is a higher budget deficit, and a higher trade deficit. Quantity supplied of financial capi al = Quantity demanded of financial capi al S + (M – X) = I + (G – T) 4000 + 2000 = 5000 + 1000 3. In this case, the national saving and investment identity is written in this way: Quantity supplied of financial capi al = Quantity demanded of financial capi al (T – G) + (M – X) + S = I The increase in the government budget surplus and the increase in the trade deficit both increased the supply of financial capital. If investment in physical capital remained unchanged, then private savings must go down, and if savings remained unchanged, then investment must go up. In fact, both effects happened; that is, in the late 1990s, in the U.S. economy, savings declined and investment rose. 4. Ricardian equivalence means that private saving changes to offset exactly any changes in the government budget. So, if the deficit increases by 20, private saving increases by 20 as well, and the trade deficit and the budget deficit will not change from their original levels. The original national saving and investment identity is written below. Notice that if any change in the (G – T) term is offset by a change in the S term, then the other terms do not change. So if (G – T) rises by 20, then S must also increase by 20. Quantity supplied of financial capi al = Quantity demanded of financial capi al S + (M – X) = I + (G – T) 130 + 20 = 100 + 50 5. In the last few decades, spending per student has climbed substantially. However, test scores have fallen over this time. This experience has led a number of experts to argue that the problem is not resources—or is not just resources by itself—but is also a problem of how schools are organized and managed and what incentives they have for success. There are a number of proposals to alter the incentives that schools face, but relatively little hard evidence on what proposals work well. Without trying to evaluate whether these proposals are good or bad ideas, you can just list some of them: testing students regularly; rewarding teachers or schools that perform well on such tests; requiring additional teacher training; allowing students to choose between public schools; allowing teachers and parents to start new schools; giving student “vouchers” that they can use to pay tuition at either public or private schools. 6. The government can direct government spending to R&D. It can also create tax incentives for business to invest in R&D. Chapter 19 1. The answers are shown in the following two tables. Region GDP (in millions) East Asia Latin America South Asia $10,450,032 $5,339,390 $2,288,812 Europe and Central Asia $1,862,384 Middle East and North Africa $1,541,900 This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Answer Key 587 Region GDP (in millions) Sub-Saharan Africa $1,287,650 Region GDP Per Capita (in millions) East Asia Latin America South Asia Europe and Central Asia $5,246 $1,388 $1,415 $9,190 Middle East and North Africa $4,535 Sub-Saharan Africa $6,847 East Asia appears to be the largest economy on GDP basis, but on a per capita basis it drops to third, after Europe and Central Asia and Sub-Saharan Africa. 2. A region can have some of high-income countries and some of the low-income countries. Aggregating per capita real GDP will vary widely across countries within a region, so aggregating data for a region has little meaning. For example, if you were to compare per capital real GDP for the United States, Canada, Haiti, and Honduras, it looks much different than if you looked at the same data for North America as a whole. Thus, regional comparisons are broad-based and may not adequately capture an individual country’s economic attributes. 3. The following table provides a summary of possible answers. 588 Answer Key High-Income Countries Middle-Income C
ountries Low-Income Countries • Invest in technology, human capital, and physical capital • Eradicate poverty and extreme hunger • Achieve universal primary • Provide incentives of a education • Foster a more educated workforce • Create, invest in, and apply new technologies • Adopt fiscal policies focused on investment, including investment in human capital, in technology, and in physical plant and equipment • Create stable and market- oriented economic climate marketoriented economic context • Work to reduce government economic controls on market activities • Use monetary policy to keep • Deregulate the banking inflation low and stable and financial sector • Minimize the risk of exchange • Reduce protectionist rate fluctuations, while also encouraging domestic and international competition policies • Promote gender equality • Reduce child mortality rates Improve maternal health • • Combat HIV/AIDS, malaria, and other diseases • Ensure environmental sustainability • Develop global partnerships for development 4. Low-income countries must adopt government policies that are market-oriented and that educate the workforce and population. After this is done, low-income countries should focus on eradicating other social ills that inhibit their growth. The economically challenged are stuck in poverty traps. They need to focus more on health and education and create a stable macroeconomic and political environment. This will attract foreign aid and foreign investment. Middle-income countries strive for increases in physical capital and innovation, while higher-income countries must work to maintain their economies through innovation and technology. 5. If there is a recession and unemployment increases, we can call on an expansionary fiscal policy (lower taxes or increased government spending) or an expansionary monetary policy (increase the money supply and lower interest rates). Both policies stimulate output and decrease unemployment. 6. Aside from a high natural rate of unemployment due to government regulations, subsistence households may be counted as not working. 7. Indexing wage contracts means wages rise when prices rise. This means what you can buy with your wages, your standard of living, remains the same. When wages are not indexed, or rise with inflation, your standard of living falls. 8. An increase in government spending shifts the AD curve to the right, raising both income and price levels. 9. A decrease in the money supply will shift the AD curve leftward and reduce income and price levels. Banks will have less money to lend. Interest rates will increase, affecting consumption and investment, which are both key determinants of aggregate demand. 10. Given the high level of activity in international financial markets, it is typically believed that financial flows across borders are the real reason for trade imbalances. For example, the United States had an enormous trade deficit in This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Answer Key 589 the late 1990s and early 2000s because it was attracting vast inflows of foreign capital. Smaller countries that have attracted such inflows of international capital worry that if the inflows suddenly turn to outflows, the resulting decline in their currency could collapse their banking system and bring on a deep recession. 11. The demand for the country’s currency would decrease, lowering the exchange rate. Chapter 20 1. False. Anything that leads to different levels of productivity between two economies can be a source of comparative advantage. For example, the education of workers, the knowledge base of engineers and scientists in a country, the part of a split-up value chain where they have their specialized learning, economies of scale, and other factors can all determine comparative advantage. 2. Brazil has the absolute advantage in producing beef and the United States has the absolute advantage in autos. The opportunity cost of producing one pound of beef is 1/10 of an auto; in the United States it is 3/4 of an auto. 3. In answering questions like these, it is often helpful to begin by organizing the information in a table, such as in the following table. Notice that, in this case, the productivity of the countries is expressed in terms of how many workers it takes to produce a unit of a product. Country One Sweater One Bottle of wine France 1 worker 1 worker Tunisia 2 workers 3 workers In this example, France has an absolute advantage in the production of both sweaters and wine. You can tell because it takes France less labor to produce a unit of the good. 4. a. In Germany, it takes fewer workers to make either a television or a video camera. Germany has an absolute advantage in the production of both goods. b. Producing an additional television in Germany requires three workers. Shifting those three German workers will reduce video camera production by 3/4 of a camera. Producing an additional television set in Poland requires six workers, and shifting those workers from the other good reduces output of video cameras by 6/ 12 of a camera, or 1/2. Thus, the opportunity cost of producing televisions is lower in Poland, so Poland has the comparative advantage in the production of televisions. Note: Do not let the fractions like 3/4 of a camera or 1/2 of a video camera bother you. If either country was to expand television production by a significant amount—that is, lots more than one unit—then we will be talking about whole cameras and not fractional ones. You can also spot this conclusion by noticing that Poland’s absolute disadvantage is relatively lower in televisions, because Poland needs twice as many workers to produce a television but three times as many to produce a video camera, so the product with the relatively lower absolute disadvantage is Poland’s comparative advantage. c. Producing a video camera in Germany requires four workers, and shifting those four workers away from television production has an opportunity cost of 4/3 television sets. Producing a video camera in Poland requires 12 workers, and shifting those 12 workers away from television production has an opportunity cost of two television sets. Thus, the opportunity cost of producing video cameras is lower in Germany, and video cameras will be Germany’s comparative advantage. In this example, absolute advantage differs from comparative advantage. Germany has the absolute advantage in the production of both goods, but Poland has a comparative advantage in the production of televisions. e. Germany should specialize, at least to some extent, in the production of video cameras, export video cameras, and import televisions. Conversely, Poland should specialize, at least to some extent, in the production of televisions, export televisions, and import video cameras. d. 590 Answer Key 5. There are a number of possible advantages of intra-industry trade. Both nations can take advantage of extreme specialization and learning in certain kinds of cars with certain traits, like gas-efficient cars, luxury cars, sportutility vehicles, higher- and lower-quality cars, and so on. Moreover, nations can take advantage of economies of scale, so that large companies will compete against each other across international borders, providing the benefits of competition and variety to customers. This same argument applies to trade between U.S. states, where people often buy products made by people of other states, even though a similar product is made within the boundaries of their own state. All states—and all countries—can benefit from this kind of competition and trade. 6. a. Start by plotting the points on a sketch diagram and then drawing a line through them. The following figure illustrates the average costs of production of semiconductors. The curve illustrates economies of scale by showing that as the scale increases—that is, as production at this particular factory goes up—the average cost of production declines. The economies of scale exist up to an output of 40,000 semiconductors; at higher outputs, the average cost of production does not seem to decline any further. b. At any quantity demanded above 40,000, this economy can take full advantage of economies of scale; that is, it can produce at the lowest cost per unit. Indeed, if the quantity demanded was quite high, like 500,000, then there could be a number of different factories all taking full advantage of economies of scale and competing with each other. If the quantity demanded falls below 40,000, then the economy by itself, without foreign trade, cannot take full advantage of economies of scale. c. The simplest answer to this question is that the small country could have a large enough factory to take full advantage of economies of scale, but then export most of the output. For semiconductors, countries like Taiwan and Korea have recently fit this description. Moreover, this country could also import semiconductors from other countries which also have large factories, thus getting the benefits of competition and variety. A slightly more complex answer is that the country can get these benefits of economies of scale without producing semiconductors, but simply by buying semiconductors made at low cost around the world. An economy, especially a smaller country, may well end up specializing and producing a few items on a large scale, but then trading those items for other items produced on a large scale, and thus gaining the benefits of economies of scale by trade, as well as by direct production. 7. A nation might restrict trade on imported products to protect an industry that is important for national security. For example, nation X and nation Y may be geopolitical rivals, each with ambitions of increased political and economic strength. Even if nation Y has comparative advantage in the production of missile defense systems, it is unlikely that nation Y would seek to export those goods to nation X. It is also the c
ase that, for some nations, the production of a particular good is a key component of national identity. In Japan, the production of rice is culturally very important. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Answer Key 591 It may be difficult for Japan to import rice from a nation like Vietnam, even if Vietnam has a comparative advantage in rice production. Chapter 21 1. This is the opposite case of the Work It Out feature. A reduced tariff is like a decrease in the cost of production, which is shown by a downward (or rightward) shift in the supply curve. 2. A subsidy is like a reduction in cost. This shifts the supply curve down (or to the right), driving the price of sugar down. If the subsidy is large enough, the price of sugar can fall below the cost of production faced by foreign producers, which means they will lose money on any sugar they produce and sell. 3. Trade barriers raise the price of goods in protected industries. If those products are inputs in other industries, it raises their production costs and then prices, so sales fall in those other industries. Lower sales lead to lower employment. Additionally, if the protected industries are consumer goods, their customers pay higher prices, which reduce demand for other consumer products and thus employment in those industries. 4. Trade based on comparative advantage raises the average wage rate economy-wide, though it can reduce the incomes of import-substituting industries. By moving away from a country’s comparative advantage, trade barriers do the opposite: they give workers in protected industries an advantage, while reducing the average wage economywide. 5. By raising incomes, trade tends to raise working conditions also, even though those conditions may not (yet) be equivalent to those in high-income countries. 6. They typically pay more than the next-best alternative. If a Nike firm did not pay workers at least as much as they would earn, for example, in a subsistence rural lifestyle, they many never come to work for Nike. 7. Since trade barriers raise prices, real incomes fall. The average worker would also earn less. 8. Workers working in other sectors and the protected sector see a decrease in their real wage. 9. If imports can be sold at extremely low prices, domestic firms would have to match those prices to be competitive. By definition, matching prices would imply selling under cost and, therefore, losing money. Firms cannot sustain losses forever. When they leave the industry, importers can “take over,” raising prices to monopoly levels to cover their short-term losses and earn long-term profits. 10. Because low-income countries need to provide necessities—food, clothing, and shelter—to their people. In other words, they consider environmental quality a luxury. 11. Low-income countries can compete for jobs by reducing their environmental standards to attract business to their countries. This could lead to a competitive reduction in regulations, which would lead to greater environmental damage. While pollution management is a cost for businesses, it is tiny relative to other costs, like labor and adequate infrastructure. It is also costly for firms to locate far away from their customers, which many low-income countries are. 12. The decision should not be arbitrary or unnecessarily discriminatory. It should treat foreign companies the same way as domestic companies. It should be based on science. 13. Restricting imports today does not solve the problem. If anything, it makes it worse since it implies using up domestic sources of the products faster than if they are imported. Also, the national security argument can be used to support protection of nearly any product, not just things critical to our national security. 14. The effect of increasing standards may increase costs to the small exporting country. The supply curve of toys will shift to the left. Exports will decrease and toy prices will rise. Tariffs also raise prices. So the effect on the price of toys is the same. A tariff is a “second best” policy and also affects other sectors. However, a common standard across countries is a “first best” policy that attacks the problem at its root. 592 Answer Key 15. A free trade association offers free trade between its members, but each country can determine its own trade policy outside the association. A common market requires a common external trade policy in addition to free trade within the group. An economic union is a common market with coordinated fiscal and monetary policy. 16. International agreements can serve as a political counterweight to domestic special interests, thereby preventing stronger protectionist measures. 17. Reductions in tariffs, quotas, and other trade barriers, improved transportation, and communication media have made people more aware of what is available in the rest of the world. 18. Competition from firms with better or cheaper products can reduce a business’s profits, and may drive it out of business. Workers would similarly lose income or even their jobs. 19. Consumers get better or less expensive products. Businesses with the better or cheaper products increase their profits. Employees of those businesses earn more income. On balance, the gains outweigh the losses to a nation. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 References 593 REFERENCES Welcome to Economics! Bureau of Labor Statistics, U.S. Department of Labor. 2015. "The Employment Situation—February 2015." Accessed March 27, 2015. http://www.bls.gov/news.release/pdf/empsit.pdf. Williamson, Lisa. “US Labor Market in 2012.” Bureau of Labor Statistics. 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Macroeconomic Policy Around the World International Labour Organization. “Global Employment Trends for Youth 2013.” http://www.ilo.org/global/research/ global-reports/global-employment-trends/youth/2013/lang--en/index.htm International Monetary Fund. “World Economic and Financial Surveys: World Economic Outlook—Transitions and Tensions.” Last modified October 2013. http://www.imf.org/external/pubs/ft/weo/2013/02/pdf/text.pdf. Nobelprize.org. “The Prize in Economics 1987 - Press Release.” Nobel Media AB 2013. Last modified October 21, 1987. http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1987/press.html. Redvers, Louise. BBC News Business. “Youth unemployment: The big question and South Africa.” Last modified October 31, 2012. http://www.bbc.co.uk/news/business-20125053. The World Bank. “The Complete World Development Report Online.” http://www.wdronline.worldbank.org/. The World Bank. “World DataBank.” http://databank.worldbank.org/data/home.aspx. 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Vercillo, Siera. “The Failures of Canadian Foreign Aid: Tied, Mismanaged and Uncoordinated.” The Attaché Journal of International Affairs. (2010). http://theattachejia.files.wordpress.com/2013/10/the-attache-2010-issue.pdf. Viscusi, Gregory, and Mark Deen. “Why France Has So Many 49-Employee Companies.” Business Week. Last http://www.businessweek.com/articles/2012-05-03/why-france-has-so- 2012. modified May many-49-employee-companies. 3, Edwards, S. (n.d.). “America’s Unsustainable Current Account Deficit.” National Bureau of Economic Research http://www.ustr.gov/trade-agreements/free-trade- http://www.nber.org/digest/mar06/w11541.html. Digest. agreements/north-american-free-trade-agreement-nafta. New Country Classifications \| Data. (n.d.). Accessed January 14, 2014. http://data.worldbank.org/news/new-country- classifications. Office of the United States Trade Representative: Executive Office of the President. “North American Free Trade Agreement (NAFTA).” Why India’s Labour Laws are a Problem. (2006, May 18). BBC. May 18, 2006. http://news.bbc.co.uk/2/hi/south_asia/ 4984256.stm. International Trade Krugman, Paul R. Pop Internationalism. The MIT Press, Cambridge. 1996. Krugman, Paul R. “What Do Undergrads Need to Know about Trade?” American Economic Review 83, no. 2. 1993. 23-26. Ricardo, David. On the Principles of Political Economy and Taxation. London: John Murray, 1817. Ricardo, David. “On the Principles of Political Economy and Taxation.” Library of Economics and Liberty. http://www.econlib.org/library/Ricardo/ricP.html. Bernstein, William J. A Splendid Exchange: How Trade Shaped the World. Atlantic Monthly Press. New York. 2008. U.S. Census Bureau. 2015. “U.S. International Trade in Goods and Services: December 2014.” Accessed April 13, 2015. http://www.bea.gov/newsreleases/international/trade/2015/pdf/trad1214.pdf. U.S. Census Bureau. U.S. Bureau of Economic Analysis. 2015. “U.S. International Trade in Goods and Services https://www.census.gov/foreign-trade/Press-Release/ 2015. 2015.” Accessed April 10, February current_press_release/ft900.pdf. Vernengo, Matias. “What Do Undergraduates Really Need to Know About Trade and Finance?” in Political Economy and Contemporary Capitalism: Radical Perspectives on Economic Theory and Policy, ed. Ron Baiman, Heather Boushey, and Dawn Saunders. M. E. Sharpe Inc, 2000. Armonk. 177-183. World Trade Organization. “The Doha Round.” Accessed October 2013. http://www.wto.org/english/tratop_e/dda_e/ dda_e.htm. The World Bank. “Data: World Development Indicators.” Accessed October 2013. http://data.worldbank.org/data- catalog/world-development-indicators. 602 References Globalization and Protectionism Bureau of Labor Statistics. “Industries at a Glance.” Accessed December 31, 2013. http://www.bls.gov/iag/. Oxfam International. Accessed January 6, 2014. http://www.oxfam.org/. Bureau of Labor Statistics. “Data Retrieval: Employment, Hours, and Earnings (CES).” Last modified February 1, 2013. http://www.bls.gov/webapps/legacy/cesbtab1.htm. Dhillon, Kiran. 2015. “Why Are U.S. Oil Imports Falling?” Time.com. Accessed April 1, 2015. http://time.com/ 67163/why-are-u-s-oil-imports-falling/. Kristof, Nicholas. “Let Them Sweat.” The New York Times, June 25, 2002. http://www.nytimes.com/2002/06/25/ opinion/let-them-sweat.html. Kohut, Andrew, Richard Wike, and Juliana Horowitz. “The Pew Global Attitudes Project.” Pew Research Center. Last modified October 4, 2007. http://www.pewglobal.org/files/pdf/258.pdf. Lutz, Hannah. 2015. “U.S. Auto Exports Hit Record in 2014.” Automotive News. Accessed April 1, 2015. http://www.autonews.com/article/20150206/OEM01/150209875/u.s.-auto-exports-hit-record-in-2014. United States Department of Labor. Bureau of Labor Statistics. 2015. “Employment Situation Summary.” Accessed April 1, 2015. http://www.bls.gov/news.release/empsit.nr0.htm. United States Department of Commerce. “About the Department of Commerce.” Accessed January 6, 2014. http://www.commerce.gov/about-department-commerce. United States International Trade Commission. “About the USITC.” Accessed January 6, 2014. http://www.usitc.gov/ press_room/about_usitc.htm. E. Helpman, and O. Itskhoki, “Labour Market Rigidities, Trade and Unemployment,” The Review of Economic Studies, 77. 3 (2010): 1100-1137. M.J. Melitz, and D. Trefler. “Gains from Trade wh
en Firms Matter.” The Journal of Economic Perspectives, 26.2 (2012): 91-118. Rauch, J. “Was Mancur Olson Wrong?” The American, February 15, 2013. http://www.american.com/archive/2013/ february/was-mancur-olson-wrong. Office of the United States Trade Representative. “U.S. Trade Representative Froman Announces FY 2014 WTO Tariff-Rate Quota Allocations for Raw Cane Sugar, Refined and Specialty Sugar and Sugar-Containing Products.”Accessed January 6, 2014. http://www.ustr.gov/about-us/press-office/press-releases/2013/september/ WTO-trq-for-sugar. The World Bank. “Merchandise trade (% of GDP).” Accessed January 4, 2014. http://data.worldbank.org/indicator/ TG.VAL.TOTL.GD.ZS. World Trade Organization. 2014. “Annual Report 2014.” Accessed April 1, 2015. https://www.wto.org/english/res_e/ booksp_e/anrep_e/anrep14_chap10_e.pdf. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Index INDEX Symbols 401(k), 234 A A.W. Phillips, 306 Abhijit Bannerjee, 461 Abraham García, 178 absolute advantage, 476, 492 Adam Smith, 12, 39, 271 adaptive expectations, 322, 331 adjustable-rate mortgage (ARM), 237, 240 adverse selection of wage cuts argument, 202, 212 aggregate demand, 271, 299, 318, 322, 327, 369, 373, 395, 418, 463, 549 aggregate demand (AD), 135, 289 Aggregate demand (AD), 274 aggregate demand (AD) curve, 274, 289 aggregate demand/aggregate supply (AD/AS), 336 aggregate demand/aggregate supply model, 272, 289, 317 aggregate expenditure function, 550 aggregate expenditure line, 549 aggregate expenditure schedule, 542 aggregate expenditures, 549 aggregate production function, 168, 174, 183, 184 aggregate supply, 271, 318, 418 aggregate supply (AS), 135, 289 Aggregate supply (AS), 272 aggregate supply (AS) curve, 273, 289 aggregate supply curve, 327 Alexander Gerschenkron, 180 Alfred Marshall, 73 Allocative efficiency, 36 allocative efficiency, 42 American Recovery and Reinvestment Act of 2009, 305 Anti-dumping laws, 510 anti-dumping laws, 520 appreciating, 386, 404 arbitrage, 394, 404 Asian Financial Crisis, 467 asset, 342, 350 asset-liability time mismatch, 345 assets, 360 asset–liability time mismatch, 350 automatic stabilizers, 421, 429, 463 B balance of payments, 254 balance of trade, 246, 262, 402 balance of trade (trade balance), 264 balance sheet, 342, 350 balanced budget, 410, 427, 429 bank capital, 342, 350 Bank capital, 359 Bank regulation, 359 bank run, 360, 377 bankrupt, 396 bar graph, 534 Barter, 336 barter, 350 base year, 221, 240 basic quantity equation of money, 372, 377 basket of goods and services, 219, 240 bonds, 238, 343, 363 budget constraint, 29, 42 budget deficit, 410, 429 budget surplus, 410, 429 Bureau of Economic Analysis (BEA), 247 Bureau of Labor Statistics, 156 business confidence, 281 business cycle, 151, 158 C capital deepening, 174, 184 central bank, 356, 370, 377, 395, 400 certificates of deposit (CDs), 339 ceteris paribus, 52, 64, 75, 86 circular flow diagram, 16, 23 coins and currency in circulation, 339, 350 command economy, 18, 23 commodity money, 337, 350 Commodity-backed currencies, 337 603 commodity-backed currencies, 350 common market, 520 common markets, 515 comparative advantage, 13, 37, 42, 253, 477, 507 complements, 55, 75 compound growth rate, 173, 184 Constant unitary elasticity, 114 constant unitary elasticity, 127 consumer confidence, 281 Consumer Price Index (CPI), 222, 240 consumer surplus, 71, 75, 503 consumption budget constraint, 35 consumption demand, 137 consumption function, 542 contractionary fiscal policy, 309, 311, 418, 429 contractionary monetary policy, 365, 377, 399, 446 contractual rights, 166, 184 convergence, 178, 184 converging economy, 465, 470 coordination argument, 303, 311 core competency, 13 core inflation index, 225, 240 corporate income tax, 414, 429 cost, 35 cost of living, 222 cost-of-living adjustments (COLAs), 237, 240 countercyclical, 367, 377 credit card, 340, 350 credit union, 342 cross-price elasticity of demand, 123, 127 crowding out, 424, 429, 444 current account balance, 247, 264 cyclical unemployment, 201, 212, 285, 326 D David Ricardo, 476 deadweight loss, 72, 75 dealers, 385 debit card, 340, 350 deficit, 437 deflation, 228, 240 Deflation, 371 604 Index demand, 47, 75, 135, 271, 382 demand and supply diagram, 71 demand and supply models, 98 demand curve, 47, 52, 75, 111, 113, 391, 445, 501 demand deposit, 350 demand deposits, 339 demand schedule, 47, 75 deposit insurance, 361, 377 depository institution, 350 depository institutions, 341 depreciating, 386, 404 depreciation, 143, 158 depression, 151, 158, 196 direct investment, 400 discount rate, 365, 377 Discouraged workers, 193 discouraged workers, 212 discretionary fiscal policy, 421, 429, 463 disposable income, 299, 311 disruptive market change, 518, 520 diversify, 345, 350 division of labor, 12, 23, 487 dollarize, 382, 404 double coincidence of wants, 336, 350 double counting, 142, 158 Dow Jones, 374 dumping, 490, 520 Dumping, 510 durable good, 158 durable goods, 139 E East Asian Tigers, 459, 470 economic efficiency, 39 economic growth, 336 economic surplus, 72, 75 economic union, 520 economic unions, 515 Economics, 10 economics, 23 economies of scale, 13, 23, 488 efficiency, 71 Efficiency wage theory, 202 efficiency wage theory, 212 elastic demand, 109, 127 elastic supply, 109, 127 Elasticity, 108 elasticity, 127 elasticity of savings, 124, 127 Employment Cost Index, 226, 240 equilibrium, 51, 71, 75, 86, 499, 550 equilibrium exchange rate, 391 equilibrium price, 51, 75 equilibrium quantity, 51, 66, 75 estate and gift tax, 414, 429 Esther Duflo, 461 European Union, 515 European Union (EU), 70 excess demand, 51, 75 excess reserves, 370, 377 excess supply, 51, 75 exchange rate, 152, 158, 382, 440 exchange rates, 375 excise tax, 414, 429 expansionary fiscal policy, 308, 311, 418, 429 expansionary monetary policy, 365, 377, 399, 446, 463 expected inflation, 323, 331 expenditure multiplier, 305, 311 expenditure-output model, 541 export, 484 Exports, 21 exports, 23, 247, 275, 301, 395 exports of goods and services as a percentage of GDP, 252, 264 F factors of production, 57, 75 Federal Deposit Insurance Corporation (FDIC), 361 federal funds rate, 366, 377 Federal Open Market Committee (FOMC), 362 Federal Reserve, 356, 359, 374, 446, 466 Federal Reserve Bank, 339 Federal Reserve Economic Data (FRED), 195, 387, 398 fiat money, 338, 350 final good and service, 158 final goods and services, 142 financial capital, 93, 252, 256, 264, 375, 436 financial capital market, 255 financial capital markets, 424, 436 financial intermediary, 341, 350 firm, 37, 59 firms, 383 fiscal policy, 15, 23, 410, 463 floating exchange rate, 397, 404 Foreign direct investment (FDI), 384 This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 foreign direct investment (FDI), 404 foreign exchange market, 382, 392, 404 foreign financial capital, 259 foreign investment capital, 396 free trade, 511 free trade agreement, 520 free trade agreements, 515 frictional unemployment, 205, 212 full-employment GDP, 274, 289 function, 525 G gain from trade, 480, 492 GDP, 382, 394 GDP deflator, 145, 226, 240 GDP per capita, 154, 156, 158, 174, 278, 455 General Agreement on Tariffs and Trade (GATT), 514, 520 globalization, 21, 23, 476, 507 good, 48 goods and services market, 16, 23 Great Depression, 151, 272, 316, 329, 476 Great Recession, 139, 151, 229, 316, 464 Gross domestic product (GDP), 21 gross domestic product (GDP) , 23, 135, 158 gross national product (GNP), 143, 158 growth consensus, 458, 470 growth rate, 529 H hard peg, 398, 404 Head Start program, 448, 450 hedge, 385, 404 hidden unemployment, 193 High-income countries, 502 high-income countries, 511 high-income country, 470 Human capital, 167, 174 human capital, 184, 317, 427, 448, 460 hyperinflation, 230, 240 I implementation lag, 425, 429 implicit contract, 202, 212 Index 605 import quotas, 498, 520 Imports, 21 imports, 23, 247, 275, 301, 484 income elasticity of demand, 123 income payments, 248 index number, 221, 240 indexed, 237, 240 individual income tax, 413, 429 Industrial Revolution, 164, 184 inelastic demand, 109, 127 inelastic supply, 109, 127 infant industry argument, 466, 508 inferior good, 54, 75, 123 Infinite elasticity, 113 infinite elasticity, 127 Inflation, 218 inflation, 240, 270, 284, 308, 336, 356, 464 inflation rate, 368 inflation targeting, 374, 377 inflationary gap, 299, 311, 555 infrastructure, 174, 184, 427 innovation, 167, 184 inputs, 57, 75 insider-outsider model, 202, 212 interbank market, 385 interest rate, 93, 103, 300 interest rates, 356, 366 intermediate good, 158 intermediate goods, 142 intermediate zone, 288, 289 international capital flows, 400, 404 international financial flows, 400 International Price Index, 226, 240 international trade, 397, 489, 518 intertemporal choices, 41 intertemporal decision making, 95 intra-industry trade, 487, 492 invention, 167, 184 inventories, 139 inventory, 158 Investment demand, 137 Investment expenditure, 137 investment expenditure, 300 investment function, 544 investment income, 254 invisible hand, 40, 42 involuntary unemployment, 201 J James Tobin, 400 Jan Luiten van Zanden, 164 Janet L. Yellen, 357 Jean-Baptiste Say, 271 John Maynard Keynes, 16, 272, 321, 423 K key input, 118 Keynesian aggregate supply curve, 366 Keynesian cross diagram, 541 Keynesian economic model, 463 Keynesian economics, 317, 329 Keynesian macroeconomic policy, 427 Keynesian zone, 287, 289 Keynes’ law, 271, 287, 289 L labor force participation rate, 193, 212 labor market, 16, 23, 86, 201 labor markets, 237 Labor productivity, 167 labor productivity, 184 law of demand, 47, 75, 94 law of diminishing marginal utility, 32, 42 law of diminishing returns, 35, 42, 180 law of supply, 48, 75 legislative lag, 425, 429 lender of last resort, 361, 377 level of trade, 261 leverage cycle, 374 liability, 342, 350 line graphs, 530 Liquidity, 338 living wage, 90 loan market, 343 long run aggregate
supply (LRAS) curve, 278, 289 loose monetary policy, 365, 377 low-income countries, 200, 502, 511 low-income country, 470 M M1, 371 M1 money supply, 339, 350 M2, 372 M2 money supply, 339, 350 macro economy, 200 macroeconomic externality, 304, 311 Macroeconomics, 14 macroeconomics, 23 marginal analysis, 32, 42 marginal propensity to consume (MPC), 542 marginal propensity to import (MPI), 547 marginal propensity to save (MPS), 542 marginal tax rates, 414, 429 market, 19, 23 market economy, 19, 23, 37, 205, 235 median, 530 medium of exchange, 337, 350 menu costs, 303, 311 merchandise trade balance, 247, 264 merged currency, 401, 404 Microeconomics, 14 microeconomics, 23 middle-income country, 470 Midpoint Formula, 111 Midpoint Method, 109, 112 Milton Friedman, 326, 373, 398 minimum wage, 90, 103, 201, 233, 507 model, 16, 23 modern economic growth, 164, 184 monetary policy, 15, 23, 356, 362, 399 money, 337, 350 money market fund, 350 money market funds, 339 money multiplier, 375 money multiplier formula, 347, 350 multiplier effect, 555 N Nasdaq, 374 National Bureau of Economic Research, 466 National Bureau of Economic Research (NBER), 152 National Credit Union Administration (NCUA), 359 national debt, 416, 429 national income, 141, 143, 158, 541 national interest argument, 513, 606 Index 520 national saving and investment identity, 255 national savings and investment identity, 264 natural rate of unemployment, 204, 212, 285, 326 negative slope, 527 neoclassical determinants of growth, 458 neoclassical economists, 271, 289 neoclassical model, 373 neoclassical perspective, 317, 331 neoclassical zone, 287, 289 net national product (NNP), 143, 158 net worth, 342, 351, 359 nominal GDP, 149, 372 nominal interest rate, 233, 371 nominal value, 144, 158 nondurable good, 158 nondurable goods, 139 Nontariff barriers, 499 nontariff barriers, 520 normal good, 54, 75 normal goods, 123 normative statement, 42 normative statements, 39 North American Free Trade Agreement (NAFTA), 465, 505, 515 O open market operations, 362, 377 opportunity cost, 29, 42, 190, 400, 477, 485, 505 opportunity set, 42 out of the labor force, 191, 212 Oxfam International, 502 P payment system, 341, 351 payroll tax, 413, 429 peak, 151, 158 pensions, 234 Per capita GDP, 219 per capita GDP, 260 percentage change, 220 perfect elasticity, 113, 127 perfect inelasticity, 113, 127 Pew Research Center for People and the Press, 63 Phillips curve, 306, 311, 324 physical capital, 174, 184, 444, 460 Physical capital per person, 317 physical capital per person, 331 pie chart, 533 pie graph, 533 Pierre Mohnen, 178 portfolio investment, 384, 400, 404 positive slope, 527 positive statement, 42 positive statements, 39 potential GDP, 273, 289, 298, 309, 317, 366, 374, 542 price, 31, 47, 52, 75 price ceiling, 68, 72, 75 price control, 72, 75 price controls, 68, 100 Price elasticity, 108 price elasticity, 127 price elasticity of demand, 108, 127 price elasticity of supply, 108, 127 price floor, 68, 73, 76 price level, 219 private enterprise, 19, 23 private markets, 237 Producer Price Index (PPI), 226, 240 producer surplus, 72, 76, 503 production function, 168, 184 production possibilities frontier (PPF), 33, 42 production possibility frontier (PPF), 478 Productive efficiency, 36 productive efficiency, 42 productivity, 482 Productivity growth, 170 productivity growth, 278 progressive tax, 413, 429 property rights, 166 proportional tax, 414, 429 protectionism, 498, 502, 520 Protectionism, 505 purchasing power parity, 455 purchasing power parity (PPP), 152, 394, 404 Q quality/new goods bias, 223, 240 quantitative easing (QE), 369, 377 quantity demanded, 47, 76, 399 quantity supplied, 48, 76, 399 R race to the bottom, 511, 520 rational expectations, 321, 331 real GDP, 149, 246, 261, 299, 311, 317, 370, 372, 542 real interest rate, 233 real value, 144, 158 recession, 151, 158, 196, 271, 283, 302, 370, 441, 463 recessionary gap, 299, 311, 554 recognition lag, 424, 429 redistributions, 233, 236 regressive tax, 414, 429 relative wage coordination argument, 202, 212 reserve requirement, 364, 377 reserves, 343, 351, 359, 364, 400 revenue, 415 Ricardian equivalence, 443, 450 Richard Easterlin, 166 Robert Shiller, 232 Robert Solow, 329 rule of law, 166, 184 S salary, 84 savings deposit, 351 savings deposits, 339 Say’s law, 271, 287, 289 Scarcity, 10 scarcity, 23, 39 Sebastian Edwards, 466 Securitization, 344 service, 48, 158 services, 139, 299 shift in demand, 55, 76 shift in supply, 57, 76 short run aggregate supply (SRAS) curve, 278, 289 shortage, 51, 76 shortages, 236 slope, 34, 527 smart card, 340, 351 Social Security Indexing Act of 1972, 238 social surplus, 72, 76 soft peg, 398, 404 special economic zone (SEZ), 184 special economic zones (SEZ), 178 specialization, 13, 23, 480 This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Index 607 Treasury bonds, 369 trough, 151, 158 twin deficits, 443, 450 U U.S. Census Bureau, 54 U.S. Department of Commerce, 247 U.S. Patent and Trademark Office, 176 underemployed, 193, 212 underground economies, 20 underground economy, 23 unemployment, 270, 284, 308, 336, 356, 463 unemployment rate, 191, 212, 368 unilateral transfers, 248, 264 unit of account, 337, 351 Unitary elasticities, 109 unitary elasticity, 127 usury laws, 98, 103 utility, 32, 42 V value chain, 488, 492 variable, 526 velocity, 371, 377 W wage, 84 wage elasticity of labor supply, 124, 127 wages, 206, 219, 233 World Trade Organization (WTO), 490, 499, 510, 514, 520 Z Zero elasticity, 113 zero inelasticity, 127 splitting up the value chain, 488, 492 stagflation, 279, 289, 308 standard of deferred payment, 337, 351 standard of living, 155, 158 standardized employment budget, 422, 429 standards of living, 457 sticky, 202 sticky wages and prices, 302, 311 store of value, 337, 351 straight-line demand curve, 111 structural unemployment, 205, 212 structure, 158 structures, 139 subprime loans, 345 subsidies, 502 substitute, 55, 76 substitution bias, 223, 240 sunk costs, 33, 42 supply, 48, 76, 271, 382 supply curve, 49, 52, 76, 391, 445, 501 supply schedule, 49, 76 surplus, 51, 76, 248, 437 surpluses, 236 T T-account, 343, 351 Tariffs, 490 tariffs, 492, 498 tax, 282 tax incidence, 120, 127 Technological change, 167 technological change, 184 technology, 174, 184, 460 The Land of Funny Money, 232 theory, 16, 23 tight monetary policy, 365, 377 time deposit, 351 time deposits, 339 time series, 532 Tobin taxes, 400, 404 total surplus, 72, 76 trade balance, 138, 158 trade deficit, 138, 158, 246, 466 trade surplus, 138, 158, 246, 466 tradeoffs, 39 traditional economy, 18, 23 Transaction costs, 341 transaction costs, 351 Treasury bills, 369
elieve more than ever in this approach to teaching economics. The Second Edition: What’s New Although the first edition was a resounding success, quickly becoming one of the best-selling economics textbooks, there is always room for improvement. For the second edition, we have undertaken a significant revision. We hope that these revisions lead to a more successful teaching experience for you. We look forward to your comments. Here are the major second-edition changes: New Chapter Order The most substantive change is the new organization of chapters, reflecting a more traditional sequence. Organizational changes include the following: ➤ Tax coverage has been consolidated into a single new chapter. Our first edition treatment of taxes had been spread across several chapters. The second edition consolidates the material into one early chapter: Chapter 7, “Taxes.” ➤ Consumer theory now precedes producer theory, so that the market structure chapters are grouped together. Although many instructors choose not to teach consumer theory, the majority of those who do cover it before producer theory. In response, we’ve rearranged the chapters so that consumer theory (Chapters 10 and 11) now precedes producer theory (Chapters 12 and 13). As a result, chapters on perfectly competitive industries are now immediately followed by the monopoly, oligopoply, and monopolistic competition chapters (Chapters 14, 15, and 16), allowing a continuous treatment of industrial organization. ➤ The international trade chapter appears earlier. Along with adding the new “Global Comparison” feature, described on the next page, placing international trade earlier greatly enhances the international focus of the text. ➤ The consumer and producer surplus chapter has moved earlier to follow the demand and supply chapter. This change allows for an earlier introduction to the modern tools of consumer and producer surplus, giving readers a better sense of what happens xvii xviii P R E F A C E under price ceilings and price floors. We believe this change results in better motivation and clearer exposition of the benefits of competitive markets. ➤ Optional chapters on factors markets and risk have moved to the end of the microeconomics text. While some instructors will find these chapters very useful to teach, placing these optional chapters at the end of the microeconomics portion of the text improves the pedagogical flow of core material. New Chapter 7, “Taxes” Material that previously appeared in the various contexts of quotas, elasticity, and consumer and producer surplus has been consolidated into a single early chapter. This change allows an instructor to give a comprehensive overview of the economics of taxation, with early applications of concepts from supply and demand, consumer and producer surplus, and elasticity. New Chapter 19, “The Economics of the Welfare State” This new chapter on the welfare state, although optional for many of you, covers a topic that is deeply important to us and is at the heart of much of today’s political debates. It is also a response to those who have asked to see more of Paul’s unique voice in the book. The chapter focuses on timely topics such as the economics of health care and federal entitlement spending, carefully presenting the arguments for both expanding the welfare state as well as the arguments for reducing it. As in Paul’s New York Times columns, this chapter takes a complex topic and reduces it to its essential elements, illuminating the intellectual foundations of our policy choices. In addition, this chapter provides a timely and engaging examination of the challenges that economists and policy makers face when applying economic concepts to daily realities. We believe that this chapter and the new examples of SCHIP (The State Children’s Health Insurance Program), poverty in the world’s rich nations, a comparison of the welfare state in France and the United States, and much more will motivate students to think more deeply about economic trade-offs, social welfare, and the political process. New “Global Comparison” Boxed Feature Another major change is greater international focus and global coverage of issues. Toward this end, we’ve created a new feature, Global Comparison boxes, which use data-driven examples to illustrate the international dimension of economic concepts. These examples will help students develop a greater appreciation for how economics really works. From international differences in institutional structures, resource endowments, and preferences, students will learn how different countries arrive at different economic destinations. Some Global Comparisons will give students deeper understanding of how the United States is similar to and different from other advanced countries. Others focus on differences between advanced and developing countries for an understanding of the promise and challenge of international growth; see, for example, the Chapter 9 Global Comparison “Portion Sizes” (page 236), which addresses the question of why restaurant portion sizes in the United States are typically larger than in European countries. With this example, students see a practical application of marginal analysis and come to understand that America’s large portions are the optimal response to lower food prices. Similarly, the Chapter 7 Global Comparison “You Think You Pay High Taxes?” (page 189), compares tax rates in the United States to those in other advanced countries, giving students a more informed view of U.S. tax policy. For a complete listing of Global Comparison boxes, see the inside front cover. An Even Stronger Focus on Global Issues Throughout In addition to the new Global Comparison feature, we’ve enhanced our focus on global issues in two more ways. First, the international trade chapter (Chapter 8) has moved up in the sequence to give students an early grounding in the importance of comparative advantage and trade. Second, we include globally focused examples in every single chapter of this book except for one (we were at a loss in the chapter on indifference curves). Some of our favorites include the For Inquiring Minds “Chinese Pants Explosion” (page 217), a discussion of the significant distributional consequences arising from the elimination of a U.S. quota on imports of Chinese pants and the Economics in Action “The Doha Deadlock” (page 219), which explains why world trade negotiations have stalled. Throughout the text, global examples are highlighted with an orange globe stamp. For a list of all such examples, see the inside cover and its facing page. Advantages of This Book Although a lot is new in this second edition, our basic approach to textbook writing remains the same: ➤ Chapters build intuition through realistic examples. In every chapter, we use real-world examples, stories, applications, and case studies to teach the core concepts and motivate student learning. The best way to introduce concepts and reinforce them is through real-world examples; students simply relate more easily to them. ➤ Pedagogical features reinforce learning. We’ve crafted what we believe are a genuinely helpful set of features that are described in the next section, “Tools for Learning.” ➤ Chapters are accessible and entertaining. We use a fluid and friendly writing style to make concepts accessible. Whenever possible, we use examples that are familiar to students: choosing which course to take, paying a high price for a cup of coffee, buying a used textbook, or deciding where to eat at the food court at the local shopping mall. ➤ Although easy to understand, the book also prepares students for further coursework. Too often, instructors find that selecting a textbook means choosing between two unappealing alternatives: a textbook that is “easy to teach” but leaves major gaps in students’ understanding, or a textbook that is “hard to teach” but adequately prepares students for future coursework. We offer an easy-to-understand textbook that offers the best of both worlds. Tools for Learning Every chapter is structured around a common set of features that help students learn while keeping them engaged. Opening Story Each chapter opens with a compelling story that often extends through the entire chapter. Stories were chosen to accomplish three things: to illustrate important concepts in the chapter, to build intuition with realistic examples, and then to encourage students to read on and learn more. For example, Chapter 3 uses the price of coffee at the local Starbucks and the supply of coffee beans to teach the supply and demand model. Chapter 4 teaches consumer and producer surplus in the context of a market for used textbooks. Because each chapter is introduced with a real-world story, students are drawn in and can relate more easily to the material. Five of our opening stories in this edition are new. A complete list of opening stories appears on the inside front cover. “What You Will Learn in This Chapter” Following every opening story is a preview of the chapter in an easyto-review bulleted list format that alerts students to critical concepts and chapter objectives. “Economics in Action” Case Studies In addition to the vivid stories that open every chapter, we conclude virtually every major text section with still more examples: a real-world case study called Economics in Action. This much-lauded feature provides a short but compelling application of the major concept just covered in that section. Students experience an immediate payoff when they can apply concepts they’ve just read about to real phenomena. For example, in Chapter 3 we use the tortilla crisis of 2007 to illustrate how changes in supply P R E F A C E xix impact consumers as bread-and-butter (and tortilla) issues (page 87). In Chapter 4, we use the case of eBay, the online auctioneer, to communicate the concept of efficiency (page 110). For a list of all the Economics in Action cases, see the page facing the inside front c
over and the table of contents. Unique End-of-Section Review: “Quick Review” and “Check Your Understanding” Questions Every Economics in Action case study is followed by two opportunities for review: Quick Reviews and Check Your Understanding questions. Because jargon and abstract concepts can quickly overwhelm the principles student, the Quick Reviews (short, bulleted summaries of key concepts) help ensure that students understand what they have just read. Then the Check Your Understanding questions (a short set of review questions with solutions at the back of the book) allow students to immediately test their understanding of a section. If they’re not getting the questions right, it’s a clear signal for them to go back and reread before moving on. We’ve received a lot of positive feedback about this end-of-section pedagogy that encourages students to apply what they’ve learned (via the Economics in Action) and then review it (with the Quick Reviews and Check Your Understanding questions). Boxed Features We include three types of boxes: “For Inquiring Minds”: To further our goal of helping students build intuition with real-world examples and infuse chapters with Paul’s voice, every chapter contains one or more For Inquiring Minds boxes. In these boxes, concepts are applied to real-world events in unexpected and sometimes surprising ways, generating a sense of the power and breadth of economics. These boxes show students that economics can be fun despite being labeled “the dismal science.” In a Chapter 18 box on water bottling in Maine, students learn how one of America’s favorite bottled waters, Poland Spring, is at the center of a dispute over the management of a common resource (page 471). For a list of all For Inquiring Minds boxes, see the page facing the inside front cover and the table of contents. “Global Comparison”: As explained earlier, in this new box we explore concepts using real data to illustrate how and why countries reach different economic outcomes. “Pitfalls”: Certain concepts are prone to be misunderstood when students begin their study of economics. We alert students to these mistakes in the Pitfalls boxes. Here common misunderstandings are spelled out and corrected. For example, in a Chapter 3 Pitfalls, we clarify the difference between demand and quantity demanded (page 66). The distinction between increasing total cost and increasing marginal cost is the topic of Pitfalls in Chapter 9 (page 232). For an overview of all the Pitfalls boxes in chapters, see the table of contents. xx P R E F A C E Definitions of Key Terms Every key term is defined in the text and then again in the margin, making it easier for students to study and review. “A Look Ahead” Each chapter ends with A Look Ahead, a short overview of what lies ahead in upcoming chapters. This conclusion provides students with a sense of continuity among chapters. End-of-Chapter Review In addition to the opportunities for review at the end of every major section, each chapter ends with a brief but complete Summary of the key concepts, a list of key terms, and a comprehensive set of end-of-chapter problems. Users and reviewers alike have praised the problem sets for how effectively they test intuition as well as the ability to calculate important variables. We have also responded to requests for more problems drawn from real life. So for the second edition we’ve added news- and data-based problems to every chapter. The Organization of This Book The organization of the second edition has been inspired by users and reviewers who spoke loudly and clearly about their desire for a more traditional sequence of chapters: consumer theory before producer theory, consolidated coverage of taxes, consecutive market structure chapters, and earlier treatment of consumer and producer surplus. We have revised accordingly. But our chapters are still grouped into building blocks in which conceptual material learned at one stage is built upon and then integrated into the conceptual material covered in the next stage. And our organization remains flexible: we recognize that a number of chapters will be considered optional and that many instructors will prefer to teach the chapters using a different order. Chapters and sections have been written to incorporate a degree of flexibility in the sequence in which they are taught, without sacrificing conceptual continuity. Following is a walkthrough of coverage in the second edition. Part 1: What Is Economics? The Introduction initiates students into the study of economics in the context of a shopping trip on any given Sunday in everyday America. It provides students with definitions of basic terms such as economics, the invisible hand, and market structure and serves as a “tour d’horizon” of economics, explaining the difference between microeconomics and macroeconomics. It is followed by Chapter 1, “First Principles,” with its twelve principles underlying the study of economics: four principles of individual choice, covering concepts such as opportunity cost, marginal analysis, and incentives; five principles of interaction between individuals, covering concepts such as gains from trade, market efficiency, and market failure; and three principles of economy-wide interaction, covering concepts that underlie the multiplier effect, recession and inflation, and macroeconomic policy. In later chapters, we build intuition by referring to these principles in the explanation of specific models. Students learn that these twelve principles form a cohesive conceptual foundation for all of economics. Chapter 2, “Economic Models: Trade-offs and Trade,” shows students how to think like economists by using two models—the production possibility frontier and comparative advantage. It gives students an early introduction to gains from trade and to international comparisons. The Chapter 2 appendix offers a comprehensive math and graphing review that provides a solid preparation for later material in the book. Part 2: Supply and Demand Chapter 3, “Supply and Demand,” begins with an all-new opening story that uses the market for coffee beans to illustrate supply and demand, market equilibrium, and surplus and shortage. Students learn how the demand and supply curves of coffee beans shift in response to events like changes in consumer tastes and changes in global coffee production. By showing how increases in the cost of a cappuccino at Starbucks can be traced to drought in Vietnam, we introduce students to the standard material in a way that is fresh and compelling. The story is supplemented with a Global Comparison on gas prices that shows how differences in gas prices across countries have led to different consumer choices. Through examples such as the market for used textbooks and eBay, students learn how markets increase welfare in Chapter 4, “Consumer and Producer Surplus.” This revised chapter contains an expanded discussion of market efficiency and the ways in which markets fail, addressing topics such as the role of prices as signals and property rights. A new For Inquiring Minds on the best mechanism for allocating transplant organs prompts students to think about nonmarket allocation systems and how they compare to markets. Chapter 5, “The Market Strikes Back,” covers various types of market interventions and their consequences: price and quantity controls, inefficiency, and deadweight loss. Through tangible examples such as New York City rent-control regulations and New York City taxi licenses, as well as rent control in Mumbai, India, and shopping in Hugo Chavez’s Venezuela, the costs generated by attempts to control markets are made real to students. Chapter 6, “Elasticity,” introduces the various elasticity measures. It contains a new opening story on the flu vaccine shortage of 2004–2005. Through a discussion of how patients and vaccine suppliers responded to a sudden shortfall of available flu vaccine, students are given a real-world example of how markets respond to events. Part 3: Individuals and Markets In new Chapter 7, “Taxes,” we aggregate material on taxation that had previously appeared in several first edition chapters. Basic tax analysis is covered, along with a review of the burden of taxation and considerations of equity versus efficiency. The chapter also provides an in-depth overview of the structure of taxation, current tax policy, and public spending in the United States. The chapter on taxes is paired with Chapter 8, “International Trade,” which now appears much earlier in the sequence. The chapter’s new opening story on conflict arising from increased importation of shrimp into the United States builds on the material in Chapter 2 on comparative advantage and trade. Here we trace the sources of comparative advantage, consider tariffs and quotas, and explore the politics of trade protection. We also provide in-depth coverage on the controversy over imports from low-wage countries. Part 4: Economic Decision Making Chapter 9, “Making Decisions,” is unique and important because microeconomics is fundamentally a science of how to make decisions. In the chapter we focus on developing an understanding of how decisions should be made in any context rather than placing the emphasis on comprehending the consequences of decisions. We want students to be able to distinguish between what is and what isn’t a marginal decision, and to do that we have included an entire section on “either–or” versus “how much” decisions—a distinction that is particularly useful when students are asked to compare a firm’s output decision to its entry/exit decision. In this chapter we also reprise the concept of opportunity cost, present a thorough treatment of marginal analysis, explain the concept of sunk cost, and cover present discounted value. This chapter will help students develop a deeper intuition about the common conceptual foundations of microeconomic models, and it will serve a valuable foundation for the following
four chapters on consumer and producer theory. Part 5: The Consumer Chapters on consumer theory now precede the chapters on producer theory. Chapter 10, “The Rational Consumer,” provides a complete treatment of consumer behavior for instructors who don’t cover indifference curves. There is a simple, intuitive exposition of the budget line, the optimal consumption choice, diminishing marginal utility, and income and substitution effects and their relationship to market demand. Students learn, for example, that a budget line constructed using prices is much like a Weight Watchers’ diet plan constructed using a “point” system. Chapter 11, “Consumer Preferences and Consumer Choice,” offers a more detailed treatment for those who wish to cover indifference curves. It contains an analysis of the optimal consumption choice using the marginal P R E F A C E xxi rate of substitution as well as income and substitution effects. An Economics in Action on the relationship between music file downloads and albums prompts students to think more deeply about the problem of classifying a pair of goods as substitutes rather than complements. Part 6: The Production Decision In Chapter 12, “Behind the Supply Curve: Inputs and Costs,” we develop the production function and the various cost measures of the firm. There is an extensive discussion of the difference between average cost and marginal cost, illustrated by examples such as a student’s grade point average. Chapter 13, “Perfect Competition and the Supply Curve,” explains the output decision of the perfectly competitive firm, its entry/exit decision, the industry supply curve, and the equilibrium of a perfectly competitive market. Here, a timely Economics in Action on the ethanol-driven rise in the demand for corn and the accompanying rise in the cost of inputs for corn production provides students with a real-world illustration of the adjustment to long-term equilibrium in a competitive industry. Part 7: Market Structure: Beyond Perfect Competition The market structure chapters now appear consecutively. Chapter 14, “Monopoly,” is a full treatment of monopoly, including topics such as price discrimination and the welfare effects of monopoly. We provide an array of compelling examples, such as De Beers diamonds, price manipulation by California power companies, and airline ticket-pricing. A Global Comparison features an analysis of why Americans pay higher prices for prescription drugs. In Chapter 15, “Oligopoly,” we present basic game theory in both a one-shot and repeated-game context, as well as an integrated treatment of the kinked demand curve model. The models are applied to a wide set of actual examples, such as Archer Daniels Midland, a European vitamin cartel, OPEC, and airline ticketpricing wars. We’ve expanded our treatment of antitrust policy, enhancing it with a discussion of the differences between American and European enforcement policies. In Chapter 16, “Monopolistic Competition and Product Differentiation,” students are brought face to face early on with an example of monopolistic competition that is a familiar feature of their lives: the food court at the local mall. We go on to cover entry and exit, efficiency considerations, and advertising in monopolistic competition. Part 8: Microeconomics and Public Policy Chapter 17, “Externalities,” covers negative externalities and solutions to them, such as Coasian private trades, emissions taxes, and a system of tradable permits. We also xxii P R E F A C E examine positive externalities, technological spillovers, and the resulting arguments for industrial policy. We’ve added a new section, “Network Externalities,” with an Economics in Action on the Microsoft case, which brings to life the unique qualities and challenges posed by goods like software and music downloads. Chapter 18, “Public Goods and Common Resources,” makes an immediate impression by opening with the story of how “The Great Stink” of 1858 compelled Londoners to build a public sewer system. Students learn how to classify goods into four categories (private goods, common resources, public goods, and artificially scarce goods) based on two dimensions: excludability and rivalry in consumption. With this system, they can develop an intuitive understanding of why some goods but not others can be efficiently managed by markets. New Chapter 19, “The Economics of the Welfare State,” provides a comprehensive overview of the American welfare state as well as its philosophical foundations. Sure to pique students’ interests is a section on the American health care system, written with Paul’s signature lucidity. It also provides a cogent analysis of the problem of poverty and the issue of income inequality. Part 9: Factor Markets and Risk Chapter 20, “Factor Markets and the Distribution of Income,” covers the competitive factor market model and the factor distribution of income. It also contains modifications and alternative interpretations of the labor market: the efficiency-wage model of the labor market and the influences of education, discrimination, and market power. For instructors who covered indifference curves in Chapter 11, the Chapter 20 appendix offers a detailed examination of the labor–leisure trade-off and the backward-bending labor supply curve. Finally, in Chapter 21, “Uncertainty, Risk, and Private Information,” we explain attitudes toward risk in a careful and methodical way, grounded in the basic concept of diminishing marginal utility. This allows us to analyze a simple competitive insurance market and to examine the benefits and limits of diversification. Next comes an easily comprehensible and intuitive presentation of private information in the context of adverse selection and moral hazard, with illustrations drawn from the market for used cars (lemons) and franchising. Instructors have told us how easy it is to teach this chapter and how much it helps to enlighten students about the relevance of economics to their everyday lives. What’s Core, What’s Optional? To help with lecture planning, on the facing page we list the chapters we view as core and those that could be considered optional—with helpful explanatory annotations for each optional chapter. Supplements and Media Worth Publishers is pleased to offer an enhanced and completely revised supplements and media package to accompany this textbook. The package has been crafted to help instructors teach their principles course and to give students the tools to develop their skills in economics. For Instructors Instructor’s Resource Manual with Solutions Manual The Instructor’s Resource Manual, written by Margaret Ray, University of Washington, is a resource meant to provide materials and tips to enhance the classroom experience. The Instructor’s Resource Manual provides the following: ➤ Chapter-by-chapter learning objectives ➤ Chapter outlines ➤ Teaching tips and ideas that include: ➤ Hints on how to create student interest ➤ Tips on presenting the material in class ➤ Discussion of the examples used in the text, includ- ing points to emphasize with your students ➤ Activities that can be conducted in or out of the classroom ➤ Hints for dealing with common misunderstandings that are typical among students ➤ Web resources ➤ Solutions manual with detailed solutions to all of the end-of-chapter Problems from the textbook Printed Test Bank Coordinator and Consultant: Doris Bennett, Jacksonville State University. Contributing Authors: Eric R. Dodge, Rivers Institute at Hanover College; Karen Gebhardt, Colorado State University; Solina Lindahl, California Polytechnic State University; and Janice Yee, Worcester State College. The Test Bank provides a wide range of questions appropriate for assessing your students’ comprehension, interpretation, analysis, and synthesis skills. Totaling over 5,500 questions, the Test Bank offers multiple-choice, true/false, and short-answer questions designed for comprehensive coverage of the text concepts. Questions have been checked for continuity with the text content, overall usability, and accuracy. The Test Bank features include the following: ➤ To aid instructors in building tests, each question has been categorized according to its general degree of difficulty. The three levels are: easy, moderate, and difficult. ➤ Easy questions require students to recognize con- cepts and definitions. These are questions that can be answered by direct reference to the textbook. P R E F A C E xxiii Core Optional WHAT'S CORE, WHAT'S OPTIONAL: MICROECONOMICS 1. First Principles 2. Economic Models: Trade-offs and Trade Appendix: Graphs in Economics Introduction: The Ordinary Business of Life A comprehensive review of graphing and math for students who would find such a refresher helpful. This appendix is more detailed than most because our goal is to reduce students’ difficulty in grasping the concepts found in this book as well as to better prepare them for economic literacy in the real world. 8. International Trade This chapter recaps comparative advantage, considers tariffs and quotas, and explores the politics of trade protection. Coverage here links back to the international coverage in Chapter 2. 11. Consumer Preferences and Consumer Choice This chapter offers a more detailed treatment of consumer behavior for instructors who wish to cover indifference curves. 3. Supply and Demand 4. Consumer and Producer Surplus 5. The Market Strikes Back 6. Elasticity 7. Taxes 9. Making Decisions 10. The Rational Consumer 12. Behind the Supply Curve: Inputs and Costs 13. Perfect Competition and the Supply Curve 14. Monopoly 15. Oligopoly 16. Monopolistic Competition and Product Differentiation 17. Externalities 18. Public Goods and Common Resources 19. The Economics of the Welfare State A unique chapter that gives a succinct overview of the American welfare state and its intellectual foundation. It provides a brief introduction to the economics of health care provision, as well as add
ressing the topics of poverty and income inequality. 20. Factor Markets and the Distribution of Income Plus Appendix: Indifference Curve Analysis of Labor Supply For instructors who want to go into more depth, this chapter covers the efficiency-wage model of the labor market as well as the influences of education, discrimination, and market power. The appendix examines the labor–leisure trade-off and the backwardbending labor supply curve. 21. Uncertainty, Risk, and Private Information This unique, applied chapter explains attitudes toward risk, examines the benefits and limits of diversification, and considers private information in the context of adverse selection and moral hazard. xxiv P R E F A C E ➤ Moderate questions require some analysis on the student’s part. ➤ Difficult questions usually require more detailed analysis by the student. ➤ Each question has also been categorized according to a skill descriptor. These include: Fact-Based, Definitional, Concept-Based, Critical-Thinking, and Analytical-Thinking. ➤ Fact-Based Questions require students to identify facts presented in the text. ➤ Definitional Questions require students to define an economic term or concept. ➤ Concept-Based Questions require a straightforward knowledge of basic concepts. ➤ Critical-Thinking Questions require the student to apply a concept to a particular situation. ➤ Analytical-Thinking Questions require another level of analysis to answer the question. Students must be able to apply a concept and use this knowledge for further analysis of a situation or scenario. ➤ To further aid instructors in building tests, each ques- tion is conveniently cross-referenced to the appropriate topic heading in the textbook. Questions are presented in the order in which concepts are presented in the text. ➤ The Test Bank includes questions with tables that students must analyze to solve for numerical answers. It contains questions based on the graphs that appear in the book. These questions ask students to use the graphical models developed in the textbook and to interpret the information presented in the graph. Selected questions are paired with scenarios to reinforce comprehension. ➤ Questions have been designed to correlate with the various questions in the text. Study Guide Questions are also available in each chapter. This is a unique set of 25–30 questions per chapter that are parallel to the Chapter Review Questions in the printed Study Guide. These questions focus on the key concepts from the text that students should grasp after reading the chapter. These questions reflect the types of questions that the students have likely already worked through in homework assignments or in self-testing. These questions can also be used for testing or for brief in-class quizzes. Diploma 6 Computerized Test Bank The Krugman/Wells printed Test Banks are also available in CD-ROM format for both Windows and Macintosh users. WebCT and Blackboard-formatted versions of the Test Bank are also available on the CDROM. With Diploma, you can easily write and edit questions as well as cre- ate and print tests. You can sort questions according to various information fields and scramble questions to create different versions of your tests. You can preview and reformat tests before printing them. Tests can be printed in a wide range of formats. The software’s unique synthesis of flexible word-processing and database features creates a program that is extremely intuitive and capable. Lecture PowerPoint Presentation Created by Can Erbil, Brandeis University, the enhanced PowerPoint presentation slides are designed to assist you with lecture preparation and presentations. The slides are organized by topic and contain graphs, data tables, and bulleted lists of key concepts suitable for lecture presentation. Key figures from the text are replicated and animated to demonstrate how they build. Notes to the Instructor are now also included to provide added tips, class exercises, examples, and explanations to enhance classroom presentations. The slides have been designed to allow for easy editing of graphs and text. These slides can be customized to suit your individual needs by adding your own data, questions, and lecture notes. These files may be accessed on the instructor’s side of the website or on the Instructor’s Resource CD-ROM. Instructor’s Resource CD-ROM Using the Instructor’s Resource CD-ROM, you can easily build classroom presentations or enhance your online courses. This CDROM contains all text figures (in JPEG and PPT formats), PowerPoint lecture slides, and detailed solutions to all end-of-chapter Problems. You can choose from the various resources, edit, and save for use in your classroom. The Instructor’s Resource CD-ROM includes: ➤ Instructor’s Resource Manual (PDF): containing chapter-by-chapter learning objectives, chapter outlines, teaching tips, examples used in the text, activities, hints for dealing with common student misunderstandings, and web resources. ➤ Solutions Manual (PDF): including detailed solu- tions to all of the end-of-chapter Problems from the textbook. ➤ Lecture PowerPoint Presentations (PPT): PowerPoint slides including graphs, data tables, and bulleted lists of key concepts suitable for lecture presentation. ➤ Images from the Textbook (JPEG): a complete set of textbook images in high-res and low-res JPEG formats. ➤ Illustration PowerPoint Slides (PPT): a complete set of figures and tables from the textbook in PPT format. For Students Study Guide Prepared by Elizabeth Sawyer-Kelly, University of Wisconsin–Madison, the Study Guide reinforces the topics and key concepts covered in the text. For each chapter, the Study Guide is organized as follows: ➤ Before You Read the Chapter ➤ Summary: an opening paragraph that provides a brief overview of the chapter. ➤ Objectives: a numbered list outlining and describing the material that the student should have learned in the chapter. These objectives can be easily used as a study tool for students. ➤ Key Terms: a list of boldface key terms with their definitions—including room for note-taking. ➤ After You Read the Chapter ➤ Tips: numbered list of learning tips with graphical analysis. ➤ Problems and Exercises: a set of 10–15 comprehen- sive problems. ➤ Before You Take the Test ➤ Chapter Review Questions: a set of 30 multiplechoice questions that focus on the key concepts from the text students should grasp after reading the chapter. These questions are designed for student exam preparation. A parallel set of these questions is also available to instructors in the Test Bank. ➤ Answer Key ➤ Answers to Problems and Exercises: detailed solutions to the Problems and Exercises in the Study Guide. ➤ Answers to Chapter Review Questions: solutions to the multiple-choice questions in the Study Guide— along with thorough explanations. ONLINE OFFERINGS VERSION 2.0 Companion Website for Students and Instructors www.worthpublishers.com/krugmanwells The companion website for the Krugman/Wells text offers valuable tools for both the instructor and students. For instructors, the site gives you the ability to track students’ interaction with the site and gives you access to additional instructor resources. The following instructor resources are available: ➤ Quiz Gradebook: The site gives you the ability to track students’ work by accessing an online gradebook. Instructors also have the option to have student results e-mailed directly to them. All student answers to the Self-Test Quizzes are saved in this online database. Student responses and interactions with the Graphing Exercises are also tracked and stored. ➤ Lecture PowerPoint Presentations: Instructors have access to helpful lecture material in PowerPoint® format. These PowerPoint slides are P R E F A C E xxv designed to assist instructors with lecture preparation and presentation. ➤ Illustration PowerPoint Slides: A complete set of figures and tables from the textbook in PowerPoint format is available. ➤ Images from the Textbook: Instructors have access to a complete set of figures and tables from the textbook in high-res and low-res JPEG formats. The textbook art has been processed for “high-resolution” (150 dpi). These figures and photographs have been especially formatted for maximum readability in large lecture halls and follow standards that were set and tested in a real university auditorium. ➤ Instructor’s Resource Manual: Instructors have access to the files for the Instructor’s Resource Manual. ➤ Solutions Manual: Instructors have access to the files for the detailed solutions to the text’s end-ofchapter Problems. For students, the site offers many opportunities for self-testing and review. The following resources are available for students: ➤ Self-Test Quizzes: This quizzing engine provides 20 multiple-choice questions per chapter. Immediate and appropriate feedback is provided to students along with topic references for further review. The questions as well as the answer choices are randomized to give students a different quiz with every refresh of the screen. ➤ Key Term Flashcards: Students can test them- selves on the key terms with these pop-up electronic flashcards. ➤ Graphing Exercises: Selected graphs from the textbook have been animated in a Flash format. Working with these animated figures enhances student understanding of the effects of concepts such as the shifts or movements of the curves. Every interactive graph is accompanied by questions that quiz students on key concepts from the textbook and provide instructors with feedback on student progress. ➤ Web Links: Created and continually updated by Jules Kaplan, University of Colorado–Boulder, these Web Links allow students to easily and effectively locate outside resources and readings that relate to topics covered in the textbook. They list web addresses that hotlink to relevant websites; each URL is accompanied by a detailed description of the site and its relevance to each chapter.
This allows students to conduct research and explore related readings on specific topics with ease. Also hotlinked are relevant articles by Paul Krugman. xxvi P R E F A C E ➤ Aplia Aplia, founded by Paul Romer, Stanford University, is the first web-based company to integrate pedagogical features from a textbook with interactive media. Aplia and Worth Publishers were the first to offer an Integrated Text Solution and all Aplia tools. The features of the Krugman/Wells text have been combined with Aplia’s interactive media to save time for professors and encourage students to exert more effort in their learning. The structure adheres to that of the Krugman/Wells text and works framework. The consistently within Krugman/Wells Aplia ITS offers a content section, followed up by an application (Economics in Action), a Quick Review, and a short quiz (Check Your Understanding). With this structure, students are presented bite-sized, easily-digestible portions of content and are immediately tested on that material before moving on. the Aplia The integrated online version of the Aplia media and the Krugman/Wells text includes: ➤ Extra problem sets (derived from in-chapter questions in the book) suitable for homework and keyed to specific topics from each chapter ➤ Regularly updated news analyses ➤ Real-time online simulations of market interactions ➤ Interactive tutorials to assist with math ➤ Graphs and statistics ➤ Instant online reports that allow instructors to target student trouble areas more efficiently With Aplia, you retain complete control and flexibility for your course. You choose the content you want students to cover, and you decide how to organize it. You decide whether online activities are practice (ungraded or graded). For a preview of Aplia materials and to learn more, visit http://www.aplia.com/worth. TM WebCT E-pack The Krugman/Wells WebCT E-packs enable you to create a thorough, interactive, and pedagogically sound online course or course website. The Krugman/Wells E-pack provides you with online materials that facilitate critical thinking and learning, including Test Bank material, quizzes, links, and graphing exercises. Best of all, this material is preprogrammed and fully functional in the WebCT environment. Prebuilt materials eliminate hours of course-preparation work and offer significant support as you develop your online course. Blackboard The Krugman/Wells Blackboard Course Cartridge allows you to combine Blackboard’s popular tools and easy-to-use interface with the Krugman/Wells’ text-specific resources: Test Bank material, quizzes, links, and graphing exercises. The result is an interactive, comprehensive online course that allows for effortless implementation, management, and use. The Worth electronic files are organized and prebuilt to work within the Blackboard software and can be easily downloaded from the Blackboard content showcases directly onto your department server. VERSION 3.0—AVAILABLE WITH KRUGMAN/WELLS MICROECONOMICS FOR SPRING 2010 EconPortal EconPortal is the digital gateway to Krugman/Wells Microeconomics, designed to enrich your course, help you organize and better utilize resources, and improve your students’ understanding of economics. EconPortal provides a powerful, easy-to-use, completely customizable teaching and learning management system complete with the following: ➤ An Interactive eBook with Embedded Learning Resources and Enhanced Assessment: The eBook’s functionality will provide for highlighting, notetaking, graph and example enlargements, a fully searchable glossary, as well as a full text search. You can customize any eBook page with comments, external web links, and supplemental resources. Unlike most eBooks, which are static pages of text, this interactive eBook will bring the book to life with embedded icons that link directly to resources that include Tutorials, Graphing Exercises, and Quizzes. ➤ Student Tutorials will be available in coordination with key topics in the text. The tutorials are meant to provide a detailed, guided tour through a specific concept (such as shift of a curve vs. movement along a curve). They will cover topics that students typically have trouble understanding or concepts that require more class time to fully explain. They’ll bring these concepts to life with pictures, animations, and useful worked-out examples. These tutorials would be available to students as a self-guided resource. Optional assessment will be tied to each tutorial to assess whether students have grasped the concepts presented. You can choose how to use the tutorials to best meet P R E F A C E xxvii your students’ needs. Assigning these tutorials ensures that valuable class time isn’t spent on remediation of topics already covered. ➤ Test Bank Questions: Assignments can be generated by pulling from the pool of Krugman/Wells Test Bank questions. ➤ A Personalized Study Plan for Students Featuring Diagnostic Quizzing: A Personalized Study Plan is available to assess students’ knowledge of the material and to guide further study. Students will be asked to take the PSP: Self-Check Quiz after they have read the chapter and before they come to the lecture that discusses that chapter. Once they’ve taken the quiz, they can view their Personalized Study Plan based on the quiz results. This Personalized Study Plan will provide a path to the appropriate eBook materials and resources for further study and exploration. ➤ A Fully Integrated Learning Management System: The EconPortal is meant to be a one-stop shop for all the resources tied to the book. The system will carefully integrate the teaching and learning resources for the book into an easy-to-use system. The Assignment Center organizes pre-loaded assignments centered on a comprehensive course outline, but it also provides the flexibility for you to add your own assignments. EconPortal will enable you to create assignments from a variety of question types to prepare self-graded homework, quizzes, or tests. Assignments may be created from the following: ➤ End-of-Chapter Quiz Questions: The Krugman/Wells end-of-chapter Problems will be available in a self-graded format—perfect for quick in-class quizzes or homework assignments. The questions have been carefully edited to ensure that they maintain the integrity of the text’s end-ofchapter Problems. ➤ Algorithmic Questions: A question generator will be available that allows the variables of each question to be algorithmically generated—an ideal resource for creating randomized sets of quizzes and for ensuring that students get as much practice as they need. ➤ Graphing Questions: Pulled from our graphing tool engine, EconPortal can provide electronically gradable graphing-related problems. Students will be asked to draw their response to a question, and the software will grade that response. These graphing exercises are meant to replicate the pencil-and-paper experience of drawing graphs—with the bonus to you of not having to hand-grade each assignment! ➤ Multipart Assignments: This allows a great degree of flexibility in assigning sections of the eBook, Tutorials, Quizzes, or any resources available within the EconPortal as one complete assignment for your students to complete. The EconPortal’s Assignment Center will allow you to select your preferred policies for scheduling, maximum attempts, time limitations, feedback, and more. A wizard will guide you through the creation of assignments. You can assign and track any aspect of your students’ EconPortal. The Gradebook will capture your students’ results and allow for easily exporting reports. The ready-to-use course can save you many hours of preparation time. It is fully customizable and highly interactive. ADDITIONAL OFFERINGS i>clicker Developed by a team of University of Illinois physicists, i>clicker is the most flexible and most reliable classroom response system available. It is the only solution created for educators, by educators, with continuous product improvements made through direct classroom testing and faculty feedback. You’ll love i>clicker no matter your level of technical expertise because the focus is on your teaching, not the technology. To learn more about packaging i>clicker with this textbook, please contact your local sales rep or visit www.iclicker.com. Wall Street Journal Edition: For adopters of the Krugman/Wells text, Worth Publishers and the Wall Street Journal are offering a 15-week subscription to students at a tremendous savings. Professors also receive their own free Wall Street Journal subscription plus additional instructor supplements created exclusively by the Wall Street Journal. Please contact your local sales rep for more information or go to the Wall Street Journal online at www.wsj.com. Financial Times Edition: For adopters of the Krugman/Wells text, Worth Publishers and the Financial Times are offering a 15-week subscription to students at a tremendous savings. Professors also receive their own free Financial Times subscription for one year. Students and professors may access research and archived information at www.ft.com. Dismal Scientist: A high-powered business database and analysis service comes to the classroom! Dismal Scientist offers real-time monitoring of the global economy, produced locally by economists and professionals at Economy.com’s London, Sydney, and West Chester offices. Dismal Scientist is free when packaged with the Krugman/Wells text. Please contact your local sales rep for more information or go to www.economy.com. xxviii P R E F A C E Acknowledgments We are indebted to the following reviewers, focus group participants, and other consultants for their suggestions and advice on the first edition: Ashley Abramson, Barstow College; Lee Adkins, Oklahoma State University; Terry Alexander, Iowa State University; Elena Alvarez, State University of New York, Albany; David A. Anderson, Centre College; Charles Antholt, Western Washington University; Richard Bal
l, Haverford University; Sheryl Ball, Virginia Polytechnic Institute and State University; Charles L. Ballard, Michigan State University; Richard Barrett, University of Montana; Daniel Barszcz, College of DuPage; Leon Battista, Bronx Community College; Richard Beil, Auburn University; Charles A. Bennett, Gannon University; Andreas Bentz, Dartmouth College; Harmanna Bloemen, Houston Community College; Edward Blomdahl, Bridgewater State College; John Bockino, Suffolk County Community College; Michael Bordo, Rutgers University, NBER; Ellen Bowen, Fisher College, New Bedford; Michael Brace, Jamestown Community College; James Bradley, Jr., University of South Carolina; William Branch, University of Oregon; Michael Brandl, University of Texas, Austin; Anne Bresnock, University of California, Los Angeles; Kathleen Bromley, Monroe Community College; Bruce Brown, California State Polytechnic University, Pomona; John Buck, Jacksonville University; Raymonda Burgman, University of Southern Florida; Charles Callahan, III, State University of New York, College at Brockport; William Carlisle, University of Utah; Kevin Carlson, University of Massachusetts, Boston; Leonard A. Carlson, Emory University; Fred Carstensen, University of Connecticut; Shirley Cassing, University of Pittsburgh; Ramon Castillo-Ponce, California State University, Los Angeles; Emily Chamlee-Wright, Beloit College; Anthony Chan, Santa Monica College; Yuna Chen, South Georgia College; Maryanne Clifford, Eastern Connecticut State University; Jim Cobbe, Florida State University; Gregory Colman, Pace University; Barbara Connolly, Westchester Community College; Tom Cooper, Georgetown College; Eleanor D. Craig, University of Delaware; James Craven, Clark College; Tom Creahan, Morehead State University; Sarah Culver, University of Alabama; Will Cummings, Grossmont College; Rosemary Thomas Cunningham, Agnes Scott College; James Cypher, California State University, Fresno; Susan Dadres, Southern Methodist University; Ardeshir Dalal, Northern Illinois University; Rosa Lea Danielson, College of DuPage; Stephen Davis, University of Minnesota, Crookston; A. Edward Day, University of Texas, Dallas; Stephen J. DeCanio, University of California, Santa Barbara; Tom DelGiudice, Hofstra University; J. Bradford DeLong, University of California, Berkeley; Arna Desser, United States Naval Academy; Asif Dowla, St. Mary’s College of Maryland; James Dulgeroff, San Bernardino Valley Community College; Tom Duston, Keene State College; Debra Dwyer, State University of New York, Stony Brook; Dorsey Dyer, Davidson County Community College; Jim Eden, Portland Community College; Mary Edwards, St. Cloud State University; Fritz Efaw, University of Tennessee at Chattanooga; Herb Elliot, Alan Hancock College; Michael Ellis, New Mexico State University; Can Erbil, Brandeis University; Joe Essuman, University of Wisconsin, Waukesha; David W. Findlay, Colby College; Chuck Fischer, Pittsburgh State University; Eric Fisher, The Ohio State University; David Flath, North Carolina State University; Oliver Franke, Athabasca University; Rhona Free, Eastern Connecticut State University; Yee Tien Fu, Stanford University; Susan Gale, New York University; Yoram Gelman, Lehman College, The City University of New York; E.B. Gendel, Woodbury College; Doug Gentry, St. Mary’s College; Satyajit Ghosh, University of Scranton; J. Robert Gillette, University of Kentucky; Lynn G. Gillette, University of Kentucky; James N. Giordano, Villanova University; Robert Godby, University of Wyoming; David Goodwin, University of New Brunswick; Richard Gosselin, Houston Community College, Central Campus; Patricia Graham, University of Northern Colorado; Kathleen Greer Rossman, Birmingham Southern College; Lisa Grobar, California State University, Long Beach; Philip Grossman, St. Cloud State University; Wayne Grove, Syracuse University; Eleanor Gubins, Rosemont College; Jang-Ting Guo, University of California, Riverside; Alan Haight, State University of New York, Cortland; Jonathan Hamilton, University of Florida; Gautam Hazarika, University of Texas, Brownsville; Tom Head, George Fox University; Julie Heath, University of Memphis; Susan Helper, Case Western Reserve University; Jill M. Hendrickson, University of the South; Gus Herring, Brookhaven College; Paul Hettler, Duquesne University; Roger Hewett, Drake University; Hart Hodges, Western Washington University; Jill Holman, University of Wisconsin, Milwaukee; David Horlacher, Middlebury College; Robert Horn, James Madison University; Scott Houser, California State University, Fresno; Yu Hsing, Southeastern Louisiana University; Ray Hubbard, Central Georgia Technical College; Patrik T. Hultberg, University of Wyoming; Murat Iyigun, University of Colorado; Habib Jam, Rowan University; Nancy Jianakoplos, Colorado State University; Bruce Johnson, Centre College; Donn Johnson, Quinnipiac University; Louis Johnston, College of St. Benedict/St. John’s University; James Jozefowicz, Indiana University of Pennsylvania; Indiana University of Pennsylvania; Elia Kacapyr, Ithaca College; Soheila Kahkashan, Towson University; Matthew Kahn, Columbia University; Charles Kaplan, St. Joseph’s College; Bentzil Kasper, Broome Community College; Barry Keating, University of Notre Dame; Diane Keenan, Cerritos College; Julian, Jack Bill Kerby, California State University, Sacramento; Farida Khan, University of Wisconsin, Parkside; Kyoo Kim, Bowling Green University; Philip King, San Francisco State University; Sharmila King, University of the Pacific; Kent Klitgaard, Wells College; Sinan Koont, Dickinson College; Kala Krishna, Penn State University, NBER; Kenneth Kriz, University of Nebraska, Omaha; Margaret Landman, Bridgewater State College; Tom Larson, California State University, Los Angeles; Susan K. Laury, Georgia State University; Bill Lee, St. Mary’s College; Jim Lee, Texas A&M University, Corpus Christi; Tony Lima, California State University, Hayward; Delores Linton, Tarrant County College, Northwest; Rolf Lokke, Albuquerque Academy; Ellen Magenheim, Swarthmore College; Diana McCoy, Truckee Meadows Community College; Rachel McCulloch, Brandeis University; Diego Mendez-Carbajo, Illinois Wesleyan University; Juan Mendoza, State University of New York, Buffalo; Jeffrey Michael, Towson University; Garrett Milam, Ryerson University; Robert Miller, Fisher College, New Bedford Campus; Michael Milligan, Front Range Community College; Cathy Miners, Fairfield University; Larry Miners, Fairfield University; Jenny Minier, University of Miami; Ida A. Mirzaie, John Carroll University; Kristen Monaco, California State University, Long Beach; Marie Mora, University of Texas, Pan American; Peter B. Morgan, University of Michigan; W. Douglas Morgan, University of California, Santa Barbara; James Mueller, Alma College; Ranganath Murthy, Bucknell University; Nelson Nagai, San Joaquin Delta College; Gerardo Nebbia, Glendale College; Anthony Negbenebor, Gardner-Webb University; John A. Neri, University of Maryland; Joseph Nowakowski, Muskingum College; Seamus O’Cleireacain, Columbia University / State University of New York, Purchase; William O’Dea, State University of New York, Oneonta; Charles Okeke, Community College of Southern Nevada; Martha Olney, University of California, Berkeley; Douglas Orr, Eastern Washington University; Kimberley Ott, Kent State University, Salem Campus; Philip Packard, St. Mary’s College; Chris Papageorgiou, Louisiana State University; Jamie Pelley, Mary Baldwin College; Mary K. Perkins, Howard University; Brian Peterson, Central College; John Pharr, Dallas County Community College; Raymond E. Polchow, Zane State College; Ernest Poole, Fashion Institute of Technology; Kevin Quinn, Bowling Green State University; Jeffrey Racine, University of South Florida; Matthew Rafferty, Quinnipiac University; Reza Ramazani, St. Michael’s College; Dixie Watts Reaves, Virginia Polytechnic Institute and State University; Charles Reichheld, Cuyahoga Community College; Siobhán Reilly, Mills College; Thomas Rhoads, Towson University; Libby Rittenberg, Colorado College; Malcolm Robinson, Thomas More College; Charles Rock, Rollins College; Michael Rolleigh, Williams College; Richard Romano, Broome P R E F A C E xxix Community College; Christina Romer, University of California, Berkeley; Jeff Romine, University of Colorado, Denver; Bernie Rose, Rocky Mountain College; Patricia Rottschaefer, California State University, Fullerton; Dan Rubenson, Southern Oregon University; Jeff Rubin, Rutgers University; Lynda Rush, California State Polytechnic University, Pomona; Henry D. Ryder, Gloucester County College; Martin Sabo, Community College of Denver; Sara Saderion, Houston Community College, Southwest; Allen Sanderson, University of Chicago; Rolando Santos, Lakeland Community College; Christine Sauer, University of New Mexico; George Sawdy, Providence College; Elizabeth Sawyer-Kelly, University of Wisconsin, Madison; Edward Sayre, Agnes Scott College; Richard Schatz, Whitworth College; Ted Scheinman, Mt. Hood Community College; Robert Schwab, University of Maryland; Stanley Sedo, University of Maryland; Kathleen Segerson, University of Connecticut; Russell Settle, University of Delaware; Anna Shostya, Pace University; Eugene Silberberg, University of Washington; Millicent Sites, Carson-Newman College; Bill Smith, University of Memphis; Herrick Smith, Nease High School; Marcia S. Snyder, College of Charleston; John Solow, University of Iowa; John Somers, Portland Community College; Jim Spellicy, Lowell High School; David E. Spencer, Brigham Young University; Denise Stanley, California State University, Fullerton; Martha A. Starr, American University; Richard Startz, University of Washington; Kurt Stephenson, Virginia Tech; Jill Stowe, Texas A&M University, Austin; Charles Stull, Kalamazoo College; Laddie Sula, Loras College; Rodney Swanson, University of California, Los Angeles; David Switzer, University
of Northern Michigan; Jason Taylor, University of Virginia; Mark Thoma, University of California, San Diego; J. Ross Thomas, Albuquerque Technical Vocational Institute; Deborah Thorsen, Palm Beach Community College; Andrew Toole, Cook College/Rutgers University; Karen Travis, Pacific Lutheran University; Brian Trinque, University of Texas, Austin; Arienne Turner, Fullerton College; Anthony Uremovic, Joliet Junior College; Abu Wahid, Tennessee State University; Jane Wallace, University of Pittsburgh; Tom Watkins, Eastern Kentucky University; Stephan Weiler, Colorado State University; Maurice Weinrobe, Clark University; Robert Whaples, Wake Forest University; Jonathan B. Wight, University of Richmond; Mark Wohar, University of Nebraska, Omaha; Larry Wolfenbarger, Macon State College; Gary Wolfram, Hillsdale College; William C. Wood, James Madison University; James Woods, Portland State University; Mickey Wu, Coe College; Ranita Wyatt, Dallas Community College; Cemile Yavas, Pennsylvania State University; Lou Zaera, Fashion Institute of Technology; Paul Zak, Claremont Graduate University; Andrea Zanter, Hillsborough Community College, Dale Mabry Campus. xxx P R E F A C E Our deep appreciation and heartfelt thanks to the following reviewers, class-testers, survey participants, and other contributors whose input helped us shape this second edition. Carlos Aguilar, El Paso Community College Terence Alexander, Iowa State University Morris Altman, University of Saskatchewan Farhad Ameen, State University of New York, Westchester Community College Christopher P. Ball, Quinnipiac University Sue Bartlett, University of South Florida Scott Beaulier, Mercer University David Bernotas, University of Georgia Robert Francis, Shoreline Community College Shelby Frost, Georgia State University Frank Gallant, George Fox University Robert Gazzale, Williams College Robert Godby, University of Wyoming Michael Goode, Central Piedmont Community College Douglas E. Goodman, University of Puget Sound Marvin Gordon, University of Illinois at Chicago Kathryn Graddy, Brandeis University Alan Day Haight, State University of New York, Cortland Mehdi Haririan, Bloomsburg University Clyde A. Haulman, College of William and Mary Marc Bilodeau, Indiana University and Purdue University, Indianapolis Richard R. Hawkins, University of West Florida Kelly Blanchard, Purdue University Anne Bresnock, California State Polytechnic University Douglas M. Brown, Georgetown University Joseph Calhoun, Florida State University Douglas Campbell, University of Memphis Kevin Carlson, University of Massachusetts, Boston Andrew J. Cassey, Washington State University Shirley Cassing, University of Pittsburgh Sewin Chan, New York University Mitchell M. Charkiewicz, Central Connecticut State University Joni S. Charles, Texas State University, San Marcos Adhip Chaudhuri, Georgetown University Eric P. Chiang, Florida Atlantic University Hayley H. Chouinard, Washington State University Kenny Christianson, Binghamton University Lisa Citron, Cascadia Community College Steven L. Cobb, University of North Texas Barbara Z. Connolly, Westchester Community College Stephen Conroy, University of San Diego Thomas E. Cooper, Georgetown University Cesar Corredor, Texas A&M University and University of Texas, Tyler Jim F. Couch, University of Northern Alabama Daniel Daly, Regis University H. Evren Damar, Pacific Lutheran University Antony Davies, Duquesne University Greg Delemeester, Marietta College Patrick Dolenc, Keene State College Christine Doyle-Burke, Framingham State College Ding Du, South Dakota State University Jerry Dunn, Southwestern Oklahoma State University Robert R. Dunn, Washington and Jefferson College Ann Eike, University of Kentucky Tisha L. N. Emerson, Baylor University Hadi Salehi Esfahani, University of Illinois William Feipel, Illinois Central College Rudy Fichtenbaum, Wright State University David W. Findlay, Colby College Mickey A. Hepner, University of Central Oklahoma Michael Hilmer, San Diego State University Tia Hilmer, San Diego State University Jane Himarios, University of Texas, Arlington Jim Holcomb, University of Texas, El Paso Don Holley, Boise State University Alexander Holmes, University of Oklahoma Julie Holzner, Los Angeles City College Robert N. Horn, James Madison University Steven Husted, University of Pittsburgh John O. Ifediora, University of Wisconsin, Platteville Hiro Ito, Portland State University Mike Javanmard, RioHondo Community College Robert T. Jerome, James Madison University Shirley Johnson-Lans, Vassar College David Kalist, Shippensburg University Lillian Kamal, Northwestern University Roger T. Kaufman, Smith College Herb Kessel, St. Michael’s College Rehim Kılıç, Georgia Institute of Technology Grace Kim, University of Michigan, Dearborn Michael Kimmitt, University of Hawaii, Manoa Robert Kling, Colorado State University Sherrie Kossoudji, University of Michigan Charles Kroncke, College of Mount Saint Joseph Reuben Kyle, Middle Tennessee State University (retired) Katherine Lande-Schmeiser, University of Minnesota, Twin Cities David Lehr, Longwood College Mary Jane Lenon, Providence College Mary H. Lesser, Iona College Solina Lindahl, California Polytechnic Institute, San Luis Obispo Haiyong Liu, East Carolina University Jane S. Lopus, California State University, East Bay María José Luengo-Prado, Northeastern University Rotua Lumbantobing, North Carolina State University Ed Lyell, Adams State College John Marangos, Colorado State University Mary Flannery, University of California, Santa Cruz Ralph D. May, Southwestern Oklahoma State University P R E F A C E xxxi Wayne McCaffery, University of Wisconsin, Madison Jesse A. Schwartz, Kennesaw State University Larry McRae, Appalachian State University Chad Settle, University of Tulsa Mary Ruth J. McRae, Appalachian State University Steve Shapiro, University of North Florida Ellen E. Meade, American University Meghan Millea, Mississippi State University Norman C. Miller, Miami University (of Ohio) Khan A. Mohabbat, Northern Illinois University Myra L. Moore, University of Georgia Jay Morris, Champlain College in Burlington Akira Motomura, Stonehill College Kevin J. Murphy, Oakland University Robert Murphy, Boston College Ranganath Murthy, Bucknell University Robert L. Shoffner III, Central Piedmont Community College Joseph Sicilian, University of Kansas Judy Smrha, Baker University John Solow, University of Iowa John Somers, Portland Community College Stephen Stageberg, University of Mary Washington Monty Stanford, DeVry University Rebecca Stein, University of Pennsylvania William K. Tabb, Queens College, City University of New York (retired) Sarinda Taengnoi, University of Wisconsin, Oshkosh Anthony Myatt, University of New Brunswick, Canada Henry Terrell, University of Maryland Randy A. Nelson, Colby College Charles Newton, Houston Community College Daniel X. Nguyen, Purdue University Dmitri Nizovtsev, Washburn University Thomas A. Odegaard, Baylor University Constantin Oglobin, Georgia Southern University Charles C. Okeke, College of Southern Nevada Terry Olson, Truman State University Una Okonkwo Osili, Indiana University and Purdue University, Indianapolis Maxwell Oteng, University of California, Davis P. Marcelo Oviedo, Iowa State University Jeff Owen, Gustavus Adolphus College James Palmieri, Simpson College Walter G. Park, American University Elliott Parker, University of Nevada, Reno Michael Perelman, California State University, Chico Nathan Perry, Utah State University Dean Peterson, Seattle University Ken Peterson, Furman University Paul Pieper, University of Illinois at Chicago Dennis L. Placone, Clemson University Michael Polcen, Northern Virginia Community College Raymond A. Polchow, Zane State College Linnea Polgreen, University of Iowa Eileen Rabach, Santa Monica College Matthew Rafferty, Quinnipiac University Jaishankar Raman, Valparaiso University Margaret Ray, Mary Washington College Helen Roberts, University of Illinois at Chicago Jeffrey Rubin, Rutgers University, New Brunswick Rose M. Rubin, University of Memphis Lynda Rush, California State Polytechnic University, Pomona Michael Ryan, Western Michigan University Sara Saderion, Houston Community College Djavad Salehi-Isfahani, Virginia Tech Elizabeth Sawyer Kelly, University of Wisconsin Rebecca Achée Thornton, University of Houston Michael Toma, Armstrong Atlantic State University Brian Trinque, University of Texas, Austin Boone A. Turchi, University of North Carolina, Chapel Hill Nora Underwood, University of Central Florida J. S. Uppal, State University of New York, Albany John Vahaly, University of Louisville Jose J. Vazquez-Cognet, University of Illinois, Urbana-Champaign Daniel Vazzana, Georgetown College Roger H. von Haefen, North Carolina State University Andreas Waldkirch, Colby College Christopher Waller, University of Notre Dame Gregory Wassall, Northeastern University Robert Whaples, Wake Forest University Thomas White, Assumption College Jennifer P. Wissink, Cornell University Mark Witte, Northwestern University Kristen M. Wolfe, St. Johns River Community College Larry Wolfenbarger, Macon State College Louise B. Wolitz, University of Texas, Austin Gavin Wright, Stanford University Bill Yang, Georgia Southern University Jason Zimmerman, South Dakota State University We must also thank the many people at Worth Publishers for their contributions and the talented team of consultants and contributors they assembled to work with us. As in the first edition, Andreas Bentz did yeoman’s work, granting us the ability to focus on larger issues because we could trust him to focus on the details. More than ever we count ourselves fortunate to have found Andreas. Development editor Marilyn Freedman’s sharp eye and commonsense appraisals were critical inputs in this significant revision, helping us to sort out the pedagogical issues as before. Many thanks to Kathryn Graddy, Brandeis University, for her invaluable
contributions to this revision. Katy also brought us Charles Brendon, who assisted us with extremely quick and thorough data research, as well as xxxii P R E F A C E Nikhil Agarwal, who helped with the important work of devising problem sets. Special thanks go to Eric P. Chiang, Florida Atlantic University, and Myra L. Moore, University of Georgia, for the sharp eye and astonishing attention to detail that they brought to their ongoing role as reviewers of all page-proof stages. Special thanks, too, to David W. Findlay, Colby College, for his close review of pages in both editions. And, for their insightful reading of chapters in page proof, many thanks to Carlos Aguilar, El Paso Community College; Kevin Carlson, University of Massachusetts, Boston; Hiro Ito, Portland State University; Robert Murphy, Boston College; Helen Roberts, University of Illinois, Chicago; Nora Underwood, University of Central Florida; and, of course, Jose J. Vazquez-Cognet, University of Illinois at Urbana-Champaign. Craig Bleyer, publisher at Worth, has brought so much to both editions of this book. His sales savvy and incredibly thorough understanding of the textbook market helped to make the first edition such a huge success. Most recently, we’ve relied on Craig’s keen instincts in developing our revision strategy for the second edition. Elizabeth Widdicombe, president of Freeman and Worth, and Catherine Woods, publisher at Worth, played an important role in planning for this revision. We have Liz to thank for the idea that became our Global Comparison box. And special thanks to Paul Shensa, who, many moons ago, suggested that we write this book; most recently, we’ve been thrilled to have Paul’s wisdom and expertise on hand to help with market research and planning for the revision. Once again, we have had an incredible production and design team on this book, people whose hard work, creativity, dedication, and patience continue to amaze us. Thank you all: Tracey Kuehn and Anthony Calcara for producing this book; Babs Reingold and Lyndall Culbertson for their beautiful interior design and the absolutely spectacular cover; Lee Mahler, who lays out pages like no other; Karen Osborne, for her thoughtful copyedit; Barbara Seixas, who worked her magic once again on the manufacturing end and despite the vagaries of the project schedule; Cecilia Varas, Elyse Rieder, Julie Tesser, and Ted Szczepanski for photo research; Stacey Alexander, Laura McGinn, and Jenny Chiu for coordinating the production on all supplemental materials; and Tom Acox, editorial assistant extraordinaire. It is a thrill to behold a book that one has written; but it’s a particularly special thrill to behold a book so beautifully published. Many thanks to Sarah Dorger, Marie McHale, and Matt Driskill for devising and coordinating the impressive collection of media and supplements that accompany our book. Thanks to the incredible team of supplements writers and coordinators who worked with them on the supplements and media package. And we would be remiss if we didn’t also thank Sarah for her helpful editorial suggestions and market insights during the revision process. Thanks to Scott Guile, marketing manager, for his tireless advocacy of this book; to Steve Rigolosi, director of market development, for his many contributions; to Bruce Kaplan for his support of the sales effort on both editions; and to Tom Kling for his critical role in launching this book in the sales department. And most of all, special thanks to Sharon Balbos, executive development editor on this edition as well as the first edition. Much of the success of this book is owed to Sharon’s dedication and professionalism. As always, she kept her cool through some rough spots. Sharon, we’re not sure we deserved an editor as good as you, but we’re sure that everyone involved, as well as our adopters and readers, have been made better off by your presence. Paul Krugman Robin Wells intro: >> Introduction: The Ordinary Business of Life AY I T’S SUNDAY AFTERNOON IN THE SPRING OF The scene along Route 1 on this spring day is, of 2008, and Route 1 in central New Jersey is a busy course, perfectly ordinary—very much like the scene place. Thousands of people crowd the shopping along hundreds of other stretches of road, all across malls that line the road for 20 miles, all the way from America, that same afternoon. And the discipline of Trenton to New Brunswick. Most of the shoppers are economics is mainly concerned with ordinary things. As cheerful—and why not? The stores in those malls offer an the great nineteenth-century economist Alfred Marshall extraordinary range of choice; you can buy everything put it, economics is “a study of mankind in the ordinary from sophisticated electronic equipment to fashionable business of life.” Delivering the goods: the market economy in action clothes to organic carrots. There are probably 100,000 What can economics say about this “ordinary busi- distinct items available along that stretch of road. And ness”? Quite a lot, it turns out. What we’ll see in this most of these items are not luxury goods that only the book is that even familiar scenes of economic life pose rich can afford; they are products that millions of some very important questions—questions that econom- Americans can and do purchase every day. ics can help answer. Among these questions are AT ? ■ How does our economic system work? That is, how ■ Finally, why is the long run mainly a story of ups does it manage to deliver the goods? rather than downs? That is, why has America, along ■ When and why does our economic system go astray, with other advanced nations, become so much richer leading people into counterproductive behavior? over time? ■ Why are there ups and downs in the economy? That is, Let’s take a look at these questions and offer a brief why does the economy sometimes have a “bad year”? preview of what you will learn in this book. The Invisible Hand That ordinary scene in central New Jersey would not have looked at all ordinary to an American from colonial times—say, one of the patriots who helped George Washington win the Battle of Trenton in 1776. At the time, Trenton was a small village, and farms lined the route of Washington’s epic night march from Trenton to Princeton—a march that took him right past the future site of the giant Quakerbridge shopping mall. Imagine that you could transport an American from the colonial period forward in time to our own era. (Isn’t that the plot of a movie? Several, actually.) What would this time-traveler find amazing? Surely the most amazing thing would be the sheer prosperity of modern America— the range of goods and services that ordinary families can afford. Looking at all that wealth, our transplanted colonial would wonder, “How can I get some of that?” Or perhaps he would ask himself, “How can my society get some of that?” The answer is that to get this kind of prosperity, you need a well-functioning system for coordinating productive activities—the activities that create the goods and services people want and get them to the people who want them. That kind of system is what we mean when we talk about the economy. And economics is the social science that studies the production, distribution, and consumption of goods and services. An economy succeeds to the extent that it, literally, delivers the goods. A timetraveler from the eighteenth century—or even from 1950—would be amazed at how many goods and services the modern American economy delivers and at how many people can afford them. Compared with any past economy and with all but a few other countries today, America has an incredibly high standard of living. So our economy must be doing something right, and the time-traveler might want to compliment the person in charge. But guess what? There isn’t anyone in charge. The United States has a market economy, in which production and consumption are the result of decentralized decisions by many firms and individuals. There is no central authority telling people what to produce or where to ship it. Each individual producer makes what he or she thinks will be most profitable; each consumer buys what he or she chooses. The alternative to a market economy is a command economy, in which there is a central authority making decisions about production and consumption. Command economies have been tried, most notably in the Soviet Union between 1917 and 1991. But they didn’t work very well. Producers in the Soviet Union routinely found themselves unable to produce because they did not have crucial raw materials, or they succeeded in producing but then found that nobody wanted their products. Consumers were often unable to find necessary items—command economies are famous for long lines at shops. Market economies, however, are able to coordinate even highly complex activities and to reliably provide consumers with the goods and services they want. Indeed, people quite casually trust their lives to the market system: residents of any major city would starve in days if the unplanned yet somehow orderly actions of thousands of businesses did not deliver a steady supply of food. Surprisingly, the unplanned “chaos” of a market economy turns out to be far more orderly than the “planning” of a command economy. In 1776, in a famous passage in his book The Wealth of Nations, the pioneering Scottish economist Adam Smith wrote about how individuals, in pursuing their own An economy is a system for coordinating society’s productive activities. Economics is the social science that studies the production, distribution, and consumption of goods and services. A market economy is an economy in which decisions about production and consumption are made by individual producers and consumers. interests, often end up serving the interests of society as a whole. Of a businessman whose pursuit of profit makes the nation wealthier, Smith wrote: “[H]e intends only his own gain, and he is in this, a
s in many other cases, led by an invisible hand to promote an end which was no part of his intention.” Ever since, economists have used the term invisible hand to refer to the way a market economy manages to harness the power of self-interest for the good of society. The study of how individuals make decisions and how these decisions interact is called microeconomics. One of the key themes in microeconomics is the validity of Adam Smith’s insight: individuals pursuing their own interests often do promote the interests of society as a whole. So part of the answer to our time © traveler’s question—“How can my society achieve the kind of prosperity you take for granted?”—is that his society should learn to appreciate the virtues of a market economy and the power of the invisible hand. But the invisible hand isn’t always our friend. It’s also important to understand when and why the individual pursuit of self-interest can lead to counterproductive behavior. My Benefit, Your Cost One thing that our time-traveler would not admire about modern Route 1 is the traffic. In fact, although most things have gotten better in America over time, traffic congestion has gotten a lot worse. When traffic is congested, each driver is imposing a cost on all the other drivers on the road—he is literally getting in their way (and they are getting in his way). This cost can be substantial: in major metropolitan areas, each time someone drives to work, instead of taking public transportation or working at home, he can easily impose $15 or more in hidden costs on other drivers. Yet when deciding whether or not to drive, commuters have no incentive to take the costs they impose on others into account. Traffic congestion is a familiar example of a much broader problem: sometimes the individual pursuit of one’s own interest, instead of promoting the interests of society as a whole, can actually make society worse off. When this happens, it is known as market failure. Other important examples of market failure involve air and water pollution as well as the overexploitation of natural resources such as fish and forests. The good news, as you will learn as you use this book to study microeconomics, is that economic analysis can be used to diagnose cases of market failure. And often, economic analysis can also be used to devise solutions for the problem. Good Times, Bad Times Route 1 was bustling on that day in 2008. But if you’d visited the malls in 2002, the scene wouldn’t have been quite as cheerful. That’s because New Jersey’s economy, along with that of the United States as a whole, was somewhat depressed in 2002: in early 2001, businesses began laying off workers in large numbers, and employment didn’t start bouncing back until the summer of 2003. The invisible hand refers to the way in which the individual pursuit of selfinterest can lead to good results for society as a whole. Microeconomics is the branch of economics that studies how people make decisions and how these decisions interact. When the individual pursuit of selfinterest leads to bad results for society as a whole, there is market failure. 4 P A R T 1 W H AT recession is a downturn in the economy. Macroeconomics is the branch of economics that is concerned with overall ups and downs in the economy. Economic growth is the growing ability of the economy to produce goods and services. Such troubled periods are a regular feature of modern economies. The fact is that the economy does not always run smoothly: it experiences fluctuations, a series of ups and downs. By middle age, a typical American will have experienced three or four downs, known as recessions. (The U.S. economy experienced serious recessions beginning in 1973, 1981, 1990, and 2001.) During a severe recession, millions of workers may be laid off. Like market failure, recessions are a fact of life; but also like market failure, they are a problem for which economic analysis offers some solutions. Recessions are one of the main concerns of the branch of economics known as macroeconomics, which is concerned with the overall ups and downs of the economy. If you study macroeconomics, you will learn how economists explain recessions and how government policies can be used to minimize the damage from economic fluctuations. Despite the occasional recession, however, over the long run the story of the U.S. economy contains many more ups than downs. And that long-run ascent is the subject of our final question. Onward and Upward At the beginning of the twentieth century, most Americans lived under conditions that we would now think of as extreme poverty. Only 10 percent of homes had flush toilets, only 8 percent had central heating, only 2 percent had electricity, and almost nobody had a car, let alone a washing machine or air conditioning. Such comparisons are a stark reminder of how much our lives have been changed by economic growth, the growing ability of the economy to produce goods and services. Why does the economy grow over time? And why does economic growth occur faster in some times and places than in others? These are key questions for economics because economic growth is a good thing, as those shoppers on Route 1 can attest, and most of us want more of it. An Engine for Discovery We hope we have convinced you that the “ordinary business of life” is really quite extraordinary, if you stop to think about it, and that it can lead us to ask some very interesting and important questions. In this book, we will describe the answers economists have given to these questions. But this book, like economics as a whole, isn’t a list of answers: it’s an introduction to a discipline, a way to address questions like those we have just asked. Or as Alfred Marshall, who described economics as a study of the “ordinary business of life,” put it: “Economics . . . is not a body of concrete truth, but an engine for the discovery of concrete truth.” So let’s turn the key and start the ignition. K E Y T E R M S Economy, p. 2 Economics, p. 2 Market economy, p. 2 Invisible hand, p. 3 Microeconomics, p. 3 Market failure, p. 3 Recession, p. 4 Macroeconomics, p. 4 Economic growth, p. 4 www.worthpublishers.com/krugmanwells chapter: 1 THE AMERICAN But to understand how an economy works, you need to >> First Principles HE ANNUAL MEETING OF T Economic Association draws thousands of understand more than how individuals make choices. economists, young and old, famous and obscure. There are booksellers, business meetings, and quite a few None of us are Robinson Crusoe, alone on an island—we must make decisions in an environment that is shaped by job interviews. But mainly the economists gather to talk the decisions of others. Indeed, in a modern economy even and listen. During the busiest times, 60 or more presenta- the simplest decisions you make—say, what to have for tions may be taking place simultaneously, on questions breakfast—are shaped by the decisions of thousands of that range from the future of the stock market to who does the cooking in two-earner families. What do these people have in common? An expert on the stock market probably knows very little about the economics of house- work, and vice versa. Yet an economist who wanders into the wrong seminar and ends up lis- tening to presentations on some unfamiliar topic is nonetheless likely to hear much that is famil- iar. The reason is that all economic analysis is based on a set of common principles that apply to many different issues. One must choose. other people, from the banana grower in Costa Rica who decided to grow the fruit you eat to the farmer in Iowa who provided the corn in your cornflakes. And because each of us in a market economy depends on so many oth- ers—and they, in turn, depend on us—our choices interact. So although all economics at a basic level is about individual choice, in order to understand how market economies behave we must also understand economic interaction— how my choices affect your choic- es, and vice versa © Many important economic interactions can be under- Some of these principles involve individual choice—for stood by looking at the markets for individual goods, like economics is, first of all, about the choices that individ- the market for corn. But an economy as a whole has its uals make. Do you choose to work over the summer or ups and downs—and we therefore need to understand take a backpacking trip? Do you buy a new CD or go to economy-wide interactions as well as the more limited a movie? These decisions involve making a choice from interactions that occur in individual markets. among a limited number of alternatives—limited because In this chapter, we will look at twelve basic principles no one can have everything that he or she wants. Every of economics—four principles involving individual question in economics at its most basic level involves choice, five involving the way individual choices interact, individuals making choices. and three more involving economy-wide interactions AT ? WHAT YOU WILL LEARN IN THIS CHAPTER: ➤ A set of principles for understanding the economics of how individuals make choices ➤ A set of principles for understanding ➤ A set of principles for understanding how individual choices interact economy-wide interactions Individual Choice: The Core of Economics Every economic issue involves, at its most basic level, individual choice—decisions by an individual about what to do and what not to do. In fact, you might say that it isn’t economics if it isn’t about choice. Step into a big store like a Wal-Mart or Target. There are thousands of different products available, and it is extremely unlikely that you—or anyone else—could afford to buy everything you might want to have. And anyway, there’s only so much space in your dorm room or apartment. So will you buy another bookcase or a minirefrigerator? Given limitations on your budget and your living space, you must choose which products to buy and which to leave on the shel
f. The fact that those products are on the shelf in the first place involves choice—the store manager chose to put them there, and the manufacturers of the products chose to produce them. All economic activities involve individual choice. Four economic principles underlie the economics of individual choice, as shown in Table 1-1. We’ll now examine each of these principles in more detail. Resources Are Scarce You can’t always get what you want. Everyone would like to have a beautiful house in a great location (and help with the housecleaning), two or three luxury cars, and frequent vacations in fancy hotels. But even in a rich country like the United States, not many families can afford all that. So they must make choices—whether to go to Disney World this year or buy a better car, whether to make do with a small backyard or accept a longer commute in order to live where land is cheaper. Limited income isn’t the only thing that keeps people from having everything they want. Time is also in limited supply: there are only 24 hours in a day. And because the time we have is limited, choosing to spend time on one activity also means choosing not to spend time on a different activity—spending time studying for an exam means forgoing a night at the movies. Indeed, many people are so limited by the number of hours in the day that they are willing to trade money for time. For example, convenience stores normally charge higher prices than a regular supermarket. But they fulfill a valuable role by catering to time-pressured customers who would rather pay more than travel farther to the supermarket. Why do individuals have to make choices? The ultimate reason is that resources are scarce. A resource is anything that can be used to produce something else. Lists of the economy’s resources usually begin with land, labor (the time of workers), capital (machinery, buildings, and other man-made productive assets), and human capital (the educational achievements and skills of workers). A resource is scarce when there’s not enough of the resource available to satisfy all the various ways a society wants to use it. There are many scarce resources. These include natural resources—resources that come from the physical environment, such as minerals, lumber, and petroleum. There is also a limited quantity of human resources—labor, skill, and intelligence. And in a growing world economy with a rapidly increasing human population, even clean air and water have become scarce resources. Just as individuals must make choices, the scarcity of resources means that society as a whole must make choices. One way for a society to make choices is simply to allow them to emerge as the result of many individual choices, which is what usually happens in a market economy. For example, Americans as a group have only so many TABLE 1-1 Principles That Underlie the Economics of Individual Choice 1. Resources are scarce. 2. The real cost of something is what you must give up to get it. 3. “How much?” is a decision at the margin. 4. People usually exploit opportunities to make themselves better off. Individual choice is the decision by an individual of what to do, which necessarily involves a decision of what not to do. A resource is anything that can be used to produce something else. Resources are scarce—there is not enough of the resources available to satisfy all the various ways a society wants to use them The real cost of an item is its opportunity cost: what you must give up in order to get it. hours in a week: how many of those hours will they spend going to supermarkets to get lower prices, rather than saving time by shopping at convenience stores? The answer is the sum of individual decisions: each of the millions of individuals in the economy makes his or her own choice about where to shop, and the overall choice is simply the sum of those individual decisions. But for various reasons, there are some decisions that a society decides are best not left to individual choice. For example, the authors live in an area that until recently was mainly farmland but is now being rapidly built up. Most local residents feel that the community would be a more pleasant place to live if some of the land were left undeveloped. But no individual has an incentive to keep his or her land as open space, rather than sell it to a developer. So a trend has emerged in many communities across the United States of local governments purchasing undeveloped land and preserving it as open space. We’ll see in later chapters why decisions about how to use scarce resources are often best left to individuals but sometimes should be made at a higher, community-wide, level. The Real Cost of Something Is What You Must Give Up to Get It It is the last term before you graduate, and your class schedule allows you to take only one elective. There are two, however, that you would really like to take: History of Jazz and Beginning Tennis. Suppose you decide to take the History of Jazz course. What’s the cost of that decision? It is the fact that you can’t take Beginning Tennis, your next best alternative choice. Economists call that kind of cost—what you must give up in order to get an item you want—the opportunity cost of that item. So the opportunity cost of taking the History of Jazz class is the enjoyment you would have derived from the Beginning Tennis class. The concept of opportunity cost is crucial to understanding individual choice because, in the end, all costs are opportunity costs. That’s because every choice you make means forgoing some other alternative. Sometimes critics claim that economists are concerned only with costs and benefits that can be measured in dollars and cents. But that is not true. Much economic analysis involves cases like our elective course example, where it costs no extra tuition to take one elective course—that is, there is no direct monetary cost. Nonetheless, the elective you choose has an opportunity cost— the other desirable elective course that you must forgo because your limited time permits taking only one. More specifically, the opportunity cost of a choice is what you forgo by not choosing your next best alternative. You might think that opportunity cost is an add-on—that is, something additional to the monetary cost of an item. Suppose that an elective class costs additional tuition of $750; now there is a monetary cost to taking History of Jazz. Is the opportunity cost of taking that course something separate from that monetary cost? Well, consider two cases. First, suppose that taking Beginning Tennis also costs $750. In this case, you would have to spend that $750 no matter which class you take. So what you give up to take the History of Jazz class is still the Beginning Tennis class, period—you would have to spend that $750 either way. But suppose there isn’t any fee for the tennis class. In that case, what you give up to take the jazz class is the enjoyment from the tennis class plus the enjoyment that you could have gained from spending the $750 on other things. Either way, the real cost of taking your preferred class is what you must give up to get it. As you expand the set of decisions that underlie each choice—whether to take an elective or not, whether to finish this term or not, whether to drop out or not— you’ll realize that all costs are ultimately opportunity costs. Sometimes the money you have to pay for something is a good indication of its opportunity cost. But many times it is not. One very important example of how poorly monetary cost can indicate opportunity cost is the cost of attending college. Tuition 8 P A R T 1 W H AT Got a Penny? At many cash registers—for example, the one downstairs in our college cafeteria— there is a little basket full of pennies. People are encouraged to use the basket to round their purchases up or down: if it costs $5.02, you give the cashier $5 and take two pennies from the basket; if it costs $4.99, you pay $5 and the cashier throws in a penny. It makes everyone’s life a bit easier. Of course, it would be easier still if we just abolished the penny, a step that some economists have urged. But then why do we have pennies in the first place? If it’s too small a sum to worry about, why calculate prices that exactly? The answer is that a penny wasn’t always such a negligible sum: the purchasing power of a penny has been greatly reduced by inflation, a general rise in the prices of all goods and services over time. Forty years ago, a penny had more purchasing power than a nickel does today. Why does this matter? Well, remember the saying: “A penny saved is a penny earned.” But there are other ways to earn money, so you must decide whether saving a penny is a productive use of your time. Could you earn more by devoting that time to other uses? Sixty years ago, the average wage was about $1.20 an hour. A penny was equivalent to 30 seconds’ worth of work—it was worth saving a penny if doing so took less than 30 seconds. But wages have risen along with overall prices, so that the average worker is now paid more than $17 per hour. A penny is therefore equivalent to just over 2 seconds of work—and so it’s not worth the opportunity cost of the time it takes to worry about a penny more or less. In short, the rising opportunity cost of time in terms of money has turned a penny from a useful coin into a nuisance and housing are major monetary expenses for most students; but even if these things were free, attending college would still be an expensive proposition because most college students, if they were not in college, would have a job. That is, by going to college, students forgo the income they could have made if they had worked instead. This means that the opportunity cost of attending college is what you pay for tuition and housing plus the forgone income you would have earned in a job. It’s easy to see that the opportunity cost of going to college is especially high for people who could be earning a
lot during what would otherwise have been their college years. That is why star athletes like LeBron James often skip college. Some, like Tiger Woods, leave before graduating. “How Much?” Is a Decision at the Margin Some important decisions involve an “either–or” choice—for example, you decide either to go to college or to begin working; you decide either to take economics or to take something else. But other important decisions involve “how much” choices—for example, if you are taking both economics and chemistry this semester, you must decide how much time to spend studying for each. When it comes to understanding “how much” decisions, economics has an important insight to offer: “how much” is a decision made at the margin. Suppose you are taking both economics and chemistry. And suppose you are a pre-med student, so that your grade in chemistry matters more to you than your grade in economics. Does that therefore imply that you should spend all your study time on chemistry and wing it on the economics exam? Probably not; even if you think your chemistry grade is more important, you should put some effort into studying for economics. Spending more time studying for economics involves a benefit (a higher expected grade in that course) and a cost (you could have spent that time doing something else, such as studying to get a higher grade in chemistry). That is, your decision involves a trade-off—a comparison of costs and benefits. How do you decide this kind of “how much” question? The typical answer is that you make the decision a bit at a time, by asking how you should spend the next hour. Say both exams are on the same day, and the night before you spend time reviewing your notes for both courses. At 6:00 P.M., you decide that it’s a good idea to spend at least an hour on each course. At 8:00 P.M., you decide you’d better spend another LeBron James understood the concept of opportunity cost. You make a trade-off when you compare the costs with the benefits of doing something Decisions about whether to do a bit more or a bit less of an activity are marginal decisions. The study of such decisions is known as marginal analysis. An incentive is anything that offers rewards to people who change their behavior. hour on each course. At 10:00 P.M., you are getting tired and figure you have one more hour to study before bed—chemistry or economics? If you are pre-med, it’s likely to be chemistry; if you are pre-MBA, it’s likely to be economics. Note how you’ve made the decision to allocate your time: at each point the question is whether or not to spend one more hour on either course. And in deciding whether to spend another hour studying for chemistry, you weigh the costs (an hour forgone of studying for economics or an hour forgone of sleeping) versus the benefits (a likely increase in your chemistry grade). As long as the benefit of studying one more hour for chemistry outweighs the cost, you should choose to study for that additional hour. Decisions of this type—what to do with your next hour, what to do with your next dollar, and so on—are marginal decisions. They involve making trade-offs at the margin: comparing the costs and benefits of doing a little bit more of an activity versus doing a little bit less. The study of such decisions is known as marginal analysis. Many of the questions that we face in economics—as well as in real life—involve marginal analysis: How many workers should I hire in my shop? At what mileage should I change the oil in my car? What is an acceptable rate of negative side effects from a new medicine? Marginal analysis plays a central role in economics because it is the key to deciding “how much” of an activity to do. People Usually Exploit Opportunities to Make Themselves Better Off One day, while listening to the morning financial news, the authors heard a great tip about how to park cheaply in Manhattan. Garages in the Wall Street area charge as much as $30 per day. But according to the newscaster, some people had found a better way: instead of parking in a garage, they had their oil changed at the Manhattan Jiffy Lube, where it costs $19.95 to change your oil—and they keep your car all day! It’s a great story, but unfortunately it turned out not to be true—in fact, there is no Jiffy Lube in Manhattan. But if there were, you can be sure there would be a lot of oil changes there. Why? Because when people are offered opportunities to make themselves better off, they normally take them—and if they could find a way to park their car all day for $19.95 rather than $30, they would. When you try to predict how individuals will behave in an economic situation, it is a very good bet that they will exploit opportunities to make themselves better off. Furthermore, individuals will continue to exploit these opportunities until they have been fully exhausted—that is, people will exploit opportunities until those opportunities have been fully exploited. If there really was a Manhattan Jiffy Lube and an oil change really was a cheap way to park your car, we can safely predict that before long the waiting list for oil changes would be weeks, if not months. In fact, the principle that people will exploit opportunities to make themselves better off is the basis of all predictions by economists about individual behavior. If the earnings of those who get MBAs soar while the earnings of those who get law degrees decline, we can expect more students to go to business school and fewer to go to law school. If the price of gasoline rises and stays high for an extended period of time, we can expect people to buy smaller cars with higher gas mileage—making themselves better off in the presence of higher gas prices by driving more fuel-efficient cars. When changes in the available opportunities offer rewards to those who change their behavior, we say that people face new incentives. If the price of parking in Manhattan rises, those who can find alternative ways to get to their Wall Street jobs will save money by doing so—and so we can expect fewer people to drive to work. One last point: economists tend to be skeptical of any attempt to change people’s behavior that doesn’t change their incentives. For example, a plan that calls on manufacturers to reduce pollution voluntarily probably won’t be effective; a plan that gives them a financial incentive to reduce pollution is a lot more likely to work. 10 P A R T 1 W H AT Pay for Grades? The true reward for learning is, of course, the learning itself. But teachers and schools often feel that it’s worth throwing in a few extras. Elementary school students who do well get gold stars; at higher levels, students who score well on tests may receive trophies, plaques, or even gift certificates. But what about cash? A few years ago, some Florida schools stirred widespread debate by offering actual cash bonuses to students who scored high on the state’s standardized exams. At Parrott Middle School, which offered the highest amounts, an eighthgrader with a top score on an exam received a $50 savings bond. Many people questioned the monetary awards. In fact, the great majority of teachers feel that cash rewards for learning are a bad idea—the dollar amounts can’t be made large enough to give students a real sense of how important their education is, and they make learning seem like work-for-pay. So why did the schools engage in the practice? The answer, it turns out, is that the previous year the state government had introduced a pay-for-performance scheme for schools: schools whose students earned high marks on the state exams received extra state funds. The problem arose of how to motivate the students to take the exams as seriously as the school administrators did. Parrott’s principal defended the pay-for-grades practice by pointing out that good students would often “Christmas tree” their exams—ignore the questions and fill out the bubble sheets in the shape of Christmas trees. With large sums of money for the school at stake, he decided to set aside his misgivings and pay students to do well on the exams. Does paying students for grades lead to higher grades? Interviews with students suggest that it does spur at least some students to try harder on state exams. And some Florida schools that have introduced rewards for good grades on state exams report substantial improvements in student performance. Individual Choice: Summing It Up We have just seen that there are four basic principles of individual choice: ■ Resources are scarce. It is always necessary to make choices. ■ The real cost of something is what you must give up to get it. All costs are opportunity costs. ■ “How much?” is a decision at the margin. Usually the question is not “whether” but “how much.” And that is a question whose answer hinges on the costs and benefits of doing a bit more or a bit less. ■ People usually exploit opportunities to make themselves better off. As a result, people will respond to incentives. So are we ready to do economics? Not yet—because most of the interesting things that happen in the economy are the result not merely of individual choices but of the way in which individual choices interact. ➤ECONOMICS IN ACTION A Woman’s Work One of the great social transformations of the twentieth century was the change in the nature of women’s work. In 1900, only 6 percent of married women worked for pay outside the home. By 2005, the number was about 60 percent. What caused this transformation? Changing attitudes toward work outside the home certainly played a role: in the first half of the twentieth century, it was often considered improper for a married woman to work outside the home if she could afford not to, whereas today it is considered normal. But an important driving force was the invention and growing availability of home appliances, especially washing machines. Before these appliances became available, housework was an extremely laborious task—much more so than a full-time job.
In 1945, government researchers clocked a farm wife as she did the weekly wash by hand; she spent 4 hours washing clothes and 41⁄2 hours ironing, and she walked more than a mile. Then she was 11 equipped with a washing machine; the same wash took 41 minutes, ironing was reduced to 13⁄4 hours, and the distance walked was reduced by 90 percent. The point is that in pre-appliance days, the opportunity cost of working outside the home was very high: it was something women typically did only in the face of dire financial necessity. With modern appliances, the opportunities available to women changed—and the rest is history. ▲ > > > > > > > > > > > > ➤ CHECK YOUR UNDERSTANDING 1-1 1. Explain how each of the following situations illustrates one of the four principles of individual choice. a. You are on your third trip to a restaurant’s all-you-can-eat dessert buffet and are feeling very full. Although it would cost you no additional money, you forgo a slice of coconut cream pie but have a slice of chocolate cake. b. Even if there were more resources in the world, there would still be scarcity. c. Different teaching assistants teach several Economics 101 tutorials. Those taught by the teaching assistants with the best reputations fill up quickly, with spaces left unfilled in the ones taught by assistants with poor reputations. d. To decide how many hours per week to exercise, you compare the health benefits of one more hour of exercise to the effect on your grades of one less hour spent studying. 2. You make $45,000 per year at your current job with Whiz Kids Consultants. You are consider- ing a job offer from Brainiacs, Inc., which will pay you $50,000 per year. Which of the following are elements of the opportunity cost of accepting the new job at Brainiacs, Inc.? a. The increased time spent commuting to your new job b. The $45,000 salary from your old job c. The more spacious office at your new job Solutions appear at back of book. Interaction: How Economies Work As we learned in the Introduction, an economy is a system for coordinating the productive activities of many people. In a market economy, such as the one we live in, that coordination takes place without any coordinator: each individual makes his or her own choices. Yet those choices are by no means independent of each other: each individual’s opportunities, and hence choices, depend to a large extent on the choices made by other people. So to understand how a market economy behaves, we have to examine this interaction in which my choices affect your choices, and vice versa. When studying economic interaction, we quickly learn that the end result of indi- vidual choices may be quite different from what any one individual intends. For example, over the past century farmers in the United States have eagerly adopted new farming techniques and crop strains that have reduced their costs and increased their yields. Clearly, it’s in the interest of each farmer to keep up with the latest farming techniques. But the end result of each farmer trying to increase his or her own income has actually been to drive many farmers out of business. Because American farmers have been so successful at producing larger yields, agricultural prices have steadily fallen. These falling prices have reduced the incomes of many farmers, and as a result fewer and fewer people find farming worth doing. That is, an individual farmer who plants a better variety of corn is better off; but when many farmers plant a better variety of corn, the result may be to make farmers as a group worse off. A farmer who plants a new, more productive corn variety doesn’t just grow more corn. Such a farmer also affects the market for corn through the increased yields attained, with consequences that will be felt by other farmers, consumers, and beyond. Just as there are four economic principles that fall under the theme of choice, there are five principles that fall under the theme of interaction. These five principles are summarized in Table 1-2. We will now examine each of these principles more closely. ➤➤ ➤ All economic activities involve individual choice. ➤ People must make choices because resources are scarce. ➤ The real cost of something is what you must give up to get it—specifically, giving up your next best alternative. All costs are opportunity costs. Monetary costs are sometimes a good indicator of opportunity costs, but not always. ➤ Many choices are not whether to do something but how much. “How much” choices are made by making a trade-off at the margin. The study of marginal decisions is known as marginal analysis. ➤ Because people usually exploit opportunities to make themselves better off, incentives can change people’s behavior. Interaction of choices—my choices affect your choices, and vice versa—is a feature of most economic situations. The results of this interaction are often quite different from what the individuals intend. TABLE 1-2 Principles That Underlie the Interaction of Individual Choices 1. There are gains from trade. 2. Markets move toward equilibrium. 3. Resources should be used as efficiently as possible to achieve society’s goals. 4. Markets usually lead to efficiency. 5. When markets don’t achieve efficiency, government intervention can improve society’s welfare. 12 P A R T 1 W H AT ? In a market economy, individuals engage in trade: they provide goods and services to others and receive goods and services in return. There are gains from trade: people can get more of what they want through trade than they could if they tried to be self-sufficient. This increase in output is due to specialization: each person specializes in the task that he or she is good at performing. There Are Gains from Trade Why do the choices I make interact with the choices you make? A family could try to take care of all its own needs—growing its own food, sewing its own clothing, providing itself with entertainment, writing its own economics textbooks. But trying to live that way would be very hard. The key to a much better standard of living for everyone is trade, in which people divide tasks among themselves and each person provides a good or service that other people want in return for different goods and services that he or she wants. The reason we have an economy, not many self-sufficient individuals, is that there are gains from trade: by dividing tasks and trading, two people (or 6 billion people) can each get more of what they want than they could get by being self-sufficient. Gains from trade arise, in particular, from this division of tasks, which economists call specialization—a situation in which different people each engage in a different task. The advantages of specialization, and the resulting gains from trade, were the starting point for Adam Smith’s 1776 book The Wealth of Nations, which many regard as the beginning of economics as a discipline. Smith’s book begins with a description of an eighteenth-century pin factory where, rather than each of the 10 workers making a pin from start to finish, each worker specialized in one of the many steps in pin-making: One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a particular business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations. . . . Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. But if they had all wrought separately and independently, and without any of them having been educated to this particular business, they certainly could not each of them have made twenty, perhaps not one pin a dayI hunt and she gathers—otherwise we couldn’t make ends meet.” The same principle applies when we look at how people divide tasks among themselves and trade in an economy. The economy, as a whole, can produce more when each person specializes in a task and trades with others. The benefits of specialization are the reason a person typically chooses only one career. It takes many years of study and experience to become a doctor; it also takes many years of study and experience to become a commercial airline pilot. Many doctors might well have had the potential to become excellent pilots, and vice versa; but it is very unlikely that anyone who decided to pursue both careers would be as good a pilot or as good a doctor as someone who decided at the beginning to specialize in that field. So it is to everyone’s advantage that individuals specialize in their career choices. Markets are what allow a doctor and a pilot to specialize in their own fields. Because markets for commercial flights and for doctors’ services exist, a doctor is assured that she can find a flight and a pilot is assured that he can find a doctor. As long as individuals know that they can find the goods and services that they want in the market, they are willing to forgo self-sufficiency and are willing to specialize. But what assures people that markets will deliver what they want? The answer to that question leads us to our second principle of how individual choices interact. Markets Move Toward Equilibrium It’s a busy afternoon at the supermarket; there are long lines at the checkout counters. Then one of the previously closed cash registers opens. What happens? The first thing that happens, of course, is a rush to that register. After a couple of minutes, however, things will have settled down; shoppers will have rearranged themselves so that the line at the newly opened register is about the same length as the lines at all the other registers. How do we know that? We know from our fourth principle of individual choice that people will exploit opportunities to make themselves better off. This means that people will ru
sh to the newly opened register in order to save time standing in line. And things will settle down when shoppers can no longer improve their position by switching lines—that is, when the opportunities to make themselves better off have all been exploited. A story about supermarket checkout lines may seem to have little to do with how individual choices interact, but in fact it illustrates an important principle. A situation in which individuals cannot make themselves better off by doing something different—the situation in which all the checkout lines are the same length—is what economists call an equilibrium. An economic situation is in equilibrium when no individual would be better off doing something different. Recall the story about the mythical Jiffy Lube, where it was supposedly cheaper to leave your car for an oil change than to pay for parking. If that opportunity had really existed and people were still paying $30 to park in garages, the situation would not have been an equilibrium. And that should have been a giveaway that the story couldn’t be true. In reality, people would have seized an opportunity to park cheaply, just as they seize opportunities to save time at the checkout line. And in so doing they would have eliminated the opportunity! Either it would have become very hard to get an appointment for an oil change or the price of a lube job would have increased to the point that it was no longer an attractive option (unless you really needed a lube job). 13 Witness equilibrium in action at the checkout lines in your neighborhood supermarket. As we will see, markets usually reach equilibrium via changes in prices, which rise or fall until no opportunities for individuals to make themselves better off remain. The concept of equilibrium is extremely helpful in understanding economic interactions because it provides a way of cutting through the sometimes complex details of those interactions. To understand what happens when a new line is opened at a supermarket, you don’t need to worry about exactly how shoppers rearrange themselves, who moves ahead of whom, which register just opened, and so on. What you need to know is that any time there is a change, the situation will move to an equilibrium. An economic situation is in equilibrium when no individual would be better off doing something different. L D VIE Choosing Sides Why do people in America drive on the right side of the road? Of course, it’s the law. But long before it was the law, it was an equilibrium. Before there were formal traffic laws, there were informal “rules of the road,” practices that everyone expected everyone else to follow. These rules included an understanding that people would normally keep to one side of the road. In some places, such as England, the rule was to keep to the left; in others, such as France, it was to keep to the right. Why would some places choose the right and others, the left? That’s not completely clear, although it may have W E I V D L VIEWWOR W O R L D depended on the dominant form of traffic. Men riding horses and carrying swords on their left hip preferred to ride on the left (think about getting on or off the horse, and you’ll see why). On the other hand, right-handed people walking but leading horses apparently preferred to walk on the right. In any case, once a rule of the road was established, there were strong incentives for each individual to stay on the “usual” side of the road: those who didn’t would keep colliding with oncoming traffic. So once established, the rule of the road would be self-enforcing—that is, it would be an equilibrium. Nowadays, of course, which side you drive on is determined by law; some countries have even changed sides (Sweden went from left to right in 1967). But what about pedestrians? There are no laws—but there are informal rules. In the United States, urban pedestrians normally keep to the right. But if you should happen to visit a country where people drive on the left, watch out: people who drive on the left also typically walk on the left. So when in a foreign country, do as the locals do. You won’t be arrested if you walk on the right, but you will be worse off than if you accept the equilibrium and walk on the left. 14 P A R T 1 W H AT ? An economy is efficient if it takes all opportunities to make some people better off without making other people worse off. Equity means that everyone gets his or her fair share. Since people can disagree about what’s “fair,” equity isn’t as well defined a concept as efficiency. The fact that markets move toward equilibrium is why we can depend on them to work in a predictable way. In fact, we can trust markets to supply us with the essentials of life. For example, people who live in big cities can be sure that the supermarket shelves will always be fully stocked. Why? Because if some merchants who distribute food didn’t make deliveries, a big profit opportunity would be created for any merchant who did— and there would be a rush to supply food, just like the rush to a newly opened cash register. So the market ensures that food will always be available for city dwellers. And, returning to our previous principle, this allows city dwellers to be city dwellers—to specialize in doing city jobs rather than living on farms and growing their own food. A market economy also allows people to achieve gains from trade. But how do we know how well such an economy is doing? The next principle gives us a standard to use in evaluating an economy’s performance. Resources Should Be Used as Efficiently as Possible to Achieve Society’s Goals Suppose you are taking a course in which the classroom is too small for the number of students—many people are forced to stand or sit on the floor—despite the fact that large, empty classrooms are available nearby. You would say, correctly, that this is no way to run a college. Economists would call this an inefficient use of resources. But if an inefficient use of resources is undesirable, just what does it mean to use resources efficiently? You might imagine that the efficient use of resources has something to do with money, maybe that it is measured in dollars-and-cents terms. But in economics, as in life, money is only a means to other ends. The measure that economists really care about is not money but people’s happiness or welfare. Economists say that an economy’s resources are used efficiently when they are used in a way that has fully exploited all opportunities to make everyone better off. To put it another way, an economy is efficient if it takes all opportunities to make some people better off without making other people worse off. In our classroom example, there clearly was a way to make everyone better off— moving the class to a larger room would make people in the class better off without hurting anyone else in the college. Assigning the course to the smaller classroom was an inefficient use of the college’s resources, whereas assigning the course to the larger classroom would have been an efficient use of the college’s resources. When an economy is efficient, it is producing the maximum gains from trade possible given the resources available. Why? Because there is no way to rearrange how resources are used in a way that can make everyone better off. When an economy is efficient, one person can be made better off by rearranging how resources are used only by making someone else worse off. In our classroom example, if all larger classrooms were already occupied, the college would have been run in an efficient way: your class could be made better off by moving to a larger classroom only by making people in the larger classroom worse off by making them move to a smaller classroom. Should economic policy makers always strive to achieve economic efficiency? Well, not quite, because efficiency is not the only criterion by which to evaluate an economy. People also care about issues of fairness, or equity. And there is typically a trade-off between equity and efficiency: policies that promote equity often come at a cost of decreased efficiency in the economy, and vice versa. To see this, consider the case of disabled-designated parking spaces in public parking lots. Many people have great difficulty walking due to age or disability, so it seems only fair to assign closer parking spaces specifically for their use. You may have noticed, however, that a certain amount of inefficiency is involved. To make sure that there is always an appropriate space available should a disabled person want one, there are typically quite a number of disabled-designated spaces. So at any one time there are typically more such spaces available than there are disabled people who want one. As a result, desirable parking spaces are unused. (And the 15 temptation for nondisabled people to use them is so great that we must be dissuaded by fear of getting a ticket.) So, short of hiring parking valets to allocate spaces, there is a conflict between equity, making life “fairer” for disabled people, and efficiency, making sure that all opportunities to make people better off have been fully exploited by never letting close-in parking spaces go unused. Exactly how far policy makers should go in promoting equity over efficiency is a difficult question that goes to the heart of the political process. As such, it is not a question that economists can answer. What is important for economists, however, is always to seek to use the economy’s resources as efficiently as possible in the pursuit of society’s goals, whatever those goals may be. Markets Usually Lead to Efficiency No branch of the U.S. government is entrusted with ensuring the general economic efficiency of our market economy—we don’t have agents who go around making sure that brain surgeons aren’t plowing fields, that Minnesota farmers aren’t trying to grow oranges, that prime beachfront property isn’t taken up by used-car dealerships, that colleges aren’t wasting valuable cl
assroom space. The government doesn’t need to enforce efficiency because in most cases the invisible hand does the job. In other words, the incentives built into a market economy already ensure that resources are usually put to good use, that opportunities to make people better off are not wasted. If a college were known for its habit of crowding students into small classrooms while large classrooms go unused, it would soon find its enrollment dropping, putting the jobs of its administrators at risk. The “market” for college students would respond in a way that induces administrators to run the college efficiently. A detailed explanation of why markets are usually very good at making sure that resources are used well will have to wait until we have studied how markets actually work. But the most basic reason is that in a market economy, in which individuals are free to choose what to consume and what to produce, opportunities for mutual gain are normally taken. If there is a way in which some people can be made better off, people will usually be able to take advantage of that opportunity. And that is exactly what defines efficiency: all the opportunities to make some people better off without making other people worse off have been exploited. As we learned in the Introduction, however, there are exceptions to this principle that markets are generally efficient. In cases of market failure, the individual pursuit of self-interest found in markets makes society worse off—that is, the market outcome is inefficient. And, as we will see in examining the next principle, when markets fail, government intervention can help. But short of instances of market failure, the general rule is that markets are a remarkably good way of organizing an economy. When Markets Don’t Achieve Efficiency, Government Intervention Can Improve Society’s Welfare Let’s recall from the Introduction the nature of the market failure caused by traffic congestion—a commuter driving to work has no incentive to take into account the cost that his or her action inflicts on other drivers in the form of increased traffic congestion. There are several possible remedies to this situation; examples include charging road tolls, subsidizing the cost of public transportation, and taxing sales of gasoline to individual drivers. All these remedies work by changing the incentives of would-be drivers— motivating them to drive less and use alternative transportation. But they also share another feature: each relies on government intervention in the market. This brings us to our fifth and last principle of interaction: When markets don’t achieve efficiency, government intervention can improve society’s welfare. That is, when markets go wrong, an appropriately designed government policy can sometimes move society closer to an efficient outcome by changing how society’s resources are used. 16 P A R T 1 W H AT very important branch of economics is devoted to studying why markets fail and what policies should be adopted to improve social welfare. We will study these problems and their remedies in depth in later chapters, but here we give a brief overview of three principal ways in which they fail: ■ Individual actions have side effects that are not properly taken into account by the market. An example is an action that causes pollution. ■ One party prevents mutually beneficial trades from occurring in an attempt to capture a greater share of resources for itself. An example is a drug company that keeps its prices so high that some people who would benefit from their drugs cannot afford to buy them. ■ Some goods, by their very nature, are unsuited for efficient management by mar- kets. An example of such a good is air traffic control. An important part of your education in economics is learning to identify not just when markets work but also when they don’t work—and to judge what government policies are appropriate in each situation. ➤ECONOMICS IN ACTION Restoring Equilibrium on the Freeways Back in 1994 a powerful earthquake struck the Los Angeles area, causing several freeway bridges to collapse and thereby disrupting the normal commuting routes of hundreds of thousands of drivers. The events that followed offer a particularly clear example of interdependent decision making—in this case, the decisions of commuters about how to get to work. In the immediate aftermath of the earthquake, there was great concern about the impact on traffic, since motorists would now have to crowd onto alternative routes or detour around the blockages by using city streets. Public officials and news programs warned commuters to expect massive delays and urged them to avoid unnecessary travel, reschedule their work to commute before or after the rush, or use mass transit. These warnings were unexpectedly effective. In fact, so many people heeded them that in the first few days following the quake, those who maintained their regular commuting routine actually found the drive to and from work faster than before. Of course, this situation could not last. As word spread that traffic was actually not bad at all, people abandoned their less convenient new commuting methods and reverted to their cars—and traffic got steadily worse. Within a few weeks after the quake, serious traffic jams had appeared. After a few more weeks, however, the situation stabilized: the reality of worse-than-usual congestion discouraged enough drivers to prevent the nightmare of citywide gridlock from materializing. Los Angeles traffic, in short, had settled into a new equilibrium, in which each commuter was making the best choice he or she could, given what everyone else was doing. This was not, by the way, the end of the story: fears that the city would strangle on traffic led local authorities to repair the roads with record speed. Within only 18 months after the quake, all the freeways were back to normal, ready for the next one. ▲ < < < < < < < < < < < < ➤ CHECK YOUR UNDERSTANDING 1-2 1. Explain how each of the following situations illustrates one of the five principles of interaction. a. Using the college website, any student who wants to sell a used textbook for at least $30 is able to sell it to someone who is willing to pay $30. b. At a college tutoring co-op, students can arrange to provide tutoring in subjects they are good in (like economics) in return for receiving tutoring in subjects they are poor in (like philosophy). ➤➤ feature of most economic situations is the interaction of choices made by individuals, the end result of which may be quite different from what was intended. In a market economy, interaction takes the form of trade between individuals. ➤ Individuals interact because there are gains from trade. Gains from trade arise from specialization. ➤ Economic situations normally move toward equilibrium. ➤ As far as possible, there should be an efficient use of resources to achieve society’s goals. But efficiency is not the only way to evaluate an economy; equity may also be desirable, and there is often a trade-off between equity and efficiency. ➤ Markets normally are efficient, except for certain well-defined exceptions. ➤ When markets fail to achieve efficiency, government intervention can improve society’s welfare 17 c. The local municipality imposes a law that requires bars and nightclubs near residential areas to keep their noise levels below a certain threshold. d. To provide better care for low-income patients, the local municipality has decided to close some underutilized neighborhood clinics and shift funds to the main hospital. e. On the college website, books of a given title with approximately the same level of wear and tear sell for about the same price. 2. Which of the following describes an equilibrium situation? Which does not? Explain your answer. a. The restaurants across the street from the university dining hall serve better-tasting and cheaper meals than those served at the university dining hall. The vast majority of students continue to eat at the dining hall. b. You currently take the subway to work. Although taking the bus is cheaper, the ride takes longer. So you are willing to pay the higher subway fare in order to save time. Solutions appear at back of book. Economy-Wide Interactions As we mentioned in the Introduction, the economy as a whole has its ups and downs. For example, business in America’s shopping malls was somewhat depressed in 2002, because the economy hadn’t fully recovered from the 2001 recession. To understand recessions, we need to understand economy-wide interactions, and understanding the big picture of the economy requires understanding three more important economic principles. Those three economy-wide principles are summarized in Table 1-3. One Person’s Spending is Another Person’s Income In 2001, corporations that had been buying a lot of computers, software, and other high-tech supplies in the late 1990s suddenly decided to cut back on their purchases. The result, economists agree, was a recession caused mainly by these cuts in business investment spending. As we mentioned in the previous chapter, this was followed by a sharp drop-off in spending at the nation’s retail stores. But why should a cut in spending by businesses mean empty stores in the shopping malls? After all, malls are places where families, not businesses, do their shopping. The answer is that lower business spending led to lower incomes throughout the economy, because people who had been making those computers or designing that software either lost their jobs or were forced to take pay cuts. And as incomes fell, so did spending by consumers. This story illustrates a general principle: One person’s spending is another person’s income. In a market economy, people make a living selling things—including their labor—to other people. If some group in the economy decides, for whatever reason, to spend more, the income of other groups will rise. If some group decides to spend less, the inc
ome of other groups will fall. Because one person’s spending is another person’s income, a chain reaction of changes in spending behavior tends to have repercussions that spread through the economy. For example, a cut in business investment spending, like the one that happened in 2001, leads to reduced family incomes; families respond by reducing consumer spending; this leads to another round of income cuts; and so on. These repercussions play an important role in our understanding of recessions and recoveries. Overall Spending Sometimes Gets Out of Line With the Economy’s Productive Capacity Macroeconomics emerged as a separate branch of economics in the 1930s, when a collapse of consumer and business spending, a crisis in the banking industry, and other factors led to a plunge in overall spending. This plunge in spending, in turn, led to a period of very high unemployment known as the Great Depression. TABLE 1-3 Principles That Underlie Economy-Wide Interactions 1. One person’s spending is another person’s income. 2. Overall spending sometimes gets out of line with the economy’s productive capacity. 3. Government policies can change spending. 18 P A R T 1 W H AT ? The lesson economists learned from the troubles of the 1930s is that overall spending—the amount of goods and services that consumers and businesses want to buy—sometimes doesn’t match the amount of goods and services the economy is capable of producing. In the 1930s, spending fell far short of what was needed to keep American workers employed, and the result was a severe economic slump. In fact, shortfalls in spending are responsible for most, though not all, recessions— although nothing like the Great Depression has happened since the 1930s. It’s also possible for overall spending to be too high. In that case, the economy experiences inflation, a rise in prices throughout the economy. This rise in prices occurs because when the amount that people want to buy outstrips the supply, producers can raise their prices and still find willing customers. Government Policies Can Change Spending Overall spending sometimes gets out of line with the economy’s productive capacity. But can anything be done about that? Yes, a lot. Government policies can have strong effects on spending. For one thing, the government itself does a lot of spending on everything from military equipment to education—and it can choose to do more or less. The government can also vary how much it collects from the public in taxes, which in turn affects how much income consumers and businesses have left to spend. And the government’s control of the quantity of money in circulation, it turns out, gives it another powerful tool with which to affect total spending. Government spending, taxes, and control of money are the tools of macroeconomic policy. Modern governments deploy these tools of macroeconomic policy in an effort to manage overall spending in the economy, trying to steer it between the perils of recession and inflation. These efforts aren’t always successful—recessions still happen, and so do periods of inflation. But it’s widely believed that the growing sophistication of macroeconomic policy is an important reason why the United States and other major economies seem to be more stable today than they were in the past. ➤ECONOMICS IN ACTION Adventures in Babysitting The website myarmylifetoo.com, which offers advice to army families, suggests that parents join a babysitting cooperative—an arrangement that is common in many walks of life. In a babysitting cooperative, a number of parents exchange babysitting services rather than hire someone to babysit. But how do these organizations make sure that everyone does their fair share of the work? As myarmylifetoo.com explains, “Instead of money, most co-ops exchange tickets or points. When you need a sitter, you call a friend on the list, and you pay them with tickets. You earn tickets by babysitting other children within the co-op.” In other words, a babysitting co-op is a miniature economy in which people buy and sell babysitting services. And it happens to be a type of economy that can have macroeconomic problems! A famous article titled “Monetary Theory and the Great Capitol Hill Babysitting Co-Op Crisis,” published in 1977, described the troubles of a babysitting cooperative that issued too few tickets. Bear in mind that, on average, people in a babysitting co-op want to have a reserve of tickets stashed away in case they need to go out several times before they can replenish their stash by doing some more babysitting. In this case, because there weren’t that many tickets out there to begin with, most parents were anxious to add to their reserves by babysitting but reluctant to run them down by going out. But one parent’s decision to go out was another’s chance to babysit, so it became difficult to earn tickets. Knowing this, parents became even more reluctant to use their reserves except on special occasions 19 ➤➤ ➤ Because individuals in a market economy derive their income from selling things, including their labor, to other people, one person’s spending is another person’s income. As a result, changes in spending behavior tend to have repercussions that spread through the economy. ➤ Overall spending sometimes gets out of line with the economy’s capacity to produce goods and services. When spending is too low, the result is a recession. When spending is too high, it causes inflation. ➤ Governments have a number of tools at their disposal that can strongly affect the overall level of spending. Modern governments use these tools in an effort to steer the economy between the perils of recession and inflation. In short, the co-op had fallen into a recession. Recessions in the larger, nonbabysitting economy are a bit more complicated than this, but the troubles of the Capitol Hill babysitting co-op demonstrate two of our three principles of economy-wide interactions. One person’s spending is another person’s income: opportunities to babysit arose only to the extent that other people went out. And an economy can suffer from too little spending: when not enough people were willing to go out, everyone was frustrated at the lack of babysitting opportunities. And what about government policies to change spending? Actually, the Capitol Hill co-op did that, too. Eventually, it solved its problem by handing out more tickets, and with increased reserves, people were willing to go out more. ▲ > > > > > > > > > > > > ➤ CHECK YOUR UNDERSTANDING 1-3 1. Explain how each of the following examples illustrates one of the three principles of economy-wide interactions. a. The White House urged Congress to pass major tax cuts in the spring of 2001, when it became clear that the U.S. economy was experiencing a slump. b. Oil companies are investing heavily in projects that will extract oil from the “oil sands” of Canada. In Edmonton, Alberta, near the projects, restaurants and other consumer businesses are booming. c. In the mid-2000s, Spain, which was experiencing a big housing boom, also had the high- est inflation rate in Europe. Solutions appear at back of book. [ ➤➤ A LOOK AHEAD ••• The twelve basic principles we have described lie behind almost all economic analysis. Although they can be immediately helpful in understanding many situations, they are usually not enough. Applying the principles to real economic issues takes one more step. That step is the creation of models—simplified representations of economic situations. Models must be realistic enough to provide real-world guidance but simple enough to allow us to clearly see the implications of the principles described in this chapter. So our next step is to show how models are used to actually do economic analysis.] S U M M A R Y 1. All economic analysis is based on a list of basic principles. These principles apply to three levels of economic understanding. First, we must understand how individuals make choices; second, we must understand how these choices interact; and third, we must understand how the economy functions overall. 2. Everyone has to make choices about what to do and what not to do. Individual choice is the basis of economics— if it doesn’t involve choice, it isn’t economics. 3. The reason choices must be made is that resources—anything that can be used to produce something else—are scarce. Individuals are limited in their choices by money and time; economies are limited by their supplies of human and natural resources. 4. Because you must choose among limited alternatives, the true cost of anything is what you must give up to get it— all costs are opportunity costs. 5. Many economic decisions involve questions not of “whether” but of “how much”—how much to spend on some good, how much to produce, and so on. Such decisions must be taken by performing a trade-off at the margin—by comparing the costs and benefits of doing a bit more or a bit less. Decisions of this type are called marginal decisions, and the study of them, marginal analysis, plays a central role in economics. 6. The study of how people should make decisions is also a good way to understand actual behavior. Individuals usually exploit opportunities to make themselves better off. 20 P A R T 1 W H AT ? If opportunities change, so does behavior: people respond to incentives. 7. Interaction—my choices depend on your choices, and vice versa—adds another level to economic understanding. When individuals interact, the end result may be different from what anyone intends. 8. The reason for interaction is that there are gains from trade: by engaging in the trade of goods and services with one another, the members of an economy can all be made better off. Underlying gains from trade are the advantages of specialization, of having individuals specialize in the tasks they are good at. 9. Economies normally move toward equilibrium—a situation in which no individual can make himself or herself better off by taking a different
action. 10. An economy is efficient if all opportunities to make some people better off without making other people worse off are taken. Resources should be used as efficiently as possible to achieve society’s goals. But efficiency is not the sole way to evaluate an economy: equity, or fairness, is also desirable, and there is often a trade-off between equity and efficiency. 11. Markets usually lead to efficiency, with some well- defined exceptions. 12. When markets fail and do not achieve efficiency, govern- ment intervention can improve society’s welfare. 13. One person’s spending is another person’s income. 14. Overall spending in the economy can get out of line with the economy’s productive capacity, leading to recession or inflation. 15. Governments have the ability to strongly affect overall spending, an ability they use in an effort to steer the economy between recession and inflation. K E Y T E R M S Individual choice, p. 6 Resource, p. 6 Scarce, p. 6 Opportunity cost, p. 7 Trade-off, p Marginal decisions, p. 9 Marginal analysis, p. 9 Incentive, p. 9 Interaction, p. 11 Trade, p. 12 Gains from trade, p. 12 Specialization, p. 12 Equilibrium, p. 13 Efficient, p. 14 Equity, p. 14 1. In each of the following situations, identify which of the g. There is limited lab space available to do the project twelve principles is at work. a. You choose to shop at the local discount store rather than paying a higher price for the same merchandise at the local department store. b. On your spring break trip, your budget is limited to $35 a day. c. The student union provides a website on which departing students can sell items such as used books, appliances, and furniture rather than giving them away to their roommates as they formerly did. d. After a hurricane did extensive damage to homes on the island of St. Crispin, homeowners wanted to purchase many more building materials and hire many more workers than were available on the island. As a result, prices for goods and services rose dramatically across the board. e. You buy a used textbook from your roommate. Your roommate uses the money to buy songs from iTunes. f. You decide how many cups of coffee to have when studying the night before an exam by considering how much more work you can do by having another cup versus how jittery it will make you feel. required in Chemistry 101. The lab supervisor assigns lab time to each student based on when that student is able to come. h. You realize that you can graduate a semester early by for- going a semester of study abroad. i. At the student union, there is a bulletin board on which people advertise used items for sale, such as bicycles. Once you have adjusted for differences in quality, all the bikes sell for about the same price. j. You are better at performing lab experiments, and your lab partner is better at writing lab reports. So the two of you agree that you will do all the experiments, and she will write up all the reports. k. State governments mandate that it is illegal to drive with- out passing a driving exam. l. Your parents’ after-tax income has increased because of a tax cut passed by Congress. They therefore increase your allowance, which you spend on a spring break vacation. 2. Describe some of the opportunity costs when you decide to do the following. a. Attend college instead of taking a job b. Watch a movie instead of studying for an exam c. Ride the bus instead of driving your car 3. Liza needs to buy a textbook for the next economics class. The price at the college bookstore is $65. One online site offers it for $55 and another site, for $57. All prices include sales tax. The accompanying table indicates the typical shipping and handling charges for the textbook ordered online. Shipping method Standard shipping Second-day air Next-day air Delivery time 3–7 days 2 business days 1 business day Charge $3.99 8.98 13.98 a. What is the opportunity cost of buying online instead of at the bookstore? Note that if you buy the book online, you must wait to get it. b. Show the relevant choices for this student. What determines which of these options the student will choose? 4. Use the concept of opportunity cost to explain the following. a. More people choose to get graduate degrees when the job market is poor. b. More people choose to do their own home repairs when the economy is slow and hourly wages are down. c. There are more parks in suburban than in urban areas. d. Convenience stores, which have higher prices than super- markets, cater to busy people. e. Fewer students enroll in classes that meet before 10:00 A.M. 5. In the following examples, state how you would use the prin- ciple of marginal analysis to make a decision. a. Deciding how many days to wait before doing your laundry b. Deciding how much library research to do before writing your term paper c. Deciding how many bags of chips to eat d. Deciding how many lectures of a class to skip 6. This morning you made the following individual choices: you bought a bagel and coffee at the local café, you drove to school in your car during rush hour, and you typed your roommate’s term paper because you are a fast typist—in return for which she will do your laundry for a month. For each of these actions, describe how your individual choices interacted with the individual choices made by others. Were other people left better off or worse off by your choices in each case? 7. The Hatfield family lives on the east side of the Hatatoochie River, and the McCoy family lives on the west side. Each family’s diet consists of fried chicken and corn-on-the-cob, and each is self-sufficient, raising their own chickens and growing their own corn. Explain the conditions under which each of the following would be true 21 a. The two families are made better off when the Hatfields specialize in raising chickens, the McCoys specialize in growing corn, and the two families trade. b. The two families are made better off when the McCoys specialize in raising chickens, the Hatfields specialize in growing corn, and the two families trade. 8. Which of the following situations describes an equilibrium? Which does not? If the situation does not describe an equilibrium, what would an equilibrium look like? a. Many people regularly commute from the suburbs to downtown Pleasantville. Due to traffic congestion, the trip takes 30 minutes when you travel by highway but only 15 minutes when you go by side streets. b. At the intersection of Main and Broadway are two gas stations. One station charges $3.00 per gallon for regular gas and the other charges $2.85 per gallon. Customers can get service immediately at the first station but must wait in a long line at the second. c. Every student enrolled in Economics 101 must also attend a weekly tutorial. This year there are two sections offered: section A and section B, which meet at the same time in adjoining classrooms and are taught by equally competent instructors. Section A is overcrowded, with people sitting on the floor and often unable to see the chalkboard. Section B has many empty seats. 9. In each of the following cases, explain whether you think the situation is efficient or not. If it is not efficient, why not? What actions would make the situation efficient? a. Electricity is included in the rent at your dorm. Some residents in your dorm leave lights, computers, and appliances on when they are not in their rooms. b. Although they cost the same amount to prepare, the cafeteria in your dorm consistently provides too many dishes that diners don’t like, such as tofu casserole, and too few dishes that diners do like, such as roast turkey with dressing. c. The enrollment for a particular course exceeds the spaces available. Some students who need to take this course to complete their major are unable to get a space even though others who are taking it as an elective do get a space. 10. Discuss the efficiency and equity implications of each of the following policies. How would you go about balancing the concerns of equity and efficiency in these areas? a. The government pays the full tuition for every college student to study whatever subject he or she wishes. b. When people lose their jobs, the government provides unemployment benefits until they find new ones. 11. Governments often adopt certain policies in order to promote desired behavior among their citizens. For each of the following policies, determine what the incentive is and what behavior the government wishes to promote. In each case, why do you think that the government might wish to change people’s behavior, rather than allow their actions to be solely determined by individual choice? a. A tax of $5 per pack is imposed on cigarettes. 22 P A R T 1 W H AT . The government pays parents $100 when their child is vaccinated for measles. c. The government pays college students to tutor children from low-income families. d. The government imposes a tax on the amount of air pollution that a company discharges. 12. In each of the following situations, explain how government intervention could improve society’s welfare by changing people’s incentives. In what sense is the market going wrong? a. Pollution from auto emissions has reached unhealthy levels. b. Everyone in Woodville would be better off if streetlights were installed in the town. But no individual resident is willing to pay for installation of a streetlight in front of his or her house because it is impossible to recoup the cost by charging other residents for the benefit they receive from it. 13. In his January 31, 2007, speech on the state of the economy, President George W. Bush said that “Since we enacted major tax relief into law in 2003, our economy has created nearly 7.2 million new jobs. Our economy has expanded by more than 13 percent.” Which two of the three principles of economywide interaction are at work in this statement? 14. In August 2007, a sharp downturn in the U.S. housing market reduced the income of many who w
orked in the home construction industry. A Wall Street Journal news article reported that Wal-Mart’s wire-transfer business was likely to suffer because many construction workers are Hispanics who regularly send part of their wages back to relatives in their home countries via Wal-Mart. With this information, use one of the principles of economy-wide interaction to trace a chain of links that explains how reduced spending for U.S. home purchases is likely to affect the performance of the Mexican economy. 15. In 2005, Hurricane Katrina caused massive destruction to the U.S. Gulf Coast. Tens of thousands of people lost their homes and possessions. Even those who weren’t directly affected by the destruction were hurt because businesses and jobs dried up. Using one of the principles of economy-wide interaction, explain how government intervention can help in this situation. 16. During the Great Depression, food was left to rot in the fields or fields that had once been actively cultivated were left fallow. Use one of the principles of economy-wide interaction to explain how this could have occurred. www.worthpublishers.com/krugmanwells chapter: 2 >> Economic Models: Trade-offs and Trade 1901 WILBUR AND ORVILLE WRIGHT BUILT In fact, you could say that economic theory consists something that would change the world. No, not mainly of a collection of models, a series of simplified rep- the airplane—their successful flight at Kitty Hawk resentations of economic reality that allow us to under- would come two years later. What made the Wright stand a variety of economic issues. In this chapter, we will brothers true visionaries was their wind tunnel, an appa- look at two economic models that are crucially important ratus that let them experiment with many different in their own right and also illustrate why such models are designs for wings and control surfaces. These experi- so useful. We’ll conclude with a look at how economists ments gave them the knowledge that would make actually use models in their work. heavier-than-air flight possible. A miniature airplane sitting motionless in a wind tunnel isn’t the same thing as an actual aircraft in flight. But it is a very useful model of a flying plane—a simplified representation of the real thing that can be used to answer crucial questions, such as how much lift a given wing shape will generate at a given air- speed. Needless to say, testing an airplane design in a wind tunnel is cheaper and safer than building a full-scale version and hoping it will fly. More generally, models play a crucial role in almost all scientific research—economics very much included. Clearly, the Wright brothers believed in their model WHAT YOU WILL LEARN IN THIS CHAPTER: ➤ Why models—simplified representations ➤ The circular-flow diagram, a of reality—play a crucial role in economics ➤ Two simple but important models: the production possibility frontier and comparative advantage schematic representation of the economy describe the economy and predict its behavior, and normative economics, which tries to prescribe economic policy ➤ The difference between positive ➤ When economists agree and why they economics, which tries to sometimes disagree 23 24 model is a simplified representation of a real situation that is used to better understand real-life situations. The other things equal assumption means that all other relevant factors remain unchanged. Models in Economics: Some Important Examples A model is any simplified representation of reality that is used to better understand real-life situations. But how do we create a simplified representation of an economic situation? One possibility—an economist’s equivalent of a wind tunnel—is to find or create a real but simplified economy. For example, economists interested in the economic role of money have studied the system of exchange that developed in World War II prison camps, in which cigarettes became a universally accepted form of payment even among prisoners who didn’t smoke. Another possibility is to simulate the workings of the economy on a computer. For example, when changes in tax law are proposed, government officials use tax models— large mathematical computer programs—to assess how the proposed changes would affect different types of people. Models are important because their simplicity allows economists to focus on the effects of only one change at a time. That is, they allow us to hold everything else constant and study how one change affects the overall economic outcome. So an important assumption when building economic models is the other things equal assumption, which means that all other relevant factors remain unchanged. But you can’t always find or create a small-scale version of the whole economy, and a computer program is only as good as the data it uses. (Programmers have a saying: garbage in, garbage out.) For many purposes, the most effective form of economic modeling is the construction of “thought experiments”: simplified, hypothetical versions of real-life situations. In Chapter 1 we illustrated the concept of equilibrium with the example of how customers at a supermarket would rearrange themselves when a new cash register opens. Though we didn’t say it, this was an example of a simple model—an imaginary Models for Money What’s an economic model worth, anyway? In some cases, quite a lot of money. Although many economic models are developed for purely scientific purposes, others are developed to help governments make economic policies. And there is a growing business in developing economic models to help corporations make decisions. Who models for money? There are dozens of consulting firms that use models to predict future trends, offer advice based on their models, or develop custom models for business and government clients. A notable example is Global Insight, the world’s biggest economic consulting firm. It was created by a merger between Data Resources, Inc., founded by professors from Harvard and MIT, and Wharton Economic Forecasting Associates, founded by professors at the University of Pennsylvania. One particularly lucrative branch of economics is finance theory, which helps investors figure out what assets, such as shares in a company, are worth. Finance theorists often become highly paid “rocket scientists” at big Wall Street firms because financial models demand a high level of technical expertise. Unfortunately, the most famous business application of finance theory came spectacularly to grief. In 1994 a group of Wall Street traders teamed up with famous finance theorists—including two Nobel Prize winners—to form Long-Term Capital Management (LTCM), a fund that used sophisticated financial models to invest the money of wealthy clients. At first, the fund did very well. But in 1998 bad economic news from all over the world— with countries as disparate as Russia, Japan, and Brazil in financial trouble at the same time—inflicted huge losses on LTCM’s investments. For a few anxious days, many people feared not only that the fund would collapse but also that it would bring many other companies down with it. Thanks in part to a rescue operation organized by government officials, this did not happen; but LTCM was closed a few months later, having lost millions of dollars and with some of its investors losing most of the money they had put in. What went wrong? Partly it was bad luck. But experienced hands also faulted the economists at LTCM for taking too many risks. Although LTCM’s models indicated that a run of bad news like the one that actually happened was extremely unlikely, a sensible economist knows that sometimes even the best model misses important possibilities. Interestingly, a similar phenomenon occurred in the summer of 2007, when problems in the financial market for home mortgage loans caused severe losses for several investment funds. It turns out that these funds had made the same mistake as LTCM—omitting from their models the possibility of a severe downturn in the home mortgage loan market 25 supermarket, in which many details were ignored (what are the customers buying? never mind), that could be used to answer a “what if” question: what if another cash register were opened? As the cash register story showed, it is often possible to describe and analyze a useful economic model in plain English. However, because much of economics involves changes in quantities—in the price of a product, the number of units produced, or the number of workers employed in its production—economists often find that using some mathematics helps clarify an issue. In particular, a numerical example, a simple equation, or—especially—a graph can be key to understanding an economic concept. Whatever form it takes, a good economic model can be a tremendous aid to understanding. The best way to grasp this point is to consider some simple but important economic models and what they tell us. First, we will look at the production possibility frontier, a model that helps economists think about the trade-offs every economy faces. Then we will turn to comparative advantage, a model that clarifies the principle of gains from trade—trade both between individuals and between countries. In addition, we’ll examine the circular-flow diagram, a schematic representation that helps us understand how flows of money, goods, and services are channeled through the economy. In discussing these models, we make considerable use of graphs to represent mathematical relationships. Such graphs will play an important role throughout this book. If you are already familiar with the use of graphs, the material that follows should not present any problem. If you are not, this would be a good time to turn to the appendix of this chapter, which provides a brief introduction to the use of graphs in economics. Trade-offs: The Production Possibility Frontier The hit movie Cast Away, starring Tom Hanks, was an update of the classic story of Robinson Crusoe, the h
ero of Daniel Defoe’s eighteenth-century novel. Hanks played the sole survivor of a plane crash, stranded on a remote island. As in the original story of Robinson Crusoe, the character played by Hanks had limited resources: the natural resources of the island, a few items he managed to salvage from the plane, and, of course, his own time and effort. With only these resources, he had to make a life. In effect, he became a one-man economy. The first principle of economics we introduced in Chapter 1 was that resources are scarce and that, as a result, any economy—whether it contains one person or millions of people—faces trade-offs. For example, if a castaway devotes resources to catching fish, he cannot use those same resources to gather coconuts. To think about the trade-offs that face any economy, economists often use the model known as the production possibility frontier. The idea behind this model is to improve our understanding of trade-offs by considering a simplified economy that produces only two goods. This simplification enables us to show the trade-off graphically. Figure 2-1 on the next page shows a hypothetical production possibility frontier for Tom, a castaway alone on an island, who must make a trade-off between production of fish and production of coconuts. The frontier—the line in the diagram—shows the maximum quantity of fish Tom can catch during a week given the quantity of coconuts he gathers, and vice versa. That is, it answers questions of the form, “What is the maximum quantity of fish Tom can catch if he also gathers 9 (or 15, or 30) coconuts?” There is a crucial distinction between points inside or on the production possibility frontier (the shaded area) and outside the frontier. If a production point lies inside or on the frontier—like point C, at which Tom catches 20 fish and gathers 9 coconuts—it is feasible. After all, the frontier tells us that if Tom catches 20 fish, he could also gather a maximum of 15 coconuts, so he could The production possibility frontier illustrates the trade-offs facing an economy that produces only two goods. It shows the maximum quantity of one good that can be produced for any given quantity produced of the other. What to do? Even a castaway faces trade-offs 26 ? FIGURE 2-1 The Production Possibility Frontier The production possibility frontier illustrates the trade-offs facing an economy that produces two goods. It shows the maximum quantity of one good that can be produced given the quantity of the other good produced. Here, the maximum quantity of coconuts that Tom can gather depends on the quantity of fish he catches, and vice versa. His feasible production is shown by the area inside or on the curve. Production at point C is feasible but not efficient. Points A and B are feasible and efficient in production, but point D is not feasible. Quantity of coconuts 30 15 9 0 Feasible and efficient in production A Feasible but not efficient C B D Not feasible Production possibility frontier PPF 20 28 40 Quantity of fish certainly gather 9 coconuts. However, a production point that lies outside the frontier—such as the hypothetical production point D, where Tom catches 40 fish and gathers 30 coconuts—isn’t feasible. (In this case, Tom could catch 40 fish and gather no coconuts or he could gather 30 coconuts and catch no fish, but he can’t do both.) In Figure 2-1 the production possibility frontier intersects the horizontal axis at 40 fish. This means that if Tom devoted all his resources to catching fish, he would catch 40 fish per week but would have no resources left over to gather coconuts. The production possibility frontier intersects the vertical axis at 30 coconuts. This means that if Tom devoted all his resources to gathering coconuts, he could gather 30 coconuts per week but would have no resources left over to catch fish. The figure also shows less extreme trade-offs. For example, if Tom decides to catch 20 fish, he is able to gather at most 15 coconuts; this production choice is illustrated by point A. If Tom decides to catch 28 fish, he can gather at most only 9 coconuts, as shown by point B. Thinking in terms of a production possibility frontier simplifies the complexities of reality. The real-world economy produces millions of different goods. Even a castaway on an island would produce more than two different items (for example, he would need clothing and housing as well as food). But in this model we imagine an economy that produces only two goods. By simplifying reality, however, the production possibility frontier helps us understand some aspects of the real economy better than we could without the model: efficiency, opportunity cost, and economic growth. Efficiency First of all, the production possibility frontier is a good way to illustrate the general economic concept of efficiency. Recall from Chapter 1 that an economy is efficient if there are no missed opportunities—there is no way to make some people better off without making other people worse off. One key element of efficiency is that there are no missed opportunities in production—there is no way to produce more of one good without producing less of other goods. As long as Tom is on the production possibility frontier, his production is efficient. At point A, the 15 coconuts he gathers are the maximum quantity he can get given that he has chosen to catch 20 fish; at point B, the 9 coconuts he gathers are the maximum he can get given his choice to catch 28 fish; and so on. If an economy is producing at a point on its production possibility frontier, we say that the economy is efficient in production 27 But suppose that for some reason Tom was at point C, producing 20 fish and 9 coconuts. Then this one-person economy would definitely not be efficient in production, and would therefore be inefficient: it could be producing more of both goods. Another example of this occurs when people are involuntarily unemployed: they want to work but are unable to find jobs. When that happens, the economy is not efficient in production because it could be producing more output if these people were employed. Although the production possibility frontier helps clarify what it means for an economy to be efficient in production, it’s important to understand that efficiency in production is only part of what’s required for the economy as a whole to be efficient. Efficiency also requires that the economy allocate its resources so that consumers are as well off as possible. If an economy does this, we say that it is efficient in allocation. To see why efficiency in allocation is as important as efficiency in production, notice that points A and B in Figure 2-1 both represent situations in which the economy is efficient in production, because in each case it can’t produce more of one good without producing less of the other. But these two situations may not be equally desirable. Suppose that Tom prefers point B to point A—that is, he would rather consume 28 fish and 9 coconuts than 20 fish and 15 coconuts. Then point A is inefficient from the point of view of the economy as a whole: it’s possible to make Tom better off without making anyone else worse off. (Of course, in this castaway economy there isn’t anyone else: Tom is all alone.) This example shows that efficiency for the economy as a whole requires both efficiency in production and efficiency in allocation: to be efficient, an economy must produce as much of each good as it can given the production of other goods, and it must also produce the mix of goods that people want to consume. In the real world, command economies, such as the former Soviet Union, were notorious for inefficiency in allocation. For example, it was common for consumers to find a store stocked with a few odd items of merchandise, but lacking such basics as soap and toilet paper. Opportunity Cost The production possibility frontier is also useful as a reminder of the fundamental point that the true cost of any good is not just the amount of money it costs to buy, but everything else in addition to money that must be given up in order to get that good—the opportunity cost. If, for example, Tom decides to go from point A to point B, he will produce 8 more fish but 6 fewer coconuts. So the opportunity cost of those 8 fish is the 6 coconuts not gathered. Since 8 extra fish have an opportunity cost of 6 coconuts, each 1 fish has an opportunity cost of 6⁄8 = 3⁄4 of a coconut. Is the opportunity cost of an extra fish in terms of coconuts always the same, no matter how many fish Tom catches? In the example illustrated by Figure 2-1, the answer is yes. If Tom increases his catch from 28 to 40 fish, the number of coconuts he gathers falls from 9 to zero. So his opportunity cost per additional fish is 9⁄12 = 3⁄4 of a coconut, the same as it was when he went from 20 fish caught to 28. However, the fact that in this example the opportunity cost of an additional fish in terms of coconuts is always the same is a result of an assumption we’ve made, an assumption that’s reflected in how Figure 2-1 is drawn. Specifically, whenever we assume that the opportunity cost of an additional unit of a good doesn’t change regardless of the output mix, the production possibility frontier is a straight line. Moreover, as you might have already guessed, the slope of a straight-line production possibility frontier is equal to the opportunity cost—specifically, the opportunity cost for the good measured on the horizontal axis in terms of the good measured on the vertical axis. In Figure 2-1, the production possibility frontier has a constant slope of −3⁄4, implying that Tom faces a constant opportunity cost for 1 fish equal to 3⁄4 of a coconut. (A review of how to calculate the slope of a straight line is found in this chapter’s appendix.) This is the simplest case, but the production possibility frontier model can also be used to examine situations in which opportunity costs change as the mix of output changes. 28
? FIGURE 2-2 Increasing Opportunity Cost The bowed-out shape of the production possibility frontier reflects increasing opportunity cost. In this example, to produce the first 20 fish, Tom must give up 5 coconuts. But to produce an additional 20 fish, he must give up 25 more coconuts. Quantity of coconuts 35 30 25 20 15 10 5 0 Producing the first 20 fish . . . . . . requires giving up 5 coconuts. But producing 20 more fish . . . A . . . requires giving up 25 more coconuts. PPF 40 50 Quantity of fish 10 20 30 Figure 2-2 illustrates a different assumption, a case in which Tom faces increasing opportunity cost. Here, the more fish he catches, the more coconuts he has to give up to catch an additional fish, and vice versa. For example, to go from producing zero fish to producing 20 fish, he has to give up 5 coconuts. That is, the opportunity cost of those 20 fish is 5 coconuts. But to increase his fish production to 40—that is, to produce an additional 20 fish—he must give up 25 more coconuts, a much higher opportunity cost. As you can see in Figure 2-2, when opportunity costs are increasing rather than constant, the production possibility frontier is a bowed-out curve rather than a straight line. Although it’s often useful to work with the simple assumption that the production possibility frontier is a straight line, economists believe that in reality opportunity costs are typically increasing. When only a small amount of a good is produced, the opportunity cost of producing that good is relatively low because the economy needs to use only those resources that are especially well suited for its production. For example, if an economy grows only a small amount of corn, that corn can be grown in places where the soil and climate are perfect for corn-growing but less suitable for growing anything else, like wheat. So growing that corn involves giving up only a small amount of potential wheat output. Once the economy grows a lot of corn, however, land that is well suited for wheat but isn’t so great for corn must be used to produce corn anyway. As a result, the additional corn production involves sacrificing considerably more wheat production. In other words, as more of a good is produced, its opportunity cost typically rises because well-suited inputs are used up and less adaptable inputs must be used instead. Economic Growth Finally, the production possibility frontier helps us understand what it means to talk about economic growth. We introduced the concept of economic growth in the Introduction, defining it as the growing ability of the economy to produce goods and services. As we saw, economic growth is one of the fundamental features of the real economy. But are we really justified in saying that the economy has grown over time? After all, although the U.S. economy produces more of many things than it did a century ago, it produces less of other things—for example, horse-drawn carriages. Production of many goods, in other words, is actually down. So how can we say for sure that the economy as a whole has grown? The answer, illustrated in Figure 2-3, is that economic growth means an expansion of the economy’s production possibilities: the economy can produce more of everything. For example, if Tom’s production is initially at point A (20 fish and 25 coconuts), 29 FIGURE 2-3 Economic Growth Economic growth results in an outward shift of the production possibility frontier because production possibilities are expanded. The economy can now produce more of everything. For example, if production is initially at point A (20 fish and 25 coconuts), it could move to point E (25 fish and 30 coconuts). Quantity of coconuts 35 30 25 20 15 10 5 0 E A 10 20 25 30 Original PPF New PPF 40 50 Quantity of fish economic growth means that he could move to point E (25 fish and 30 coconuts). E lies outside the original frontier; so in the production possibility frontier model, growth is shown as an outward shift of the frontier. What can lead the production possibility frontier to shift outward? There are basically two sources of economic growth. One is an increase in the economy’s factors of production, the resources used to produce goods and services. Economists usually use the term factor of production to refer to a resource that is not used up in production. For example, workers use sewing machines to convert cloth into shirts; the workers and the sewing machines are factors of production, but the cloth is not. Once a shirt is made, a worker and a sewing machine can be used to make another shirt; but the cloth used to make one shirt cannot be used to make another. Broadly speaking, the main factors of production are the resources land, labor, capital, and human capital. Land is a resource supplied by nature; labor is the economy’s pool of workers; capital refers to “created” resources such as machines and buildings; and human capital refers to the educational achievements and skills of the labor force, which enhance its productivity. Of course, each of these is really a category rather than a single factor: land in North Dakota is quite different from land in Florida. To see how adding to an economy’s factors of production leads to economic growth, suppose that Tom finds a fishing net washed ashore on the beach that is larger than the net he currently uses. The fishing net is a factor of production, a resource he can use to produce more fish in the course of a day spent fishing. We can’t say how many more fish Tom will catch; that depends on how much time he decides to spend fishing now that he has the larger net. But because the larger net makes his fishing more productive, he can catch more fish without reducing the number of coconuts he gathers, or gather more coconuts without reducing his fish catch. So his production possibility frontier shifts outward. The other source of economic growth is progress in technology, the technical means for the production of goods and services. Suppose Tom figures out a better way either to catch fish or to gather coconuts—say, by inventing a fishing hook or a wagon for transporting coconuts. Either invention would shift his production possibility frontier outward. In real-world economies, innovations in the techniques we use to produce goods and services have been a crucial force behind economic growth. Again, economic growth means an increase in what the economy can produce. What the economy actually produces depends on the choices people make. After his production possibilities expand, Tom might not choose to produce both more fish and more Factors of production are resources used to produce goods and services. Technology is the technical means for producing goods and services. 30 ? coconuts—he might choose to increase production of only one good, or he might even choose to produce less of one good. For example, if he gets better at catching fish, he might decide to go on an all-fish diet and skip the coconuts—just as the introduction of motor vehicles led most people to give up on horse-drawn carriages. But even if, for some reason, he chooses to produce either fewer coconuts or fewer fish than before, we would still say that his economy has grown—because he could have produced more of everything. The production possibility frontier is a very simplified model of an economy. Yet it teaches us important lessons about real-life economies. It gives us our first clear sense of what constitutes economic efficiency, it illustrates the concept of opportunity cost, and it makes clear what economic growth is all about. Comparative Advantage and Gains from Trade Among the twelve principles of economics described in Chapter 1 was the principle of gains from trade—the mutual gains that individuals can achieve by specializing in doing different things and trading with one another. Our second illustration of an economic model is a particularly useful model of gains from trade—trade based on comparative advantage. Let’s stick with Tom stranded on his island, but now let’s suppose that a second castaway, who just happens to be named Hank, is washed ashore. Can they benefit from trading with each other? It’s obvious that there will be potential gains from trade if the two castaways do different things particularly well. For example, if Tom is a skilled fisherman and Hank is very good at climbing trees, clearly it makes sense for Tom to catch fish and Hank to gather coconuts—and for the two men to trade the products of their efforts. But one of the most important insights in all of economics is that there are gains from trade even if one of the trading parties isn’t especially good at anything. Suppose, for example, that Hank is less well suited to primitive life than Tom; he’s not nearly as good at catching fish, and compared to Tom even his coconutgathering leaves something to be desired. Nonetheless, what we’ll see is that both Tom and Hank can live better by trading with each other than either could alone. For the purposes of this example, let’s go back to the simpler case of straight-line production possibility frontiers. Tom’s production possibilities are represented by the FIGURE 2-4 Production Possibilities for Two Castaways (a) Tom’s Production Possibilities (b) Hank’s Production Possibilities Quantity of coconuts 30 9 0 Quantity of coconuts Tom’s consumption without trade Tom’s PPF 28 40 Quantity of fish 20 8 0 Hank’s consumption without trade Hank’s PPF 6 10 Quantity of fish Here, each of the two castaways has a constant opportunity cost of fish and a straight-line production possibility frontier. In Tom’s case, each fish always has an opportunity cost of 3⁄4 of a coconut. In Hank’s case, each fish always has an opportunity cost of 2 coconuts 31 production possibility frontier in panel (a) of Figure 2-4, which is the same as the production possibility frontier in Figure 2-1. According to this diagram, Tom could catch 40 fish, but only if he gathered no coconuts, and could gather 30 coconuts, but
only if he caught no fish, as before. Recall that this means that the slope of his production possibility frontier is −3⁄4: his opportunity cost of 1 fish is 3⁄4 of a coconut. An individual has a comparative advantage in producing a good or service if the opportunity cost of producing the good or service is lower for that individual than for other people. TABLE 2-1 Tom’s and Hank’s Opportunity Costs of Fish and Coconuts Tom’s Opportunity Cost 3/4 coconut 4/3 fish Hank’s Opportunity Cost 2 coconuts 1/2 fish Panel (b) of Figure 2-4 shows Hank’s production possibilities. Like Tom’s, Hank’s production possibility frontier is a straight line, implying a constant opportunity cost of fish in terms of coconuts. His production possibility frontier has a constant slope of −2. Hank is less productive all around: at most he can produce 10 fish or 20 coconuts. But he is particularly bad at fishing; whereas Tom sacrifices 3⁄4 of a coconut per fish caught, for Hank the opportunity cost of a fish is 2 whole coconuts. Table 2-1 summarizes the two castaways’ opportunity costs of fish and coconuts. One coconut One fish Now, Tom and Hank could go their separate ways, each living on his own side of the island, catching his own fish and gathering his own coconuts. Let’s suppose that they start out that way and make the consumption choices shown in Figure 2-4: in the absence of trade, Tom consumes 28 fish and 9 coconuts per week, while Hank consumes 6 fish and 8 coconuts. But is this the best they can do? No, it isn’t. Given that the two castaways have different opportunity costs, they can strike a deal that makes both of them better off. Table 2-2 shows how such a deal works: Tom specializes in the production of fish, catching 40 per week, and gives 10 to Hank. Meanwhile, Hank specializes in the production of coconuts, gathering 20 per week, and gives 10 to Tom. The result is shown in Figure 2-5 on the next page. Tom now consumes more of both goods than before: instead of 28 fish and 9 coconuts, he consumes 30 fish and 10 coconuts. And Hank also consumes more, going from 6 fish and 8 coconuts to 10 fish and 10 coconuts. As Table 2-2 also shows, both Tom and Hank experience gains from trade: Tom’s consumption of fish increases by two, and his consumption of coconuts increases by one. Hank’s consumption of fish increases by four, and his consumption of coconuts increases by two. So both castaways are better off when they each specialize in what they are good at and trade. It’s a good idea for Tom to catch the fish for both of them because his opportunity cost of a fish is only 3⁄4 of a coconut not gathered versus 2 coconuts for Hank. Correspondingly, it’s a good idea for Hank to gather coconuts for both of them. Or we could put it the other way around: Because Tom is so good at catching fish, his opportunity cost of gathering coconuts is high: 4⁄3 of a fish not caught for every coconut gathered. Because Hank is a pretty poor fisherman, his opportunity cost of gathering coconuts is much less, only 1⁄2 of a fish per coconut. What we would say in this case is that Tom has a comparative advantage in catching fish and Hank has a comparative advantage in gathering coconuts. An individual has a comparative advantage in producing something if the opportunity cost of that production is lower for that individual than for other people. In other words, Hank has a comparative advantage over Tom in producing a particular good or service if Hank’s opportunity cost of producing that good or service is lower than Tom’s. TABLE 2-2 How the Castaways Gain from Trade Without Trade With Trade Gains from Trade Production Consumption Production Consumption Tom Hank Fish Coconuts Fish Coconuts 28 9 6 8 28 9 6 8 40 0 0 20 30 10 10 10 +2 +1 +4 +2 32 ? FIGURE 2-5 Comparative Advantage and Gains From Trade (a) Tom’s Production and Consumption (b) Hank’s Production and Consumption Quantity of coconuts Quantity of coconuts 30 10 9 0 Tom’s consumption without trade Tom’s consumption with trade Tom’s production with trade Tom's PPF Hank’s production with trade 20 10 8 Hank’s consumption with trade Hank’s consumption without trade Hank's PPF 28 30 40 0 6 10 Quantity of fish Quantity of fish By specializing and trading, the two castaways can produce and consume more of both goods. Tom specializes in catching fish, his comparative advantage, and Hank— who has an absolute disadvantage in both goods but a comparative advantage in coconuts—specializes in gathering coconuts. The result is that each castaway can consume more of both goods than either could without trade. One point of clarification before we proceed further. You may have wondered why Tom and Hank traded 10 fish for 10 coconuts. Why not some other deal, like trading 15 coconuts for 5 fish? The answer to that question has two parts. First, there may indeed be deals other than 10 fish for 10 coconuts that Tom and Hank are willing to agree to. Second, there are some deals that we can, however, safely rule out—one like 15 coconuts for 5 fish. To understand why, reexamine Table 2-1 and consider Hank first. When Hank works on his own without trading with Tom, his opportunity cost of 1 fish is 2 coconuts. Therefore, it’s clear that Hank will not accept any deal with Tom in which he must give up more than 2 coconuts per fish—otherwise, he’s better off not trading at all. So we can rule out a deal that requires Hank to pay 3 coconuts per fish—such as trading 15 coconuts for 5 fish. But Hank will accept a trade in which he pays less than 2 coconuts per fish—such as paying 1 coconut for 1 fish. Likewise, Tom will reject a deal that requires him to give up more than 4⁄3 of a fish per coconut. For example, Tom would refuse a trade that required him to give up 10 fish for 6 coconuts. But he will accept a deal where he pays less than 4⁄3 of a fish per coconut— and 1 fish for 1 coconut works. You can check for yourself why a trade of 1 fish for 1.5 coconuts would also be acceptable to both Tom and Hank. So the point to remember is that Tom and Hank will be willing to engage in a trade only if the “price” of the good each person is obtaining from the trade is less than his own opportunity cost of producing the good himself. Moreover, that’s a general statement that is true whenever two parties trade voluntarily. The story of Tom and Hank clearly simplifies reality. Yet it teaches us some very important lessons that apply to the real economy, too. First, the model provides a clear illustration of the gains from trade: by agreeing to specialize and provide goods to each other, Tom and Hank can produce more and therefore both be better off than if they tried to be self-sufficient. Second, the model demonstrates a very important point that is often overlooked in real-world arguments: as long as people have different opportunity costs, everyone has a comparative advantage in something, and everyone has a comparative disadvantage in something 33 An individual has an absolute advantage in an activity if he or she can do it better than other people. Having an absolute advantage is not the same thing as having a comparative advantage. Notice that in our example Tom is actually better than Hank at producing both goods: Tom can catch more fish in a week, and he can also gather more coconuts. That is, Tom has an absolute advantage in both activities: he can produce more output with a given amount of input (in this case, his time) than Hank. You might therefore be tempted to think that Tom has nothing to gain from trading with the less competent Hank. But we’ve just seen that Tom can indeed benefit from a deal with Hank because comparative, not absolute, advantage is the basis for mutual gain. It doesn’t matter that it takes Hank more time to gather a coconut; what matters is that for him the opportunity cost of that coconut in terms of fish is lower. So Hank, despite his absolute disadvantage, even in coconuts, has a comparative advantage in coconutgathering. Meanwhile Tom, who can use his time better by catching fish, has a comparative disadvantage in coconut-gathering. If comparative advantage were relevant only to castaways, it might not be that interesting. In fact, however, the idea of comparative advantage applies to many activities in the economy. Perhaps its most important application is to trade—not between individuals, but between countries. So let’s look briefly at how the model of comparative advantage helps in understanding both the causes and the effects of international trade. Comparative Advantage and International Trade Look at the label on a manufactured good sold in the United States, and there’s a good chance you will find that it was produced in some other country—in China, or Japan, or even in Canada, eh? On the other side, many U.S. industries sell a large fraction of their output overseas. (This is particularly true of agriculture, high technology, and entertainment.) Should all this international exchange of goods and services be celebrated, or is it cause for concern? Politicians and the public often question the desirability of international trade, arguing that the nation should produce goods for itself rather than buying them from foreigners. Industries around the world demand protection from foreign competition: Japanese farmers want to keep out American rice, American steelworkers want to keep out European steel. And these demands are often supported by public opinion. Economists, however, have a very positive view of international trade. Why? Because they view it in terms of comparative advantage. Figure 2-6 on the next page shows, with a simple example, how international trade can be interpreted in terms of comparative advantage. Although the example as constructed is hypothetical, it is based on an actual pattern of international trade: American exports of pork to Canada and Canadian exports of aircraft to the United States. Panels (a) and (b) illustrate hypothetical production possibility frontiers for
the United States and Canada, with pork measured on the horizontal axis and aircraft measured on the vertical axis. The U.S. production possibility frontier is flatter than the Canadian frontier, implying that producing one more ton of pork costs a lot fewer aircraft in the United States than it does in Canada. This means that the United States has a comparative advantage in pork and Canada has a comparative advantage in aircraft. Although the consumption points in Figure 2-6 are hypothetical, they illustrate a general principle: just like the example of Tom and Hank, the United States and Canada can both achieve mutual gains from trade. If the United States concentrates on producing pork and ships some of its output to Canada, while Canada concentrates on aircraft and ships some of its output to the United States, both countries can consume more than if they insisted on being self-sufficient. P I T F A L L S misunderstanding comparative advantage Students do it, pundits do it, and politicians do it all the time: they confuse comparative advantage with absolute advantage. For example, back in the 1980s, when the U.S. economy seemed to be lagging behind that of Japan, one often heard commentators warn that if we didn’t improve our productivity, we would soon have no comparative advantage in anything. What those commentators meant was that we would have no absolute advantage in anything—that there might come a time when the Japanese were better at everything than we were. (It didn’t turn out that way, but that’s another story.) And they had the idea that in that case we would no longer be able to benefit from trade with Japan. But just as Hank is able to benefit from trade with Tom (and vice versa) despite the fact that Tom is better at everything, nations can still gain from trade even if they are less productive in all industries than the countries they trade with. 34 ? FIGURE 2-6 Comparative Advantage and International Trade (a) U.S. Production Possibility Frontier (b) Canadian Production Possibility Frontier Quantity of aircraft 1,500 1,000 U.S. consumption without trade U.S. consumption with trade U.S. production with trade U.S. PPF Quantity of aircraft 3,000 2,000 1,500 Canadian production with trade Canadian consumption without trade Canadian consumption with trade Canadian PPF 0 1 2 3 0 0.5 1 1.5 Quantity of pork (millions of tons) Quantity of pork (millions of tons) In this hypothetical example, Canada and the United States produce only two goods: pork and aircraft. Aircraft are measured on the vertical axis and pork on the horizontal axis. Panel (a) shows the U.S. production possibility frontier. It is relatively flat, implying that the United States has a comparative advantage in pork production. Panel (b) shows the Canadian production possibility frontier. It is relatively steep, implying that Canada has a comparative advantage in aircraft production. Just like two individuals, both countries gain from specialization and trade. Moreover, these mutual gains don’t depend on each country being better at producing one kind of good. Even if one country has, say, higher output per person-hour in both industries—that is, even if one country has an absolute advantage in both industries—there are still mutual gains from trade. PAJAMA REPUBLICS Poor countries tend to have low productivity in clothing manufacture, but even lower productivity in other industries (see the upcoming Economics in Action). As a result, they have a comparative advantage in clothing production, which actually dominates the industries of some very poor countries. An official from one such country once joked, “We are not a banana republic—we are a pajama republic.” This figure, which compares per capita income (the total income of the country divided by the size of the population) with the share of the clothing industry in manufacturing employment, shows just how strong this effect is. According to a U.S. Department of Commerce assessment, Bangladesh’s clothing industry has “low productivity, largely low literacy levels, frequent labor unrest, and outdated technology.” Yet it devotes most of its manufacturing workforce to clothing, the sector in which it nonetheless has a comparative advantage because its productivity in nonclothing industries is even lower. The same assessment describes Costa Rica as having “relatively high productivity” in clothing—yet a much smaller and declining fraction of Costa Rica’s workforce is employed in clothing production. That’s because productivity in nonclothing industries is somewhat higher in Costa Rica than in Bangladesh. Employment in clothing production (percent of total manufacturing employment) 60% Bangladesh 50 40 30 20 10 El Salvador Costa Rica South Korea United States 0 $10,000 20,000 30,000 40,000 50,000 Income per capita Source: World Bank, World Development Indicators; Nicita A. and M. Olarreaga “Trade, Production and Protection 1976–2004,” World Bank Economic Review 21 no. 1 (2007): 165–171 35 Trade takes the form of barter when people directly exchange goods or services that they have for goods or services that they want. The circular-flow diagram represents the transactions in an economy by flows around a circle. A household is a person or a group of people that share their income. A firm is an organization that produces goods and services for sale. Firms sell goods and services that they produce to households in markets for goods and services. Firms buy the resources they need to produce goods and services in factor markets. Transactions: The Circular-Flow Diagram The little economy created by Tom and Hank on their island lacks many features of the modern American economy. For one thing, though millions of Americans are self-employed, most workers are employed by someone else, usually a company with hundreds or thousands of employees. Also, Tom and Hank engage only in the simplest of economic transactions, barter, in which an individual directly trades a good or service he or she has for a good or service he or she wants. In the modern economy, simple barter is rare: usually people trade goods or services for money—pieces of colored paper with no inherent value—and then trade those pieces of colored paper for the goods or services they want. That is, they sell goods or services and buy other goods or services. And they both sell and buy a lot of different things. The U.S. economy is a vastly complex entity, with more than a hundred million workers employed by millions of companies, producing millions of different goods and services. Yet you can learn some very important things about the economy by considering the simple graphic shown in Figure 2-7, the circular-flow diagram. This diagram represents the transactions that take place in an economy by two kinds of flows around a circle: flows of physical things such as goods, services, labor, or raw materials in one direction, and flows of money that pay for these physical things in the opposite direction. In this case the physical flows are shown in yellow, the money flows in green. The simplest circular-flow diagram illustrates an economy that contains only two kinds of “inhabitants”: households and firms. A household consists of either an individual or a group of people (usually, but not necessarily, a family) that share their income. A firm is an organization (usually, but not necessarily, a corporation) that produces goods and services for sale—and that employs members of households. As you can see in Figure 2-7, there are two kinds of markets in this simple economy. On one side (here the left side) there are markets for goods and services in which households buy the goods and services they want from firms. This produces a flow of goods and services to households and a return flow of money to firms. On the other side, there are factor markets in which firms buy the resources they need to produce goods and services. Recall from earlier in the chapter that the main factors of production are land, labor, capital, and human capital. FIGURE 2-7 The Circular-Flow Diagram This diagram represents the flows of money and goods and services in the economy. In the markets for goods and services, households purchase goods and services from firms, generating a flow of money to the firms and a flow of goods and services to the households. The money flows back to households as firms purchase factors of production from the households in factor markets. Money Households Money Markets for goods and services Goods and services Goods and services Factors Factors Factor markets Money Firms Money 36 ? An economy’s income distribution is the way in which total income is divided among the owners of the various factors of production. The factor market most of us know best is the labor market, in which workers are paid for their time. Besides labor, we can think of households as owning and selling the other factors of production to firms. For example, when a corporation pays dividends to its stockholders, who are members of households, it is in effect paying them for the use of the machines and buildings that ultimately belong to those investors. In this case, the transactions are occurring in the capital market, the market in which capital is bought and sold. As we’ll examine in detail later, factor markets ultimately determine an economy’s income distribution, how the total income created in an economy is allocated between less skilled workers, highly skilled workers, and the owners of capital and land. The circular-flow diagram ignores a number of real-world complications in the interests of simplicity. A few examples: ■ In the real world, the distinction between firms and households isn’t always that clear-cut. Consider a small, family-run business—a farm, a shop, a small hotel. Is this a firm or a household? A more complete picture would include a separate box for family businesses. ■ Many of the sales firms make are not to households but to other firms; fo
r example, steel companies sell mainly to other companies such as auto manufacturers, not to households. A more complete picture would include these flows of goods, services, and money within the business sector. ■ The figure doesn’t show the government, which in the real world diverts quite a lot of money out of the circular flow in the form of taxes but also injects a lot of money back into the flow in the form of spending. Figure 2-7, in other words, is by no means a complete picture either of all the types of inhabitants of the real economy or of all the flows of money and physical items that take place among these inhabitants. Despite its simplicity, the circular-flow diagram is a very useful aid to thinking about the economy. L D VIE W R W O ➤ECONOMICS IN ACTION Rich Nation, Poor Nation Try taking off your clothes—at a suitable time and in a suitable place, of course—and take a look at the labels inside that say where they were made. It’s a very good bet that much, if not most, of your clothing was manufactured overseas, in a country that is much poorer than the United States—say, in El Salvador, Sri Lanka, or Bangladesh. VIEWWOR Why are these countries so much poorer than we are? The immediate reason is that their economies are much less productive—firms in these countries are just not able to produce as much from a given quantity of resources as comparable firms in the United States or other wealthy countries. Why countries differ so much in productivity is a deep question—indeed, one of the main questions that preoccupy economists. But in any case, the difference in productivity is a fact Although less productive than American workers, Bangladeshi workers have a comparative advantage in clothing production. But if the economies of these countries are so much less productive than ours, how is it that they make so much of our clothing? Why don’t we do it for ourselves? The answer is “comparative advantage.” Just about every industry in Bangladesh is much less productive than the corresponding industry in the United States. But the productivity difference between rich and poor countries varies across goods; it is very large in the production of sophisticated goods like aircraft but not that large in the production of simpler goods like clothing. So Bangladesh’s position with regard to clothing production is like Hank’s position with respect to coconutgathering: he’s not as good at it as his fellow castaway, but it’s the thing he does comparatively well 37 Bangladesh, though it is at an absolute disadvantage compared with the United States in almost everything, has a comparative advantage in clothing production. This means that both the United States and Bangladesh are able to consume more because they specialize in producing different things, with Bangladesh supplying our clothing and the United States supplying Bangladesh with more sophisticated goods. ▲ > > > > > > > > > > > > ➤ CHECK YOUR UNDERSTANDING 2-1 1. True or false? Explain your answer. a. An increase in the amount of resources available to Tom for use in producing coconuts and fish does not change his production possibility frontier. b. A technological change that allows Tom to catch more fish for any amount of coconuts gathered results in a change in his production possibility frontier. c. The production possibility frontier is useful because it illustrates how much of one good an economy must give up to get more of another good regardless of whether resources are being used efficiently. 2. In Italy, an automobile can be produced by 8 workers in one day and a washing machine by 3 workers in one day. In the United States, an automobile can be produced by 6 workers in one day, and a washing machine by 2 workers in one day. a. Which country has an absolute advantage in the production of automobiles? In washing machines? b. Which country has a comparative advantage in the production of washing machines? In automobiles? c. What pattern of specialization results in the greatest gains from trade between the two countries? 3. Explain why Tom and Hank are willing to engage in a trade of 1 fish for 1.5 coconuts. 4. Use the circular-flow diagram to explain how an increase in the amount of money spent by households results in an increase in the number of jobs in the economy. Describe in words what the circular-flow diagram predicts. Solutions appear at back of book. ➤➤ ➤ Most economic models are “thought experiments” or simplified representations of reality, which rely on the other things equal assumption. ➤ An important economic model is the production possibility frontier, which illustrates the concepts of efficiency, opportunity cost, and economic growth. ➤ Comparative advantage is a model that explains the source of gains from trade but is often confused with absolute advantage. Every person and every country has a comparative advantage in something, giving rise to gains from trade. ➤ In the simplest economies people barter rather than trade with money as in a modern economy. The circular-flow diagram illustrates transactions within the economy as flows of goods and services, factors of production, and money between households and firms. These transactions occur in markets for goods and services and factor markets. Ultimately, factor markets determine the economy’s income distribution, how total income is divided among the owners of the various factors of production. Using Models Economics, we have now learned, is mainly a matter of creating models that draw on a set of basic principles but add some more specific assumptions that allow the modeler to apply those principles to a particular situation. But what do economists actually do with their models? Positive versus Normative Economics Imagine that you are an economic adviser to the governor of your state. What kinds of questions might the governor ask you to answer? Well, here are three possible questions: 1. How much revenue will the tolls on the state turnpike yield next year? 2. How much would that revenue increase if the toll were raised from $1 to $1.50? 3. Should the toll be raised, bearing in mind that a toll increase will reduce traffic and air pollution near the road but will impose some financial hardship on frequent commuters? There is a big difference between the first two questions and the third one. The first two are questions about facts. Your forecast of next year’s toll collection will be proved right or wrong when the numbers actually come in. Your estimate of the impact of a change in the toll is a little harder to check—revenue depends on other factors besides the toll, and it may be hard to disentangle the causes of any change in revenue. Still, in principle there is only one right answer. 38 ? Positive economics is the branch of economic analysis that describes the way the economy actually works. Normative economics makes prescriptions about the way the economy should work. A forecast is a simple prediction of the future. But the question of whether tolls should be raised may not have a “right” answer— two people who agree on the effects of a higher toll could still disagree about whether raising the toll is a good idea. For example, someone who lives near the turnpike but doesn’t commute on it will care a lot about noise and air pollution but not so much about commuting costs. A regular commuter who doesn’t live near the turnpike will have the opposite priorities. This example highlights a key distinction between two roles of economic analysis. Analysis that tries to answer questions about the way the world works, which have definite right and wrong answers, is known as positive economics. In contrast, analysis that involves saying how the world should work is known as normative economics. To put it another way, positive economics is about description, normative economics is about prescription. Positive economics occupies most of the time and effort of the economics profession. And models play a crucial role in almost all positive economics. As we mentioned earlier, the U.S. government uses a computer model to assess proposed changes in national tax policy, and many state governments have similar models to assess the effects of their own tax policy. It’s worth noting that there is a subtle but important difference between the first and second questions we imagined the governor asking. Question 1 asked for a simple prediction about next year’s revenue—a forecast. Question 2 was a “what if” question, asking how revenue would change if the tax law were to change. Economists are often called upon to answer both types of questions, but models are especially useful for answering “what if” questions. The answers to such questions often serve as a guide to policy, but they are still predictions, not prescriptions. That is, they tell you what will happen if a policy is changed; they don’t tell you whether or not that result is good. Suppose that your economic model tells you that the governor’s proposed increase in highway tolls will raise property values in communities near the road but will hurt people who must use the turnpike to get to work. Does that make this proposed toll increase a good idea or a bad one? It depends on whom you ask. As we’ve just seen, someone who is very concerned with the communities near the road will support the increase, but someone who is very concerned with the welfare of drivers will feel differently. That’s a value judgment—it’s not a question of economic analysis. Still, economists often do engage in normative economics and give policy advice. How can they do this when there may be no “right” answer? One answer is that economists are also citizens, and we all have our opinions. But economic analysis can often be used to show that some policies are clearly better than others, regardless of anyone’s opinions. Suppose that policies A and B achieve the same goal, but policy A makes everyone better off than policy B—or at least makes some people better
off without making other people worse off. Then A is clearly more efficient than B. That’s not a value judgment: we’re talking about how best to achieve a goal, not about the goal itself. For example, two different policies have been used to help low-income families obtain housing: rent control, which limits the rents landlords are allowed to charge, and rent subsidies, which provide families with additional money to pay rent. Almost all economists agree that subsidies are the more efficient policy. (In Chapter 5 we’ll see why this is so.) And so the great majority of economists, whatever their personal politics, favor subsidies over rent control. When policies can be clearly ranked in this way, then economists generally agree. But it is no secret that economists sometimes disagree. When and Why Economists Disagree Economists have a reputation for arguing with each other. Where does this reputation come from? One important answer is that media coverage tends to exaggerate the real differences in views among economists. If nearly all economists agree on an issue—for 39 example, the proposition that rent controls lead to housing shortages—reporters and editors are likely to conclude that there is no story worth covering, and so the professional consensus tends to go unreported. But when there is some issue on which prominent economists take opposing sides on the same issue—for example, whether cutting taxes right now would help the economy—that does make a good news story. So you hear much more about the areas of disagreement within economics than you do about the large areas of agreement. It is also worth remembering that economics is, unavoidably, often tied up in politics. On a number of issues powerful interest groups know what opinions they want to hear; they therefore have an incentive to find and promote economists who profess those opinions, giving these economists a prominence and visibility out of proportion to their support among their colleagues. But although the appearance of disagreement among economists exceeds the reality, it remains true that economists often do disagree about important things. For example, some very respected economists argue vehemently that the U.S. government should replace the income tax with a value-added tax (a national sales tax, which is the main source of government revenue in many European countries). Other equally respected economists disagree. Why this difference of opinion? One important source of differences is in values: as in any diverse group of individuals, reasonable people can differ. In comparison to an income tax, a value-added tax typically falls more heavily on people of modest means. So an economist who values a society with more social and income equality for its own sake will tend to oppose a value-added tax. An economist with different values will be less likely to oppose it. A second important source of differences arises from economic modeling. Because economists base their conclusions on models, which are simplified representations of reality, two economists can legitimately disagree about which simplifications are appropriate—and therefore arrive at different conclusions. Suppose that the U.S. government was considering introducing a value-added tax. Economist A may rely on a model that focuses on the administrative costs of tax systems—that is, the costs of monitoring, processing papers, collecting the tax, and so on. This economist might then point to the well-known high costs of administering a valueadded tax and argue against the change. But economist B may think that the right way to approach the question is to ignore the administrative costs and focus on how the proposed law would change savings behavior. This economist might point to studies suggesting that value-added taxes promote higher consumer saving, a desirable result When Economists Agree “If all the economists in the world were laid end to end, they still couldn’t reach a conclusion.” So goes one popular economist joke. But do economists really disagree that much? Not according to a classic survey of members of the American Economic Association, reported in the May 1992 issue of the American Economic Review. The authors asked respondents to agree or disagree with a number of statements about the economy; what they found was a high level of agreement among professional economists on many of the statements. At the top, with more than 90 percent of the economists agreeing, were “Tariffs and import quotas usually reduce general economic welfare” and “A ceiling on rents reduces the quantity and quality of housing available.” What’s striking about these two statements is that many noneconomists disagree: tariffs and import quotas to keep out foreign-produced goods are favored by many voters, and proposals to do away with rent control in cities like New York and San Francisco have met fierce political opposition. So is the stereotype of quarreling economists a myth? Not entirely: economists do disagree quite a lot on some issues, especially in macroeconomics. But there is a large area of common ground. 40 ? Because the economists have used different models—that is, made different simplifying assumptions—they arrive at different conclusions. And so the two economists may find themselves on different sides of the issue. Most such disputes are eventually resolved by the accumulation of evidence showing which of the various models proposed by economists does a better job of fitting the facts. However, in economics, as in any science, it can take a long time before research settles important disputes—decades, in some cases. And since the economy is always changing, in ways that make old models invalid or raise new policy questions, there are always new issues on which economists disagree. The policy maker must then decide which economist to believe. The important point is that economic analysis is a method, not a set of conclusions. ➤ECONOMICS IN ACTION Economists in Government Many economists are mainly engaged in teaching and research. But quite a few economists have a more direct hand in events. As described earlier in the chapter (For Inquiring Minds, “Models for Money”), economists play a significant role in the business world, especially in the financial industry. But the most striking involvement of economists in the “real” world is their extensive participation in government. This shouldn’t be surprising: one of the most important functions of government is to make economic policy, and almost every government policy decision must take economic effects into consideration. So governments around the world employ economists in a variety of roles. In the U.S. government, a key role is played by the Council of Economic Advisers, a branch of the Executive Office (that is, the staff of the President) whose sole purpose is to advise the White House on economic matters and to prepare the annual Economic Report of the President. Unlike most employees in government agencies, the majority of the economists at the Council are not long-term civil servants; instead, they are mainly professors on leave for one or two years from their universities. Many of the nation’s best-known economists have served on the Council of Economic Advisers at some point during their careers. Economists also play an important role in many other parts of the U.S. government. Indeed, as the Bureau of Labor Statistics Occupational Outlook Handbook says, “Government employed 58 percent of economists in a wide range of government agencies.” Needless to say, the Bureau of Labor Statistics is itself a major employer of economists. And economists dominate the staff of the Federal Reserve, a government agency that controls the supply of money in the economy and is crucial to its operation. It’s also worth noting that economists play an especially important role in two international organizations headquartered in Washington, D.C.: the International Monetary Fund, which provides advice and loans to countries experiencing economic difficulties, and the World Bank, which provides advice and loans to promote longterm economic development. Do all these economists in government disagree with each other all the time? Are their positions largely dictated by political affiliation? The answer to both questions is no. Although there are important disputes over economic issues in government, and politics inevitably plays some role, there is broad agreement among economists on many issues, and most economists in government try very hard to assess issues as objectively as possible. ▲ < < < < < < < < < < < < ➤➤ ➤ Economists do mostly positive economics, analysis of the way the world works, in which there are definite right and wrong answers and which involve making forecasts. But in normative economics, which makes prescriptions about how things ought to be, there are often no right answers and only value judgments. ➤ Economists do disagree—though not as much as legend has it—for two main reasons. One, they may disagree about which simplifications to make in a model. Two, economists may disagree—like everyone else—about values 41 ➤ CHECK YOUR UNDERSTANDING 2-2 1. Which of the following statements is a positive statement? Which is a normative statement? a. Society should take measures to prevent people from engaging in dangerous personal behavior. b. People who engage in dangerous personal behavior impose higher costs on society through higher medical costs. 2. True or false? Explain your answer. a. Policy choice A and policy choice B attempt to achieve the same social goal. Policy choice A, however, results in a much less efficient use of resources than policy choice B. Therefore, economists are more likely to agree on choosing policy choice B. b. When two economists disagree on the desirability of a policy, it’s typically because one of them has made a mistake. c. Policy makers can always use economics to figure out which goals a society should
try to achieve. Solutions appear at back of book. [ ➤➤ A LOOK AHEAD • • • This chapter has given you a first view of what it means to do economics, starting with the general idea of models as a way to make sense of a complicated world and then moving on to two simple introductory models. To get a real sense of how economic analysis works, however, and to show just how useful such analysis can be, we need to move on to a more powerful model. In the next two chapters we will study the quintessential economic model, one that has an amazing ability to make sense of many policy issues, predict the effects of many forces, and change the way you look at the world. That model is known as “supply and demand.”] S U M M A R Y 1. Almost all economics is based on models, “thought experiments” or simplified versions of reality, many of which use mathematical tools such as graphs. An important assumption in economic models is the other things equal assumption, which allows analysis of the effect of a change in one factor by holding all other relevant factors unchanged. 2. One important economic model is the production possibility frontier. It illustrates: opportunity cost (showing how much less of one good can be produced if more of the other good is produced); efficiency (an economy is efficient in production if it produces on the production possibility frontier and efficient in allocation if it produces the mix of goods and services that people want to consume); and economic growth (an outward shift of the production possibility frontier). There are two basic sources of growth: an increase in factors of production, resources such as land, labor, capital, and human capital, inputs that are not used up in production, and improved technology. 3. Another important model is comparative advantage, which explains the source of gains from trade between individuals and countries. Everyone has a comparative advantage in something—some good or service in which that person has a lower opportunity cost than everyone else. But it is often confused with absolute advantage, an ability to produce a particular good or service better than anyone else. This confusion leads some to erroneously conclude that there are no gains from trade between people or countries. 4. In the simplest economies people barter—trade goods and services for one another—rather than trade them for money, as in a modern economy. The circular-flow diagram represents transactions within the economy as flows of goods, services, and money between households and firms. These transactions occur in markets for goods and services and factor markets, markets for factors of production—land, labor, capital, and human capital. It is useful in understanding how spending, production, employment, income, and growth are related in the economy. Ultimately, factor markets determine the economy’s income distribution, how an economy’s total income is allocated to the owners of the factors of production. 5. Economists use economic models for both positive economics, which describes how the economy works, and for normative economics, which prescribes how the economy should work. Positive economics often involves making forecasts. Economists can determine correct answers for positive questions, but typically not 42 ? for normative questions, which involve value judgments. The exceptions are when policies designed to achieve a certain prescription can be clearly ranked in terms of efficiency. 6. There are two main reasons economists disagree. One, they may disagree about which simplifications to make in a model. Two, economists may disagree—like everyone else—about values. K E Y T E R M S Model, p. 24 Absolute advantage, p. 33 Other things equal assumption, p. 24 Barter, p. 35 Production possibility frontier, p. 25 Circular-flow diagram, p. 35 Factors of production, p. 29 Technology, p. 29 Household, p. 35 Firm, p. 35 Comparative advantage, p. 31 Markets for goods and services, p. 35 Factor markets, p. 35 Income distribution, p. 36 Positive economics, p. 38 Normative economics, p. 38 Forecast, p. 38 P R O B L E M S 1. Two important industries on the island of Bermuda are fishing and tourism. According to data from the World Resources Institute and the Bermuda Department of Statistics, in the year 2000 the 307 registered fishermen in Bermuda caught 286 metric tons of marine fish. And the 3,409 people employed by hotels produced 538,000 hotel stays (measured by the number of visitor arrivals). Suppose that this production point is efficient in production. Assume also that the opportunity cost of one additional metric ton of fish is 2,000 hotel stays and that this opportunity cost is constant (the opportunity cost does not change). a. If all 307 registered fishermen were to be employed by hotels (in addition to the 3,409 people already working in hotels), how many hotel stays could Bermuda produce? b. If all 3,409 hotel employees were to become fishermen (in addition to the 307 fishermen already working in the fishing industry), how many metric tons of fish could Bermuda produce? c. Draw a production possibility frontier for Bermuda, with fish on the horizontal axis and hotel stays on the vertical axis, and label Bermuda’s actual production point for the year 2000. 2. Atlantis is a small, isolated island in the South Atlantic. The inhabitants grow potatoes and catch fish. The accompanying table shows the maximum annual output combinations of potatoes and fish that can be produced. Obviously, given their limited resources and available technology, as they use more of their resources for potato production, there are fewer resources available for catching fish. Maximum annual output options Quantity of potatoes (pounds) Quantity of fish (pounds) A B C D E F 1,000 800 600 400 200 0 0 300 500 600 650 675 a. Draw a production possibility frontier with potatoes on the horizontal axis and fish on the vertical axis illustrating these options, showing points A–F. b. Can Atlantis produce 500 pounds of fish and 800 pounds of potatoes? Explain. Where would this point lie relative to the production possibility frontier? c. What is the opportunity cost of increasing the annual output of potatoes from 600 to 800 pounds? d. What is the opportunity cost of increasing the annual output of potatoes from 200 to 400 pounds? e. Can you explain why the answers to parts c and d are not the same? What does this imply about the slope of the production possibility frontier? 3. According to data from the U.S. Department of Agriculture’s National Agricultural Statistics Service, 124 million acres of land in the United States were used for wheat or corn farming in 2004. Of those 124 million acres, farmers used 50 million acres to grow 2.158 billion bushels of wheat and 74 million acres of land to grow 11.807 billion bushels of corn. Suppose that U.S. wheat and corn farming is efficient in production. At that production point, the opportunity cost of producing one additional bushel of wheat is 1.7 fewer bushels of corn. However, farmers have increasing opportunity costs, so that additional bushels of wheat have an opportunity cost greater than 1.7 bushels of corn. For each of the following production points, decide whether that production point is (i) feasible and efficient in production, (ii) feasible but not efficient in production, (iii) not feasible, or (iv) unclear as to whether or not it is feasible. a. Farmers use 40 million acres of land to produce 1.8 billion bushels of wheat, and they use 60 million acres of land to produce 9 billion bushels of corn. The remaining 24 million acres are left unused. b. From their original production point, farmers transfer 40 million acres of land from corn to wheat production. They now produce 3.158 billion bushels of wheat and 10.107 bushels of corn. c. Farmers reduce their production of wheat to 2 billion bushels and increase their production of corn to 12.044 43 billion bushels. Along the production possibility frontier, the opportunity cost of going from 11.807 billion bushels of corn to 12.044 billion bushels of corn is 0.666 bushel of wheat per bushel of corn. 4. In the ancient country of Roma, only two goods, spaghetti and meatballs, are produced. There are two tribes in Roma, the Tivoli and the Frivoli. By themselves, the Tivoli each month can produce either 30 pounds of spaghetti and no meatballs, or 50 pounds of meatballs and no spaghetti, or any combination in between. The Frivoli, by themselves, each month can produce 40 pounds of spaghetti and no meatballs, or 30 pounds of meatballs and no spaghetti, or any combination in between. a. Assume that all production possibility frontiers are straight lines. Draw one diagram showing the monthly production possibility frontier for the Tivoli and another showing the monthly production possibility frontier for the Frivoli. Show how you calculated them. b. Which tribe has the comparative advantage in spaghetti production? In meatball production? In A.D. 100 the Frivoli discover a new technique for making meatballs that doubles the quantity of meatballs they can produce each month. c. Draw the new monthly production possibility frontier for the Frivoli. d. After the innovation, which tribe now has an absolute advantage in producing meatballs? In producing spaghetti? Which has the comparative advantage in meatball production? In spaghetti production? 5. According to the U.S. Census Bureau, in July 2006 the United States exported aircraft worth $1 billion to China and imported aircraft worth only $19,000 from China. During the same month, however, the United States imported $83 million worth of men’s trousers, slacks, and jeans from China but exported only $8,000 worth of trousers, slacks, and jeans to China. Using what you have learned about how trade is determined by comparative advantage, answer the following questions. a. Which country has the comparative advantage in aircraft production? In production of trousers, slacks, and j
eans? b. Can you determine which country has the absolute advan- tage in aircraft production? In production of trousers, slacks, and jeans? 6. Peter Pundit, an economics reporter, states that the European Union (EU) is increasing its productivity very rapidly in all industries. He claims that this productivity advance is so rapid that output from the EU in these industries will soon exceed that of the United States and, as a result, the United States will no longer benefit from trade with the EU. a. Do you think Peter Pundit is correct or not? If not, what do you think is the source of his mistake? b. If the EU and the United States continue to trade, what do you think will characterize the goods that the EU exports to the United States and the goods that the United States exports to the EU? 7. You are in charge of allocating residents to your dormitory’s baseball and basketball teams. You are down to the last four people, two of whom must be allocated to baseball and two to basketball. The accompanying table gives each person’s batting average and free-throw average. Name Kelley Jackie Curt Gerry Batting average Free-throw average 70% 50% 10% 80% 60% 50% 30% 70% a. Explain how you would use the concept of comparative advantage to allocate the players. Begin by establishing each player’s opportunity cost of free throws in terms of batting average. b. Why is it likely that the other basketball players will be unhappy about this arrangement but the other baseball players will be satisfied? Nonetheless, why would an economist say that this is an efficient way to allocate players for your dormitory’s sports teams? 8. The inhabitants of the fictional economy of Atlantis use money in the form of cowry shells. Draw a circular-flow diagram showing households and firms. Firms produce potatoes and fish, and households buy potatoes and fish. Households also provide the land and labor to firms. Identify where in the flows of cowry shells or physical things (goods and services, or resources) each of the following impacts would occur. Describe how this impact spreads around the circle. a. A devastating hurricane floods many of the potato fields. b. A very productive fishing season yields a very large num- ber of fish caught. c. The inhabitants of Atlantis discover Shakira and spend several days a month at dancing festivals. 9. An economist might say that colleges and universities “produce” education, using faculty members and students as inputs. According to this line of reasoning, education is then “consumed” by households. Construct a circular-flow diagram to represent the sector of the economy devoted to college education: colleges and universities represent firms, and households both consume education and provide faculty and students to universities. What are the relevant markets in this diagram? What is being bought and sold in each direction? What would happen in the diagram if the government decided to subsidize 50% of all college students’ tuition? 10. Your dormitory roommate plays loud music most of the time; you, however, would prefer more peace and quiet. You suggest that she buy some earphones. She responds that although she would be happy to use earphones, she has many other things that she would prefer to spend her money on right now. You discuss this situation with a friend who is an economics major. The following exchange takes place: He: How much would it cost to buy earphones? You: $15. 44 ? He: How much do you value having some peace and quiet for the rest of the semester? You: $30. He: It is efficient for you to buy the earphones and give them to your roommate. You gain more than you lose; the benefit exceeds the cost. You should do that. You: It just isn’t fair that I have to pay for the earphones when I’m not the one making the noise. a. Which parts of this conversation contain positive statements and which parts contain normative statements? b. Compose an argument supporting your viewpoint that your roommate should be the one to change her behavior. Similarly, compose an argument from the viewpoint of your roommate that you should be the one to buy the earphones. If your dormitory has a policy that gives residents the unlimited right to play music, whose argument is likely to win? If your dormitory has a rule that a person must stop playing music whenever a roommate complains, whose argument is likely to win? 11. A representative of the American clothing industry recently made the following statement: “Workers in Asia often work in sweatshop conditions earning only pennies an hour. American workers are more productive and as a result earn higher wages. In order to preserve the dignity of the American workplace, the government should enact legislation banning imports of low-wage Asian clothing.” a. Which parts of this quote are positive statements? Which parts are normative statements? b. Is the policy that is being advocated consistent with the preceding statements about the wages and productivities of American and Asian workers? c. Would such a policy make some Americans better off without making any other Americans worse off? That is, would this policy be efficient from the viewpoint of all Americans? d. Would low-wage Asian workers benefit from or be hurt by such a policy? 12. Are the following statements true or false? Explain your answers. a. “When people must pay higher taxes on their wage earnings, it reduces their incentive to work” is a positive statement. b. “We should lower taxes to encourage more work” is a positive statement. www.worthpublishers.com/krugmanwells c. Economics cannot always be used to completely decide what society ought to do. d. “The system of public education in this country generates greater benefits to society than the cost of running the system” is a normative statement. e. All disagreements among economists are generated by the media. 13. Evaluate the following statement: “It is easier to build an economic model that accurately reflects events that have already occurred than to build an economic model to forecast future events.” Do you think that this is true or not? Why? What does this imply about the difficulties of building good economic models? 14. Economists who work for the government are often called on to make policy recommendations. Why do you think it is important for the public to be able to differentiate normative statements from positive statements in these recommendations? 15. The mayor of Gotham City, worried about a potential epidemic of deadly influenza this winter, asks an economic adviser the following series of questions. Determine whether a question requires the economic adviser to make a positive assessment or a normative assessment. a. How much vaccine will be in stock in the city by the end of November? b. If we offer to pay 10% more per dose to the pharmaceutical companies providing the vaccines, will they provide additional doses? c. If there is a shortage of vaccine in the city, whom should we vaccinate first—the elderly or the very young? (Assume that a person from one group has an equal likelihood of dying from influenza as a person from the other group.) d. If the city charges $25 per shot, how many people will pay? e. If the city charges $25 per shot, it will make a profit of $10 per shot, money that can go to pay for inoculating poor people. Should the city engage in such a scheme? 16. Assess the following statement: “If economists just had enough data, they could solve all policy questions in a way that maximizes the social good. There would be no need for divisive political debates, such as whether the government should provide free medical care for all.” >> Chapter 2 Appendix: Graphs in Economics Getting the Picture Whether you’re reading about economics in the Wall Street Journal or in your economics textbook, you will see many graphs. Visual images can make it much easier to understand verbal descriptions, numerical information, or ideas. In economics, graphs are the type of visual image used to facilitate understanding. To fully understand the ideas and information being discussed, you need to be familiar with how to interpret these visual aids. This appendix explains how graphs are constructed and interpreted and how they are used in economics. Graphs, Variables, and Economic Models One reason to attend college is that a bachelor’s degree provides access to higherpaying jobs. Additional degrees, such as MBAs or law degrees, increase earnings even more. If you were to read an article about the relationship between educational attainment and income, you would probably see a graph showing the income levels for workers with different amounts of education. And this graph would depict the idea that, in general, more education increases income. This graph, like most of those in economics, would depict the relationship between two economic variables. A variable is a quantity that can take on more than one value, such as the number of years of education a person has, the price of a can of soda, or a household’s income. As you learned in this chapter, economic analysis relies heavily on models, simplified descriptions of real situations. Most economic models describe the relationship between two variables, simplified by holding constant other variables that may affect the relationship. For example, an economic model might describe the relationship between the price of a can of soda and the number of cans of soda that consumers will buy, assuming that everything else that affects consumers’ purchases of soda stays constant. This type of model can be described mathematically or verbally, but illustrating the relationship in a graph makes it easier to understand. Next we show how graphs that depict economic models are constructed and interpreted. How Graphs Work Most graphs in economics are based on a grid built around two perpendicular lines that show the values of two variables, helping you visualize the relationship between them. So a fi
rst step in understanding the use of such graphs is to see how this system works. Two-Variable Graphs Figure 2A-1 on the next page shows a typical two-variable graph. It illustrates the data in the accompanying table on outside temperature and the number of sodas a typical vendor can expect to sell at a baseball stadium during one game. The first column shows the values of outside temperature (the first variable) and the second column shows the values of the number of sodas sold (the second variable). Five combinations or pairs of the two variables are shown, each denoted by A through E in the third column. Now let’s turn to graphing the data in this table. In any two-variable graph, one variable is called the x-variable and the other is called the y-variable. Here we have made outside temperature the x-variable and number of sodas sold the y-variable. The A quantity that can take on more than one value is called a variable. 45 46 P A R T 1 W H AT ? FIGURE 2A-1 Plotting Points on a Two-Variable Graph y Number of sodas sold vertical axis or y-axis y-variable is the dependent variable. 70 60 50 40 30 20 10 A (0, 10) B (10, 0) D (60, 50) C (40, 30) Origin (0, 0) 0 10 30 20 60 Outside temperature (degrees Fahrenheit) 70 80 50 90 40 E (80, 70) x-variable: outside temperature y-variable: number of sodas sold Point 0 °F 10 40 60 80 10 0 30 50 70 A B C D E horizontal axis or x-axis x x-variable is the independent variable. The data from the table are plotted where outside temperature (the independent variable) is measured along the horizontal axis and number of sodas sold (the dependent variable) is measured along the vertical axis. Each of the five combinations of temperature and sodas sold is represented by a point: A, B, C, D, and E. Each point in the graph is identified by a pair of values. For example, point C corresponds to the pair (40, 30)—an outside temperature of 40°F (the value of the x-variable) and 30 sodas sold (the value of the y-variable). solid horizontal line in the graph is called the horizontal axis or x-axis, and values of the x-variable—outside temperature—are measured along it. Similarly, the solid vertical line in the graph is called the vertical axis or y-axis, and values of the y-variable— number of sodas sold—are measured along it. At the origin, the point where the two axes meet, each variable is equal to zero. As you move rightward from the origin along the x-axis, values of the x-variable are positive and increasing. As you move up from the origin along the y-axis, values of the y-variable are positive and increasing. You can plot each of the five points A through E on this graph by using a pair of numbers—the values that the x-variable and the y-variable take on for a given point. In Figure 2A-1, at point C, the x-variable takes on the value 40 and the y-variable takes on the value 30. You plot point C by drawing a line straight up from 40 on the x-axis and a horizontal line across from 30 on the y-axis. We write point C as (40, 30). We write the origin as (0, 0). Looking at point A and point B in Figure 2A-1, you can see that when one of the variables for a point has a value of zero, it will lie on one of the axes. If the value of the x-variable is zero, the point will lie on the vertical axis, like point A. If the value of the y-variable is zero, the point will lie on the horizontal axis, like point B. Most graphs that depict relationships between two economic variables represent a causal relationship, a relationship in which the value taken by one variable directly influences or determines the value taken by the other variable. In a causal relationship, the determining variable is called the independent variable; the variable it determines is called the dependent variable. In our example of soda sales, the outside temperature is the independent variable. It directly influences the number of sodas that are sold, the dependent variable in this case. The line along which values of the xvariable are measured is called the horizontal axis or x-axis. The line along which values of the y-variable are measured is called the vertical axis or y-axis. The point where the axes of a two-variable graph meet is the origin. A causal relationship exists between two variables when the value taken by one variable directly influences or determines the value taken by the other variable. In a causal relationship, the determining variable is called the independent variable; the variable it determines is called the dependent variable 47 By convention, we put the independent variable on the horizontal axis and the dependent variable on the vertical axis. Figure 2A-1 is constructed consistent with this convention; the independent variable (outside temperature) is on the horizontal axis and the dependent variable (number of sodas sold) is on the vertical axis. An important exception to this convention is in graphs showing the economic relationship between the price of a product and quantity of the product: although price is generally the independent variable that determines quantity, it is always measured on the vertical axis. A curve is a line on a graph that depicts a relationship between two variables. It may be either a straight line or a curved line. If the curve is a straight line, the variables have a linear relationship. If the curve is not a straight line, the variables have a nonlinear relationship. Curves on a Graph Panel (a) of Figure 2A-2 contains some of the same information as Figure 2A-1, with a line drawn through the points B, C, D, and E. Such a line on a graph is called a curve, regardless of whether it is a straight line or a curved line. If the curve that shows the relationship between two variables is a straight line, or linear, the variables have a linear relationship. When the curve is not a straight line, or nonlinear, the variables have a nonlinear relationship. A point on a curve indicates the value of the y-variable for a specific value of the x-variable. For example, point D indicates that at a temperature of 60°F, a vendor can expect to sell 50 sodas. The shape and orientation of a curve reveal the general nature of the relationship between the two variables. The upward tilt of the curve in panel (a) of Figure 2A-2 suggests that vendors can expect to sell more sodas at higher outside temperatures. FIGURE 2A-2 Drawing Curves (a) Positive Linear Relationship (b) Negative Linear Relationship Number of sodas sold 70 60 50 40 30 20 10 0 (80, 70) E (60, 50) D (40, 30) C Horizontal intercept (10, 0) B 10 20 30 50 Outside temperature (degrees Fahrenheit) 80 70 60 40 Number of hot drinks sold 70 60 50 40 30 20 10 0 J (0, 70) Vertical intercept K (20, 50) L (40, 30) (70, 0) M 10 20 30 50 Outside temperature (degrees Fahrenheit) 60 70 80 40 The curve in panel (a) illustrates the relationship between the two variables, outside temperature and number of sodas sold. The two variables have a positive linear relationship: positive because the curve has an upward tilt, and linear because it is a straight line. It implies that an increase in the x-variable (outside temperature) leads to an increase in the y-variable (number of sodas sold). The curve in panel (b) is also a straight line, but it tilts downward. The two variables here, out- side temperature and number of hot drinks sold, have a negative linear relationship: an increase in the x-variable (outside temperature) leads to a decrease in the y-variable (number of hot drinks sold). The curve in panel (a) has a horizontal intercept at point B, where it hits the horizontal axis. The curve in panel (b) has a vertical intercept at point J, where it hits the vertical axis, and a horizontal intercept at point M, where it hits the horizontal axis. 48 P A R T 1 W H AT ? Two variables have a positive relationship when an increase in the value of one variable is associated with an increase in the value of the other variable. It is illustrated by a curve that slopes upward from left to right. Two variables have a negative relationship when an increase in the value of one variable is associated with a decrease in the value of the other variable. It is illustrated by a curve that slopes downward from left to right. The horizontal intercept of a curve is the point at which it hits the horizontal axis; it indicates the value of the xvariable when the value of the yvariable is zero. The vertical intercept of a curve is the point at which it hits the vertical axis; it shows the value of the y-variable when the value of the x-variable is zero. The slope of a line or curve is a measure of how steep it is. The slope of a line is measured by “rise over run”— the change in the y-variable between two points on the line divided by the change in the x-variable between those same two points. When variables are related this way—that is, when an increase in one variable is associated with an increase in the other variable—the variables are said to have a positive relationship. It is illustrated by a curve that slopes upward from left to right. Because this curve is also linear, the relationship between outside temperature and number of sodas sold illustrated by the curve in panel (a) of Figure 2A-2 is a positive linear relationship. When an increase in one variable is associated with a decrease in the other variable, the two variables are said to have a negative relationship. It is illustrated by a curve that slopes downward from left to right, like the curve in panel (b) of Figure 2A-2. Because this curve is also linear, the relationship it depicts is a negative linear relationship. Two variables that might have such a relationship are the outside temperature and the number of hot drinks a vendor can expect to sell at a baseball stadium. Return for a moment to the curve in panel (a) of Figure 2A-2 and you can see that it hits the horizontal axis at point B. This point, known as the horizontal intercept, shows the value of the x-variable when the value of the y-variable
is zero. In panel (b) of Figure 2A-2, the curve hits the vertical axis at point J. This point, called the vertical intercept, indicates the value of the y-variable when the value of the x-variable is zero. A Key Concept: The Slope of a Curve The slope of a line or curve is a measure of how steep it is and indicates how sensitive the y-variable is to a change in the x-variable. In our example of outside temperature and the number of cans of soda a vendor can expect to sell, the slope of the curve would indicate how many more cans of soda the vendor could expect to sell with each 1° increase in temperature. Interpreted this way, the slope gives meaningful information. Even without numbers for x and y, it is possible to arrive at important conclusions about the relationship between the two variables by examining the slope of a curve at various points. The Slope of a Linear Curve Along a linear curve the slope, or steepness, is measured by dividing the “rise” between two points on the curve by the “run” between those same two points. The rise is the amount that y changes, and the run is the amount that x changes. Here is the formula: Change in y Change in x = Δy Δx = Slope In the formula, the symbol Δ (the Greek uppercase delta) stands for “change in.” When a variable increases, the change in that variable is positive; when a variable decreases, the change in that variable is negative. The slope of a curve is positive when the rise (the change in the y-variable) has the same sign as the run (the change in the x-variable). That’s because when two numbers have the same sign, the ratio of those two numbers is positive. The curve in panel (a) of Figure 2A-2 has a positive slope: along the curve, both the y-variable and the x-variable increase. The slope of a curve is negative when the rise and the run have different signs. That’s because when two numbers have different signs, the ratio of those two numbers is negative. The curve in panel (b) of Figure 2A-2 has a negative slope: along the curve, an increase in the x-variable is associated with a decrease in the y-variable. Figure 2A-3 illustrates how to calculate the slope of a linear curve. Let’s focus first on panel (a). From point A to point B the value of the y-variable changes from 25 to 20 and the value of the x-variable changes from 10 to 20. So the slope of the line between these two points is: Change in y Change in x = Δy Δx = −5 10 = − 1 2 = −0. 49 FIGURE 2A-3 Calculating the Slope (a) Negative Constant Slope (b) Positive Constant Slope Δy = –5 A 1 Slope = – 2 B Δx = 10 y 60 50 40 30 20 10 D Slope = 5 C Δy = 20 B Δx = 4 Δy = 10 Slope = 5 A Δx = 2 5 10 15 20 25 30 35 40 45 10 x Panels (a) and (b) show two linear curves. Between points A Δy Δx = 20 4 = 5. The slope is positive, indicating that the curve is and B on the curve in panel (a), the change in y (the rise) is −5 upward sloping. Furthermore, the slope between A and B is the y 30 25 20 15 10 5 0 and the change in x (the run) is 10. So the slope from A to B is Δy Δx = − = −0.5, where the negative sign indicates that = − 5 10 1 2 same as the slope between C and D, making this a linear curve. The slope of a linear curve is constant: it is the same regardless the curve is downward sloping. In panel (b), the curve has a of where it is calculated along the curve. slope from A to B of Δy Δx = 10 2 = 5. The slope from C to D is Because a straight line is equally steep at all points, the slope of a straight line is the same at all points. In other words, a straight line has a constant slope. You can check this by calculating the slope of the linear curve between points A and B and between points C and D in panel (b) of Figure 2A-3. Between A and B: Between C and D: Δy Δx Δy Δx = = 10 2 20 4 = 5 = 5 Horizontal and Vertical Curves and Their Slopes When a curve is horizontal, the value of the y-variable along that curve never changes—it is constant. Everywhere along the curve, the change in y is zero. Now, zero divided by any number is zero. So, regardless of the value of the change in x, the slope of a horizontal curve is always zero. If a curve is vertical, the value of the x-variable along the curve never changes—it is constant. Everywhere along the curve, the change in x is zero. This means that the slope of a vertical line is a ratio with zero in the denominator. A ratio with zero in the denominator is equal to infinity—that is, an infinitely large number. So the slope of a vertical line is equal to infinity. A vertical or a horizontal curve has a special implication: it means that the x-variable and the y-variable are unrelated. Two variables are unrelated when a change in one variable (the independent variable) has no effect on the other variable (the dependent variable). Or to put it a slightly different way, two variables are unrelated when the dependent variable is constant regardless of the value of the independent variable. If, as is usual, the y-variable is the dependent variable, the curve is horizontal. If the dependent variable is the x-variable, the curve is vertical. 50 P A R T 1 W H AT nonlinear curve is one in which the slope is not the same between every pair of points. The Slope of a Nonlinear Curve A nonlinear curve is one in which the slope changes as you move along it. Panels (a), (b), (c), and (d) of Figure 2A-4 show various nonlinear curves. Panels (a) and (b) show nonlinear curves whose slopes change as you move along them, but the slopes always remain positive. Although both curves tilt upward, the curve in panel FIGURE 2A-4 Nonlinear Curves (a) Positive Increasing Slope (b) Positive Decreasing Slope y 45 40 35 30 25 20 15 10 5 0 y 45 40 35 30 25 20 15 10 5 0 Δy = 15 D Positive slope gets steeper. Slope = 15 C B Δx = 1 Δy = 10 Slope = 2.5 A Δx = 10 11 12 x (c) Negative Increasing Slope Δx = 3 A Slope = 1 –3 3 Δy = –10 B Negative slope gets steeper. Δx = 1 C Δy = –15 D Slope = –15 1 2 3 4 5 6 7 8 9 10 11 12 x y 45 40 35 30 25 20 15 10 5 0 y 45 40 35 30 25 20 15 10 5 0 2 Slope = 1 3 C Slope = 10 B Δx = 3 D Δy = 5 Δy = 10 Positive slope gets flatter. A Δx = 10 11 12 x (d) Negative Decreasing Slope Δx = 1 A Δy = –20 Negative slope gets flatter. Slope = –20 B Slope = –1 2 3 1 2 3 4 5 6 Δx = 3 Δy = –5 D 10 8 9 11 12 x C 7 In panel (a) the slope of the curve from A to B is Δy Δx = 10 4 = it gets steeper as you move to the right. And in panel (d) the 2.5, and from C to D it is Δy Δx = 15 1 = 15. The slope is positive slope from A to B is Δy Δx = –20 1 = −20, and from C to D it is and increasing; it gets steeper as you move to the right. In panel (b) the slope of the curve from A to B is Δy Δx = 10 1 = 10, and from C to D it is Δy Δx = 5 3 = 1 . The slope is positive and 2 3 Δy Δx = –5 3 = −1 . The slope is negative and decreasing; it gets 2 3 flatter as you move to the right. The slope in each case has been calculated by using the arc method—that is, by drawing decreasing; it gets flatter as you move to the right. In panel a straight line connecting two points along a curve. The aver- (c) the slope from A to B is Δy Δx = –10 3 = −3 , and from C to 1 3 age slope between those two points is equal to the slope of D it is Δy Δx = –15 1 = −15. The slope is negative and increasing; the straight line between those two points 51 The absolute value of a negative number is the value of the negative number without the minus sign. A tangent line is a straight line that just touches, or is tangent to, a nonlinear curve at a particular point. The slope of the tangent line is equal to the slope of the nonlinear curve at that point. (a) gets steeper as you move from left to right in contrast to the curve in panel (b), which gets flatter. A curve that is upward sloping and gets steeper, as in panel (a), is said to have positive increasing slope. A curve that is upward sloping but gets flatter, as in panel (b), is said to have positive decreasing slope. When we calculate the slope along these nonlinear curves, we obtain different values for the slope at different points. How the slope changes along the curve determines the curve’s shape. For example, in panel (a) of Figure 2A-4, the slope of the curve is a positive number that steadily increases as you move from left to right, whereas in panel (b), the slope is a positive number that steadily decreases. The slopes of the curves in panels (c) and (d) are negative numbers. Economists often prefer to express a negative number as its absolute value, which is the value of the negative number without the minus sign. In general, we denote the absolute value of a number by two parallel bars around the number; for example, the absolute value of −4 is written as \|−4\| = 4. In panel (c), the absolute value of the slope steadily increases as you move from left to right. The curve therefore has negative increasing slope. And in panel (d), the absolute value of the slope of the curve steadily decreases along the curve. This curve therefore has negative decreasing slope. Calculating the Slope Along a Nonlinear Curve We’ve just seen that along a nonlinear curve, the value of the slope depends on where you are on that curve. So how do you calculate the slope of a nonlinear curve? We will focus on two methods: the arc method and the point method. The Arc Method of Calculating the Slope An arc of a curve is some piece or segment of that curve. For example, panel (a) of Figure 2A-4 shows an arc consisting of the segment of the curve between points A and B. To calculate the slope along a nonlinear curve using the arc method, you draw a straight line between the two endpoints of the arc. The slope of that straight line is a measure of the average slope of the curve between those two end-points. You can see from panel (a) of Figure 2A-4 that the straight line drawn between points A and B increases along the x-axis from 6 to 10 (so that Δx = 4) as it increases along the y-axis from 10 to 20 (so that Δy = 10). Therefore the slope of the straight line connecting points A and B is: Δy Δx
= 10 4 = 2.5 This means that the average slope of the curve between points A and B is 2.5. Now consider the arc on the same curve between points C and D. A straight line drawn through these two points increases along the x-axis from 11 to 12 (Δx = 1) as it increases along the y-axis from 25 to 40 (Δy = 15). So the average slope between points C and D is: Δy Δx = 15 1 = 15 Therefore the average slope between points C and D is larger than the average slope between points A and B. These calculations verify what we have already observed— that this upward-tilted curve gets steeper as you move from left to right and therefore has positive increasing slope. The Point Method of Calculating the Slope The point method calculates the slope of a nonlinear curve at a specific point on that curve. Figure 2A-5 on the next page illustrates how to calculate the slope at point B on the curve. First, we draw a straight line that just touches the curve at point B. Such a line is called a tangent line: the fact that it just touches the curve at point B and does not touch the curve at any other point on the curve means that the straight line is tangent to the curve at point B. The slope of this tangent line is equal to the slope of the nonlinear curve at point B. 52 P A R T 1 W H AT ? FIGURE 2A-5 Calculating the Slope Using the Point Method Here a tangent line has been drawn, a line that just touches the curve at point B. The slope of this line is equal to the slope of the curve at point B. The slope of the tangent line, measuring from A to C, is Δy Δx = 15 5 = 3. y 25 20 15 10 5 0 Tangent line C Slope = 3 B Δy = 15 A Δx = 5 1 2 3 4 5 6 7 x You can see from Figure 2A-5 how the slope of the tangent line is calculated: from point A to point C, the change in y is 15 and the change in x is 5, generating a slope of: Δy Δx = 15 5 = 3 By the point method, the slope of the curve at point B is equal to 3. A natural question to ask at this point is how to determine which method to use— the arc method or the point method—in calculating the slope of a nonlinear curve. The answer depends on the curve itself and the data used to construct it. You use the arc method when you don’t have enough information to be able to draw a smooth curve. For example, suppose that in panel (a) of Figure 2A-4 you have only the data represented by points A, C, and D and don’t have the data represented by point B or any of the rest of the curve. Clearly, then, you can’t use the point method to calculate the slope at point B; you would have to use the arc method to approximate the slope of the curve in this area by drawing a straight line between points A and C. But if you have sufficient data to draw the smooth curve shown in panel (a) of Figure 2A4, then you could use the point method to calculate the slope at point B—and at every other point along the curve as well. Maximum and Minimum Points The slope of a nonlinear curve can change from positive to negative or vice versa. When the slope of a curve changes from positive to negative, it creates what is called a maximum point of the curve. When the slope of a curve changes from negative to positive, it creates a minimum point. Panel (a) of Figure 2A-6 illustrates a curve in which the slope changes from positive to negative as you move from left to right. When x is between 0 and 50, the slope of the curve is positive. At x equal to 50, the curve attains its highest point—the largest value of y along the curve. This point is called the maximum of the curve. When x exceeds 50, the slope becomes negative as the curve turns downward. Many important curves in economics, such as the curve that represents how the profit of a firm changes as it produces more output, are hill-shaped like this. A nonlinear curve may have a maximum point, the highest point along the curve. At the maximum, the slope of the curve changes from positive to negative 53 y 0 FIGURE 2A-6 Maximum and Minimum Points (a) Maximum (b) Minimum Maximum point y Minimum point 50 x 0 50 x y increases as x increases. y decreases as x increases. y decreases as x increases. y increases as x increases. Panel (a) shows a curve with a maximum point, the point at which the slope changes from positive to negative. Panel (b) shows a curve with a minimum point, the point at which the slope changes from negative to positive. In contrast, the curve shown in panel (b) of Figure 2A-6 is U-shaped: it has a slope that changes from negative to positive. At x equal to 50, the curve reaches its lowest point—the smallest value of y along the curve. This point is called the minimum of the curve. Various important curves in economics, such as the curve that represents how the costs of some firms change as output increases, are U–shaped like this. Calculating the Area Below or Above a Curve Sometimes it is useful to be able to measure the size of the area below or above a curve. We will encounter one such case in Chapter 4. To keep things simple, we’ll only calculate the area below or above a linear curve. How large is the shaded area below the linear curve in panel (a) of Figure 2A-7 on the next page? First note that this area has the shape of a right triangle. A right triangle is a triangle that has two sides that make a right angle with each other. We will refer to one of these sides as the height of the triangle and the other side as the base of the triangle. For our purposes, it doesn’t matter which of these two sides we refer to as the base and which as the height. Calculating the area of a right triangle is straightforward: multiply the height of the triangle by the base of the triangle, and divide the result by 2. The height of the triangle in panel (a) of Figure 2A-7 is 10 − 4 = 6. And the base of the triangle is 3 − 0 = 3. So the area of that triangle is 6 × 3 2 = 9 How about the shaded area above the linear curve in panel (b) of Figure 2A-7? We can use the same formula to calculate the area of this right triangle. The height of the triangle is 8 − 2 = 6. And the base of the triangle is 4 − 0 = 4. So the area of that triangle is 6 × 4 2 = 12 A nonlinear curve may have a minimum point, the lowest point along the curve. At the minimum, the slope of the curve changes from negative to positive. 54 P A R T 1 W H AT ? FIGURE 2A-7 Calculating the Area Below and Above a Linear Curve (a) Area Below a Linear Curve (b) Area Above a Linear Curve Height of triangle = 10 – 4 = 6 y 10 Area = 6 × 3 = 9 2 Base of triangle = Height of triangle = 8 – 2 = 6 y 10 Base of triangle = 4 – 0 = 4 Area = 6 × 4 = 12 2 1 2 3 4 5 x The area above or below a linear curve forms a right tri- triangle, and dividing the result by 2. In panel (a) the angle. The area of a right triangle is calculated by multi- area of the shaded triangle is plying the height of the triangle by the base of the area of the shaded triangle is . In panel (b) the = 12. Graphs That Depict Numerical Information Graphs can also be used as a convenient way to summarize and display data without assuming some underlying causal relationship. Graphs that simply display numerical information are called numerical graphs. Here we will consider four types of numerical graphs: time-series graphs, scatter diagrams, pie charts, and bar graphs. These are widely used to display real, empirical data about different economic variables because they often help economists and policy makers identify patterns or trends in the economy. But as we will also see, you must be careful not to misinterpret or draw unwarranted conclusions from numerical graphs. That is, you must be aware of both the usefulness and the limitations of numerical graphs. Types of Numerical Graphs You have probably seen graphs in newspapers that show what has happened over time to economic variables such as the unemployment rate or stock prices. A time-series graph has successive dates on the horizontal axis and the values of a variable that occurred on those dates on the vertical axis. For example, Figure 2A-8 shows the unemployment rate in the United States from 1989 to late 2006. A line connecting the points that correspond to the unemployment rate for each month during those years gives a clear idea of the overall trend in unemployment over these years. Figure 2A-9 is an example of a different kind of numerical graph. It represents information from a sample of 158 countries on average life expectancy and gross national product (GNP) per capita—a rough measure of a country’s standard of living. Each point here indicates an average resident’s life expectancy and the log of GNP per capita for a given country. (Economists have found that the log of GNP rather than the simple level of GNP is more closely tied to average life expectancy.) A time-series graph has dates on the horizontal axis and values of a variable that occurred on those dates on the vertical axis 55 Unemployment Rate, 1989–2006 (seasonally adjusted) FIGURE 2A-8 Time-Series Graph Time-series graphs show successive dates on the x-axis and values for a variable on the y-axis. This time-series graph shows the seasonally adjusted unemployment rate in the United States from 1989 to late 2006. Source: Bureau of Labor Statistics. Unemployment rate (percent) 8% 7 6 5 4 1989 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 2000 ’01 ’02 ’03 ’04 ’05 ’06 Year The points lying in the upper right of the graph, which show combinations of high life expectancy and high log GNP per capita, represent economically advanced countries such as the United States. Points lying in the bottom left of the graph, which show combinations of low life expectancy and low log GNP per capita, represent economically less advanced countries such as Afghanistan and Sierra Leone. The pattern of points indicates that there is a positive relationship between life expectancy and log GNP per capita: on the whole, people live longer in countries with a higher standard of living. This type of graph is called a scatter diagram, a diagram in which each point corresponds to a
n actual observation of the x-variable and the y-variable. In scatter diagrams, a curve is typically fitted to the scatter of points; that is, a curve is drawn that approximates as closely as possible the general relationship between the variables. As you can see, the fitted curve in Figure 2A-9 is upward-sloping, indicating the underlying positive relationship between the two variables. Scatter diagrams are often used to show how a general relationship can be inferred from a set of data. A scatter diagram shows points that correspond to actual observations of the x- and y-variables. A curve is usually fitted to the scatter of points. FIGURE 2A-9 Scatter Diagram In a scatter diagram, each point represents the corresponding values of the x- and y-variables for a given observation. Here, each point indicates the observed average life expectancy and the log of GNP per capita of a given country for a sample of 158 countries. The upward-sloping fitted line here is the best approximation of the general relationship between the two variables. Source: Eduard Bos et al., Health, Nutrition, and Population Indicators: A Statistical Handbook (Washington, DC: World Bank, 1999). Life expectancy at birth (years) 85 75 65 55 45 35 0 Standard of Living and Average Life Expectancy 4 6 8 12 10 Log GNP (per capita) 56 P A R T 1 W H AT ? FIGURE 2A-10 Pie Chart A pie chart shows the percentages of a total amount that can be attributed to various components. This pie chart shows the percentages of total federal revenues that come from each source. Source: Office of Management and Budget. Receipts by Source for U.S. Government Budget 2005 (total: $2,153.9 billion) Corporation income taxes 13% Social insurance receipts 37% Individual income taxes 43% Excise taxes 3% Other 4% A pie chart shows the share of a total amount that is accounted for by various components, usually expressed in percentages. For example, Figure 2A-10 is a pie chart that depicts the various sources of revenue for the U.S. government budget in 2005, expressed in percentages of the total revenue amount, $2,153.9 billion. As you can see, social insurance receipts (the revenues collected to fund Social Security, Medicare, and unemployment insurance) accounted for 37% of total government revenue and individual income tax receipts accounted for 43%. Bar graphs use bars of various heights or lengths to indicate values of a variable. In the bar graph in Figure 2A-11, the bars show the percent change in the number of unemployed workers in the United States from 2001 to 2002, separately for White, Black or African-American, and Asian workers. Exact values of the variable that is being measured may be written at the end of the bar, as in this figure. For instance, the number of unemployed Asian workers in the United States increased by 35% between 2001 and 2002. But even without the precise values, comparing the heights or lengths of the bars can give useful insight into the relative magnitudes of the different values of the variable. A pie chart shows how some total is divided among its components, usually expressed in percentages. A bar graph uses bars of varying height or length to show the comparative sizes of different observations of a variable. FIGURE 2A-11 Bar Graph A bar graph measures a variable by using bars of various heights or lengths. This bar graph shows the percent change in the number of unemployed workers between 2001 and 2002, separately for White, Black or AfricanAmerican, and Asian workers. Source: Bureau of Labor Statistics. Changes in the Number of Unemployed by Race (2001–2002) Percent change in number of unemployed Change in number of unemployed White Black or AfricanAmerican Asian 24% 1,168,000 20% 277,000 35% 101,000 57 An axis is truncated when some of the values on the axis are omitted, usually to save space. Problems in Interpreting Numerical Graphs Although the beginning of this appendix emphasized that graphs are visual images that make ideas or information easier to understand, graphs can be constructed (intentionally or unintentionally) in ways that are misleading and can lead to inaccurate conclusions. This section raises some issues that you should be aware of when you interpret graphs. Features of Construction Before drawing any conclusions about what a numerical graph implies, you should pay attention to the scale, or size of increments, shown on the axes. Small increments tend to visually exaggerate changes in the variables, whereas large increments tend to visually diminish them. So the scale used in construction of a graph can influence your interpretation of the significance of the changes it illustrates—perhaps in an unwarranted way. Take, for example, Figure 2A-12, which shows the unemployment rate in the United States in 2002 using a 0.1% scale. You can see that the unemployment rate rose from 5.6% at the beginning of 2002 to 6.0% by the end of the year. Here, the rise of 0.4% in the unemployment rate looks enormous and could lead a policy maker to conclude that it was a relatively significant event. But if you go back and reexamine Figure 2A-8, which shows the unemployment rate in the United States from 1989 to late 2006, you can see that this would be a misguided conclusion. Figure 2A-8 includes the same data shown in Figure 2A-12, but it is constructed with a 1% scale rather than a 0.1% scale. From it you can see that the rise of 0.4% in the unemployment rate during 2002 was, in fact, a relatively insignificant event, at least compared to the rise in unemployment during 1990 or during 2001. This comparison shows that if you are not careful to factor in the choice of scale in interpreting a graph, you can arrive at very different, and possibly misguided, conclusions. Related to the choice of scale is the use of truncation in constructing a graph. An axis is truncated when part of the range is omitted. This is indicated by two slashes (//) in the axis near the origin. You can see that the vertical axis of Figure 2A-12 has been truncated—the range of values from 0 to 5.6 has been omitted and a // appears in the axis. Truncation saves space in the presentation of a graph and allows smaller increments to be used in constructing it. As a result, changes in the variable depicted on a graph that has been truncated appear larger compared to a graph that has not been truncated and that uses larger increments. Unemployment Rate, 2002 (seasonally adjusted): 0.1% increments FIGURE 2A-12 Interpreting Graphs: The Effect of Scale Some of the same data for the year 2002 used in Figure 2A-8 are represented here, except that here they are shown using 0.1% increments rather than 1% increments. As a result of this change in scale, the rise in the unemployment rate during 2002 looks much larger in this figure compared to Figure 2A-8. Source: Bureau of Labor Statistics. Unemployment rate (percent) 6.0% 5.9 5.8 5.7 5.6 1/02 2/02 3/02 4/02 5/02 6/02 7/02 8/02 9/02 10/02 11/02 12/02 Month 58 P A R T 1 W H AT ? An omitted variable is an unobserved variable that, through its influence on other variables, creates the erroneous appearance of a direct causal relationship among those variables. The error of reverse causality is committed when the true direction of causality between two variables is reversed. You must also pay close attention to exactly what a graph is illustrating. For example, in Figure 2A-11, you should recognize that what is being shown here are percentage changes in the number of unemployed, not numerical changes. The unemployment rate for Asian workers increased by the highest percentage, 35% in this example. If you confused numerical changes with percentage changes, you would erroneously conclude that the greatest number of newly unemployed workers were Asian. But, in fact, a correct interpretation of Figure 2A-11 shows that the greatest number of newly unemployed workers were White: the total number of unemployed White workers grew by 1,168,000 workers, which is greater than the increase in the number of unemployed Asian workers, which is 101,000 in this example. Although there was a higher percentage increase in the number of unemployed Asian workers, the number of unemployed Asian workers in the United States in 2001 was much smaller than the number of unemployed White workers, leading to a smaller number of newly unemployed Asian workers than White workers. Omitted Variables From a scatter diagram that shows two variables moving either positively or negatively in relation to each other, it is easy to conclude that there is a causal relationship. But relationships between two variables are not always due to direct cause and effect. Quite possibly an observed relationship between two variables is due to the unobserved effect of a third variable on each of the other two variables. An unobserved variable that, through its influence on other variables, creates the erroneous appearance of a direct causal relationship among those variables is called an omitted variable. For example, in New England, a greater amount of snowfall during a given week will typically cause people to buy more snow shovels. It will also cause people to buy more de-icer fluid. But if you omitted the influence of the snowfall and simply plotted the number of snow shovels sold versus the number of bottles of de-icer fluid sold, you would produce a scatter diagram that showed an upward tilt in the pattern of points, indicating a positive relationship between snow shovels sold and de-icer fluid sold. To attribute a causal relationship between these two variables, however, is misguided; more snow shovels sold do not cause more de-icer fluid to be sold, or vice versa. They move together because they are both influenced by a third, determining, variable—the weekly snowfall, which is the omitted variable in this case. So before assuming that a pattern in a scatter diagram implies a cause-and-effect relationship, it is important to consider whether the pattern is instead
the result of an omitted variable. Or to put it succinctly: correlation is not causation. Reverse Causality Even when you are confident that there is no omitted variable and that there is a causal relationship between two variables shown in a numerical graph, you must also be careful that you don’t make the mistake of reverse causality— coming to an erroneous conclusion about which is the dependent and which is the independent variable by reversing the true direction of causality between the two variables. For example, imagine a scatter diagram that depicts the grade point averages (GPAs) of 20 of your classmates on one axis and the number of hours that each of them spends studying on the other. A line fitted between the points will probably have a positive slope, showing a positive relationship between GPA and hours of studying. We could reasonably infer that hours spent studying is the independent variable and that GPA is the dependent variable. But you could make the error of reverse causality: you could infer that a high GPA causes a student to study more, whereas a low GPA causes a student to study less. The significance of understanding how graphs can mislead or be incorrectly interpreted is not purely academic. Policy decisions, business decisions, and political arguments are often based on interpretation of the types of numerical graphs that we’ve just discussed. Problems of misleading features of construction, omitted variables, and reverse causality can lead to very important and undesirable consequences. Study the four accompanying diagrams. Consider the following statements and indicate which diagram matches each statement. Which variable would appear on the horizontal and which on the vertical axis? In each of these statements, is the slope positive, negative, zero, or infinity? Panel (a) Panel (b) Panel (c) Panel (d 59 b. What would tax revenue be at a 0% income tax rate? c. The maximum possible income tax rate is 100%. What would tax revenue be at a 100% income tax rate? d. Estimates now show that the maximum point on the Laffer curve is (approximately) at a tax rate of 80%. For tax rates less than 80%, how would you describe the relationship between the tax rate and tax revenue, and how is this relationship reflected in the slope? For tax rates higher than 80%, how would you describe the relationship between the tax rate and tax revenue, and how is this relationship reflected in the slope? 3. In the accompanying figures, the numbers on the axes have been lost. All you know is that the units shown on the vertical axis are the same as the units on the horizontal axis. y Panel (a) y Panel (b) a. If the price of movies increases, fewer consumers go to see movies. b. More experienced workers typically have higher incomes than less experienced workers. x x a. In panel (a), what is the slope of the line? Show that the c. Whatever the temperature outside, Americans consume slope is constant along the line. the same number of hot dogs per day. b. In panel (b), what is the slope of the line? Show that the d. Consumers buy more frozen yogurt when the price of ice slope is constant along the line. cream goes up. e. Research finds no relationship between the number of diet books purchased and the number of pounds lost by the average dieter. f. Regardless of its price, Americans buy the same quantity of salt. 2. During the Reagan administration, economist Arthur Laffer argued in favor of lowering income tax rates in order to increase tax revenues. Like most economists, he believed that at tax rates above a certain level, tax revenue would fall because high taxes would discourage some people from working and that people would refuse to work at all if they received no income after paying taxes. This relationship between tax rates and tax revenue is graphically summarized in what is widely known as the Laffer curve. Plot the Laffer curve relationship assuming that it has the shape of a nonlinear curve. The following questions will help you construct the graph. a. Which is the independent variable? Which is the dependent variable? On which axis do you therefore measure the income tax rate? On which axis do you measure income tax revenue? 4. Answer each of the following questions by drawing a schematic diagram. a. Taking measurements of the slope of a curve at three points farther and farther to the right along the horizontal axis, the slope of the curve changes from −0.3, to −0.8, to −2.5, measured by the point method. Draw a schematic diagram of this curve. How would you describe the relationship illustrated in your diagram? b. Taking measurements of the slope of a curve at five points farther and farther to the right along the horizontal axis, the slope of the curve changes from 1.5, to 0.5, to 0, to −0.5, to −1.5, measured by the point method. Draw a schematic diagram of this curve. Does it have a maximum or a minimum? 60 P A R T 1 W H AT . For each of the accompanying diagrams, calculate the area of the shaded right triangle. curve between Diego’s and Emily’s data points using the arc method? Panel (a) 1 2 3 4 x Panel (c) y 5 4 3 2 1 0 y 50 40 30 20 10 0 10 20 30 40 50 x y 100 80 60 40 20 0 y 10 8 6 4 2 0 Panel (b) 5 10 15 20 25 x Panel (d) 1 2 3 4 5 x 6. The base of a right triangle is 10, and its area is 20. What is the height of this right triangle? 7. The accompanying table shows the relationship between workers’ hours of work per week and their hourly wage rate. Apart from the fact that they receive a different hourly wage rate and work different hours, these five workers are otherwise identical. Name Athena Boris Curt Diego Emily Quantity of labor (hours per week) Wage rate (per hour) 30 35 37 36 32 $15 30 45 60 75 a. Which variable is the independent variable? Which is the dependent variable? b. Draw a scatter diagram illustrating this relationship. Draw a (nonlinear) curve that connects the points. Put the hourly wage rate on the vertical axis. c. As the wage rate increases from $15 to $30, how does the number of hours worked respond according to the relationship depicted here? What is the average slope of the curve between Athena’s and Boris’s data points using the arc method? d. As the wage rate increases from $60 to $75, how does the number of hours worked respond according to the relationship depicted here? What is the average slope of the 8. Studies have found a relationship between a country’s yearly rate of economic growth and the yearly rate of increase in airborne pollutants. It is believed that a higher rate of economic growth allows a country’s residents to have more cars and travel more, thereby releasing more airborne pollutants. a. Which variable is the independent variable? Which is the dependent variable? b. Suppose that in the country of Sudland, when the yearly rate of economic growth fell from 3.0% to 1.5%, the yearly rate of increase in airborne pollutants fell from 6% to 5%. What is the average slope of a nonlinear curve between these points using the arc method? c. Now suppose that when the yearly rate of economic growth rose from 3.5% to 4.5%, the yearly rate of increase in airborne pollutants rose from 5.5% to 7.5%. What is the average slope of a nonlinear curve between these two points using the arc method? d. How would you describe the relationship between the two variables here? 9. An insurance company has found that the severity of property damage in a fire is positively related to the number of firefighters arriving at the scene. a. Draw a diagram that depicts this finding with number of firefighters on the horizontal axis and amount of property damage on the vertical axis. What is the argument made by this diagram? Suppose you reverse what is measured on the two axes. What is the argument made then? b. In order to reduce its payouts to policyholders, should the insurance company therefore ask the city to send fewer firefighters to any fire? 10. The accompanying table illustrates annual salaries and income tax owed by five individuals. Apart from the fact that they receive different salaries and owe different amounts of income tax, these five individuals are otherwise identical. Name Susan Eduardo John Camila Peter Annual salary Annual income tax owed $22,000 63,000 3,000 94,000 37,000 $3,304 14,317 454 23,927 7,020 a. If you were to plot these points on a graph, what would be the average slope of the curve between the points for Eduardo’s and Camila’s salaries and taxes using the arc method? How would you interpret this value for slope? b. What is the average slope of the curve between the points for John’s and Susan’s salaries and taxes using the arc method? How would you interpret that value for slope? c. What happens to the slope as salary increases? What does this relationship imply about how the level of income taxes affects a person’s incentive to earn a higher salary? chapter: 3 >> Supply and Demand L D VIE W R W O WA VIEWWOR W O R L D F OR THOSE WHO NEED A CAPPUCCINO, MOCHA latte, or frappuccino to get through the day, cof- fee drinking can become an expensive habit. And on October 6, 2006, the habit got a little more expensive. country best known to Americans as a place we fought a war has become a coffee-growing giant.) In Brazil, the decline in supply was a delayed reaction to low prices ear- lier in the decade, which led coffee growers to cut back On that day Starbucks raised its drink prices for the first on planting. In Vietnam, the problem was weather: a time in six years. The average price of coffee beverages at prolonged drought sharply reduced coffee harvests. the world’s leading chain of coffeehouses rose about 11 And a lower supply of coffee beans from Vietnam or cents per cup. Brazil inevitably translates into a higher price of coffee Starbucks had kept its prices unchanged for six years. on Main Street. It’s just a matter of supply and demand. So what compelled them to finally raise their prices in What do we mean by that? Many people use “supply
the fall of 2006? Mainly the fact that the cost of a major and demand” as a sort of catchphrase to mean “the laws ingredient—coffee beans—had gone up significantly. In of the marketplace at work.” To economists, however, the fact, coffee bean prices doubled between 2002 and 2006. concept of supply and demand has a precise meaning: it Who decided to raise the prices of coffee beans? is a model of how a market behaves that is extremely use- Nobody: prices went up because of events outside any- ful for understanding many—but not all—markets. one’s control. Specifically, the main cause of rising bean In this chapter, we lay out the pieces that make up the prices was a significant decline in the supply of coffee supply and demand model, put them together, and show beans from the world’s two leading coffee exporters: how this model can be used to understand how many— Brazil and Vietnam. (Yes, Vietnam: since the 1990s, a but not all—markets behave. Reduced coffee bean production in Vietnam inevitably translates into higher coffee prices at your local Starbucks 61 62 P A R T 2 S U P P LY A N D D E M A N D WHAT YOU WILL LEARN IN THIS CHAPTER: ➤ What a competitive market is and ➤ The difference between how it is described by the supply and demand model movements along a curve and shifts of a curve ➤ What the demand curve and supply curve are ➤ How the supply and demand curves determine a market’s equilibrium price and equilibrium quantity ➤ In the case of a shortage or surplus, how price moves the market back to equilibrium Supply and Demand: A Model of a Competitive Market Coffee bean sellers and coffee bean buyers constitute a market—a group of producers and consumers who exchange a good or service for payment. In this chapter, we’ll focus on a particular type of market known as a competitive market. Roughly, a competitive market is a market in which there are many buyers and sellers of the same good or service. More precisely, the key feature of a competitive market is that no individual’s actions have a noticeable effect on the price at which the good or service is sold. It’s important to understand, however, that this is not an accurate description of every market. For example, it’s not an accurate description of the market for cola beverages. That’s because in the market for cola beverages, Coca-Cola and Pepsi account for such a large proportion of total sales that they are able to influence the price at which cola beverages are bought and sold. But it is an accurate description of the market for coffee beans. The global marketplace for coffee beans is so huge that even a coffee retailer as large as Starbucks accounts for only a tiny fraction of transactions, making it unable to influence the price at which coffee beans are bought and sold. It’s a little hard to explain why competitive markets are different from other markets until we’ve seen how a competitive market works. So let’s take a rain check—we’ll return to that issue at the end of this chapter. For now, let’s just say that it’s easier to model competitive markets than other markets. When taking an exam, it’s always a good strategy to begin by answering the easier questions. In this book, we’re going to do the same thing. So we will start with competitive markets. When a market is competitive, its behavior is well described by the supply and demand model. Because many markets are competitive, the supply and demand model is a very useful one indeed. There are five key elements in this model: ■ The demand curve ■ The supply curve ■ The set of factors that cause the demand curve to shift and the set of factors that cause the supply curve to shift ■ The market equilibrium, which includes the equilibrium price and equilibrium quantity ■ The way the market equilibrium changes when the supply curve or demand curve shifts To understand the supply and demand model, we will examine each of these elements. The Demand Curve How many pounds of coffee beans do consumers around the world want to buy in a given year? You might at first think that we can answer this question by looking at the total number of cups of coffee drunk around the world each day and the amount of coffee beans it takes to brew a cup, then multiplying by 365. But that’s not enough to answer the question, because how many pounds of coffee beans consumers want A competitive market is a market in which there are many buyers and sellers of the same good or service, none of whom can influence the price at which the good or service is sold. The supply and demand model is a model of how a competitive market works LY A N D D E M A N D 63 A demand schedule shows how much of a good or service consumers will want to buy at different prices. to buy—and therefore how much coffee people want to drink—depends on the price of coffee beans. When the price of coffee rises, as it did in 2006, some people drink less of it, perhaps switching completely to other caffeinated beverages, such as tea or Coca-Cola. (Yes, there are people who drink Coke in the morning.) In general, the quantity of coffee beans, or of any good or service that people want to buy, depends on the price. The higher the price, the less of the good or service people want to purchase; alternatively, the lower the price, the more they want to purchase. So the answer to the question “How many pounds of coffee beans do consumers want to buy?” depends on the price of coffee beans. If you don’t yet know what the price will be, you can start by making a table of how many pounds of coffee beans people would want to buy at a number of different prices. Such a table is known as a demand schedule. This, in turn, can be used to draw a demand curve, which is one of the key elements of the supply and demand model. The Demand Schedule and the Demand Curve A demand schedule is a table showing how much of a good or service consumers will want to buy at different prices. At the right of Figure 3-1, we show a hypothetical demand schedule for coffee beans. It’s hypothetical in that it doesn’t use actual data on the world demand for coffee beans and it assumes that all coffee beans are of equal quality (with our apologies to coffee connoisseurs). According to the table, if coffee beans cost $1 a pound, consumers around the world will want to purchase 10 billion pounds of coffee beans over the course of a year. If the price is $1.25 a pound, they will want to buy only 8.9 billion pounds; if FIGURE 3-1 The Demand Schedule and the Demand Curve Price of coffee beans (per pound) $2.00 1.75 1.50 1.25 1.00 0.75 0.50 As price rises, the quantity demanded falls. Demand curve, D Demand Schedule for Coffee Beans Price of coffee beans (per pound) $2.00 1.75 1.50 1.25 1.00 0.75 0.50 Quantity of coffee beans demanded (billions of pounds) 7.1 7.5 8.1 8.9 10.0 11.5 14.2 0 7 9 11 13 15 Quantity of coffee beans (billions of pounds) 17 The demand schedule for coffee beans yields the corresponding demand curve, which shows how much of a good or service consumers want to buy at any given price. The demand curve and the demand schedule reflect the law of demand: As price rises, the quantity demanded falls. Similarly, a decrease in price raises the quantity demanded. As a result, the demand curve is downward sloping. 64 P A R T 2 S U P P LY A N D D E M A N D The quantity demanded is the actual amount of a good or service consumers are willing to buy at some specific price. A demand curve is a graphical representation of the demand schedule. It shows the relationship between quantity demanded and price. The law of demand says that a higher price for a good or service, other things equal, leads people to demand a smaller quantity of that good or service. the price is only $0.75 a pound, they will want to buy 11.5 billion pounds; and so on. So the higher the price, the fewer pounds of coffee beans consumers will want to purchase. In other words, as the price rises, the quantity demanded of coffee beans— the actual amount consumers are willing to buy at some specific price—falls. The graph in Figure 3-1 is a visual representation of the information in the table. (You might want to review the discussion of graphs in economics in the appendix to Chapter 2.) The vertical axis shows the price of a pound of coffee beans and the horizontal axis shows the quantity of coffee beans. Each point on the graph corresponds to one of the entries in the table. The curve that connects these points is a demand curve. A demand curve is a graphical representation of the demand schedule, another way of showing the relationship between the quantity demanded and price. Note that the demand curve shown in Figure 3-1 slopes downward. This reflects the general proposition that a higher price reduces the quantity demanded. For example, some people who drink two cups of coffee a day when beans are $1 per pound will cut down to one cup when beans are $2 per pound. Similarly, some who drink one cup when beans are $1 a pound will drink tea instead if the price doubles to $2 per pound and so on. In the real world, demand curves almost always do slope downward. (The exceptions are so rare that for practical purposes we can ignore them.) Generally, the proposition that a higher price for a good, other things equal, leads people to demand a smaller quantity of that good is so reliable that economists are willing to call it a “law”—the law of demand. Shifts of the Demand Curve Even though coffee prices were a lot higher in 2006 than they had been in 2002, total world consumption of coffee was higher in 2006. How can we reconcile this fact with the law of demand, which says that a higher price reduces the quantity demanded, other things equal? PAY MORE, PUMP LESS For a real-world illustration of the law of demand, consider how gasoline consumption varies according to the prices consumers pay at the pump. Because of high taxes, gasoline and diesel fuel are more than twice as expensive in most European countries as in the United Stat
es. According to the law of demand, this should lead Europeans to buy less gasoline than Americans—and they do. As you can see from the figure, per person, Europeans consume less than half as much fuel as Americans, mainly because they drive smaller cars with better mileage. Prices aren’t the only factor affecting fuel consumption, but they’re probably the main cause of the difference between European and American fuel consumption per person. Source: U.S. Energy Information Administration, 2007. Price of gasoline (per gallon) $8 7 6 5 4 3 0 Germany United Kingdom Italy France Spain Japan Canada United States 0.2 0.6 1.0 1.4 Consumption of gasoline (gallons per day per capita LY A N D D E M A N D 65 A shift of the demand curve is a change in the quantity demanded at any given price, represented by the change of the original demand curve to a new position, denoted by a new demand curve. The answer lies in the crucial phrase other things equal. In this case, other things weren’t equal: the world had changed between 2002 and 2006, in ways that increased the quantity of coffee demanded at any given price. For one thing, the world’s population, and therefore the number of potential coffee drinkers, increased. In addition, the growing popularity of different types of coffee beverages, like lattes and cappuccinos, led to an increase in the quantity demanded at any given price. Figure 3-2 illustrates this phenomenon using the demand schedule and demand curve for coffee beans. (As before, the numbers in Figure 3-2 are hypothetical.) The table in Figure 3-2 shows two demand schedules. The first is a demand schedule for 2002, the same one shown in Figure 3-1. The second is a demand schedule for 2006. It differs from the 2002 demand schedule due to factors such as a larger population and the greater popularity of lattes, factors that led to an increase in the quantity of coffee beans demanded at any given price. So at each price the 2006 schedule shows a larger quantity demanded than the 2002 schedule. For example, the quantity of coffee beans consumers wanted to buy at a price of $1 per pound increased from 10 billion to 12 billion pounds per year, the quantity demanded at $1.25 per pound went from 8.9 billion to 10.7 billion pounds, and so on. What is clear from this example is that the changes that occurred between 2002 and 2006 generated a new demand schedule, one in which the quantity demanded was greater at any given price than in the original demand schedule. The two curves in Figure 3-2 show the same information graphically. As you can see, the demand schedule for 2006 corresponds to a new demand curve, D2, that is to the right of the demand curve for 2002, D1. This shift of the demand curve shows the change in the quantity demanded at any given price, represented by the change in position of the original demand curve D1 to its new location at D2. FIGURE 3-2 An Increase in Demand Price of coffee beans (per pound) $2.00 1.75 1.50 1.25 1.00 0.75 0.50 Demand curve in 2006 Demand curve in 2002 D1 D2 Demand Schedules for Coffee Beans Price of coffee beans (per pound) $2.00 1.75 1.50 1.25 1.00 0.75 0.50 Quantity of coffee beans demanded (billions of pounds) in 2002 7.1 7.5 8.1 8.9 10.0 11.5 14.2 in 2006 8.5 9.0 9.7 10.7 12.0 13.8 17.0 0 7 9 11 13 15 Quantity of coffee beans (billions of pounds) 17 An increase in the population and other factors generate an increase in demand—a rise in the quantity demanded at any given price. This is represented by the two demand schedules—one showing demand in 2002, before the rise in population, the other showing demand in 2006, after the rise in population—and their corresponding demand curves. The increase in demand shifts the demand curve to the right. 66 P A R T 2 S U P P LY A N D D E M A N D FIGURE 3-3 Movement Along the Demand Curve Versus Shift of the Demand Curve The rise in quantity demanded when going from point A to point B reflects a movement along the demand curve: it is the result of a fall in the price of the good. The rise in quantity demanded when going from point A to point C reflects a shift of the demand curve: it is the result of a rise in the quantity demanded at any given price. Price of coffee beans (per pound) $2.00 1.75 1.50 1.25 1.00 0.75 0.50 A shift of the demand curve . . . A C B . . . is not the same thing as a movement along the demand curve. D1 D2 0 7 8.1 9.7 10 15 13 Quantity of coffee beans (billions of pounds) 17 P I T F A L L S demand versus quantity demanded When economists say “an increase in demand,” they mean a rightward shift of the demand curve, and when they say “a decrease in demand,” they mean a leftward shift of the demand curve—that is, when they’re being careful. In ordinary speech most people, including professional economists, use the word demand casually. For example, an economist might say “the demand for air travel has doubled over the past 15 years, partly because of falling air fares” when he or she really means that the quantity demanded has doubled. It’s OK to be a bit sloppy in ordinary conversation. But when you’re doing economic analysis, it’s important to make the distinction between changes in the quantity demanded, which involve movements along a demand curve, and shifts of the demand curve. Sometimes students end up writing something like this: “If demand increases, the price will go up, but that will lead to a fall in demand, which pushes the price down . . .” and then go around in circles. If you make a clear distinction between changes in demand, which mean shifts of the demand curve, and changes in quantity demanded, you can avoid a lot of confusion. It’s crucial to make the distinction between such shifts of the demand curve and movements along the demand curve, changes in the quantity demanded of a good that result from a change in that good’s price. Figure 3-3 illustrates the difference. The movement from point A to point B is a movement along the demand curve: the quantity demanded rises due to a fall in price as you move down D1. Here, a fall in the price of coffee beans from $1.50 to $1 per pound generates a rise in the quantity demanded from 8.1 billion to 10 billion pounds per year. But the quantity demanded can also rise when the price is unchanged if there is an increase in demand—a rightward shift of the demand curve. This is illustrated in Figure 3-3 by the shift of the demand curve from D1 to D2. Holding the price constant at $1.50 a pound, the quantity demanded rises from 8.1 billion pounds at point A on D1 to 9.7 billion pounds at point C on D2. When economists say “the demand for X increased” or “the demand for Y decreased,” they mean that the demand curve for X or Y shifted—not that the quantity demanded rose or fell because of a change in the price. Understanding Shifts of the Demand Curve Figure 3-4 illustrates the two basic ways in which demand curves can shift. When economists talk about an “increase in demand,” they mean a rightward shift of the demand curve: at any given price, consumers demand a larger quantity of the good or service than before. This is shown by the rightward shift of the original demand curve D1 to D2. And when economists talk about a “decrease in demand,” they mean a leftward shift of the demand curve: at any given price, consumers demand a smaller quantity of the good or service than before. This is shown by the leftward shift of the original demand curve D1 to D3. A movement along the demand curve is a change in the quantity demanded of a good that is the result of a change in that good’s price LY A N D D E M A N D 67 FIGURE 3-4 Shifts of the Demand Curve Price Any event that increases demand shifts the demand curve to the right, reflecting a rise in the quantity demanded at any given price. Any event that decreases demand shifts the demand curve to the left, reflecting a fall in the quantity demanded at any given price. Increase in demand Decrease in demand D3 D1 D2 Quantity What caused the demand curve for coffee beans to shift? We have already mentioned two reasons: changes in population and a change in the popularity of coffee beverages. If you think about it, you can come up with other things that would be likely to shift the demand curve for coffee beans. For example, suppose that the price of tea rises. This will induce some people who previously drank tea to drink coffee instead, increasing the demand for coffee beans. Economists believe that there are five principal factors that shift the demand curve for a good or service: ■ Changes in the prices of related goods or services ■ Changes in income ■ Changes in tastes ■ Changes in expectations ■ Changes in the number of consumers Although this is not an exhaustive list, it contains the five most important factors that can shift demand curves. So when we say that the quantity of a good or service demanded falls as its price rises, other things equal, we are in fact stating that the factors that shift demand are remaining unchanged. Let’s now explore, in more detail, how those factors shift the demand curve. Changes in the Prices of Related Goods or Services While there’s nothing quite like a good cup of coffee to start your day, a cup or two of strong tea isn’t a bad alternative. Tea is what economists call a substitute for coffee. A pair of goods are substitutes if a rise in the price of one good (coffee) makes consumers more willing to buy the other good (tea). Substitutes are usually goods that in some way serve a similar function: concerts and theater plays, muffins and doughnuts, train rides and air flights. A rise in the price of the alternative good induces some consumers to purchase the original good instead of it, shifting demand for the original good to the right. But sometimes a fall in the price of one good makes consumers more willing to buy another good. Such pairs of goods are known as complements. Complements are usually goods that in some sense are consumed together: computers and software, cappuccin
os and croissants, cars and gasoline. Because consumers like to consume a good and its complement together, a change in the price of one of the goods will affect the demand for its complement. In particular, when the price of one good Two goods are substitutes if a rise in the price of one of the goods leads to an increase in the demand for the other good. Two goods are complements if a rise in the price of one good leads to a decrease in the demand for the other good. 68 P A R T 2 S U P P LY A N D D E M A N D When a rise in income increases the demand for a good—the normal case— it is a normal good. When a rise in income decreases the demand for a good, it is an inferior good. rises, the demand for its complement decreases, shifting the demand curve for the complement to the left. So the October 2006 rise in Starbucks’ cappuccino prices is likely to have precipitated a leftward shift of the demand curve for croissants, as people consumed fewer cappuccinos and croissants. Likewise, when the price of one good falls, the quantity demanded of its complement rises, shifting the demand curve for the complement to the right. This means that if, for some reason, the price of cappuccinos falls, we should see a rightward shift of the demand curve for croissants as people consume more cappuccinos and croissants. Changes in Income When individuals have more income, they are normally more likely to purchase a good at any given price. For example, if a family’s income rises, it is more likely to take that summer trip to Disney World—and therefore also more likely to buy plane tickets. So a rise in consumer incomes will cause the demand curves for most goods to shift to the right. Why do we say “most goods,” not “all goods”? Most goods are normal goods— the demand for them increases when consumer income rises. However, the demand for some products falls when income rises. Goods for which demand decreases when income rises are known as inferior goods. Usually an inferior good is one that is considered less desirable than more expensive alternatives—such as a bus ride versus a taxi ride. When they can afford to, people stop buying an inferior good and switch their consumption to the preferred, more expensive alternative. So when a good is inferior, a rise in income shifts the demand curve to the left. And, not surprisingly, a fall in income shifts the demand curve to the right. One example of the distinction between normal and inferior goods that has drawn considerable attention in the business press is the difference between so-called casualdining restaurants such as Applebee’s or Olive Garden and fast-food chains such as McDonald’s and KFC. When Americans’ income rises, they tend to eat out more at casual-dining restaurants. However, some of this increased dining out comes at the expense of fast-food venues—to some extent, people visit McDonald’s less once they can afford to move upscale. So casual dining is a normal good, while fast-food consumption appears to be an inferior good. Changes in Tastes Why do people want what they want? Fortunately, we don’t need to answer that question—we just need to acknowledge that people have certain preferences, or tastes, that determine what they choose to consume and that these tastes can change. Economists usually lump together changes in demand due to fads, beliefs, cultural shifts, and so on under the heading of changes in tastes or preferences. For example, once upon a time men wore hats. Up until around World War II, a respectable man wasn’t fully dressed unless he wore a dignified hat along with his suit. But the returning GIs adopted a more informal style, perhaps due to the rigors of the war. And President Eisenhower, who had been supreme commander of Allied Forces before becoming president, often went hatless. After World War II, it was clear that the demand curve for hats had shifted leftward, reflecting a decrease in the demand for hats. We’ve already mentioned one way in which changing tastes played a role in the increase in the demand for coffee beans from 2002 to 2006: the increase in the popularity of coffee beverages such as lattes and cappuccinos. In addition, there was another route by which changing tastes increased worldwide demand for coffee beans: the switch by consumers in traditionally tea-drinking countries to coffee. “In 1999,” reported Roast magazine, “the ratio of Russian tea drinkers to coffee drinkers was five to one. In 2005, the ratio is roughly two to one.” Economists have little to say about the forces that influence consumers’ tastes. (Although marketers and advertisers have plenty to say about them!) However, a change in tastes has a predictable impact on demand. When tastes change in favor of a good, more people want to buy it at any given price, so the demand curve shifts to the right. When tastes change against a good, fewer people want to buy it at any given price, so the demand curve shifts to the left LY A N D D E M A N D 69 An individual demand curve illustrates the relationship between quantity demanded and price for an individual consumer. Changes in Expectations When consumers have some choice about when to make a purchase, current demand for a good is often affected by expectations about its future price. For example, savvy shoppers often wait for seasonal sales— say, buying next year’s holiday gifts during the post-holiday markdowns. In this case, expectations of a future drop in price lead to a decrease in demand today. Alternatively, expectations of a future rise in price are likely to cause an increase in demand today. For example, savvy shoppers, knowing that Starbucks was going to increase the price of its coffee beans on October 6, 2006, would stock up on Starbucks coffee beans before that date. Expected changes in future income can also lead to changes in demand: if you expect your income to rise in the future, you will typically borrow today and increase your demand for certain goods; and if you expect your income to fall in the future, you are likely to save today and reduce your demand for some goods. Changes in the Number of Consumers As we’ve already noted, one of the reasons for rising coffee demand between 2002 and 2006 was a growing world population. Because of population growth, overall demand for coffee would have risen even if each individual coffee-drinker’s demand for coffee had remained unchanged. Let’s introduce a new concept: the individual demand curve, which shows the relationship between quantity demanded and price for an individual consumer. For example, suppose that Darla is a consumer of coffee beans and that panel (a) of Figure 3-5 shows how many pounds of coffee beans she will buy per year at any given price per pound. Then DDarla is Darla’s individual demand curve. The market demand curve shows how the combined quantity demanded by all consumers depends on the market price of that good. (Most of the time, when economists refer to the demand curve, they mean the market demand curve.) The market demand curve is the horizontal sum of the individual demand curves of all FIGURE 3-5 Individual Demand Curves and the Market Demand Curve Price of coffee beans (per pound) $2 1 0 (a) Darla’s Individual Demand Curve (b) Dino’s Individual Demand Curve Price of coffee beans (per pound) $2 DDarla 20 30 Quantity of coffee beans (pounds) 1 0 DDino 10 20 Quantity of coffee beans (pounds) An individual demand curve illustrates (c) Market Demand Curve the relationship between quantity demanded and price for an individual consumer. Price of coffee beans (per pound) The quantity supplied is the actual $2 amount of a good or service people are willing to sell at some specific price. A supply schedule shows how much of a good or service would be supplied at different prices. 1 DMarket A supply curve shows the relationship between quantity supplied and price. 30 A shift of the supply curve is a change in the quantity supplied of a good or 40 0 service at any given price. It is repreQuantity of coffee beans (pounds) sented by the change of the original supply curve to a new position, denoted by a new supply curve. 50 Darla and Dino are the only two consumers of coffee beans in the market. Panel (a) shows Darla’s individual demand curve: the number of pounds of coffee beans she will buy per year at any given price. Panel (b) shows Dino’s individual demand curve. Given that Darla and Dino are the only two consumers, the market demand curve, which shows the quantity of coffee demanded by all consumers at any given price, is shown in panel (c). The market demand curve is the horizontal sum of the individual demand curves of all consumers. In this case, at any given price, the quantity demanded by the market is the sum of the quantities demanded by Darla and Dino. A movement along the supply curve is a change in the quantity supplied of a 70 P A R T 2 S U P P LY A N D D E M A N D TABLE 3-1 Factors That Shift Demand Changes in the prices of related goods or services If A and B are substitutes . . . . . . and the price of B rises, . . . . . . and the price of B falls, . . . If A and B are complements . . . . . . and the price of B rises, . . . . . . and the price of B falls, . . . Changes in income If A is a normal good . . . . . . and income rises, . . . . . . and income falls, . . . If A is an inferior good . . . . . . and income rises, . . . . . . and income falls, . . . Changes in tastes If tastes change in favor of A, . . . If tastes change against A, . . . Changes in expectations . . . demand for A increases. . . . demand for A decreases. . . . demand for A decreases. . . . demand for A increases. . . . demand for A increases. . . . demand for A decreases. . . . demand for A decreases. . . . demand for A increases. . . . demand for A increases. . . . demand for A decreases. If the price of A is expected to rise in the future, . . . . . . demand for A increases today. If the price of A is expected to fall in the future, . . . . . . d
emand for A decreases today. If A is a normal good . . . . . . and income is expected to rise in the future, . . . . . . demand for A may increase today. If A is an inferior good . . . . . . and income is expected to rise in the future, . . . . . . demand for A may decrease today. . . . and income is expected to fall in the future, . . . . . . demand for A may decrease today. . . . and income is expected to fall in the future, . . . . . . demand for A may increase today. Changes in the number of consumers If the number of consumers of A rises, . . . . . . market demand for A increases. If the number of consumers of A falls, . . . . . . market demand for A decreases. consumers in that market. To see what we mean by the term horizontal sum, assume for a moment that there are only two consumers of coffee, Darla and Dino. Dino’s individual demand curve, DDino, is shown in panel (b). Panel (c) shows the market demand curve. At any given price, the quantity demanded by the market is the sum of the quantities demanded by Darla and Dino. For example, at a price of $2 per pound, Darla demands 20 pounds of coffee beans per year and Dino demands 10 pounds per year. So the quantity demanded by the market is 30 pounds per year. Clearly, the quantity demanded by the market at any given price is larger with Dino present than it would be if Darla was the only consumer. The quantity demanded at any given price would be even larger if we added a third consumer, then a fourth, and so on. So an increase in the number of consumers leads to an increase in demand. For an overview of the factors that shift demand, see Table 3-1. W E L D VIE W R W O W ➤ECONOMICS IN ACTION Beating the Traffic All big cities have traffic problems, and many local authorities try to discourage driving in the crowded city center. If we think of an auto trip to the city center as a good that people consume, we can use the economics of demand to analyze anti-traffic policies. VIEWWOR LY A N D D E M A N D 71 One common strategy of local governments is to reduce the demand for auto trips by lowering the prices of substitutes. Many metropolitan areas subsidize bus and rail service, hoping to lure commuters out of their cars. An alternative strategy is to raise the price of complements: several major U.S. cities impose high taxes on commercial parking garages, both to raise revenue and to discourage people from driving into the city. Short time limits on parking meters, combined with vigilant parking enforcement, is a related tactic. However, few cities have been willing to adopt the politically controversial direct approach: reducing congestion by raising the price of driving. So it was a shock when, in 2003, London imposed a “congestion charge” on all cars entering the city center during business hours—currently £8 (about $16) for drivers who pay on the same day they travel. Compliance is monitored with automatic cameras that photograph license plates. People can either pay the charge in advance or pay it by midnight of the day they have driven. If they pay on the day after they have driven, the charge increases to £10 (about $20). And if they don’t pay and are caught, a fine of £120 (about $240) is imposed for each transgression. (A full description of the rules can be found at www.cclondon.com.) Not surprisingly, the result of the new policy confirms the law of demand: three years after the charge was put in place, traffic in central London was about 10 percent lower than before the charge. In February 2007, the British government doubled the area of London covered by the congestion charge, and it suggested that it might institute congestion charging across the country by 2015. Several American and European municipalities, having seen the success of London’s congestion charge, have said that they are seriously considering adopting a congestion charge as well. ▲ > > > > > > > > > > > > ➤ CHECK YOUR UNDERSTANDING 3-1 1. Explain whether each of the following events represents (i) a shift of the demand curve or (ii) a movement along the demand curve. a. A store owner finds that customers are willing to pay more for umbrellas on rainy days. b. When XYZ Telecom, a long-distance telephone service provider, offered reduced rates on weekends, its volume of weekend calling increased sharply. c. People buy more long-stem roses the week of Valentine’s Day, even though the prices are higher than at other times during the year. d. The sharp rise in the price of gasoline leads many commuters to join carpools in order to reduce their gasoline purchases. Solutions appear at back of book. The Supply Curve Some parts of the world are especially well suited to growing coffee beans, which is why, as the lyrics of an old song put it, “There’s an awful lot of coffee in Brazil.” But even in Brazil, some land is better suited to growing coffee than other land. Whether Brazilian farmers restrict their coffee-growing to only the most ideal locations or expand it to less suitable land depends on the price they expect to get for their beans. Moreover, there are many other areas in the world where coffee beans could be grown—such as Madagascar and Vietnam. Whether farmers there actually grow coffee depends, again, on the price. So just as the quantity of coffee beans that consumers want to buy depends on the price they have to pay, the quantity that producers are willing to produce and sell— the quantity supplied—depends on the price they are offered. The Supply Schedule and the Supply Curve The table in Figure 3-6 on the next page shows how the quantity of coffee beans made available varies with the price—that is, it shows a hypothetical supply schedule for coffee beans. ➤➤ ➤ The supply and demand model is a model of a competitive market—one in which there are many buyers and sellers of the same good or service. ➤ The demand schedule shows how the quantity demanded changes as the price changes. This relationship is illustrated by a demand curve. ➤ The law of demand asserts that demand curves normally slope downward—that is, a higher price reduces the quantity demanded. ➤ Increases or decreases in demand correspond to shifts of the demand curve. An increase in demand is a rightward shift: the quantity demanded rises for any given price. A decrease in demand is a leftward shift: the quantity demanded falls for any given price. A change in price results in a movement along the demand curve—a change in the quantity demanded. ➤ The five main factors that can shift the demand curve are changes in (1) the price of a related good, such as a substitute or a complement, (2) income, (3) tastes, (4) expectations, and (5) the number of consumers. ➤ The market demand curve is the horizontal sum of the individual demand curves of all consumers in the market. The quantity supplied is the actual amount of a good or service producers are willing to sell at some specific price. A supply schedule shows how much of a good or service producers will supply at different prices. 72 P A R T 2 S U P P LY A N D D E M A N D FIGURE 3-6 The Supply Schedule and the Supply Curve Price of coffee beans (per pound) $2.00 1.75 1.50 1.25 1.00 0.75 0.50 Supply curve, S As price rises, the quantity supplied rises. Supply Schedule for Coffee Beans Price of coffee beans (per pound) $2.00 1.75 1.50 1.25 1.00 0.75 0.50 Quantity of coffee beans supplied (billions of pounds) 11.6 11.5 11.2 10.7 10.0 9.1 8.0 0 7 9 13 15 11 17 Quantity of coffee beans (billions of pounds) The supply schedule for coffee beans is plotted to yield the corresponding supply curve, which shows how much of a good producers are willing to sell at any given price. The supply curve and the supply schedule reflect the fact that supply curves are usually upward sloping: the quantity supplied rises when the price rises. A supply schedule works the same way as the demand schedule shown in Figure 3-1: in this case, the table shows the quantity of coffee beans farmers are willing to sell at different prices. At a price of $0.50 per pound, farmers are willing to sell only 8 billion pounds of coffee beans per year. At $0.75 per pound, they’re willing to sell 9.1 billion pounds. At $1, they’re willing to sell 10 billion pounds, and so on. In the same way that a demand schedule can be represented graphically by a demand curve, a supply schedule can be represented by a supply curve, as shown in Figure 3-6. Each point on the curve represents an entry from the table. Suppose that the price of coffee beans rises from $1 to $1.25; we can see that the quantity of coffee beans farmers are willing to sell rises from 10 billion to 10.7 billion pounds. This is the normal situation for a supply curve, reflecting the general proposition that a higher price leads to a higher quantity supplied. So just as demand curves normally slope downward, supply curves normally slope upward: the higher the price being offered, the more of any good or service producers will be willing to sell. A supply curve shows the relationship between quantity supplied and price. Shifts of the Supply Curve Compared to earlier trends, coffee beans were unusually cheap in the early years of the twenty-first century. One reason was the emergence of new coffee bean– producing countries, which began competing with the traditional sources in Latin LY A N D D E M A N D 73 FIGURE 3-7 An Increase in Supply Price of coffee beans (per pound) $2.00 1.75 1.50 1.25 1.00 0.75 0.50 S1 S2 Supply curve f before entry o new producers Supply curve after entry of new producers Supply Schedules for Coffee Beans Price of coffee beans (per pound) Quantity of coffee beans supplied (billions of pounds) Before entry After entry $2.00 1.75 1.50 1.25 1.00 0.75 0.50 11.6 11.5 11.2 10.7 10.0 9.1 8.0 13.9 13.8 13.4 12.8 12.0 10.9 9.6 0 7 9 15 13 11 17 Quantity of coffee beans (billions of pounds) The entry of Vietnam into the coffee bean business generated an increase in supply—a rise in the quantity supplied at any given price. This event
is represented by the two supply schedules—one showing supply before Vietnam’s entry, the other showing supply after Vietnam came in—and their corresponding supply curves. The increase in supply shifts the supply curve to the right. America. Vietnam, in particular, emerged as a big new source of coffee beans. Figure 3-7 illustrates this event in terms of the supply schedule and the supply curve for coffee beans. The table in Figure 3-7 shows two supply schedules. The schedule before new producers such as Vietnam arrived on the scene is the same one as in Figure 3-6. The second schedule shows the supply of coffee beans after the entry of new producers. Just as a change in demand schedules leads to a shift of the demand curve, a change in supply schedules leads to a shift of the supply curve—a change in the quantity supplied at any given price. This is shown in Figure 3-7 by the shift of the supply curve before the entry of the new producers, S1, to its new position after the entry of the new producers, S2. Notice that S2 lies to the right of S1, a reflection of the fact that quantity supplied increases at any given price. As in the analysis of demand, it’s crucial to draw a distinction between such shifts of the supply curve and movements along the supply curve—changes in the quantity supplied that result from a change in price. We can see this difference in Figure 3-8 on the next page. The movement from point A to point B is a movement along the supply curve: the quantity supplied rises along S1 due to a rise in price. Here, a rise in price from $1 to $1.50 leads to a rise in the quantity supplied from 10 billion to 11.2 billion pounds of coffee beans. But the quantity supplied can also rise when the price is unchanged if there is an increase in supply—a rightward shift of the supply curve. This is shown by the rightward shift of the supply curve from S1 to S2. Holding price constant at $1, the quantity supplied rises from 10 billion pounds at point A on S1 to 12 billion pounds at point C on S2. A shift of the supply curve is a change in the quantity supplied of a good or service at any given price. It is represented by the change of the original supply curve to a new position, denoted by a new supply curve. A movement along the supply curve is a change in the quantity supplied of a good that is the result of a change in that good’s price. 74 P A R T 2 S U P P LY A N D D E M A N D FIGURE 3-8 Movement Along the Supply Curve Versus Shift of the Supply Curve The increase in quantity supplied when going from point A to point B reflects a movement along the supply curve: it is the result of a rise in the price of the good. The increase in quantity supplied when going from point A to point C reflects a shift of the supply curve: it is the result of an increase in the quantity supplied at any given price. Price of coffee beans (per pound) $2.00 1.75 1.50 1.25 1.00 0.75 0.50 0 7 A movement along the supply curve . . . S2 S1 B A C . . . is not the same thing as a shift of the supply curve. 10 11.2 12 15 17 Quantity of coffee beans (billions of pounds) Understanding Shifts of the Supply Curve Figure 3-9 illustrates the two basic ways in which supply curves can shift. When economists talk about an “increase in supply,” they mean a rightward shift of the supply curve: at any given price, producers supply a larger quantity of the good than before. This is shown in Figure 3-9 by the rightward shift of the original supply curve S1 to S2. And when economists talk about a “decrease in supply,” they mean a leftward shift of the supply curve: at any given price, producers supply a smaller quantity of the good than before. This is represented by the leftward shift of S1 to S3. FIGURE 3-9 Shifts of the Supply Curve Price Any event that increases supply shifts the supply curve to the right, reflecting a rise in the quantity supplied at any given price. Any event that decreases supply shifts the supply curve to the left, reflecting a fall in the quantity supplied at any given price. S3 S1 S2 Increase in supply Decrease in supply Quantity Economists believe that shifts of the supply curve for a good or service are mainly the result of five factors (though, as in the case of demand, there are other possible causes): An input is a good or service that is used to produce another good or service LY A N D D E M A N D 75 ■ Changes in input prices ■ Changes in the prices of related goods or services ■ Changes in technology ■ Changes in expectations ■ Changes in the number of producers Changes in Input Prices To produce output, you need inputs. For example, to make vanilla ice cream, you need vanilla beans, cream, sugar, and so on. An input is any good or service that is used to produce another good or service. Inputs, like output, have prices. And an increase in the price of an input makes the production of the final good more costly for those who produce and sell it. So producers are less willing to supply the final good at any given price, and the supply curve shifts to the left. For example, newspaper publishers buy large quantities of newsprint (the paper on which newspapers are printed). When newsprint prices rose sharply in 1994–1995, the supply of newspapers fell: several newspapers went out of business and a number of new publishing ventures were canceled. Similarly, a fall in the price of an input makes the production of the final good less costly for sellers. They are more willing to supply the good at any given price, and the supply curve shifts to the right. Changes in the Prices of Related Goods or Services A single producer often produces a mix of goods rather than a single product. For example, an oil refinery produces gasoline from crude oil, but it also produces heating oil and other products from the same raw material. When a producer sells several products, the quantity of any one good it is willing to supply at any given price depends on the prices of its other co-produced goods. This effect can run in either direction. An oil refiner will supply less gasoline at any given price when the price of heating oil rises, shifting the supply curve for gasoline to the left. But it will supply more gasoline at any given price when the price of heating oil falls, shifting the supply curve for gasoline to the right. This means that gasoline and other co-produced oil products are substitutes in production for refiners. In contrast, due to the nature of the production process, other goods can be complements in production. For example, producers of crude oil—oil-well drillers—often find that oil wells also produce natural gas as a by-product of oil extraction. The higher the price at which a driller can sell its natural gas, the more oil wells it will drill and the more oil it will supply at any given price for oil. As a result, natural gas is a complement in production for crude oil. Changes in Technology When economists talk about “technology,” they don’t necessarily mean high technology—they mean all the methods people can use to turn inputs into useful goods and services. In that sense, the whole complex sequence of activities that turn corn from an Iowa farm into cornflakes on your breakfast table is technology. And when a better technology becomes available, reducing the cost of production—that is, letting a producer spend less on inputs yet produce the same output—supply increases, and the supply curve shifts to the right. For example, an improved strain of corn that is more resistant to disease makes farmers willing to supply more corn at any given price. Changes in Expectations Just as changes in expectations can shift the demand curve, they can also shift the supply curve. When suppliers have some choice about when they put their good up for sale, changes in the expected future price of the good can lead a supplier to supply less or more of the good today. For example, consider the fact that gasoline and other oil products are often stored for significant periods of time at oil refineries before being sold to consumers. In fact, storage is normally part of producers’ business strategy. Knowing that the demand for gasoline 76 P A R T 2 S U P P LY A N D D E M A N D An individual supply curve illustrates the relationship between quantity supplied and price for an individual producer. peaks in the summer, oil refiners normally store some of their gasoline produced during the spring for summer sale. Similarly, knowing that the demand for heating oil peaks in the winter, they normally store some of their heating oil produced during the fall for winter sale. In each case, there’s a decision to be made between selling the product now versus storing it for later sale. Which choice a producer makes depends on a comparison of the current price versus the expected future price. This example illustrates how changes in expectations can alter supply: an increase in the anticipated future price of a good or service reduces supply today, a leftward shift of the supply curve. But a fall in the anticipated future price increases supply today, a rightward shift of the supply curve. Changes in the Number of Producers Just as changes in the number of consumers affect the demand curve, changes in the number of producers affect the supply curve. Let’s examine the individual supply curve, which shows the relationship between quantity supplied and price for an individual producer. For example, suppose that Mr. Figueroa is a Brazilian coffee farmer and that panel (a) of Figure 3-10 shows how many pounds of beans he will supply per year at any given price. Then SFigueroa is his individual supply curve. The market supply curve shows how the combined total quantity supplied by all individual producers in the market depends on the market price of that good. Just as the market demand curve is the horizontal sum of the individual demand curves of all consumers, the market supply curve is the horizontal sum of the individual supply curves of all producers.
Assume for a moment that there are only two producers of coffee beans, Mr. Figueroa and Mr. Bien Pho, a Vietnamese coffee farmer. Mr. Bien Pho’s individual supply curve is shown in panel (b). Panel (c) shows the market supply curve. At any given price, the quantity supplied to the market is the sum of the quantities supplied by Mr. Figueroa and Mr. Bien Pho. For example, at a price of $2 per pound, Mr. Figueroa supplies 3,000 pounds of coffee beans per year and Mr. Bien Pho supplies 2,000 pounds per year, making the quantity supplied to the market 5,000 pounds. FIGURE 3-10 The Individual Supply Curve and the Market Supply Curve (a) Mr. Figueroa’s Individual Supply Curve (b) Mr. Bien Pho’s Individual Supply Curve (c) Market Supply Curve Price of coffee beans (per pound) $2 Price of coffee beans (per pound) $2 SFigueroa SBien Pho Price of coffee beans (per pound) $2 1 SMarket 1 0 1 2 3 Quantity of coffee beans (thousands of pounds Quantity of coffee beans (thousands of pounds) Quantity of coffee beans (thousands of pounds) Panel (a) shows the individual supply curve for Mr. Figueroa, SFigueroa, the quantity of coffee beans he will sell at any given price. Panel (b) shows the individual supply curve for Mr. Bien Pho, SBien Pho. The market supply curve, which shows the quantity of coffee beans supplied by all producers at any given price, is shown in panel (c). The market supply curve is the horizontal sum of the individual supply curves of all producers LY A N D D E M A N D 77 TABLE 3-2 Factors That Shift Supply Changes in input prices If the price of an input used to produce A rises, . . . . . . supply of A decreases. If the price of an input used to produce A falls, . . . . . . supply of A increases. Changes in the prices of related goods or services If A and B are substitutes in production . . . . . . and the price of B rises, . . . . . . supply of A decreases. If A and B are complements in production . . . . . . and the price of B rises, . . . . . . and the price of B falls, . . . . . . and the price of B falls, . . . . . . supply of A increases. . . . supply of A increases. . . . supply of A decreases. Changes in technology Changes in expectations Changes in the number of producers If the technology used to produce A improves, . . . . . . supply of A increases. If the price of A is expected to rise in the future, . . . . . . supply of A decreases today. If the price of A is expected to fall in the future, . . . . . . supply of A increases today. If the number of producers of A rises, . . . . . . market supply of A increases. If the number of producers of A falls, . . . . . . market supply of A decreases. Clearly, the quantity supplied to the market at any given price is larger with Mr. Bien Pho present than it would be if Mr. Figueroa was the only supplier. The quantity supplied at a given price would be even larger if we added a third producer, then a fourth, and so on. So an increase in the number of producers leads to an increase in supply and a rightward shift of the supply curve. For an overview of the factors that shift supply, see Table 3-2. ➤ECONOMICS IN ACTION Only Creatures Small and Pampered During the 1970s, British television featured a popular show titled All Creatures Great and Small. It chronicled the real life of James Herriot, a country veterinarian who tended to cows, pigs, sheep, horses, and the occasional house pet, often under arduous conditions, in rural England during the 1930s. The show made it clear that in those days the local vet was a critical member of farming communities, saving valuable farm animals and helping farmers survive financially. And it was also clear that Mr. Herriot considered his life’s work well spent. But that was then and this is now. According to a 2007 article in the New York Times, the United States has experienced a severe decline in the number of farm veterinarians over the past two decades. The source of the problem is competition. As the number of household pets has increased and the incomes of pet owners have grown, the demand for pet veterinarians has increased sharply. As a result, vets are being drawn away from the business of caring for farm animals into the more lucrative business of caring for pets. As one vet stated, she began her career caring for farm animals but changed her mind after “doing a C-section on a cow and it’s 50 bucks. Do a C-section on a Chihuahua and you get $300. It’s the money. I hate to say that.” How can we translate this into supply and demand curves? Farm veterinary services and pet veterinary services are like gasoline and fuel oil: they’re related goods that are substitutes in production. A veterinarian typically specializes in one type of practice or the other, and that decision often depends on the going price for the service. 78 P A R T 2 S U P P LY A N D D E M A N D ➤➤ ➤ The supply schedule shows how the quantity supplied depends on the price. The relationship between the two is illustrated by the supply curve. ➤ Supply curves are normally upward sloping: at a higher price, producers are willing to supply more of a good or service. ➤ A change in price results in a movement along the supply curve and a change in the quantity supplied. ➤ As with demand, increases or decreases in supply correspond to shifts of the supply curve. An increase in supply is a rightward shift: the quantity supplied rises for any given price. A decrease in supply is a leftward shift: the quantity supplied falls for any given price. ➤ The five main factors that can shift the supply curve are changes in (1) input prices, (2) prices of related goods or services, (3) technology, (4) expectations, and (5) number of producers. ➤ The market supply curve is the horizontal sum of the individual supply curves of all producers in the market. A competitive market is in equilibrium when price has moved to a level at which the quantity of a good or service demanded equals the quantity of that good or service supplied. The price at which this takes place is the equilibrium price, also referred to as the market-clearing price. The quantity of the good or service bought and sold at that price is the equilibrium quantity. America’s growing pet population, combined with the increased willingness of doting owners to spend on their companions’ care, has driven up the price of pet veterinary services. As a result, fewer and fewer veterinarians have gone into farm animal practice. So the supply curve of farm veterinarians has shifted leftward—fewer farm veterinarians are offering their services at any given price. In the end, farmers understand that it is all a matter of dollars and cents—that they get fewer veterinarians because they are unwilling to pay more. As one farmer, who had recently lost an expensive cow due to the unavailability of a veterinarian, stated, “The fact that there’s nothing you can do, you accept it as a business expense now. You didn’t used to. If you have livestock, sooner or later you’re going to have deadstock.” (Although we should note that this farmer could have chosen to pay more for a vet who would have then saved his cow.) ▲ < < < < < < < < < < < < ➤ CHECK YOUR UNDERSTANDING 3-2 1. Explain whether each of the following events represents (i) a shift of the supply curve or (ii) a movement along the supply curve. a. More homeowners put their houses up for sale during a real estate boom that causes house prices to rise. b. Many strawberry farmers open temporary roadside stands during harvest season, even though prices are usually low at that time. c. Immediately after the school year begins, fast-food chains must raise wages, which repre- sent the price of labor, to attract workers. d. Many construction workers temporarily move to areas that have suffered hurricane damage, lured by higher wages. e. Since new technologies have made it possible to build larger cruise ships (which are cheaper to run per passenger), Caribbean cruise lines have offered more cabins, at lower prices, than before. Solutions appear at back of book. Supply, Demand, and Equilibrium We have now covered the first three key elements in the supply and demand model: the demand curve, the supply curve, and the set of factors that shift each curve. The next step is to put these elements together to show how they can be used to predict the actual price at which the good is bought and sold, as well as the actual quantity transacted. What determines the price at which a good or service is bought and sold? What determines the quantity transacted of the good or service? In Chapter 1 we learned the general principle that markets move toward equilibrium, a situation in which no individual would be better off taking a different action. In the case of a competitive market, we can be more specific: a competitive market is in equilibrium when the price has moved to a level at which the quantity of a good demanded equals the quantity of that good supplied. At that price, no individual seller could make herself better off by offering to sell either more or less of the good and no individual buyer could make himself better off by offering to buy more or less of the good. In other words, at the market equilibrium, price has moved to a level that exactly matches the quantity demanded by consumers to the quantity supplied by sellers. The price that matches the quantity supplied and the quantity demanded is the equilibrium price; the quantity bought and sold at that price is the equilibrium quantity. The equilibrium price is also known as the market-clearing price: it is the price that “clears the market” by ensuring that every buyer willing to pay that price finds a seller willing to sell at that price, and vice versa. So how do we find the equilibrium price and quantity LY A N D D E M A N D 79 P I T F A L L S bought and sold? We have been talking about the price at which a good or service is bought and sold, as if the two were the same. But shouldn’t we make a distinction between the pri
ce received by sellers and the price paid by buyers? In principle, yes; but it is helpful at this point to sacrifice a bit of realism in the interest of simplicity—by assuming away the difference between the prices received by sellers and those paid by buyers. In reality, there is often a middleman—someone who brings buyers and sellers together— who buys from suppliers, then sells to consumers at a markup, for example, coffee merchants who buy from coffee growers and sell to consumers. The growers generally receive less than those who eventually buy the coffee beans pay. No mystery there: that difference is how coffee merchants or any other middlemen make a living. In many markets, however, the difference between the buying and selling price is quite small. So it’s not a bad approximation to think of the price paid by buyers as being the same as the price received by sellers. And that is what we assume in this chapter. Finding the Equilibrium Price and Quantity The easiest way to determine the equilibrium price and quantity in a market is by putting the supply curve and the demand curve on the same diagram. Since the supply curve shows the quantity supplied at any given price and the demand curve shows the quantity demanded at any given price, the price at which the two curves cross is the equilibrium price: the price at which quantity supplied equals quantity demanded. Figure 3-11 combines the demand curve from Figure 3-1 and the supply curve from Figure 3-6. They intersect at point E, which is the equilibrium of this market; that is, $1 is the equilibrium price and 10 billion pounds is the equilibrium quantity © FIGURE 3-11 Market Equilibrium Market equilibrium occurs at point E, where the supply curve and the demand curve intersect. In equilibrium, the quantity demanded is equal to the quantity supplied. In this market, the equilibrium price is $1 per pound and the equilibrium quantity is 10 billion pounds per year. Price of coffee beans (per pound) $2.00 1.75 1.50 1.25 1.00 0.75 0.50 Equilibrium price Supply E Equilibrium Demand 0 7 10 13 15 17 Quantity of coffee beans (billions of pounds) Equilibrium quantity 80 P A R T 2 S U P P LY A N D D E M A N D There is a surplus of a good or service when the quantity supplied exceeds the quantity demanded. Surpluses occur when the price is above its equilibrium level. Let’s confirm that point E fits our definition of equilibrium. At a price of $1 per pound, coffee bean producers are willing to sell 10 billion pounds a year and coffee bean consumers want to buy 10 billion pounds a year. So at the price of $1 a pound, the quantity of coffee beans supplied equals the quantity demanded. Notice that at any other price the market would not clear: every willing buyer would not be able to find a willing seller, or vice versa. More specifically, if the price were more than $1, the quantity supplied would exceed the quantity demanded; if the price were less than $1, the quantity demanded would exceed the quantity supplied. The model of supply and demand, then, predicts that given the demand and supply curves shown in Figure 3-11, 10 billion pounds of coffee beans would change hands at a price of $1 per pound. But how can we be sure that the market will arrive at the equilibrium price? We begin by answering three simple questions: 1. Why do all sales and purchases in a market take place at the same price? 2. Why does the market price fall if it is above the equilibrium price? 3. Why does the market price rise if it is below the equilibrium price? Why Do All Sales and Purchases in a Market Take Place at the Same Price? There are some markets where the same good can sell for many different prices, depending on who is selling or who is buying. For example, have you ever bought a souvenir in a “tourist trap” and then seen the same item on sale somewhere else (perhaps even in the shop next door) for a lower price? Because tourists don’t know which shops offer the best deals and don’t have time for comparison shopping, sellers in tourist areas can charge different prices for the same good. But in any market where the buyers and sellers have both been around for some time, sales and purchases tend to converge at a generally uniform price, so that we can safely talk about the market price. It’s easy to see why. Suppose a seller offered a potential buyer a price noticeably above what the buyer knew other people to be paying. The buyer would clearly be better off shopping elsewhere—unless the seller was prepared to offer a better deal. Conversely, a seller would not be willing to sell for significantly less than the amount he knew most buyers were paying; he would be better off waiting to get a more reasonable customer. So in any well-established, ongoing market, all sellers receive and all buyers pay approximately the same price. This is what we call the market price. Why Does the Market Price Fall If It Is Above the Equilibrium Price? Suppose the supply and demand curves are as shown in Figure 3-11 but the market price is above the equilibrium level of $1—say, $1.50. This situation is illustrated in Figure 3-12. Why can’t the price stay there? As the figure shows, at a price of $1.50 there would be more coffee beans available than consumers wanted to buy: 11.2 billion pounds, versus 8.1 billion pounds. The difference of 3.1 billion pounds is the surplus—also known as the excess supply—of coffee beans at $1.50. This surplus means that some coffee producers are frustrated: at the current price, they cannot find consumers who want to buy their coffee beans. The surplus offers an incentive for those frustrated would-be sellers to offer a lower price in order to poach business from other producers and entice more consumers to buy. The result of this price cutting will be to push the prevailing price down until it reaches the equilibrium price. So the price of a good will fall whenever there is a surplus—that is, whenever the market price is above its equilibrium level LY A N D D E M A N D 81 FIGURE 3-12 Price Above Its Equilibrium Level Creates a Surplus Price of coffee beans (per pound) The market price of $1.50 is above the equilibrium price of $1. This creates a surplus: at a price of $1.50, producers would like to sell 11.2 billion pounds but consumers want to buy only 8.1 billion pounds, so there is a surplus of 3.1 billion pounds. This surplus will push the price down until it reaches the equilibrium price of $1. $2.00 1.75 1.50 1.25 1.00 0.75 0.50 Supply Surplus E Demand 0 7 8.1 10 11.2 13 15 17 Quantity demanded Quantity of coffee beans (billions of pounds) Quantity supplied Why Does the Market Price Rise if It Is Below the Equilibrium Price? Now suppose the price is below its equilibrium level—say, at $0.75 per pound, as shown in Figure 3-13. In this case, the quantity demanded, 11.5 billion pounds, exceeds the quantity supplied, 9.1 billion pounds, implying that there are would-be FIGURE 3-13 Price Below Its Equilibrium Level Creates a Shortage The market price of $0.75 is below the equilibrium price of $1. This creates a shortage: consumers want to buy 11.5 billion pounds, but only 9.1 billion pounds are for sale, so there is a shortage of 2.4 billion pounds. This shortage will push the price up until it reaches the equilibrium price of $1. Price of coffee beans (per pound) $2.00 1.75 1.50 1.25 1.00 0.75 0.50 Supply E Shortage Demand 0 7 9.1 10 Quantity supplied 11.5 13 15 17 Quantity of coffee beans (billions of pounds) Quantity demanded 82 P A R T 2 S U P P LY A N D D E M A N D There is a shortage of a good or service when the quantity demanded exceeds the quantity supplied. Shortages occur when the price is below its equilibrium level. ➤➤ ➤ Price in a competitive market moves to the equilibrium price, or market-clearing price, where the quantity supplied is equal to the quantity demanded. This quantity is the equilibrium quantity. ➤ All sales and purchases in a market take place at the same price. If the price is above its equilibrium level, there is a surplus that drives the price down. If the price is below its equilibrium level, there is a shortage that drives the price up. buyers who cannot find coffee beans: there is a shortage, also known as an excess demand, of 2.4 billion pounds. When there is a shortage, there are frustrated would-be buyers—people who want to purchase coffee beans but cannot find willing sellers at the current price. In this situation, either buyers will offer more than the prevailing price or sellers will realize that they can charge higher prices. Either way, the result is to drive up the prevailing price. This bidding up of prices happens whenever there are shortages—and there will be shortages whenever the price is below its equilibrium level. So the market price will always rise if it is below the equilibrium level. Using Equilibrium to Describe Markets We have now seen that a market tends to have a single price, the equilibrium price. If the market price is above the equilibrium level, the ensuing surplus leads buyers and sellers to take actions that lower the price. And if the market price is below the equilibrium level, the ensuing shortage leads buyers and sellers to take actions that raise the price. So the market price always moves toward the equilibrium price, the price at which there is neither surplus nor shortage. ➤ECONOMICS IN ACTION The Price of Admission The market equilibrium, so the theory goes, is pretty egalitarian because the equilibrium price applies to everyone. That is, all buyers pay the same price—the equilibrium price—and all sellers receive that same price. But is this realistic? The market for concert tickets is an example that seems to contradict the theory— there’s one price at the box office, and there’s another price (typically much higher) for the same event on Internet sites where people who already have tickets resell them, such as StubHub.com or eBay. For example, compare the box office price for a recent Just
in Timberlake concert in Miami, Florida, to the StubHub.com price for seats in the same location: $88.50 versus $155. Puzzling as this may seem, there is no contradiction once we take opportunity costs and tastes into account. For major events, buying tickets from the box office means waiting in very long lines. Ticket buyers who use Internet resellers have decided that the opportunity cost of their time is too high to spend waiting in line. And for those major events with online box offices selling tickets at face value, tickets often sell out within minutes. In this case, some people who want to go to the concert badly but have missed out on the opportunity to buy cheaper tickets from the online box office are willing to pay the higher Internet reseller price. Not only that, perusing the StubHub.com website you can see that markets really do move to equilibrium. You’ll notice that the prices quoted by different sellers for seats close to one another are also very close: $184.99 versus $185 for seats on the main floor of the Justin Timberlake concert. As the competitive market model predicts, units of the same good end up selling for the same price. And prices move in response to demand and supply. According to an article in the New York Times, tickets on StubHub.com can sell for less than the face value for events with little appeal, while prices can skyrocket for events that are in high demand. (The article quotes a price of $3,530 for a recent Madonna concert.) Even StubHub.com’s chief executive says his site is “the embodiment of supply-anddemand economics.” So the theory of competitive markets isn’t just speculation. If you want to experi- ence it for yourself, try buying tickets to a concert LY A N D D E M A N D 83 ➤ CHECK YOUR UNDERSTANDING 3-3 1. In the following three situations, the market is initially in equilibrium. After each event described below, does a surplus or shortage exist at the original equilibrium price? What will happen to the equilibrium price as a result? a. 2005 was a very good year for California wine-grape growers, who produced a bumper crop. b. After a hurricane, Florida hoteliers often find that many people cancel their upcoming vacations, leaving them with empty hotel rooms. c. After a heavy snowfall, many people want to buy secondhand snowblowers at the local tool shop. Solutions appear at back of book. Changes in Supply and Demand The emergence of Vietnam as a major coffee-producing country came as a surprise, but the subsequent fall in the price of coffee beans was no surprise at all. Suddenly the quantity of coffee beans available at any given price rose—that is, there was an increase in supply. Predictably, an increase in supply lowers the equilibrium price. The entry of Vietnamese producers into the coffee bean business was an example of an event that shifted the supply curve for a good without having much effect on the demand curve. There are many such events. There are also events that shift the demand curve without shifting the supply curve. For example, a medical report that chocolate is good for you increases the demand for chocolate but does not affect the supply. That is, events often shift either the supply curve or the demand curve, but not both; it is therefore useful to ask what happens in each case. We have seen that when a curve shifts, the equilibrium price and quantity change. We will now concentrate on exactly how the shift of a curve alters the equilibrium price and quantity. What Happens When the Demand Curve Shifts Coffee and tea are substitutes: if the price of tea rises, the demand for coffee will increase, and if the price of tea falls, the demand for coffee will decrease. But how does the price of tea affect the market equilibrium for coffee? Figure 3-14 on the next page shows the effect of a rise in the price of tea on the market for coffee. The rise in the price of tea increases the demand for coffee. Point E1 shows the equilibrium corresponding to the original demand curve, with P1 the equilibrium price and Q1 the equilibrium quantity bought and sold. An increase in demand is indicated by a rightward shift of the demand curve from D1 to D2. At the original market price P1, this market is no longer in equilibrium: a shortage occurs because the quantity demanded exceeds the quantity supplied. So the price of coffee rises and generates an increase in the quantity supplied, an upward movement along the supply curve. A new equilibrium is established at point E2, with a higher equilibrium price, P2, and higher equilibrium quantity, Q2. This sequence of events reflects a general principle: When demand for a good or service increases, the equilibrium price and the equilibrium quantity of the good or service both rise. What would happen in the reverse case, a fall in the price of tea? A fall in the price of tea reduces the demand for coffee, shifting the demand curve to the left. At the original price, a surplus occurs as quantity supplied exceeds quantity demanded. The price falls and leads to a decrease in the quantity supplied, resulting in a lower equilibrium price and a lower equilibrium quantity. This illustrates another general principle: When demand for a good or service decreases, the equilibrium price and the equilibrium quantity of the good or service both fall. To summarize how a market responds to a change in demand: An increase in demand leads to a rise in both the equilibrium price and the equilibrium quantity. A decrease in demand leads to a fall in both the equilibrium price and the equilibrium quantity. 84 P A R T 2 S U P P LY A N D D E M A N D FIGURE 3-14 Equilibrium and Shifts of the Demand Curve Price of coffee Price rises P2 P1 The original equilibrium in the market for coffee is at E1, at the intersection of the supply curve and the original demand curve, D1. A rise in the price of tea, a substitute, shifts the demand curve rightward to D2. A shortage exists at the original price, P1, causing both the price and quantity supplied to rise, a movement along the supply curve. A new equilibrium is reached at E2, with a higher equilibrium price, P2, and a higher equilibrium quantity, Q2. When demand for a good or service increases, the equilibrium price and the equilibrium quantity of the good or service both rise. An increase in demand . . . E2 E1 Supply . . . leads to a movement along the supply curve to a higher equilibrium price and higher equilibrium quantity. D2 D1 Q1 Q2 Quantity rises Quantity of coffee What Happens When the Supply Curve Shifts In the real world, it is a bit easier to predict changes in supply than changes in demand. Physical factors that affect supply, like the availability of inputs, are easier to get a handle on than the fickle tastes that affect demand. Still, with supply as with demand, what we can best predict are the effects of shifts of the supply curve. As we mentioned in this chapter’s opening story, a prolonged drought in Vietnam sharply reduced its supply of coffee beans. Figure 3-15 shows how this shift affected the market equilibrium. The original equilibrium is at E1, the point of intersection of the original supply curve, S1, and the demand curve, with an equilibrium price P1 and FIGURE 3-15 Equilibrium and Shifts of the Supply Curve The original equilibrium in the market for coffee beans is at E1. A drought causes a fall in the supply of coffee beans and shifts the supply curve leftward from S1 to S2. A new equilibrium is established at E2, with a higher equilibrium price, P2, and a lower equilibrium quantity, Q2. Price of coffee beans Price rises P2 P1 S2 E2 S1 A decrease in supply . . . . . . leads to a movement along the demand curve to a higher equilibrium price and lower equilibrium quantity. E1 Demand Q2 Q1 Quantity falls Quantity of coffee beans LY A N D D E M A N D 85 equilibrium quantity Q1. As a result of the drought, supply falls and S1 shifts leftward to S2. At the original price P1, a shortage of coffee beans now exists and the market is no longer in equilibrium. The shortage causes a rise in price and a fall in quantity demanded, an upward movement along the demand curve. The new equilibrium is at E2, with an equilibrium price P2, and an equilibrium quantity Q2. In the new equilibrium E2, the price is higher and the equilibrium quantity lower than before. This may be stated as a general principle: When supply of a good or service decreases, the equilibrium price of the good or service rises and the equilibrium quantity of the good or service falls. What happens to the market when supply increases? An increase in supply leads to a rightward shift of the supply curve. At the original price, a surplus now exists; as a result, the equilibrium price falls and the quantity demanded rises. This describes what happened to the market for coffee beans when Vietnam entered the field. We can formulate a general principle: When supply of a good or service increases, the equilibrium price of the good or service falls and the equilibrium quantity of the good or service rises. To summarize how a market responds to a change in supply: An increase in supply leads to a fall in the equilibrium price and a rise in the equilibrium quantity. A decrease in supply leads to a rise in the equilibrium price and a fall in the equilibrium quantity. Simultaneous Shifts of Supply and Demand Curves Finally, it sometimes happens that events shift both the demand and supply curves at the same time. This is not unusual; in real life, supply curves and demand curves for many goods and services typically shift quite often because the economic environment continually changes. Figure 3-16 illustrates two examples of simultaneous shifts. In both panels there is an increase in demand—that is, a rightward shift of the demand curve, from D1 to D2—say, for example, representing the increase in the demand for P I T F A L L S which curve is it, anyway? When the price of some good or service changes, in general, we can say that t
his reflects a change in either supply or demand. But it is easy to get confused about which one. A helpful clue is the direction of change in the quantity. If the quantity sold changes in the same direction as the price—for example, if both the price and the quantity rise—this suggests that the demand curve has shifted. If the price and the quantity move in opposite directions, the likely cause is a shift of the supply curve. FIGURE 3-16 Simultaneous Shifts of the Demand and Supply Curves Price of coffee P2 P1 (a) One Possible Outcome: Price Rises, Quantity Rises S2 S1 Small decrease in supply E2 E1 D1 D2 Large increase in demand Price of coffee P2 P1 (b) Another Possible Outcome: Price Rises, Quantity Falls Large decrease in supply S2 S1 E2 E1 Small increase in demand D2 D1 Q1 Q2 Quantity of coffee Q2 Q1 Quantity of coffee In panel (a) there is a simultaneous rightward shift of the demand curve and leftward shift of the supply curve. Here the increase in demand is relatively larger than the decrease in supply, so the equilibrium price and equilibrium quantity both rise. In panel (b) there is also a simultaneous rightward shift of the demand curve and leftward shift of the supply curve. Here the decrease in supply is relatively larger than the increase in demand, so the equilibrium price rises and the equilibrium quantity falls. 86 P A R T 2 S U P P LY A N D D E M A N D coffee due to changing tastes. Notice that the rightward shift in panel (a) is larger than the one in panel (b): we can suppose that panel (a) represents a year in which many more people than usual choose to drink double lattes and panel (b) represents a normal year. Both panels also show a decrease in supply—that is, a leftward shift of the supply curve from S1 to S2. Also notice that the leftward shift in panel (b) is relatively larger than the one in panel (a): we can suppose that panel (b) represents the effect of a particularly extreme drought in Vietnam and panel (a) represents the effect of a much less severe weather event. In both cases, the equilibrium price rises from P1 to P2, as the equilibrium moves from E1 to E2. But what happens to the equilibrium quantity, the quantity of coffee bought and sold? In panel (a) the increase in demand is large relative to the decrease in supply, and the equilibrium quantity rises as a result. In panel (b), the decrease in supply is large relative to the increase in demand, and the equilibrium quantity falls as a result. That is, when demand increases and supply decreases, the actual quantity bought and sold can go either way, depending on how much the demand and supply curves have shifted. In general, when supply and demand shift in opposite directions, we can’t predict what the ultimate effect will be on the quantity bought and sold. What we can say is that a curve that shifts a disproportionately greater distance than the other curve will have a disproportionately greater effect on the quantity bought and sold. That said, L D VIE Tribulations on the Runway You probably don’t spend much time worrying about the trials and tribulations of fashion models. Most of them don’t lead glamorous lives; in fact, except for a lucky few, life as a fashion model today can be very trying and not very lucrative. And it’s all because of supply and demand. Consider the case of Bianca Gomez, a willowy 18-year-old from Los Angeles, with green eyes, honey-colored hair, and flawless skin, whose experience was detailed in a 2007 article in the Wall Street Journal. Bianca began modeling while still in high school, earning about $30,000 in modeling fees during her senior year. Having attracted the interest of some top designers in New York, she moved there after graduation, hoping to land jobs in leading fashion houses and photo-shoots for leading fashion magazines. But once in New York, Bianca entered the global market for fashion models. And it wasn’t very pretty. Due to the ease of transmitting photos over the Internet and the relatively low cost of international travel, top fashion centers such as New York and Milan, Italy, are now deluged with beautiful young women from all over the world, eagerly trying to make it as models. W E I V D L VIEWWOR W O R L D rightward shift of the supply curve in the market for fashion models, which would by itself tend to lower the price paid to models. And that wasn’t the only change in the market. Unfortunately for Bianca and others like her, the tastes of many of those who hire models have changed as well. Over the past few years, fashion magazines have come to prefer using celebrities such as Angelina Jolie on their pages rather than anonymous models, believing that their readers connect better with a familiar face. This amounts to a leftward shift of the demand curve for models—again reducing the equilibrium price paid to models. This was borne out in Bianca’s experiences. After paying her rent, her transportation, all her modeling expenses, and 20% of her earnings to her modeling agency (which markets her to prospective clients and books her jobs), Bianca found that she was barely breaking even. Sometimes she even had to dip into savings from her high school years. To save money, she ate macaroni and hot dogs; she traveled to auditions, often four or five in one day, by subway. As the Wall Street Journal reported, Bianca was seriously considering quitting modeling altogether Bianca Gomez on the runway before intense global competition got her thinking about switching careers. Although Russians, other Eastern Europeans, and Brazilians are particularly numerous, some hail from places such as Kazakhstan and Mozambique. As one designer said, “There are so many models now. . . .There are just thousands every year.” Returning to our (less glamorous) economic model of supply and demand, the influx of aspiring fashion models from around the world can be represented by LY A N D D E M A N D 87 we can make the following prediction about the outcome when the supply and demand curves shift in opposite directions: ■ When demand increases and supply decreases, the equilibrium price rises but the change in the equilibrium quantity is ambiguous. ■ When demand decreases and supply increases, the equilibrium price falls but the change in the equilibrium quantity is ambiguous. But suppose that the demand and supply curves shift in the same direction. This was the case in the global market for coffee beans, where both supply and demand have increased over the past decade. Can we safely make any predictions about the changes in price and quantity? In this situation, the change in quantity bought and sold can be predicted but the change in price is ambiguous. The two possible outcomes when the supply and demand curves shift in the same direction (which you should check for yourself) are as follows: ■ When both demand and supply increase, the equilibrium quantity increases but the change in equilibrium price is ambiguous. ■ When both demand and supply decrease, the equilibrium quantity decreases but the change in equilibrium price is ambiguous. L D VIE ECONOMICS IN ACTION The Great Tortilla Crisis “Thousands in Mexico City protest rising food prices.” So read the headline in the New York Times on February 1, 2007. Specifically, the demonstrators were protesting a sharp rise in the price of tortillas, a staple food of Mexico’s poor, which had gone from 25 cents a pound to between 35 and 45 cents a pound in just a few months. Why were tortilla prices soaring? It was a classic example of what happens to equilibrium prices when supply falls. Tortillas are made from corn; much of Mexico’s corn is imported from the United States, with the price of corn in both countries basically set in the U.S. corn market. And U.S. corn prices were rising rapidly thanks to surging demand in a new market: the market for ethanol. VIEWWOR Ethanol’s big break came with the Energy Policy Act of 2005, which mandated the use of a large quantity of “renewable” fuels starting in 2006, and rising steadily thereafter. In practice, that meant increased use of ethanol. Ethanol producers rushed to build new production facilities and quickly began buying lots of corn. The result was a rightward shift of the demand curve for corn, leading to a sharp rise in the price of corn. And since corn is an input in the production of tortillas, a sharp rise in the price of corn led to a fall in the supply of tortillas and higher prices for tortilla consumers. The increase in the price of corn was good news in Iowa, where farmers began planting more corn than ever before. But it was bad news for Mexican consumers, who found themselves paying more for their tortillas. ▲ > > > > > > > > > > > > ➤ CHECK YOUR UNDERSTANDING 3-4 1. In each of the following examples, determine (i) the market in question; (ii) whether a shift in demand or supply occurred, the direction of the shift, and what induced the shift; and (iii) the effect of the shift on the equilibrium price and the equilibrium quantity. a. As the price of gasoline fell in the United States during the 1990s, more people bought large cars. b. As technological innovation has lowered the cost of recycling used paper, fresh paper made from recycled stock is used more frequently. c. When a local cable company offers cheaper pay-per-view films, local movie theaters have more unfilled seats. ➤➤ ➤ Changes in the equilibrium price and quantity in a market result from shifts of the supply curve, the demand curve, or both. ➤ An increase in demand increases both the equilibrium price and the equilibrium quantity. A decrease in demand pushes both the equilibrium price and the equilibrium quantity down. ➤ An increase in supply drives the equilibrium price down but increases the equilibrium quantity. A decrease in supply raises the equilibrium price but reduces the equilibrium quantity. ➤ Often the fluctuations in markets involve shifts of both the supply and demand curves. When they shift in the same direction,
the change in equilibrium quantity is predictable but the change in equilibrium price is not. When they move in opposite directions, the change in equilibrium price is predictable but the change in equilibrium quantity is not. When there are simultaneous shifts of the demand and supply curves, the curve that shifts the greater distance has a greater effect on the change in equilibrium price and quantity. 88 P A R T 2 S U P P LY . Periodically, a computer chip maker like Intel introduces a new chip that is faster than the previous one. In response, demand for computers using the earlier chip decreases as customers put off purchases in anticipation of machines containing the new chip. Simultaneously, computer makers increase their production of computers containing the earlier chip in order to clear out their stocks of those chips. Draw two diagrams of the market for computers containing the earlier chip: (a) one in which the equilibrium quantity falls in response to these events and (b) one in which the equilibrium quantity rises. What happens to the equilibrium price in each diagram? Solutions appear at back of book. Competitive Markets—And Others Early in this chapter, we defined a competitive market and explained that the supply and demand framework is a model of competitive markets. But we took a rain check on the question of why it matters whether or not a market is competitive. Now that we’ve seen how the supply and demand model works, we can offer some explanation. To understand why competitive markets are different from other markets, compare the problems facing two individuals: a wheat farmer who must decide whether to grow more wheat, and the president of a giant aluminum company—say, Alcoa—who must decide whether to produce more aluminum. For the wheat farmer, the question is simply whether the extra wheat can be sold at a price high enough to justify the extra production cost. The farmer need not worry about whether producing more wheat will affect the price of the wheat he or she was already planning to grow. That’s because the wheat market is competitive. There are thousands of wheat farmers, and no one farmer’s decision will have much impact on the market price. For the Alcoa executive, things are not that simple because the aluminum market is not competitive. There are only a few big players, including Alcoa, and each of them is well aware that its actions do have a noticeable impact on the market price. This adds a whole new level of complexity to the decisions producers have to make. Alcoa can’t decide whether or not to produce more aluminum just by asking whether the additional product will sell for more than it costs to make. The company also has to ask whether producing more aluminum will drive down the market price and reduce its profit, its net gain from producing and selling its output. When a market is competitive, individuals can base decisions on less complicated analyses than those used in a noncompetitive market. This in turn means that it’s easier for economists to build a model of a competitive market than of a noncompetitive market. Don’t take this to mean that economic analysis has nothing to say about noncompetitive markets. On the contrary, economists can offer some very important insights into how other kinds of markets work. But those insights require other models, which we will learn about later in this text. In the next chapter, we will focus on how competitive markets benefit producers and consumers. [ ➤➤ A LOOK AHEAD ••• We’ve now developed a model that explains how markets arrive at prices and why markets “work” in the sense that buyers can almost always find sellers, and vice versa. But what we haven’t yet explained is what motivates buyers and sellers to participate in markets. In the next chapter, we’ll study how a competitive market allocates gains—and potentially losses—to buyers and sellers. And we’ll discover a surprisingly strong result: under certain conditions, a competitive market maximizes the total gains to buyers from consuming and to sellers from producing.] LY A N D D E M A N D 89 S U M M A R Y 1. The supply and demand model illustrates how a competitive market, one with many buyers and sellers, none of whom can influence the market price, works. the quantity supplied at any given price. An increase in supply causes a rightward shift of the supply curve. A decrease in supply causes a leftward shift. 2. The demand schedule shows the quantity demanded 8. There are five main factors that shift the supply curve: at each price and is represented graphically by a demand curve. The law of demand says that demand curves slope downward; that is, a higher price for a good or service leads people to demand a smaller quantity, other things equal. 3. A movement along the demand curve occurs when a price change leads to a change in the quantity demanded. When economists talk of increasing or decreasing demand, they mean shifts of the demand curve—a change in the quantity demanded at any given price. An increase in demand causes a rightward shift of the demand curve. A decrease in demand causes a leftward shift. 4. There are five main factors that shift the demand curve: ■ A change in the prices of related goods or services, such as substitutes or complements ■ A change in income: when income rises, the demand for normal goods increases and the demand for inferior goods decreases. ■ A change in tastes ■ A change in expectations ■ A change in the number of consumers 5. The market demand curve for a good or service is the horizontal sum of the individual demand curves of all consumers in the market. 6. The supply schedule shows the quantity supplied at each price and is represented graphically by a supply curve. Supply curves usually slope upward. 7. A movement along the supply curve occurs when a price change leads to a change in the quantity supplied. When economists talk of increasing or decreasing supply, they mean shifts of the supply curve—a change in ■ A change in input prices ■ A change in the prices of related goods and services ■ A change in technology ■ A change in expectations ■ A change in the number of producers 9. The market supply curve for a good or service is the horizontal sum of the individual supply curves of all producers in the market. 10. The supply and demand model is based on the principle that the price in a market moves to its equilibrium price, or market-clearing price, the price at which the quantity demanded is equal to the quantity supplied. This quantity is the equilibrium quantity. When the price is above its market-clearing level, there is a surplus that pushes the price down. When the price is below its market-clearing level, there is a shortage that pushes the price up. 11. An increase in demand increases both the equilibrium price and the equilibrium quantity; a decrease in demand has the opposite effect. An increase in supply reduces the equilibrium price and increases the equilibrium quantity; a decrease in supply has the opposite effect. 12. Shifts of the demand curve and the supply curve can happen simultaneously. When they shift in opposite directions, the change in equilibrium price is predictable but the change in equilibrium quantity is not. When they shift in the same direction, the change in equilibrium quantity is predictable but the change in equilibrium price is not. In general, the curve that shifts the greater distance has a greater effect on the changes in equilibrium price and quantity. K E Y T E R M S Competitive market, p. 62 Supply and demand model, p. 62 Demand schedule, p. 63 Quantity demanded, p. 64 Demand curve, p. 64 Law of demand, p. 64 Complements, p. 67 Normal good, p. 68 Inferior good, p. 68 Individual demand curve, p. 69 Quantity supplied, p. 71 Supply schedule, p. 71 Shift of the demand curve, p. 65 Supply curve, p. 72 Movement along the demand curve, p. 66 Shift of the supply curve, p. 73 Substitutes, p. 67 Movement along the supply curve, p. 73 Input, p. 75 Individual supply curve, p. 76 Equilibrium price, p. 78 Equilibrium quantity, p. 78 Market-clearing price, p. 78 Surplus, p. 80 Shortage, p. 82 90 P A R T 2 S U P P LY . A survey indicated that chocolate is Americans’ favorite ice cream flavor. For each of the following, indicate the possible effects on demand, supply, or both as well as equilibrium price and quantity of chocolate ice cream. c. The market for bagels Case 1: People realize how fattening bagels are. Case 2: People have less time to make themselves a cooked breakfast. a. A severe drought in the Midwest causes dairy farmers to d. The market for the Krugman and Wells economics textbook reduce the number of milk-producing cattle in their herds by a third. These dairy farmers supply cream that is used to manufacture chocolate ice cream. b. A new report by the American Medical Association reveals that chocolate does, in fact, have significant health benefits. c. The discovery of cheaper synthetic vanilla flavoring lowers the price of vanilla ice cream. d. New technology for mixing and freezing ice cream lowers manufacturers’ costs of producing chocolate ice cream. 2. In a supply and demand diagram, draw the shift of the demand curve for hamburgers in your hometown due to the following events. In each case show the effect on equilibrium price and quantity. a. The price of tacos increases. b. All hamburger sellers raise the price of their french fries. c. Income falls in town. Assume that hamburgers are a nor- mal good for most people. d. Income falls in town. Assume that hamburgers are an inferior good for most people. e. Hot dog stands cut the price of hot dogs. 3. The market for many goods changes in predictable ways according to the time of year, in response to events such as holidays, vacation times, seasonal changes in production, and so on. Using supply and demand, explain the change in price in each of the following cases. Note that supply and demand may shift simultaneously. a. Lob
ster prices usually fall during the summer peak lobster harvest season, despite the fact that people like to eat lobster during the summer more than at any other time of year. b. The price of a Christmas tree is lower after Christmas than before but fewer trees are sold. c. The price of a round-trip ticket to Paris on Air France falls by more than $200 after the end of school vacation in September. This happens despite the fact that generally worsening weather increases the cost of operating flights to Paris, and Air France therefore reduces the number of flights to Paris at any given price. 4. Show in a diagram the effect on the demand curve, the supply curve, the equilibrium price, and the equilibrium quantity of each of the following events. a. The market for newspapers in your town Case 1: Case 2: The salaries of journalists go up. There is a big news event in your town, which is reported in the newspapers. b. The market for St. Louis Rams cotton T-shirts Case 1: Case 2: The Rams win the Super Bowl. The price of cotton increases. Case 1: Your professor makes it required reading for all Case 2: of his or her students. Printing costs for textbooks are lowered by the use of synthetic paper. 5. The U.S. Department of Agriculture reported that in 1997 each person in the United States consumed an average of 41 gallons of soft drinks (nondiet) at an average price of $2 per gallon. Assume that, at a price of $1.50 per gallon, each individual consumer would demand 50 gallons of soft drinks. The U.S. population in 1997 was 267 million. From this information about the individual demand schedule, calculate the market demand schedule for soft drinks for the prices of $1.50 and $2 per gallon. 6. Suppose that the supply schedule of Maine lobsters is as follows: Price of lobster (per pound) Quantity of lobster supplied (pounds) $25 $20 $15 $10 $ 5 800 700 600 500 $400$ Suppose that Maine lobsters can be sold only in the United States. The U.S. demand schedule for Maine lobsters is as follows: Price of lobster (per pound) Quantity of lobster demanded (pounds) $25 $20 $15 $10 $ 5 200 400 600 800 1,000$ a. Draw the demand curve and the supply curve for Maine lobsters. What are the equilibrium price and quantity of lobsters? Now suppose that Maine lobsters can be sold in France. The French demand schedule for Maine lobsters is as follows: Price of lobster (per pound) Quantity of lobster demanded (pounds) $25 $20 $15 $10 $ 5 100 300 500 700 $900 LY A N D D E M A N D 91 b. What is the demand schedule for Maine lobsters now that French consumers can also buy them? Draw a supply and demand diagram that illustrates the new equilibrium price and quantity of lobsters. What will happen to the price at which fishermen can sell lobster? What will happen to the price paid by U.S. consumers? What will happen to the quantity consumed by U.S. consumers? 7. Find the flaws in reasoning in the following statements, paying particular attention to the distinction between shifts of and movements along the supply and demand curves. Draw a diagram to illustrate what actually happens in each situation. a. “A technological innovation that lowers the cost of producing a good might seem at first to result in a reduction in the price of the good to consumers. But a fall in price will increase demand for the good, and higher demand will send the price up again. It is not certain, therefore, that an innovation will really reduce price in the end.” b. “A study shows that eating a clove of garlic a day can help prevent heart disease, causing many consumers to demand more garlic. This increase in demand results in a rise in the price of garlic. Consumers, seeing that the price of garlic has gone up, reduce their demand for garlic. This causes the demand for garlic to decrease and the price of garlic to fall. Therefore, the ultimate effect of the study on the price of garlic is uncertain.” 10. Aaron Hank is a star hitter for the Bay City baseball team. He is close to breaking the major league record for home runs hit during one season, and it is widely anticipated that in the next game he will break that record. As a result, tickets for the team’s next game have been a hot commodity. But today it is announced that, due to a knee injury, he will not in fact play in the team’s next game. Assume that season ticket-holders are able to resell their tickets if they wish. Use supply and demand diagrams to explain the following. a. Show the case in which this announcement results in a lower equilibrium price and a lower equilibrium quantity than before the announcement. b. Show the case in which this announcement results in a lower equilibrium price and a higher equilibrium quantity than before the announcement. c. What accounts for whether case a or case b occurs? d. Suppose that a scalper had secretly learned before the announcement that Aaron Hank would not play in the next game. What actions do you think he would take? 11. In Rolling Stone magazine, several fans and rock stars, including Pearl Jam, were bemoaning the high price of concert tickets. One superstar argued, “It just isn’t worth $75 to see me play. No one should have to pay that much to go to a concert.” Assume this star sold out arenas around the country at an average ticket price of $75. 8. The following table shows a demand schedule for a normal a. How would you evaluate the arguments that ticket prices good. Price $23 $21 $19 $17 Quantity demanded 70 90 110 130 a. Do you think that the increase in quantity demanded (say, from 90 to 110 in the table) when price decreases (from $21 to $19) is due to a rise in consumers’ income? Explain clearly (and briefly) why or why not. b. Now suppose that the good is an inferior good. Would the demand schedule still be valid for an inferior good? c. Lastly, assume you do not know whether the good is normal or inferior. Devise an experiment that would allow you to determine which one it was. Explain. 9. According to the New York Times (November 18, 2006), the number of car producers in China is increasing rapidly. The newspaper reports that “China has more car brands now than the United States. . . . But while car sales have climbed 38 percent in the first three quarters of this year, automakers have increased their output even faster, causing fierce competition and a slow erosion in prices.” At the same time, Chinese consumers’ incomes have risen. Assume that cars are a normal good. Use a diagram of the supply and demand curves for cars in China to explain what has happened in the Chinese car market. are too high? b. Suppose that due to this star’s protests, ticket prices were lowered to $50. In what sense is this price too low? Draw a diagram using supply and demand curves to support your argument. c. Suppose Pearl Jam really wanted to bring down ticket prices. Since the band controls the supply of its services, what do you recommend they do? Explain using a supply and demand diagram. d. Suppose the band’s next CD was a total dud. Do you think they would still have to worry about ticket prices being too high? Why or why not? Draw a supply and demand diagram to support your argument. e. Suppose the group announced their next tour was going to be their last. What effect would this likely have on the demand for and price of tickets? Illustrate with a supply and demand diagram. 12. The accompanying table gives the annual U.S. demand and supply schedules for pickup trucks. Price of truck $20,000 $25,000 $30,000 $35,000 $40,000 Quantity of trucks demanded (millions) Quantity of trucks supplied (millions) 20 18 16 14 12 14 15 16 17 18 92 P A R T 2 S U P P LY . Plot the demand and supply curves using these schedules. b. The bubonic plague, a deadly infectious disease, breaks out Indicate the equilibrium price and quantity on your diagram. in London. b. Suppose the tires used on pickup trucks are found to be defective. What would you expect to happen in the market for pickup trucks? Show this on your diagram. c. Suppose that the U.S. Department of Transportation imposes costly regulations on manufacturers that cause them to reduce supply by one-third at any given price. Calculate and plot the new supply schedule and indicate the new equilibrium price and quantity on your diagram. 13. After several years of decline, the market for handmade acoustic guitars is making a comeback. These guitars are usually made in small workshops employing relatively few highly skilled luthiers. Assess the impact on the equilibrium price and quantity of handmade acoustic guitars as a result of each of the following events. In your answers indicate which curve(s) shift(s) and in which direction. a. Environmentalists succeed in having the use of Brazilian rosewood banned in the United States, forcing luthiers to seek out alternative, more costly woods. b. A foreign producer reengineers the guitar-making process and floods the market with identical guitars. c. Music featuring handmade acoustic guitars makes a comeback as audiences tire of heavy metal and grunge music. d. The country goes into a deep recession and the income of the average American falls sharply. 14. Demand twisters: Sketch and explain the demand relationship in each of the following statements. a. I would never buy a Britney Spears CD! You couldn’t even give me one for nothing. b. I generally buy a bit more coffee as the price falls. But once the price falls to $2 per pound, I’ll buy out the entire stock of the supermarket. c. I spend more on orange juice even as the price rises. (Does this mean that I must be violating the law of demand?) d. Due to a tuition rise, most students at a college find themselves with less disposable income. Almost all of them eat more frequently at the school cafeteria and less often at restaurants, even though prices at the cafeteria have risen, too. (This one requires that you draw both the demand and the supply curves for school cafeteria meals.) 15. Will Shakespeare is a struggling playwright
in sixteenth-century London. As the price he receives for writing a play increases, he is willing to write more plays. For the following situations, use a diagram to illustrate how each event affects the equilibrium price and quantity in the market for Shakespeare’s plays. c. To celebrate the defeat of the Spanish Armada, Queen Elizabeth declares several weeks of festivities, which involves commissioning new plays. 16. The small town of Middling experiences a sudden doubling of the birth rate. After three years, the birth rate returns to normal. Use a diagram to illustrate the effect of these events on the following. a. The market for an hour of babysitting services in Middling today b. The market for an hour of babysitting services 14 years into the future, after the birth rate has returned to normal, by which time children born today are old enough to work as babysitters c. The market for an hour of babysitting services 30 years into the future, when children born today are likely to be having children of their own 17. Use a diagram to illustrate how each of the following events affects the equilibrium price and quantity of pizza. a. The price of mozzarella cheese rises. b. The health hazards of hamburgers are widely publicized. c. The price of tomato sauce falls. d. The incomes of consumers rise and pizza is an inferior good. e. Consumers expect the price of pizza to fall next week. 18. Although he was a prolific artist, Pablo Picasso painted only 1,000 canvases during his “Blue Period.” Picasso is now dead, and all of his Blue Period works are currently on display in museums and private galleries throughout Europe and the United States. a. Draw a supply curve for Picasso Blue Period works. Why is this supply curve different from ones you have seen? b. Given the supply curve from part a, the price of a Picasso Blue Period work will be entirely dependent on what factor(s)? Draw a diagram showing how the equilibrium price of such a work is determined. c. Suppose rich art collectors decide that it is essential to acquire Picasso Blue Period art for their collections. Show the impact of this on the market for these paintings. 19. Draw the appropriate curve in each of the following cases. Is it like or unlike the curves you have seen so far? Explain. a. The demand for cardiac bypass surgery, given that the gov- ernment pays the full cost for any patient b. The demand for elective cosmetic plastic surgery, given that the patient pays the full cost a. The playwright Christopher Marlowe, Shakespeare’s chief c. The supply of reproductions of Rembrandt paintings rival, is killed in a bar brawl. www.worthpublishers.com/krugmanwells chapter: 4 >> Consumer and Producer Surplus HERE IS A LIVELY MARKET IN SECOND-HAND college textbooks. At the end of each term, some students who took a course decide that the money they can make by selling their used books is worth more from being able to purchase a good—known as consumer surplus. And we will see that there is a corresponding measure, producer surplus, of the benefits sellers receive from being able to sell a good. to them than keeping the books. And some students who The concepts of consumer surplus and producer sur- are taking the course next term prefer to buy a somewhat plus are extremely useful for analyzing a wide variety of battered but less expensive used textbook rather than pay economic issues. They let us calculate how much benefit full price for a new one. Textbook publishers and authors are not happy about these transactions, because they cut into sales of new books. But both the students who sell used books and those who buy them clearly benefit from the existence of the market. That is why many college bookstores facilitate their trade, buying used text- books and selling them alongside the new books. producers and consumers receive from the existence of a market. They also allow us to calculate how the wel- fare of consumers and pro- ducers is affected by changes in market prices. Such calculations play a crucial role in evaluating many economic policies. What information do we need to calculate con- sumer and producer sur- plus? Surprisingly, all we need are the demand and supply curves for a good How much am I willing to pay for that used textbook? But can we put a number on what used textbook buy- That is, the supply and demand model isn’t just a model ers and sellers gain from these transactions? Can we of how a competitive market works—it’s also a model of answer the question, “How much do the buyers and sell- how much consumers and producers gain from partici- ers of textbooks gain from the existence of the used-book pating in that market. So our first step will be to learn market?” how consumer and producer surplus can be derived from Yes, we can. In this chapter we will see how to meas- the demand and supply curves. We will then see how ure benefits, such as those to buyers of used textbooks, these concepts can be applied to actual economic issues. 93 94 P A R T 2 S U P P LY A N D D E M A N D WHAT YOU WILL LEARN IN THIS CHAPTER: ➤The meaning of consumer surplus and its relationship to the demand curve ➤The meaning of producer surplus and its relationship to the supply curve ➤The meaning and importance of ➤The critical importance of property total surplus and how it can be used both to measure the gains from trade and to illustrate why markets work so well rights and prices as economic signals to the smooth functioning of a market ➤Why markets typically lead to efficient outcomes and why markets sometimes fail Consumer Surplus and the Demand Curve The market in used textbooks is a big business in terms of dollars and cents—approximately $1.9 billion in 2004–2005. More importantly for us, it is a convenient starting point for developing the concepts of consumer and producer surplus. We’ll use the concepts of consumer and producer surplus to understand exactly how buyers and sellers benefit from a competitive market and how big those benefits are. In addition, these concepts play important roles in analyzing what happens when competitive markets don’t work well or there is interference in the market. So let’s begin by looking at the market for used textbooks, starting with the buyers. The key point, as we’ll see in a minute, is that the demand curve is derived from their tastes or preferences—and that those same preferences also determine how much they gain from the opportunity to buy used books. Willingness to Pay and the Demand Curve A used book is not as good as a new book—it will be battered and coffee-stained, may include someone else’s highlighting, and may not be completely up to date. How much this bothers you depends on your preferences. Some potential buyers would prefer to buy the used book even if it is only slightly cheaper than a new one, while others would buy the used book only if it is considerably cheaper. Let’s define a potential buyer’s willingness to pay as the maximum price at which he or she would buy a good, in this case a used textbook. An individual won’t buy the good if it costs more than this amount but is eager to do so if it costs less. If the price is just equal to an individual’s willingness to pay, he or she is indifferent between buying and not buying. For the sake of simplicity, we’ll assume that the individual buys the good in this case. The table in Figure 4-1 shows five potential buyers of a used book that costs $100 new, listed in order of their willingness to pay. At one extreme is Aleisha, who will buy a second-hand book even if the price is as high as $59. Brad is less willing to have a used book and will buy one only if the price is $45 or less. Claudia is willing to pay only $35 and Darren, only $25. And Edwina, who really doesn’t like the idea of a used book, will buy one only if it costs no more than $10. How many of these five students will actually buy a used book? It depends on the price. If the price of a used book is $55, only Aleisha buys one; if the price is $40, Aleisha and Brad both buy used books, and so on. So the information in the table can be used to construct the demand schedule for used textbooks. As we saw in Chapter 3, we can use this demand schedule to derive the market demand curve shown in Figure 4-1. Because we are considering only a small number of consumers, this curve doesn’t look like the smooth demand curves of Chapter 3, where markets contained hundreds or thousands of consumers. This demand curve is step-shaped, with alternating horizontal and vertical segments. Each horizontal segment—each step—corresponds to one potential buyer’s willingness to pay. However, we’ll see shortly that for the analysis of consumer surplus it doesn’t matter whether the demand curve is step-shaped, as in this figure, or whether there are many consumers, making the curve smooth. A consumer’s willingness to pay for a good is the maximum price at which he or she would buy that good 95 FIGURE 4-1 The Demand Curve for Used Textbooks Price of book $59 Aleisha 45 35 25 10 Brad Claudia Darren Edwina D Potential buyers Willingness to pay Aleisha Brad Claudia Darren Edwina $59 45 35 25 10 0 1 2 3 4 5 Quantity of books With only five potential consumers in this market, the demand curve is step-shaped. Each step represents one consumer, and its height indicates that consumer’s willingness to pay—the maximum price at which each will buy a used textbook—as indicated in the table. Aleisha has the highest willingness to pay at $59, Brad has the next highest at $45, and so on down to Edwina with the lowest willingness to pay at $10. At a price of $59, the quantity demanded is one (Aleisha); at a price of $45, the quantity demanded is two (Aleisha and Brad); and so on until you reach a price of $10, at which all five students are willing to purchase a book. Willingness to Pay and Consumer Surplus Suppose that the campus bookstore makes used textbooks available at a price of $30. In that case Aleisha, Brad, and Claudia
will buy books. Do they gain from their purchases, and if so, how much? The answer, shown in Table 4-1, is that each student who purchases a book does achieve a net gain but that the amount of the gain differs among students. Aleisha would have been willing to pay $59, so her net gain is $59 — $30 = $29. Brad would have been willing to pay $45, so his net gain is $45 — $30 = $15. Claudia would have been willing to pay $35, so her net gain is $35 — $30 = $5. Darren and Edwina, however, won’t be willing to buy a used book at a price of $30, so they neither gain nor lose. TABLE 4-1 Consumer Surplus When the Price of a Used Textbook Is $30 Potential buyer Aleisha Brad Claudia Darren Edwina All buyers Willingness to pay Price paid Individual consumer surplus = Willingness to pay − Price paid $59 45 35 25 10 $30 30 30 — — $29 15 5 — — Total consumer surplus = $49 96 P A R T 2 S U P P LY A N D D E M A N D Individual consumer surplus is the net gain to an individual buyer from the purchase of a good. It is equal to the difference between the buyer’s willingness to pay and the price paid. Total consumer surplus is the sum of the individual consumer surpluses of all the buyers of a good in a market. The term consumer surplus is often used to refer to both individual and to total consumer surplus. The net gain that a buyer achieves from the purchase of a good is called that buyer’s individual consumer surplus. What we learn from this example is that whenever a buyer pays a price less than his or her willingness to pay, the buyer achieves some individual consumer surplus. The sum of the individual consumer surpluses achieved by all the buyers of a good is known as the total consumer surplus achieved in the market. In Table 4-1, the total consumer surplus is the sum of the individual consumer surpluses achieved by Aleisha, Brad, and Claudia: $29 + $15 + $5 = $49. Economists often use the term consumer surplus to refer to both individual and total consumer surplus. We will follow this practice; it will always be clear in context whether we are referring to the consumer surplus achieved by an individual or by all buyers. Total consumer surplus can be represented graphically. Figure 4-2 reproduces the demand curve from Figure 4-1. Each step in that demand curve is one book wide and represents one consumer. For example, the height of Aleisha’s step is $59, her willingness to pay. This step forms the top of a rectangle, with $30—the price she actually pays for a book—forming the bottom. The area of Aleisha’s rectangle, ($59 — $30) × 1 = $29, is her consumer surplus from purchasing one book at $30. So the individual consumer surplus Aleisha gains is the area of the dark blue rectangle shown in Figure 4-2. In addition to Aleisha, Brad and Claudia will also each buy a book when the price is $30. Like Aleisha, they benefit from their purchases, though not as much, because they each have a lower willingness to pay. Figure 4-2 also shows the consumer surplus gained by Brad and Claudia; again, this can be measured by the areas of the appropriate rectangles. Darren and Edwina, because they do not buy books at a price of $30, receive no consumer surplus. The total consumer surplus achieved in this market is just the sum of the individual consumer surpluses received by Aleisha, Brad, and Claudia. So total consumer surplus is equal to the combined area of the three rectangles—the entire shaded area in Figure 4-2. Another way to say this is that total consumer surplus is equal to the area below the demand curve but above the price. FIGURE 4-2 Consumer Surplus in the Used-Textbook Market Price of book At a price of $30, Aleisha, Brad, and Claudia each buy a book but Darren and Edwina do not. Aleisha, Brad, and Claudia get individual consumer surpluses equal to the difference between their willingness to pay and the price, illustrated by the areas of the shaded rectangles. Both Darren and Edwina have a willingness to pay less than $30, so they are unwilling to buy a book in this market; they receive zero consumer surplus. The total consumer surplus is given by the entire shaded area—the sum of the individual consumer surpluses of Aleisha, Brad, and Claudia—equal to $29 + $15 + $5 = $49. $59 Aleisha Aleisha’s consumer surplus: $59 − $30 = $29 Brad’s consumer surplus: $45 − $30 = $15 45 35 30 25 10 Brad Claudia’s consumer surplus: $35 − $30 = $5 Claudia Darren Price = $30 Edwina D 0 1 2 3 4 5 Quantity of books 97 FIGURE 4-3 Consumer Surplus The demand curve for computers is smooth because there are many potential buyers. At a price of $1,500, 1 million computers are demanded. The consumer surplus at this price is equal to the shaded area: the area below the demand curve but above the price. This is the total net gain to consumers generated from buying and consuming computers when the price is $1,500. Price of computer $1,500 0 Consumer surplus Price = $1,500 D 1 million Quantity of computers This illustrates the following general principle: The total consumer surplus generated by purchases of a good at a given price is equal to the area below the demand curve but above that price. The same principle applies regardless of the number of consumers. When we consider large markets, this graphical representation becomes extremely helpful. Consider, for example, the sales of personal computers to millions of potential buyers. Each potential buyer has a maximum price that he or she is willing to pay. With so many potential buyers, the demand curve will be smooth, like the one shown in Figure 4-3. Suppose that at a price of $1,500, a total of 1 million computers are purchased. How much do consumers gain from being able to buy those 1 million computers? We could answer that question by calculating the individual consumer surplus of each buyer and then adding these numbers up to arrive at a total. But it is much easier just to look at Figure 4-3 and use the fact that total consumer surplus is equal to the shaded area. As in our original example, consumer surplus is equal to the area below the demand curve but above the price. (You can refresh your memory on how to calculate the area of a right triangle by turning to the appendix to Chapter 2.) How Changing Prices Affect Consumer Surplus It is often important to know how much consumer surplus changes when the price changes. For example, we may want to know how much consumers are hurt if a frost in Florida drives up orange prices or how much consumers gain if the introduction of fish farming makes salmon steaks less expensive. The same approach we have used to derive consumer surplus can be used to answer questions about how changes in prices affect consumers. Let’s return to the example of the market for used textbooks. Suppose that the bookstore decided to sell used textbooks for $20 instead of $30. How much would this fall in price increase consumer surplus? The answer is illustrated in Figure 4-4 on the next page. As shown in the figure, there are two parts to the increase in consumer surplus. The first part, shaded dark blue, is the gain of those who would have bought books even at the higher price of $30. 98 P A R T 2 S U P P LY A N D D E M A N D Each of the students who would have bought books at $30—Aleisha, Brad, and Claudia—now pays $10 less, and therefore each gains $10 in consumer surplus from the fall in price to $20. So the dark blue area represents the $10 × 3 = $30 increase in consumer surplus to those three buyers. The second part, shaded light blue, is the gain to those who would not have bought a book at $30 but are willing to pay more than $20. In this case that gain goes to Darren, who would not have bought a book at $30 but does buy one at $20. He gains $5—the difference between his willingness to pay of $25 and the new price of $20. So the light blue area represents a further $5 gain in consumer surplus. The total increase in consumer surplus is the sum of the shaded areas, $35. Likewise, a rise in price from $20 to $30 would decrease consumer surplus by an amount equal to the sum of the shaded areas. Figure 4-4 illustrates that when the price of a good falls, the area under the demand curve but above the price—which we have seen is equal to total consumer surplus—increases. Figure 4-5 shows the same result for the case of a smooth demand curve, the demand for personal computers. Here we assume that the price of computers falls from $5,000 to $1,500, leading to an increase in the quantity demanded from 200,000 to 1 million units. As in the used-textbook example, we divide the gain in consumer surplus into two parts. The dark blue rectangle in Figure 4-5 corresponds to the dark blue area in Figure 4-4: it is the gain to the 200,000 people who would have bought computers even at the higher price of $5,000. As a result of the price reduction, each receives additional surplus of $3,500. The light blue triangle in Figure 4-5 corresponds to the light blue area in Figure 4-4: it is the gain to people who would not have bought the good at the higher price but are willing to do so at a price of $1,500. For example, the light blue triangle includes the gain to someone who would have been willing to pay $2,000 for a computer and therefore gains $500 in consumer surplus when it is possible to buy a computer for only $1,500. As before, the total gain in consumer surplus is the sum of the shaded areas, the increase in the area under the demand curve but above the price. FIGURE 4-4 Consumer Surplus and a Fall in the Price of Used Textbooks Price of book There are two parts to the increase in consumer surplus generated by a fall in price from $30 to $20. The first is given by the dark blue rectangle: each person who would have bought at the original price of $30—Aleisha, Brad, and Claudia—receives an increase in consumer surplus equal to the total reduction in price, $10. So the area of the dark blue rectangle corresponds to an amount equal to 3 × $10 = $30. The second part is given by the light b
lue area: the increase in consumer surplus for those who would not have bought at the original price of $30 but who buy at the new price of $20—namely, Darren. Darren’s willingness to pay is $25, so he now receives consumer surplus of $5. The total increase in consumer surplus is 3 × $10 + $5 = $35, represented by the sum of the shaded areas. Likewise, a rise in price from $20 to $30 would decrease consumer surplus by an amount equal to the sum of the shaded areas. $59 Aleisha Increase in Aleisha’s consumer surplus 45 35 30 25 20 10 Increase in Brad’s consumer surplus Brad Increase in Claudia’s consumer surplus Claudia Darren Original price = $30 New price = $20 Darren’s consumer surplus Edwina D 0 1 2 3 4 5 Quantity of books 99 FIGURE 4-5 A Fall in the Price Increases Consumer Surplus A fall in the price of a computer from $5,000 to $1,500 leads to an increase in the quantity demanded and an increase in consumer surplus. The change in total consumer surplus is given by the sum of the shaded areas: the total area below the demand curve and between the old and new prices. Here, the dark blue area represents the increase in consumer surplus for the 200,000 consumers who would have bought a computer at the original price of $5,000; they each receive an increase in consumer surplus of $3,500. The light blue area represents the increase in consumer surplus for those willing to buy at a price equal to or greater than $1,500 but less than $5,000. Similarly, a rise in the price of a computer from $1,500 to $5,000 generates a decrease in consumer surplus equal to the sum of the two shaded areas. Price of computer $5,000 1,500 Increase in consumer surplus to original buyers Consumer surplus gained by new buyers D 0 200,000 1 million Quantity of computers What would happen if the price of a good were to rise instead of fall? We would do the same analysis in reverse. Suppose, for example, that for some reason the price of computers rises from $1,500 to $5,000. This would lead to a fall in consumer surplus, equal to the sum of the shaded areas in Figure 4-5. This loss consists of two parts. The dark blue rectangle represents the loss to consumers who would still buy a computer, even at a price of $5,000. The light blue triangle represents the loss to consumers who decide not to buy a computer at the higher price Matter of Life and Death Each year, about 4,000 people in the United States die while waiting for a kidney transplant. In 2007, some 70,000 more were wait-listed. Since the number of those in need of a kidney far exceeds availability, what is the best way to allocate available organs? A market isn’t feasible. For understandable reasons, the sale of human body parts is illegal in this country. So the task of establishing a protocol for these situations has fallen to the nonprofit group United Network for Organ Sharing (UNOS). Under current UNOS guidelines, a donated kidney goes to the person who has been waiting the longest. According to this system, an available kidney would go to a 75year-old who has been waiting for 2 years instead of to a 25-year-old who has been waiting 6 months, even though the 25year-old will likely live longer and benefit from the transplanted organ for a longer period of time. To address this issue, UNOS is devising a new set of guidelines based on a concept it calls “net benefit.” According to these new guidelines, kidneys would be allocated on the basis of who will receive the greatest net benefit, where net benefit is measured as the expected increase in lifespan from the transplant. And age is by far the biggest predictor of how long someone will live after a transplant. For example, a typical 25-year-old diabetic will gain an extra 8.7 years of life from a transplant, but a typical 55-year-old diabetic will gain only 3.6 extra years. Under the current system, based on waiting times, transplants lead to about 44,000 extra years of life for recipients; under the new system, that number would jump to 55,000 extra years. The share of kidneys going to those in their 20s would triple; the share going to those 60 and older would be halved. What does this have to do with consumer surplus? As you may have guessed, the UNOS concept of “net benefit” is a lot like individual consumer surplus—the individual consumer surplus generated from getting a new kidney. In essence, UNOS has devised a system that allocates donated kidneys according to who gets the greatest individual consumer surplus. In terms of results, then, its proposed “net benefit” system operates a lot like a competitive market. 100 P A R T 2 S U P P LY A N D D E M A N D ➤➤ ➤ The demand curve for a good is determined by each potential consumer’s willingness to pay. ➤ Individual consumer surplus is the net gain an individual consumer gets from buying a good. ➤ The total consumer surplus in a given market is equal to the area under the market demand curve but above the price. ➤ A fall in the price of a good increases consumer surplus through two channels: a gain to consumers who would have bought at the original price and a gain to consumers who are persuaded to buy by the lower price. A rise in the price of a good reduces consumer surplus in a similar fashion. ➤ECONOMICS IN ACTION When Money Isn’t Enough The key insight we get from the concept of consumer surplus is that purchases yield a net benefit to the consumer, because the consumer typically pays a price less than his or her willingness to pay for the good. Another way to say this is that the right to buy a good at the going price is a valuable thing in itself. Most of the time we don’t think about the value associated with the right to buy a good. In a market economy, we take it for granted that we can buy whatever we want, as long as we are willing to pay the market price. But that hasn’t always been true. For example, during World War II the demands of wartime production created shortages of consumer goods when these goods were sold at pre-war prices. Rather than allow prices to rise, government officials created a system of rationing many goods. To buy sugar, meat, coffee, gasoline, and many other goods, you not only had to pay cash; you also had to present stamps or coupons from special books issued to each family by the government. These pieces of paper, which represented the right to buy goods at the government-regulated price, quickly became valuable commodities in themselves. As a result, illegal markets in meat stamps and gasoline coupons sprang into existence. Moreover, criminals began stealing coupons and even counterfeiting stamps. The funny thing was that even if you had bought a gasoline coupon on the illegal market, you still had to pay to purchase gasoline. So what you were buying on the illegal market was not the good but the right to buy the good at the government-regulated price. That is, people who bought ration coupons on the illegal market were paying for the right to get some consumer surplus. ▲ < < < < < < < < < < < < ➤ CHECK YOUR UNDERSTANDING 4-1 1. Consider the market for cheese-stuffed jalapeno peppers. There are two consumers, Casey and Josey, and their willingness to pay for each pepper is given in the accompanying table. (Neither Quantity of peppers Casey’s willingness to pay Josey’s willingness to pay 1st pepper 2nd pepper 3rd pepper 4th pepper $0.90 0.70 0.50 0.30 $0.80 0.60 0.40 0.30 is willing to consume more than 4 peppers at any price.) Use the table (i) to construct the demand schedule for peppers for prices of $0.00, $0.10, and so on, up to $0.90, and (ii) to calculate the total consumer surplus when the price of a pepper is $0.40. Solutions appear at back of book. Producer Surplus and the Supply Curve Just as some buyers of a good would have been willing to pay more for their purchase than the price they actually pay, some sellers of a good would have been willing to sell it for less than the price they actually receive. We can therefore carry out an analysis of producer surplus and the supply curve that is almost exactly parallel to that of consumer surplus and the demand curve. Cost and Producer Surplus Consider a group of students who are potential sellers of used textbooks. Because they have different preferences, the various potential sellers differ in the price at which they are willing to sell their books. The table in Figure 4-6 shows the prices at which several different students would be willing to sell. Andrew is willing to sell the book as long as he can get at least $5; Betty won’t sell unless she can get at least $15; Carlos, unless he can get $25; Donna, unless she can get $35; Engelbert, unless he can get $45 101 Price of book $45 35 25 15 5 0 FIGURE 4-6 The Supply Curve for Used Textbooks S Engelbert Donna Carlos Potential sellers Andrew Betty Carlos Donna Engelbert Cost $5 15 25 35 45 Betty Andrew 1 2 3 4 5 Quantity of books The supply curve illustrates sellers’ cost, the lowest price at which a potential seller is willing to sell the good, and the quantity supplied at that price. Each of the five students has one book to sell and each has a different cost, as indicated in the accompanying table. At a price of $5 the quantity supplied is one (Andrew), at $15 it is two (Andrew and Betty), and so on until you reach $45, the price at which all five students are willing to sell. The lowest price at which a potential seller is willing to sell has a special name in economics: it is called the seller’s cost. So Andrew’s cost is $5, Betty’s is $15, and so on. Using the term cost, which people normally associate with the monetary cost of producing a good, may sound a little strange when applied to sellers of used textbooks. The students don’t have to manufacture the books, so it doesn’t cost the student who sells a book anything to make that book available for sale, does it? Yes, it does. A student who sells a book won’t have it later, as part of his or her personal collection. So there is an opportunity cost to selling a textbook
, even if the owner has completed the course for which it was required. And remember that one of the basic principles of economics is that the true measure of the cost of doing something is always its opportunity cost. That is, the real cost of something is what you must give up to get it. So it is good economics to talk of the minimum price at which someone will sell a good as the “cost” of selling that good, even if he or she doesn’t spend any money to make the good available for sale. Of course, in most real-world markets the sellers are also those who produce the good and therefore do spend money to make the good available for sale. In this case the cost of making the good available for sale includes monetary costs, but it may also include other opportunity costs. Getting back to the example, suppose that Andrew sells his book for $30. Clearly he has gained from the transaction: he would have been willing to sell for only $5, so he has gained $25. This net gain, the difference between the price he actually gets and his cost—the minimum price at which he would have been willing to sell—is known as his individual producer surplus. Just as we derived the demand curve from the willingness to pay of different consumers, we can derive the supply curve from the cost of different producers. The stepshaped curve in Figure 4-6 shows the supply curve implied by the costs shown in the accompanying table. At a price less than $5, none of the students are willing to sell; at a price between $5 and $15, only Andrew is willing to sell, and so on. A seller’s cost is the lowest price at which he or she is willing to sell a good. Individual producer surplus is the net gain to an individual seller from selling a good. It is equal to the difference between the price received and the seller’s cost. 102 P A R T 2 S U P P LY A N D D E M A N D Total producer surplus in a market is the sum of the individual producer surpluses of all the sellers of a good in a market. Economists use the term producer surplus to refer both to individual and to total producer surplus. TABLE 4-2 Producer Surplus When the Price of a Used Textbook Is $30 Potential seller Andrew Betty Carlos Donna Engelbert All sellers Cost Price received Individual producer surplus = Price received − Cost $5 15 25 35 45 $30 30 30 — — $25 15 5 — — Total producer surplus = $45 As in the case of consumer surplus, we can add the individual producer surpluses of sellers to calculate the total producer surplus, the total net gain to all sellers in the market. Economists use the term producer surplus to refer to either total or individual producer surplus. Table 4-2 shows the net gain to each of the students who would sell a used book at a price of $30: $25 for Andrew, $15 for Betty, and $5 for Carlos. The total producer surplus is $25 + $15 + $5 = $45. As with consumer surplus, the producer surplus gained by those who sell books can be represented graphically. Figure 4-7 reproduces the supply curve from Figure 4-6. Each step in that supply curve is one book wide and represents one seller. The height of Andrew’s step is $5, his cost. This forms the bottom of a rectangle, with $30, the price he actually receives for his book, forming the top. The area of this rectangle, ($30 − $5) × 1 = $25, is his producer surplus. So the producer surplus Andrew gains from selling his book is the area of the dark red rectangle shown in the figure. Let’s assume that the campus bookstore is willing to buy all the used copies of this book that students are willing to sell at a price of $30. Then, in addition to Andrew, Betty and Carlos will also sell their books. They will also benefit from their sales, though not as much as Andrew, because they have higher costs. Andrew, as we have FIGURE 4-7 Producer Surplus in the Used-Textbook Market At a price of $30, Andrew, Betty, and Carlos each sell a book but Donna and Engelbert do not. Andrew, Betty, and Carlos get individual producer surpluses equal to the difference between the price and their cost, illustrated here by the shaded rectangles. Donna and Engelbert each have a cost that is greater than the price of $30, so they are unwilling to sell a book and so receive zero producer surplus. The total producer surplus is given by the entire shaded area, the sum of the individual producer surpluses of Andrew, Betty, and Carlos, equal to $25 + $15 + $5 = $45. Price of book $45 35 30 25 15 5 0 S Engelbert Donna Carlos Price = $30 Betty’s producer surplus Carlos’s producer surplus Andrew’s producer surplus Betty Andrew 1 2 3 4 5 Quantity of books 103 FIGURE 4-8 Producer Surplus Here is the supply curve for wheat. At a price of $5 per bushel, farmers supply 1 million bushels. The producer surplus at this price is equal to the shaded area: the area above the supply curve but below the price. This is the total gain to producers— farmers in this case—from supplying their product when the price is $5. Price of wheat (per bushel) $5 Producer surplus S Price = $5 0 1 million Quantity of wheat (bushels) seen, gains $25. Betty gains a smaller amount: since her cost is $15, she gains only $15. Carlos gains even less, only $5. Again, as with consumer surplus, we have a general rule for determining the total producer surplus from sales of a good: The total producer surplus from sales of a good at a given price is the area above the supply curve but below that price. This rule applies both to examples like the one shown in Figure 4-7, where there are a small number of producers and a step-shaped supply curve, and to more realistic examples, where there are many producers and the supply curve is more or less smooth. Consider, for example, the supply of wheat. Figure 4-8 shows how producer surplus depends on the price per bushel. Suppose that, as shown in the figure, the price is $5 per bushel and farmers supply 1 million bushels. What is the benefit to the farmers from selling their wheat at a price of $5? Their producer surplus is equal to the shaded area in the figure—the area above the supply curve but below the price of $5 per bushel. How Changing Prices Affect Producer Surplus As in the case of consumer surplus, a change in price alters producer surplus. However, although a fall in price increases consumer surplus, it reduces producer surplus. Similarly, a rise in price reduces consumer surplus but increases producer surplus. To see this, let’s first consider a rise in the price of the good. Producers of the good will experience an increase in producer surplus, though not all producers gain the same amount. Some producers would have produced the good even at the original price; they will gain the entire price increase on every unit they produce. Other producers will enter the market because of the higher price; they will gain only the difference between the new price and their cost. Figure 4-9 on the next page is the supply counterpart of Figure 4-5. It shows the effect on producer surplus of a rise in the price of wheat from $5 to $7 per bushel. The increase in producer surplus is the sum of the shaded areas, which consists of two parts. First, there is a dark red rectangle corresponding to the gains to those farmers who would have supplied wheat even at the original $5 price. Second, there is an additional light red 104 P A R T 2 S U P P LY A N D D E M A N D FIGURE 4-9 A Rise in the Price Increases Producer Surplus Price of wheat (per bushel) A rise in the price of wheat from $5 to $7 leads to an increase in the quantity supplied and an increase in producer surplus. The change in total producer surplus is given by the sum of the shaded areas: the total area above the supply curve but between the old and new prices. The dark red area represents the gain to the farmers who would have supplied 1 million bushels at the original price of $5; they each receive an increase in producer surplus of $2 for each of those bushels. The triangular light red area represents the increase in producer surplus achieved by the farmers who supply the additional 500,000 bushels because of the higher price. Similarly, a fall in the price of wheat generates a reduction in producer surplus equal to the sum of the shaded areas. Increase in producer surplus to original sellers Producer surplus gained by new sellers S $7 5 0 1 million 1.5 million Quantity of wheat (bushels) triangle that corresponds to the gains to those farmers who would not have supplied wheat at the original price but are drawn into the market by the higher price. If the price were to fall from $7 to $5 per bushel, the story would run in reverse. The sum of the shaded areas would now be the decline in producer surplus, the decrease in the area above the supply curve but below the price. The loss would consist of two parts, the loss to farmers who would still grow wheat at a price of $5 (the dark red rectangle) and the loss to farmers who decide to no longer grow wheat because of the lower price (the light red triangle). ➤ECONOMICS IN ACTION When the Corn Is High The average value of farmland in Iowa hit a record high in 2006. A lot of people, it seems, wanted to be Iowa farmers. And there was no mystery why: it was all about the ethanol. Let’s explain: ethanol—the same kind of alcohol that’s in beer and other alcoholic drinks—can also fuel automobiles. And in recent years government policy, at both the federal and state levels, has encouraged the use of gasoline that contains a percentage of ethanol. There are a couple of reasons for this policy, including some benefits in fighting air pollution and the hope that using more ethanol will reduce U.S. dependence on imported oil. But where is the ethanol to come from? Ethanol advocates look to the example of Brazil, which has shifted much of its fuel consumption from gasoline to ethanol. Brazil gets its ethanol by fermenting sugarcane, then distilling out the alcohol. The United States can’t follow the same strategy: we don’t grow enough sugarcane to satisfy our own sweet too
ths, let alone run our cars. But we do produce an awful lot of corn. And corn can also be turned into ethanol. One result of the shift to ethanol fuel has been a rise in the demand for corn, leading to a surge in corn prices, which rose from $1.85 a bushel in late 2005 to about $4 a bushel in early 2007. And there’s no place like Iowa for growing corn. Iowa farmers gained from high prices both because they could sell the corn they would have 105 grown even at lower prices for more money, and because they could shift land away from other crops—especially soybeans—to corn. What does this have to do with the price of land? A person who buys a farm in Iowa buys the producer surplus that farm generates. And higher prices for corn, which raise the producer surplus of Iowa farmers, make Iowa farmland more valuable. According to the U.S. Department of Agriculture, Iowa farmland went from an average of $1,800 per acre in 2000 to $2,930 per acre in 2006, a 63% increase. ▲ > > > > > > > > > > > > ➤ CHECK YOUR UNDERSTANDING 4-2 1. Consider the market for cheese-stuffed jalapeno peppers. There are two producers, Cara and Jamie, and their costs of producing each pepper are given in the accompanying table. (Neither is willing to produce more than 4 peppers at any price.) Use the table (i) to construct the supply schedule for peppers for prices of $0.00, $0.10, and so on, up to $0.90, and (ii) to calculate the total producer surplus when the price of a pepper is $0.70. Quantity of peppers 1st pepper 2nd pepper 3rd pepper 4th pepper Jamie’s cost $0.30 0.50 0.70 0.90 Cara’s cost $0.10 0.10 0.40 0.60 Solutions appear at back of book. Consumer Surplus, Producer Surplus, and the Gains from Trade One of the 12 core principles of economics we introduced in Chapter 1 is that markets are a remarkably effective way to organize economic activity: they generally make society as well off as possible given the available resources. The concepts of consumer surplus and producer surplus can help us deepen our understanding of why this is so. The Gains from Trade Let’s return to the market in used textbooks, but now consider a much bigger market— say, one at a large state university. There are many potential buyers and sellers, so the market is competitive. Let’s line up incoming students who are potential buyers of a book in order of their willingness to pay, so that the entering student with the highest willingness to pay is potential buyer number 1, the student with the next highest willingness to pay is number 2, and so on. Then we can use their willingness to pay to derive a demand curve like the one in Figure 4-10 on the next page. Similarly, we can line up outgoing students, who are potential sellers of the book, in order of their cost, starting with the student with the lowest cost, then the student with the next lowest cost, and so on, to derive a supply curve like the one shown in the same figure. As we have drawn the curves, the market reaches equilibrium at a price of $30 per book, and 1,000 books are bought and sold at that price. The two shaded triangles show the consumer surplus (blue) and the producer surplus (red) generated by this market. The sum of consumer and producer surplus is known as the total surplus generated in a market. The striking thing about this picture is that both consumers and producers gain— that is, both consumers and producers are better off because there is a market in this good. But this should come as no surprise—it illustrates another core principle of economics: There are gains from trade. These gains from trade are the reason everyone is better off participating in a market economy than they would be if each individual tried to be self-sufficient. But are we as well off as we could be? This brings us to the question of the effi- ciency of markets. ➤➤ ➤ The supply curve for a good is determined by the cost of each seller. ➤ The difference between the price and cost is the seller’s individual producer surplus. ➤ The total producer surplus is equal to the area above the market supply curve but below the price. ➤ When the price of a good rises, producer surplus increases through two channels: the gains of those who would have supplied the good at the original price and the gains of those who are induced to supply the good by the higher price. A fall in the price of a good similarly leads to a fall in producer surplus. The total surplus generated in a market is the total net gain to consumers and producers from trading in the market. It is the sum of the producer and the consumer surplus. 106 P A R T 2 S U P P LY A N D D E M A N D FIGURE 4-10 Total Surplus In the market for used textbooks, the equilibrium price is $30 and the equilibrium quantity is 1,000 books. Consumer surplus is given by the blue area, the area below the demand curve but above the price. Producer surplus is given by the red area, the area above the supply curve but below the price. The sum of the blue and the red areas is total surplus, the total benefit to society from the production and consumption of the good. Price of book Equilibrium price $30 Consumer surplus Producer surplus E S D 0 1,000 Quantity of books Equilibrium quantity The Efficiency of Markets Markets produce gains from trade, but in Chapter 1 we made an even bigger claim: that markets are usually efficient. That is, we claimed that once the market has produced its gains from trade, there is no way to make some people better off without making other people worse off, except under some well-defined conditions. The analysis of consumer and producer surplus helps us understand why markets are usually efficient. To gain more intuition into why this is so, consider the fact that market equilibrium is just one way of deciding who consumes the good and who sells the good. There are other possible ways of making that decision. Consider, for example, the case of kidney transplants, discussed earlier in For Inquiring Minds. There you learned that available kidneys currently go to the people who have been waiting the longest, rather than to those most likely to benefit from the organ for longer. To address this inefficiency, a new set of guidelines is being devised to determine eligibility for a kidney transplant based on “net benefit,” a concept an awful lot like consumer surplus: kidneys would be allocated largely on the basis of who will benefit from them the most. Similarly, imagine a committee charged with improving on the market equilibrium by deciding who gets and who gives up a used textbook. The committee’s ultimate goal: to bypass the market outcome and come up with another arrangement that would produce higher total surplus. Let’s consider the three ways in which the committee might try to increase the total surplus: 1. Reallocate consumption among consumers 2. Reallocate sales among sellers 3. Change the quantity traded Reallocate Consumption Among Consumers The committee might try to increase total surplus by selling books to different consumers. Figure 4-11 shows why this will result in lower surplus compared to the market equilibrium outcome. Points A and B show the positions on the demand curve of two potential buyers of used books, Ana and Bob. As we can see from the figure, Ana is willing to pay $35 for a book, but 107 FIGURE 4-11 Reallocating Consumption Lowers Consumer Surplus Price of book Ana (point A) has a willingness to pay of $35. Bob (point B) has a willingness to pay of only $25. At the market equilibrium price of $30, Ana purchases a book but Bob does not. If we rearrange consumption by taking a book from Ana and giving it to Bob, consumer surplus declines by $10 and, as a result, total surplus declines by $10. The market equilibrium generates the highest possible consumer surplus by ensuring that those who consume the good are those who most value it. $35 30 25 Loss in consumer surplus if the book is taken from Ana and given to Bob A E B S D 0 1,000 Quantity of books Bob is willing to pay only $25. Since the market equilibrium price is $30, under the market outcome Ana gets a book and Bob does not. Now suppose the committee reallocates consumption. This would mean taking the book away from Ana and giving it to Bob. Since the book is worth $35 to Ana but only $25 to Bob, this change reduces total consumer surplus by $35 − $25 = $10. Moreover, this result doesn’t depend on which two students we pick. Every student who buys a book in the market equilibrium has a willingness to pay of $30 or more, and every student who doesn’t buy a book has a willingness to pay of less than $30. So reallocating the good among consumers always means taking a book away from a student who values it more and giving it to one who values it less. This necessarily reduces total consumer surplus. Reallocate Sales Among Sellers The committee might try to increase total surplus by altering who sells their books, taking sales away from sellers who would have sold their books in the market equilibrium and instead compelling those who would not have sold their books in the market equilibrium to sell them. Figure 4-12 on the next page shows why this will result in lower surplus. Here points X and Y show the positions on the supply curve of Xavier, who has a cost of $25, and Yvonne, who has a cost of $35. At the equilibrium market price of $30, Xavier would sell his book but Yvonne would not sell hers. If the committee reallocated sales, forcing Xavier to keep his book and Yvonne to sell hers, total producer surplus would be reduced by $35 − $25 = $10. Again, it doesn’t matter which two students we choose. Any student who sells a book in the market equilibrium has a lower cost than any student who keeps a book. So reallocating sales among sellers necessarily increases total cost and reduces total producer surplus. Change the Quantity Traded The committee might try to increase total surplus by compelling students to trade either more books or fewer books than the market equilibrium qu
antity. Figure 4-13 on the next page shows why this will result in lower surplus. It shows all four students: potential buyers Ana and Bob, and potential sellers Xavier and Yvonne. To reduce sales, the committee will have to prevent a transaction that would have occurred in the market equilibrium—that is, prevent Xavier from selling to Ana. Since Ana is willing to pay $35 and Xavier’s cost is $25, preventing this transaction reduces total surplus by $35 − $25 = $10. Once again, this result doesn’t depend on which two students we pick: any student who would have sold the book in the market equilibrium has a cost of $30 or less, and any student who would 108 P A R T 2 S U P P LY A N D D E M A N D FIGURE 4-12 Reallocating Sales Lowers Producer Surplus Price of book S Yvonne (point Y) has a cost of $35, $10 more than Xavier (point X), who has a cost of $25. At the market equilibrium price of $30, Xavier sells a book but Yvonne does not. If we rearrange sales by preventing Xavier from selling his book and compelling Yvonne to sell hers, producer surplus declines by $10 and, as a result, total surplus declines by $10. The market equilibrium generates the highest possible producer surplus by assuring that those who sell the good are those who most value the right to sell it. $35 30 25 E X Y Loss in producer surplus if Yvonne is made to sell the book instead of Xavier 0 1,000 Quantity of books D have purchased the book in the market equilibrium has a willingness to pay of $30 or more. So preventing any sale that would have occurred in the market equilibrium necessarily reduces total surplus. Finally, the committee might try to increase sales by forcing Yvonne, who would not have sold her book in the market equilibrium, to sell it to someone like Bob, who would not have bought a book in the market equilibrium. Because Yvonne’s cost is $35, but Bob is only willing to pay $25, this transaction reduces total surplus by $10. And once again it doesn’t matter which two students we pick—anyone who wouldn’t have bought the book has a willingness to pay of less than $30, and anyone who wouldn’t have sold has a cost of more than $30. FIGURE 4-13 Changing the Quantity Lowers Total Surplus Price of book If Xavier (point X) were prevented from selling his book to someone like Ana (point A), total surplus would fall by $10, the difference between Ana’s willingness to pay ($35) and Xavier’s cost ($25). This means that total surplus falls whenever fewer than 1,000 books—the equilibrium quantity—are transacted. Likewise, if Yvonne (point Y ) were compelled to sell her book to someone like Bob (point B), total surplus would also fall by $10, the difference between Yvonne’s cost ($35) and Bob’s willingness to pay ($25). This means that total surplus falls whenever more than 1,000 books are transacted. These two examples show that at market equilibrium, all mutually beneficial transactions—and only mutually beneficial transactions—occur. $35 30 25 Loss in total surplus if the transaction between Ana and Xavier is prevented A X E Y B S Loss in total surplus if the transaction between Yvonne and Bob is forced D 0 1,000 Quantity of books 109 Maximizing total surplus at your local hardware store. The key point to remember is that once this market is in equilibrium, there is no way to increase the gains from trade. Any other outcome reduces total surplus. (This is why UNOS is trying, with its new guidelines based on “net benefit,” to reproduce the allocation of donated kidneys that would occur if there were a market for the organs.) We can summarize our results by stating that an efficient market performs four important functions: 1. It allocates consumption of the good to the potential buyers who most value it, as indicated by the fact that they have the highest willingness to pay. 2. It allocates sales to the potential sellers who most value the right to sell the good, as indicated by the fact that they have the lowest cost. 3. It ensures that every consumer who makes a purchase values the good more than every seller who makes a sale, so that all transactions are mutually beneficial. 4. It ensures that every potential buyer who doesn’t make a purchase values the good less than every potential seller who doesn’t make a sale, so that no mutually beneficial transactions are missed. There are three caveats, however. First, although a market may be efficient, it isn’t necessarily fair. In fact, fairness, or equity, is often in conflict with efficiency. We’ll discuss this next. The second caveat is that markets sometimes fail. As we mentioned in Chapter 1, under some well-defined conditions, markets can fail to deliver efficiency. When this occurs, markets no longer maximize total surplus. We provide a brief overview of why markets fail at the end of this chapter, reserving a more detailed analysis for later chapters. Third, even when the market equilibrium maximizes total surplus, this does not mean that it results in the best outcome for every individual consumer and producer. Other things equal, each buyer would like to pay a lower price and each seller would like to receive a higher price. So if the government were to intervene in the market— say, by lowering the price below the equilibrium price to make consumers happy or by raising the price above the equilibrium price to make producers happy—the outcome would no longer be efficient. Although some people would be happier, society as a whole would be worse off because total surplus would be lower. Equity and Efficiency For many patients who need kidney transplants, the proposed UNOS guidelines, covered earlier, will be unwelcome news. Those who had waited years for a transplant will no doubt find these guidelines, which give precedence to younger patients, . . . well . . . unfair. And the guidelines raise other questions about fairness: Why limit potential transplant recipients to Americans? Why include younger patients with other chronic diseases? Why not give precedence to those who have made recognized contributions to society? And so on. The point is that efficiency is about how to achieve goals, not what those goals should be. For example, UNOS decided that its goal is to maximize the life span of kidney recipients. Some might have argued for a different goal, and efficiency does not address which goal is the best. What efficiency does address is the best way to achieve a goal once it has been determined—in this case, using the UNOS concept of “net benefit.” It’s easy to get carried away with the idea that markets are always right and that economic policies that interfere with efficiency are bad. But that would be misguided because there is another factor to consider: society cares about equity, or what’s “fair.” As we discussed in Chapter 1, there is often a trade-off between equity and efficiency: policies that promote equity often come at the cost of decreased efficiency, and policies that promote efficiency often result in decreased equity. So it’s important to realize that a society’s choice to sacrifice some efficiency for the sake of equity, however it defines equity, is a valid one. And it’s important to understand that fairness, unlike efficiency, can be very hard to define. Fairness is a concept about which well-intentioned people often disagree. 110 P A R T 2 S U P P LY ECONOMICS IN ACTION eBay and eFficiency Garage sales are an old American tradition: they are a way for people to sell items they don’t want to others who have some use for them, to the benefit of both parties. But many potentially beneficial trades are missed. For all Mr. Smith knows, there is someone 1,000 miles away who would really love that 1930s gramophone he has in the basement; for all Ms. Jones knows, there is someone 1,000 miles away who has that 1930s gramophone she has always wanted. When garage sales are the only means by which buyers and sellers meet, there is no way for people like Mr. Smith and Ms. Jones to find each otherI got it from eBay” Enter eBay, the online auction service. eBay was founded in 1995 by Pierre Omidyar, a programmer whose fiancée was a collector of Pez candy dispensers and wanted a way to find potential sellers. The company, which says that its mission is “to help practically anyone trade practically anything on earth,” provides a way for would-be buyers and would-be sellers of unique or used items to find each other, even if they . © ➤➤ ➤ Total surplus measures the gains from trade in a market. ➤ Markets are efficient except under some well-defined conditions. We can demonstrate the efficiency of a market by considering what happens to total surplus if we start from the equilibrium and reallocate consumption, reallocate sales, or change the quantity traded. Any outcome other than the market equilibrium reduces total surplus, which means that the market equilibrium is efficient. ➤ Because society cares about equity, government intervention in a market that reduces efficiency while increasing equity can be justified. don’t live in the same neighborhood or even the same city. The potential gains from trade were evidently large: by late 2007, eBay had 83.2 million active users, and in 2007, $60 billion in goods were bought and sold using the service. The Omidyars now possess a large collection of Pez dispensers. They are also billionaires. ▲ < < < < < < < < < < < < ➤ CHECK YOUR UNDERSTANDING 4-3 1. Using the tables in Check Your Understanding 4-1 and 4-2, find the equilibrium price and quantity in the market for cheese-stuffed jalapeno peppers. What is total surplus in the equilibrium in this market, and who receives it? 2. Show how each of the following three actions reduces total surplus: a. Having Josey consume one less pepper, and Casey one more pepper, than in the market equilibrium b. Having Cara produce one less pepper, and Jamie one more pepper, than in the market equilibrium c. Having Josey consume one less pepper, and Cara produce one less pepper, than in the market e
quilibrium 3. Suppose UNOS alters its guidelines for the allocation of donated kidneys, no longer relying solely on the concept of “net benefit” but also giving preference to patients with small children. If “total surplus” in this case is defined to be the total life span of kidney recipients, is this new guideline likely to reduce, increase, or leave total surplus unchanged? How might you justify this new guideline? Solutions appear at back of book. A Market Economy As we learned earlier in the book, in a market economy decisions about production and consumption are made via markets. In fact, the economy as a whole is made up of many interrelated markets. Up until now, to learn how markets work we’ve been examining a single market—the market for used textbooks. But in reality, consumers and producers do not make decisions in isolated markets. For example, a student’s decision in the market for used textbooks might be affected by how much interest must be paid on a student loan; thus, the decision in the used textbook market would be influenced by what is going on in the market for money 111 Property rights are the rights of owners of valuable items, whether resources or goods, to dispose of those items as they choose. An economic signal is any piece of information that helps people make better economic decisions. We know that an efficient market equilibrium maximizes total surplus—the gains to buyers and sellers in that market. Is there a comparable result for an economy as a whole, an economy composed of a vast number of individual markets? The answer is yes, but with qualifications. When each and every market in the economy maximizes total surplus, then the economy as a whole is efficient. This is a very important result: just as it is impossible to make someone better off without making other people worse off in a single market when it is efficient, it is impossible to improve upon the outcome of a market economy when each and every market in that economy is efficient. However, it is important to realize that this is a theoretical result: it is virtually impossible to find an economy in which every market is efficient. For now, let’s examine why markets and market economies typically work so well. Once we understand why, we can then briefly address why markets sometimes get it wrong. Why Markets Typically Work So Well Economists have written volumes about why markets are an effective way to organize an economy. In the end, well-functioning markets owe their effectiveness to two powerful features: property rights and the role of prices as economic signals. By property rights we mean a system in which valuable items in the economy have specific owners who can dispose of them as they choose. In a system of property rights, by purchasing a good you receive “ownership rights”: the right to use and dispose of the good as you see fit. Property rights are what make the mutually beneficial transactions in the used-textbook market, or any market, possible. To see why property rights are crucial, imagine that students do not have full property rights in their textbooks and are prohibited from reselling them when the semester ends. This restriction on property rights would prevent many mutually beneficial transactions. Some students would be stuck with textbooks they will never reread when they would be much happier receiving some cash instead. Other students would be forced to pay full price for brand-new books when they would be happier getting slightly battered copies at a lower price. Once a system of well-defined property rights is in place, the second necessary feature of well-functioning markets—prices as economic signals—can operate. An economic signal is any piece of information that helps people make better economic decisions. There are thousands of signals that businesses watch in the real world. For example, business forecasters say that sales of cardboard boxes are a good early indicator of changes in industrial production: if businesses are buying lots of cardboard boxes, you can be sure that they will soon increase their production. But prices are far and away the most important signals in a market economy, because they convey essential information about other people’s costs and their willingness to pay. If the equilibrium price of used books is $30, this in effect tells everyone both that there are consumers willing to pay $30 and up and that there are potential sellers with a cost of $30 or less. The signal given by the market price ensures that total surplus is maximized by telling people whether to buy books, sell books, or do nothing at all. Each potential seller with a cost of $30 or less learns from the market price that it’s a good idea to sell her book; if she has a higher cost, it’s a good idea to keep it. Likewise, each consumer willing to pay $30 or more learns from the market price that it’s a good idea to buy a book; if he is unwilling to pay $30, then it’s a good idea not to buy a book. This example shows that the market price “signals” to consumers with a willingness to pay equal to or more than the market price that they should buy the good, just as it signals to producers with a cost equal to or less than the market price that they should sell the good. And since, in equilibrium, the quantity demanded equals the quantity supplied, all willing consumers will find willing sellers. Prices can sometimes fail as economic signals. Sometimes a price is not an accurate indicator of how desirable a good is. When there is uncertainty about the quality of a good, price alone may not be an accurate indicator of the value of the good. For example, you can’t infer from the price alone whether a used car is good or a 112 P A R T 2 S U P P LY market or an economy is inefficient if there are missed opportunities: some people could be made better off without making other people worse off. Market failure occurs when a market fails to be efficient. “lemon.” In fact, a well-known problem in economics is “the market for lemons,” a market in which prices don’t work well as economic signals. (We’ll learn about the market for lemons in Chapter 21.) A Few Words of Caution As we’ve seen, markets are an amazingly effective way to organize economic activity. But as we’ve noted, markets can sometimes get it wrong. We first learned about this in Chapter 1 in our fifth principle of interaction: When markets don’t achieve efficiency, government intervention can improve society’s welfare. When markets are inefficient, there are missed opportunities—ways in which production or consumption can be rearranged that would make some people better off without making other people worse off. In other words, there are gains from trade that go unrealized: total surplus could be increased. And when a market or markets are inefficient, the economy in which they are embedded is also inefficient. Markets can be rendered inefficient for a number of reasons. Two of the most important are a lack of property rights and inaccuracy of prices as economic signals. When a market is inefficient, we have what is known as market failure. We will examine various types of market failure in later chapters; for now, let’s review the three main ways in which markets sometimes fall short of efficiency. First, markets can fail when, in an attempt to capture more surplus, one party prevents mutually beneficial trades from occurring. This situation arises, for instance, when a market contains only a single seller of a good, known as a monopolist. In this case, the assumption we have relied on in supply and demand analysis—that no individual buyer or seller can have a noticeable effect on the market price—is no longer valid; the monopolist can determine the market price. As we’ll see in Chapter 14, this gives rise to inefficiency as a monopolist manipulates the market price in order to increase profits, thereby preventing mutually beneficial trades from occurring. Second, actions of individuals sometimes have side effects on the welfare of others that markets don’t take into account. In economics, these side effects are known as externalities, and the best-known example is pollution. We can think of the problem of pollution as a problem of incomplete property rights; for example, existing property rights don’t guarantee a right to ownership of clean air. We’ll see in Chapter 17 that pollution and other externalities also give rise to inefficiency. Third, markets for some goods fail because these goods, by their very nature, are unsuited for efficient management by markets. In Chapter 21, we will analyze goods that fall into this category because of problems of private information—information about a good that some people possess but others don’t. The seller of a used car that is a “lemon” may have information that is unknown to potential buyers. In cases like this where there is private information, prices don’t always accurately reflect true value. In Chapter 18, we will encounter other types of goods that fall into the category of being unsuited for efficient management by markets—public goods, common resources, and artificially scarce goods. Markets for these goods fail because of problems in limiting people’s access to and consumption of the good; examples are fish in the sea and trees in the Amazonian rainforest. In these instances, markets generally fail due to incomplete property rights. But even with these caveats, it’s remarkable how well markets work at maximizing the gains from trade. R L D VIE W W O ➤ECONOMICS IN ACTION A Great Leap—Backward Economies in which a central planner, rather than markets, makes consumption and production decisions are known as planned economies. Russia (formerly part of the U.S.S.R.), many Eastern European countries, and several Southeast Asian countries once had planned economies, and countries such as India and Brazil once had significant parts of their economies under central planning. China still does today. VI
EWWOR 113 ➤➤ ➤ In a market economy, markets are interrelated. When each and every market in an economy is efficient, the economy as a whole is efficient. But in the real world, some markets in a market economy will almost certainly fail to be efficient. ➤ A system of property rights and the operation of prices as economic signals are two key factors that enable a market to be efficient. But under conditions in which property rights are incomplete or prices give inaccurate economic signals, markets can fail. ➤ Under certain conditions, market failure occurs and the market is inefficient: gains to trade are unrealized. The three principal ways in which markets fail are the prevention of mutually beneficial transactions caused by one party’s attempt to capture more surplus, side effects that aren’t properly accounted for, and problems in the nature of the goods themselves. Planned economies are notorious for their inefficiency, and what is probably the most compelling example of that is the so-called Great Leap Forward, an ambitious economic plan instituted in China during the late 1950s by its leader Mao Zedong. Its intention was to speed up the country’s industrialization. Key to this plan was a shift from urban to rural manufacturing: farming villages were supposed to start producing heavy industrial goods such as steel. Unfortunately, the plan backfired. Diverting farmers from their usual work led to a sharp fall in food production. Meanwhile, because raw materials for steel, such as coal and iron ore, were sent to ill-equipped and inexperienced rural producers rather than to urban factories, industrial output declined as well. The plan, in short, led to a fall in the production of everything in China. Because China was a very poor country to start with, the results were catastrophic. The famine that followed is estimated to have reduced China’s population by as much as 30 million. ▲ > > > > > > > > > > > > ➤ CHECK YOUR UNDERSTANDING 4-4 1. In some states that are rich in natural resources, such as oil, the law separates the right to above-ground use of the land from the right to drill below ground (called “mineral rights”). Someone who owns both the above-ground rights and the mineral rights can sell the two rights separately. Explain how this division of the property rights enhances efficiency compared to a situation in which the two rights must always be sold together. 2. Suppose that in the market for used textbooks the equilibrium price is $30, but it is mistakenly announced that the equilibrium price is $300. How does this affect the efficiency of the market? Be specific. 3. What is wrong with the following statement? “Markets are always the best way to organize economic activity. Any policies that interfere with markets reduce society’s welfare.” Solutions appear at back of book. [ ➤➤ A LOOK AHEAD ••• We have now seen how to measure the gains producers and consumers receive by trading in a market, and we’ve also seen that, subject to certain caveats, a market equilibrium maximizes these gains. Nonetheless, governments sometimes object to the equilibrium price or equilibrium quantity arising from an efficient market, and they intervene to change the result. In the next chapter, we’ll describe the usually unpleasant consequences of attempts to tell efficient markets what to do.] S U M M A R Y 1. The willingness to pay of each individual consumer determines the demand curve. When price is less than or equal to the willingness to pay, the potential consumer purchases the good. The difference between willingness to pay and price is the net gain to the consumer, the individual consumer surplus. 2. Total consumer surplus in a market, the sum of all individual consumer surpluses in a market, is equal to the area below the market demand curve but above the price. A rise in the price of a good reduces consumer surplus; a fall in the price increases consumer surplus. The term consumer surplus is often used to refer to both individual and total consumer surplus. 3. The cost of each potential producer, the lowest price at which he or she is willing to supply a unit of that good, determines the supply curve. If the price of a good is above a producer’s cost, a sale generates a net gain to the producer, known as the individual producer surplus. 4. Total producer surplus in a market, the sum of the individual producer surpluses in a market, is equal to the area above the market supply curve but below the price. A rise in the price of a good increases producer surplus; a fall in the price reduces producer surplus. The term producer surplus is often used to refer to both individual and total producer surplus. 114 P A R T 2 S U P P LY . Total surplus, the total gain to society from the production and consumption of a good, is the sum of consumer and producer surplus. 6. Usually, markets are efficient and achieve the maximum total surplus. Any possible reallocation of consumption or sales, or change in the quantity bought and sold, reduces total surplus. However, society also cares about equity. So government intervention in a market that reduces efficiency but increases equity can be a valid choice by society. 7. An economy composed of efficient markets is also efficient, although this is virtually impossible to achieve in reality. The keys to the efficiency of a market economy are property rights and the operation of prices as economic signals. Under certain conditions, market failure occurs, making a market inefficient. Three principal sources of market failure are: attempts to capture more surplus that create inefficiencies, side effects of some transactions, and problems in the nature of the good. K E Y T E R M S Willingness to pay, p. 94 Individual producer surplus, p. 101 Economic signal, p. 111 Individual consumer surplus, p. 96 Total producer surplus, p. 102 Total consumer surplus, p. 96 Producer surplus, p. 102 Inefficient, p. 112 Market failure, p. 112 Consumer surplus, p. 96 Cost, p. 101 Total surplus, p. 105 Property rights, p. 111 P R O B L E M S 1. Determine the amount of consumer surplus generated in a. Suppose the market price is $29. What is the total each of the following situations. consumer surplus? a. Leon goes to the clothing store to buy a new T-shirt, for which he is willing to pay up to $10. He picks out one he likes with a price tag of exactly $10. When he is paying for it, he learns that the T-shirt has been discounted by 50%. b. Alberto goes to the CD store hoping to find a used copy of Nirvana’s Greatest Hits for up to $10. The store has one copy selling for $10, which he purchases. c. After soccer practice, Stacey is willing to pay $2 for a bottle of mineral water. The 7-Eleven sells mineral water for $2.25 per bottle, so she declines to purchase it. 2. Determine the amount of producer surplus generated in each of the following situations. a. Gordon lists his old Lionel electric trains on eBay. He sets a minimum acceptable price, known as his reserve price, of $75. After five days of bidding, the final high bid is exactly $75. He accepts the bid. b. So-Hee advertises her car for sale in the used-car section of the student newspaper for $2,000, but she is willing to sell the car for any price higher than $1,500. The best offer she gets is $1,200, which she declines. c. Sanjay likes his job so much that he would be willing to do it for free. However, his annual salary is $80,000. 3. There are six potential consumers of computer games, each willing to buy only one game. Consumer 1 is willing to pay $40 for a computer game, consumer 2 is willing to pay $35, consumer 3 is willing to pay $30, consumer 4 is willing to pay $25, consumer 5 is willing to pay $20, and consumer 6 is willing to pay $15. b. The market price decreases to $19. What is the total consumer surplus now? c. When the price fell from $29 to $19, how much did each consumer’s individual consumer surplus change? How does total consumer surplus change? 4. a. In an auction, potential buyers compete for a good by submitting bids. Adam Galinsky, a social psychologist at Northwestern University, compared eBay auctions in which the same good was sold. He found that, on average, the higher the number of bidders, the higher the sales price. For example, in two auctions of identical iPods, the one with the higher number of bidders brought a higher selling price. According to Galinsky, this explains why smart sellers on eBay set absurdly low opening prices (the lowest price that the seller will accept), such as 1 cent for a new iPod. Use the concepts of consumer and producer surplus to explain Galinsky’s reasoning. b. You are considering selling your vintage 1969 convertible Volkswagen Beetle. If the car is in good condition, it is worth a lot; if it is in poor condition, it is useful only as scrap. Assume that your car is in excellent condition but that it costs a potential buyer $500 for an inspection to learn the car’s condition. Use what you learned in part a to explain whether or not you should pay for an inspection and share the results with all interested buyers. 5. According to the Bureau of Transportation Statistics, due to an increase in demand, the average domestic airline fare increased from $367.17 in the fourth quarter of 2005 to $381.99 in the first quarter of 2006, an increase of $14.82 115 The number of passenger tickets sold in the fourth quarter of 2005 was 178.1 million. Over the same period, the airlines’ costs remained roughly the same: the price of jet fuel averaged around $1.85 per gallon in both quarters (Source: Energy Information Administration), and airline pilots’ salaries remained roughly the same (according to the Bureau of Labor Statistics, they averaged $135,040 per year in 2005). Can you determine precisely by how much producer surplus has increased as a result of the $14.82 increase in the average fare? If you cannot be precise, can you determine whether it will be less than, or more than, a specific amount?
6. Hollywood screenwriters negotiate a new agreement with movie producers stipulating that they will receive 10% of the revenue from every video rental of a movie they authored. They have no such agreement for movies shown on pay-perview television. a. When the new writers’ agreement comes into effect, what will happen in the market for video rentals—that is, will supply or demand shift, and how? As a result, how will consumer surplus in the market for video rentals change? Illustrate with a diagram. Do you think the writers’ agreement will be popular with consumers who rent videos? b. Consumers consider video rentals and pay-per-view movies substitutable to some extent. When the new writers’ agreement comes into effect, what will happen in the market for pay-per-view movies—that is, will supply or demand shift, and how? As a result, how will producer surplus in the market for pay-per-view movies change? Illustrate with a diagram. Do you think the writers’ agreement will be popular with cable television companies that show pay-per-view movies? 7. The accompanying table shows the supply and demand schedules for used copies of the first edition of this textbook. The supply schedule is derived from offers at amazon.com. The demand schedule is hypothetical. b. Now the second edition of this textbook becomes available. As a result, the willingness to pay of each potential buyer for a second-hand copy of the first edition falls by $20. In a table, show the new demand schedule and again calculate consumer and producer surplus at the new equilibrium. 8. On Thursday nights, a local restaurant has a pasta special. Ari likes the restaurant’s pasta, and his willingness to pay for each serving is shown in the accompanying table. Quantity of pasta (servings) Willingness to pay for pasta (per serving) 1 2 3 4 5 6 $10 8 6 4 2 0 a. If the price of a serving of pasta is $4, how many servings will Ari buy? How much consumer surplus does he receive? b. The following week, Ari is back at the restaurant again, but now the price of a serving of pasta is $6. By how much does his consumer surplus decrease compared to the previous week? c. One week later, he goes to the restaurant again. He discovers that the restaurant is offering an “all-you-caneat” special for $25. How much pasta will Ari eat, and how much consumer surplus does he receive now? d. Suppose you own the restaurant and Ari is a “typical” customer. What is the highest price you can charge for the “all-you-can-eat” special and still attract customers? Price of book $60 65 70 75 80 85 90 95 100 105 110 Quantity of books demanded Quantity of books supplied 9. You are the manager of Fun World, a small amusement park. The accompanying diagram shows the demand curve of a typical customer at Fun World. 30 27 25 20 17 15 12 9 8 2 0 0 3 7 7 8 15 16 17 29 31 34 Price of ride $10 5 0 10 D 20 Quantity of rides (per day) a. Calculate consumer and producer surplus at the a. Suppose that the price of each ride is $5. At that price, equilibrium in this market. how much consumer surplus does an individual consumer get? (Recall that the area of a right triangle is 1⁄ 2 × the height of the triangle × the base of the triangle.) 116 P A R T 2 S U P P LY . Suppose that Fun World considers charging an admission fee, even though it maintains the price of each ride at $5. What is the maximum admission fee it could charge? (Assume that all potential customers have enough money to pay the fee.) c. Suppose that Fun World lowered the price of each ride to zero. How much consumer surplus does an individual consumer get? What is the maximum admission fee Fun World could charge? 10. The accompanying diagram illustrates a taxi driver’s individual supply curve (assume that each taxi ride is the same distance). Price of taxi ride S $8 4 0 40 80 Quantity of taxi rides a. Suppose the city sets the price of taxi rides at $4 per ride, and at $4 the taxi driver is able to sell as many taxi rides as he desires. What is this taxi driver’s producer surplus? (Recall that the area of a right triangle is 1⁄ 2 × the height of the triangle × the base of the triangle.) b. Suppose that the city keeps the price of a taxi ride set at $4, but it decides to charge taxi drivers a “licensing fee.” www.worthpublishers.com/krugmanwells What is the maximum licensing fee the city could extract from this taxi driver? c. Suppose that the city allowed the price of taxi rides to increase to $8 per ride. Again assume that, at this price, the taxi driver sells as many rides as he is willing to offer. How much producer surplus does an individual taxi driver now get? What is the maximum licensing fee the city could charge this taxi driver? 11. On November 18, 2006, the New York Times reported that “The Universal Music Group, the world’s largest music company, filed a copyright infringement lawsuit yesterday against MySpace, the popular social networking Web site, for allowing users to upload and download songs and music videos. . . . In court papers, Universal noted that unauthorized copies of music and video from one of its biggest acts, U2, were easily available on the site, as is material from an unreleased album by the rap star Jay-Z.” Allowing Internet users to download music and video for free limits Universal’s right to dispose of the music and video as it chooses; in particular, it limits Universal’s right to give access to its music only to those who have paid for it. In other words, it limits Universal’s property rights. a. If everyone were to obtain music and video content for free from websites such as MySpace, instead of paying Universal, what would Universal’s producer surplus be from music sales? What are the implications for Universal’s incentive to produce music and video content in the future? b. If Universal loses the lawsuit and music can be freely downloaded from the Internet, what do you think will happen to mutually beneficial transactions (the producing and buying of music) in the future? chapter: 5 >> The Market Strikes Back B I G C I T Y EW YORK CITY IS A PLACE WHERE YOU CAN find almost anything—that is, almost anything, except a taxicab when you need one or a decent apartment at a rent you can afford. You might think that predictable ways. Our ability to predict what will happen when governments try to defy supply and demand shows the power and usefulness of supply and demand analysis itself. New York’s notorious shortages of cabs and apartments The shortages of apartments and taxicabs in New York are the inevitable price of big-city living. However, they are particular examples that illuminate what happens are largely the product of government policies—specifi- when the logic of the market is defied. New York’s hous- cally, of government policies that have, one way or ing shortage is the result of rent control, a law that pre- another, tried to prevail over the market forces of supply and demand. In Chapter 3, we learned the principle that a market moves to equilibri- um—that the market price rises or falls to the level at which the quantity of a good that people are will- ing to supply is equal to the quantity that other people demand. In Chapter 4, we New York City: an empty taxi is hard to find. vents landlords from raising rents except when specifically given permis- sion. Rent control was introduced during World War II to protect the inter- ests of tenants, and it still remains in force. Many other American cities have had rent control at one time or another, but with the notable exceptions of New York and San learned that markets are typically efficient: at equilibrium Francisco, these controls have largely been done away a market typically maximizes the gains from trade—that with. Similarly, New York’s limited supply of taxis is the is, the sum of consumer and producer surplus. We also result of a licensing system introduced in the 1930s. New learned in Chapter 4 that government intervention in a York taxi licenses are known as “medallions,” and only market can sometimes be justified on the grounds of taxis with medallions are allowed to pick up passengers. equity or when the market itself is inefficient. But it’s Although this system was originally intended to protect important to note that governments also frequently inter- the interests of both drivers and customers, it has generat- vene in markets without these justifications, often to ed a shortage of taxis in the city. The number of medal- please powerful interests. lions remained fixed for nearly 60 years, with no Whenever a government tries to dictate either a mar- significant increase until 2004. ket price or a market quantity that’s different from the In this chapter, we begin by examining what happens equilibrium price or quantity, the market strikes back in when governments try to control prices in a competitive 117 118 P A R T 2 S U P P LY A N D D E M A N D market, keeping the price in a market either below its workers in many countries. We then turn to schemes equilibrium level—a price ceiling such as rent control—or such as taxi medallions that attempt to dictate the quan- above it—a price floor such as the minimum wage paid to tity of a good bought and sold. WHAT YOU WILL LEARN IN THIS CHAPTER: ➤ The meaning of price controls and quantity ➤ What deadweight loss is ➤ Who benefits and who loses from controls, two kinds of government intervention in markets ➤ How price and quantity controls create problems and can make a market inefficient ➤ Why the predictable side effects of intervention in markets often lead economists to be skeptical of its usefulness market interventions, and why they are used despite their well-known problems Why Governments Control Prices You learned in Chapter 3 that a market moves to equilibrium—that is, the market price moves to the level at which the quantity supplied equals the quantity demanded. But this equilibrium price does not necessarily please either buyers or sellers. After all, buyers would always like
to pay less if they could, and sometimes they can make a strong moral or political case that they should pay lower prices. For example, what if the equilibrium between supply and demand for apartments in a major city leads to rental rates that an average working person can’t afford? In that case, a government might well be under pressure to impose limits on the rents landlords can charge. Sellers, however, would always like to get more money for what they sell, and sometimes they can make a strong moral or political case that they should receive higher prices. For example, consider the labor market: the price for an hour of a worker’s time is the wage rate. What if the equilibrium between supply and demand for less skilled workers leads to wage rates that yield an income below the poverty level? In that case, a government might well be pressured to require employers to pay a rate no lower than some specified minimum wage. In other words, there is often a strong political demand for governments to intervene in markets. And powerful interests can make a compelling case that a market intervention favoring them is “fair.” When a government intervenes to regulate prices, we say that it imposes price controls. These controls typically take the form either of an upper limit, a price ceiling, or a lower limit, a price floor. Unfortunately, it’s not that easy to tell a market what to do. As we will now see, when a government tries to legislate prices—whether it legislates them down by imposing a price ceiling or up by imposing a price floor—there are certain predictable and unpleasant side effects. We make an important assumption in this chapter: the markets in question are efficient before price controls are imposed. As we noted in Chapter 4, markets can sometimes be inefficient—for example, a market dominated by a monopolist, a single seller who has the power to influence the market price. When markets are inefficient, price controls don’t necessarily cause problems and can potentially move the market closer to efficiency. In practice, however, price controls often are imposed on efficient markets—like the New York apartment market. And so the analysis in this chapter applies to many important real-world situations. Price Ceilings Aside from rent control, there are not many price ceilings in the United States today. But at times they have been widespread. Price ceilings are typically imposed during crises—wars, harvest failures, natural disasters—because these events often lead to sudden price increases that hurt many people but produce big gains for a lucky few. Price controls are legal restrictions on how high or low a market price may go. They can take two forms: a price ceiling, a maximum price sellers are allowed to charge for a good or service, or a price floor, a minimum price buyers are required to pay for a good or service 119 The U.S. government imposed ceilings on many prices during World War II: the war sharply increased demand for raw materials, such as aluminum and steel, and price controls prevented those with access to these raw materials from earning huge profits. Price controls on oil were imposed in 1973, when an embargo by Arab oilexporting countries seemed likely to generate huge profits for U.S. oil companies. Price controls were imposed on California’s wholesale electricity market in 2001, when a shortage created big profits for a few power-generating companies but led to higher electricity bills for consumers. Rent control in New York is, believe it or not, a legacy of World War II: it was imposed because wartime production produced an economic boom, which increased demand for apartments at a time when the labor and raw materials that might have been used to build them were being used to win the war instead. Although most price controls were removed soon after the war ended, New York’s rent limits were retained and gradually extended to buildings not previously covered, leading to some very strange situations. You can rent a one-bedroom apartment in Manhattan on fairly short notice—if you are able and willing to pay several thousand dollars a month and live in a lessthan-desirable area. Yet some people pay only a small fraction of this for comparable apartments, and others pay hardly more for bigger apartments in better locations. Aside from producing great deals for some renters, however, what are the broader consequences of New York’s rent-control system? To answer this question, we turn to the model we developed in Chapter 3: the supply and demand model. Modeling a Price Ceiling To see what can go wrong when a government imposes a price ceiling on an efficient market, consider Figure 5-1, which shows a simplified model of the market for apartments in New York. For the sake of simplicity, we imagine that all apartments are FIGURE 5-1 The Market for Apartments in the Absence of Government Controls Monthly rent (per apartment) $1,400 1,300 1,200 1,100 1,000 900 800 700 600 0 E Quantity of apartments (millions) Monthly rent (per apartment) Quantity demanded Quantity supplied $1,400 1,300 1,200 1,100 1,000 900 800 700 600 1.6 1.7 1.8 1.9 2.0 2.1 2.2 2.3 2.4 2.4 2.3 2.2 2.1 2.0 1.9 1.8 1.7 1.6 S D 1.6 1.7 1.8 1.9 2.0 2.3 2.4 Quantity of apartments (millions) 2.2 2.1 Without government intervention, the market for apartments reaches equilibrium at point E with a market rent of $1,000 per month and 2 million apartments rented. 120 P A R T 2 S U P P LY A N D D E M A N D FIGURE 5-2 The Effects of a Price Ceiling The black horizontal line represents the government-imposed price ceiling on rents of $800 per month. This price ceiling reduces the quantity of apartments supplied to 1.8 million, point A, and increases the quantity demanded to 2.2 million, point B. This creates a persistent shortage of 400,000 units: 400,000 people who want apartments at the legal rent of $800 but cannot get them. Monthly rent (per apartment) $1,400 1,200 1,000 800 600 S E A Price ceiling B Housing shortage of 400,000 apartments caused by price ceiling D 0 1.6 1.8 2.0 2.2 2.4 Quantity of apartments (millions) exactly the same and so would rent for the same price in an unregulated market. The table in the figure shows the demand and supply schedules; the demand and supply curves are shown on the left. We show the quantity of apartments on the horizontal axis and the monthly rent per apartment on the vertical axis. You can see that in an unregulated market the equilibrium would be at point E: 2 million apartments would be rented for $1,000 each per month. Now suppose that the government imposes a price ceiling, limiting rents to a price below the equilibrium price—say, no more than $800. Figure 5-2 shows the effect of the price ceiling, represented by the line at $800. At the enforced rental rate of $800, landlords have less incentive to offer apartments, so they won’t be willing to supply as many as they would at the equilibrium rate of $1,000. They will choose point A on the supply curve, offering only 1.8 million apartments for rent, 200,000 fewer than in the unregulated market. At the same time, more people will want to rent apartments at a price of $800 than at the equilibrium price of $1,000; as shown at point B on the demand curve, at a monthly rent of $800 the quantity of apartments demanded rises to 2.2 million, 200,000 more than in the unregulated market and 400,000 more than are actually available at the price of $800. So there is now a persistent shortage of rental housing: at that price, 400,000 more people want to rent than are able to find apartments. Do price ceilings always cause shortages? No. If a price ceiling is set above the equilibrium price, it won’t have any effect. Suppose that the equilibrium rental rate on apartments is $1,000 per month and the city government sets a ceiling of $1,200. Who cares? In this case, the price ceiling won’t be binding—it won’t actually constrain market behavior—and it will have no effect. How a Price Ceiling Causes Inefficiency The housing shortage shown in Figure 5-2 is not merely annoying: like any shortage induced by price controls, it can be seriously harmful because it leads to inefficiency. In other words, there are gains from trade that go unrealized. Rent control, like all price ceilings, creates inefficiency in at least four distinct ways. It reduces the quantity of 121 apartments rented below the efficient level; it typically leads to misallocation of apartments among would-be renters; it leads to wasted time and effort as people search for apartments; and it leads landlords to maintain apartments in inefficiently low quality or condition. In addition to inefficiency, price ceilings give rise to illegal behavior as people try to circumvent them. Deadweight loss is the loss in total surplus that occurs whenever an action or a policy reduces the quantity transacted below the efficient market equilibrium quantity. Inefficiently Low Quantity In Chapter 4 we learned that the market equilibrium of an efficient market leads to the “right” quantity of a good or service being bought and sold—that is, the quantity that maximizes the sum of producer and consumer surplus. Because rent controls reduce the number of apartments supplied, they reduce the number of apartments rented, too. Figure 5-3 shows the implications for total surplus. Recall that total surplus is the sum of the area above the supply curve and below the demand curve. If the only effect of rent control was to reduce the number of apartments available, it would cause a loss of surplus equal to the area of the shaded triangle in the figure. The area represented by that triangle has a special name in economics, deadweight loss: the lost surplus associated with the transactions that no longer occur due to the market intervention. In this example, the deadweight loss is the lost surplus associated with the apartment rentals that no longer occur due to the price ceiling, a loss that is experienced by both disapp
ointed renters and frustrated landlords. Economists often call triangles like the one in Figure 5-3 a deadweight-loss triangle. Deadweight loss is a key concept in economics, one that we will encounter whenever an action or a policy leads to a reduction in the quantity transacted below the efficient market equilibrium quantity. It is important to realize that deadweight loss is a loss to society—it is a reduction in total surplus, a loss in surplus that accrues to no one as a gain. It is not the same as a loss in surplus to one person that then accrues as a gain to someone else, what an economist would call a transfer of surplus from one person to another. For an example of how a price ceiling leads to a transfer of surplus between renters and landlords and the deadweight loss that arises, see For Inquiring Minds on the next page. FIGURE 5-3 A Price Ceiling Causes Inefficiently Low Quantity A price ceiling reduces the quantity supplied below the market equilibrium quantity, leading to a deadweight loss. The area of the shaded triangle corresponds to the amount of total surplus lost due to inefficiently low quantity transacted. Monthly rent (per apartment) $1,400 1,200 1,000 800 600 Deadweight loss from fall in number of apartments rented S E Price ceiling D 2.4 Quantity of apartments (millions) 0 1.6 1.8 2.0 2.2 Quantity supplied with rent control Quantity supplied without rent control 122 P A R T 2 S U P P LY Winners, Losers, and Rent Control Price controls create winners and losers: some people benefit from the policy but others are made worse off. In New York City, some of the biggest beneficiaries of rent control are affluent tenants who have lived for decades in choice apartments that would now command very high rents. These winners include celebrities like the pop singer Cyndi Lauper, who in 2005 was paying only $989 a month for an apartment that would have been worth $3,750 if unregulated. There is also the classic case of the actress Mia Farrow’s apartment, which, when it lost its rent-control status, rose from the bargain rate of $2,900 per month to $8,000. Ironically, in cases like these, the losers are the working-class renters the system was intended to help. We can use the concepts of consumer and producer surplus, which you learned about in Chapter 4, to evaluate graphically the winners and the losers from rent control. Panel (a) of Figure 5-4 shows the con- sumer surplus and producer surplus in the equilibrium of the unregulated market for apartments—before rent control. Recall that the consumer surplus, represented by the area below the demand curve and above the price, is the total net gain to consumers in the market equilibrium. Likewise, producer surplus, represented by the area above the supply curve and below the price, is the total net gain to producers in the market equilibrium. Panel (b) of this figure shows the consumer and producer surplus in the market after the price ceiling of $800 has been imposed. As you can see, for those consumers who can still obtain apartments under rent control, consumer surplus has increased. These renters are clearly winners: those who obtain an apartment at $800, paying $200 less than the unregulated market price. These people receive a direct transfer of surplus from landlords in the form of lower rent. But not all renters win: there are fewer apartments to rent now than if the market had remained unregulated, making it hard, if not impossible, for some to find a place to call home. Without direct calculation of the surpluses gained and lost, it is generally unclear whether renters as a whole are made better or worse off by rent control. What we can say is that the greater the deadweight loss—the larger the reduction in the quantity of apartments rented—the more likely it is that renters as a whole lose. However, we can say unambiguously that landlords are worse off: producer surplus has clearly decreased. Landlords who continue to rent out their apartments get $200 a month less in rent, and others withdraw their apartments from the market altogether. The deadweight-loss triangle, shaded yellow in panel (b), represents the value lost to both renters and landlords from rentals that essentially vanish thanks to rent control. FIGURE 5-4 Winners and Losers from Rent Control (a) Before Rent Control (b) After Rent Control Monthly rent (per apartment) $1,400 1,200 1,000 800 600 0 1.6 Consumer surplus E Producer surplus S D 1.8 2.0 2.2 Quantity of apartments (millions) 2.4 Monthly rent (per apartment) Consumer surplus $1,400 1,200 1,000 800 600 0 1.6 Consumer surplus transferred from producers E S Price ceiling Producer surplus Deadweight loss D 1.8 2.0 2.2 Quantity of apartments (millions) 2.4 Panel (a) shows the consumer surplus and producer surplus in the equilibrium of the unregulated market for apartments—before rent control. Panel (b) shows the consumer and producer surplus in the market after a price ceiling of $800 has been imposed. As you can see, for those consumers who can still obtain apartments under rent control, consumer surplus has increased but producer surplus and total surplus have decreased 123 Price ceilings often lead to inefficiency in the form of inefficient allocation to consumers: people who want the good badly and are willing to pay a high price don’t get it, and those who care relatively little about the good and are only willing to pay a low price do get it. Price ceilings typically lead to inefficiency in the form of wasted resources: people expend money, effort, and time to cope with the shortages caused by the price ceiling. Deadweight loss is not the only type of inefficiency that arises from a price ceiling. The types of inefficiency created by rent control go beyond reducing the quantity of apartments available. These additional inefficiencies—inefficient allocation to consumers, wasted resources, and inefficiently low quality—lead to a loss of surplus over and above the deadweight loss. Inefficient Allocation to Consumers Rent control doesn’t just lead to too few apartments being available. It can also lead to misallocation of the apartments that are available: people who badly need a place to live may not be able to find an apartment, while some apartments may be occupied by people with much less urgent needs. In the case shown in Figure 5-2, 2.2 million people would like to rent an apartment at $800 per month, but only 1.8 million apartments are available. Of those 2.2 million who are seeking an apartment, some want an apartment badly and are willing to pay a high price to get one. Others have a less urgent need and are only willing to pay a low price, perhaps because they have alternative housing. An efficient allocation of apartments would reflect these differences: people who really want an apartment will get one and people who aren’t all that anxious to find an apartment won’t. In an inefficient distribution of apartments, the opposite will happen: some people who are not especially anxious to find an apartment will get one and others who are very anxious to find an apartment won’t. Because people usually get apartments through luck or personal connections under rent control, it generally results in an inefficient allocation to consumers of the few apartments available. To see the inefficiency involved, consider the plight of the Lees, a family with young children who have no alternative housing and would be willing to pay up to $1,500 for an apartment—but are unable to find one. Also consider George, a retiree who lives most of the year in Florida but still has a lease on the New York apartment he moved into 40 years ago. George pays $800 per month for this apartment, but if the rent were even slightly more—say, $850—he would give it up and stay with his children when he is in New York. This allocation of apartments—George has one and the Lees do not—is a missed opportunity: there is a way to make the Lees and George both better off at no additional cost. The Lees would be happy to pay George, say, $1,200 a month to sublease his apartment, which he would happily accept since the apartment is worth no more than $849 a month to him. George would prefer the money he gets from the Lees to keeping his apartment; the Lees would prefer to have the apartment rather than the money. So both would be made better off by this transaction—and nobody else would be made worse off. Generally, if people who really want apartments could sublease them from people who are less eager to live there, both those who gain apartments and those who trade their occupancy for money would be better off. However, subletting is illegal under rent control because it would occur at prices above the price ceiling. The fact that subletting is illegal doesn’t mean it never happens. In fact, chasing down illegal subletting is a major business for New York private investigators. A 2007 report in the New York Times described how private investigators use hidden cameras and other tricks to prove that the legal tenants in rent-controlled apartments actually live in the suburbs, or even in other states, and have sublet their apartments at two or three times the controlled rent. This subletting is a kind of illegal activity, which we will discuss shortly. For now, just notice that landlords’ pursuit of illegal subletting surely discourages the practice, so there isn’t enough subletting to eliminate the inefficient allocation of apartments. Wasted Resources Another reason a price ceiling causes inefficiency is that it leads to wasted resources: people expend money, effort, and time to cope with the shortages caused by the price ceiling. Back in 1979, U.S. price controls on gasoline led to shortages that forced millions of Americans to spend hours each week waiting in lines 124 P A R T 2 S U P P LY A N D D E M A N D Price ceilings often lead to inefficiency in that the goods being offered are of inefficiently low quality: sellers offer low-quality goods at a low pr
ice even though buyers would prefer a higher quality at a higher price. at gas stations. The opportunity cost of the time spent in gas lines—the wages not earned, the leisure time not enjoyed—constituted wasted resources from the point of view of consumers and of the economy as a whole. Because of rent control, the Lees will spend all their spare time for several months searching for an apartment, time they would rather have spent working or in family activities. That is, there is an opportunity cost to the Lees’ prolonged search for an apartment—the leisure or income they had to forgo. If the market for apartments worked freely, the Lees would quickly find an apartment at the equilibrium rent of $1,000, leaving them time to earn more or to enjoy themselves—an outcome that would make them better off without making anyone else worse off. Again, rent control creates missed opportunities. Inefficiently Low Quality Yet another way a price ceiling causes inefficiency is by causing goods to be of inefficiently low quality. Inefficiently low quality means that sellers offer low-quality goods at a low price even though buyers would rather have higher quality and are willing to pay a higher price for it. Again, consider rent control. Landlords have no incentive to provide better conditions because they cannot raise rents to cover their repair costs but are able to find tenants easily. In many cases, tenants would be willing to pay much more for improved conditions than it would cost for the landlord to provide them—for example, the upgrade of an antiquated electrical system that cannot safely run air conditioners or computers. But L D VIE Rent Control, Mumbai Style How far would you go to keep a rentcontrolled apartment? Some tenants in the city of Mumbai, India, went very far indeed. According to a Wall Street Journal article, in May 2006 three people were killed when four floors in a rent-controlled apartment building in Mumbai collapsed. Despite demands by the city government to vacate the deteriorated building, 58 other tenants refused to leave. They stayed put even after having their electricity and water shut off, being locked out of their apartments, and surviving a police raid on the building. Tenants camped out on the building’s veranda, vowing not to give up. Not all of these tenants were desperately poor and lacking other options. One rentcontrolled tenant is the owner of a thriving textile business who was paying a total of $8.50 a month for a spacious two-bedroom apartment. (Luxury apartments in Mumbai can go for thousands of dollars a month.) Although it’s a world away, the dynamics of rent control in Mumbai are a lot like those in New York (although Mumbai has clearly had a much more extreme experience). Rent control began in Mumbai in 1947, to address a critical shortage of W E I V D L VIEWWOR In Mumbai, rent control has led to a steep deterioration in housing quality. housing caused by a flood of refugees fleeing conflict between Hindus and Muslims. Clearly intended to be a temporary measure, it was so popular politically that it has been extended 20 times and now applies to about 60% of the buildings in the city’s center. Tenants pass apartments on to their heirs or sell the right to occupy to other tenants. Despite the fact that land prices in Mumbai surged more than 30% in 2005, landlords of rent-controlled buildings have suffered financially, with the result that across the city prime buildings have been abandoned to decay, even though half of the city’s 12 million residents live in slums because of a lack of new housing 125 A black market is a market in which goods or services are bought and sold illegally—either because it is illegal to sell them at all or because the prices charged are legally prohibited by a price ceiling. any additional payment for such improvements would be legally considered a rent increase, which is prohibited. Indeed, rent-controlled apartments are notoriously badly maintained, rarely painted, subject to frequent electrical and plumbing problems, sometimes even hazardous to inhabit. As one former manager of Manhattan buildings described: “At unregulated apartments we’d do most things that the tenants requested. But on the rent-regulated units, we did absolutely only what the law required. . . . We had a perverse incentive to make those tenants unhappy. With regulated apartments, the ultimate objective is to get people out of the building.” This whole situation is a missed opportunity—some tenants would be happy to pay for better conditions, and landlords would be happy to provide them for payment. But such an exchange would occur only if the market were allowed to operate freely. Black Markets And that leads us to a last aspect of price ceilings: the incentive they provide for illegal activities, specifically the emergence of black markets. We have already described one kind of black market activity—illegal subletting by tenants. But it does not stop there. Clearly, there is a temptation for a landlord to say to a potential tenant, “Look, you can have the place if you slip me an extra few hundred in cash each month”—and for the tenant to agree, if he or she is one of those people who would be willing to pay much more than the maximum legal rent. What’s wrong with black markets? In general, it’s a bad thing if people break any law, because it encourages disrespect for the law in general. Worse yet, in this case illegal activity worsens the position of those who try to be honest. If the Lees are scrupulous about upholding the rent-control law but other people—who may need an apartment less than the Lees—are willing to bribe landlords, the Lees may never find an apartment. So Why Are There Price Ceilings? We have seen three common results of price ceilings: ■ A persistent shortage of the good ■ Inefficiency arising from this persistent shortage in the form of inefficiently low quantity (deadweight loss), inefficient allocation of the good to consumers, resources wasted in searching for the good, and the inefficiently low quality of the good offered for sale ■ The emergence of illegal, black market activity Given these unpleasant consequences, why do governments still sometimes impose price ceilings? Why does rent control, in particular, persist in New York? One answer is that although price ceilings may have adverse effects, they do benefit some people. In practice, New York’s rent-control rules—which are more complex than our simple model—hurt most residents but give a small minority of renters much cheaper housing than they would get in an unregulated market. And those who benefit from the controls are typically better organized and more vocal than those who are harmed by them. Also, when price ceilings have been in effect for a long time, buyers may not have a realistic idea of what would happen without them. In our previous example, the rental rate in an unregulated market (Figure 5-1) would be only 25% higher than in the regulated market (Figure 5-2): $1,000 instead of $800. But how would renters know that? Indeed, they might have heard about black market transactions at much higher prices—the Lees or some other family paying George $1,200 or more—and would not realize that these black market prices are much higher than the price that would prevail in a fully unregulated market. A last answer is that government officials often do not understand supply and demand analysis! It is a great mistake to suppose that economic policies in the real world are always sensible or well informed. 126 P A R T 2 S U P P LY VIE W R W O ➤ECONOMICS IN ACTION Hard Shopping in Caracas Supermarket shopping in Caracas, Venezuela, reported the New York Times in February 2007, “is a bizarre experience. Shelves are fully stocked with Scotch whiskey, Argentine wines and imported cheeses like brie and Camembert, but basic staples like black beans and desirable cuts of beef like sirloin are often absent.” Why? Because of price controls. VIEWWOR Since 1998, Venezuela has been governed by Hugo Chavez, a populist president who has routinely denounced the nation’s economic elite and pursued policies favoring the poor and working classes. Among those policies were price controls on basic foods such as beans, sugar, beef, and chicken, intended to hold down the cost of living. These policies led to sporadic shortages beginning in 2003, but the shortages became much more severe in 2006. On one side, generous government policies led to higher spending by consumers and sharply rising prices for goods that weren’t subject to price controls. The result was a big increase in demand for price-controlled goods. On the other side, a sharp decline in the value of Venezuela’s currency led to a fall in imports of foreign food. The result was empty shelves in the nation’s food stores. The Venezuelan government responded by accusing food producers, wholesalers, and grocers of profiteering, threatening to seize control of supermarkets if they didn’t make more food available. Yet even Mercal, a government-owned grocery chain, had empty shelves. The government also instituted rationing, restricting shoppers’ purchases of sugar to two large bags. Predictably, reported the Times, “a black market in sugar has developed among street vendors.” All in all, food shortages in Venezuela offer a textbook example both of why governments sometimes think price ceilings would be a good idea and of why they’re usually wrong. ▲ < < < < < < < < < < < < ➤ CHECK YOUR UNDERSTANDING 5-1 1. On game days, homeowners near Middletown University’s stadium used to rent parking spaces in their driveways to fans at a going rate of $11. A new town ordinance now sets a maximum parking S E fee of $7. Use the accompanying supply and demand diagram to explain how each of the following corresponds to a price-ceiling concept. a. Some homeowners now think it’s not worth the hassle to rent out spaces. b. Some fans who used to carpool to the game now drive alon
e. c. Some fans can’t find parking and leave without seeing the game. Explain how each of the following adverse effects arises from the price ceiling. D d. Some fans now arrive several hours early to find parking. e. Friends of homeowners near the stadium regularly attend ➤➤ ➤ Price controls take the form of either legal maximum prices—price ceilings—or legal minimum prices—price floors. ➤ A price ceiling below the equilibri- um price benefits successful buyers but causes predictable adverse effects such as persistent shortages, which lead to four types of inefficiencies: deadweight loss, inefficient allocation to consumers, wasted resources, and inefficiently low quality. ➤ A deadweight loss is a loss of total surplus that occurs whenever a policy or action reduces the quantity transacted below the efficient market equilibrium level. ➤ Price ceilings also lead to black markets, as buyers and sellers attempt to evade the price controls. Parking fee $15 11 7 3 0 3,200 3,600 4,000 4,400 4,800 games, even if they aren’t big fans. But some serious fans have given up because of the parking situation. Quantity of parking spaces f. Some homeowners rent spaces for more than $7 but pretend that the buyers are nonpaying friends or family. 2. True or false? Explain your answer. A price ceiling below the equilibrium price of an otherwise efficient market does the following: a. Increases quantity supplied b. Makes some people who want to consume the good worse off c. Makes all producers worse off 3. Which of the following create deadweight loss? Which do not and are simply a transfer of sur- plus from one person to another? Explain your answer 127 The minimum wage is a legal floor on the wage rate, which is the market price of labor. a. You have been evicted from your rent-controlled apartment after the landlord discovered your pet boa constrictor. The apartment is quickly rented to someone else at the same price. You and the new renter do not necessarily have the same willingness to pay for the apartment. b. In a contest, you won a ticket to a jazz concert. But you can’t go to the concert because of an exam, and the terms of the contest do not allow you to sell the ticket or give it to someone else. Would your answer to this question change if you could not sell the ticket but could give it to someone else? c. Your school’s dean of students, who is a proponent of a low-fat diet, decrees that ice cream can no longer be served on campus. d. Your ice cream cone falls on the ground and your dog eats it. (Take the liberty of counting your dog as a member of society, and that, if he could, your dog would be willing to pay the same amount for the ice cream cone as you.) Solutions appear at back of book. Price Floors Sometimes governments intervene to push market prices up instead of down. Price floors have been widely legislated for agricultural products, such as wheat and milk, as a way to support the incomes of farmers. Historically, there were also price floors on such services as trucking and air travel, although these were phased out by the U.S. government in the 1970s. If you have ever worked in a fast-food restaurant, you are likely to have encountered a price floor: governments in the United States and many other countries maintain a lower limit on the hourly wage rate of a worker’s labor— that is, a floor on the price of labor—called the minimum wage. Just like price ceilings, price floors are intended to help some people but generate predictable and undesirable side effects. Figure 5-5 shows hypothetical supply and demand curves for butter. Left to itself, the market would move to equilibrium at FIGURE 5-5 The Market for Butter in the Absence of Government Controls Price of butter (per pound) $1.40 1.30 1.20 1.10 1.00 0.90 0.80 0.70 0.60 S Price of butter (per pound) Quantity demanded Quantity supplied Quantity of butter (millions of pounds) $1.40 $1.30 $1.20 $1.10 $1.00 $0.90 $0.80 $0.70 $0.60 8.0 8.5 9.0 9.5 10.0 10.5 11.0 11.5 12.0 14.0 13.0 12.0 11.0 10.0 9.0 8.0 7.0 6.0 E D 0 6 7 8 9 10 11 12 13 14 Quantity of butter (millions of pounds) Without government intervention, the market for butter reaches equilibrium at a price of $1 per pound with 10 million pounds of butter bought and sold. 128 P A R T 2 S U P P LY A N D D E M A N D FIGURE 5-6 The Effects of a Price Floor The dark horizontal line represents the government-imposed price floor of $1.20 per pound of butter. The quantity of butter demanded falls to 9 million pounds, and the quantity supplied rises to 12 million pounds, generating a persistent surplus of 3 million pounds of butter. Price of butter (per pound) $1.40 1.20 1.00 0.80 0.60 Butter surplus of 3 million pounds caused by price floor S A E Price floor B D 0 6 8 9 10 12 14 Quantity of butter (millions of pounds) point E, with 10 million pounds of butter bought and sold at a price of $1 per pound. Now suppose that the government, in order to help dairy farmers, imposes a price floor on butter of $1.20 per pound. Its effects are shown in Figure 5-6, where the line at $1.20 represents the price floor. At a price of $1.20 per pound, producers would want to supply 12 million pounds (point B on the supply curve) but consumers would want to buy only 9 million pounds (point A on the demand curve). So the price floor leads to a persistent surplus of 3 million pounds of butter. Does a price floor always lead to an unwanted surplus? No. Just as in the case of a price ceiling, the floor may not be binding—that is, it may be irrelevant. If the equilibrium price of butter is $1 per pound but the floor is set at only $0.80, the floor has no effect. But suppose that a price floor is binding: what happens to the unwanted surplus? The answer depends on government policy. In the case of agricultural price floors, governments buy up unwanted surplus. As a result, the U.S. government has at times found itself warehousing thousands of tons of butter, cheese, and other farm products. (The European Commission, which administers price floors for a number of European countries, once found itself the owner of a so-called butter mountain, equal in weight to the entire population of Austria.) The government then has to find a way to dispose of these unwanted goods. Some countries pay exporters to sell products at a loss overseas; this is standard procedure for the European Union. The United States gives surplus food away to schools, which use the products in school lunches (see For Inquiring Minds on the next page). In some cases, governments have actually destroyed the surplus production. To avoid the problem of dealing with the unwanted surplus, the U.S. government typically pays farmers not to produce the products at all. When the government is not prepared to purchase the unwanted surplus, a price floor means that would-be sellers cannot find buyers. This is what happens when there is a price floor on the wage rate paid for an hour of labor, the minimum wage: when the minimum wage is above the equilibrium wage rate, some people who are willing to work— that is, sell labor—cannot find buyers—that is, employers—willing to give them jobs 129 Price Floors and School Lunches When you were in grade school, did your school offer free or very cheap lunches? If so, you were probably a beneficiary of price floors. Where did all the cheap food come from? During the 1930s, when the U.S. economy was going through the Great Depression, a prolonged economic slump, prices were low and farmers were suffering severely. In an effort to help rural Americans, the U.S. government imposed price floors on a number of agricultural products. The system of agricultural price floors—officially called price support programs—continues to this day. Among the products subject to price support are sugar and various dairy products; at times grains, beef, and pork have also had a minimum price. The big problem with any attempt to impose a price floor is that it creates a surplus. To some extent the U.S. Department of Agriculture has tried to head off surpluses by taking steps to reduce supply; for example, by paying farmers not to grow crops. As a last resort, however, the U.S. government has been willing to buy up the surplus, taking the excess supply off the market. But then what? The government has to find a way to get rid of the agricultural products it has bought. It can’t just sell them: that would depress market prices, forcing the government to buy the stuff right back. So it has to give it away in ways that don’t depress market prices. One of the ways it does this is by giving surplus food, free, to school lunch programs. These gifts are known as “bonus foods.” Along with financial aid, bonus foods are what allow many school districts to provide free or very cheap lunches to their students. Is this a story with a happy ending? Not really. Nutritionists, concerned about growing child obesity in the United States, place part of the blame on those bonus foods. Schools get whatever the government has too much of—and that has tended to include a lot of dairy products, beef, and corn, and not much in the way of fresh vegetables or fruit. As a result, school lunches that make extensive use of bonus foods tend to be very high in fat and calories. So this is a case in which there is such a thing as a free lunch—but this lunch may be bad for your health. How a Price Floor Causes Inefficiency The persistent surplus that results from a price floor creates missed opportunities— inefficiencies—that resemble those created by the shortage that results from a price ceiling. These include deadweight loss from inefficiently low quantity, inefficient allocation of sales among sellers, wasted resources, inefficiently high quality, and the temptation to break the law by selling below the legal price. Inefficiently Low Quantity Because a price floor raises the price of a good to consumers, it reduces the quantity of that good demanded; because sellers can’t sell more unit
s of a good than buyers are willing to buy, a price floor reduces the quantity of a good bought and sold below the market equilibrium quantity and leads to a deadweight loss. Notice that this is the same effect as a price ceiling. You might be tempted to think that a price floor and a price ceiling have opposite effects, but both have the effect of reducing the quantity of a good bought and sold (see Pitfalls to the right). Since the equilibrium of an efficient market maximizes the sum of consumer and producer surplus, a price floor that reduces the quantity below the equilibrium quantity reduces total surplus. Figure 5-7 on the next page shows the implications for total surplus of a price floor on the price of butter. Total surplus is the sum of the area above the supply curve and below the demand curve. By reducing the quantity of butter sold, a price floor causes a deadweight loss equal to the area of the shaded triangle in the figure. As in the case of a price ceiling, however, deadweight loss is only one of the forms of inefficiency that the price control creates. P I T F A L L S ceilings, floors, and quantities A price ceiling pushes the price of a good down. A price floor pushes the price of a good up. So it’s easy to assume that the effects of a price floor are the opposite of the effects of a price ceiling. In particular, if a price ceiling reduces the quantity of a good bought and sold, doesn’t a price floor increase the quantity? No, it doesn’t. In fact, both floors and ceilings reduce the quantity bought and sold. Why? When the quantity of a good supplied isn’t equal to the quantity demanded, the actual quantity sold is determined by the “short side” of the market—whichever quantity is less. If sellers don’t want to sell as much as buyers want to buy, it’s the sellers who determine the actual quantity sold, because buyers can’t force unwilling sellers to sell. If buyers don’t want to buy as much as sellers want to sell, it’s the buyers who determine the actual quantity sold, because sellers can’t force unwilling buyers to buy. 130 FIGURE 5-7 A Price Floor Causes Inefficiently Low Quantity A price floor reduces the quantity demanded below the market equilibrium quantity and leads to a deadweight loss. Price of butter (per pound) $1.40 1.20 1.00 0.80 0.60 Deadweight loss E S Price floor D 0 6 8 9 10 12 14 Quantity demanded with price floor Quantity demanded without price floor Quantity of butter (millions of pounds) Inefficient Allocation of Sales Among Sellers Like a price ceiling, a price floor can lead to inefficient allocation—but in this case inefficient allocation of sales among sellers rather than inefficient allocation to consumers. An episode from the Belgian movie Rosetta, a realistic fictional story, illustrates the problem of inefficient allocation of selling opportunities quite well. Like many European countries, Belgium has a high minimum wage, and jobs for young people are scarce. At one point Rosetta, a young woman who is very anxious to work, loses her job at a fast-food stand because the owner of the stand replaces her with his son— a very reluctant worker. Rosetta would be willing to work for less money, and with the money he would save, the owner could give his son an allowance and let him do something else. But to hire Rosetta for less than the minimum wage would be illegal. Wasted Resources Also like a price ceiling, a price floor generates inefficiency by wasting resources. The most graphic examples involve government purchases of the unwanted surpluses of agricultural products caused by price floors. The surplus production is sometimes destroyed, which is pure waste; in other cases the stored produce goes, as officials euphemistically put it, “out of condition” and must be thrown away. Price floors also lead to wasted time and effort. Consider the minimum wage. Would-be workers who spend many hours searching for jobs, or waiting in line in the hope of getting jobs, play the same role in the case of price floors as hapless families searching for apartments in the case of price ceilings. Inefficiently High Quality Again like price ceilings, price floors lead to inefficiency in the quality of goods produced. We saw that when there is a price ceiling, suppliers produce products that are of inefficiently low quality: buyers prefer higher-quality products and are willing to pay for them, but sellers refuse to improve the quality of their products because the price ceiling prevents their being compensated for doing so. This same logic applies to price floors, but in reverse: suppliers offer goods of inefficiently high quality. How can this be? Isn’t high quality a good thing? Yes, but only if it is worth the cost. Suppose that suppliers spend a lot to make goods of very high quality but that this quality isn’t worth much to consumers, who would rather receive the money spent on that quality in the form of a lower price. This represents a missed opportunity: suppliers and buyers could make a mutually beneficial deal in which buyers got goods of lower quality for a much lower price. Price floors lead to inefficient allocation of sales among sellers: those who would be willing to sell the good at the lowest price are not always those who actually manage to sell it. Price floors often lead to inefficiency in that goods of inefficiently high quality are offered: sellers offer high-quality goods at a high price, even though buyers would prefer a lower quality at a lower price 131 A good example of the inefficiency of excessive quality comes from the days when transatlantic airfares were set artificially high by international treaty. Forbidden to compete for customers by offering lower ticket prices, airlines instead offered expensive services, like lavish in-flight meals that went largely uneaten. At one point the regulators tried to restrict this practice by defining maximum service standards—for example, that snack service should consist of no more than a sandwich. One airline then introduced what it called a “Scandinavian Sandwich,” a towering affair that forced the convening of another conference to define sandwich. All of this was wasteful, especially considering that what passengers really wanted was less food and lower airfares. Since the deregulation of U.S. airlines in the 1970s, American passengers have experienced a large decrease in ticket prices accompanied by a decrease in the quality of in-flight service—smaller seats, lower-quality food, and so on. Everyone complains about the service—but thanks to lower fares, the number of people flying on U.S. carriers has grown several hundred percent since airline deregulation. Illegal Activity Finally, like price ceilings, price floors provide incentives for illegal activity. For example, in countries where the minimum wage is far above the equilibrium wage rate, workers desperate for jobs sometimes agree to work off the books for employers who conceal their employment from the government—or bribe the government inspectors. This practice, known in Europe as “black labor,” is especially common in Southern European countries such as Italy and Spain (see Economics in Action on the next page). So Why Are There Price Floors? To sum up, a price floor creates various negative side effects: ■ A persistent surplus of the good ■ Inefficiency arising from the persistent surplus in the form of inefficiently low quantity (deadweight loss), inefficient allocation of sales among sellers, wasted resources, and an inefficiently high level of quality offered by suppliers ■ The temptation to engage in illegal activity, particularly bribery and corruption of government officials CHECK OUT OUR LOW, LOW WAGES! The minimum wage rate in the United States, as you can see in this graph, is actually quite low compared with other rich countries. Since minimum wages are set in national currency—the British minimum wage is set in British pounds, the French minimum wage is set in euros, and so on—the comparison depends on the exchange rate on any given day. As of November 1, 2007, Australia had a minimum wage about twice as high as the U.S. rate, with Ireland and France not far behind. You can see one effect of this difference in the supermarket checkout line. In the United States there is usually someone to bag your groceries—someone typically paid the minimum wage or at best slightly more. In Europe, where hiring a bagger is a lot more expensive, you’re almost always expected to do the bagging yourself. Australia Ireland France Britain Canada* United States A$13.74 = US$12.62 €8.65 = US$12.49 €8.44 = US$12.18 £5.52 = US$11.49 C$8.50* = US$8.95 $5.85 0 2 4 6 8 10 12 $14 Minimum wage (per hour) Source: Department of Enterprise, Trade and Employment (Ireland); Ministere du Travail, des Relations Sociales et de la Solidarite (France); Australian Fair Pay Commission (Australia); Department for Business, Enterprise and Regulatory Reform (Britain); Human Resources and Social Development Canada (Canada); Department of Labor (U.S.); Federal Reserve Bank of St. Louis (exchange rates as of 11/1/2007). *The Canadian minimum wage varies by province from C$7.25 to C$8.50. 132 P A R T 2 S U P P LY A N D D E M A N D So why do governments impose price floors when they have so many negative side effects? The reasons are similar to those for imposing price ceilings. Government officials often disregard warnings about the consequences of price floors either because they believe that the relevant market is poorly described by the supply and demand model or, more often, because they do not understand the model. Above all, just as price ceilings are often imposed because they benefit some influential buyers of a good, price floors are often imposed because they benefit some influential sellers. L D VIE W R W O ➤ECONOMICS IN ACTION “Black Labor” in Southern Europe The best-known example of a price floor is the minimum wage. Most economists believe, however, that the minimum wage has re
latively little effect on the job market in the United States, mainly because the floor is set so low. In 1968, the U.S. minimum wage was 53% of the average wage of blue-collar workers; by 2005, it had fallen to about 32%. VIEWWOR The situation is different, however, in many European countries, where minimum wages have been set much higher than in the United States. This has happened despite the fact that workers in most European countries are somewhat less productive than their American counterparts, which means that the equilibrium wage in Europe—the wage that would clear the labor market—is probably lower in Europe than in the United States. Moreover, European countries often require employers to pay for health and retirement benefits, which are more extensive and so more costly than comparable American benefits. These mandated benefits make the actual cost of employing a European worker considerably more than the worker’s paycheck. The result is that in Europe the price floor on labor is definitely binding: the minimum wage is well above the wage rate that would make the quantity of labor supplied by workers equal to the quantity of labor demanded by employers. The persistent surplus that results from this price floor appears in the form of high unemployment—millions of workers, especially young workers, seek jobs but cannot find them. In countries where the enforcement of labor laws is lax, however, there is a second, entirely predictable result: widespread evasion of the law. In both Italy and Spain, officials believe there are hundreds of thousands, if not millions, of workers who are employed by companies that pay them less than the legal minimum, fail to provide the required health and retirement benefits, or both. In many cases the jobs are simply unreported: Spanish economists estimate that about a third of the country’s reported unemployed are in the black labor market—working at unreported jobs. In fact, Spaniards waiting to collect checks from the unemployment office have been known to complain about the long lines that keep them from getting back to work! Employers in these countries have also found legal ways to evade the wage floor. For example, Italy’s labor regulations apply only to companies with 15 or more workers. This gives a big cost advantage to small Italian firms, many of which remain small in order to avoid paying higher wages and benefits. And sure enough, in some Italian industries there is an astonishing proliferation of tiny companies. For example, one of Italy’s most successful industries is the manufacture of fine woolen cloth, centered in the Prato region. The average textile firm in that region employs only four workers! ▲ < < < < < < < < < < < < ➤➤ ➤ The most familiar price floor is the minimum wage. Price floors are also commonly imposed on agricultural goods. ➤ A price floor above the equilibrium price benefits successful sellers but causes predictable adverse effects such as a persistent surplus, which leads to four kinds of inefficiencies: deadweight loss from inefficiently low quantities, inefficient allocation of sales among sellers, wasted resources, and inefficiently high quality. ➤ Price floors encourage illegal activity, such as workers who work off the books, often leading to official corruption 133 ➤ CHECK YOUR UNDERSTANDING 5-2 1. The state legislature mandates a price floor for gasoline of PF per gallon. Assess the following statements and illustrate your answer using the figure provided. a. Proponents of the law claim it will increase the income of gas station owners. Opponents claim it will hurt gas station owners because they will lose customers. b. Proponents claim consumers will be better off because gas stations will provide better service. Opponents claim consumers will be generally worse off because they prefer to buy gas at cheaper prices. c. Proponents claim that they are helping gas station owners without hurting anyone else. Opponents claim that consumers are hurt and will end up doing things like buying gas in a nearby state or on the black market. Solutions appear at back of book. Price of gas PF PE A S B Price floor E QF QE D Quantity of gas Controlling Quantities In the 1930s, New York City instituted a system of licensing for taxicabs: only taxis with a “medallion” were allowed to pick up passengers. Because this system was intended to assure quality, medallion owners were supposed to maintain certain standards, including safety and cleanliness. A total of 11,787 medallions were issued, with taxi owners paying $10 for each medallion. In 1995, there were still only 11,787 licensed taxicabs in New York, even though the city had meanwhile become the financial capital of the world, a place where hundreds of thousands of people in a hurry tried to hail a cab every day. (An additional 400 medallions were issued in 1995, and after several rounds of sales of additional medallions, today there are 13,089 medallions.) The result of this restriction on the number of taxis was that a New York City taxi medallion became very valuable: if you wanted to operate a taxi in New York, you had to lease a medallion from someone else or buy one for a going price of several hundred thousand dollars. It turns out that this story is not unique; other cities introduced similar medallion systems in the 1930s and, like New York, have issued few new medallions since. In San Francisco and Boston, as in New York, taxi medallions trade for sixfigure prices. A taxi medallion system is a form of quantity control, or quota, by which the government regulates the quantity of a good that can be bought and sold rather than the price at which it is transacted. The total amount of the good that can be transacted under the quantity control is called the quota limit. Typically, the government limits quantity in a market by issuing licenses; only people with a license can legally supply the good. A taxi medallion is just such a license. The government of New York City limits the number of taxi rides that can be sold by limiting the number of taxis to only those who hold medallions. There are many other cases of quantity controls, ranging from limits on how much foreign currency (for instance, British pounds or Mexican pesos) people are allowed to buy to the quantity of clams New Jersey fishing boats are allowed to catch. Notice, by the way, that although there are price controls on both sides of the equilibrium price—price ceilings and price floors—in the real world, quantity controls always set an upper, not a lower, limit on quantities. After all, nobody can be forced to buy or sell more than they want to! A quantity control, or quota, is an upper limit on the quantity of some good that can be bought or sold. The total amount of the good that can be legally transacted is the quota limit. A license gives its owner the right to supply a good. 134 P A R T 2 S U P P LY A N D D E M A N D The demand price of a given quantity is the price at which consumers will demand that quantity. Some attempts to control quantities are undertaken for good economic reasons, some for bad ones. In many cases, as we will see, quantity controls introduced to address a temporary problem become politically hard to remove later because the beneficiaries don’t want them abolished, even after the original reason for their existence is long gone. But whatever the reasons for such controls, they have certain predictable—and usually undesirable—economic consequences. The Anatomy of Quantity Controls To understand why a New York taxi medallion is worth so much money, we consider a simplified version of the market for taxi rides, shown in Figure 5-8. Just as we assumed in the analysis of rent control that all apartments are the same, we now suppose that all taxi rides are the same—ignoring the real-world complication that some taxi rides are longer, and so more expensive, than others. The table in the figure shows supply and demand schedules. The equilibrium—indicated by point E in the figure and by the shaded entries in the table—is a fare of $5 per ride, with 10 million rides taken per year. (You’ll see in a minute why we present the equilibrium this way.) The New York medallion system limits the number of taxis, but each taxi driver can offer as many rides as he or she can manage. (Now you know why New York taxi drivers are so aggressive!) To simplify our analysis, however, we will assume that a medallion system limits the number of taxi rides that can legally be given to 8 million per year. Until now, we have derived the demand curve by answering questions of the form: “How many taxi rides will passengers want to take if the price is $5 per ride?” But it is possible to reverse the question and ask instead: “At what price will consumers want to buy 10 million rides per year?” The price at which consumers want to buy a given quantity—in this case, 10 million rides at $5 per ride—is the demand price of that quantity. You can see from the demand schedule in Figure 5-8 that the demand price of 6 million rides is $7 per ride, the demand price of 7 million rides is $6.50 per ride, and so on. FIGURE 5-8 The Market for Taxi Rides in the Absence of Government Controls Fare (per ride) $7.00 6.50 6.00 5.50 5.00 4.50 4.00 3.50 3.00 0 6 7 E S D Quantity of rides (millions per year) Fare (per ride) Quantity demanded Quantity supplied $7.00 $6.50 $6.00 $5.50 $5.00 $4.50 $4.00 $3.50 $3.00 6 7 8 9 10 11 12 13 14 14 13 12 11 10 9 8 7 6 8 9 11 Quantity of rides (millions per year) 12 14 10 13 Without government intervention, the market reaches equilibrium with 10 million rides taken per year at a fare of $5 per ride 135 The supply price of a given quantity is the price at which producers will supply that quantity. Similarly, the supply curve represents the answer to questions of the form: “How many taxi rides would taxi drivers supply at a price of $5 each?” But we can also reverse this question to ask: “At what price will suppliers
be willing to supply 10 million rides per year?” The price at which suppliers will supply a given quantity—in this case, 10 million rides at $5 per ride—is the supply price of that quantity. We can see from the supply schedule in Figure 5-8 that the supply price of 6 million rides is $3 per ride, the supply price of 7 million rides is $3.50 per ride, and so on. Now we are ready to analyze a quota. We have assumed that the city government limits the quantity of taxi rides to 8 million per year. Medallions, each of which carries the right to provide a certain number of taxi rides per year, are made available to selected people in such a way that a total of 8 million rides will be provided. Medallion holders may then either drive their own taxis or rent their medallions to others for a fee. Figure 5-9 shows the resulting market for taxi rides, with the black vertical line at 8 million rides per year representing the quota limit. Because the quantity of rides is limited to 8 million, consumers must be at point A on the demand curve, corresponding to the shaded entry in the demand schedule: the demand price of 8 million rides is $6 per ride. Meanwhile, taxi drivers must be at point B on the supply curve, corresponding to the shaded entry in the supply schedule: the supply price of 8 million rides is $4 per ride. But how can the price received by taxi drivers be $4 when the price paid by taxi riders is $6? The answer is that in addition to the market in taxi rides, there is also a market in medallions. Medallion-holders may not always want to drive their taxis: they may be ill or on vacation. Those who do not want to drive their own taxis will sell the right to use the medallion to someone else. So we need to consider two sets of transactions here, and so two prices: (1) the transactions in taxi rides and the price FIGURE 5-9 Effect of a Quota on the Market for Taxi Rides Fare (per ride) $7.00 6.50 6.00 5.50 5.00 4.50 4.00 3.50 3.00 The “wedge” 0 6 7 Deadweight loss E A B Quota S D Quantity of rides (millions per year) Fare (per ride) Quantity demanded Quantity supplied $7.00 $6.50 $6.00 $5.50 $5.00 $4.50 $4.00 $3.50 $3.00 6 7 8 9 10 11 12 13 14 14 13 12 11 10 9 8 7 6 8 9 11 Quantity of rides (millions per year) 10 12 13 14 The table shows the demand price and the supply price corresponding to each quantity: the price at which that quantity would be demanded and supplied, respectively. The city government imposes a quota of 8 million rides by selling licenses for only 8 million rides, represented by the black vertical line. The price paid by consumers rises to $6 per ride, the demand price of 8 million rides, shown by point A. The supply price of 8 million rides is only $4 per ride, shown by point B. The difference between these two prices is the quota rent per ride, the earnings that accrue to the owner of a license. The quota rent drives a wedge between the demand price and the supply price. And since the quota discourages mutually beneficial transactions, it creates a deadweight loss equal to the shaded triangle. 136 P A R T 2 S U P P LY quantity control, or quota, drives a wedge between the demand price and the supply price of a good; that is, the price paid by buyers ends up being higher than that received by sellers. The difference between the demand and supply price at the quota limit is the quota rent, the earnings that accrue to the license-holder from ownership of the right to sell the good. It is equal to the market price of the license when the licenses are traded. at which these will occur, and (2) the transactions in medallions and the price at which these will occur. It turns out that since we are looking at two markets, the $4 and $6 prices will both be right. To see how this all works, consider two imaginary New York taxi drivers, Sunil and Harriet. Sunil has a medallion but can’t use it because he’s recovering from a severely sprained wrist. So he’s looking to rent his medallion out to someone else. Harriet doesn’t have a medallion but would like to rent one. Furthermore, at any point in time there are many other people like Harriet who would like to rent a medallion. Suppose Sunil agrees to rent his medallion to Harriet. To make things simple, assume that any driver can give only one ride per day and that Sunil is renting his medallion to Harriet for one day. What rental price will they agree on? To answer this question, we need to look at the transactions from the viewpoints of both drivers. Once she has the medallion, Harriet knows she can make $6 per day—the demand price of a ride under the quota. And she is willing to rent the medallion only if she makes at least $4 per day—the supply price of a ride under the quota. So Sunil cannot demand a rent of more than $2—the difference between $6 and $4. And if Harriet offered Sunil less than $2—say, $1.50—there would be other eager drivers willing to offer him more, up to $2. So, in order to get the medallion, Harriet must offer Sunil at least $2. Since the rent can be no more than $2 and no less than $2, it must be exactly $2. It is no coincidence that $2 is exactly the difference between $6, the demand price of 8 million rides, and $4, the supply price of 8 million rides. In every case in which the supply of a good is legally restricted, there is a wedge between the demand price of the quantity transacted and the supply price of the quantity transacted. This wedge, illustrated by the double-headed arrow in Figure 5-9, has a special name: the quota rent. It is the earnings that accrue to the license-holder from ownership of a valuable commodity, the license. In the case of Sunil and Harriet, the quota rent of $2 goes to Sunil because he owns the license, and the remaining $4 from the total fare of $6 goes to Harriet. So Figure 5-9 also illustrates the quota rent in the market for New York taxi rides. The quota limits the quantity of rides to 8 million per year, a quantity at which the demand price of $6 exceeds the supply price of $4. The wedge between these two prices, $2, is the quota rent that results from the restrictions placed on the quantity of taxi rides in this market. But wait a second. What if Sunil doesn’t rent out his medallion? What if he uses it himself? Doesn’t this mean that he gets a price of $6? No, not really. Even if Sunil doesn’t rent out his medallion, he could have rented it out, which means that the medallion has an opportunity cost of $2: if Sunil decides to use his own medallion and drive his own taxi rather than renting his medallion to Harriet, the $2 represents his opportunity cost of not renting out his medallion. That is, the $2 quota rent is now the rental income he forgoes by driving his own taxi. In effect, Sunil is in two businesses—the taxi-driving business and the medallion-renting business. He makes $4 per ride from driving his taxi and $2 per ride from renting out his medallion. It doesn’t make any difference that in this particular case he has rented his medallion to himself! So regardless of whether the medallion owner uses the medallion himself or herself, or rents it to others, it is a valuable asset. And this is represented in the going price for a New York City taxi medallion: in February 2008, it was around $429,000. Notice, by the way, that quotas—like price ceilings and price floors—don’t always have a real effect. If the quota were set at 12 million rides—that is, above the equilibrium quantity in an unregulated market—it would have no effect because it would not be binding. The Costs of Quantity Controls Like price controls, quantity controls can have some predictable and undesirable side effects. The first is the by-now-familiar problem of inefficiency due to missed opportunities: quantity controls create deadweight loss by preventing mutually beneficial transactions from occurring, transactions that would benefit both buyers and sellers 137 Looking back at Figure 5-9, you can see that starting at the quota limit of 8 million rides, New Yorkers would be willing to pay at least $5.50 per ride for an additional 1 million rides and that taxi drivers would be willing to provide those rides as long as they got at least $4.50 per ride. These are rides that would have taken place if there were no quota limit. The same is true for the next 1 million rides: New Yorkers would be willing to pay at least $5 per ride when the quantity of rides is increased from 9 to 10 million, and taxi drivers would be willing to provide those rides as long as they got at least $5 per ride. Again, these rides would have occurred without the quota limit. Only when the market has reached the unregulated market equilibrium quantity of 10 million rides are there no “missed-opportunity rides”—the quota limit of 8 million rides has caused 2 million “missed-opportunity rides.” Generally, as long as the demand price of a given quantity exceeds the supply price, there is a deadweight loss. A buyer would be willing to buy the good at a price that the seller would be willing to accept, but such a transaction does not occur because it is forbidden by the quota. The deadweight loss arising from the 2 million in missed-opportunity rides is represented by the shaded triangle in Figure 5-9. And because there are transactions that people would like to make but are not allowed to, quantity controls generate an incentive to evade them or even to break the law. New York’s taxi industry again provides clear examples. Taxi regulation applies only to those drivers who are hailed by passengers on the street. A car service that makes prearranged pickups does not need a medallion. As a result, such hired cars provide much of the service that might otherwise be provided by taxis, as in other cities. In addition, there are substantial numbers of unlicensed cabs that simply defy the law by picking up passengers without a medallion. Because these cabs are illegal, their drivers are completely unregulated, and they generate a disproportionately large share
of traffic accidents in New York City. In fact, in 2004 the hardships caused by the limited number of New York taxis led city leaders to authorize an increase in the number of licensed taxis. In a series of sales, the city sold almost 1,000 new medallions, to bring the total number up to the current 13,089 medallions—a move that certainly cheered New York riders. But those who already owned medallions were less happy with the increase; they understood that the nearly 1,000 new taxis would reduce or eliminate the shortage of taxis. As a result, taxi drivers anticipated a decline in their revenues as they would no longer always be assured of finding willing customers. And, in turn, the value of a medallion would fall. So to placate the medallion owners, city officials also raised taxi fares: by 25% in 2004, and again—by a smaller percentage—in 2006. Although taxis are now easier to find, a ride now costs more—and that price increase slightly diminished the newfound cheer of New York taxi riders. In sum, quantity controls typically create the following undesirable side effects: ■ Deadweight loss because some mutually beneficial transactions don’t occur ■ Incentives for illegal activities ➤ECONOMICS IN ACTION The Clams of New Jersey Forget the refineries along the Jersey Turnpike; one industry that New Jersey really dominates is clam fishing. In 2005 the Garden State supplied 71% of the country’s surf clams, whose tongues are used in fried-clam dinners, and 92% of the quahogs, which are used to make clam chowder. In the 1980s, however, excessive fishing threatened to wipe out New Jersey’s clam beds. To save the resource, the U.S. government introduced a clam quota, which sets an overall limit on the number of bushels of clams that may be caught and allocates licenses to owners of fishing boats based on their historical catches. 138 P A R T 2 S U P P LY A N D D E M A N D ➤➤ ➤ Quantity controls, or quotas, are government-imposed limits on how much of a good may be bought or sold. The quantity allowed for sale is the quota limit. The government then issues a license—the right to sell a given quantity of a good under the quota. ➤ When the quota limit is smaller than the equilibrium quantity in an unregulated market, the demand price is higher than the supply price—there is a wedge between them at the quota limit. ➤ This wedge is the quota rent, the earnings that accrue to the licenseholder from ownership of the right to sell the good—whether by actually supplying the good or by renting the license to someone else. The market price of a license equals the quota rent. ➤ Like price controls, quantity controls create deadweight loss and encourage illegal activity. Notice, by the way, that this is an example of a quota that is probably justified by broader economic and environmental considerations—unlike the New York taxicab quota, which has long since lost any economic rationale. Still, whatever its rationale, the New Jersey clam quota works the same way as any other quota. Once the quota system was established, many boat owners stopped fishing for clams. They realized that rather than operate a boat part time, it was more profitable to sell or rent their licenses to someone else, who could then assemble enough licenses to operate a boat full time. Today, there are about 50 New Jersey boats fishing for clams; the license required to operate one is worth more than the boat itself. ▲ < < < < < < < < < < < < ➤ CHECK YOUR UNDERSTANDING 5-3 1. Suppose that the supply and demand for taxi rides is given by Figure 5-8 but the quota is set at 6 million rides instead of 8 million. Find the following and indicate them on Figure 5-8. a. The price of a ride b. The quota rent c. The deadweight loss d. Suppose the quota limit on taxi rides is increased to 9 million. What happens to the quota rent? To the deadweight loss? 2. Assume that the quota limit is 8 million rides. Suppose demand decreases due to a decline in tourism. What is the smallest parallel leftward shift in demand that would result in the quota no longer having an effect on the market? Illustrate your answer using Figure 5-8. [ ➤➤ A LOOK AHEAD ••• It’s important to remember that the supply and demand model isn’t a static model, limited to describing a market at only one point in time. Instead, it can also be used to understand how markets change over time in response to events. To understand the relationship between an event and the magnitude of its effect on a market, we now turn to the concept that’s the subject of the next chapter, elasticity.] Solutions appear at back of book. S U M M A R Y 1. Even when a market is efficient, governments often intervene to pursue greater fairness or to please a powerful interest group. Interventions can take the form of price controls or quantity controls, both of which generate predictable and undesirable side effects consisting of various forms of inefficiency and illegal activity. 2. A price ceiling, a maximum market price below the equilibrium price, benefits successful buyers but creates persistent shortages. Because the price is maintained below the equilibrium price, the quantity demanded is increased and the quantity supplied is decreased compared to the equilibrium quantity. This leads to predictable problems: inefficiencies in the form of deadweight loss from inefficiently low quantity, inefficient allocation to consumers, wasted resources, and inefficiently low quality. It also encourages illegal activity as people turn to black markets to get the good. Because of these problems, price ceilings have generally lost favor as an economic policy tool. But some governments continue to impose them either because they don’t understand the effects or because the price ceilings benefit some influential group. 3. A price floor, a minimum market price above the equilibrium price, benefits successful sellers but creates persistent surplus. Because the price is maintained above the equilibrium price, the quantity demanded is decreased and the quantity supplied is increased compared to the equilibrium quantity. This leads to predictable problems: inefficiencies in the form of deadweight loss from inefficiently low quantity, inefficient allocation of sales among sellers, wasted resources, and inefficiently high quality. It also encourages illegal activity and black markets. The most well known kind of price floor is the minimum wage, but price floors are also commonly applied to agricultural products. 4. Quantity controls, or quotas, limit the quantity of a good that can be bought or sold. The quantity allowed for sale is the quota limit. The government issues licenses to individuals, the right to sell a given quantity of the good. The owner of a license earns a quota rent, earnings that accrue from ownership of the right to sell the good. It is equal to the difference between the demand price at the quota limit, what consumers are willing to pay for that 139 quantity, and the supply price at the quota limit, what suppliers are willing to accept for that quantity. Economists say that a quota drives a wedge between the demand price and the supply price; this wedge is equal to the quota rent. Quantity controls lead to deadweight loss in addition to encouraging illegal activity. K E Y T E R M S Price controls, p. 118 Price ceiling, p. 118 Price floor, p. 118 Deadweight loss, p. 121 Black markets, p. 125 Minimum wage, p. 127 Quota limit, p. 133 License, p. 133 Inefficient allocation of sales among sellers, Demand price, p. 134 p. 130 Supply price, p. 135 Wedge, p. 136 Quota rent, p. 136 Inefficient allocation to consumers, p. 123 Inefficiently high quality, p. 130 Wasted resources, p. 123 Inefficiently low quality, p. 124 Quantity control, p. 133 Quota, p. 133 P R O B L E M S 1. Suppose it is decided that rent control in New York City will be abolished and that market rents will now prevail. Assume that all rental units are identical and so are offered at the same rent. To address the plight of residents who may be unable to pay the market rent, an income supplement will be paid to all low-income households equal to the difference between the old controlled rent and the new market rent. a. Use a diagram to show the effect on the rental market of the elimination of rent control. What will happen to the quality and quantity of rental housing supplied? b. Use a second diagram to show the additional effect of the income-supplement policy on the market. What effect does it have on the market rent and quantity of rental housing supplied in comparison to your answers to part a? c. Are tenants better or worse off as a result of these policies? Are landlords better or worse off? Is society as a whole better or worse off? d. From a political standpoint, why do you think cities have been more likely to resort to rent control rather than a policy of income supplements to help low-income people pay for housing? 2. In order to ingratiate himself with voters, the mayor of Gotham City decides to lower the price of taxi rides. Assume, for simplicity, that all taxi rides are the same distance and therefore cost the same. The accompanying table shows the demand and supply schedules for taxi rides. Fare (per ride) $7.00 6.50 6.00 5.50 5.00 4.50 Quantity of rides (millions per year) Quantity demanded Quantity supplied 10 11 12 13 14 15 12 11 10 9 8 7 a. Assume that there are no restrictions on the number of taxi rides that can be supplied (there is no medallion system). Find the equilibrium price and quantity. b. Suppose that the mayor sets a price ceiling at $5.50. How large is the shortage of rides? Illustrate with a diagram. Who loses and who benefits from this policy? c. Suppose that the stock market crashes and, as a result, people in Gotham City are poorer. This reduces the quantity of taxi rides demanded by 6 million rides per year at any given price. What effect will the mayor’s new policy have now? Illustrate with a diagram. d. Suppose that the stock mar
ket rises and the demand for taxi rides returns to normal (that is, returns to the demand schedule given in the table). The mayor now decides to ingratiate himself with taxi drivers. He announces a policy in which operating licenses are given to existing taxi drivers; the number of licenses is restricted such that only 10 million rides per year can be given. Illustrate the effect of this policy on the market, and indicate the resulting price and quantity transacted. What is the quota rent per ride? 3. In the late eighteenth century, the price of bread in New York City was controlled, set at a predetermined price above the market price. a. Draw a diagram showing the effect of the policy. Did the policy act as a price ceiling or a price floor? b. What kinds of inefficiencies were likely to have arisen when the controlled price of bread was above the market price? Explain in detail. One year during this period, a poor wheat harvest caused a leftward shift in the supply of bread and therefore an increase in its market price. New York bakers found that the controlled price of bread in New York was below the market price. c. Draw a diagram showing the effect of the price control on the market for bread during this one-year period. Did the policy act as a price ceiling or a price floor? 140 P A R T 2 S U P P LY . What kinds of inefficiencies do you think occurred during this period? Explain in detail. 4. The U.S. Department of Agriculture (USDA) administers the price floor for milk, set at $0.10 per pound of milk. (The price floor is officially set at $9.90 per hundredweight of milk. One hundredweight is 100 pounds.) At that price, according to data from the USDA, the quantity of milk produced in 2003 by U.S. producers was 170 billion pounds, and the quantity demanded was 169 billion pounds. To support the price of milk at the price floor, the USDA had to buy up 1 billion pounds of milk. The accompanying diagram shows supply and demand curves illustrating the market for milk. Price of milk (per pound) $0.16 0.14 0.12 0.10 0.08 0.06 0.04 0.02 0 E S Price floor D 169.0 169.5 170.0 Quantity of milk (billions of pounds) a. In the absence of a price floor, how much consumer surplus is created? How much producer surplus? What is the total surplus? b. With the price floor at $0.10 per pound of milk, con- sumers buy 169 billion pounds of milk. How much consumer surplus is created now? c. With the price floor at $0.10 per pound of milk, producers sell 170 billion pounds of milk (some to consumers and some to the USDA). How much producer surplus is created now? d. How much money does the USDA spend on buying up surplus milk? e. Taxes must be collected to pay for the purchases of surplus milk by the USDA. As a result, total surplus (producer plus consumer) is reduced by the amount the USDA spent on buying surplus milk. Using your answers for parts b—d, what is the total surplus when there is a price floor? How does this compare to the total surplus without a price floor from part a? 5. The accompanying table shows hypothetical demand and supply schedules for milk per year. The U.S. government decides that the incomes of dairy farmers should be maintained at a level that allows the traditional family dairy farm to survive. So it implements a price floor of $1 per pint by buying surplus milk until the market price is $1 per pint. Price of milk (per pint) Quantity of milk (millions of pints per year) Quantity demanded Quantity supplied $1.20 $1.10 $1.00 $0.90 $0.80 550 600 650 700 750 850 800 750 700 650 a. In a diagram, show the deadweight loss from the ineffi- ciently low quantity bought and sold. b. How much surplus milk will be produced as a result of this policy? c. What will be the cost to the government of this policy? d. Since milk is an important source of protein and calcium, the government decides to provide the surplus milk it purchases to elementary schools at a price of only $0.60 per pint. Assume that schools will buy any amount of milk available at this low price. But parents now reduce their purchases of milk at any price by 50 million pints per year because they know their children are getting milk at school. How much will the dairy program now cost the government? e. Explain how inefficiencies in the form of inefficient allocation to sellers and wasted resources arise from this policy. 6. As noted in the text, European governments tend to make greater use of price controls than does the U.S. government. For example, the French government sets minimum starting yearly wages for new hires who have completed le bac, certification roughly equivalent to a high school diploma. The demand schedule for new hires with le bac and the supply schedule for similarly credentialed new job seekers are given in the accompanying table. The price here—given in euros, the currency used in France—is the same as the yearly wage. Wage (per year) €45,000 €40,000 €35,000 €30,000 €25,000 Quantity demanded (new job offers per year) Quantity supplied (new job seekers per year) 200,000 220,000 250,000 290,000 370,000 325,000 320,000 310,000 290,000 200,000 a. In the absence of government interference, what are the equilibrium wage and number of graduates hired per year? Illustrate with a diagram. Will there be anyone seeking a job at the equilibrium wage who is unable to find one— that is, will there be anyone who is involuntarily unemployed? b. Suppose the French government sets a minimum yearly wage of €35,000. Is there any involuntary unemployment at this wage? If so, how much? Illustrate with a diagram. What if the minimum wage is set at €40,000? Also illustrate with a diagram. c. Given your answer to part b and the information in the table, what do you think is the relationship between the level of involuntary unemployment and the level of the minimum wage? Who benefits from such a policy? Who loses? What is the missed opportunity here? 7. Until recently, the standard number of hours worked per week for a full-time job in France was 39 hours, just as in the United States. But in response to social unrest over high levels of involuntary unemployment, the French government instituted a 35-hour workweek—a worker could not work more than 35 hours per week even if both the worker and employer wanted it. The motivation behind this policy was that if current employees worked fewer hours, employers would be forced to hire more new workers. Assume that it is costly for employers to train new workers. French employers were greatly opposed to this policy and threatened to move their operations to neighboring countries that did not have such employment restrictions. Can you explain their attitude? Give an example of both an inefficiency and an illegal activity that are likely to arise from this policy. 8. For the last 70 years the U.S. government has used price supports to provide income assistance to American farmers. To implement these price supports, at times the government has used price floors, which it maintains by buying up the surplus farm products. At other times, it has used target prices, a policy by which the government gives the farmer an amount equal to the difference between the market price and the target price for each unit sold. Consider the market for corn depicted in the accompanying diagram. Price of corn (per bushel) $,000 800 Quantity of corn (bushels) 1,200 a. If the government sets a price floor of $5 per bushel, how many bushels of corn are produced? How many are purchased by consumers? By the government? How much does the program cost the government? How much revenue do corn farmers receive? b. Suppose the government sets a target price of $5 per bushel for any quantity supplied up to 1,000 bushels. How many bushels of corn are purchased by consumers and at what price? By the government? How much does the 141 program cost the government? How much revenue do corn farmers receive? c. Which of these programs (in parts a and b) costs corn consumers more? Which program costs the government more? Explain. d. Is one of these policies less inefficient than the other? Explain. 9. The waters off the North Atlantic coast were once teeming with fish. Now, due to overfishing by the commercial fishing industry, the stocks of fish are seriously depleted. In 1991, the National Marine Fishery Service of the U.S. government implemented a quota to allow fish stocks to recover. The quota limited the amount of swordfish caught per year by all U.S.-licensed fishing boats to 7 million pounds. As soon as the U.S. fishing fleet had met the quota limit, the swordfish catch was closed down for the rest of the year. The accompanying table gives the hypothetical demand and supply schedules for swordfish caught in the United States per year. Price of swordfish (per pound) Quantity of swordfish (millions of pounds per year) Quantity demanded Quantity supplied $20 18 16 14 12 6 7 8 9 10 15 13 11 9 7 a. Use a diagram to show the effect of the quota on the market for swordfish in 1991. In your diagram, illustrate the deadweight loss from inefficiently low quantity. b. How do you think fishermen will change how they fish in response to this policy? 10. In Maine, you must have a license to harvest lobster commercially; these licenses are issued yearly. The state of Maine is concerned about the dwindling supplies of lobsters found off its coast. The state fishery department has decided to place a yearly quota of 80,000 pounds of lobsters harvested in all Maine waters. It has also decided to give licenses this year only to those fishermen who had licenses last year. The accompanying diagram shows the demand and supply curves for Maine lobsters. Price of lobster (per pound) $22 20 18 16 14 12 10 8 6 4 E S D 0 20 40 60 80 100 120 140 Quantity of lobsters (thousands of pounds) 142 P A R T 2 S U P P LY . In the absence of government restrictions, what are the equilibrium price and quantity? b. What is the demand price at which consumers wish to pur- chase 80,000
pounds of lobsters? c. What is the supply price at which suppliers are willing to supply 80,000 pounds of lobsters? d. What is the quota rent per pound of lobster when 80,000 pounds are sold? Illustrate the quota rent and the deadweight loss on the diagram. e. Explain a transaction that benefits both buyer and seller but is prevented by the quota restriction. 11. The Venezuelan government has imposed a price ceiling on the retail price of roasted coffee beans. The accompanying diagram shows the market for coffee beans. In the absence of price controls, the equilibrium is at point E, with an equilibrium price of PE and an equilibrium quantity bought and sold of QE. Price of coffee beans E PE PC S Price ceiling D QC QE Quantity of coffee beans a. Show the consumer and producer surplus before the introduction of the price ceiling. After the introduction of the price ceiling, the price falls to PC and the quantity bought and sold falls to QC. b. Show the consumer surplus after the introduction of the price ceiling (assuming that the consumers with the highest willingness to pay get to buy the available coffee beans; that is, assuming that there is no inefficient allocation to consumers). c. Show the producer surplus after the introduction of the price ceiling (assuming that the producers with the lowest cost get to sell their coffee beans; that is, assuming that there is no inefficient allocation of sales among producers). www.worthpublishers.com/krugmanwells d. Using the diagram, show how much of what was producer surplus before the introduction of the price ceiling has been transferred to consumers as a result of the price ceiling? e. Using the diagram, show how much of what was total surplus before the introduction of the price ceiling has been lost? That is, how great is the deadweight loss? 12. The accompanying diagram shows data from the U.S. Bureau of Labor Statistics on the average price of an airline ticket in the United States from 1975 until 1985, adjusted to eliminate the effect of inflation (the general increase in the prices of all goods over time). In 1978, the United States Airline Deregulation Act removed the price floor on airline fares, and it also allowed the airlines greater flexibility to offer new routes. Price of airline ticket (index: 1975 = 100) 160 140 120 100 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 Year Source: U.S. Bureau of Labor Statistics. a. Looking at the data on airline ticket prices in the diagram, do you think the price floor that existed before 1978 was binding or nonbinding? That is, do you think it was set above or below the equilibrium price? Draw a supply and demand diagram, showing where the price floor that existed before 1978 was in relation to the equilibrium price. b. Most economists agree that the average airline ticket price per mile traveled actually fell as a result of the Airline Deregulation Act. How might you reconcile that view with what you see in the diagram? chapter: 6 >> Elasticity ANIC WAS THE ONLY WORD TO DESCRIBE THE shots. People lined up in the middle of the night at the situation at hospitals, clinics, and nursing few locations that had somehow obtained the vaccine and homes across America in October 2004. Early were offering it at a reasonable price: the crowds included that month, Chiron Corporation, one of only two sup- seniors with oxygen tanks, parents with sleeping children, pliers of flu vaccine for the entire U.S. market, and others in wheelchairs. Meanwhile, some pharmaceu- announced that contamination problems would force tical distributors—the companies that obtain vaccine the closure of its manufacturing plant. With that clo- from manufacturers and then distribute it to hospitals sure, the U.S. supply of vaccine for the 2004–2005 flu and pharmacies—detected a profit-making opportunity in season was suddenly cut in half, from 100 million to 50 the frenzy. One company, Med-Stat, which normally million doses. Because making flu vaccine is a costly and charged $8.50 for a dose, began charging $90, more than time-consuming process, no more doses could be made 10 times the normal price. A survey of pharmacists found to replace Chiron’s lost output. And since every country that price-gouging was fairly widespread. jealously guards its supply of flu vaccine for its own citizens, none could be obtained from other countries. If you’ve ever had a real case of the flu, you know just how unpleas- ant an experience it is. And it can be worse than unpleasant: every year the flu kills around 36,000 Americans and sends another 200,000 to the hospital. Victims are Although most people refused or were unable to pay such a high price for the vaccine, many others undoubtedly did. Med-Stat judged, correctly, that con- sumers of the vaccine were relatively unresponsive to price; that is, the large increase in the price of the vaccine left the quantity demanded by consumers relatively unchanged. Clearly, the demand for flu vaccine is unusu- A shortage of flu vaccine created panic during the flu season of 2004 most commonly children, seniors, or those with com- al in this respect. For many, getting vaccinated meant promised immune systems. In a normal flu season, this the difference between life and death. Let’s consider a part of the population, along with health care workers, very different and less urgent scenario. Suppose, for are immunized first. example, that the supply of a particular type of break- But the flu vaccine shortfall of 2004 upended those fast cereal was halved due to manufacturing problems. plans. As news of it spread, there was a rush to get the It would be extremely unlikely, if not impossible, to find 143 144 P A R T 2 S U P P LY consumer willing to pay 10 times the original price for of demand. In this chapter we will show how the price a box of this particular cereal. In other words, con- elasticity of demand is calculated and why it is the best sumers of breakfast cereal are much more responsive to measure of how the quantity demanded responds to price than consumers of flu vaccine. But how do we changes in price. We will then see that the price elastic- define responsiveness? ity of demand is only one of a family of related concepts, Economists measure responsiveness of consumers to including the income elasticity of demand and the price price with a particular number, called the price elasticity elasticity of supply. WHAT YOU WILL LEARN IN THIS CHAPTER: ➤ The definition of elasticity, a measure of responsiveness to changes in prices or incomes ➤ The importance of the price elasticity of demand, which measures the responsiveness of the quantity demanded to changes in price ➤ The meaning and importance of the income elasticity of demand, a measure of the responsiveness of demand to changes in income ➤ The significance of the price elasticity of supply, which measures the responsiveness of the quantity supplied to changes in price ➤ How the cross-price elasticity of demand measures the responsiveness of demand for one good to changes in the price of another good. ➤ The factors that influence the size of these various elasticities Defining and Measuring Elasticity In order for Flunomics, a hypothetical flu vaccine distributor, to know whether it could raise its revenue by significantly raising the price of its flu vaccine during the 2004 flu vaccine panic, it would have to know the price elasticity of demand for flu vaccinations. Calculating the Price Elasticity of Demand Figure 6-1 shows a hypothetical demand curve for flu vaccinations. At a price of $20 per vaccination, consumers would demand 10 million vaccinations per year (point A); at a price of $21, the quantity demanded would fall to 9.9 million vaccinations per year (point B). Figure 6-1, then, tells us the change in the quantity demanded for a particular change in the price. But how can we turn this into a measure of price responsiveness? The answer is to calculate the price elasticity of demand. The price elasticity of demand compares the percent change in quantity demanded to the percent change in price as we move along the demand curve. As we’ll see later in this chapter, the reason economists use percent changes is to get a measure that doesn’t depend on the units in which a good is measured (say, a child-size dose versus an adult-size dose of vaccine). But before we get to that, let’s look at how elasticity is calculated. To calculate the price elasticity of demand, we first calculate the percent change in the quantity demanded and the corresponding percent change in the price as we move along the demand curve. These are defined as follows: (6-1) % change in quantity demanded = Change in quantity demanded Initial quantity demanded × 100 and (6-2) % change in price = Change in price Initial price × 100 In Figure 6-1, we see that when the price rises from $20 to $21, the quantity demanded falls from 10 million to 9.9 million vaccinations, yielding a change in The price elasticity of demand is the ratio of the percent change in the quantity demanded to the percent change in the price as we move along the demand curve (dropping the minus sign). 145 FIGURE 6-1 The Demand for Vaccinations At a price of $20 per vaccination, the quantity of vaccinations demanded is 10 million per year (point A). When price rises to $21 per vaccination, the quantity demanded falls to 9.9 million vaccinations per year (point B). Price of vaccination $21 20 B A D 0 9.9 10.0 Quantity of vaccinations (millions) the quantity demanded of 0.1 million vaccinations. So the percent change in the quantity demanded is % change in quantity demanded = −0.1 million vaccinations 10 million vaccinations × 100 = −1% The initial price is $20 and the change in the price is $1, so the percent change in price is % change in price = $1 $20 × 100 = 5% To calculate the price elasticity of demand, we find the ratio of the percent change in the quantity demanded to the percent change in the price: (6-3) Price
elasticity of demand = % change in quantity demanded % change in price In Figure 6-1, the price elasticity of demand is therefore Price elasticity of demand = 1% 5% = 0.2 The law of demand says that demand curves are downward sloping, so price and quantity demanded always move in opposite directions. In other words, a positive percent change in price (a rise in price) leads to a negative percent change in the quantity demanded; a negative percent change in price (a fall in price) leads to a positive percent change in the quantity demanded. This means that the price elasticity of demand is, in strictly mathematical terms, a negative number. However, it is inconvenient to repeatedly write a minus sign. So when economists talk about the price elasticity of demand, they usually drop the minus sign and report the absolute value of the price elasticity of demand. In this case, for example, economists would usually say “the price elasticity of demand is 0.2,” taking it for granted that you understand they mean minus 0.2. We follow this convention here. The larger the price elasticity of demand, the more responsive the quantity demanded is to the price. When the price elasticity of demand is large—when consumers change their quantity demanded by a large percentage compared with the percent change in the price—economists say that demand is highly elastic. 146 P A R T 2 S U P P LY A N D D E M A N D The midpoint method is a technique for calculating the percent change. In this approach, we calculate changes in a variable compared with the average, or midpoint, of the starting and final values. As we’ll see shortly, a price elasticity of 0.2 indicates a small response of quantity demanded to price. That is, the quantity demanded will fall by a relatively small amount when price rises. This is what economists call inelastic demand. And inelastic demand was exactly what Flunomics needed for its strategy to increase revenue by raising the price of its flu vaccines. An Alternative Way to Calculate Elasticities: the Midpoint Method Price elasticity of demand compares the percent change in quantity demanded with the percent change in price. When we look at some other elasticities, which we will do shortly, we’ll see why it is important to focus on percent changes. But at this point we need to discuss a technical issue that arises when you calculate percent changes in variables and how economists deal with it. The best way to understand the issue is with a real example. Suppose you were trying to estimate the price elasticity of demand for gasoline by comparing gasoline prices and consumption in different countries. Because of high taxes, gasoline usually costs about three times as much per gallon in Europe as it does in the United States. So what is the percent difference between American and European gas prices? Well, it depends on which way you measure it. Because the price of gasoline in Europe is approximately three times higher than in the United States, it is 200 percent higher. Because the price of gasoline in the United States is one-third as high as in Europe, it is 66.7 percent lower. This is a nuisance: we’d like to have a percent measure of the difference in prices that doesn’t depend on which way you measure it. A good way to avoid computing different elasticities for rising and falling prices is to use the midpoint method. The midpoint method replaces the usual definition of the percent change in a variable, X, with a slightly different definition: (6-4) % change in X = Change in X Average value of X × 100 where the average value of X is defined as Average value of X = Starting value of X + Final value of X 2 When calculating the price elasticity of demand using the midpoint method, both the percent change in the price and the percent change in the quantity demanded are found using this method. To see how this method works, suppose you have the following data for some good: Situation A Situation B Price $0.90 $1.10 Quantity demanded 1,100 900 To calculate the percent change in quantity going from situation A to situation B, we compare the change in the quantity demanded—a fall of 200 units—with the average of the quantity demanded in the two situations. So we calculate % change in quantity demanded = −200 (1,100 + 900)/2 × 100 = −200 1,000 × 100 = −20% In the same way, we calculate % change in price = $0.20 ($0.90 + $1.10)/2 × 100 = $0.20 $1.00 × 100 = 20% So in this case we would calculate the price elasticity of demand to be Price elasticity of demand = % change in quantity demanded % change in price = 20% 20% = 1 again dropping the minus sign. The important point is that we would get the same result, a price elasticity of demand of 1, whether we go up the demand curve from situation A to situation B or down from situation B to situation A. To arrive at a more general formula for price elasticity of demand, suppose that we have data for two points on a demand curve. At point 1 the quantity demanded and price are (Q1, P1); at point 2 they are (Q2, P2). Then the formula for calculating the price elasticity of demand is: Q2 − Q1 (Q1 + Q2)/2 (6-5) Price elasticity of demand = P2 − P1 (P1 + P2)/2 As before, when reporting a price elasticity of demand calculated by the midpoint method, we drop the minus sign and report the absolute value. ➤ECONOMICS IN ACTION Estimating Elasticities You might think it’s easy to estimate price elasticities of demand from real-world data: just compare percent changes in prices with percent changes in quantities demanded. Unfortunately, it’s rarely that simple because changes in price aren’t the only thing affecting changes in the quantity demanded: other factors—such as changes in income, changes in population, and changes in the prices of other goods— shift the demand curve, thereby changing the quantity demanded at any given price. To estimate price elasticities of demand, economists must use careful statistical analysis to separate the influence of these different factors, holding other things equal. The most comprehensive effort to estimate price elasticities of demand was a mammoth study by the economists Hendrik S. Houthakker and Lester D. Taylor. Some of their results are summarized in Table 6-1. These estimates show a wide range of price elasticities. There are some goods, like eggs, for which demand hardly responds at all to changes in the price; there are other goods, most notably foreign travel, for which the quantity demanded is very sensitive to the price. Notice that Table 6-1 is divided into two parts: inelastic and elastic demand. We’ll explain in the next section the significance of that division. ▲ > > > > > > > > > > > > ➤ CHECK YOUR UNDERSTANDING 6-1 1. The price of strawberries falls from $1.50 to $1.00 per carton and the quantity demanded goes from 100,000 to 200,000 cartons. Use the midpoint method to find the price elasticity of demand. 2. At the present level of consumption, 4,000 movie tickets, and at the current price, $5 per ticket, the price elasticity of demand for movie tickets is 1. Using the midpoint method, calculate the percentage by which the owners of movie theaters must reduce price in order to sell 5,000 tickets. 3. The price elasticity of demand for ice-cream sandwiches is 1.2 at the current price of $0.50 per sandwich and the current consumption level of 100,000 sandwiches. Calculate the change in the quantity demanded when price rises by $0.05. Use Equations 6-1 and 6-2 to calculate percent changes and Equation 6-3 to relate price elasticity of demand to the percent changes. Solutions appear at back of book 147 TABLE 6-1 Some Estimated Price Elasticities of Demand Price elasticity of demand Good Inelastic demand Eggs Beef Stationery Gasoline Elastic demand Housing Restaurant meals Airline travel Foreign travel 0.1 0.4 0.5 0.5 1.2 2.3 2.4 4.1 Please find source information on the copyright page. ➤➤ ➤ The price elasticity of demand is equal to the percent change in the quantity demanded divided by the percent change in the price as you move along the demand curve (dropping the minus sign). ➤ In practice, percent changes are best measured using the midpoint method, in which the percent change in each variable is calculated using the average of starting and final values. 148 P A R T 2 S U P P LY A N D D E M A N D Demand is perfectly inelastic when the quantity demanded does not respond at all to changes in the price. When demand is perfectly inelastic, the demand curve is a vertical line. Interpreting the Price Elasticity of Demand Med-Stat and other pharmaceutical distributors believed they could sharply drive up flu vaccine prices in the face of a shortage because the price elasticity of vaccine demand was low. But what does that mean? How low does a price elasticity have to be for us to classify it as low? How high does it have to be for us to consider it high? And what determines whether the price elasticity of demand is high or low, anyway? To answer these questions, we need to look more deeply at the price elasticity of demand. How Elastic Is Elastic? As a first step toward classifying price elasticities of demand, let’s look at the extreme cases. First, consider the demand for a good when people pay no attention to the price— say, shoelaces. Suppose that consumers will buy 1 billion pairs of shoelaces per year regardless of the price. In this case, the demand curve for shoelaces would look like the curve shown in panel (a) of Figure 6-2: it would be a vertical line at 1 billion pairs of shoelaces. Since the percent change in the quantity demanded is zero for any change in the price, the price elasticity of demand in this case is zero. The case of a zero price elasticity of demand is known as perfectly inelastic demand. The opposite extreme occurs when even a tiny rise in the price will cause the quantity demanded to drop to zero or even a tiny fall in the price will cause the quantity demanded to get extremely large. Panel (b) of Figure 6-2
shows the case of pink tennis balls; we suppose that tennis players really don’t care what color their balls are and that other colors, such as neon green and vivid yellow, are available at $5 per dozen balls. In this case, consumers will buy no pink balls if they cost more than $5 per dozen but will buy only pink balls if they cost less than $5. The demand curve will therefore be a horizontal line at a price of $5 per dozen balls. As you move back and forth along this line, there is a change in the quantity demanded but no change in the price. Roughly FIGURE 6-2 Two Extreme Cases of Price Elasticity of Demand (a) Perfectly Inelastic Demand: Price Elasticity of Demand = 0 (b) Perfectly Elastic Demand: Price Elasticity of Demand = ∞∞ Price of shoelaces (per pair) D1 An increase in price . . . $3 2 0 Price of pink tennis balls (per dozen) At any price above $5, quantity demanded is zero. $5 At any price below $5, quantity demanded is infinite. . . . leaves the quantity demanded unchanged. At exactly $5, consumers will buy any quantity. D2 1 Quantity of shoelaces (billions of pairs per year) 0 Quantity of pink tennis balls (dozens per year) Panel (a) shows a perfectly inelastic demand curve, which is a vertical line. The quantity of shoelaces demanded is always 1 billion pairs, regardless of price. As a result, the price elasticity of demand is zero—the quantity demanded is unaffected by the price. Panel (b) shows a perfectly elastic demand curve, which is a horizontal line. At a price of $5, consumers will buy any quantity of pink tennis balls, but will buy none at a price above $5. If the price falls below $5, they will buy an extremely large number of pink tennis balls and none of any other color 149 Demand is perfectly elastic when any price increase will cause the quantity demanded to drop to zero. When demand is perfectly elastic, the demand curve is a horizontal line. Demand is elastic if the price elasticity of demand is greater than 1, inelastic if the price elasticity of demand is less than 1, and unit-elastic if the price elasticity of demand is exactly 1. speaking, when you divide a number by zero, you get infinity, denoted by the symbol ∞. So a horizontal demand curve implies an infinite price elasticity of demand. When the price elasticity of demand is infinite, economists say that demand is perfectly elastic. The price elasticity of demand for the vast majority of goods is somewhere between these two extreme cases. Economists use one main criterion for classifying these intermediate cases: they ask whether the price elasticity of demand is greater or less than 1. When the price elasticity of demand is greater than 1, economists say that demand is elastic. When the price elasticity of demand is less than 1, they say that demand is inelastic. The borderline case is unit-elastic demand, where the price elasticity of demand is—surprise—exactly 1. To see why a price elasticity of demand equal to 1 is a useful dividing line, let’s consider a hypothetical example: a toll bridge operated by the state highway department. Other things equal, the number of drivers who use the bridge depends on the toll, the price the highway department charges for crossing the bridge: the higher the toll, the fewer the drivers who use the bridge. Figure 6-3 shows three hypothetical demand curves—one in which demand is unitelastic, one in which it is inelastic, and one in which it is elastic. In each case, point FIGURE 6-3 Unit-Elastic Demand, Inelastic Demand, and Elastic Demand (a) Unit-Elastic Demand: Price Elasticity of Demand = 1 (b) Inelastic Demand: Price Elasticity of Demand = 0.5 Price of crossing A 20% increase in the price . . . $1.10 0.90 B A Price of crossing A 20% increase in the price . . . $1.10 0.90 B A D1 Quantity of crossings (per day) 0 900 1,100 . . . generates a 20% decrease in the quantity of crossings demanded. (c) Elastic Demand: Price Elasticity of Demand = 2 Price of crossing A 20% increase in the price . . . $1.10 0.90 B A 0 800 1,200 . . . generates a 40% decrease in the quantity of crossings demanded. D3 Quantity of crossings (per day) 0 950 1,050 . . . generates a 10% decrease in the quantity of crossings demanded. D2 Quantity of crossings (per day) Panel (a) shows a case of unit-elastic demand: a 20% increase in price generates a 20% decline in quantity demanded, implying a price elasticity of demand of 1. Panel (b) shows a case of inelastic demand: a 20% increase in price generates a 10% decline in quantity demanded, implying a price elasticity of demand of 0.5. A case of elastic demand is shown in Panel (c): a 20% increase in price causes a 40% decline in quantity demanded, implying a price elasticity of demand of 2. All percentages are calculated using the midpoint method. 150 P A R T 2 S U P P LY A N D D E M A N D The total revenue is the total value of sales of a good or service. It is equal to the price multiplied by the quantity sold. A shows the quantity demanded if the toll is $0.90 and point B shows the quantity demanded if the toll is $1.10. An increase in the toll from $0.90 to $1.10 is an increase of 20% if we use the midpoint method to calculate percent changes. Panel (a) shows what happens when the toll is raised from $0.90 to $1.10 and the demand curve is unit-elastic. Here the 20% price rise leads to a fall in the quantity of cars using the bridge each day from 1,100 to 900, which is a 20% decline (again using the midpoint method). So the price elasticity of demand is 20%/20% = 1. Panel (b) shows a case of inelastic demand when the toll is raised from $0.90 to $1.10. The same 20% price rise reduces the quantity demanded from 1,050 to 950. That’s only a 10% decline, so in this case the price elasticity of demand is 10%/20% = 0.5. Panel (c) shows a case of elastic demand when the toll is raised from $0.90 to $1.10. The 20% price increase causes the quantity demanded to fall from 1,200 to 800—a 40% decline, so the price elasticity of demand is 40%/20% = 2. Why does it matter whether demand is unit-elastic, inelastic, or elastic? Because this classification predicts how changes in the price of a good will affect the total revenue earned by producers from the sale of that good. In many real-life situations, such as the one faced by Med-Stat, it is crucial to know how price changes affect total revenue. Total revenue is defined as the total value of sales of a good or service: the price multiplied by the quantity sold. (6-6) Total revenue = Price × Quantity sold Total revenue has a useful graphical representation that can help us understand why knowing the price elasticity of demand is crucial when we ask whether a price rise will increase or reduce total revenue. Panel (a) of Figure 6-4 shows the same demand curve as panel (a) of Figure 6-3. We see that 1,100 drivers will use the bridge if the toll is $0.90. So the total revenue at a price of $0.90 is $0.90 × 1,100 = $990. This value is equal to the area of the green rectangle, which is drawn with the bottom left corner at the point (0, 0) and the top right corner at (1,100, 0.90). In general, Price of crossing $0.90 0 FIGURE 6-4 Total Revenue (a) Total Revenue by Area (b) Effect of a Price Increase on Total Revenue Price of crossing $1.10 0.90 Price effect of price increase: higher price for each unit sold Quantity effect of price increase: fewer units sold A D C B Total revenue = price x quantity = $990 D 1,100 Quantity of crossings (per day) 0 900 1,100 Quantity of crossings (per day) The green rectangle in panel (a) represents total revenue generated from 1,100 drivers who each pay a toll of $0.90. Panel (b) shows how total revenue is affected when the price increases from $0.90 to $1.10. Due to the quantity effect, total revenue falls by area A. Due to the price effect, total revenue increases by the area C. In general, the overall effect can go either way, depending on the price elasticity of demand 151 the total revenue at any given price is equal to the area of a rectangle whose height is the price and whose width is the quantity demanded at that price. To get an idea of why total revenue is important, consider the following scenario. Suppose that the toll on the bridge is currently $0.90 but that the highway department must raise extra money for road repairs. One way to do this is to raise the toll on the bridge. But this plan might backfire, since a higher toll will reduce the number of drivers who use the bridge. And if traffic on the bridge dropped a lot, a higher toll would actually reduce total revenue instead of increasing it. So it’s important for the highway department to know how drivers will respond to a toll increase. We can see graphically how the toll increase affects total bridge revenue by examining panel (b) of Figure 6-4. At a toll of $0.90, total revenue is given by the sum of the areas A and B. After the toll is raised to $1.10, total revenue is given by the sum of areas B and C. So when the toll is raised, revenue represented by area A is lost but revenue represented by area C is gained. These two areas have important interpretations. Area C represents the revenue gain that comes from the additional $0.20 paid by drivers who continue to use the bridge. That is, the 900 who continue to use the bridge contribute an additional $0.20 × 900 = $180 per day to total revenue, represented by area C. But 200 drivers who would have used the bridge at a price of $0.90 no longer do so, generating a loss to total revenue of $0.90 × 200 = $180 per day, represented by area A. (In this particular example, because demand is unit-elastic—the same as in panel (a) of Figure 6–3 —the rise in the toll has no effect on total revenue; areas A and B are the same size.) Except in the rare case of a good with perfectly elastic or perfectly inelastic demand, when a seller raises the price of a good, two countervailing effects are present: ■ A price effect. After a price increase, each unit sold sells at a higher price, which tends t
o raise revenue. ■ A quantity effect. After a price increase, fewer units are sold, which tends to lower revenue. But then, you may ask, what is the net ultimate effect on total revenue: does it go up or down? The answer is that, in general, the effect on total revenue can go either way—a price rise may either increase total revenue or lower it. If the price effect, which tends to raise total revenue, is the stronger of the two effects, then total revenue goes up. If the quantity effect, which tends to reduce total revenue, is the stronger, then total revenue goes down. And if the strengths of the two effects are exactly equal—as in our toll bridge example, where a $180 gain offsets a $180 loss— total revenue is unchanged by the price increase. The price elasticity of demand tells us what happens to total revenue when price changes: its size determines which effect—the price effect or the quantity effect—is stronger. Specifically: ■ If demand for a good is unit-elastic (the price elasticity of demand is 1), an increase in price does not change total revenue. In this case, the quantity effect and the price effect exactly offset each other. ■ If demand for a good is inelastic (the price elasticity of demand is less than 1), a higher price increases total revenue. In this case, the price effect is stronger than the quantity effect. ■ If demand for a good is elastic (the price elasticity of demand is greater than 1), an increase in price reduces total revenue. In this case, the quantity effect is stronger than the price effect. Table 6-2 on the next page shows how the effect of a price increase on total revenue depends on the price elasticity of demand, using the same data as in Figure 63. An increase in the price from $0.90 to $1.10 leaves total revenue unchanged at $990 when demand is unit-elastic. When demand is inelastic, the price effect dominates the quantity effect; the same price increase leads to an increase in total revenue 152 P A R T 2 S U P P LY A N D D E M A N D TABLE 6-2 Price Elasticity of Demand and Total Revenue Price of crossing = $0.90 Price of crossing = $1.10 Unit-elastic demand (price elasticity of demand = 1) Quantity demanded Total revenue Inelastic demand (price elasticity of demand = 0.5) Quantity demanded Total revenue Elastic demand (price elasticity of demand = 2) Quantity demanded Total revenue 1,1000 $990 1,050 $945 1,200 $1,080 900 $990 $$ 950 $1,045 0800 $880 from $945 to $1,045. And when demand is elastic, the quantity effect dominates the price effect; the price increase leads to a decline in total revenue from $1,080 to $880. The price elasticity of demand also predicts the effect of a fall in price on total revenue. When the price falls, the same two countervailing effects are present, but they work in the opposite directions as compared to the case of a price rise. There is the price effect of a lower price per unit sold, which tends to lower revenue. This is countered by the quantity effect of more units sold, which tends to raise revenue. Which effect dominates depends on the price elasticity. Here is a quick summary: ■ When demand is unit-elastic, the two effects exactly balance; so a fall in price has no effect on total revenue. ■ When demand is inelastic, the price effect dominates the quantity effect; so a fall in price reduces total revenue. ■ When demand is elastic, the quantity effect dominates the price effect; so a fall in price increases total revenue. Price Elasticity Along the Demand Curve Suppose an economist says that “the price elasticity of demand for coffee is 0.25.” What he or she means is that at the current price the elasticity is 0.25. In the previous discussion of the toll bridge, what we were really describing was the elasticity at the price of $0.90. Why this qualification? Because for the vast majority of demand curves, the price elasticity of demand at one point along the curve is different from the price elasticity of demand at other points along the same curve. To see this, consider the table in Figure 6-5, which shows a hypothetical demand schedule. It also shows in the last column the total revenue generated at each price and quantity combination in the demand schedule. The upper panel of the graph in Figure 6-5 shows the corresponding demand curve. The lower panel illustrates the same data on total revenue: the height of a bar at each quantity demanded—which corresponds to a particular price—measures the total revenue generated at that price. In Figure 6-5, you can see that when the price is low, raising the price increases total revenue: starting at a price of $1, raising the price to $2 increases total revenue from $9 to $16. This means that when the price is low, demand is inelastic. Moreover, you can see that demand is inelastic on the entire section of the demand curve from a price of $0 to a price of $5. When the price is high, however, raising it further reduces total revenue: starting at a price of $8, raising the price to $9 reduces total revenue, from $16 to $9. This FIGURE 6-5 The Price Elasticity of Demand Changes Along the Demand Curve 153 Price $10 Total revenue $25 24 21 16 9 0 Elastic Unit-elastic Inelastic D 10 9 Quantity 10 9 Quantity Demand is elastic: a higher price reduces total revenue. Demand is inelastic: a higher price increases total revenue. Demand Schedule and Total Revenue for a Linear Demand Curve Price Quantity demanded Total revenue $ 10 10 0 9 16 21 24 25 24 21 16 9 0 The upper panel shows a demand curve corresponding to the demand schedule in the table. The lower panel shows how total revenue changes along that demand curve: at each price and quantity combination, the height of the bar represents the total revenue generated. You can see that at a low price, raising the price increases total revenue. So demand is inelastic at low prices. At a high price, however, a rise in price reduces total revenue. So demand is elastic at high prices. means that when the price is high, demand is elastic. Furthermore, you can see that demand is elastic over the section of the demand curve from a price of $5 to $10. For the vast majority of goods, the price elasticity of demand changes along the demand curve. So whenever you measure a good’s elasticity, you are really measuring it at a particular point or section of the good’s demand curve. What Factors Determine the Price Elasticity of Demand? The flu vaccine shortfall of 2004–2005 allowed vaccine distributors to significantly raise their prices for two important reasons: there were no substitutes, and for many people the vaccine was a medical necessity. People responded in various ways. Some paid the high prices, and some traveled to Canada and other countries to get vaccinated. Some simply did without (and over time often changed their habits to avoid catching the flu, such as eating out less often and avoiding mass transit). This experience illustrates the four main factors that determine elasticity: whether close substitutes are available, whether the good is a necessity or a luxury, the share of income a consumer spends on the good, and how much time has elapsed since the price change. We’ll briefly examine each of these factors. 154 P A R T 2 S U P P LY Whether Close Substitutes Are Available The price elasticity of demand tends to be high if there are other goods that consumers regard as similar and would be willing to consume instead. The price elasticity of demand tends to be low if there are no close substitutes. Whether the Good Is a Necessity or a Luxury The price elasticity of demand tends to be low if a good is something you must have, like a life-saving medicine. The price elasticity of demand tends to be high if the good is a luxury—something you can easily live without. Share of Income Spent on the Good The price elasticity of demand tends to be low when spending on a good accounts for a small share of a consumer’s income. In that case, a significant change in the price of the good has little impact on how much the consumer spends. In contrast, when a good accounts for a significant share of a consumer’s spending, the consumer is likely to be very responsive to a change in price. In this case, the price elasticity of demand is high. Time In general, the price elasticity of demand tends to increase as consumers have more time to adjust to a price change. This means that the long-run price elasticity of demand is often higher than the shortrun elasticity. A good illustration of the effect of time on the elasticity of demand is drawn from the 1970s, the first time gasoline prices increased dramatically in the United States. Initially, consumption fell very little because there were no close substitutes for gasoline and because driving their cars was necessary for people to carry out the ordinary tasks of life. Over time, however, Americans changed their habits in ways that enabled them to gradually reduce their gasoline consumption. The result was a steady decline in gasoline consumption over the next decade, even though the price of gasoline did not continue to rise, confirming that the long-run price elasticity of demand for gasoline was indeed much larger than the short-run elasticity. ➤ECONOMICS IN ACTION Responding to Your Tuition Bill College costs more than ever—and not just because of overall inflation. Tuition has been rising faster than the overall cost of living for years. But does rising tuition keep people from going to college? Two studies found that the answer depends on the type of college. Both studies assessed how responsive the decision to go to college is to a change in tuition. A 1988 study found that a 3% increase in tuition led to an approximately 2% fall in the number of students enrolled at four-year institutions, giving a price elasticity of demand of 0.67 (2%/3%). In the case of two-year institutions, the study found a significantly higher response: a 3% increase in tuition led to a 2.7% fall in enrollments, giving a price elasticity
of demand of 0.9. In other words, the enrollment decision for students at two-year colleges was significantly more responsive to price than for students at four-year colleges. The result: students at two-year colleges are more likely to forgo getting a degree because of tuition costs than students at fouryear colleges 155 ➤➤ ➤ Demand is perfectly inelastic if it is completely unresponsive to price. It is perfectly elastic if it is infinitely responsive to price. ➤ Demand is elastic if the price elasticity of demand is greater than 1; it is inelastic if the price elasticity of demand is less than 1; and it is unit-elastic if the price elasticity of demand is exactly 1. ➤ When demand is elastic, the quantity effect of a price increase dominates the price effect and total revenue falls. When demand is inelastic, the price effect of a price increase dominates the quantity effect and total revenue rises. ➤ Because the price elasticity of demand can change along the demand curve, economists refer to a particular point on the demand curve when speaking of “the” price elasticity of demand. ➤ The availability of close substitutes makes demand for a good more elastic, as does the length of time elapsed since the price change. Demand for a necessary good is less elastic, and demand for a luxury good is more elastic. Demand tends to be inelastic for goods that absorb a small share of a consumer’s income and elastic for goods that absorb a large share of income. A 1999 study confirmed this pattern. In comparison to four-year colleges, it found that two-year college enrollment rates were significantly more responsive to changes in state financial aid (a decline in aid leading to a decline in enrollments), a predictable effect given these students’ greater sensitivity to the cost of tuition. Another piece of evidence suggests that students at two-year colleges are more likely to be paying their own way and making a trade-off between attending college versus working: the study found that enrollments at two-year colleges are much more responsive to changes in the unemployment rate (an increase in the unemployment rate leading to an increase in enrollments) than enrollments at four-year colleges. So is the cost of tuition a barrier to getting a college degree in the United States? Yes, but more so at two-year colleges than at four-year colleges. Interestingly, the 1999 study found that for both two-year and four-year colleges, price sensitivity of demand had fallen somewhat since the 1988 study. One possible explanation is that because the value of a college education has risen considerably over time, fewer people forgo college, even if tuition goes up. (See source note on copyright page.) ▲ > > > > > > > > > > > > ➤ CHECK YOUR UNDERSTANDING 6-2 1. For each case, choose the condition that characterizes demand: elastic demand, inelastic demand, or unit-elastic demand. a. Total revenue decreases when price increases. b. The additional revenue generated by an increase in quantity sold is exactly offset by rev- enue lost from the fall in price received per unit. c. Total revenue falls when output increases. d. Producers in an industry find they can increase their total revenues by working together to reduce industry output. 2. For the following goods, what is the elasticity of demand? Explain. What is the shape of the demand curve? a. Demand by a snake-bite victim for an antidote b. Demand by students for green erasers Solutions appear at back of book. Other Demand Elasticities The quantity of a good demanded depends not only on the price of that good but also on other variables. In particular, demand curves shift because of changes in the prices of related goods and changes in consumers’ incomes. It is often important to have a measure of these other effects, and the best measures are—you guessed it— elasticities. Specifically, we can best measure how the demand for a good is affected by prices of other goods using a measure called the cross-price elasticity of demand, and we can best measure how demand is affected by changes in income using the income elasticity of demand. The Cross-Price Elasticity of Demand In Chapter 3 you learned that the demand for a good is often affected by the prices of other, related goods—goods that are substitutes or complements. There you saw that a change in the price of a related good shifts the demand curve of the original good, reflecting a change in the quantity demanded at any given price. The strength of such a “cross” effect on demand can be measured by the cross-price elasticity of demand, defined as the ratio of the percent change in the quantity demanded of one good to the percent change in the price of the other. The cross-price elasticity of demand between two goods measures the effect of the change in one good’s price on the quantity demanded of the other good. It is equal to the percent change in the quantity demanded of one good divided by the percent change in the other good’s price. 156 P A R T 2 S U P P LY A N D D E M A N D The income elasticity of demand is the percent change in the quantity of a good demanded when a consumer’s income changes divided by the percent change in the consumer’s income. (6-7) Cross-price elasticity of demand between goods A and B = % change in quantity of A demanded % change in price of B When two goods are substitutes, like hot dogs and hamburgers, the cross-price elasticity of demand is positive: a rise in the price of hot dogs increases the demand for hamburgers—that is, it causes a rightward shift of the demand curve for hamburgers. If the goods are close substitutes, the cross-price elasticity will be positive and large; if they are not close substitutes, the cross-price elasticity will be positive and small. So when the cross-price elasticity of demand is positive, its size is a measure of how closely substitutable the two goods are. When two goods are complements, like hot dogs and hot dog buns, the cross-price elasticity is negative: a rise in the price of hot dogs decreases the demand for hot dog buns—that is, it causes a leftward shift of the demand curve for hot dog buns. As with substitutes, the size of the cross-price elasticity of demand between two complements tells us how strongly complementary they are: if the cross-price elasticity is only slightly below zero, they are weak complements; if it is very negative, they are strong complements. Note that in the case of the cross-price elasticity of demand, the sign (plus or minus) is very important: it tells us whether the two goods are complements or substitutes. So we cannot drop the minus sign as we did for the price elasticity of demand. Our discussion of the cross-price elasticity of demand is a useful place to return to a point we made earlier: elasticity is a unit-free measure—that is, it doesn’t depend on the units in which goods are measured. To see the potential problem, suppose someone told you that “if the price of hot dog buns rises by $0.30, Americans will buy 10 million fewer hot dogs this year.” If you’ve ever bought hot dog buns, you’ll immediately wonder: is that a $0.30 increase in the price per bun, or is it a $0.30 increase in the price per package (buns are usually sold by the dozen)? It makes a big difference what units we are talking about! However, if someone says that the cross-price elasticity of demand between buns and hot dogs is −0.3, it doesn’t matter whether buns are sold individually or by the package. So elasticity is defined as a ratio of percent changes, as a way of making sure that confusion over units doesn’t arise. The Income Elasticity of Demand The income elasticity of demand is a measure of how much the demand for a good is affected by changes in consumers’ incomes. It allows us to determine whether a good is a normal or inferior good as well as to measure how intensely the demand for the good responds to changes in income. (6-8) Income elasticity of demand = % change in quantity demanded % change in income Just as the cross-price elasticity of demand between two goods can be either positive or negative, depending on whether the goods are substitutes or complements, the income elasticity of demand for a good can also be either positive or negative. Recall from Chapter 3 that goods can be either normal goods, for which demand increases when income rises, or inferior goods, for which demand decreases when income rises. These definitions relate directly to the sign of the income elasticity of demand: ■ When the income elasticity of demand is positive, the good is a normal good—that is, the quantity demanded at any given price increases as income increases. ■ When the income elasticity of demand is negative, the good is an inferior good— that is, the quantity demanded at any given price decreases as income increases 157 Where Have All the Farmers Gone? What percentage of Americans live on farms? Sad to say, the U.S. government no longer publishes that number. In 1991 the official percentage was 1.9, but in that year the government decided it was no longer a meaningful indicator of the size of the agricultural sector because a large proportion of those who live on farms actually make their living doing something else. But in the days of the Founding Fathers, the great majority of Americans lived on farms. As recently as the 1940s, one American in six—or approximately 17%—still did. Why do so few people now live and work on farms in the United States? There are two main reasons, both involving elasticities. First, the income elasticity of demand for food is much less than 1—it is income- inelastic. As consumers grow richer, other things equal, spending on food rises less than income. As a result, as the U.S. economy has grown, the share of income it spends on food—and therefore the share of total U.S. income earned by farmers—has fallen. Second, agriculture has been a techno- logically progressive sector for approximately 150 years in the United States, wi
th steadily increasing yields over time. You might think that technological progress would be good for farmers. But competition among farmers means that technological progress leads to lower food prices. Meanwhile, the demand for food is price-inelastic, so falling prices of agricultural goods, other things equal, reduce the total revenue of farmers. That’s right: progress in farming is good for consumers but bad for farmers. The combination of these effects explains the relative decline of farming. Even if farming weren’t such a technologically progressive sector, the low income elasticity of demand for food would ensure that the income of farmers grows more slowly than the economy as a whole. The combination of rapid technological progress in farming with price-inelastic demand for farm products reinforces this effect, further reducing the growth of farm income. In short, the U.S. farm sector has been a victim of success—the U.S. economy’s success as a whole (which reduces the importance of spending on food) and its own success in increasing yields. Economists often use estimates of the income elasticity of demand to predict which industries will grow most rapidly as the incomes of consumers grow over time. In doing this, they often find it useful to make a further distinction among normal goods, identifying which are income-elastic and which are income-inelastic. The demand for a good is income-elastic if the income elasticity of demand for that good is greater than 1. When income rises, the demand for income-elastic goods rises faster than income. Luxury goods such as second homes and international travel tend to be income-elastic. The demand for a good is income-inelastic if the income elasticity of demand for that good is positive but less than 1. When income rises, the demand for income-inelastic goods rises, but more slowly than income. Necessities such as food and clothing tend to be income-inelastic. The demand for a good is incomeelastic if the income elasticity of demand for that good is greater than 1. The demand for a good is incomeinelastic if the income elasticity of demand for that good is positive but less than 1. FOOD’S BITE IN WORLD BUDGETS If the income elasticity of demand for food is less than 1, we would expect to find that people in poor countries spend a larger share of their income on food than people in rich countries. And that’s exactly what the data show. In this graph, we compare per capita income—a country’s total income, divided by the population—with the share of income that is spent on food. (To make the graph a manageable size, per capita income is measured as a percentage of U.S. per capita income.) In very poor countries, like Sri Lanka, people spend most of their income on food. In middle-income countries, like Israel, the share of spending that goes to food is much lower. And it’s even lower in rich countries, like the United States. Spending on food (% of income) 80% Sri Lanka 60 40 20 0 Mexico Israel United States 20 60 Income (% of U.S. income per capita) 100% 40 80 Data: Food shares from U.S. Department of Agriculture database. Income per capita from OECD, The World Economy: Historical Statistics. 158 P A R T 2 S U P P LY VIE W R W O W E ➤ECONOMICS IN ACTION Spending It The U.S. Bureau of Labor Statistics carries out extensive surveys of how families spend their incomes. This is not just a matter of intellectual curiosity. Quite a few government programs involve some adjustment for changes in the cost of living; to estimate those changes, the government must know how people spend their money. But an additional payoff to these surveys is data on the income elasticity of demand for various goods. VIEW WOR O R L D L W V D I What stands out from these studies? The classic result is that the income elasticity of demand for “food eaten at home” is considerably less than 1: as a family’s income rises, the share of its income spent on food consumed at home falls. Correspondingly, the lower a family’s income, the higher the share of income spent on food consumed at home. In poor countries, many families spend more than half their income on food consumed at home. Although the income elasticity of demand for “food eaten at home” is estimated at less than 0.5 in the United States, the income elasticity of demand for “food eaten away from home” (restaurant meals) is estimated to be much higher—close to 1. Families with higher incomes eat out more often and at fancier places. In 1950, about 19% of U.S. income was spent on food consumed at home, a number that has dropped to 7% today. But over the same time period, the share of U.S. income spent on food away from home has stayed constant at 5%. In fact, a sure sign of rising income levels in developing countries is the arrival of fast-food restaurants that cater to newly affluent customers. For example, McDonald’s can now be found in Jakarta, Shanghai, and Mumbai. Judging from the activity at this busy McDonald’s, incomes are rising in Jakarta, Indonesia ➤➤ ➤ Goods are substitutes when the cross-price elasticity of demand is positive. Goods are complements when the cross-price elasticity of demand is negative. ➤ Inferior goods have a negative income elasticity of demand. Most goods are normal goods, which have a positive income elasticity of demand. ➤ Normal goods may be either income-elastic, with an income elasticity of demand greater than 1, or income-inelastic, with an income elasticity of demand that is positive but less than 1. There is one clear example of an inferior good found in the surveys: rental housing. Families with higher income actually spend less on rent than families with lower income, because they are much more likely to own their own homes. And the category identified as “other housing”—which basically means second homes—is highly income-elastic. Only higher-income families can afford a vacation home at all, so “other housing” has an income elasticity of demand greater than 1. ▲ < < < < < < < < < < < < ➤ CHECK YOUR UNDERSTANDING 6-3 1. After Chelsea’s income increased from $12,000 to $18,000 a year, her purchases of CDs increased from 10 to 40 CDs a year. Calculate Chelsea’s income elasticity of demand for CDs using the midpoint method. 2. Expensive restaurant meals are income-elastic goods for most people, including Sanjay. Suppose his income falls by 10% this year. What can you predict about the change in Sanjay’s consumption of expensive restaurant meals? 3. As the price of margarine rises by 20%, a manufacturer of baked goods increases its quantity of butter demanded by 5%. Calculate the cross-price elasticity of demand between butter and margarine. Are butter and margarine substitutes or complements for this manufacturer? Solutions appear at back of book. The Price Elasticity of Supply In the wake of the flu vaccine shortfall of 2004, attempts by vaccine distributors to drive up the price of vaccines would have been much less effective if a higher price had induced a large increase in the output of flu vaccines by flu vaccine manufacturers 159 The price elasticity of supply is a measure of the responsiveness of the quantity of a good supplied to the price of that good. It is the ratio of the percent change in the quantity supplied to the percent change in the price as we move along the supply curve. other than Chiron. In fact, if the rise in price had precipitated a significant increase in flu vaccine production, the price would have been pushed back down. But that didn’t happen because, as we mentioned earlier, it would have been far too costly and technically difficult to produce more vaccine for the 2004–2005 flu season. (In reality, the production of flu vaccine is begun a year before it is to be distributed.) This was another critical element in the ability of some flu vaccine distributors, like Med-Stat, to get significantly higher prices for their product: a low responsiveness in the quantity of output supplied to the higher price of flu vaccine by flu vaccine producers. To measure the response of producers to price changes, we need a measure parallel to the price elasticity of demand—the price elasticity of supply. Measuring the Price Elasticity of Supply The price elasticity of supply is defined the same way as the price elasticity of demand (although there is no minus sign to be eliminated here): (6-9) Price elasticity of supply = % change in quantity supplied % change in price The only difference is that here we consider movements along the supply curve rather than movements along the demand curve. Suppose that the price of tomatoes rises by 10%. If the quantity of tomatoes supplied also increases by 10% in response, the price elasticity of supply of tomatoes is 1 (10%/10%) and supply is unit-elastic. If the quantity supplied increases by 5%, the price elasticity of supply is 0.5 and supply is inelastic; if the quantity increases by 20%, the price elasticity of supply is 2 and supply is elastic. As in the case of demand, the extreme values of the price elasticity of supply have a simple graphical representation. Panel (a) of Figure 6-6 shows the supply of cell phone frequencies, the portion of the radio spectrum that is suitable for sending and receiving cell phone signals. Governments own the right to sell the use of this part FIGURE 6-6 Two Extreme Cases of Price Elasticity of Supply (a) Perfectly Inelastic Supply: Price Elasticity of Supply = 0 (b) Perfectly Elastic Supply: Price Elasticity of Supply = ∞∞ Price of cell phone frequency S1 An increase in price . . . $3,000 2,000 Price of pizza At any price above $12, quantity supplied is infinite. $12 At any price below $12, quantity supplied is zero. . . . leaves the quantity supplied unchanged. At exactly $12, producers will produce any quantity. S2 0 100 Quantity of cell phone frequencies 0 Quantity of pizzas Panel (a) shows a perfectly inelastic supply curve, which is a vertical line. The price elasticity of supply is zero: the quantity sup
plied is always the same, regardless of price. Panel (b) shows a perfectly elastic supply curve, which is a horizontal line. At a price of $12, producers will supply any quantity, but they will supply none at a price below $12. If price rises above $12, they will supply an extremely large quantity. 160 P A R T 2 S U P P LY A N D D E M A N D There is perfectly inelastic supply when the price elasticity of supply is zero, so that changes in the price of the good have no effect on the quantity supplied. A perfectly inelastic supply curve is a vertical line. There is perfectly elastic supply when even a tiny increase or reduction in the price will lead to very large changes in the quantity supplied, so that the price elasticity of supply is infinite. A perfectly elastic supply curve is a horizontal line. of the radio spectrum to cell phone operators inside their borders. But governments can’t increase or decrease the number of cell phone frequencies that they have to offer—for technical reasons, the quantity of frequencies suitable for cell phone operation is a fixed quantity. So the supply curve for cell phone frequencies is a vertical line, which we have assumed is set at the quantity of 100 frequencies. As you move up and down that curve, the change in the quantity supplied by the government is zero, whatever the change in price. So panel (a) illustrates a case in which the price elasticity of supply is zero. This is a case of perfectly inelastic supply. Panel (b) shows the supply curve for pizza. We suppose that it costs $12 to produce a pizza, including all opportunity costs. At any price below $12, it would be unprofitable to produce pizza and all the pizza parlors in America would go out of business. Alternatively, there are many producers who could operate pizza parlors if they were profitable. The ingredients—flour, tomatoes, cheese—are plentiful. And if necessary, more tomatoes could be grown, more milk could be produced to make mozzarella, and so on. So any price above $12 would elicit an extremely large quantity of pizzas supplied. The implied supply curve is therefore a horizontal line at $12. Since even a tiny increase in the price would lead to a huge increase in the quantity supplied, the price elasticity of supply would be more or less infinite. This is a case of perfectly elastic supply. As our cell phone frequencies and pizza examples suggest, real-world instances of both perfectly inelastic and perfectly elastic supply are easy to find—much easier than their counterparts in demand. What Factors Determine the Price Elasticity of Supply? Our examples tell us the main determinant of the price elasticity of supply: the availability of inputs. In addition, as with the price elasticity of demand, time may also play a role in the price elasticity of supply. Here we briefly summarize the two factors. The Availability of Inputs The price elasticity of supply tends to be large when inputs are readily available and can be shifted into and out of production at a relatively low cost. It tends to be small when inputs are difficult to obtain—and can be shifted into and out of production only at a relatively high cost. Time The price elasticity of supply tends to grow larger as producers have more time to respond to a price change. This means that the long-run price elasticity of supply is often higher than the short-run elasticity. (In the case of the flu vaccine shortfall, time was the crucial element because flu vaccine must be grown in cultures over many months.) The price elasticity of pizza supply is very high because the inputs needed to expand the industry are readily available. The price elasticity of cell phone frequencies is zero because an essential input—the radio spectrum—cannot be increased at all. Many industries are like pizza and have large price elasticities of supply: they can be readily expanded because they don’t require any special or unique resources. On the other hand, the price elasticity of supply is usually substantially less than perfectly elastic for goods that involve limited natural resources: minerals like gold or copper, agricultural products like coffee that flourish only on certain types of land, and renewable resources like ocean fish that can only be exploited up to a point without destroying the resource. But given enough time, producers are often able to significantly change the amount they produce in response to a price change, even when production involves 161 ➤➤ ➤ The price elasticity of supply is the percent change in the quantity supplied divided by the percent change in the price. ➤ Under perfectly inelastic supply, the quantity supplied is completely unresponsive to price and the supply curve is a vertical line. Under perfectly elastic supply, the supply curve is horizontal at some specific price. If the price falls below that level, the quantity supplied is zero. If the price rises above that level, the quantity supplied is infinite. ➤ The price elasticity of supply depends on the availability of inputs, the ease of shifting inputs into and out of alternative uses, and on the period of time that has elapsed since the price change. a limited natural resource. For example, consider again the effects of a surge in flu vaccine prices, but this time focus on the supply response. If the price were to rise to $90 per vaccination and stay there for a number of years, there would almost certainly be a substantial increase in flu vaccine production. Producers such as Chiron would eventually respond by increasing the size of their manufacturing plants, hiring more lab technicians, and so on. But significantly enlarging the capacity of a biotech manufacturing lab takes several years, not weeks or months or even a single year. For this reason, economists often make a distinction between the short-run elasticity of supply, usually referring to a few weeks or months, and the long-run elasticity of supply, usually referring to several years. In most industries, the longrun elasticity of supply is larger than the short-run elasticity. L D VIE W R W O W E ➤ECONOMICS IN ACTION European Farm Surpluses One of the policies we analyzed in Chapter 5 was the imposition of a price floor, a lower limit below which price of a good could not fall. We saw that price floors are often used by governments to support the incomes of farmers but create large unwanted surpluses of farm products. The most dramatic example of this is found in the European Union, where price floors have created a “butter mountain,” a “wine lake,” and so on. VIEW WOR O R L D L W V D I Were European politicians unaware that their price floors would create huge surpluses? They probably knew that surpluses would arise but underestimated the price elasticity of agricultural supply. In fact, when the agricultural price supports were put in place, many analysts thought they were unlikely to lead to big increases in production. After all, European countries are densely populated and there was little new land available for cultivation. What the analysts failed to realize, however, was how much farm production could expand by adding other resources, especially fertilizer and pesticides which were readily available. So although European farm acreage didn’t increase much in response to the imposition of price floors, European farm production did! ▲ > > > > > > > > > > > > ➤ CHECK YOUR UNDERSTANDING 6-4 1. Using the midpoint method, calculate the price elasticity of supply for web-design services when the price per hour rises from $100 to $150 and the number of hours transacted increases from 300,000 hours to 500,000. Is supply elastic, inelastic, or unit-elastic? 2. True or false? If the demand for milk rose, then, in the long run, milk-drinkers would be better off if supply was elastic rather than inelastic. 3. True or false? Long-run price elasticities of supply are generally larger than short-run price elasticities of supply. As a result, the short-run supply curves are generally flatter than the long-run supply curves. 4. True or false? When supply is perfectly elastic, changes in demand have no effect on price. Solutions appear at back of book. An Elasticity Menagerie We’ve just run through quite a few different elasticities. Keeping them all straight can be a challenge. So in Table 6-3 on the next page we provide a summary of all the elasticities we have discussed and their implications. 162 P A R T 2 S U P P LY A N D D E M A N D TABLE 6-3 An Elasticity Menagerie Name Possible values Significance Price elasticity of demand = % change in quantity demanded % change in price (dropping the minus sign) Perfectly inelastic demand 0 Price has no effect on quantity demanded (vertical demand curve). Inelastic demand Between 0 and 1 A rise in price increases total revenue. Unit-elastic demand Exactly 1 Elastic demand Perfectly elastic demand Greater than 1, less than ∞ ∞ Changes in price have no effect on total revenue. A rise in price reduces total revenue. A rise in price causes quantity demanded to fall to 0. A fall in price leads to an infinite quantity demanded (horizontal demand curve). Cross-price elasticity of demand = % change in quantity of one good demanded % change in price of another good Complements Negative Substitutes Positive Quantity demanded of one good falls when the price of another rises. Quantity demanded of one good rises when the price of another rises. Income elasticity of demand = % change in quantity demanded % change in income Inferior good Normal good, income-inelastic Negative Positive, less than 1 Normal good, income-elastic Greater than 1 Quantity demanded falls when income rises. Quantity demanded rises when income rises, but not as rapidly as income. Quantity demanded rises when income rises, and more rapidly than income. Price elasticity of supply = % change in quantity supplied % change in price Perfectly inelastic supply 0 Perfectly elastic supply Greater than 0, less than ∞ ∞ Price has no effect
on quantity supplied (vertical supply curve). Ordinary upward-sloping supply curve. Any fall in price causes quantity supplied to fall to 0. Any rise in price elicits an infinite quantity supplied (horizontal supply curve). [➤➤ A LOOK AHEAD ••• The concept of elasticity deepens our understanding of supply and demand, helping us to predict changes in equilibrium prices and quantities in response to events. For example, we now know why vaccine distributors could significantly raise the market price of flu vaccine during the 2004–2005 flu season—because both supply and demand for flu vaccine were inelastic. Using the concept of income elasticity, we’ve also learned how changes in the incomes of consumers affect the demand for a good. With this we can explain why you’d rather be a fast-food producer than a farmer in a country where incomes are growing quickly. But there is even more to learn with the help of elasticities. In the next chapter, we’ll see that elasticities are vitally important for tax policy: in determining how much revenue is gained by imposing a tax, in determining who actually pays the cost of the tax, and in predicting how much inefficiency is caused by a tax.] 163 the good is a necessity or a luxury, the share of income spent on the good, and the length of time that has elapsed since the price change. 6. The cross-price elasticity of demand measures the effect of a change in one good’s price on the quantity of another good demanded. The cross-price elasticity of demand can be positive, in which case the goods are substitutes, or negative, in which case they are complements. 7. The income elasticity of demand is the percent change in the quantity of a good demanded when a consumer’s income changes divided by the percent change in income. The income elasticity of demand indicates how intensely the demand for a good responds to changes in income. It can be negative; in that case the good is an inferior good. Goods with positive income elasticities of demand are normal goods. If the income elasticity is greater than 1, a good is incomeelastic; if it is positive and less than 1, the good is income-inelastic. 8. The price elasticity of supply is the percent change in the quantity of a good supplied divided by the percent change in the price. If the quantity supplied does not change at all, we have an instance of perfectly inelastic supply; the supply curve is a vertical line. If the quantity supplied is zero below some price but infinite above that price, we have an instance of perfectly elastic supply; the supply curve is a horizontal line. 9. The price elasticity of supply depends on the availability of resources to expand production and on time. It is higher when inputs are available at relatively low cost and the longer the time elapsed since the price change. S U M M A R Y 1. Many economic questions depend on the size of consumer or producer responses to changes in prices or other variables. Elasticity is a general measure of responsiveness that can be used to answer such questions. 2. The price elasticity of demand—the percent change in the quantity demanded divided by the percent change in the price (dropping the minus sign)—is a measure of the responsiveness of the quantity demanded to changes in the price. In practical calculations, it is usually best to use the midpoint method, which calculates percent changes in prices and quantities based on the average of starting and final values. 3. The responsiveness of the quantity demanded to price can range from perfectly inelastic demand, where the quantity demanded is unaffected by the price, to perfectly elastic demand, where there is a unique price at which consumers will buy as much or as little as they are offered. When demand is perfectly inelastic, the demand curve is a vertical line; when it is perfectly elastic, the demand curve is a horizontal line. 4. The price elasticity of demand is classified according to whether it is more or less than 1. If it is greater than 1, demand is elastic; if it is less than 1, demand is inelastic; if it is exactly 1, demand is unit-elastic. This classification determines how total revenue, the total value of sales, changes when the price changes. If demand is elastic, total revenue falls when the price increases and rises when the price decreases. If demand is inelastic, total revenue rises when the price increases and falls when the price decreases. 5. The price elasticity of demand depends on whether there are close substitutes for the good in question, whether K E Y T E R M S Price elasticity of demand, p. 144 Inelastic demand, p. 149 Midpoint method, p. 146 Unit-elastic demand, p. 149 Perfectly inelastic demand, p. 148 Total revenue, p. 150 Income-elastic demand, p. 157 Income-inelastic demand, p. 157 Price elasticity of supply, p. 159 Perfectly elastic demand, p. 149 Cross-price elasticity of demand, p. 155 Perfectly inelastic supply, p. 160 Elastic demand, p. 149 Income elasticity of demand, p. 156 Perfectly elastic supply, p. 160 164 P A R T 2 S U P P LY . Nile.com, the online bookseller, wants to increase its total revenue. One strategy is to offer a 10% discount on every book it sells. Nile.com knows that its customers can be divided into two distinct groups according to their likely responses to the discount. The accompanying table shows how the two groups respond to the discount. Volume of sales before the 10% discount Volume of sales after the 10% discount Group A (sales per week) Group B (sales per week) 1.55 million 1.50 million 1.65 million 1.70 million a. Using the midpoint method, calculate the price elasticities of demand for group A and group B. b. Explain how the discount will affect total revenue from each group. c. Suppose Nile.com knows which group each customer belongs to when he or she logs on and can choose whether or not to offer the 10% discount. If Nile.com wants to increase its total revenue, should discounts be offered to group A or to group B, to neither group, or to both groups? 2. Do you think the price elasticity of demand for Ford sportutility vehicles (SUVs) will increase, decrease, or remain the same when each of the following events occurs? Explain your answer. a. Other car manufacturers, such as General Motors, decide to make and sell SUVs. b. SUVs produced in foreign countries are banned from the American market. a. Using the midpoint method, calculate the price elasticity of demand for winter wheat. b. What is the total revenue for U.S. wheat farmers in 1998 and 1999? c. Did the bumper harvest increase or decrease the total revenue of American wheat farmers? How could you have predicted this from your answer to part a? 4. The accompanying table gives part of the supply schedule for personal computers in the United States. Price of computer $1,100 900 Quantity of computers supplied 12,000 8,000 a. Calculate the price elasticity of supply when the price increases from $900 to $1,100 using the midpoint method. b. Suppose firms produce 1,000 more computers at any given price due to improved technology. As price increases from $900 to $1,100, is the price elasticity of supply now greater than, less than, or the same as it was in part a? c. Suppose a longer time period under consideration means that the quantity supplied at any given price is 20% higher than the figures given in the table. As price increases from $900 to $1,100, is the price elasticity of supply now greater than, less than, or the same as it was in part a? 5. The accompanying table lists the cross-price elasticities of demand for several goods, where the percent quantity change is measured for the first good of the pair, and the percent price change is measured for the second good. c. Due to ad campaigns, Americans believe that SUVs are much safer than ordinary passenger cars. Good Cross-price elasticities of demand d. The time period over which you measure the elasticity lengthens. During that longer time, new models such as four-wheel-drive cargo vans appear. 3. U.S. winter wheat production increased dramatically in 1999 after a bumper harvest. The supply curve shifted rightward; as a result, the price decreased and the quantity demanded increased (a movement along the demand curve). The accompanying table describes what happened to prices and the quantity of wheat demanded. 1998 1999 Quantity demanded (bushels) 1.74 billion 1.9 billion Average price (per bushel) $3.70 $2.72 Air-conditioning units and kilowatts of electricity Coke and Pepsi High-fuel-consuming sport-utility vehicles (SUVs) and gasoline McDonald’s burgers and Burger King burgers Butter and margarine −0.34 +0.63 −0.28 +0.82 +1.54 a. Explain the sign of each of the cross-price elasticities. What does it imply about the relationship between the two goods in question? b. Compare the absolute values of the cross-price elasticities and explain their magnitudes. For example, why is the cross-price elasticity of McDonald’s burgers and Burger King burgers less than the cross-price elasticity of butter and margarine? c. Use the information in the table to calculate how a 5% increase in the price of Pepsi affects the quantity of Coke demanded. d. Use the information in the table to calculate how a 10% decrease in the price of gasoline affects the quantity of SUVs demanded. 6. What can you conclude about the price elasticity of demand in each of the following statements? a. “The pizza delivery business in this town is very competitive. I’d lose half my customers if I raised the price by as little as 10%.” b. “I owned both of the two Jerry Garcia autographed litho- graphs in existence. I sold one on eBay for a high price. But when I sold the second one, the price dropped by 80%.” c. “My economics professor has chosen to use the Krugman/Wells textbook for this class. I have no choice but to buy this book.” d. “I always spend a total of exactly $10 per week on coffee.” 7. Take a linear demand curve like that shown in Figure 6-5, where the range of p
rices for which demand is elastic and inelastic is labeled. In each of the following scenarios, the supply curve shifts. Show along which portion of the demand curve (that is, the elastic or the inelastic portion) the supply curve must have shifted in order to generate the event described. In each case, show on the diagram the quantity effect and the price effect. a. Recent attempts by the Colombian army to stop the flow of illegal drugs into the United States have actually benefited drug dealers. b. New construction increased the number of seats in the football stadium and resulted in greater total revenue from box-office ticket sales. c. A fall in input prices has led to higher output of Porsches. But total revenue for the Porsche Company has declined as a result. 8. The accompanying table shows the price and yearly quantity sold of souvenir T-shirts in the town of Crystal Lake according to the average income of the tourists visiting. Quantity of T-shirts demanded when average tourist income is $20,000 Quantity of T-shirts demanded when average tourist income is $30,000 Price of T-shirt $4 5 6 7 3,000 2,400 1,600 800 5,000 4,200 3,000 1,800 a. Using the midpoint method, calculate the price elasticity of demand when the price of a T-shirt rises from $5 to $6 and the average tourist income is $20,000. Also calculate it when the average tourist income is $30,000. b. Using the midpoint method, calculate the income elasticity of demand when the price of a T-shirt is $4 and the average tourist income increases from $20,000 to $30,000. Also calculate it when the price is $7 165 9. A recent study determined the following elasticities for Volkswagen Beetles: Price elasticity of demand = 2 Income elasticity of demand = 1.5 The supply of Beetles is elastic. Based on this information, are the following statements true or false? Explain your reasoning. a. A 10% increase in the price of a Beetle will reduce the quantity demanded by 20%. b. An increase in consumer income will increase the price and quantity of Beetles sold. Since price elasticity of demand is greater than 1, total revenue will go down. 10. In each of the following cases, do you think the price elasticity of supply is (i) perfectly elastic; (ii) perfectly inelastic; (iii) elastic, but not perfectly elastic; or (iv) inelastic, but not perfectly inelastic? Explain using a diagram. a. An increase in demand this summer for luxury cruises leads to a huge jump in the sales price of a cabin on the Queen Mary 2. b. The price of a kilowatt of electricity is the same during periods of high electricity demand as during periods of low electricity demand. c. Fewer people want to fly during February than during any other month. The airlines cancel about 10% of their flights as ticket prices fall about 20% during this month. d. Owners of vacation homes in Maine rent them out during the summer. Due to the soft economy this year, a 30% decline in the price of a vacation rental leads more than half of homeowners to occupy their vacation homes themselves during the summer. 11. Use an elasticity concept to explain each of the following observations. a. During economic booms, the number of new personal care businesses, such as gyms and tanning salons, is proportionately greater than the number of other new businesses, such as grocery stores. b. Cement is the primary building material in Mexico. After new technology makes cement cheaper to produce, the supply curve for the Mexican cement industry becomes relatively flatter. c. Some goods that were once considered luxuries, like a telephone, are now considered virtual necessities. As a result, the demand curve for telephone services has become steeper over time. d. Consumers in a less developed country like Guatemala spend proportionately more of their income on equipment for producing things at home, like sewing machines, than consumers in a more developed country like Canada. 12. Taiwan is a major world supplier of semiconductor chips. A recent earthquake severely damaged the production facilities of Taiwanese chip-producing companies, sharply reducing the amount of chips they could produce. a. Assume that the total revenue of a typical non-Taiwanese chip manufacturer rises due to these events. In terms of an elasticity, what must be true for this to happen? 166 P A R T 2 S U P P LY A N D D E M A N D Illustrate the change in total revenue with a diagram, indicating the price effect and the quantity effect of the Taiwan earthquake on this company’s total revenue. b. Now assume that the total revenue of a typical non- Taiwanese chip manufacturer falls due to these events. In terms of an elasticity, what must be true for this to happen? Illustrate the change in total revenue with a diagram, indicating the price effect and the quantity effect of the Taiwan earthquake on this company’s total revenue. 13. There is a debate about whether sterile hypodermic needles should be passed out free of charge in cities with high drug use. Proponents argue that doing so will reduce the incidence of diseases, such as HIV/AIDS, that are often spread by needle sharing among drug users. Opponents believe that doing so will encourage more drug use by reducing the risks of this behavior. As an economist asked to assess the policy, you must know the following: (i) how responsive the spread of diseases like HIV/AIDS is to the price of sterile needles and (ii) how responsive drug use is to the price of sterile needles. Assuming that you know these two things, use the concepts of price elasticity of demand for sterile needles and the cross-price elasticity between drugs and sterile needles to answer the following questions. a. In what circumstances do you believe this is a beneficial policy? b. In what circumstances do you believe this is a bad policy? 14. Worldwide, the average coffee grower has increased the amount of acreage under cultivation over the past few years. The result has been that the average coffee plantation produces significantly more coffee than it did 10 to 20 years ago. Unfortunately for the growers, however, this has also been a period in which their total revenues have plunged. In terms of an elasticity, what must be true for these events to have occurred? Illustrate these events with a diagram, indicating the quantity effect and the price effect that gave rise to these events. www.worthpublishers.com/krugmanwells 15. A recent report by the U.S. Centers for Disease Control and Prevention (CDC), published in the CDC’s Morbidity and Mortality Weekly Report, studied the effect of an increase in the price of beer on the incidence of new cases of sexually transmitted disease in young adults. In particular, the researchers analyzed the responsiveness of gonorrhea cases to a taxinduced increase in the price of beer. The report concluded that “the . . . analysis suggested that a beer tax increase of $0.20 per six-pack could reduce overall gonorrhea rates by 8.9%.” Assume that a six-pack costs $5.90 before the price increase. Use the midpoint method to determine the percent increase in the price of a six-pack, and then calculate the cross-price elasticity of demand between beer and incidence of gonorrhea. According to your estimate of this cross-price elasticity of demand, are beer and gonorrhea complements or substitutes? 16. The U.S. government is considering reducing the amount of carbon dioxide that firms are allowed to produce by issuing a limited number of tradable allowances for carbon dioxide (CO2) emissions. In an April 25, 2007, report, the U.S. Congressional Budget Office (CBO) argues that “most of the cost of meeting a cap on CO2 emissions would be borne by consumers, who would face persistently higher prices for products such as electricity and gasoline . . . poorer households would bear a larger burden relative to their income than wealthier households would.” What assumption about one of the elasticities you learned about in this chapter has to be true for poorer households to be disproportionately affected? 17. According to a Honda press release on October 23, 2006, sales of the fuel-efficient four-cylinder Honda Civic rose by 7.1% from 2005 to 2006. Over the same period, according to data from the U.S. Energy Information Administration, the average price of regular gasoline rose from $2.27 per gallon to $2.57 per gallon. Using the midpoint method, calculate the crossprice elasticity of demand between Honda Civics and regular gasoline. According to your estimate of the cross-price elasticity, are the two goods complements or substitutes? Does your answer make sense? chapter: 7 L D VIE W R W O >> Taxes A TA X R I O T O N MARCH 31, 1990, HUNDREDS OF THOUSANDS of British citizens marched across London, protesting a new tax that had been introduced by Prime Minister Margaret Thatcher. As some protesters W E I V D L VIEWWOR W O R L D payment from each individual over the age of 18. Although the amount of the poll tax varied from town to town, every adult in a given town owed the same amount, regardless of income or the value of his or her property. clashed with police, the initially peaceful demonstration Supporters of the poll tax argued that it was more effi- turned into a riot, with hundreds injured. The violence cient than the tax it replaced. Because the old tax came as a surprise, but maybe it shouldn’t have: the tax depended on the value of property, it discouraged people had aroused angry opposition throughout Britain. Later both from buying more expensive homes and from that year, Mrs. Thatcher was forced to resign, and many improving the homes they had. Supporters also argued observers believed that the tax controversy was the pri- that the poll tax was fair, because the cost of providing mary cause of her fall. local public services depended mainly on how many peo- The tax at issue was officially known as the ple lived in a town, not on how rich those people were. “Community Charge” but was popularly known as the But op
ponents argued that the poll tax was extremely “poll tax.” Until 1989 local public services like street unfair because it did not take into account differences in cleaning and trash collection had been financed with people’s ability to pay—a single mother who worked as a “the rates,” a tax that depended on the value of a person’s waitress and a millionaire stockbroker owed the same home. (Most local services in the United States are amount if they lived in the same town. financed with similar property-based taxes.) Mrs. One moral of this story is that making tax policy isn’t Thatcher, however, replaced these property taxes with a easy—in fact, if you are a politician, it can be dangerous Margaret Thatcher and these protesters differed sharply over the fairness of the poll tax 167 168 to your professional health. But the story also illustrates one principle used for guiding tax policy is efficiency: taxes some crucial issues in tax policy—issues that economic should be designed to distort incentives as little as possible. models help clarify. But efficiency is not the only concern when designing tax Taxes are necessary: all governments need money to rates. As the British government learned from the poll tax function. Without taxes, governments could not provide riot, it’s also important that a tax be seen as fair. Tax poli- the services we want, from national defense to public parks. cy always involves striking a balance between the pursuit of But taxes have a cost that normally exceeds the money efficiency and the pursuit of perceived fairness. actually paid to the government. That’s because taxes dis- In this chapter, we will look at the economics of tax tort incentives to engage in mutually beneficial transac- policy and show how attempts to make the best of the tions. For example, as mentioned above, Britain’s “rates” trade-off between efficiency and fairness influence the discouraged homeowners from improving their homes. So design of actual tax systems. WHAT YOU WILL LEARN IN THIS CHAPTER: ➤ The effects of taxes on supply and ➤ The costs and benefits of taxes, ➤ The difference between progressive and demand ➤ What determines who really bears the burden of a tax and why taxes impose a cost that is larger than the tax revenue they raise regressive taxes and the trade-off between tax equity and tax efficiency. ➤ The structure of the U.S. tax system The Economics of Taxes: A Preliminary View To understand the economics of taxes, it’s helpful to look at a simple type of tax known as an excise tax—a tax charged on each unit of a good or service that is sold. Most tax revenue in the United States comes from other kinds of taxes, which we’ll describe later in this chapter. But excise taxes are common. For example, there are excise taxes on gasoline, cigarettes, and foreign-made trucks, and many local governments impose excise taxes on services such as hotel room rentals. The lessons we’ll learn from studying excise taxes apply to other, more complex taxes as well. The Effect of an Excise Tax on Quantities and Prices Suppose that the supply and demand for hotel rooms in the city of Potterville are as shown in Figure 7-1. We’ll make the simplifying assumption that all hotel rooms are the same. In the absence of taxes, the equilibrium price of a room is $80 per night and the equilibrium quantity of hotel rooms rented is 10,000 per night. Now suppose that Potterville’s government imposes an excise tax of $40 per night on hotel rooms—that is, every time a room is rented for the night, the owner of the hotel must pay the city $40. For example, if a customer pays $80, $40 is collected as a tax, leaving the hotel owner with only $40. As a result, hotel owners are less willing to supply rooms at any given price. What does this imply about the supply curve for hotel rooms in Potterville? To answer this question, we must compare the incentives of hotel owners pre-tax (before the tax is levied) to their incentives post-tax (after the tax is levied). From Figure 7-1 we know that pre-tax, hotel owners are willing to supply 5,000 rooms per night at a price of $60 per room. But after the $40 tax per room is levied, they are willing to supply the same amount, 5,000 rooms, only if they receive $100 per room—$60 for themselves plus $40 paid to the city as tax. In other words, in order for hotel owners to be willing to supply the same quantity post-tax as they would have pre-tax, they must receive an additional $40 per room, the amount of the tax. This implies that the posttax supply curve shifts up by the amount of the tax compared to the pre-tax supply An excise tax is a tax on sales of a good or service. FIGURE 7-1 The Supply and Demand for Hotel Rooms in Potterville Price of hotel room In the absence of taxes, the equilibrium price of hotel rooms is $80 a night, and the equilibrium number of rooms rented is 10,000 per night, as shown by point E. The supply curve, S, shows the quantity supplied at any given price, pre-tax. At a price of $60 a night, hotel owners are willing to supply 5,000 rooms, point B. But post-tax, hotel owners are willing to supply the same quantity only at a price of $100: $60 for themselves plus $40 paid to the city as tax. Equilibrium price $140 120 100 80 60 40 20 0 C H A P T E R 7 TA X E S 169 E B S D 5,000 10,000 Equilibrium quantity 15,000 Quantity of hotel rooms curve. At every quantity supplied, the supply price—the price that producers must receive to produce a given quantity—has increased by $40. The upward shift of the supply curve caused by the tax is shown in Figure 7-2, where S1 is the pre-tax supply curve and S2 is the post-tax supply curve. As you can see, the market equilibrium moves from E, at the equilibrium price of $80 per room and 10,000 rooms rented each night, to A, at a market price of $100 per room and only 5,000 rooms rented each night. A is, of course, on both the demand curve D and FIGURE 7-2 An Excise Tax Imposed on Hotel Owners Price of hotel room A $40 per room tax imposed on hotel owners shifts the supply curve from S1 to S2, an upward shift of $40. The equilibrium price of hotel rooms rises from $80 to $100 a night, and the equilibrium quantity of rooms rented falls from 10,000 to 5,000. Although hotel owners pay the tax, they actually bear only half the burden: the price they receive net of tax falls only $20, from $80 to $60. Guests who rent rooms bear the other half of the burden, because the price they pay rises by $20, from $80 to $100. Excise tax = $40 per room $140 120 100 80 60 40 20 0 Supply curve shifts upward by the amount of the tax. A B E S2 S1 D 5,000 10,000 15,000 Quantity of hotel rooms 170 the new supply curve S2. In this case, $100 is the demand price of 5,000 rooms—but in effect hotel owners receive only $60, when you account for the fact that they have to pay the $40 tax. From the point of view of hotel owners, it is as if they were on their original supply curve at point B. Let’s check this again. How do we know that 5,000 rooms will be supplied at a price of $100? Because the price net of tax is $60, and according to the original supply curve, 5,000 rooms will be supplied at a price of $60, as shown by point B in Figure 7-2. Does this look familiar? It should. In Chapter 5 we described the effects of a quota on sales: a quota drives a wedge between the price paid by consumers and the price received by producers. An excise tax does the same thing. As a result of this wedge, consumers pay more and producers receive less. In our example, consumers—people who rent hotel rooms—end up paying $100 a night, $20 more than the pre-tax price of $80. At the same time, producers—the hotel owners—receive a price net of tax of $60 per room, $20 less than the pre-tax price. In addition, the tax creates missed opportunities: 5,000 potential consumers who would have rented hotel rooms—those willing to pay $80 but not $100 per night—are discouraged from renting rooms. Correspondingly, 5,000 rooms that would have been made available by hotel owners when they receive $80 are not offered when they receive only $60. Like a quota, this tax leads to inefficiency by distorting incentives and creating missed opportunities for mutually beneficial transactions. It’s important to recognize that as we’ve described it, Potterville’s hotel tax is a tax on the hotel owners, not their guests—it’s a tax on the producers, not the consumers. Yet the price received by producers, net of tax, is down by only $20, half the amount of the tax, and the price paid by consumers is up by $20. In effect, half the tax is being paid by consumers. What would happen if the city levied a tax on consumers instead of producers? That is, suppose that instead of requiring hotel owners to pay $40 a night for each room they rent, the city required hotel guests to pay $40 for each night they stayed in a hotel. The answer is shown in Figure 7-3. If a hotel guest must pay a tax of $40 per night, then the price for a room paid by that guest must be reduced by $40 in order for the quantity of hotel rooms demanded post-tax to be the same as that demanded pre-tax. So the demand curve shifts downward, from D1 to D2, by the amount of the tax. At every quantity demanded, the demand price—the price that consumers must be offered FIGURE 7-3 An Excise Tax Imposed on Hotel Guests A $40 per room tax imposed on hotel guests shifts the demand curve from D1 to D2, a downward shift of $40. The equilibrium price of hotel rooms falls from $80 to $60 a night, and the quantity of rooms rented falls from 10,000 to 5,000. Although in this case the tax is officially paid by consumers, while in Figure 7-2 the tax was paid by producers, the outcome is the same: after taxes, hotel owners receive $60 per room but guests pay $100. This illustrates a general principle: The incidence of an excise tax doesn’t depend on whether consumers or producers officially pay the tax. Price of hotel room Excise tax = $40 per room $140 120 100 80 60 40 20
0 Demand curve shifts downward by the amount of the tax. E A B S D1 D2 5,000 10,000 15,000 Quantity of hotel rooms C H A P T E R 7 TA X E S 171 The incidence of a tax is a measure of who really pays it. to demand a given quantity—has fallen by $40. This shifts the equilibrium from E to B, where the market price of hotel rooms is $60 and 5,000 hotel rooms are bought and sold. In effect, hotel guests pay $100 when you include the tax. So from the point of view of guests, it is as if they were on their original demand curve at point A. If you compare Figures 7-2 and 7-3, you will immediately notice that they show the same price effect. In each case, consumers pay an effective price of $100, producers receive an effective price of $60, and 5,000 hotel rooms are bought and sold. In fact, it doesn’t matter who officially pays the tax—the equilibrium outcome is the same. This insight illustrates a general principle of the economics of taxation: the incidence of a tax—who really bears the burden of the tax—is typically not a question you can answer by asking who writes the check to the government. In this particular case, a $40 tax on hotel rooms is reflected in a $20 increase in the price paid by consumers and a $20 decrease in the price received by producers. Here, regardless of whether the tax is levied on consumers or producers, the incidence of the tax is evenly split between them. Price Elasticities and Tax Incidence We’ve just learned that the incidence of an excise tax doesn’t depend on who officially pays it. In the example shown in Figures 7-1 through 7-3, a tax on hotel rooms falls equally on consumers and producers, no matter who the tax is levied on. But it’s important to note that this 50–50 split between consumers and producers is a result of our assumptions in this example. In the real world, the incidence of an excise tax usually falls unevenly between consumers and producers: one group bears more of the burden than the other. What determines how the burden of an excise tax is allocated between consumers and producers? The answer depends on the shapes of the supply and the demand curves. More specifically, the incidence of an excise tax depends on the price elasticity of supply and the price elasticity of demand. We can see this by looking first at a case in which consumers pay most of an excise tax, then at a case in which producers pay most of the tax. When an Excise Tax Is Paid Mainly by Consumers Figure 7-4 shows an excise tax that falls mainly on consumers: an excise tax on gasoline, which we set at $1 per gallon. (There really is a federal excise tax on gasoline, though it is actually only about $0.18 per gallon in the United States. In addition, states impose excise taxes between $0.08 and $0.31 per gallon.) According to Figure 7-4, in the absence of the tax, gasoline would sell for $2 per gallon. FIGURE 7-4 An Excise Tax Paid Mainly by Consumers The relatively steep demand curve here reflects a low price elasticity of demand for gasoline. The relatively flat supply curve reflects a high price elasticity of supply. The pre-tax price of a gallon of gasoline is $2.00, and a tax of $1.00 per gallon is imposed. The price paid by consumers rises by $0.95 to $2.95, reflecting the fact that most of the burden of the tax falls on consumers. Only a small portion of the tax is borne by producers: the price they receive falls by only $0.05 to $1.95. Price of gasoline (per gallon) $2.95 Excise tax = $1 per gallon 2.00 1.95 Tax burden falls mainly on consumers. S D 0 Quantity of gasoline (gallons) 172 Two key assumptions are reflected in the shapes of the supply and demand curves in Figure 7-4. First, the price elasticity of demand for gasoline is assumed to be very low, so the demand curve is relatively steep. Recall that a low price elasticity of demand means that the quantity demanded changes little in response to a change in price. Second, the price elasticity of supply of gasoline is assumed to be very high, so the supply curve is relatively flat. A high price elasticity of supply means that the quantity supplied changes a lot in response to a change in price. We have just learned that an excise tax drives a wedge, equal to the size of the tax, between the price paid by consumers and the price received by producers. This wedge drives the price paid by consumers up and the price received by producers down. But as we can see from Figure 7-4, in this case those two effects are very unequal in size. The price received by producers falls only slightly, from $2.00 to $1.95, but the price paid by consumers rises by a lot, from $2.00 to $2.95. This means that consumers bear the greater share of the tax burden. This example illustrates another general principle of taxation: When the price elasticity of demand is low and the price elasticity of supply is high, the burden of an excise tax falls mainly on consumers. Why? A low price elasticity of demand means that consumers have few substitutes and so little alternative to buying higher-priced gasoline. In contrast, a high price elasticity of supply results from the fact that producers have many production substitutes for their gasoline (that is, other uses for the crude oil from which gasoline is refined). This gives producers much greater flexibility in refusing to accept lower prices for their gasoline. And, not surprisingly, the party with the least flexibility—in this case, consumers—gets stuck paying most of the tax. This is a good description of how the burden of the main excise taxes actually collected in the United States today, such as those on cigarettes and alcoholic beverages, is allocated between consumers and producers. When an Excise Tax Is Paid Mainly by Producers Figure 7-5 shows an example of an excise tax paid mainly by producers, a $5.00 per day tax on downtown parking in a small city. In the absence of the tax, the market equilibrium price of parking is $6.00 per day. We’ve assumed in this case that the price elasticity of supply is very low because the lots used for parking have very few alternative uses. This makes the supply curve for parking spaces relatively steep. The price elasticity of demand, however, is assumed to be high: consumers can easily switch from the downtown spaces to other parking spaces a few minutes’ walk from downtown, spaces that are not subject to the tax. This makes the demand curve relatively flat. FIGURE 7-5 An Excise Tax Paid Mainly by Producers The relatively flat demand curve here reflects a high price elasticity of demand for downtown parking, and the relatively steep supply curve results from a low price elasticity of supply. The pre-tax price of a daily parking space is $6.00 and a tax of $5.00 is imposed. The price received by producers falls a lot, to $1.50, reflecting the fact that they bear most of the tax burden. The price paid by consumers rises a small amount, $0.50, to $6.50, so they bear very little of the burden. Price of parking space $6.50 6.00 Excise tax = $5 per parking space 1.50 0 S D Tax burden falls mainly on producers. Quantity of parking spaces C H A P T E R 7 TA X E S 173 The tax drives a wedge between the price paid by consumers and the price received by producers. In this example, however, the tax causes the price paid by consumers to rise only slightly, from $6.00 to $6.50, but the price received by producers falls a lot, from $6.00 to $1.50. In the end, a consumer bears only $0.50 of the $5 tax burden, with a producer bearing the remaining $4.50. Again, this example illustrates a general principle: When the price elasticity of demand is high and the price elasticity of supply is low, the burden of an excise tax falls mainly on producers. A real-world example is a tax on purchases of existing houses. Over the past few years in many American towns, house prices in desirable locations have risen significantly as well-off outsiders move in and purchase homes from the less well-off original occupants, a phenomenon called gentrification. Some of these towns have imposed taxes on house sales intended to extract money from the new arrivals. But this ignores the fact that the price elasticity of demand for houses in a particular town is often high, because potential buyers can choose to move to other towns. Furthermore, the price elasticity of supply is often low because most sellers must sell their houses due to job transfers or to provide funds for their retirement. So taxes on home purchases are actually paid mainly by the less well-off sellers—not, as town officials imagine, by wealthy buyers. Putting It All Together We’ve just seen that when the price elasticity of supply is high and the price elasticity of demand is low, an excise tax falls mainly on consumers. And when the price elasticity of supply is low and the price elasticity of demand is high, an excise tax falls mainly on producers. This leads us to the general rule: When the price elasticity of demand is higher than the price elasticity of supply, an excise tax falls mainly on producers. When the price elasticity of supply is higher than the price elasticity of demand, an excise tax falls mainly on consumers. So elasticity—not who officially pays the tax—determines the incidence of an excise tax. ➤ECONOMICS IN ACTION Who Pays the FICA? Anyone who works for an employer receives a paycheck that itemizes not only the wages paid but also the money deducted from the paycheck for various taxes. For most people, one of the big deductions is FICA, also known as the payroll tax. FICA, which stands for the Federal Insurance Contributions Act, pays for the Social Security and Medicare systems, federal social insurance programs that provide income and medical care to retired and disabled Americans. As of the time of writing, most American workers paid 7.65% of their earnings in FICA. But this is literally only the half of it: each employer is required to pay an amount equal to the contribution of his or her employee. How should we think a
bout FICA? Is it really shared equally by workers and employers? We can use our previous analysis to answer that question because FICA is like an excise tax—a tax on the sale and purchase of labor. Half of it is a tax levied on the sellers—that is, workers. The other half is a tax levied on the buyers—that is, employers. But we already know that the incidence of a tax does not really depend on who actually makes out the check. Almost all economists agree that FICA is a tax actually paid by workers, not by their employers. The reason for this conclusion lies in a comparison of the price elasticities of the supply of labor by households and the demand for labor by firms. Evidence indicates that the price elasticity of demand for labor is quite high, at least 3. That is, an increase in average wages of 1% would lead to at least a 3% decline in the number of hours of work demanded by employers. Labor economists believe, however, that the price elasticity of supply of labor is very low. The reason is that although a fall in the wage rate reduces the incentive to work more hours, it also makes people poorer and less able to afford leisure time. The 174 ➤➤ ➤ An excise tax drives a wedge between the price paid by consumers and that received by producers, leading to a fall in the quantity transacted. It creates inefficiency by distorting incentives and creating missed opportunities. ➤ The incidence of an excise tax doesn’t depend on who the tax is officially levied on. Rather, it depends on the price elasticities of demand and of supply. ➤ The higher the price elasticity of supply and the lower the price elasticity of demand, the heavier the burden of an excise tax on consumers. The lower the price elasticity of supply and the higher the price elasticity of demand, the heavier the burden on producers. Price of butter (per pound) $1.40 1.30 1.20 1.10 1.00 0.90 0.80 0.70 0.60 0 6 strength of this second effect is shown in the data: the number of hours people are willing to work falls very little—if at all—when the wage per hour goes down. Our general rule of tax incidence says that when the price elasticity of demand is much higher than the price elasticity of supply, the burden of an excise tax falls mainly on the suppliers. So the FICA falls mainly on the suppliers of labor, that is, workers— even though on paper half the tax is paid by employers. In other words, the FICA is largely borne by workers in the form of lower wages, rather than by employers in lower profits. This conclusion tells us something important about the American tax system: the FICA, rather than the much-maligned income tax, is the main tax burden on most families. FICA is 15.3% of all wages and salaries up to $102,000 per year (note that 7.65% + 7.65% = 15.3%). That is, the great majority of workers in the United States pay 15.3% of their wages in FICA. Only a minority of American families pay more than 15% of their income in income tax. In fact, according to estimates by the Congressional Budget Office, for more than 70% of families FICA is Uncle Sam’s main bite out of their income. ▲ < < < < < < < < < < < < ➤ CHECK YOUR UNDERSTANDING 7-1 1. Consider the market for butter, shown in the accompanying figure. The government imposes an excise tax of $0.30 per pound of butter. What is the price paid by consumers post-tax? What is the price received by producers post-tax? What is the quantity of butter transacted? How is the incidence of the tax allocated between consumers and producers? Show this on the figure. 2. The demand for economics textbooks is very inelastic, but the supply is somewhat elastic. What does this imply about the incidence of an excise tax? Illustrate with a diagram. S 3. True or false? When a substitute for a good is readily available to E D 8 9 7 11 Quantity of butter (millions of pounds) 14 12 13 10 consumers, but it is difficult for producers to adjust the quantity of the good produced, then the burden of a tax on the good falls more heavily on producers. 4. The supply of bottled spring water is very inelastic, but the demand for it is somewhat elastic. What does this imply about the incidence of a tax? Illustrate with a diagram. 5. True or false? Other things equal, consumers would prefer to face a less elastic supply curve for a good or service when an excise tax is imposed. Solutions appear at back of book. The Benefits and Costs of Taxation When a government is considering whether to impose a tax or how to design a tax system, it has to weigh the benefits of a tax against its costs. We don’t usually think of a tax as something that provides benefits, but governments need money to provide things people want, such as national defense and health care for those unable to afford it. The benefit of a tax is the revenue it raises for the government to pay for these services. Unfortunately, this benefit comes at a cost—a cost that is normally larger than the amount consumers and producers pay. Let’s look first at what determines how much money a tax raises, then at the costs a tax imposes. The Revenue from an Excise Tax How much revenue does the government collect from an excise tax? In our hotel tax example, the revenue is equal to the area of the shaded rectangle in Figure 7-6. To see why this area represents the revenue collected by a $40 tax on hotel rooms, notice that the height of the rectangle is $40, equal to the tax per room. It is also, as C H A P T E R 7 TA X E S 175 FIGURE 7-6 The Revenue from an Excise Tax The revenue from a $40 excise tax on hotel rooms is $200,000, equal to the tax rate, $40—the size of the wedge that the tax drives between the supply price and the demand price—multiplied by the number of rooms rented, 5,000. This is equal to the area of the shaded rectangle. Price of hotel room Excise tax = $40 per room $140 120 100 80 60 40 20 0 Area = tax revenue A B E S D 5,000 10,000 Quantity of hotel rooms 15,000 we’ve seen, the size of the wedge that the tax drives between the supply price (the price received by producers) and the demand price (the price paid by consumers). Meanwhile, the width of the rectangle is 5,000 rooms, equal to the equilibrium quantity of rooms given the $40 tax. With that information, we can make the following calculations. The tax revenue collected is: Tax revenue = $40 per room × 5,000 rooms = $200,000 The area of the shaded rectangle is: Area = Height × Width = $40 per room × 5,000 rooms = $200,000 or, Tax revenue = Area of shaded rectangle This is a general principle: The revenue collected by an excise tax is equal to the area of the rectangle whose height is the tax wedge between the supply and demand curves and whose width is the quantity transacted under the tax. Tax Rates and Revenue In Figure 7-6, $40 per room is the tax rate on hotel rooms. A tax rate is the amount of tax levied per unit of whatever is being taxed. Sometimes tax rates are defined in terms of dollar amounts per unit of a good or service; for example, $2.46 per pack of cigarettes sold. In other cases, they are defined as a percentage of the price; for example, the payroll tax is 15.3% of a worker’s earnings up to $102,000. There’s obviously a relationship between tax rates and revenue. That relationship is not, however, one-for-one. In general, doubling the excise tax rate on a good or service won’t double the amount of revenue collected, because the tax increase will reduce the quantity of the good or service transacted. And the relationship between the level of the tax and the amount of revenue collected may not even be positive: in some cases raising the tax rate actually reduces the amount of revenue the government collects. A tax rate is the amount of tax people are required to pay per unit of whatever is being taxed. 176 We can illustrate these points using our hotel room example. Figure 7-6 showed the revenue the government collects from a $40 tax on hotel rooms. Figure 7-7 shows the revenue the government would collect from two alternative tax rates—a lower tax of only $20 per room and a higher tax of $60 per room. Panel (a) of Figure 7-7 shows the case of a $20 tax, equal to half the tax rate illustrated in Figure 7-6. At this lower tax rate, 7,500 rooms are rented, generating tax revenue of: Tax revenue = $20 per room × 7,500 rooms = $150,000 Recall that the tax revenue collected from a $40 tax rate is $200,000. So the revenue collected from a $20 tax rate, $150,000, is only 75% of the amount collected when the tax rate is twice as high ($150,000/$200,000 × 100 = 75%). To put it another way, a 100% increase in the tax rate from $20 to $40 per room leads to only a one-third, or 33.3%, increase in revenue, from $150,000 to $200,000 (($200,000 − $150,000)/$150,000 × 100 = 33.3%). Panel (b) depicts what happens if the tax rate is raised from $40 to $60 per room, leading to a fall in the number of rooms rented from 5,000 to 2,500. The revenue collected at a $60 per room tax rate is: Tax revenue = $60 per room × 2,500 rooms = $150,000 This is also less than the revenue collected by a $40 per room tax. So raising the tax rate from $40 to $60 actually reduces revenue. More precisely, in this case raising the FIGURE 7-7 Tax Rates and Revenue Price of hotel room $140 120 Excise tax = $20 per room 90 80 70 40 20 0 (a) An excise tax of $20 (b) An excise tax of $60 Price of hotel room Area = tax revenue E S D Excise tax = $60 per room $140 120 110 80 50 40 20 Area = tax revenue E S D 5,000 7,500 10,000 15,000 Quantity of hotel rooms 0 2,500 5,000 10,000 15,000 Quantity of hotel rooms In general, doubling the excise tax rate on a good or service won’t double the amount of revenue collected, because the tax increase will reduce the quantity of the good or service bought and sold. And the relationship between the level of the tax and the amount of revenue collected may not even be positive. Panel (a) shows the revenue raised by a tax rate of $20 per room, only half the tax rate in Figure 7-6. The tax revenue raised,
equal to the area of the shaded rectangle, is $150,000, threequarters as much as the revenue raised by a $40 tax rate. Panel (b) shows that the revenue raised by a $60 tax rate is also $150,000. So raising the tax rate from $40 to $60 actually reduces tax revenue. C H A P T E R 7 TA X E S 177 tax rate by 50% (($60 − $40)/$40 × 100 = 50%) lowers the tax revenue by 25% (($150,000 − $200,000)/$200,000 × 100 = −25%). Why did this happen? It happened because the fall in tax revenue caused by the reduction in the number of rooms rented more than offset the increase in the tax revenue caused by the rise in the tax rate. In other words, setting a tax rate so high that it deters a significant number of transactions is likely to lead to a fall in tax revenue. One way to think about the revenue effect of increasing an excise tax is that the tax increase affects tax revenue in two ways. On one side, the tax increase means that the government raises more revenue for each unit of the good sold, which other things equal would lead to a rise in tax revenue. On the other side, the tax increase reduces the quantity of sales, which other things equal would lead to a fall in tax revenue. The end result depends both on the price elasticities of supply and demand and on the initial level of the tax. If the price elasticities of both supply and demand are low, the tax increase won’t reduce the quantity of the good sold very much, so that tax revenue will definitely rise. If the price elasticities are high, the result is less certain; if they are high enough, the tax reduces the quantity sold so much that tax revenue falls. Also, if the initial tax rate is low, the government doesn’t lose much revenue from the decline in the quantity of the good sold, so the tax increase will definitely increase tax revenue. If the initial tax rate is high, the result is again less certain. Tax revenue is likely to fall or rise very little from a tax increase only in cases where the price elasticities are high and there is already a high tax rate. The possibility that a higher tax rate can reduce tax revenue, and the corresponding possibility that cutting taxes can increase tax revenue, is a basic principle of taxation that policy makers take into account when setting tax rates. That is, when considering a tax created for the purpose of raising revenue (in contrast to taxes created to discourage undesirable behavior, known as “sin taxes”), a well-informed policy maker won’t impose a tax rate so high that cutting the tax would increase revenue. In the real world, policy makers aren’t always well informed, but they usually aren’t complete fools either. That’s why it’s very hard to find real-world examples in which raising a tax reduced revenue or cutting a tax increased revenue. Nonetheless, the theoretical possibility that a tax reduction increases tax revenue has played an important role in the folklore of American politics. As explained in For Inquiring Minds, an economist who, in the 1970s, sketched on a napkin the figure of a revenueincreasing income tax reduction had a significant impact on the economic policies adopted in the United States in the 1980s The Laffer Curve One afternoon in 1974, the economist Arthur Laffer got together in a cocktail lounge with Jude Wanniski, a writer for the Wall Street Journal, and Dick Cheney, who would later become vice president but at the time was the deputy White House chief of staff. During the course of their conversation, Laffer drew a diagram on a napkin that was intended to explain how tax cuts could sometimes lead to higher tax revenue. According to Laffer’s diagram, raising tax rates initially increases revenue, but beyond a certain level revenue falls instead as tax rates continue to rise. That is, at some point tax rates are so high and reduce the number of transactions so greatly that tax revenues fall. There was nothing new about this idea, but in later years that napkin became the stuff of legend. The editors of the Wall Street Journal began promoting the “Laffer curve” as a justification for tax cuts. And when Ronald Reagan took office in 1981, he used the Laffer curve to argue that his proposed cuts in income tax rates would not reduce the federal government’s revenue. So is there a Laffer curve? Yes—as a the- oretical proposition it’s definitely possible that tax rates could be so high that cutting taxes would increase revenue. But very few economists now believe that Reagan’s tax cuts actually increased revenue, and realworld examples in which revenue and tax rates move in opposite directions are very hard to find. That’s because it’s rare to find an existing tax rate so high that reducing it leads to an increase in revenue. 178 The Costs of Taxation What is the cost of a tax? You might be inclined to answer that it is the money taxpayers pay to the government. In other words, you might believe that the cost of a tax is the tax revenue collected. But suppose the government uses the tax revenue to provide services that taxpayers want. Or suppose that the government simply hands the tax revenue back to taxpayers. Would we say in those cases that the tax didn’t actually cost anything? No—because a tax, like a quota, prevents mutually beneficial transactions from occurring. Consider Figure 7-6 once more. Here, with a $40 tax on hotel rooms, guests pay $100 per room but hotel owners receive only $60 per room. Because of the wedge created by the tax, we know that some transactions don’t occur that would have occurred without the tax. More specifically, we know from the supply and demand curves that there are some potential guests who would be willing to pay up to $90 per night and some hotel owners who would be willing to supply rooms if they received at least $70 per night. If these two sets of people were allowed to trade with each other without the tax, they would engage in mutually beneficial transactions— hotel rooms would be rented. But such deals would be illegal, because the $40 tax would not be paid. In our example, 5,000 potential hotel room rentals that would have occurred in the absence of the tax, to the mutual benefit of guests and hotel owners, do not take place because of the tax. So an excise tax imposes costs over and above the tax revenue collected in the form of inefficiency, which occurs because the tax discourages mutually beneficial transactions. As we learned in Chapter 5, the cost to society of this kind of inefficiency—the value of the forgone mutually beneficial transactions—is called the deadweight loss. While all real-world taxes impose some deadweight loss, a badly designed tax imposes a larger deadweight loss than a well-designed one. To measure the deadweight loss from a tax, we turn to the concepts of producer and consumer surplus. Figure 7-8 shows the effects of an excise tax on consumer and producer surplus. In the absence of the tax, the equilibrium is at E and the equilibrium price and quantity are PE and QE, respectively. An excise tax drives a wedge equal to the amount of the tax between the price received by producers and the price paid by consumers, reducing the quantity sold. In this case, where the tax is T dollars per unit, the quantity sold falls to QT. The price paid by consumers rises to PC, the FIGURE 7-8 A Tax Reduces Consumer and Producer Surplus Before the tax, the equilibrium price and quantity are PE and QE, respectively. After an excise tax of T per unit is imposed, the price to consumers rises to PC and consumer surplus falls by the sum of the dark blue rectangle, labeled A, and the light blue triangle, labeled B. The tax also causes the price to producers to fall to PP; producer surplus falls by the sum of the dark red rectangle, labeled C, and the light red triangle, labeled F. The government receives revenue from the tax, QT × T, which is given by the sum of the areas A and C. Areas B and F represent the losses to consumer and producer surplus that are not collected by the government as revenue; they are the deadweight loss to society of the tax. Price PC PE PP Excise tax = T Fall in consumer surplus due to tax A C B F E Fall in producer surplus due to tax S D QT QE Quantity C H A P T E R 7 TA X E S 179 demand price of the reduced quantity, QT, and the price received by producers falls to PP, the supply price of that quantity. The difference between these prices, PC − PP, is equal to the excise tax, T. Using the concepts of producer and consumer surplus, we can show exactly how much surplus producers and consumers lose as a result of the tax. From Figure 4-5 we learned that a fall in the price of a good generates a gain in consumer surplus that is equal to the sum of the areas of a rectangle and a triangle. Similarly, a price increase causes a loss to consumers that is represented by the sum of the areas of a rectangle and a triangle. So it’s not surprising that in the case of an excise tax, the rise in the price paid by consumers causes a loss equal to the sum of the areas of a rectangle and a triangle: the dark blue rectangle labeled A and the area of the light blue triangle labeled B in Figure 7-8. Meanwhile, the fall in the price received by producers leads to a fall in producer surplus. This, too, is equal to the sum of the areas of a rectangle and a triangle. The loss in producer surplus is the sum of the areas of the dark red rectangle labeled C and the light red triangle labeled F in Figure 7-8. Of course, although consumers and producers are hurt by the tax, the government gains revenue. The revenue the government collects is equal to the tax per unit sold, T, multiplied by the quantity sold, QT. This revenue is equal to the area of a rectangle QT wide and T high. And we already have that rectangle in the figure: it is the sum of rectangles A and C. So the government gains part of what consumers and producers lose from an excise tax. But a portion of the loss to producers and consumers from the tax is not offset by a gain to the go
vernment—specifically, the two triangles B and F. The deadweight loss caused by the tax is equal to the combined area of these two triangles. It represents the total surplus lost to society because of the tax—that is, the amount of surplus that would have been generated by transactions that now do not take place because of the tax. Figure 7-9 is a version of Figure 7-8 that leaves out rectangles A (the surplus shifted from consumers to the government) and C (the surplus shifted from producers to the government) and shows only the deadweight loss, here drawn as a triangle shaded yellow. The base of that triangle is equal to the tax wedge, T; the height of the triangle is equal to the reduction in the quantity transacted due to the tax, QE − QT. Clearly, the FIGURE 7-9 The Deadweight Loss of a Tax Price A tax leads to a deadweight loss because it creates inefficiency: some mutually beneficial transactions never take place because of the tax, namely the transactions QE − QT. The yellow area here represents the value of the deadweight loss: it is the total surplus that would have been gained from the QE − QT transactions. If the tax had not discouraged transactions—had the number of transactions remained at QE—no deadweight loss would have been incurred. Excise tax = T PC PE PP Deadweight loss E S D QT QE Quantity 180 The administrative costs of a tax are the resources used by government to collect the tax, and by taxpayers to pay it, over and above the amount of the tax, as well as to evade it. larger the tax wedge and the larger the reduction in the quantity transacted, the greater the inefficiency from the tax. But also note an important, contrasting point: if the excise tax somehow didn’t reduce the quantity bought and sold in this market—if QT remained equal to QE after the tax was levied—the yellow triangle would disappear and the deadweight loss from the tax would be zero. This observation is simply the flip-side of the principle found earlier in the chapter: a tax causes inefficiency because it discourages mutually beneficial transactions between buyers and sellers. So if a tax does not discourage transactions, it causes no deadweight loss. In this case, the tax simply shifts surplus straight from consumers and producers to the government. Using a triangle to measure deadweight loss is a technique used in many economic applications. For example, triangles are used to measure the deadweight loss produced by types of taxes other than excise taxes. They are also used to measure the deadweight loss produced by monopoly, another kind of market distortion. And deadweight-loss triangles are often used to evaluate the benefits and costs of public policies besides taxation—such as whether to impose stricter safety standards on a product. In considering the total amount of inefficiency caused by a tax, we must also take into account something not shown in Figure 7-9: the resources actually used by the government to collect the tax, and by taxpayers to pay it, over and above the amount of the tax. These lost resources are called the administrative costs of the tax. The most familiar administrative cost of the U.S. tax system is the time individuals spend filling out their income tax forms or the money they spend on accountants to prepare their tax forms for them. (The latter is considered an inefficiency from the point of view of society because accountants could instead be performing other, non-tax-related services.) Included in the administrative costs that taxpayers incur are resources used to evade the tax, both legally and illegally. The costs of operating the Internal Revenue Service, the arm of the federal government tasked with collecting the federal income tax, are actually quite small in comparison to the administrative costs paid by taxpayers. So the total inefficiency caused by a tax is the sum of its deadweight loss and its administrative costs. The general rule for economic policy is that, other things equal, a tax system should be designed to minimize the total inefficiency it imposes on society. In practice, other considerations also apply (as Margaret Thatcher learned), but this principle nonetheless gives valuable guidance. Administrative costs are usually well known, more or less determined by the current technology of collecting taxes (for example, filing paper returns versus filing electronically). But how can we predict the size of the deadweight loss associated with a given tax? Not surprisingly, as in our analysis of the incidence of a tax, the price elasticities of supply and demand play crucial roles in making such a prediction. Elasticities and the Deadweight Loss of a Tax We know that the deadweight loss from an excise tax arises because it prevents some mutually beneficial transactions from occurring. In particular, the producer and consumer surplus that is forgone because of these missing transactions is equal to the size of the deadweight loss itself. This means that the larger the number of transactions that are prevented by the tax, the larger the deadweight loss. This fact gives us an important clue in understanding the relationship between elasticity and the size of the deadweight loss from a tax. Recall that when demand or supply is elastic, the quantity demanded or the quantity supplied is relatively responsive to changes in the price. So a tax imposed on a good for which either demand or supply, or both, is elastic will cause a relatively large decrease in the quantity transacted and a relatively large deadweight loss. And when we say that demand or supply is inelastic, we mean that the quantity demanded or the quantity supplied is relatively unresponsive to changes in the price. As a result, a tax imposed when demand or supply, or both, is inelastic will cause a relatively small decrease in the quantity transacted and a relatively small deadweight loss. The four panels of Figure 7-10 illustrate the positive relationship between a good’s price elasticity of either demand or supply and the deadweight loss from taxing that C H A P T E R 7 TA X E S 181 good. Each panel represents the same amount of tax imposed but on a different good; the size of the deadweight loss is given by the area of the shaded triangle. In panel (a), the deadweight-loss triangle is large because demand for this good is relatively elastic—a large number of transactions fail to occur because of the tax. In panel (b), the same supply curve is drawn as in panel (a), but demand for this good is relatively inelastic; as a result, the triangle is small because only a small number of transactions are forgone. Likewise, panels (c) and (d) contain the same demand curve but different supply curves. In panel (c), an elastic supply curve gives rise to a large FIGURE 7-10 Deadweight Loss and Elasticities Price PC PE PP Price PC PE PP Excise tax = T Excise tax = T (a) Elastic Demand (b) Inelastic Demand S Price S Deadweight loss is larger when demand is elastic. E D Excise tax = T PC PE PP E Deadweight loss is smaller when demand is inelastic. D QT QE Quantity QT QE Quantity (c) Elastic Supply Deadweight loss is larger when supply is elastic. S E Excise tax = T Price PC PE PP (d) Inelastic Supply S E Deadweight loss is smaller when supply is inelastic. D D QT QE Quantity QT QE Quantity Demand is elastic in panel (a) and inelastic in panel (b), but the supply curves are the same. Supply is elastic in panel (c) and inelastic in panel (d), but the demand curves are the same. The deadweight losses are larger in panels (a) and (c) than in panels (b) and (d) because the greater the price elasticity of demand or supply, the greater the tax-induced fall in the quantity transacted. In contrast, the lower the price elasticity of demand or supply, the smaller the tax-induced fall in the quantity transacted and the smaller the deadweight loss. 182 deadweight-loss triangle, but in panel (d) an inelastic supply curve gives rise to a small deadweight-loss triangle. The implication of this result is clear: if you want to minimize the efficiency costs of taxation, you should choose to tax only those goods for which demand or supply, or both, is relatively inelastic. For such goods, a tax has little effect on behavior because behavior is relatively unresponsive to changes in the price. In the extreme case in which demand is perfectly inelastic (a vertical demand curve), the quantity demanded is unchanged by the imposition of the tax. As a result, the tax imposes no deadweight loss. Similarly, if supply is perfectly inelastic (a vertical supply curve), the quantity supplied is unchanged by the tax and there is also no deadweight loss. So if the goal in choosing whom to tax is to minimize deadweight loss, then taxes should be imposed on goods and services that have the most inelastic response—that is, goods and services for which consumers or producers will change their behavior the least in response to the tax. (Unless they have a tendency to riot, of course.) And this lesson carries a flip-side: using a tax to purposely decrease the amount of a harmful activity, such as underage drinking, will have the most impact when that activity is elastically demanded or supplied. ➤ECONOMICS IN ACTION Taxing the Marlboro Man One of the most important excise taxes in the United States is the tax on cigarettes. The federal government imposes a tax of 39 cents a pack; state governments impose taxes that range from 7 cents a pack in South Carolina to $2.46 a pack in Rhode Island; and many cities impose further taxes. In general, tax rates on cigarettes have increased over time, because more and more governments have seen them not just as a source of revenue but as a way to discourage smoking. But the rise in cigarette taxes has not been gradual. Usually, once a state government decides to raise cigarette taxes, it raises them a lot—which provides economists with useful data on what happens when there is a big tax increase. TABLE 7-1 Results of Increases in
Cigarette Taxes State Utah Year 1997 Maryland 1999 California 1999 Michigan 1994 New York 2000 Increase in tax (per pack) New state tax (per pack) Change in quantity transacted Change in tax revenue $0.25 $0.52 −20.7% +86.2% 0.30 0.50 0.50 0.55 0.66 0.87 0.75 1.11 −15.3 −18.9 −20.8 −20.2 +52.6 +90.7 +139.9 +57.4 Source: M. C. Farrelly, C. T. Nimsch, and J. James, “State Cigarette Excise Taxes: Implications for Revenue and Tax Evasion,” RTI International 2003. Table 7-1 above shows the results of big increases in cigarette taxes. In each case, sales fell, just as our analysis predicts. Although it’s theoretically possible for tax revenue to fall after such a large tax increase, in reality tax revenue rose in each case. That’s because cigarettes have a low price elasticity of demand. ▲ < < < < < < < < < < < < ➤ CHECK YOUR UNDERSTANDING 7-2 1. The accompanying table shows five consumers’ willingness to pay for one can of diet soda each as well as five producers’ costs of selling one can of diet soda each. Each consumer buys at most one can of soda; each producer sells at most one can of soda. The government asks ➤➤ ➤ An excise tax generates tax revenue equal to the tax rate times the number of units of the good or service transacted but reduces consumer and producer surplus. ➤ The government tax revenue col- lected is less than the loss in total surplus because the tax creates inefficiency by discouraging some mutually beneficial transactions. ➤ The difference between the tax revenue from an excise tax and the reduction in total surplus is the deadweight loss from the tax. The total amount of inefficiency resulting from a tax is equal to the deadweight loss plus the administrative costs of the tax. ➤ The larger the number of transac- tions prevented by a tax, the larger the deadweight loss. As a result, taxes on goods with a greater price elasticity of supply or demand, or both, generate higher deadweight losses. There is no deadweight loss when the number of transactions is unchanged by the tax. C H A P T E R 7 TA X E S 183 your advice about the effects of an excise tax of $0.40 per can of diet soda. Assume that there are no administrative costs from the tax. a. Without the excise tax, what is the equilibrium price and the equilibrium quantity of soda transacted? b. The excise tax raises the price paid by consumers post-tax to $0.60 and lowers the price received by producers post-tax to $0.20. With the excise tax, what is the quantity of soda transacted? c. Without the excise tax, how much individual consumer surplus does each of the consumers gain? How much with the tax? How much total consumer surplus is lost as a result of the tax? Consumer Willingness to pay Producer Ana Bernice Chizuko Dagmar Ella $0.70 0.60 0.50 0.40 0.30 Zhang Yves Xavier Walter Vern Cost $0.10 0.20 0.30 0.40 0.50 d. Without the excise tax, how much individual producer surplus does each of the producers gain? How much with the tax? How much total producer surplus is lost as a result of the tax? e. How much government revenue does the excise tax create? f. What is the deadweight loss from the imposition of this excise tax? 2. In each of the following cases, focus on the price elasticity of demand and use a diagram to illustrate the likely size—small or large—of the deadweight loss resulting from a tax. Explain your reasoning. a. Gasoline b. Milk chocolate bars Solutions appear at back of book. Tax Fairness and Tax Efficiency We’ve just seen how economic analysis can be used to determine the inefficiency caused by a tax. It’s clear that, other things equal, policy makers should choose a tax that creates less inefficiency over a tax that creates more. But that guideline still leaves policy makers with wide discretion in choosing what to tax and, consequently, who bears the burden of the tax. How should they exercise this discretion? One answer is that policy makers should make the tax system fair. But what exactly does fairness mean? Moreover, however you define fairness, how should policy makers balance considerations of fairness versus considerations of efficiency? Two Principles of Tax Fairness Fairness, like beauty, is often in the eyes of the beholder. When it comes to taxes, however, most debates about fairness rely on one of two principles of tax fairness: the benefits principle and the ability-to-pay principle. According to the benefits principle of tax fairness, those who benefit from public spending should bear the burden of the tax that pays for that spending. For example, those who benefit from a road should pay for that road’s upkeep, those who fly on airplanes should pay for air traffic control, and so on. The benefits principle is the basis for some parts of the U.S. tax system. For example, revenue from the federal tax on gasoline is specifically reserved for the maintenance and improvement of federal roads, including the Interstate Highway System. In this way motorists, who benefit from the highway system, also pay for it. The benefits principle is attractive from an economic point of view because it matches well with one of the major justifications for public spending—the theory of public goods, which will be covered in Chapter 18. This theory explains why government action is sometimes needed to provide people with goods that markets alone would not provide, goods like national defense. If that’s the role of government, it seems natural to charge each person in proportion to the benefits he or she gets from those goods. Practical considerations, however, make it impossible to base the entire tax system on the benefits principle. It would be too cumbersome to have a specific tax for each of the many distinct programs that the government offers. Also, attempts to base According to the benefits principle of tax fairness, those who benefit from public spending should bear the burden of the tax that pays for that spending. 184 According to the ability-to-pay principle of tax fairness, those with greater ability to pay a tax should pay more tax. A lump-sum tax is the same for everyone, regardless of any actions people take. taxes on the benefits principle often conflict with the other major principle of tax fairness: the ability-to-pay principle, according to which those with greater ability to pay a tax should pay more. The ability-to-pay principle is usually interpreted to mean that high-income individuals should pay more in taxes than low-income individuals. Often the ability-topay principle is used to argue not only that high-income individuals should pay more taxes but also that they should pay a higher percentage of their income in taxes. We’ll consider the issue of how taxes vary as a percentage of income later. The London protest described at the beginning of this chapter was basically a protest against the failure of the poll tax to take the ability-to-pay principle into account. In some parts of Britain, the poll tax was as high as £550 (equivalent to around $1,400 in today’s dollars) per adult per year. For highly paid executives or professionals, £550 was not a lot of money. But for struggling British families, £550 per year was a crushing burden. It’s not surprising that many people were upset that the new tax completely disregarded the ability-to-pay principle. Equity versus Efficiency Margaret Thatcher’s poll tax was an example of a lump-sum tax, a tax that is the same for everyone regardless of any actions people take. It was widely perceived as much less fair than the tax structure it replaced, in which local taxes were proportional to property values. Under the old system, the highest local taxes were paid by the people with the most expensive houses. Because these people tended to be wealthy, they were also best able to bear the burden. But the old system definitely distorted incentives to engage in mutually beneficial transactions and created deadweight loss. People who were considering home improvements knew that such improvements, by making their property more valuable, would increase their tax bills. The result, surely, was that some home improvements that would have taken place without the tax did not take place because of it. In contrast, a lump-sum tax does not distort incentives. Because under a lumpsum tax people have to pay the same amount of tax regardless of their actions, it does not lead them to change their actions and therefore causes no deadweight loss. So lump-sum taxes, although unfair, are better than other taxes at promoting economic efficiency. L D VIE Killing the Lawyers Perhaps Margaret Thatcher wouldn’t have tried to impose a poll tax if she had remembered her English history. For it was the tripling of an existing poll tax that set off the great English peasant rebellion of 1381. In that rebellion, peasants under the leadership of Wat Tyler marched on London to demand a repeal of the tax. One of their slogans was “The first thing to do is to kill all the lawyers.” (Lawyers at that time were responsible for enforcing the tax.) The rebels did kill quite a few lawyers and tax collectors; they also burned part of London and came close to taking King Richard II hostage. However, they dispersed after the king promised some concessions—a promise he promptly broke. After all, in 1381 royal promises to peasants didn’t count: as the king declared before hanging Wat Tyler and the other rebel leaders, “Villeins ye are, and villeins ye shall remain.” (Villein is a fourteenthcentury English term for a peasant.) Nonetheless, the fact that the rebellion came so close to success struck terror into the hearts of the English nobility, and it remained a cautionary tale for centuries VIEWWOR W O R L D A lesson from history: in 1381, English peasants revolted over unfair taxes. C H A P T E R 7 TA X E S 185 In a well-designed tax system, there is a trade-off between equity and efficiency: the system can be made more efficient only by making it less fair, and vice versa. A tax system can be made fairer by
moving it in the direction of the benefits principle or the ability-to-pay principle. But this will come at a cost because the tax system will now tax people more heavily based on their actions, increasing the amount of deadweight loss. This observation reflects a general principle that we learned in Chapter 1: there is often a trade-off between equity and efficiency. Here, unless a tax system is badly designed, it can be made fairer only by sacrificing efficiency. Conversely, it can be made more efficient only by making it less fair. This means that there is normally a trade-off between equity and efficiency in the design of a tax system. It’s important to understand that economic analysis cannot say how much weight a tax system should give to equity and how much to efficiency. That choice is a value judgment, one we make through the political process. ➤ECONOMICS IN ACTION Federal Tax Philosophy What is the principle underlying the federal tax system? (By federal, we mean taxes collected by the federal government, as opposed to the taxes collected by state and local governments.) The answer is that it depends on the tax. The best-known federal tax, accounting for about half of all federal revenue, is the income tax. The structure of the income tax reflects the ability-to-pay principle: families with low incomes pay little or no income tax. In fact, some families pay negative income tax: a program known as the Earned Income Tax Credit “tops up” or adds to the earnings of low-wage workers. Meanwhile, those with high incomes not only pay a lot of income tax, but must pay a larger share of their income in income taxes than the average family. The second most important federal tax, FICA, also known as the payroll tax, is set up very differently. It was originally introduced in 1935 to pay for Social Security, a program that guarantees retirement income to qualifying older Americans and also provides benefits to workers who become disabled and to family members of workers who die. (Part of the payroll tax is now also used to pay for Medicare, a program that pays most medical bills of older Americans.) The Social Security system was set up to resemble a private insurance program: people pay into the system during their working years, then receive benefits based on their payments. And the tax more or less reflects the benefits principle: because the benefits of Social Security are mainly intended to assist lower- and middle-income people, and don’t increase substantially for the rich, the Social Security tax is levied only on incomes up to a maximum level—$102,000 in 2008. (The Medicare portion of the payroll tax continues to be levied on incomes over $102,000.) As a result, a highincome family doesn’t pay much more in payroll taxes than a middle-income family. Table 7-2 illustrates the difference in the two taxes, using data from a Congressional Budget Office study. The study divided American families into quintiles: the bottom quintile is the poorest 20% of families, the second quintile is the next poorest 20%, and so on. The second column shows the share of total U.S. pre-tax income received by each quintile. The third column shows the share of total federal income tax collected that is paid by each quintile. As you can see, lowincome families actually paid negative income tax through the Earned Income Tax Credit program. Even middle-income families paid a substantially smaller share of total income tax collected than their share of TABLE 7-2 Share of Pre-Tax Income, Federal Income Tax, and Payroll Tax, by Quintile in 2005 Income group Percent of total pre-tax income received Percent of total federal income tax paid Percent of total payroll tax paid Bottom quintile 4.0% Second quintile Third quintile Fourth quintile Top quintile 8.5 13.3 19.8 55.1 Source: Congressional Budget Office. −2.9% −0.9 4.4 13.1 86.3 4.3% 10.1 16.7 25.1 43.6 186 ➤➤ ➤ Other things equal, government tax policy aims for tax efficiency. But it also tries to achieve tax fairness, or tax equity. ➤ There are two important principles of tax fairness: the benefits principle and the ability-to-pay principle. ➤ A lump-sum tax is efficient because it does not distort incentives, but it is generally considered unfair. In any well-designed tax system, there is a trade-off between equity and efficiency in devising tax policy. The tax base is the measure or value, such as income or property value, that determines how much tax an individual or firm pays. The tax structure specifies how the tax depends on the tax base. An income tax is a tax on an individual’s or family’s income. A payroll tax is a tax on the earnings an employer pays to an employee. A sales tax is a tax on the value of goods sold. A profits tax is a tax on a firm’s profits. A property tax is a tax on the value of property, such as the value of a home. A wealth tax is a tax on an individual’s wealth. A proportional tax is the same percentage of the tax base regardless of the taxpayer’s income or wealth. total income. In contrast, the fifth or top quintile, the richest 20% of families, paid a much higher share of total federal income tax collected compared with their share of total income. The fourth column shows the share of total payroll tax collected that is paid by each quintile, and the results are very different: the share of total payroll tax paid by the top quintile is substantially less than their share of total income. ▲ < < < < < < < < < < < < ➤ CHECK YOUR UNDERSTANDING 7-3 1. Assess each of the following taxes in terms of the benefits principle versus the ability-to-pay principle. What, if any, actions are distorted by the tax? Assume for simplicity in each case that the purchaser of the good bears 100% of the burden of the tax. a. A federal tax of $500 for each new car purchased that finances highway safety programs b. A local tax of 20% on hotel rooms that finances local government expenditures c. A local tax of 1% on the assessed value of homes that finances local schools d. A 1% sales tax on food that pays for government food safety regulation and inspection programs Solutions appear at back of book. Understanding the Tax System An excise tax is the easiest tax to analyze, making it a good vehicle for understanding the general principles of tax analysis. However, in the United States today, excise taxes are actually a relatively minor source of government revenue. In this section, we develop a framework for understanding more general forms of taxation and look at some of the major taxes used in the United States. Tax Bases and Tax Structure Every tax consists of two pieces: a base and a structure. The tax base is the measure or value that determines how much tax an individual or firm pays. It is usually a monetary measure, like income or property value. The tax structure specifies how the tax depends on the tax base. It is usually expressed in percentage terms; for example, homeowners in some areas might pay taxes equal to 2% of the value of their homes. Some important taxes and their tax bases are as follows: ■ Income tax: a tax that depends on the income of an individual or family from wages and investments ■ Payroll tax: a tax that depends on the earnings an employer pays to an employee ■ Sales tax: a tax that depends on the value of goods sold (also known as an excise tax) ■ Profits tax: a tax that depends on a firm’s profits ■ Property tax: a tax that depends on the value of property, such as the value of a home ■ Wealth tax: a tax that depends on an individual’s wealth Once the tax base has been defined, the next question is how the tax depends on the base. The simplest tax structure is a proportional tax, also sometimes called a flat tax, which is the same percentage of the base regardless of the taxpayer’s income or wealth. For example, a property tax that is set at 2% of the value of the property, whether the property is worth $10,000 or $10,000,000, is a proportional tax. Many taxes, however, are not proportional. Instead, different people pay different percentages, usually because the tax law tries to take account of either the benefits principle or the ability-to-pay principle. C H A P T E R 7 TA X E S 187 Because taxes are ultimately paid out of income, economists classify taxes according to how they vary with the income of individuals. A tax that rises more than in proportion to income, so that high-income taxpayers pay a larger percentage of their income than low-income taxpayers, is a progressive tax. A tax that rises less than in proportion to income, so that higher-income taxpayers pay a smaller percentage of their income than low-income taxpayers, is a regressive tax. A proportional tax on income would be neither progressive nor regressive. The U.S. tax system contains a mixture of progressive and regressive taxes, though it is somewhat progressive overall. A progressive tax takes a larger share of the income of high-income taxpayers than of low-income taxpayers. A regressive tax takes a smaller share of the income of high-income taxpayers than of low-income taxpayers. The marginal tax rate is the percentage of an increase in income that is taxed away. Equity, Efficiency, and Progressive Taxation Most, though not all, people view a progressive tax system as fairer than a regressive system. The reason is the ability-to-pay principle: a high-income family that pays 35% of its income in taxes is still left with a lot more money than a low-income family that pays only 15% in taxes. But attempts to make taxes strongly progressive run up against the trade-off between equity and efficiency. To see why, consider a hypothetical example, illustrated in Table 7-3. We assume that there are two kinds of people in the nation of Taxmania: half of the population earns $40,000 a year and half earns $80,000, so the average income is $60,000 a year. We also assume that the Taxmanian government needs to collect one-fourth of that income—$15,000 a year per person—in taxes. One
way to raise this revenue would be through a proportional tax that takes one-fourth of everyone’s income. The results of this proportional tax are shown in the second column of Table 7-3: after taxes, lower-income Taxmanians would be left with an income of $30,000 a year and higherincome Taxmanians, $60,000. TABLE 7-3 Proportional versus Progressive Taxes in Taxmania Pre-tax income $40,000 $80,000 After-tax income After-tax income with proportional with progressive taxation $30,000 $60,000 taxation $40,000 $50,000 Even this system might have some negative effects on incentives. Suppose, for example, that finishing college improves a Taxmanian’s chance of getting a higherpaying job. Some people who would invest time and effort in going to college in hopes of raising their income from $40,000 to $80,000, a $40,000 gain, might not bother if the potential gain is only $30,000, the after-tax difference in pay between a lowerpaying and higher-paying job. But a strongly progressive tax system could create a much bigger incentive problem. Suppose that the Taxmanian government decided to exempt the poorer half of the population from all taxes, but still wanted to raise the same amount of revenue. To do this, it would have to collect $30,000 from each individual earning $80,000 a year. As the third column of Table 7-3 shows, people earning $80,000 would then be left with income after taxes of $50,000—only $10,000 more than the after-tax income of people earning half as much. This would greatly reduce the incentive for people to invest time and effort to raise their earnings. The point here is that any income tax system will tax away part of the gain an individual gets by moving up the income scale, reducing the incentive to earn more. But a progressive tax takes away a larger share of the gain than a proportional tax, creating a more adverse effect on incentives. In comparing the incentive effects of tax systems, economists often focus on the marginal tax rate: the percentage of an increase in income that is taxed away. In this example, the marginal tax rate on income above $40,000 is 25% with proportional taxation but 75% with progressive taxation. Our hypothetical example is much more extreme than the reality of progressive taxation in the modern United States—although, as the upcoming Economics in Action explains, in previous years the marginal tax rates paid by high earners were very high indeed. However, these have moderated over time as concerns arose about the severe incentive effects of extremely progressive taxes. In short, the ability-to-pay principle pushes governments toward a highly progressive tax system, but efficiency considerations push them the other way. 188 TABLE 7-4 Major Taxes in the United States, 2006 Federal taxes ($ billion) State and local taxes ($ billion) Income $1,537.5 Payroll Profits 901.6 373.1 Income Sales Profits Property $275.1 415.4 62.4 367.8 Source: Department of Commerce, Bureau of Economic Analysis. Taxes in the United States Table 7-4 shows the revenue raised by major taxes in the United States in 2006. Some of the taxes are collected by the federal government and the others by state and local governments. There is a major tax corresponding to five of the six tax bases we identified earlier. There are income taxes, payroll taxes, sales taxes, profits taxes, and property taxes, all of which play an important role in the overall tax system. The only item missing is a wealth tax. In fact, the United States does have a wealth tax, the estate tax, which depends on the value of someone’s estate after he or she dies. But at the time of writing, the current law phases out the estate tax over a few years, and in any case it raises much less money than the taxes shown in the table. In addition to the taxes shown, state and local governments collect substantial revenue from other sources as varied as driver’s license fees and sewer charges. These fees and charges are an important part of the tax burden but very difficult to summarize or analyze. Are the taxes in Table 7-4 progressive or regressive? It depends on the tax. The personal income tax is strongly progressive. The payroll tax, which, except for the Medicare portion, is paid only on earnings up to $102,000, is somewhat regressive. Sales taxes are generally regressive, because higher-income families save more of their income and thus spend a smaller share of it on taxable goods than do lower-income families. In addition, there are other taxes principally levied at the state and local level that are typically quite regressive: it costs the same amount to get a new driver’s license no matter what your income is. Overall, the taxes collected by the federal government are quite progressive. The second column of Table 7-5 shows estimates of the average federal tax rate paid by families at different levels of income earned in 2004. These estimates don’t count just the money families pay directly. They also attempt to estimate the incidence of taxes directly paid by businesses, like the tax on corporate profits, which ultimately falls on individual shareholders. The table shows that the federal tax system is indeed progressive, with low-income families paying a relatively small share of their income in federal taxes and high-income families paying a greater share of their income. TABLE 7-5 Federal, State, and Local Taxes as a Percentage of Income, by Income Category, 2004 Income group Federal State and local Since 2000, the federal government has cut income taxes for most families. The largest cuts, both as a share of income and as a share of federal taxes collected, have gone to families with high incomes. As a result, the federal system is less progressive (at the time of writing) than it was in 2000 because the share of income paid by highincome families has fallen relative to the share paid by middle- and low-income families. And it will become even less progressive over the next few years, as some delayed pieces of the post-2000 tax cut legislation take effect. However, even after those changes, the federal tax system will remain progressive. Total Bottom quintile 7.9% 11.8% 19.7% Second quintile Third quintile Fourth quintile Next 15% Next 4% Top 1% Average 11.4 15.8 18.7 21.1 22.5 24.6 19.8 11.9 11.2 11.0 10.5 9.7 8.2 10.3 23.3 27.0 29.8 31.6 32.2 32.8 30.1 Source: Institute on Taxation and Economic Policy. As the third column of Table 7-5 shows, however, taxes at the state and local levels are generally regressive. That’s because the sales tax, the largest source of revenue for most states, is somewhat regressive, and other items, such as vehicle licensing fees, are strongly regressive. Overall, the U.S. tax system is somewhat progressive, with the richest fifth of the population paying a somewhat higher share of income in taxes than families in the middle and the poorest fifth paying considerably less. Yet there are important differences within the American tax system: the federal income tax is more progressive than the payroll tax, which can be seen from Table 7-2. And federal taxation is more progressive than state and local taxation. C H A P T E R 7 TA X E S 189 YOU THINK YOU PAY HIGH TAXES? Taxes (percent of GDP) 60% 50 40 30 20 10 Everyone, everywhere complains about taxes. But citizens of the United States actually have less to complain about than citizens of most other wealthy countries. To assess the overall level of taxes, economists usually calculate taxes as a share of gross domestic product—the total value of goods and services produced in a country. By this measure, as you can see in the accompanying figure, U.S. taxes are near the bottom of the scale. Even our neighbor Canada has significantly higher taxes. Tax rates in Europe, where governments need a lot of revenue to pay for extensive benefits such as guaranteed health care and generous unemployment benefits, are 50% to 100% higher than in the United States. Source: OECD in Figures 2007. 50.4% 43.4% 33.5% 36.0% 25.5% 26.4% U.S. Japan Canada Britain France Sweden Different Taxes, Different Principles Why are some taxes progressive but others regressive? Can’t the government make up its mind? There are two main reasons for the mixture of regressive and progressive taxes in the U.S. system: the difference between levels of government and the fact that different taxes are based on different principles. State and especially local governments generally do not make much effort to apply the ability-to-pay principle. This is largely because they are subject to tax competition: a state or local government that imposes high taxes on people with high incomes faces the prospect that those people may move to other locations where taxes are lower. This is much less of a concern at the national level, although a handful of very rich people have given up their U.S. citizenship to avoid paying U.S. taxes. Although the federal government is in a better position than state or local governments to apply principles of fairness, it applies different principles to different taxes. We saw an example of this in the preceding Economics in Action. The most important tax, the federal income tax, is strongly progressive, reflecting the ability-to-pay principle. But the second most important tax, the federal payroll tax, is somewhat regressive Taxing Income versus Taxing Consumption L D VIE VIEWWOR W O R L D The U.S. government taxes people mainly on the money they make, not on the money they spend on consumption. Yet most tax experts argue that this policy badly distorts incentives. Someone who earns income and then invests that income for the future gets taxed twice: once on the original sum and again on any earnings made from the investment. So a system that taxes income rather than consumption discourages people from saving and investing, instead providing an incentive to spend their income today. And encouraging saving and investing is an important policy goal, both because empirical dat
a show that Americans tend to save too little for retirement and health expenses in their later years and because saving and investing contribute to economic growth. Moving from a system that taxes income to one that taxes consumption would solve this problem. In fact, the governments of many countries get much of their revenue from a value-added tax, or VAT, which acts like a national sales tax. In some countries VAT rates are very high; in Sweden, for example, the rate is 25%. The United States does not have a value-added tax for two main reasons. One is that it is difficult, though not impossible, to make a consumption tax progressive. The other is that a VAT typically has very high administrative costs. 190 because most of it is linked to specific programs—Social Security and Medicare—and, reflecting the benefits principle, is levied more or less in proportion to the benefits received from these programs. ➤ECONOMICS IN ACTION The Top Marginal Income Tax Rate The amount of money an American owes in federal income taxes is defined in terms of marginal tax rates on successively higher “brackets” of income. For example, in 2007 a single person paid 10% on the first $7,825 of taxable income (that is, income after subtracting exemptions and deductions); 15% on the next $24,050; and so on up to a top rate of 35% on his or her income, if any, over $349,700. Relatively few people (less than 1% of taxpayers) have incomes high enough to pay the top marginal rate. In fact, 77% of Americans pay no income tax or they fall into either the 10% or 15% bracket. But the top marginal income tax rate is often viewed as a useful indicator of the progressivity of the tax system, because it shows just how high a tax rate the U.S. government is willing to impose on the very affluent. FIGURE 7-11 The Top Marginal Income Tax Rate The marginal tax rate imposed on the highest income bracket has varied greatly over time. It shot up during the administration of Franklin Delano Roosevelt in the 1930s and 1940s, and it fell sharply during the administration of Ronald Reagan in the 1980s. The current top tax rate, 35%, is low by historical standards. Source: U.S. Internal Revenue Service. Top marginal tax rate 100% 80 60 40 20 1913 1920 1940 1960 1980 2000 2007 Year ➤➤ ➤ Every tax consists of a tax base and a tax structure. ➤ Among the types of taxes are income taxes, payroll taxes, sales taxes, profits taxes, property taxes, and wealth taxes. ➤ Tax systems are classified as being proportional, progressive, or regressive. ➤ Progressive taxes are often justified by the ability-to-pay principle. But strongly progressive taxes lead to high marginal tax rates, which create major incentive problems. ➤ The United States has a mixture of progressive and regressive taxes. However, the overall structure of taxes is progressive. Figure 7-11 shows the top marginal income tax rate from 1913, when the U.S. government first imposed an income tax, to 2007. The first big increase in the top marginal rate came during World War I (1914) and was reversed after the war ended (1918). After that, the figure is dominated by two big changes: a huge increase in the top marginal rate during the administration of Franklin Roosevelt (1933–1945) and a sharp reduction during the administration of Ronald Reagan (1981–1989). By comparison, recent changes have been relatively small potatoes. ▲ < < < < < < < < < < < < ➤ CHECK YOUR UNDERSTANDING 7-4 1. An income tax taxes 1% of the first $10,000 of income and 2% on all income above $10,000. a. What is the marginal tax rate for someone with income of $5,000? How much total tax does this person pay? How much is this as a percentage of his or her income? b. What is the marginal tax rate for someone with income of $20,000? How much total tax does this person pay? How much is this as a percentage of his or her income? c. Is this income tax proportional, progressive, or regressive? C H A P T E R 7 TA X E S 191 2. When comparing households at different income levels, economists find that consumption spending grows more slowly than income. Assume that when income grows by 50%, from $10,000 to $15,000, consumption grows by 25%, from $8,000 to $10,000. Compare the percent of income paid in taxes by a family with $15,000 in income to that paid by a family with $10,000 in income under a 1% tax on consumption purchases. Is this a proportional, progressive, or regressive tax? 3. True or false? Explain your answers. a. Payroll taxes do not affect a person’s incentive to take a job because they are paid by employers. b. A lump-sum tax is a proportional tax because it is the same amount for each person. Solutions appear at back of book. [ ➤➤ A LOOK AHEAD ••• The costs and benefits of taxation are often controversial—which is why economic analysis, which helps us understand those costs and benefits, is especially useful when it comes to tax policy. In the next chapter, we turn to a subject that may be even more controversial than taxes: international trade, which produces many benefits but also sometimes has important costs. We’ll see how the comparative advantage model introduced in Chapter 2, together with the supply and demand model, can help us understand the effects of international trade.] S U M M A R Y 1. Excise taxes—taxes on the purchase or sale of a good— raise the price paid by consumers and reduce the price received by producers, driving a wedge between the two. The incidence of the tax—how the burden of the tax is divided between consumers and producers—does not depend on who officially pays the tax. 2. The incidence of an excise tax depends on the price elasticities of supply and demand. If the price elasticity of demand is higher than the price elasticity of supply, the tax falls mainly on producers; if the price elasticity of supply is higher than the price elasticity of demand, the tax falls mainly on consumers. 5. An efficient tax minimizes both the sum of the deadweight loss due to distorted incentives and the administrative costs of the tax. However, tax fairness, or tax equity, is also a goal of tax policy. 6. There are two major principles of tax fairness, the benefits principle and the ability-to-pay principle. The most efficient tax, a lump-sum tax, does not distort incentives but performs badly in terms of fairness. The fairest taxes in terms of the ability-to-pay principle, however, distort incentives the most and perform badly on efficiency grounds. So in a well-designed tax system, there is a trade-off between equity and efficiency. 3. The tax revenue generated by a tax depends on the tax 7. Every tax consists of a tax base, which defines what is rate and on the number of units transacted with the tax. Excise taxes cause inefficiency in the form of deadweight loss because they discourage some mutually beneficial transactions. Taxes also impose administrative costs: resources used to collect the tax, to pay it (over and above the amount of the tax), and to evade it. 4. An excise tax generates revenue for the government but lowers total surplus. The loss in total surplus exceeds the tax revenue, resulting in a deadweight loss to society. This deadweight loss is represented by a triangle, the area of which equals the value of the transactions discouraged by the tax. The greater the elasticity of demand or supply, or both, the larger the deadweight loss from a tax. If either demand or supply is perfectly inelastic, there is no deadweight loss from a tax. taxed, and a tax structure, which specifies how the tax depends on the tax base. Different tax bases give rise to different taxes—the income tax, payroll tax, sales tax, profits tax, property tax, and wealth tax. A proportional tax is the same percentage of the tax base for all taxpayers. 8. A tax is progressive if higher-income people pay a higher percentage of their income in taxes than lower-income people and regressive if they pay a lower percentage. Progressive taxes are often justified by the ability-to-pay principle. However, a highly progressive tax system significantly distorts incentives because it leads to a high marginal tax rate, the percentage of an increase in income that is taxed away, on high earners. The U.S. tax system is progressive overall, although it contains a mixture of progressive and regressive taxes. 192 Excise tax, p. 168 Incidence, p. 171 Tax rate, p. 175 Administrative costs, p. 180 Benefits principle, p. 183 Ability-to-pay principle, p. 184 Lump-sum tax, p. 184 P R O B L E M S Trade-off between equity and efficiency, Profits tax, p. 186 p. 185 Tax base, p. 186 Tax structure, p. 186 Income tax, p. 186 Payroll tax, p. 186 Sales tax, p. 186 Property tax, p. 186 Wealth tax, p. 186 Proportional tax, p. 186 Progressive tax, p. 187 Regressive tax, p. 187 Marginal tax rate, p. 187 1. The United States imposes an excise tax on the sale of domestic airline tickets. Let’s assume that in 2006 the total excise tax was $5.80 per airline ticket (consisting of the $3.30 flight segment tax plus the $2.50 September 11 fee). According to data from the Bureau of Transportation Statistics, in 2006, 656 million passengers traveled on domestic airline trips at an average price of $389.08 per trip. The accompanying table shows the supply and demand schedules for airline trips. The quantity demanded at the average price of $389.08 is actual data; the rest is hypothetical. Price of trip $389.17 389.08 384.00 383.28 383.27 Quantity of trips demanded (millions) Quantity of trips supplied (millions) 655 656 685 700 701 1,100 1,000 685 656 655 a. What is the government tax revenue in 2006 from the excise tax? b. On January 1, 2007, the total excise tax increased to $5.90 per ticket. What is the equilibrium quantity of tickets transacted now? What is the average ticket price now? What is the 2007 government tax revenue? c. Does this increase in the excise tax increase or decrease government tax revenue? 2. The U.S. government would like to help the American auto ind
ustry compete against foreign automakers that sell trucks in the United States. It can do this by imposing an excise tax on each foreign truck sold in the United States. The hypothetical pre-tax demand and supply schedules for imported trucks are given in the accompanying table. Price of imported truck Quantity of imported trucks (thousands) Quantity demanded Quantity supplied $32,000 31,000 30,000 29,000 28,000 27,000 100 200 300 400 500 600 400 350 300 250 200 150 a. In the absence of government interference, what is the equilibrium price of an imported truck? The equilibrium quantity? Illustrate with a diagram. b. Assume that the government imposes an excise tax of $3,000 per imported truck. Illustrate the effect of this excise tax in your diagram from part a. How many imported trucks are now purchased and at what price? How much does the foreign automaker receive per truck? c. Calculate the government revenue raised by the excise tax in part b. Illustrate it on your diagram. d. How does the excise tax on imported trucks benefit American automakers? Who does it hurt? How does inefficiency arise from this government policy? 3. In 1990, the United States began to levy a tax on sales of luxury cars. For simplicity, assume that the tax was an excise tax of $6,000 per car. The accompanying figure shows hypothetical demand and supply curves for luxury cars. Price of car (thousands of dollars) $56 55 54 53 52 51 50 49 48 47 E S D 0 20 40 60 80 100 120 140 Quantity of cars (thousands) a. Under the tax, what is the price paid by consumers? What is the price received by producers? What is the government tax revenue from the excise tax? Over time, the tax on luxury automobiles was slowly phased out (and completely eliminated in 2002). Suppose that the excise tax falls from $6,000 per car to $4,500 per car. b. After the reduction in the excise tax from $6,000 to $4,500 per car, what is the price paid by consumers? What is the price received by producers? What is tax revenue now? c. Compare the tax revenue created by the taxes in parts a and b. What accounts for the change in tax revenue from the reduction in the excise tax? 4. All states impose excise taxes on gasoline. According to data from the Federal Highway Administration, the state of California imposes an excise tax of $0.18 per gallon of gasoline. In 2005, gasoline sales in California totaled 15.6 billion gallons. What was California’s tax revenue from the gasoline excise tax? If California doubled the excise tax, would tax revenue double? Why or why not? 5. In the United States, each state government can impose its own excise tax on the sale of cigarettes. Suppose that in the state of North Texarkana, the state government imposes a tax of $2.00 per pack sold within the state. In contrast, the neighboring state of South Texarkana imposes no excise tax on cigarettes. Assume that in both states the pre-tax price of a pack of cigarettes is $1.00. Assume that the total cost to a resident of North Texarkana to smuggle a pack of cigarettes from South Texarkana is $1.85 per pack. (This includes the cost of time, gasoline, and so on.) Assume that the supply curve for cigarettes is neither perfectly elastic nor perfectly inelastic. a. Draw a diagram of the supply and demand curves for cigarettes in North Texarkana showing a situation in which it makes economic sense for a North Texarkanan to smuggle a pack of cigarettes from South Texarkana to North Texarkana. Explain your diagram. b. Draw a corresponding diagram showing a situation in which it does not make economic sense for a North Texarkanan to smuggle a pack of cigarettes from South Texarkana to North Texarkana. Explain your diagram. c. Suppose the demand for cigarettes in North Texarkana is perfectly inelastic. How high could the cost of smuggling a pack of cigarettes go until a North Texarkanan no longer found it profitable to smuggle? d. Still assume that demand for cigarettes in North Texarkana is perfectly inelastic and that all smokers in North Texarkana are smuggling their cigarettes at a cost of $1.85 per pack, so no tax is paid. Is there any inefficiency in this situation? If so, how much per pack? Suppose chipembedded cigarette packaging makes it impossible to smuggle cigarettes across the state border. Is there any inefficiency in this situation? If so, how much per pack? 6. In each of the following cases involving taxes, explain: (i) whether the incidence of the tax falls more heavily on consumers or producers, (ii) why government revenue raised from the tax is not a good indicator of the true cost of the tax, and (iii) how deadweight loss arises as a result of the tax. a. The government imposes an excise tax on the sale of all college textbooks. Before the tax was imposed, 1 million textbooks were sold every year at a price of $50. After the tax is imposed, 600,000 books are sold yearly; students pay $55 per book, $30 of which publishers receive. b. The government imposes an excise tax on the sale of all airline tickets. Before the tax was imposed, 3 million airline tickets were sold every year at a price of $500. After the tax is imposed, 1.5 million tickets are sold yearly; travelers pay $550 per ticket, $450 of which the airlines receive. c. The government imposes an excise tax on the sale of all toothbrushes. Before the tax, 2 million toothbrushes were C H A P T E R 7 TA X E S 193 sold every year at a price of $1.50. After the tax is imposed, 800,000 toothbrushes are sold every year; consumers pay $2 per toothbrush, $1.25 of which producers receive. 7. The accompanying diagram shows the market for cigarettes. The current equilibrium price per pack is $4, and every day 40 million packs of cigarettes are sold. In order to recover some of the health care costs associated with smoking, the government imposes a tax of $2 per pack. This will raise the equilibrium price to $5 per pack and reduce the equilibrium quantity to 30 million packs. Price of cigarettes (per pack) $8 Excise tax = $2 5 4 3 0 E S D 30 40 Quantity of cigarettes (millions of packs per day) The economist working for the tobacco lobby claims that this tax will reduce consumer surplus for smokers by $40 million per day, since 40 million packs now cost $1 more per pack. The economist working for the lobby for sufferers of second-hand smoke argues that this is an enormous overestimate and that the reduction in consumer surplus will be only $30 million per day, since after the imposition of the tax only 30 million packs of cigarettes will be bought and each of these packs will now cost $1 more. They are both wrong. Why? 8. Consider the original market for pizza in Collegetown, illustrated in the accompanying table. Collegetown officials decide to impose an excise tax on pizza of $4 per pizza. Price of pizza $10 9 8 7 6 5 4 3 2 1 Quantity of pizza demanded Quantity of pizza supplied . What is the quantity of pizza bought and sold after the imposition of the tax? What is the price paid by consumers? What is the price received by producers? 194 . Calculate the consumer surplus and the producer surplus after the imposition of the tax. By how much has the imposition of the tax reduced consumer surplus? By how much has it reduced producer surplus? c. How much tax revenue does Collegetown earn from this tax? d. Calculate the deadweight loss from this tax. 9. The state needs to raise money, and the governor has a choice of imposing an excise tax of the same amount on one of two previously untaxed goods: the state can tax sales of either restaurant meals or gasoline. Both the demand for and the supply of restaurant meals are more elastic than the demand for and the supply of gasoline. If the governor wants to minimize the deadweight loss caused by the tax, which good should be taxed? For each good, draw a diagram that illustrates the deadweight loss from taxation. 10. Assume that the demand for gasoline is inelastic and supply is relatively elastic. The government imposes a sales tax on gasoline. The tax revenue is used to fund research into clean fuel alternatives to gasoline, which will improve the air we all breathe. a. Who bears more of the burden of this tax, consumers or producers? Show in a diagram who bears how much of the excess burden. b. Is this tax based on the benefits principle or the ability-to- pay principle? Explain. 11. Assess the following four tax policies in terms of the benefits principle versus the ability-to-pay principle. a. A tax on gasoline that finances maintenance of state roads b. An 8% tax on imported goods valued in excess of $800 per household brought in on passenger flights c. Airline-flight landing fees that pay for air traffic control d. A reduction in the amount of income tax paid based on the number of dependent children in the household 12. You are advising the government on how to pay for national defense. There are two proposals for a tax system to fund national defense. Under both proposals, the tax base is an individual’s income. Under proposal A, all citizens pay exactly the same lump-sum tax, regardless of income. Under proposal B, individuals with higher incomes pay a greater proportion of their income in taxes. a. Is the tax in proposal A progressive, proportional, or regressive? What about the tax in proposal B? b. Is the tax in proposal A based on the ability-to-pay principle or on the benefits principle? What about the tax in proposal B? c. In terms of efficiency, which tax is better? Explain. www.worthpublishers.com/krugmanwells 13. Each of the following tax proposals has income as the tax base. In each case, calculate the marginal tax rate for each level of income. Then calculate the percentage of income paid in taxes for an individual with a pre-tax income of $5,000 and for an individual with a pre-tax income of $40,000. Classify the tax as being proportional, progressive, or regressive. (Hint: You can calculate the marginal tax rate as the percentage of an additional $1 in income that is taxed aw
ay.) a. All income is taxed at 20%. b. All income up to $10,000 is tax-free. All income above $10,000 is taxed at a constant rate of 20%. c. All income between $0 and $10,000 is taxed at 10%. All income between $10,000 and $20,000 is taxed at 20%. All income higher than $20,000 is taxed at 30%. d. Each individual who earns more than $10,000 pays a lump-sum tax of $10,000. If the individual’s income is less than $10,000, that individual pays in taxes exactly what his or her income is. e. Of the four tax policies, which is likely to cause the worst incentive problems? Explain. 14. In Transylvania the basic income tax system is fairly simple. The first 40,000 sylvers (the official currency of Transylvania) earned each year are free of income tax. Any additional income is taxed at a rate of 25%. In addition, every individual pays a social security tax, which is calculated as follows: all income up to 80,000 sylvers is taxed at an additional 20%, but there is no additional social security tax on income above 80,000 sylvers. a. Calculate the marginal tax rates (including income tax and social security tax) for Transylvanians with the following levels of income: 20,000 sylvers, 40,000 sylvers, and 80,000 sylvers. (Hint: You can calculate the marginal tax rate as the percentage of an additional 1 sylver in income that is taxed away.) b. Is the income tax in Transylvania progressive, regressive, or proportional? Is the social security tax progressive, regressive, or proportional? c. Which income group’s incentives are most adversely affected by the combined income and social security tax systems? 15. You work for the Council of Economic Advisers, providing economic advice to the White House. The president wants to overhaul the income tax system and asks your advice. Suppose that the current income tax system consists of a proportional tax of 10% on all income and that there is one person in the country who earns $110 million; everyone else earns less than $100 million. The president proposes a tax cut targeted at the very rich so that the new tax system would consist of a proportional tax of 10% on all income up to $100 million and a marginal tax rate of 0% (no tax) on income above $100 million. You are asked to evaluate this tax proposal. a. For incomes of $100 million or less, is this tax system progressive, regressive, or proportional? For incomes of more than $100 million? Explain. b. Would this tax system create more or less tax revenue, other things equal? Is this tax system more or less efficient than the current tax system? Explain. chapter: 8 >> International Trade L D VIE F OR THE FIRST TIME IN RECORDED HISTORY, Americans are eating more shrimp than canned tuna.” So declared the U.S. Commerce Department in a 2002 press release. Since W E I V D L VIEWWOR W O R L D countries specialize in producing different goods and trade those goods with each other, is a source of mutual benefit to the countries involved. In Chapter 2 we laid out the basic principle that there are gains from trade; it’s a then, shrimp consumption has pulled even further principle that applies to countries as well as individuals. ahead: in 2005 the average American ate 4.1 pounds of But politicians and the public are often not con- shrimp, compared with only 3.1 pounds of canned tuna. vinced, in part because those who are hurt by foreign Where’s all that shrimp coming from? Mainly from competition are often very effective at making their voic- Asia and Latin America. Local entrepreneurs have taken es heard. In fact, in 2004 the U.S. government respond- advantage of a favorable climate, cheap labor, and large ed to complaints by domestic shrimp fishermen that they coastal tracts to produce huge quantities of “farmed” were facing unfair foreign competition. In response, the shrimp raised in ponds, shipping their catch mainly to government imposed a tax on imports called a tariff—on Japan and the United States. shrimp from Vietnam, Thailand, and other shrimp- Is it a good thing that we now buy most of our shrimp exporting nations. from abroad? It’s certainly a good thing from the point of Until now, we have analyzed the economy as if it were view of America’s shrimp-eaters, and the vast majority of self-sufficient, as if the economy produces all the goods economists would say that international trade is a good and services it consumes, and vice versa. This is, of thing from the point of view of the nation as a whole. course, true of the world economy as a whole. But it’s not That is, economists say that international trade, in which true of any individual country. Assuming self-sufficiency The mutual benefits of international trade are enjoyed by shrimp farmers in Bangkok, Thailand, and by American shrimp eaters 195 196 would have been far more accurate 40 years ago, when This chapter examines the economics of international the United States exported only a small fraction of what trade. We start from the model of comparative advantage, it produced and imported only a small fraction of what which, as we saw in Chapter 2, explains why there are it consumed. Since then, however, both U.S. imports and gains from international trade. It’s also important, how- exports have grown much faster than the U.S. economy ever, to understand how some individuals, like U.S. as a whole. Moreover, compared to the United States, shrimp producers, can be hurt by international trade. At other countries engage in far more foreign trade relative the conclusion of the chapter, we’ll examine the effects of to the size of their economies. To have a full picture of policies, like the tariff on shrimp imports, that countries how national economies work, we must understand use to limit imports or promote exports, as well as how international trade. governments work together to overcome barriers to trade. WHAT YOU WILL LEARN IN THIS CHAPTER: ➤ How comparative advantage leads to mutually beneficial international trade tional trade, and why the gains exceed the losses ➤ The sources of international compara- tive advantage ➤ Who gains and who loses from interna- ➤ How tariffs and import quotas cause inefficiency and reduce total surplus ➤ Why governments often engage in trade protection to shelter domestic industries from imports and how international trade agreements counteract this Comparative Advantage and International Trade The United States buys shrimp—and many other goods and services—from other countries. At the same time, it sells many goods and services to other countries. Goods and services purchased from abroad are imports; goods and services sold abroad are exports. As illustrated by the opening story, imports and exports have taken on an increasingly important role in the U.S. economy. Over the last 40 years, both imports into and exports from the United States have grown faster than the U.S. economy. Panel (a) of Figure 8-1 shows how the values of U.S. imports and exports have grown as a percentage of gross domestic product (GDP). Panel (b) shows imports and exports as a percentage of GDP for a number of countries. It shows that foreign trade is significantly more important for many other countries than it is for the United States. (Japan is the exception.) Foreign trade isn’t the only way countries interact economically. In the modern world, investors from one country often invest funds in another nation; many companies are multinational, with subsidiaries operating in several countries; and a growing number of individuals work in a country different from the one in which they were born. The growth of all these forms of economic linkages among countries is often called globalization. In this chapter, however, we’ll focus mainly on international trade. To understand why international trade occurs and why economists believe it is beneficial to the economy, we will first review the concept of comparative advantage. Goods and services purchased from other countries are imports; goods and services sold to other countries are exports. Globalization is the phenomenon of growing economic linkages among countries. Production Possibilities and Comparative Advantage, Revisited To produce shrimp, any country must use resources—land, labor, capital, and so on— that could have been used to produce other things. The potential production of other goods a country must forgo to produce a ton of shrimp is the opportunity cost of that ton of shrimp AT 197 FIGURE 8-1 The Growing Importance of International Trade (a) U.S. Imports and Exports, 1960–2006 (b) Imports and Exports for Different Countries, 2005 Percent of GDP 18% 16 14 12 10 8 6 4 2 Imports Exports Percent of GDP 90% 80 70 60 50 40 30 20 10 Imports Exports 1960 1970 1980 1990 2000 2006 Year U.S. Belgiu m Canada Germ any France Mexico China Japan Panel (a) illustrates the fact that over the past 40 years, the United States has exported a steadily growing share of its GDP to other countries and imported a growing share of what it consumes from abroad. Panel (b) demonstrates that international trade is significantly more important to many other countries than it is to the United States, with the exception of Japan. Source: U.S. Department of Commerce, National Income and Product Accounts [for panel (a)] and United Nations Human Development Report 2007/2008 [for panel (b)]. It’s a lot easier to produce shrimp in Vietnam, where the climate is nearly ideal and there’s plenty of coastal land suitable for shellfish farming, than it is in the United States. Conversely, other goods are not produced as easily in Vietnam as in the United States. For example, Vietnam doesn’t have the base of skilled workers and technological know-how that makes the United States so good at producing high-technology goods. So the opportunity cost of a ton of shrimp, in terms of other goods such as computers, is much less in Vietnam than it is in the United States. So we say that Vietnam has a comparative advantage in producing shrimp. Let’s repeat the d
efinition of comparative advantage from Chapter 2: a country has a comparative advantage in producing a good or service if the opportunity cost of producing the good or service is lower for that country than for other countries. Figure 8-2 on the next page provides a hypothetical numerical example of comparative advantage in international trade. We assume that only two goods are produced and consumed, shrimp and computers, and that there are only two countries in the world, the United States and Vietnam. The figure shows hypothetical production possibility frontiers for the United States and Vietnam. As in Chapter 2, we simplify the model by assuming that the production possibility frontiers are straight lines, as shown in Figure 2-1, rather than the more realistic bowed-out shape shown in Figure 2-2. The straight-line shape implies that the opportunity cost of a ton of shrimp in terms of computers in each country is constant—it does not depend on how many units of each good the country produces. The analysis of international trade under the assumption that opportunity costs are constant, which makes production possibility frontiers straight lines, is known as the Ricardian model of international trade, named after the English economist David Ricardo, who introduced this analysis in the early nineteenth century. The Ricardian model of international trade analyzes international trade under the assumption that opportunity costs are constant. 198 FIGURE 8-2 Comparative Advantage and the Production Possibility Frontier (a) U.S. Production Possibility Frontier (b) Vietnamese Production Possibility Frontier Quantity of computers 2,000 U.S. production and consumption in autarky 1,000 CUS Slope = –2 PPFUS 0 500 1,000 Quantity of computers 1,000 500 0 Vietnamese production and consumption in autarky CV Slope = –0.5 1,000 PPFV 2,000 Quantity of shrimp (tons) Quantity of shrimp (tons) The U.S. opportunity cost of each ton of shrimp in terms of computers is 2: 2 computers must be forgone for every additional ton of shrimp produced. The Vietnamese opportunity cost of each ton of shrimp in terms of computers is 0.5: only 0.5 computer must be forgone for every additional ton of shrimp produced. So Vietnam has a comparative advantage in shrimp and the United States has a comparative advantage in computers. In autarky, CUS is the U.S. production and consumption bundle and CV is the Vietnamese production and consumption bundle. Table 8-1 presents the same information shown in Figure 8-2. We assume that the United States can produce 1,000 tons of shrimp if it produces no computers or 2,000 computers if it produces no shrimp. Because we measure shrimp output in tons, the slope of the production possibility frontier in panel (a) is −2,000/1,000, or −2: to produce an additional ton of shrimp, the United States must forgo the production of 2 computers. Similarly, we assume that Vietnam can produce 2,000 tons of shrimp if it produces no computers or 1,000 computers if it produces no shrimp. The slope of the production possibility frontier in panel (b) is −1,000/2,000, or −0.5: to produce an additional ton of shrimp, Vietnam must forgo the production of 0.5 computer. Economists use the term autarky to describe a situation in which a country does not trade with other countries. We assume that in autarky the United States would choose to produce and consume 500 tons of shrimp and 1,000 computers. This autarky production and consumption bundle is shown by point CUS in panel (a) of TABLE 8-1 Production Possibilities (a) United States Quantity of shrimp (tons) Quantity of computers (b) Vietnam Autarky is a situation in which a country does not trade with other countries. Quantity of shrimp (tons) Quantity of computers Production One possibility Another possibility 1,000 0 0 2,000 Production One possibility Another possibility 2,000 0 0 1,000 AT 199 TABLE 8-2 Production and Consumption Under Autarky Production Consumption 500 1,000 500 1,000 Production Consumption 1,000 500 1,000 500 Production Consumption 1,500 1,500 1,500 1,500 Figure 8-2. We also assume that in autarky Vietnam would choose to produce and consume 1,000 tons of shrimp and 500 computers, shown by point CV in panel (b). The outcome in autarky is summarized in Table 8-2, where world production and consumption is the sum of U.S. and Vietnamese production and consumption. (a) United States Quantity of shrimp (tons) Quantity of computers (c) World (United States and Vietnam) (b) Vietnam Quantity of computers Quantity of shrimp (tons) If the countries trade with each other, they can do better than they can in autarky. In this example, Vietnam has a comparative advantage in the production of shrimp. That is, the opportunity cost of shrimp is lower in Vietnam than in the United States: 0.5 computer per ton of shrimp in Vietnam versus 2 computers per ton of shrimp in the United States. Conversely, the United States has a comparative advantage in the production of computers: to produce an additional computer, the United States must forgo the production of 0.5 ton of shrimp, but producing an additional computer in Vietnam requires forgoing the production of 2 tons of shrimp. International trade allows each country to specialize in producing the good in which it has a comparative advantage: computers in the United States, shrimp in Vietnam. As a result, each country is able to obtain the good in which it doesn’t have a comparative advantage at a lower opportunity cost than if it produced the good itself. And that leads to gains for both when they trade. Quantity of shrimp (tons) Quantity of computers The Gains from International Trade Figure 8-3 on the next page illustrates how both countries gain from specialization and trade. Again, panel (a) represents the United States and panel (b) represents Vietnam. As a result of international trade, the United States produces at point QUS: 2,000 computers but no shrimp. Vietnam produces at QV: 2,000 tons of shrimp but no computers. The new production choices are given in the second column of Table 8-3. Quantity of shrimp (tons) Quantity of computers (b) Vietnam Quantity of shrimp (tons) Quantity of computers By comparing Table 8-3 with Table 8-2, you can see that specialization increases total world production of both goods. In the absence of specialization, total world production consists of 1,500 computers and 1,500 tons of shrimp. After specialization, total world production rises to 2,000 computers and 2,000 tons of shrimp. These goods can now be traded, with the United States consuming shrimp produced in Vietnam and Vietnam consuming computers produced in the United States. The result is that each country can consume more of both goods than it did in autarky. Quantity of shrimp (tons) Quantity of computers (c) World (United States and Vietnam) In addition to showing production under trade, Figure 8-3 shows one of many possible pairs of consumption bundles for the United States and Vietnam, which is also given in Table 8-3. In this example, the United States moves from its autarky consumption of 1,000 computers and 500 tons of shrimp, shown by CUS, to consumption after trade of 1,250 computers and 750 tons of shrimp, represented by C′US. Vietnam moves from its autarky consumption of 500 computers and 1,000 tons of shrimp, shown by CV, to consumption after trade of 750 computers and 1,250 tons of shrimp, shown by C ′V. What makes this possible is the fact that with international trade countries are no longer required to consume the same bundle of goods they produce. Each country TABLE 8-3 Production and Consumption After Specialization and Trade (a) United States Production Consumption 500 2,000 750 1,250 Production Consumption 2,000 500 1,250 750 Production Consumption 2,000 2,000 2,000 2,000 200 FIGURE 8-3 The Gains from International Trade (a) U.S. Production and Consumption (b) Vietnamese Production and Consumption Quantity of computers QUS 2,000 U.S. production with trade 1,250 1,000 C’US CUS U.S. consumption with trade U.S. production and consumption in autarky PPFUS Quantity of computers Vietnamese production and consumption in autarky PPFV 1,000 750 500 Vietnamese consumption with trade C’V CV 0 500 750 1,000 0 1,000 1,250 Vietnamese production with trade QV 2,000 Quantity of shrimp (tons) Quantity of shrimp (tons) Trade increases world production of both goods, allowing both countries to consume more. Here, each country specializes its production as a result of trade: the United States produces at QUS and Vietnam produces at QV. Total world production of computers has risen from 1,500 to 2,000 and of shrimp from 1,500 tons to 2,000 tons. The United States can now consume bundle C ′US, and Vietnam can now consume bundle C′V—consumption bundles that were unattainable without trade. produces at one point (QUS for the United States, QV for Vietnam) but consumes at a different point (C ′US for the United States, C′V for Vietnam). The difference reflects imports and exports: the 750 tons of shrimp the United States consumes are imported from Vietnam; the 750 computers Vietnam consumes are imported from the United States. In this example we have simply assumed the post-trade consumption bundles of the two countries. In fact, the consumption choices of a country reflect both the preferences of its residents and the relative prices—the prices of one good in terms of another in international markets. Although we have not explicitly given the price of computers in terms of shrimp, that price is implicit in our example: Vietnam exports 750 tons of shrimp and receives 750 computers in return, so 1 ton of shrimp is traded for 1 computer. This tells us that the price of a computer on world markets must be equal to the price of 1 ton of shrimp in our example. One requirement that the relative price must satisfy is that no country pays a relative price greater than its opportunity cost of obtaining the good in autarky. That is, the United States w
on’t pay more than 2 computers for 1 ton of shrimp from Vietnam, and Vietnam won’t pay more than 2 tons of shrimp for 1 computer from the United States. Once this requirement is satisfied, the actual relative price in international trade is determined by supply and demand—and we’ll turn to supply and demand in international trade in the next section. However, first let’s look more deeply into the nature of the gains from trade. Comparative Advantage versus Absolute Advantage It’s easy to accept the idea that Vietnam has a comparative advantage in shrimp production: it has a tropical climate that’s better suited to shrimp farming than that of the United States (even along the Gulf Coast), and it has a lot of usable coastal area. In other cases, however, it may be harder to understand why we import certain goods from abroad AT 201 Consider, for example, U.S. trade with Bangladesh. We import a lot of clothing from Bangladesh—shirts, trousers, and so on. Yet there’s nothing about the climate or resources of Bangladesh that makes it especially good at sewing shirts. In fact, it takes fewer hours of labor to produce a shirt in the United States than in Bangladesh. Why, then, do we buy Bangladeshi shirts? Because the gains from trade depend on comparative advantage, not absolute advantage. Yes, it takes less labor to produce a shirt in the United States than in Bangladesh. That is, the productivity of Bangladeshi shirt workers is less than that of their U.S. counterparts. But what determines comparative advantage is not the amount of resources used to produce a good but the opportunity cost of that good—here, the quantity of other goods forgone in order to produce a shirt. And the opportunity cost of a shirt is lower in Bangladesh than in the United States. Here’s how it works: Bangladeshi workers have low productivity compared with U.S. workers in the shirt industry. But Bangladeshi workers have even lower productivity compared with U.S. workers in other industries. Because Bangladeshi labor productivity in industries other than shirt-making is very low, producing a shirt in Bangladesh, even though it takes a lot of labor, does not require forgoing the production of large quantities of other goods. In the United States, the opposite is true: very high productivity in other industries (such as high-technology goods) means that producing a shirt in the United States, even though it doesn’t require much labor, requires sacrificing lots of other goods. So the opportunity cost of producing a shirt is less in Bangladesh than in the United States. Despite its lower labor productivity, Bangladesh has a comparative advantage in clothing production, although the United States has an absolute advantage. Bangladesh’s comparative advantage in clothing gets translated into an actual advantage on world markets through its wage rates. A country’s wage rates, in general, reflect its labor productivity. In countries where labor is highly productive in many industries, employers are willing to pay high wages to attract workers, so competition among employers leads to an overall high wage rate. In countries where labor is less productive, competition for workers is less intense and wage rates are correspondingly lower. As the Global Comparison on the next page shows, there is a strong relationship between overall levels of productivity and wage rates around the world. Because Bangladesh has generally low productivity, it has a relatively low wage rate. Low wages, in turn, give Bangladesh a cost advantage in producing goods where its productivity is only moderately low, like shirts. As a result, it’s cheaper to produce shirts in Bangladesh than in the United States. The kind of trade that takes place between low-wage, low-productivity economies like Bangladesh and high-wage, high-productivity economies like the United States gives rise to two common misperceptions. One, the pauper labor fallacy, is the belief that when a country with high wages imports goods produced by workers who are paid low wages, this must hurt the standard of living of workers in the importing country. The other, the sweatshop labor fallacy, is the belief that trade must be bad for workers in poor exporting countries because those workers are paid very low wages by our standards. Both fallacies miss the nature of gains from trade: it’s to the advantage of both countries if the poorer, lower-wage country exports goods in which it has a comparative advantage, even if its cost advantage in these goods depends on low wages. That is, both countries are able to achieve a higher standard of living through trade. It’s particularly important to understand that buying a shirt made by someone who makes only 30 cents an hour doesn’t necessarily imply that you’re taking advantage of that person. It depends on the alternatives. Because workers in poor countries have low productivity across the board, they are offered low wages whether they produce goods exported to America or goods sold in local markets. A job that looks terrible by rich-country standards can be a step up for someone in a poor country. And international trade that depends on low-wage exports can nonetheless raise a country’s standard of living. Bangladesh, in particular, would be much poorer than it is— possibly its citizens would even be starving—if it weren’t able to export clothing based on its low wage rates. 202 PRODUCTIVITY AND WAGES AROUND THE WORLD Is it true that both the pauper labor argument and the sweatshop labor argument are fallacies? Yes, it is. The real explanation for low wages in poor countries is low overall productivity. The graph shows estimates of labor productivity and wages in manufacturing industries for several countries in 2002. Note that both productivity and wages are expressed as percentages of U.S. productivity and wages (for example, wages and productivity in Japan are about 79% of those in the United States). You can see the very close relationship between productivity and wages. The relationship isn’t perfect: Korea and Brazil in particular have somewhat lower wages than their productivity might lead you to expect, and the European Union has higher wages than predicted by its productivity. But simple comparisons of wages give a misleading sense of labor costs in poor countries: their low-wage advantage is mostly offset by low productivity. 100% Wage (percent of U.S. wage) 80 60 40 20 Japan United States European Union Singapore Korea India Indonesia Mexico Malaysia Brazil China 0 20 40 60 80 100% Productivity (percent of U.S. productivity) Source: Janet Ceglowski and Stephen Golub, “Just How Low Are China’s Labour Costs?” World Economy vol. 30(4), p. 597–617 (2007). Sources of Comparative Advantage International trade is driven by comparative advantage, but where does comparative advantage come from? Economists who study international trade have found three main sources of comparative advantage: international differences in climate, international differences in factor endowments, and international differences in technology. Differences in Climate A key reason the opportunity cost of producing shrimp in Vietnam is less than in the United States is that shrimp need warm water—Vietnam has plenty of that, but America doesn’t. In general, differences in climate play a significant role in international trade. Tropical countries export tropical products like coffee, sugar, bananas, and, these days, shrimp. Countries in the temperate zones export crops like wheat and corn. Some trade is even driven by the difference in seasons between the northern and southern hemispheres: winter deliveries of Chilean grapes and New Zealand apples have become commonplace in U.S. and European supermarkets. Differences in Factor Endowments Canada is a major exporter of forest products—lumber and products derived from lumber, like pulp and paper—to the United States. These exports don’t reflect the special skill of Canadian lumberjacks. Canada has a comparative advantage in forest products because its forested area is much greater compared to the size of its labor force than the ratio of forestland to the labor force in the United States. Forestland, like labor and capital, is a factor of production: an input used to produce goods and services. (Recall from Chapter 2 that the factors of production are land, labor, capital, and human capital.) Due to history and geography, the mix of available factors of production differs among countries, providing an important source of comparative advantage. The relationship between comparative advantage and factor availability is found in an influential model of international trade, the Heckscher–Ohlin model, developed by two Swedish economists in the first half of the twentieth century AT 203 The factor intensity of production of a good is a measure of which factor is used in relatively greater quantities than other factors in production. According to the Heckscher–Ohlin model, a country has a comparative advantage in a good whose production is intensive in the factors that are abundantly available in that country. A key concept in the model is factor intensity. Producers use different ratios of factors of production in the production of different goods. For example, oil refineries use much more capital per worker than clothing factories. Economists use the term factor intensity to describe this difference among goods: oil refining is capital-intensive, because it tends to use a high ratio of capital to labor, but clothing manufacture is labor-intensive, because it tends to use a high ratio of labor to capital. According to the Heckscher–Ohlin model, a country will have a comparative advantage in a good whose production is intensive in the factors that are abundantly available in that country compared to other countries. So a country that has a relative abundance of capital will have a comparative advantage in capital-intensive industries such as oil refining, but a

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